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Chapter 7

ACC406 Chapter 7.doc

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Course Code
ACC 406
Donna Zathy

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ACC406 - Chapter 7 • Limitations of Functional-Based Cost Accounting Systems o Plantwide and Departmental Rates based on direct labor hours, machine hours, or other volume-based measures  been used for decades to assign overhead costs to products o This approach to costing is equivalent to an averaging approach and may produce inaccurate costs o Need for more accurate product costs has forced many companies to take a serious look at their costing procedures o 2 major factors impair the ability of unit-based plantwide and departmental rates to assign overhead costs accurately  1) Proportion of nonunit-related overhead costs to total overhead costs is large  2) Degree of product diversity is great • Nonunit-Related Overhead Costs o Use of plantwide or departmental rates assumes that a product's consumption of overhead resources is related strictly to the units produced o Unit-level Activities = activities that are performed each time a unit is produced o Volume-based cost systems label costs associated with these activities as variable  All other costs (e.g., ones that aren't unit-level) are considered fixed by this system o Costs associated with nonunit-level activities are unlikely to vary with units produced o Proponents of ABC refer to the ABC cost hierarchy that categorizes costs as:  unit-level (vary with output volume)  batch-level (vary with the number of groups or batches that run)  product-sustaining (vary with the diversity of the product or service line)  facility-sustaining (do not vary with any factor but are necessary in operating the plant) o ABC cost hierarchy used in helping managers realize that certain costs associated with nonunit-level activities are driven by other factors o Nonunit-level activity drivers are factors that measure the consumption of nonunit-level activities by products and other cost objects  E.g., batch, product-sustaining, facility-sustaining o Unit-level activity drivers measure the consumption of unit-level activities o Activity drivers are factors that measure the consumption of activities by products and other cost objects, can be classified as either unit- level or nonunit-level • Product Diversity o Products that consume overhead activities in systematically different proportions o Presence of significant nonunit overhead costs is a necessary condition for plantwide and departmental failures o Consumption Ratio = proportion of each activity consumed by a product • Problems with Costing Accuracy o Four types of overhead activities, performed by four distinct support departments  Setting up the equipment for each batch  Moving a batch  Machining  Assembly o Main problem with either procedure is the assumption that unit-level drivers such as machine hours or direct labor hours, drive or cause all overhead costs o Each products demands for setup and material-moving activities are more logically related to the setup hours and the number of moves, respectively • Solving Problem with Cost Distribution o Can be solved by the use of activity rates o To assign overhead costs, the amount of activity consumed by each product is needed along with the activity rates • Comparison of Functional-Based and Activity-Based Product Costs o Plantwide rate based on direct labor hours is calculated by dividing the total overhead costs by the total direct labor hours  Plantwide Rate = Total Overhead Costs / Total Direct Labor Hours • Activity-Based Product Costing: Detailed Description o Functional-based overhead costing involves 2 major stages  1) Overhead costs are assigned to an organizational unit (plant or departmental)  2) Overhead costs are then assigned to cost objects o ABC system first traces costs to activities and then to cost objects  Activities consume resources, and cost objects, in turn, consume activities  ABC is a two-stage process o ABC system emphasizes direct tracing and driver tracing  Volume-based costing system tends to be allocation-intensive o Focus of ABC is activities  Identifying activities is first step in designing an ABC system o Activity Dictionary = lists the activities in an organization along with some critical activity attributes o Activity Attributes = financial and nonfinancial information items that describe individual activities • Assigning Costs to Activities o Requires identification of the resources o Activities consume resources such as labor, materials, energy, and capital o Becomes necessary to assign the resource costs to activities by using direct and driver tracing o Work Distribution Matrix = Identifies the amount of labor consumed by each activity and is derived from the interview process o If the resource is shared by several activities, then the assignment is driver tracing, and the drivers are called Resource Drivers  Resource Drivers = Factors that measure the consumption of resources by activities • Assigning Costs to Products o Activity costs are assigned to products by multiplying a predetermined activity rate by the usage of the activity, as measured by activity drivers o To assign costs, the amount of each activity consumed by each product must also be known • Activity-Based Customer Costing & Activity-Based Supplier Costing o ABC systems became popular for their ability to improve product- costing accuracy by tracing activity costs to the products that consume the activities o ABC often is used to more accurately determine the upstream costs of suppliers and the downstream costs of customers • Activity-Based Customer Costing o Customers are cost objects of fundamental interest o Customers can consume customer-driven activities in different proportions o Sources of customer diversity include order frequency, delivery frequency, geographic distance, sales and promotional support, and engineering support requirements o Because of diversity of customers, multiple drivers are needed to trace costs accurately o Customer Costing vs. Product Costing  Assigning costs of customer service to customers is done in the same way that manufacturing costs are assigned to products  Cost of resources consumed is assigned to activities, and the cost of activities is assigned to individual customers  Activity-based cost assignments reveal a much different picture of the cost of servicing each type of customer • Activity-Based Supplier Costing o ABC can help a manager to identify the true cost of a firms' suppliers o Cost of a supplier is much more than the purchase price of the components or materials acquired o Suppliers can affect many internal activities of a firm and significantly increase the cost of purchasing o ABC is the key to tracing costs relating to purchase, quality, reliability, and delivery performance to suppliers • Process-Value Analysis o Fundamental to activity-based management o Focuses on cost reduction instead of cost assignment and emphasizes the maximization of systemwide performance o Concerned with
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