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Chapter 7

ACCT 2220 Chapter Notes - Chapter 7: Income Statement, Variable Cost, Cost Driver

Course Code
ACCT 2220
Michele Bowring

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ACCT*2220 Chapter Seven
Measuring The Cost Of Product Complexity
Activity-Based Costing (ABC): A costing method based on activities that is designed to provide
information for strategic and other decisions that potentially affect capacity and therefore fixed costs
(and variable cost)
ABC is generally used as supplement rather than a replacement for a company’s usual costing
oI.e. a normal costing system for external reporting & ABC for internal use
The Treatment Of Costs Under The Activity-Based Costing Model
Ways ABC differs from traditional cost accounting:
1. Non-manufacturing can now be assigned to products, but only on a cause-and-effect basis
2. Some manufacturing costs may be excluded from product costs
3. Numerous overhead pools are used, each allocated to products and other cost objects using its
own unique measure of activity
4. Overhead rates, or activity rates, may be based on the level of activity at capacity rather than
on the budgeted level of activity
Overhead Cost Pools: Groups of overhead cost elements
Non-Manufacturing Costs And Activity-Based Costing
Many non-manufacturing costs are still related to the costs of producing, selling, distribution,
and servicing
NOTE: For ABC, “Overhead” refers to both indirect manufacturing costs AND non-manufacturing
oI.e. we find the entire cost of a product, not just the manufacturing costs
Manufacturing Costs Excluded Under Activity-Based Costing
In traditional cost accounting, all manufacturing costs are assigned to products, even if they’re
not caused by the products
oABC only assigns costs to products if there’s a good reason to believe that the cost
would be affected by decisions concerning the product
In traditional cost accounting, the costs of unused or idle capacity are assigned to products
oABC charges products only for the costs of the capacity they use
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oIdle/unused capacity (ex. waiting for a machine to finish) is a period cost with ABC
Provides more accurate measurements of costs
Peanut butter
Costs like the plant controller’s salary and the security guard’s wages are unaffected by product-
related decisions
oTheses are therefore period expenses instead of product costs under ABC
Overhead Cost Pools, Allocation Bases, And Activity-Based Costing
As processes became more automated and overhead-oriented, traditional overhead cost pools
and traditional allocation bases became more and more inaccurate
oABC fixes this issue
Activity: Any event that causes the consumption of overhead resources
Activity Cost Pool: A “bucket” in which costs are accumulated that relate to a single activity measure in
the activity-based costing system
Activity Measure: An allocation base in activity-based costing system; ideally, a measure of the amount
of activity that drives the costs in an activity cost pool; also called a cost driver
The most common types of activity measures are transaction drivers and duration drivers
oTransaction drivers are simpler & more often used
oDuration drivers are complex & more accurate
Transaction Driver: A simple count of the number of times an activity occurs (ex. # of bills sent to
Duration Driver: A measure of the amount of time require to perform an activity (ex. time spent
preparing individual bills for customers)
ABC’s 5 levels of activity:
1. Unit-Level Activities: Activities that arise as a result of the total volume of goods produced, and
services performed each time a unit is produced
a. Ex. Providing power, because it is correlated with how many units are produced
2. Batch-Level Activities: Activities performed each time a batch of goods is handled or processed,
regardless of how many units are in a batch. The amount of resources consumed depends on
the number of batched run rather than on the number of units in the batch
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ACCT*2220 Chapter Seven
a. Ex. Cost of setting up a machine, because it’s the same whether the batch is 100 or 1000
3. Product-Level Activities: Activities that relate to specific products that must be carried out
regardless of how many units are produced and sold or batches run
a. Ex. Designing a product, advertising a product, maintaining a product manager
4. Customer-Level Activities: Activities that are carried out to support customers but that are not
related to any specific product
a. Ex. Sales calls, catalogue meetings, tech support
5. Organization-Sustaining Activities: Activities that are carried out regardless of which customers
are serviced, which products are produced, how many batches are run or how many units are
a. Ex. Heating the factory, cleaning exec offices, providing computer networks, arranging
loans, preparing annual reports for shareholders
Activity Rates Based On Capacity, Not Budget
In a traditional absorption costing system, predetermined overhead rates are computed by
dividing budgeted overhead costs by a measure of budgeted activity
oIdle time/capacity is buried in inventory and misrepresents costs
oIf budgeted activity falls, the overhead rate increases because the fixed component of
costs are spread over a smaller base, = increased unit costs
In ABC, idle capacity is not used and is a period cost (i.e. goes straight to the income statement)
Designing An Activity-Based Costing System
Cost Objects Activities Consumption of Resources Cost
Steps to implement an ABC system:
1. Identify & Define Activities/Activity Cost Pools/Activity Measures
2. Assign Overhead Costs To Activity Cost Pools
3. Calculate Activity Rates
4. Assign Overhead Costs To Cost Objects Using The Activity Rates & Activity Measures
5. Prepare Management Reports
Step 1: Identify And Define Activities, Activity Cost Pools, And Activity Measures
“What activities will form the foundation for the system?”
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