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Chapter 7

ACTG 2020 Chapter Notes - Chapter 7: Activity-Based Costing, Cost Driver, Lsi Corporation

Course Code
ACTG 2020
Douglas Kong

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Chapter 7: Activity based costing and management
7.1 Limitations of volume-based cost accounting systems
oCost drivers is a factor that drives cost.
-Volume or frequency related
-Unit level drivers vs. batch level drivers
oOverhead rates
-Plant wide or departmental may not be the base case for volume-based costing because
they are average based costing and that would provide inaccurate data
-It can understate or overstate many batches of units too large or too small
-Two major factors can impair the ability of unit based plant wide 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
oNon-unit-related overhead costs
-Unit level activities are performed each time a unit is produced – this assumption makes
oABC Hierarchy
-Unit level – varies with output volume/units and traditional variable costs (cost of
indirect materials for labelling each bottle of a certain brands ketchup
-Batch level – varies with the number of batches produced – cost of cleaning the bottling
equipment for each batch of beer
-Product sustaining – varies with the number of product lines – cost of product design and
quality control of different garments produced by a certain company
-Facility sustaining – necessary to operate the plant facility but does not vary with units,
batches or product line – cost of bombardier plant manager’s salary
oNon activity level vs. non unit level activity that are driven by activities called activity divers
oProduct diversity means the product consume overhead activities in consistently different
-Could be due to difference in product size, product complexity, setup cost and branch size
oConsumption ratio is the proportion of each activity consumed by a product
oIllustration the failure of plant wide or departmental rates
-Problems with cost distortion
They think machine hours or direct labour hours drive all over head cost – not
Calculating consumption ratios
First, identify the activity driver for each activity
Divide the amount of diver used for each product by the total diver quantity
You’ll have different consumption ratios for deluxe model and regular model
Hours divided by total
Make a column for overhead activity matching the activity diver
Find the ratios for the two batches given
-Solving problems with cost distortion
Use activity rate to assign overhead costs to each activity
Use the activity cost and total driver quantity
The rates are obtained by dividing the activity cost by the total quantity
Then you calculate activity based unit costs
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This is done by multiplying the activity rates by the deluxe and the regular
model to find their manufacturing costs for each of the four activities
Once you have all the costs for the four sectors then you add them up and
divide by the number of deluxe and regular units to find out per unit cost
-Comparison of volume based and activity based product costs
1) Calculating consumption ratios
2) Calculating activity rates
3) Calculating activity-based unit costs
7.2 Activity based costing (ABC)
oThere is a shift from applying overhead rates from direct labour hours to direct machine hours or
other cost allocation bases
oa single cost driver rarely meets the cause/effect criterion
oactivity based costing is the process of assigning overhead costs to various cost categories
related to the nature of the activity that causes/ drives these costs
oby identifying costs by the activities that drive them, we can more accurately assign these costs to
the products being produced
othese costs are categorized as: unit level, batch level, product sustaining and facility sustaining
othe use of ABC has expanded into areas upstream (before the production section of the value
chain- R&D) and downstream (after the production section of the value chain- marketing,
distribution, customer service) from production
ospecifically, ABC often Is used to determine more accurately the upstream costs of suppliers, and
the downstream costs of customers
oknowing these costs (how much a supplier and a customer costs) can be vital information for
improving a company’s profitability
Example: LSI logic implemented ABC customer costing and discovered that 10% of its customers were
responsible for about 90% of its profits. It has also learned that it is losing money for 50% of its
customers. After removing the unprofitable customers, is sales decreased but the profits tripled.
1. identify activities, cost pools and activity measures
2. assign overhead cost to activity cost pools
3. calculate activity rates for each cost pool
4. assign overhead costs to cost objects using the activity rates and activity measures
5. prepare management reports
The goal is to reflect, as accurately as possible, how resources are consumed.
Assigning costs to activities (step 2 for implementing ABC):
We must identify the resources being consumed by each activity
This is the most difficult part of the implementation process
Activities consume resources such a labour, materials, energy and capital | but the money spent
on each acitivty isn’t revealed
Thus we use a work distribution matrix: this identified the amount of labour consumed by each
activity and is derived from the interview process (a written survey)
The work distribution matrix identifies resource drivers- factors that measure the consumption of
resources by activities
Assigning costs of products:
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