Topic 6 Activity-Based Costing,MAA 703 Management Accounting,Evolution of ABC,Conventional costing systems use a two-stage allocation process: 1. service department costs are allocated to production departments. 2. production department overhead costs are allocated to products using a volume-based predetermined overhead rate.,Product costs dont make sense,Problem: There may be no relationship between the overhead application base and the way that different products cause overhead costs The result: High-volume simple products are over- costed and over-priced Low-volume complex products are under-costed and under-priced,Plantwide Overhead Rates,Companies have tended to use direct labour as the overhead application base. However direct labour is now a relatively minor part of total manufacturing cost. Many tasks that used to be done by hand are now done by automated equipment.,A two stage process is necessary because costsare allocated to departmentsand then to products.,Departmental Overhead Rates,Department 1,Department 2,Department 3,Cost pools,Indirect Labor,Indirect Materials,Other Overhead,Stage One: Costs assigned to pools,Departmental Overhead Rates,Department 1,Department 2,Department 3,Cost pools,Stage One: Costs assigned to pools,Products,Stage Two: Costs applied to products,Departmental Overhead Rates,Indirect Labor,Indirect Materials,Other Overhead,Department 1,Department 2,Department 3,Cost pools,Stage One: Costs assigned to pools,Products,Stage Two: Costs applied to products,Direct Labour Hours,Machine Hours,Raw Materials Cost,Departmental Allocation Bases,Departmental Overhead Rates,Indirect Labor,Indirect Materials,Other Overhead,Cost Distortions caused by 2-stage allocations,There is a no link between the cause of support activity costs and the basis for assigning these costs to products Why? 1. Allocations are based on unit or volumerelated measures. 2. Different products consume different amounts of support activities.,Questionable profit margins,To compete in the marketplace, some companies have had to cut the prices of high volume popular items. But They have been able to achieve high mark-ups on low volume specialty products.,Erosion of company profits,Price cuts produce increased sales in units but decreased total revenue High mark-ups on specialty products didnt offset the fall in profit margins of high volume products,Causes of problems,Increased product diversity changing cost structures use of volume-based cost drivers Have resulted in: distorted product costs,Solution: Activity Based Costing,ABC uses cost drivers that directly link activities performed to products made. cost drivers are selected which measure the average demand placed on each activity by each product. activity cost pools are assigned to products in proportion to the way that they consume each activity.,Solution: Activity Based Costing,ACTIVITIES CONSUME RESOURCES PRODUCTS CONSUME ACTIVITIES Activities are used to link resource costs to products,Activity Based Costing (ABC),The objective of activity-based costing is to understand the causes of overhead costs and to identify the real profitability of products and customers.,ABC is a good supplement to our traditional cost system,I agree!,Overhead rates may be based on activity at capacity.,Activity Based Costing (ABC),Activity-Based Costing,Both manufacturing and nonmanufacturing costs may be assigned to products.,Some manufacturing costs may be excluded from product costs.,There are a number of cost pools, each ofwhich is allocated using a unique measure of activity.,Allocation bases often differ from traditional costing systems.,How Costs are Treated Under Activity-Based Costing,Level of Complexity,Overhead Allocation,Plantwide Overhead Rate,Departmental Overhead Rates,Activity Based Costing,Activity-based costing,is a way of measuring both the cost of cost objects and the performance of activities can help solve problems such as distorted product costs poor cost control the form of ABC adopted depends on the problems that need to be addressed,Designing an ABC System,Cost Objects (e.g., products and customers),Activities,Consumption of Resources,Cost,Identifying and Defining Activities,An ACTIVITY is a part of the production process for which management wants a separate reporting of costs.,Unit-Level Activities,Batch-Level Activities,Product-sustaining Activities,Facility-sustaining Activities,Output Unit-Level Costs.,are resources sacrificed on activities performed on each individual unit of product or service e.g. Energy used by machines Machine depreciation or repairs The Key Question: Does the amount of the activity cost pool increase with the number of units produced?,Batch-Level Costs.,are resources sacrificed on activities that are related to a batch of units rather than to each individual unit of product or service. Set-up activity costs may be driven by set-up hours. This will depend on the number set-ups carried out i.