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