activity based costing.docx
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Activity-Based Costing Activities
Traditionally, in a job order cost system and process cost system, overhead is allocated
to a job or function based on direct labor hours, machine hours, or direct labor dollars.
However, in some companies, new technologies have changed the manufacturing
environment such that the number of hours worked or dollars earned by employees are
no longer good indicators of how much overhead will be needed to complete a job or
process products through a particular function. In such companies, activity-based
costing (ABC) is used to allocate overhead costs to jobs or functions.
Activity-based costing assumes that the steps or activities that must be followed to
manufacture a product are what determine the overhead costs incurred. Each overhead
cost, whether variable or fixed, is assigned to a category of costs. These cost categories
are called activity cost pools. Cost drivers are the actual activities that cause the total
cost in an activity cost pool to increase. The number of times materials are ordered, the
number of production lines in a factory, and the number of shipments made to
customers are all examples of activities that impact the costs a company incurs. When
using ABC, the total cost of each activity pool is divided by the total number of units of
the activity to determine the cost per unit.
the number of activities a company has may be small, say five or six, or number in the
hundreds. Computers make using ABC easier. Assume Lady Trekkers, Inc., has
identified its activity cost pools and cost drivers (see the following table).
A per unit cost is calculated by dividing the total dollars in each activity cost pool by the
number of units of the activity cost drivers. As an example to calculate the per unit cost
for the purchasing department, the total costs of the purchasing department are divided
by the number of purchase orders. Lady Trekkers, Inc., has determined that both the
purchasing and receiving departments' costs are based on the number of purchase
orders; therefore, the two departments' costs may be added together so that one per
unit cost is calculated for these departments. Once the per unit costs are all calculated,
they are added together, and the total cost per unit is multiplied by the number of units
to assign the overhead costs to the units.
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
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