Understanding Activity-Based Costing and Overhead Allocation in

School: Northeastern State University - Course: ACCT 4193 - Subject: Accounting

Managerial Accounting Notes: Chapter 5 With a global environment, we are using technology much more in order to increase productivity However, now we become much more concerned with controlling and measuring our costs Therefore, there is greater emphasis on if we are allocating our costs in the most accurate ways as possible So far, we have been doing costing using a single driver such as labor hours which was used for traditional manufacturing as it were mainly labor intensive However, a trend that has been occurring is that more businesses are automated which in turn reduces labor intensity of a firm Labor-Intensive Process versus Automated Process oLabor-Intensive Process Overhead costs are relatively small Overhead allocations may be inaccurate, but the amounts are relatively insignificant oAutomated Process Overhead costs are relatively large Inaccurate overhead allocation can lead to questionable product cost information If using labor hours with automation, it will cause a majority of overhead costs to be allocated to workers when automation doesn't affect them at all This isn't equitable as allocation costs will disproportionately affect workers and using labor hours isn't a reasonable cost driver any more Activity-based costing (ABC)= two-stage allocation process that employs are variety of cost driver oStep 1: identify essential activities and costs required to perform the activities Think of this as buckets where you assign costs to the same bucket according to activities that cause costs to be incurred oStep 2: Allocate costs in the buckets according to the cost driver that makes most sense for each bucket Will use a variety of cost drivers as each bucket (activity pool) might vary in what its cost driver is oNow, there are four main buckets (activity pools) used to group overhead costs: 1)Unit-Level Activity -Incurred each time a product is made -Example) producing blue and black pens, each pen produced is a unit -Direct labor hours can be used to allocate unit-level overhead costs 2)Batch-Level Activity (also can view this as set-ups) -incurred each time a batch of products is made -Example) Producing a group/batch of blue pens
- Number of set ups can be used to allocate batch-level overhead costs 3)Product-Level Activity -Supports either product -Percentage of activity usage can be used to allocate product-level overhead costs 4)Facility-Level Activity -Benefits the entire process, not a specific line of products -Example) Something that benefits all different color pens being made (blue, black, red, green) & pencils -Can use percentage of units to allocate facility-level overhead costs oIn order to find overhead cost per units, add up unit allocation + batch allocation + product allocation + facility allocation = total overhead costs (do for each product line) oThen, take the total overhead cost/number of units in order to get overhead cost per unit oOver costing= when a product line is overpriced Can lead to a competitive disadvantage oUnder costing= when a product line is priced below cost Downstream costs= occur after production Upstream costs= occur before goods are manufactured To continue in business, companies must sell products at prices that exceed the total cost to develop, make, & sell them Quality refers to the degree to which actual products and services conform to their design specifications oExample) think of McDonalds or Japanese car companies Costs that companies incur to assure quality conformance can be classified as: oPrevention Costs Example) training employees to make products the same oAppraisal Costs Example) spot-checking to make sure all products are made the same oInternal failure costs Example) making mistakes/reject that can be discarded before getting to the customer oExternal failure costs Example) Bad products that aren't made right which need to get sent back

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