1 Module19 Assigning Indirect Costs: Activity-Based Costing (omit pp to 19-13)

2 Activity-Based Costing Activity-based costing system - A product costing system in which costs are assigned to products or services on the basis of their consumption of an organization’s fundamental activities. Activities consume resources, and costs should be assigned based on resource consumption. Relative to traditional cost accounting, in activity-based costing: –Non-manufacturing as well as manufacturing costs may be assigned to products. –Some manufacturing costs may be excluded from product costs. –There are a number of cost pools, each of which is allocated to products and other cost objects using its own unique measure of activity. –The allocation bases (cost drivers) often differ from those used in traditional costing systems.

3 Identifying Activities Cost pools are created for different overhead activities, and costs are allocated based on the levels of the various activities incurred (as compared to one basis for all overhead in a traditional allocation). Examples of costs pools: Machining costs: depreciation, maintenance, fuel - allocated on the basis of machine hours. Production set-up costs allocated on the basis of the number of set-ups required. Manufacturing plant: if allocated, allocated on basis of square footage. Purchasing department costs allocated on the basis of the number of purchase orders. Shipping department costs allocated based on the pounds shipped (or number of trucks shipped).

4 Traditional Cost Accounting Versus ABC Relative to traditional cost accounting, in activity-based costing: –Non-manufacturing as well as manufacturing costs may be assigned to products. –Some manufacturing costs may be excluded from product costs. –There are a number of cost pools, each of which is allocated to products and other cost objects using its own unique measure of activity. –The allocation bases (called cost drivers) often differ from those used in traditional costing systems.

5 Benefits of ABC Benefits: –Provides more accurate cost information for products and services, based on resources consumed. –Allows managers to make better decisions regarding product mix, make or buy, pricing strategies. –Enables companies to better control costs, because ABC indicates the specific drivers that causes costs to be incurred. Types of companies that benefit from ABC: –Those with a high potential for cost distortion (diverse products that consume resources differently). –Highly automated companies, with a high level of overhead in proportion to direct material and direct labor costs.

6 Limitations of ABC Limitations: –High cost of implementation – must define cost pools and cost drivers, and keep up with the cost activity with greater specificity. –Minimal benefits to companies that cannot set pricing decisions, or for companies where the products/services consume similar proportions of resources.

7 Steps in Implementing Activity-Based Costing 1.Identify and define activities and activity pools. 2.Whenever possible, directly trace costs to activities and products (DM and DL). 3.Assign indirect costs to activity cost pools. 4.Calculate overhead application rates for each activity. 5.Assign overhead costs to products using the application rates and activity levels for each product. Now look at class example (handout).

8 Class Problem No. 1 XYZ company uses activity based costing and has calculated the following cost driver rates for its overheads: Machine set up costs$1,500 per set up Processing$4 per machine run Shipping and handling costs$600 per delivery It receives an order to supply 3,000 units of its product, Zyx, to a customer. The product will be made over the next several months. Completion of this order will require 6 set ups, 2 machine runs per unit, and 20 deliveries. Calculate the amount of total overhead cost per unit relating to this order. (Note: Include shipping and handling in the total cost.)

Class Problem 1 Solution Total overhead for 3,000 units: 6 setups x $1,500 = $ 9,000 3,000 x 2 machine runs x $4 = $24, deliveries x $600 = $12,000 Total overhead= $45,000 OH cost per unit= 45,000/3,000 = $15.00