Q2 principles shown here extend readily to

Q2AActivity based costing ABC is an approach for assigning coststo products, services, projects, tasks, or acquisitions, based on – activitiesthat go into them and resources consumed by these activities.

ABC contrastswith traditional costing (cost accounting),which sometimes assigns costs using arbitrary allocation percentages foroverhead or the so-called indirect costs. It results in ABC and traditionalcost accounting can estimate cost ofgoods sold and gross margin verydifferently for individual products. Contradictory and uncertain cost estimatescan be a problem when management needs to know exactly which products areprofitable and which are selling at a loss.Cost accounting specialists  know that traditional cost accounting can hideor distort information on the costs of individual products andservices—especially where local cost allocation rules misrepresent actualresource usage. As a result, the move to ABC is usually driven by a need tounderstand the “true costs” of individual products and services moreaccurately. Companies implement activity based costing in order to -identifyindividual products that are unprofitable, improve production processefficiency and price products appropriately, with the help of accurate productcost information . It  reveals unnecessarycosts that can be eliminated.

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Firms that use ABC consistently to pursue theseobjectives are practicing activity based management ABM.The purpose of ABC is to provide information for decision supportand planning. ABC by itself usually has little or no impact on the structure ofthe firm’s financial accounting reports (Income statement, Balance sheet, orCash flow statement). This is because both ABC and traditional costingultimately assign costs to the same existing accounts. The two approachessimply use different mathematics to do so. But  ABC sometimes brings improvements inreported margins and profitability. These outcomes follow when ABC revealsunnecessary or inflated costs, or when ABC shows where to adjust pricingmodels, work flow process, or the product mix.

The different methods andoutcomes from ABC and traditional costing are easiestto illustrate in the context of a product manufacturing example. However,the principles shown here extend readily to a wide range of otherbusiness settings.Example: Traditional Cost Accounting vs. Activity Based CostingForexample, consider a firm that manufactures automobile parts through asequence of machine operations on metal raw material.

In such settings,traditional accounting views product production costs as either directcosts or indirect costs (or overhead).ExampleSources of Direct CostsTraditionally, direct costs for such firms are costs they can assignto specific product units. In product manufacturing, these might includedirect materials and direct labor costs:Direct labor costs – These can include the cost for person minutes or personhours per product unit for running production machines.Direct materials – Direct materials costs might include costs per product unit formetal stock, fasteners, and lubricants. ExampleSources of Indirect CostsTraditionally, indirect costs for such firms are manufacturing overheadcosts they cannot assign directly to specific product units.

 Instead, theyallocate these costs to specific production runs, batches, or timeperiods. These might include indirect costs such as the following:Materials purchase order costs – Firms typically do not order materials for each product unit,but rather, for entire batch runs. They may also order supply materials tocover a specific time period.Machine set up costs – Manufacturing firms do not set up production machines for eachproduct unit. They are set up instead for the production run of each productmodel.Product packaging costs – Manufacturers can sometimes package multiple product units in asingle package.

And, they may fill multiple packages in a single packaging run.Machine testing and calibration costs – Manufacturing firms perform these operationsregularly and often, but not for each individual product unit.Machine maintenance and cleaning costs – Firms normally perform these operations onlyafter producing multiple product units. Product Specific Cost SourcesForthis example, consider a firm that manufactures and sells two product models,Model A and Model B. Some aspects of A and B compare as shown in Table 1:  Table 1.  Product A and Product B compared.

Products Compared Product A Product B    Selling Price Higher price Lower price    Materials purchased More materials purchase orders, smaller orders Fewer materials purchase orders, larger orders    Production Runs More production runs, smaller runs Fewer production runs, larger runs   Mach. Set ups More machine set ups Fewer machine set ups   Packaging 1 Unit per package 4 Units per package   Direct labor More direct labor required Less direct labor required   Direct  materials Higher direct materials cost Lower direct materials cost Direct Costs Are the Same in traditional andActivity Based costingManagement must estimate the profitability of each product inorder to decide which products to produce and sell and how to price them. This, in turn, requires anunderstanding of the full cost per unit of each product. While the directcosts per unit may be found, easily, the indirect costs areless obvious. As a result, the firm will have to uncover product indirect coststhrough a costing methodology—either traditional cost allocation or activitybased costing.

 Direct costs are the same under both traditional costingand ABC. For direct costs, accountants measure a cost per product unit foreach direct cost category. The two costing methods differ, however, in the waythey assign indirect costs to products. Consequently, the twocosting approaches sometimes give quite different pictures of the profitabilityof individual products.

 The following example explains the advantages of usingABC.EXAMPLE:A company manufactures two products X and Y with thefollowing cost patterns. Product X, $ Product Y, $ Direct Material 27 24 Direct Labour @ $5 per hour 20 25 Variable Production Overhead @ 6$ per hour 3 6 Total 50 55 Production fixed overheads total $300,000 per month andare absorbed on the basis of direct labour hours. Budgeted labour hours are$25,000 per month.

The following is the activity based analysis carried out bythe company Activity Product X Product Y Total Cost ($) Set-ups 30 20 40,000 Material handling 30 20 150,000 Inspection 880 3,520 110,000 Budgeted production of X is 1,250 units and Y is 4,000 units.The company wants to make 20% profit on full production cost. Sale price is calculated using a full cost approach andactivity based costing.  ANSWERS:1) Full cost approach Product X, $ Product Y, $ Variable Cost 50 55 Fixed Production Overheads (300,000/25,000 = $12 per labour hour) 48 60 Total Cost 98 115 Profit margin @20% 20 23 Sale Price 118 138 2) Activity based costing Activity Product X Product Y Total Cost ($) Set-ups (30:20) 24,000 16,000 40,000 Material handling (30:20) 90,000 60,000 150,000 Inspection (880:3520) 22,000 88,000 110,000 Total 136,000 164,000 300,000 Budgeted units 1,250 4,000 Overhead per unit 109 41   Product X Product Y Variable Cost 50 55 Production Overheads 109 41 Total Cost 159 96 Profit margin @20% 32 19 Sale Price 191 115 Conclusion – Whenthe results of both approaches are compared we can see a huge difference insales price. This means that the company was making a loss on sale of product Xwhile it was over charging for product Y, which could lead to customerdissatisfaction and cause a drop in sales.    B The three major influences on pricing decisions are – Customers,Competitors and Costs .It is not necessarily true for all the time. For aone-time-only special order, the relevant costs are only those costs that willchange as a result of accepting the order.

In this case, full product costswill rarely be relevant. It is more likely that full product costs will berelevant costs for long-run pricing decisions. Four purposes of cost allocationare as follows -To provide information for economic decisions secondly To motivatemanagers and other employees thirdly To justify costs or compute reimbursementamounts and fourthly To measure income and assetsActivity-based costing helps managers in pricing decisions in twoways – It gives managers more accurate product-cost information for makingpricing decisions. Secondly It helps managers to manage costs during valueengineering by identifying the cost impact of eliminating, reducing, orchanging various activities. Two alternative approaches to long-run pricingdecisions are the following:1.     Market-based pricing, animportant form of which is target pricing. The market-based method asks, “Givenwhat our customers want and how our competitors will react to what we do, whatprice should we charge?      2.

     Cost-based pricing which asks, “What doesit cost us to make this product and, hence, whatprice should we charge that will recoup our costs and achieve a target returnon investment?”A target cost per unit is the estimated long-run cost per unit ofa product (or service) that, when sold at the target price, enables the companyto achieve the targeted operating income per unit Value engineering is asystematic evaluation of all aspects of the value-chain business functions, with the objective of reducing costswhile satisfying customer needs. Value engineering via improvement inproduct and process designs is a principal technique that companies use toachieve target cost per unit. A value-added cost is a cost that customersperceive as adding value, or utility, to a product or service. Examples arecosts of materials, direct labor, tools, and machinery. A non value-added costis a cost that customers do not perceive as adding value, or utility, to aproduct or service.

Examples of non value-added costs are costs of rework,scrap, expediting, and break down maintenance. No. It is important todistinguish between when costs are locked in and when costs are incurredbecause it is difficult to alter or reduce costs that have already been lockedin. Cost-plus pricing is a pricing approach in which managers add a markup tocost in order to determine price. Cost-pluspricing methods vary depending on the bases used to calculate prices.    C Managers at companies often look for betterways to figure out the cost of their products.

The company has three possiblemethods that can be used to allocate overhead costs to products—plant wideallocation, department allocation, and activity-based allocation (calledactivity-based costing).  Thechoice of an allocation method depends on how managers decide to group overheadcosts and the desired accuracy of product cost information. Groups of overheadcosts are called cost pools. Forexample, Hewlett Packard’s printerproduction division may choose to collect all factory overhead costs in onecost pool and allocate those costs from the cost pool to each product using onepredetermined overhead rate. Or company may choose to have several cost pools(perhaps for each department, such as assembly, packaging, and quality control)and allocate overhead costs from each department cost pool to products using aseparate predetermined overhead rate for each department. In general, the morecost pools used, the more accurate the allocation process.Plantwide Allocation The plantwideallocation method uses one predetermined overhead rate to allocateoverhead costs.

Regardless of the approach used toallocate overhead, a predetermined overhead rate is established for each costpool. The predetermined overhead rate is calculated as follows –  When activity-based costing is used, thedenominator can also be called estimated cost driver activity. One cost pool accounts for all overhead costs, andtherefore one predetermined overhead rate is used to apply overhead costs toproducts. where one predetermined rate—typically based on direct laborhours, direct labor costs, or machine hours—was used to allocate overheadcosts. Using SailRite Company as an example, assume annual overhead costs areestimated to be $8,000,000 and direct labor hours are used for the plantwideallocation base. Management estimates that a total of 250,000 direct laborhours are worked annually.

These estimates are based on the previous year’soverhead costs and direct labor hours and are adjusted for expected increasesin demand the coming year. The predetermined overhead rate is $32 per directlabor hour (= $8,000,000 ÷ 250,000 direct labor hours). Thus,  products are charged $32 in overhead costsfor each direct labor hour worked.Department AllocationAssumethe managers at a Company prefer a more accurate approach to allocatingoverhead costs to its two products.

As a result, they are considering using thedepartment allocation approach. The departmentallocation approach is similar to the plantwide approach except that costpools are formed for each department rather than for the entire plant, and aseparate predetermined overhead rate is established for each department. But,total estimated overhead costs will not change.

Instead, they will be brokenout into various department cost pools. This approach allows for the use ofdifferent allocation bases for different departments depending on what drivesoverhead costs for each department. For example, the Hull Fabricationdepartment at SailRite Company may find that overhead costs are driven more bythe use of machinery than by labor, and therefore decides to use machine hoursas the allocation base. The Assembly department may find that overhead costsare driven more by labor activity than by machine use and therefore decides touse labor hours or labor costs as the allocation base.

Assume that SailRiteis considering using the department approach rather than the plantwide approachfor allocating overhead. The cost pool in the Hull Fabrication department isestimated to be $3,000,000 for the year, and the cost pool in the Assemblydepartment is estimated at $5,000,000. The  total estimated overhead cost is still$8,000,000 (= $3,000,000 + $5,000,000). Machine hours (estimated at 60,000hours) will be used as the allocation base for Hull Fabrication, and directlabor hours (estimated at 217,000 hours) will be used as the allocation basefor Assembly. Thus two rates are used to allocate overhead (rounded to thenearest dollar) as follows: Hull Fabrication department rate: $50 per machine hour (= $3,000,000 ÷ 60,000 hours) Assembly department rate: $23 per direct labor hour (= $5,000,000 ÷ 217,000 hours)Theproducts going through the Hull Fabrication department are charged $50 inoverhead costs for each machine hour used.

Products goingthrough the Assembly department are charged $23 in overhead costs foreach direct labor hour used.    


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