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1. Define and explain activity based costing (ABC) system. 2. How various manufacturing and non-manufacturing costs are treated under
activity based costing system?
1. Understand activity based costing system. 2. How it differs from a traditional costing system?
Activity based costing (ABC) is a costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore "fixed cost". Activity based costing system is used to determine product costs for special management reports. This system is ordinarily used as a supplement to the company's usual costing system. Most organizations that use ABC system have two costing systems--the official costing system that is used for preparing external financial reports and the activity based costing system that is used for internal decision making and for managing activities. In traditional cost accounting systems, the objective is to value inventories and cost of goods sold for external financial reports in accordance with the generally accepted accounting principles (GAAP). In activity based costing (ABC) system the objective is to understand overhead and the profitability of products and customers and to manage overhead. As a consequence of these differences in objectives, "best practice" activity based costing system differs in a number of ways from traditional cost accounting. In activity based costing:
1. Non-manufacturing as well as manufacturing costs may be assigned to products. 2. Some manufacturing costs may be excluded from product costs. 3. A number of overhead cost pools are used, each of which is allocated to products
and other costing objects using its own unique measure of activity.
4. The allocation bases often differ from those used in traditional costing system. 5. The overhead rates or activity rates may be based on the level of activity at
capacity rather than on the budgeted level of activity. These differences from traditional cost accounting systems can dramatically impact the apparent costs of products and the profitability of products and customers.
1. How manufacturing, non-manufacturing and idol capacity costs are treated under
activity based costing system? Contents:
1. Non-manufacturing costs and activity based costing 2. Manufacturing costs and activity based costing 3. Costs of idle capacity and activity based costing
component of product costs--larger than it is today. Moreover, managers believed direct labor and overhead costs were highly correlated. (Two variables, such as direct labor and overhead costs, are highly correlated if they tend to move together.) And finally most companies produced a very limited variety of products that required similar resources to produce, so in fact there was probably little difference in the overhead costs attributable to different products. Under these conditions, it was not cost effective to use a more elaborate costing system. Conditions have changed. Many companies now sell a large variety of products and services that consume significantly different overhead resources. Consequently, a costing system that assigns essentially the same overhead cost to every product may no longer be adequate. Additionally, many managers now believe that overhead overhead costs and direct labor are no longer highly correlated and that other factors drive overhead costs. On an economy wide basis, direct labor and overhead costs have been moving in opposite directions for a long time. As a percentage of total cost, direct labor has been declining, whereas overhead has been increasing. Many tasks that used to be done by hand are now done with largely automated equipment--a component of overhead. Companies are creating new products and services at an ever-accelerating rate that differ in volume, batch size and complexity. Managing and sustaining this product diversity requires many more overhead resources such as production schedulers and production design engineers, and may of these overhead resources have no obvious connection with direct labor. Finally, computers, bar code readers, and other technology have dramatically reduced the cost of collecting and manipulating data--making more complex (and accurate) costing systems such as activity based costing much less expensive to build and maintain. Nevertheless, direct labor remains a viable base for applying overhead to products in some companies--particularly for external reports. Direct labor is an appropriate allocation base for overhead when overhead costs and direct labor are highly correlated. And indeed, most companies throughout the world continue to base overhead allocations on the direct labor or machine hours. However if factory wide costs do not move in tandem with factory wide direct labor or machine hours, some other means of assigning overhead costs must be found or product costs will be distorted.
that is designed to reflect these diverse factors more accurately when costing products. It attempts to accomplish this goal by identifying the major activities such as batch setups, purchase order processing, and so on, that consume overhead resources and thus cause costs. An activity is any event that causes the consumption of overhead resources. The costs of carrying out these activities are assigned to the products that cause the activities.
Experts agree on several essential characteristics of any successful implementation of activity based costing. First, the initiative to implement activity based costing must be strongly supported by top level managers. Second, the design and implementation of an ABC system should be the responsibility of cross functional team rather than of the accounting department. The team should include representatives from each area that will use the date provided by the ABC system. Ordinarily, this would include representatives from marketing, production, engineering and top management as well as technically trained accounting staff. An outside consultant who specializes in activity based costing may serve as and advisor to the team. The reason for insisting on strong top management support and a multifunction team approach is rooted in the fact that it is difficult to implement changes in organizations unless those changes have the full support of those who are affected. activity based costing changes the "rules of the game" since it changes some of the key measures that managers use for their decision making and for evaluating individuals' performance. Unless the managers who are directly affected by the changes in the rules have a say, resistance will be inevitable. In addition, designing a good ABC system requires intimate knowledge of many parts of the organization's overall operations. Top management must support the initiative for two reasons. First, without leadership from top management, some managers may not see any reason to change. Second, if top managers do not support the ABC system and continue to play the game by the old rules, their subordinates will quickly get the message that ABC is not important and they they will abandon the ABC initiative. Time after time, when accountants have attempted to implement an ABC system on their own without top-management support and active cooperation from other managers, the results have been ignored.
Fourth, the auditors are likely to be uncomfortable with allocation that are based on interviews with the company's personnel. Such objective data can be easily manipulated by management to make earnings and other key variables look more favorable. For all of these reasons, most companies confine their ABC efforts to special studies for management, and they do not attempt to integrate activity based costing into their formal cost accounting system.
Cost Objects (e.g., products and customers) Activities Consumption of Resources Cost
Usually, company's traditional cost accounting system adequately measures the direct material and direct labor costs of products since these costs are directly traced to products. In most of the organizations activity based costing study is usually concerned solely with the other costs of the company - manufacturing overhead and selling, general, and administrative costs. The activity based costing implementation team should carefully plan about implementing activity based costing. Implementation process may be broken down into the following six basic steps.
1. What are the advantages and disadvantages of activity based costing system?
Contents: Advantages of activity based costing system Disadvantages of activity based costing system
channels. Better understanding overhead. Easier to understand for everyone. Utilizes unit cost rather than just total cost. Integrates well with Six Sigma and other continuous improvement programs. Makes visible waste and non-value added activities. Supports performance management and scorecards Enables costing of processes, supply chains, and value streams Activity Based Costing mirrors way work is done Facilitates benchmarking
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resources. Once implemented an activity based costing system is costly to maintain. Data concerning numerous activity measures must be collected , checked, and entered into the system. ABC produces numbers such as product margins, that are odds with the numbers produced by traditional costing systems. But managers are accustomed to using traditional costing systems to run theirs operations and traditional costing systems are often used in performance evaluations. Activity based costing data can be easily misinterpreted and must be used with care when used in making decisions. Costs assigned to products, customers and other cost objects are only potentially relevant. Before making any significant decision using activity based costing data, managers must identify which costs are really relevant for the decisions at hand. Reports generated by this systems do not conform to generally accepted accounting principles (GAAP). Consequently, an organization involved in activity based costing should have two cost systems - one for internal use and one for preparing external reports.
1. A sample of fortune 100 companies, which are the largest 100 companies in the 2.
united states. A sample of world class companies that had been identified by a consultant as having the best accounting practices in the world. These comparisons are as as follows:
Activity Measure Number of invoices process Number of invoices processed Number of checks processed Number of customer accounts US WEST Cost $3.80 per invoice $8.90 per invoice $7.30 per check $12.00 per account Fortune 100 Benchmark $15.00 per invoice $7.00 per invoice $5.00 per check $16 per account World-Class Benchmark $4.60 per invoice $1.80 per invoice $1.72 per check $5.60 per account
Activity Processing accounts receivables Processing accounts payables Processing payroll checks Managing customer credits
It is clear from this analysis that US WEST does a good job of processing accounts receivable. Its average cost per invoice is $3.80, where the cost in other companies that are considered world class is even higher - $4.60 per invoice. On the other hand, the cost of processing payroll checks is significantly higher at US WEST that at benchmark companies. The cost per payroll check at US WEST is $7.30 versus $5.00 at Fortune 100 companies and $1.72 at world class companies. This suggests that it may be possible to wring some waste out of this activity using total quality management, process reengineering, or some other method.
Real Business Example: Disciplining the Software Development Process Tata Consultancy Services (TCS) of India is the largest consulting organization in India, serving both Indian and international clients. The company used activity based management to identify problem areas in its software development business. An early finding was that "quality assurance, testing and error correction activities made up a significant chunk of the overall effort required to build a system, and this cost had to be kept under control to improve productivity and profitability." The company already had in place a quality management system that helped identify the types of errors that were occurring and the corrective action that would be required, but no costs were attached these errors and actions. The activity based management system provided this cost information system, which allowed managers to set better priorities and to monitor the costs of error-correction activities. As another example of the usefulness of the system, 54 person-days in one software development project at TCS were charged to the activity "waiting for client feedback" - a non-value-added activity. Investigation revealed that the client was taking a long time to review the graphical user interface (GUI) designed by TCS. The client was showing the GUI to various end users - often resulting in contradictory suggestions The solution was to draw up guideline for the GUI with client, which were enforced. "As a result of this corrective action, subsequent client feedback was well within the time schedule. Most of our screens were accepted because they conformed to standards . . . . ."
Learning Objectives:
1. Perform the first stage allocation of overhead costs to the activity cost pools. 2. Compute activity rates for the activity cost pools. 3. Construct a table showing the overhead costs of units and four orders.
Ferris Corporation makes a single product - a fire resistant commercial filing cabinet that it sells to office furniture distributors. The company has a simple ABC system that it uses for internal decision making. The company has two overhead departments whose costs are listed below:
The company's activity based costing system has the following activity cost pools and activity measures:
Activity Cost Pool Assembling units Processing orders Supporting customers Other
Activity Measures Number of units Number of orders Number of customers Not applicable
Costs assigned to the "other" activity cost pool have no activity measure; they consist of the costs of unused capacity and organization-sustaining costs - neither of which are assigned to products, orders or customers. Ferris Corporation distributes the costs of manufacturing overhead and of selling and administrative overhead to the activity cost pools based on employee interviews, the results of which are reported below:
Distribution of Resource Consumption Across Activity Cost Pools Assembling Processing Supporting Other Units Orders Customers Manufacturing overhead Selling and administrative overhead Total activity 50% 10% 1,000 units 35% 45% 250 orders 5% 25% 100 customers 10% 20% --
Required:
1. Perform the first stage allocation of overhead costs to the activity cost pools. 2. Compute activity rates for the activity cost pools. 3. OfficeMart is one of the Ferris Corporation's customers. Last year OfficeMart
ordered filing cabinets four different times. OfficeMart ordered a total of 80 cabinets during the year. Construct a table showing the overhead costs of these 80 units and four orders.
Solution:
1. The first stage allocation of costs to the activity cost pools appears below:
Activity Cost Pools Assembling Units $250,000 30,000 Processing Orders $175,000 135,000 Supporting Customers $25,000 75,000 Other $50,000 60,000 Total $500,000 300,000
$280,000
$310,000
$100,000
$110,000
$800,000
Activity Rate $280 per unit $1,240 per order $1,000 per customer
3. The overhead cost for the four orders of a total of 80 filing cabinets would be computed as follows:
per unit
Filing Cabinet Product Margin: Sales ($595 per unit 80 units) Cost: Direct materials ($180 per unit 80 units) Direct materials ($50 per unit 80 units) Volume related overhead (above) Order related overhead (above) $14,400 4,000 22,400 4,960 45,760 $1,840 ========== Customer Profitability Analysis - OfficeMart Product margin (above) Less: Customer support overhead (above) $1,840 1,000 $840 =========== $47,600