ACC 406 Chapter Notes - Chapter 7: Cost Driver, Resource Consumption, Cost Accounting

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2 Apr 2017
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ACC 406
Chapter 7 Activity-Based Costing and
Management
LIMITATIONS OF VOLUME-BASED COST ACCOUNTING SYSTEMS
Cost Drivers
Every activity has a cost driver, which is a factor that drives or causes costs.
Cost drivers may be volume related (labour or machine costs), or they may reflect the
frequency of certain events (number of setups or km driven).
In most cases, more than one cost driver causes costs (such as insurance).
Traditionally, cost drivers have been at the unit level, which they are referred to as unit-
level drivers, which includes direct material, direct labour and some traceable overhead.
Products/services delivered in batches will have batch-level drivers that include purchase
orders, equipment maintenance, equipment depreciation and quality control.
Overhead Rates
The need for more accurate product costs has forced many companies to take a serious look
at their costing procedures.
Two major factors can impair the ability of unit-based plantwide and departmental rates to
assign overhead costs accurately:
1. If the proportion of non-unit-related overhead costs to total overhead costs is large, or
2. If the degree of product diversity is great.
Non-Unit-Related Overhead Costs
Volume-based cost systems label costs associated with unit-level activities as variable in
nature, because they increase or decrease in direct proportion to increases or decreases in the
levels of these unit-level activities.
All other costs (not unit-level) are considered fixed by volume-based cost systems.
Non-unit-level activities vary with some other factor or factors, other than units.
Proponents of activity-based costing (ABC) support the view that costs are:
Unit-level (i.e. vary with output level)
Batch-level (i.e. vary with number of groups or batches that are run)
Product-sustaining (i.e. vary with the diversity of the product or service line)
Facility-sustaining (i.e. do not vary with any factor but are necessary in operating the
manufacturing facility.
Non-unit-level activities (batch, product sustaining, facility-sustaining) are factors that
measure the consumption of non-unit-level activities by products and other cost objects,
whereas unit-level activity drivers measure the consumption of unit-level activities.
Product Diversity
The presence of non-unit overhead costs is not a sufficient condition for plantwide and
departmental rates to result in distorted costs.
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ACC 406
For example, if products consume the non-unit-level overhead activities in the same
proportion as the unit-level activities, then no product-costing distortion will occur if
traditional overhead assignment are used.
The presence of product diversity is necessary for product cost distortion to occur.
Product diversity means that products consume overhead activities in consistently
different proportion.
The proportion of each activity consumed by a product is the consumption ratio.
Illustrating the Failure of Plantwide or Departmental Rates
The main problem with using either plantwide or departmental rates for assigning overhead
costs is the assumption that unit-level drivers such as machine hours or direct labour hours’
drive (or cause) all overhead costs.
Solving the Problem of Cost Distortion
Cost distortion can be solved by the use of activity rates, which is rather than assigning the
overhead costs by using a single, plantwide rate, the rate for each overhead activity can be
used to assign overhead costs.
Because products consume activities at different rates, to assign overhead costs, the amount
of activity consumed by each product is needed along with the activity rates.
Comparison of Volume-Based and Activity-Based Product Costs
The activity-based cost assignment reflects the pattern of overhead consumption and is much
more accurate.
The discrepancies can lead to incorrect and expensive decisions being made, so it’s important
that the costing method chosen reflects the most accurate cost possible.
ACTIVITY-BASED COSTING
It’s the process of assigning overhead costs to various cost categories related to the nature of
the activity that causes (drives) these costs.
By identifying costs by activities that drive them, we can more accurately assign these
costs to the products being produced.
Each cost pool will have its own predetermined overhead applicate rate and will be
assigned to products based on that specific cost driver.
The types of costs can be categorized as unit-level, batch-level, product-sustaining, and
facility-sustaining.
The increase in the number of cost pools and the individual overhead application rates for
each pool with their own cost drivers will result in a more accurate allocation of overhead to
products.
Steps for Implementing ABC
1. Identify activities (cost drivers), cost pools and activity measures.
2. Assign overhead costs to activity cost pools.
3. Calculate activity rates for each pool.
4. Assign overhead costs to cost objects using the activity rates and activity measures.
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ACC 406
5. Prepare management reports.
Activity-based cost assignment consists of the following 3 steps:
Identify and define activities using interviews and surveys.
Assign costs to activities.
Assign costs to products.
ABC costing has several shortcomings:
It doesn’t conform to GAAP.
It suggests that some nonproduct costs (i.e. those for R&D) should be allocated
to products, whereas certain other product costs (i.e. factory building
depreciation) shouldn’t be allocated to products.
ABC requires a significant amount of time making it costly to implement.
Support is needed in the firm to overcome barriers like people need to learn new skills,
people resist change, and regulatory agencies may not accept ABC data.
To overcome these, the firm must recognize they exist, investigate their causes, and
communicate to all concerned why and how ABC is to be implemented.
ABC is a cost accounting tool that allocates overhead to products and services in a differently.
It can help identify and reduce or eliminate non-value-added activities and with that,
reduce overhead costs.
Assigning Costs to Activities
Once activities are identified and describes, next is determining how much it costs to perform
each activity.
This requires identification of the resources being consumed by each activity.
For labour resources, a work distribution matrix, which identifies the amount of labour
consumed by each activity, is often used.
If the time spent is 100%, then labour is exclusive to the activity and the assignment method is
direct tracing.
If it’s shared, the assignment method is driver tracing and the drivers are called resource
drivers, which are factors that measure the consumption of resources by activities.
Once resource drivers are identified, the cost of the resource can be assigned to the
activity.
Labour isn’t the only resource consumed by activities. They also consume materials, energy,
and capital, which costs must also be assigned to the various activities.
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