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Chapter Five Lecture Note
Chapter Five Lecture Note
There are two common methods for allocating these indirect costs to products.
Both of these methods assess overhead costs and then attach these costs to
products based on certain cost drivers. A cost driver is any component that
costs money or any factor that is related to a cost occurring, such as the
volume produced or the number of labor hours.
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won’t always be as accurate, because it doesn’t factor in nonmanufacturing
expenses or determine which overhead costs actually affect specific products.
The following chart explains the general structure of activity based (ABC)
costing model.
Cost Objects
(e.g., products and customers)
Activities
Consumption of Resources
Cost
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Advantages of Activity-Based Costing (ABC)
2. ABC produces numbers such as product margin, that are odds with the
numbers produced by traditional costing systems. But managers are
accustomed to using traditional costing systems to run theirs operations
and traditional costing systems are often used in performance
evaluation.
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3. Activity based costing data can be easily misinterpreted and must be
used with care when used in making decisions. Costs assigned to
products, customers and other cost objects are only potentially relevant.
Before making any significant decision using activity based costing data,
managers must identify which costs are really relevant for the decisions
at hand.
2. Identify the cost driver(s) associated with each activity. A cost driver
causes, or “drives,” an activity’s costs. For the order-processing activity, the
cost driver could be the number of orders.
3. Compute a cost rate per cost driver unit or transaction. The cost driver
rate could be the cost per order, for example.
4. Assign costs to products by multiplying the cost driver rate by the volume
of cost driver units consumed by the product.
A few examples of the activities and appropriate cost drivers are stated below:
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Material procurement.................................Number of materials procured
Material handling.........................................Quantity of input material
Customers' order execution........................Number of orders executed
Dispatch of goods..........................................Number of dispatches
Inspections.....................................................Number of inspections
Machine operation.........................................Machine hours
Production scheduling...................................Number of production scheduling
Production runs..............................................Number of production run
Employees' related activity...........................Number of employees
Set-ups.............................................................Number of set-ups
Illustration:
If inspection cost is $ 140,000 for assembling 100 ordinary and 100 automatic
cameras. If one ordinary camera needs 2 inspections and one automatic
camera needs 5 inspection, then find the inspection cost per inspection.
Solution,
Calculation of number of inspection:
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a driver rate. Tracing refers to the recovery of inspection cost by the product
lines by using relevant cost driver.
Illustration
The company's activity based costing system has the following activity cost
pools and activity measures:
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Costs assigned to the "other" activity cost pool have no activity measure; they
consist of the costs of unused capacity and organization-sustaining costs -
neither of which are assigned to products, orders or customers.
Required:
1. Perform the first stage allocation of overhead costs to the activity cost
pools.
3. Office Mart is one of the Ferris Corporation's customers. Last year Office
Mart ordered filing cabinet four different times. Office Mart ordered a
total of 80 cabinets during the year. Construct a table showing the
overhead costs of these 80 units and four orders.
Solution:
1. The first stage allocation of costs to the activity cost pools appears below:
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Selling and administrative
30,000 135,000 75,000 60,000 300,000
overhead
3. The overhead cost for the four orders of a total of 80 filing cabinets would be
computed as follows:
Cost:
$1,840
==========
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Customer profitability Analysis – Office Mart
$840
Raw materials are the direct materials you use to produce your products.
However, raw materials in and of themselves do not add value to your
products. The costs of purchasing, transporting and storing your raw materials
are non-value-added activities. In addition, the time your employees spend
moving the raw materials into your warehouse and entering each item into the
inventory accounting program are non-value-added activities. Returning
damaged or defective raw materials are additional non-value-added activities.
Work in Process
Taking raw materials out of storage and placing them on the production line is
a value-added activity. Your employee’s direct labor on the production line is
another value-added activity. However, inspection and quality control are non-
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valued-added activities. Inspecting the work in process or finished items do not
add value to them. Reworking defective items are non-value-added activities.
Moving defective items from the production line to the reworking station and
back to the production line are non-value-added activities.
Inventory Storage
Transporting your finished goods from the production area into storage is a
non-value-added activity, as are the costs of storing and warehousing your
finished goods. Having too much inventory on hand may indicate a problem
with estimating customer demand, and keeping inventory in storage for too
long may reduce its value through obsolescence. Your customers may view
your older inventory as inferior compared to what your competitor offers.
Sold Merchandise
While using cost drivers to assign overhead costs to individual units works well
for some activities, for some activities such as setup costs, the costs are not
incurred to produce an individual unit but rather to produce a batch of the
same units. For other costs, the costs incurred might be based on the number
of product lines or simply because there is a manufacturing facility. To assign
overhead costs more accurately, activity‐based costing assigns activities to one
of four categories:
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Unit‐level activities occur every time a service is performed or a product
is made. The costs of direct materials, direct labor, and machine
maintenance are examples of unit‐level activities.
Service companies have had problems coming up with decent cost accounting
systems because they have been modeling them after systems found in
manufacturing firms. The problems with this are that manufacturing firms
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place emphasis on valuing inventory, which service firms do not have, and use
standard costs calculated for direct materials and labor. Direct materials and
direct labor are not major cost categories in service firms and it is hard to
calculate standard costs in a service setting. Nonetheless, service firms do need
to know accurate costs for product profitability analysis. They need to find out:
This means that costing in the service sector needs to be forward-looking, and
ABC is a tool for such analysis. There are several service industries where ABC
has started to emerge, and will continue to prove useful.
Financial Services
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Sharma (1992) described step-by-step how banks should implement ABC:
Prepare a list of products associated with each profit center and a list
of product related and non-product related activities.
The former activities are spread across all products produced by the
unit. The latter category should include as few things as possible.
Many banks have already had success applying such division principles.
Healthcare
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The cost of an episode of care.
All of this information is available from an ABC system. There are examples of
hospitals successfully implementing ABC systems in the article.
Young and Pearlman (1993) believed that hospital’s cost accounting systems
evolve in a four-step process:
The system identifies factors that drive costs, the ways these factors
can be controlled, and redefines departments as profit or cost centers.
Insurance
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This industry is also making the move toward better management of costs due
to increased competition. Here workers may spend a long time working on one
task and the time on each task varies greatly depending on the case. The
discussion in this section is mainly about ABC concepts and hospital
malpractice insurance. A study found that a variety of factors drove
malpractice costs and that the risk of malpractice was also tied to geographical
locations. With these facts a malpractice insurance cost per medical procedure
was calculated and divided by the number of that type of procedure for
accurate costing.
Conclusion
ABC can be applied in service industries other than those described here. It
has become increasingly important for companies whose markets are becoming
more competitive. Since ABC is really about cost management, using it allows
service companies to reduce and control their costs in order to make correct
pricing and other decisions, and to increase their profitability. It is likely to
continue to become more prevalent in the service industry in the future.
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