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Chapter 3

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Norman Chasse

ACTG 1P11 MA CHAPTER 4: ABC A. ABC Defined 1. Activity-based costing (ABC) is a process of allocating overhead costs to products using a number of allocation bases, rather than a single base, such as direct labour hours. Each allocation base represents an activity that consumes overhead resources. 2. Examples of activities include: • Setting up a machine. • Processing a purchase order. • Inspecting materials for defects. • Performing a blood test. • Billing customers. 3. Why the need for ABC? i. Obtain more precise costing ii. Avoid cost distortion – overcosting of some products and undercosting of others due to the cost allocation system B. Multi-Departmental Overhead Rates 1. A modification of the tradtional, plant-wide overhead allocation rate approach 2. Groups overhead costs by departments when those departments incur different types and amounts of ovherhead costs 3. Each department has its own overhead allocation base 4. Each department has its own allocation rate a. Departmental OH rate = Est. Department OH Costs/Est. Departmental allocation base quantity 5. Overhead from each department is allocated to each job/product that uses that department a. Allocated OH = Sum of [Actual use of departmental OH base x Department OH rate] C. Designing an Activity- Based Costing (ABC) System 1. Steps involved in ABC a. Identify major activities b. Group costs of activities into cost pools c. Identify measures of activities - the cost drivers d. Relate costs to products using the cost drivers: e. Compute an activity rate (i.e., predetermined overhead rate) based on the estimated amount of overhead and the expected volume of activity for each activity cost pool by Activity Application Rate = total estimated cost of activity pool Total estimated usage of activity pool f. Allocate costs to cost objects such as products, jobs or departments using the activity rate and the volume of activity measure consumed by that cost object by. Activity Overhead = Activity Application * Activity Usage by the Cost Applied Rate product or Department D. Hierarchy of activities a. Unit-level activities are activities that are performed each time a unit is produced. E.g.: attaching Part a to Part B to produce a unit, cutting materials to size. b. Batch-level activities are activities that are performed not each time a unit is produced, but at a set time and are done to support the production of more than one unit. E.g.: setting up machines to produce an item, set up is done once per batch not per unit. c. Product-level activities are activities that relate directly to a specific product. These costs are not dependant on units produced or batches run but on the actual number of products produced. An example would be product development and design, marketing campaigns (a marketing campaign supports many products and product runs. d. Facility-level activities are activities to support the organization as a whole and are not dependent on the number of units, batches or products produced. any particular product, batch, or customer are activities relate to the specific customer and are driven by the number of customers. Examples would include plant maintenance, depreciation on the plant, etc. E. Benefits of ABC 1. Prevents under costing of complex, low-volume products and over costing of simple, high-volume products. 2. Leads to better cost control. F. Limitations of ABC 1. Expensive to implement 2. Limited usefulness for decision-making (1) Gives us “full cost” of products, but what about relevant costs? G. Traditional vs. Activity-based Costing 1. Traditional – one overhead cost allocation rate which is usually based on an output related activity base (e.g. DLH)  As a result, low-volume, complex problems often receive a disproportionate amount of the overhead costs assigned to them 2. ABC – several cost allocation rates based on various acitivy bases, which may or may not be volume related  Adopting activity-based costing usually results in shifting overhead costs from high volume to low volume products.  The per-unit cost of the low volume products increases and the per-unit costs of the high volume products decrease.  The effects are not symmetrical—the per unit costs of the low volume products are affected more than the per unit costs of the high volume products. H. COST FLOWS & JOURNAL ENTRIES IN ABC 1. Same under ABC as for traditinal costing systems; only difference is that ABC uses more rates/bases to allocate overhead vs. the traditional systems.  DM – debit to WIP as used  DL – debit to WIP as incurred  OH – debit to WIP according to ABC rates 2. Balance in Manufacturing Overhead account at the end of the period (after allocation entries are made) reflects amount over- or under-applied. Balance is cleared to COGS or proportionally to WIP, FG and COGS, as with the traditional costing systems. I. Activity-Based Management (ABM) versus ABC 1. ABM focuses on ways to improve the efficiency and effectiveness of activities. a. ABC focuses on better costing of products and services. 2. By identifying activities and their costs, management is better able to do a good job of managing those costs. 3. Warning! Be careful of the bases used to allocate costs. a. Management will take actions to reduce those bases in order to reduce costs. b. This behavior may have negative, as well as positive, effects on a company’s operations and profits. J. Conducting an ABM Study 1. An ABM study consists of four steps: a. Step 1: Determin
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