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Class 4

The document discusses the differences between traditional costing and activity-based costing (ABC). Traditional costing assigns overhead based on simple metrics like direct labor hours, while ABC assigns overhead based on multiple cost drivers that better reflect resource consumption. The document then provides examples of applying ABC to a manufacturer and service business.

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27 views

Class 4

The document discusses the differences between traditional costing and activity-based costing (ABC). Traditional costing assigns overhead based on simple metrics like direct labor hours, while ABC assigns overhead based on multiple cost drivers that better reflect resource consumption. The document then provides examples of applying ABC to a manufacturer and service business.

Uploaded by

carla
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Class 4 – 03/12

Pre-class

1.Discuss the difference between traditional costing and activity-based costing.

Traditional Costing Systems


Often, the most difficult part of computing accurate unit costs is determining the proper amount
of overhead cost to assign to each product, service, or job. That rate was called the
predetermined overhead rate. For job order costing, we assumed that direct labor (cost or
hours) was the relevant activity base for assigning all overhead costs to jobs. For process costing,
we frequently assumed that machine hours was the relevant activity base for assigning all
overhead to the process or department.

Activity-Based Costing
Activity-based costing (ABC) is an approach for allocating overhead costs. Specifically, ABC
allocates overhead to multiple activity cost pools and then assigns the activity cost pools to
products and services by means of cost drivers.
Activity: Any event, action, transaction, or work sequence that incurs costs when producing a
product or performing a service.
Activity cost pool: The overhead cost attributed to a distinct activity (e.g., ordering materials or
setting up machines).
Cost driver: Any factor or activity that has a direct cause-effect relationship with the resources
consumed.

2.Apply activity-based costing to a manufacturer.


Identify and Classify Activities and Allocate Overhead to Cost Pools (Step 1)

Activity-based costing starts with an analysis of the activities needed to manufacture a product or
perform a service.

Identify Cost Drivers (Step 2)

The cost driver must accurately measure the actual consumption of the activity by the various
products. To achieve accurate costing, a high degree of correlation must exist between the cost
driver and the actual consumption of the overhead costs in the cost pool.

Compute Activity-Based Overhead Rates (Step 3)

Next, the company computes an activity-based overhead rate per cost driver by dividing the
estimated overhead per activity by the number of cost drivers estimated to be used per activity.
Assign Overhead Costs to Products (Step 4)

In allocating overhead costs, the company must know the estimated use of cost drivers for each
product.

Comparing Unit Costs

The comparison shows that unit costs under traditional costing are different and often
misleading. Using a traditional costing system, each product was assigned the same amount of
overhead because both products use the same amount of the cost driver (direct labor hours). In
contrast, ABC assigns overhead to products based on multiple cost drivers. Note that activity-
based costing does not change the amount of total overhead costs. However, ABC assigns
overhead costs in a more accurate manner.
Companies that move from traditional costing to ABC often have similar experiences as ABC
shifts costs from high-volume products to low-volume products. This shift occurs because
traditional overhead allocation uses volume driven bases such as labor hours or machine hours.
The traditional approach ignores the fact that many overhead costs are not correlated with
volume. In addition, ABC recognizes products’ use of resources, which also increases the
accuracy of product costs.

3.Explain the benefits and limitations of activity-based costing.

The Advantage of Multiple Cost Pools

The main mechanism by which ABC increases product cost accuracy is the use of multiple cost
pools. Instead of one plantwide pool (or even several departmental pools) and a single cost
driver, companies use numerous activity cost pools with more relevant cost drivers. Thus, costs
are assigned more directly on the basis of the cost drivers used to produce each product.

Classification of Activity Levels

1. Unit-level activities are performed for each unit of production.


2. Batch-level activities are performed every time a company produces another batch of a
product.
3. Product-level activities are performed every time a company produces a new type of
product.
4. Facility-level activities are required to support or sustain an entire production process.

The Advantage of Enhanced Cost Control

Value-added activities are those activities of a company’s operations that increase the perceived
value of a product or service to customers.
Non–value-added activities are those activities that, if eliminated, would not reduce the
perceived value of a company’s product or service. These activities simply add cost to, or
increase the time spent on, a product or service without increasing its perceived value.
The Advantage of Better Management Decisions

Activity-based management (ABM) extends the use of ABC from product costing to a
comprehensive management tool that focuses on reducing costs and improving processes and
decision-making.

Some Limitations and Knowing When to Use ABC

1. ABC can be expensive to use. The increased cost of identifying multiple activities and
applying numerous cost drivers discourages many companies from using ABC.
2. ABC systems are more complex than traditional systems.
3. Some arbitrary allocations remain. Even though more overhead costs can be assigned directly
to products through ABC, some overhead costs might still be assigned by fairly arbitrary cost
drivers.

4.Apply activity-based costing to a service business.

What sometimes makes implementation of activity-based costing difficult in service industries is


that, compared to manufacturers, a larger proportion of overhead costs are company-wide costs
that cannot be easily traced to specific services performed by the company.

Traditional Costing Example

Activity-Based Costing Example

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