Activity-Based Costing Chapter 36 Managerial Accounting Activity-Based Costing Prepared by Diane Tanner University of North Florida Copyright ©2015. University of North Florida. All rights reserved.

Activity-Based Costing 2 Activity-Based Costing What is activity-based costing? A system of allocating indirect costs to cost objects Utilizes multiple cost pools Is used with normal costing Based on activities that drive costs rather than on volume- based denominators Primarily used to allocated manufacturing overhead Sometimes used to allocate support department costs to divisions Underlying Premises Activities underlie costs.

Comparing ABC and Traditional Costing Advantages of ABC over traditional costing ABC results in more accurate costing. ABC helps managers control costs better. ABC considers the fact that only products that use particular resources are assigned costs. ABC mitigates overcosting and undercosting of cost objects.  Disadvantages of ABC Very expensive to implement No separation of fixed and variable costs which makes incremental analysis difficult

Setting Up an ABC System Step 1:  Determine the cost object. Step 2:  Form cost pools. The costs of performing a particular activity are grouped into a cost pool. All costs in a pool should have the same cause. Step 3:  Select a cost driver that has a cause-and-effect relationship with the costs to be allocated.

How to Perform ABC 5 Step 1: Calculate the rate for each cost pool. Estimated Cost / Estimated Activity = Rate Step 2: Multiply each cost pool rate times the respective actual activity to determine allocated costs. Step 3: Total up the allocated costs from step 2. This results in the applied overhead cost. Step 4: Add the allocated costs to the direct costs of each cost object to obtain the total cost of each cost object.

Considerations of ABC Complete analysis requires allocation beyond manufacturing costs to include nonmanufacturing Activity can be measured on practical capacity, actual capacity, or other estimate Practical capacity preferred over actual capacity because Does not hide the cost of idle capacity within product costs Gives a truer cost of activities used to produce the product

ABC Implementation Issues After switching to ABC, companies may find that only 10 to 15% of their products are profitable Causes management to alter the product mix by minimizing unprofitable products which causes profits to increase Implementation mirrors the complexity of the organization Complete conversion to ABC requires auditors to accept the system when used for financial reporting

Activity-Based Management A tool in which managers analyze activities that cause indirect costs of products or services Goal is to improve efficiency and effectiveness of the activities in order to reduce costs Serves as the basis for numerous process improvement programs of companies Helps focus managerial attention on what is most important among the activities performed to create value for customers

Overcosting and Undercosting Occurs due to broad, equal costs allocated to all products Undercosting Overhead allocated under ABC is greater than if traditional is used A product consumes a relatively high level of resources but is reported to have a relatively low total cost Overcosting Overhead allocated under ABC is less than if traditional is used A product consumes a relatively low level of resources but is reported to have a relatively high total cost

ABC Vs. Traditional Costing Example A complete walk through problem using Excel is presented in a separate video.

The End