Chapter 5 Activity Based Costing Flashcards

Every organization requires information to allocate resources, monitor the actions taken, set priority and make decisions. Activity-base costing provides the accurate cost information by allocating overhead costs. However, activity-based management is focusing on enhance the use of ABC from product costing to a comprehensive management tool that concentrate on decreasing the costs and concurrently improving processes and decision making. After that, a refinement of ABC used in activity based management is the classification of activities to value-added and non-value-added. A non-value-added activity can de defined as the production or service related activities that can be eliminated with no deterioration of product attributes.

According to Horngren, Foster and Datar ‘ABC is not an alternative costing system to job costing or process costing. Rather ABC is an approach to developing the cost numbers used in job costing or process costing systems. The distinctive feature of ABC is its focus on activities as the fundamental cost objects. In contrast most traditional approaches used in job and process costing systems rely on general purpose accounting systems, not tailored to the activities found in individual organisations.

Labour related costs in an automated system may be only 5% to 10% of the total manufacturing costs and often are not related to the causes of most manufacturing overhead costs. In order to accurately charge factory overhead costs, it is necessary to identify the forces, which explain them.

Financial And Managerial Accounting

But, if we consider a long term of 10 years, we may find some co-relation with production. In the long run, we can assume the quantity of production as a cost driver for factory rent. Fixed costs remain fixed until a range of activity, and then they shoot up to a different level. For example, this business may increase https://personal-accounting.org/ the area of the factory to 1.5 times, and rent increases from $100,000 to $150,000. There is a possibility that for some time, a part of the factory remains unutilized. When deciding which driver to use in terms of allocating indirect cost, consider the cause-and-effect relation between the cost and the driver.

Looking at activity cost drivers can allow management to better understand a company’s expenses. By delineating the exact source of different expenses, companies can help to reduce or eliminate unnecessary expenses. Without proper allocation of the cost drivers, it can be meaningless to compare the costs of different products and services.

Thought On cost Drivers

The amount of orders engaged or the quantity of pieces ordered could be cost drivers in the acquiring of material activity. Cost pool is a group of separate costs connected to a single activity. By classifying the actions that go into creation of a product, cost pools can be created. Calculate the overall overhead when the costs into a pool are aggregated. The change in the name indicates that we need to manage our businesses based upon this new found understanding of what it really takes to run the business.

X & co produces two products E and F which is made from the same material. Till date X and co was using traditional absorption costing to its product. Activity Based Costing calculates the true cost of the product by the amount of resources consumed. The amount of resources consumed by a business activity such as labor hours or electricity decides the true cost of the product. These are an advantage for a product as they bring out the actual cost incurred on the products based on the correct allocation of the processes or activities.

Activity Based Costing Abc For Better Cost Management

By establishing interunit drivers, you can assure that these cost objects are driven from the corporate model to the production model . Interunit drivers ensure that specific costs get directed from one business unit to another according to the definitions that you create. There may be several activities that contribute to the expense of operation.

Accounting, Customer services, and sales are the some of the activities performed in an organization. The costs required for producing the true product is obtained by breaking all the costs involved in its manufacturing. Activity Based Costing is very useful for small businesses in making overhead decisions and product price decisions.

Activity Based Budgeting

This information shows how valuable ABC can be in many situations for providing a more accurate picture than traditional allocation. The number of activities a company has may be small, say five or six, or number in the hundreds.

A cost driver is something that controls changes in the cost of an activity. Examples of cost drivers include units, labor or machine hours, and parts. The costs of unit‐level, batch‐level, and product‐line activities are easily allocated to a specific product, either directly as a unit‐level activity or through allocation of a pooled cost for batch‐level and product‐line activities.

What Does Activity Cost Driver Mean?

These overhead costs included salaries of people to purchase, inspect, and store materials. Setting up machines for a new product would need 400 setups and overhead of $800,000. The company would have 4,000 inspections and overhead of $400,000.

• A third party should challenge the usefulness of preliminary reports generated, assumptions made and cost drivers defined in a detailed manner.
• Under ABC system, some activities are responsible for the determination of cost of a product.
• A return also reflects production, manufacturing and delivery costs that are not offset by a final sale.
• As a result, the efforts to simplify the design would show him a reduction in labor costs.
• (See the exhibit “Profitable Decisions at Banta Foods.”) Its performance has led to the distinction of being named “Innovator of the Year” by the industry journal, Institutional Distributor.

This takes care of the technical drawback of traditional ABC systems we mentioned earlier—the fact that surveyed employees respond as if their practical capacity were always fully utilized. A direct cost is an expense that you allocate specifically to an object or activity. The most common examples of direct costs in a business are the materials necessary to carry out production and the amount of labor.

Activity Based Costing Abc

In the organizations where benchmarking takes place, are usually known for their efficiency, and effectiveness in performing similar activities. However, it is important Activity Cost Driver Definition to note that one activity has no capacity to measure all the attributes. Note that activity driver analysis recognizes various factors that are activity related costs.

For example, if the customer service department gets a new database system, the reps may be able to perform a standard credit check in 20 minutes rather than 50 minutes. To accommodate the improvement, just change the unit time estimate to 20 minutes, and the new cost-driver rate automatically becomes $16 per credit check (down from $40). Of course, you then have to add back in the cost impact of purchasing the new database system by updating the cost per time unit estimate, so the final figure may be somewhat higher than $16.

Time

Activity cost drivers should only be used when the cost of collecting the cost driver information is less than the benefits to be gained from doing so. It makes little sense to set up a group of activity cost drivers if management does not act on the resulting information. ABC technique provides due importance to non-manufacturing cost which constitute a substantial portion of total cost. For example, in case of a number of products marketing and advertising costs constitute a big portion of cost. These overheads can be allocated easily using ABC because the relationship between such costs and their causes can be identified easily. Traditionally such non-manufacturing costs have been allocated under volume basis and thus high volume products have been overvalued.

The total cost is divided into two types i.e. fixed cost and variable cost which is necessary to provide quality information to design a suitable cost system in a manufacturing concern. For example, suppose students in biology classes are messier than students in history classes. As a result, the university does more maintenance per square foot in biology classrooms and labs than in history classrooms. Further, it is possible to keep track of the time maintenance people spend cleaning classrooms and labs.

Activity Driver Analysis

Identification of resources is the first step in activity-based costing. The resources include, labor, manufacturing time, sales, utilities and equipment. The true cost of the product is determined by the correct allocation of overhead cost.

• Suppose driver for labor cost is wrongly defined as material cost.
• Defines the target for the drivers, where the monetary amounts go, and how the driver method is implemented.
• For example production scheduling costs can be changed in the long term by changing number of runs rather than changing number of units produced.
• Product‐line activities are those activities that support an entire product line but not necessarily each individual unit.
• In case, an activity contains only one task, it is highly decomposed.
• Assign costs to products by multiplying the cost driver rate times the volume of cost driver units consumed by the product.

It helps management see a business’s various departments as one single business unit as these drivers create a relationship between the departments. You measure the number of items produced or delivered and then divide it by total cost. For this kind of cost driver, it can be raw materials and other items sold in bulk such as food ingredients used in fast-food restaurants, and the price of gas for a gas station. This cost driver is used in companies that operate more than one outlet, such as retail shops or restaurants. Ideally, a cost driver is an activity that is the root cause of why a cost occurs. These cost information are essential for recent approaches in productivity improvement like Total Quality Management and Business Process Reengineering.

Fixed Cost Drivers Overhead

Traditionally, in a job order cost system and process cost system, overhead is allocated to a job or function based on direct labor hours, machine hours, or direct labor dollars. In such companies, activity‐based costing is used to allocate overhead costs to jobs or functions.