Module 5 Week 5 - Managerial Accounting Today PDF

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Summary

Managerial accounting module. Period covered for 1 week for 2nd semester. Academic Year 2020 - 2021...

Description

College of Accountancy Subject Code:

Module No./Title: 5 – ACTIVITY -BASED COSTING

Subject Description: Management Accounting

Period of Coverage:

Objectives: 1. To discuss the difference between traditional costing and activity- based costing and to explain its benefits and limitations.

Content: Activity Based-Costing Method A.

Traditional Costing Systems

1. A traditional costing system allocates overhead to products on the basis of predetermined plantwide or departmentwide volume of unit-based output rates such as direct labor or machine hours. 2. Historically, there was a high correlation between direct labor and the incurrence of overhead cost. In recent years, however, manufacturers have experienced tremendous changes that have altered the manufacturing environment drastically. 3. Companies that have complex processes need to use multiple allocation bases to compute accurate product costs. An overhead cost allocation method that uses multiple bases is activity-based costing. B.

Activity-Based Costing

1. Activity-based costing (ABC) allocates overhead to multiple activity cost pools and then assigns the activity cost pools to products and services by means of cost drivers. 2. In ABC, an activity is any event, action, transaction, or work sequence that incurs cost when producing a product or providing a service. 3. ABC allocates overhead in a two-stage process. The first stage allocates overhead costs to activity cost pools. The second stage assigns the overhead allocated to the activity cost pools to products, using cost drivers. 4. A cost driver is any factor or activity that has a direct cause-effect relationship with the resources consumed. C.

Unit Costs Under ABC.

1.

Activity-based costing involves the following steps:

a. Identify and classify the activities involved in the manufacture of specific products, and assign manufacturing overhead costs to the appropriate cost pools. b. Identify the cost driver that has a strong correlation to the costs accumulated in each cost pool. c.

Compute the overhead rate for each cost pool.

d. pool.

Allocate overhead costs to products using the overhead rates determined for each cost

2. A well-designed activity-based costing system starts with an analysis of the activities performed to manufacture a product or provide a service. 3. It requires a detailed, step-by-step review of each operation, documenting every activity undertaken to accomplish a task. At this point, the company will identify activity cost pools such as inspecting, assembling, and supervising. 4. Next, the system assigns overhead costs directly to the appropriate activity cost pools identified in step #3. D. Identify Cost Drivers, Compute Overhead Rates, and Assign Overhead Costs to Products. 1. After costs are allocated to the activity cost pools, the company must identify the cost drivers for each cost pool. 2. A high degree of correlation must exist between the cost driver and the actual consumption of the overhead costs in the cost pool to achieve accurate costing. 3. The company computes an activity-based overhead rate per cost driver by dividing the estimated overhead per activity by the number of cost drivers expected to be used per activity. 4. In assigning overhead costs, it is necessary to know the expected use of cost drivers for each product. 5. The company multiplies activity-based overhead rates per cost driver by the number of cost drivers expected to be used per product to assign overhead costs to each product. 6. Under ABC, overhead costs are usually shifted from a high-volume product to a lowvolume product. This shift results in more accurate costing because: a. Low-volume products often require more special handling, (i.e.-more machine setups and inspections), than high-volume products. b. Assigning overhead using ABC will usually increase the cost per unit for low-volume products (and decrease the cost per unit for high-volume products) as compared to traditional overhead allocation.

E.

Benefits of ABC.

1.

The primary benefit of ABC is more accurate product costing because

a. ABC leads to more cost pools being used to assign overhead costs to products; therefore, costs are assigned more directly based on cost drivers b. ABC leads to enhanced control over overhead costs; companies can trace many overhead costs directly to activities under ABC. c. ABC leads to better management decisions; more accurate product costing should contribute to desired product profitability levels. F.

Classification of Activity Levels.

1.

A classification of ABC activities consisting of four levels are defined as

a. b. c. d.

Unit-level activities: activities performed for each unit of production. Batch-level activities: activities performed for each batch of products rather than each unit. Product-level activities: activities performed in support of an entire product line. Facility-level activities: activities required to support an entire production process.

2. Companies may achieve greater accuracy in overhead cost allocation by recognizing the different levels of activities and developing specific activity cost pools and their related cost drivers. 3. Nonrecognition of this classification of activities is one of the reasons that volume-based cost allocation causes distortions in product costing. 4. The resources consumed by batch-, product-, and facility-level supporting activities do not vary at the unit level, nor can managers control them at the unit level. 5. Companies can control batch-, product-, and facility-level costs only by modifying batch-, product-, and facility-level activities. G.

Value-Added Versus Non-Value-Added Activities.

1. In developing an ABC System, managers increase their awareness of the activities performed by the company in its production and supporting processes. This helps managers classify activities as value-added or non-value-added. 2. Value-added activities increase the worth of a product or service, for which the customer is willing to pay. 3. Value-added activities are the activities of actually manufacturing a product or performing a service (i.e., engineering design, assembly, packaging). 4. Non-value-added activities are production- or service-related activities that simply add cost to or increase the time spent on a product or service without increasing its market value (i.e. machine repair, building maintenance, inventory control).

5.

Companies often use activity flowcharts to help identify the ABC activities.

6. Not all non-value-added activities are totally wasteful, nor can they be totally eliminated, but managers are motivated to minimize them as much as possible. H.

The Limitations and When to Use ABC.

1.

The limitations of ABC are:

a. ABC can be expensive to use; identifying multiple activities and applying numerous cost drivers results in increased costs. b. Some arbitrary allocations continue; certain overhead costs still have to be allocated by means of some arbitrary volume-based cost driver (i.e.labor hours). 2.

The presence of one or more of the following factors would point to ABC’s possible use.

a. Product lines differ greatly in volume and manufacturing complexity. b. Product lines are numerous and diverse, and they require differing degrees of support services. c. Overhead costs constitute a significant portion of total costs. d. The manufacturing process or the number of products has changed significantly. e. Production or marketing managers are ignoring data provided by the existing system and are instead using other alternative data when pricing or making product decisions. I.

Activity-Based Costing in Service Industries:

1. The overall objective of ABC in service firms is no different than it is for a manufacturing company: The objective is to identify the key activities that generate costs and to keep track of how many activities are performed for each service provided. 2. The general approach to identifying activities, activity cost pools, and cost drivers is the same for service companies and for manufacturers. 3. Often, a larger proportion of overhead costs are company-wide costs that cannot be directly traced to specific services provided by the company, which sometimes makes implementation of ABC difficult in service industries. The major benefits of JIT processing include: a. Significant reduction or elimination of manufacturing inventories. b. Enhanced product quality. c. Reduction or elimination of rework costs and inventory storage costs. d. Production cost savings from the improved flow of goods through the processes. 6. One of the major accounting benefits of JIT is the elimination of separate raw materials and work-in-process inventory accounts. APPLICATION OF METHODS AND FORMULAS: Traditional Costing method

In a traditional costing method, we calculate one plantwide allocation rate or we could calculate an overhead allocation rate for each department. We have a three step process: Step 1: Determine the basis for allocating overhead or indirect costs. These can be anything a company decides but most common are direct labor cost, direct labor hours, direct material usage or machine hours. Step 2: Calculated a predetermined overhead rate using estimates. This is typically calculated at the end of the year to be used during the following year. The formula we use for this is:

Predetermined Overhead Rate (POHR) =

Estimated Overhead Estimated base (cost driver)

Step 3: Apply overhead throughout the period using the actual amount of our base and the predetermined overhead rate (POHR) calculated in step 2. We calculate this as: Applied Overhead =

Actual amount of base x POR

Traditional costing method example Assume High Challenge Company makes two products, touring bicycles and mountain bicycles. The touring bicycles product line is a high-volume line, while the mountain bicycle is a lowvolume, specialized product. High Challenge Company allocated manufacturing overhead costs to the two products for the month of January. Department A had estimated overhead of $2,000,000 and used 20,000 machine hours. High Challenge has decided to allocate overhead on the basis of machine hours. 

The predetermined overhead rate of $100 per machine hour is calculated as: $2,000,000 / 20,000 machine hours.



At the end of January, High Challenge had used 1,500 machine hours for the Touring bicycle product line and 500 machine hours for the Mountain bicycle product line. Overhead would be allocated to each product as follows (use the POHR calculated above at $100 per machine hour):

Touring Bicycle $150,000 (1,500 machine hours x $100 per hour)

Mountain Bicycle $50,000 (500 mhs. X $100 per hour)

Methods used for activity-based costing Activity-based costing requires accountants to use the following four steps: 1. Identify the activities that consume resources and assign costs to those activities. Purchasing materials would be an activity, for example. 2. Identify the cost drivers associated with each activity. A cost driver is an activity or transaction that causes costs to be incurred. For the purchasing materials activity, the cost drivers could be the number of orders placed or the number of items ordered. Each activity could have multiple cost drivers. 3. Compute a cost rate per cost driver unit. The cost driver rate could be the cost per purchase order, for example. 4. Assign costs to products by multiplying the cost driver rate times the volume of cost driver units consumed by the product. For example, the cost per purchase order times the number of orders required for Product A for the month of December would measure the cost of the purchasing activity for Product A for December. The next section describes these four steps. Step 1 is often the most interesting and challenging part of the exercise. This step requires people to understand all of the activities required to make the product. Imagine the activities involved in making a simple product like a pizza—ordering, receiving and inspecting materials, making the dough, putting on the ingredients, baking, and so forth. Or imagine the activities involved in making a complex product such as an automobile or computer. One of the lessons of activity-based costing has been that the more complex the business, the higher the indirect costs. Imagine that each month you produce 100,000 gallons of vanilla ice cream and your friend produces 100,000 gallons of 39 different flavors of ice cream. Further, assume your ice cream is sold only in one liter containers, while your friend sells ice cream in various containers. Your friend has more complicated ordering, storage, product testing (one of the more desirable jobs, nevertheless), and packing in containers. Your friend has more machine setups, too. Presumably, you can set the machinery to one setting to obtain the desired product quality and taste. Your friend has to set the machines each time a new flavor is produced. Although both of you produce the same total volume of ice cream, it is not hard to imagine that your friend’s overhead costs would be considerably higher. In Step 2, we identify the cost drivers. In the table below, we present several examples of the cost drivers companies use. Most cost drivers are related to either the volume of production or to the complexity of the production or marketing process.

Cost driver Miles driven Machine-hours Customers served Flight hours Number of customers

Cost of assigned cost driver Automobile costs Electricity to run machines Overhead in a bank Airplane maintenance costs Selling costs

In deciding which cost drivers to use, managers consider these three factors: 

Causal relation. Choosing a cost driver that causes the cost is ideal. For example, suppose students in biology classes are messier than students in history classes. As a result, the university does more maintenance per square foot in biology classrooms and labs than in history classrooms. Further, it is possible to keep track of the time maintenance people spend cleaning classrooms and labs. The university could assign maintenance costs based on the time spent in history classrooms and in biology classrooms and labs, respectively, to the history and biology departments.



Benefits received. Choose a cost driver so costs are assigned in proportion to benefits received. For example, if the physics department in a university benefits more from the university’s supercomputer than the German department does, the university should select a cost driver that recognizes such differences in benefits. The cost driver could be the number of faculty and/or students in each department who use the computer.



Reasonableness. Some costs that cannot be linked to products based on causality or benefits received are assigned on the basis of reasonableness.

For step 3, we need to calculate the activity rates. These are calculated using the same formula for predetermined overhead rate (POHR) that we used for traditional costing. In general, predetermined rates for allocating indirect costs to products are computed as follows: Predetermined Overhead Rate (POHR) =

Estimated Overhead Estimated Base (cost driver)

This formula applies to all indirect costs, whether manufacturing overhead, administrative costs, distribution costs, selling costs, or any other indirect cost. In Step 4, we first define the notion of an activity center. An activity center is a unit of the organization that performs some activity. For example, the costs of setting up machines would be assigned to the activity center that sets up machines. This means that each activity has associated costs. When the cost driver is the number of inspections, for example, the company must keep track of the cost of inspections. Workers and machines perform activities on each product as it is produced. Accountants allocate costs to products by multiplying each activity’s indirect cost rate by the volume of activity used in making the product. The formula we will use for each activity is:

Applied Overhead =

Actual amount of activity cost driver x Activity POR

Activity-based costing example Assume High Challenge Company makes two products, touring bicycles and mountain bicycles. The touring bicycles product line is a high-volume line, while the mountain bicycle is a lowvolume, specialized product. In using activity-based costing, the company identified four activities that were important cost drivers and a cost driver used to allocate overhead. These activities were (1) purchasing materials, (2) setting up machines when a new product was started, (3) inspecting products, and (4) operating machines. Accountants estimated the overhead and the volume of events for each activity. For example, management estimated the company would purchase 100,000 pieces of materials that would require overhead costs of $200,000 for the year. These overhead costs included salaries of people to purchase, inspect, and store materials. Setting up machines for a new product would need 400 setups and overhead of $800,000. The company would have 4,000 inspections and overhead of $400,000. Finally, running machines would cost $600,000 for 20,000 machine hours. These estimates were made last year and will be used during all of the current year. In practice, companies most frequently set rates for the entire year, although some set rates for shorter periods, such as a quarter. Look at the overhead rates computed for the four activities in the table below. Note that the total overhead for current year is $2,000,000 using activity-based costing, just as it was using a traditional costing method. The total amount of overhead should be the same whether using activity-based costing or traditional methods of cost allocation to products. The primary difference between activity-based costing and the traditional allocation methods is the amount of detail; particularly, the number of activities used to assign overhead costs to products. Traditional allocation uses just one activity, such as machine-hours. Activity-based costing used four activities in this case. In practice, companies using activity-based costing generally use more than four activities because more than four activities are important. We used four to keep the illustration as simple as possible. The activity cost rates (predetermined overhead rates) are calculated as follows: Activity

Cost Driver

Purchasing Materials pcs. of mat.

Overhead Cost

Estimated Units

$200,000

100,000 pcs. 400 setups

Machine Setups

# of setups

800,000

Inspections

insp. hrs.

400,000

4,000 insp. hrs.

Rate $2/pc.

2,000/setup 100/insp. hr.

Running Machine

mhs.

600,000

Total Overhead

20,000 mhs.

30/mh.

$2,000,000

For January, the High Challenge Company has the following information about the actual number of cost driver units for each of the two products: Touring Purchasing Materials

6,000 pieces

4,000 pieces

10 setups

30 setups

Machine Setups Inspections Running Machine

Mountain

200 hours

200 hours

1,500 hours

1,500 hours

Multiplying the actual activity events for each product times the predetermined rates computed earlier resulted in the overhead allocated to the two products: Touring Purchasing Materials<...