Module18
Assigning Indirect Costs:
Activity-Based Costing
(omit pp. 18-14 to 18-18)
1
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.
2
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).
3
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.
4
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.
5
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.
6
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).
7
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.)
8
Class Problem 1 Solution