Semester 1 Week 3 PP (Activity-based Costing) Flashcards
What are the different costs for different purposes?
- For inventory valuation and profit measurement the aim is to allocate costs between cost of goods sold (COGS) and inventories.
In order to meet financial reporting requirements, it may not be necessary to accurately trace costs individual products.
Instead, an accurate allocation is required only at the aggregate level between inventories and COGS. - Providing information for decision-making.
However, for decision-making more accurate product costs are required so that we distinguish between unprofitable and profitable products.
Here, valuation of inventory is not based necessarily on manufacturing costs. We need also to consider the Relevant non-manufacturing costs.
What is the Need for a Cost Accumulation System in Generating Relevant Information for Decision Making
- Many indirect costs are relevant for decision making (e.g., costs of support functions).
- An attention-directing information system is required that periodically identifies those unprofitable products that require more detailed special studies.
- Product decisions are not independent.
What are the types of cost systems?
Direct costing systems.
Traditional absorptions costing systems.
Activity-based costing systems.
What is the Direct Costing System?
Only direct costs are assigned to cost objects.
Indirect costs are not assigned to cost objects so that only contributions to indirect costs are reported.
Periodic profitability analysis would thus be used to highlight negative or low contribution products.
Appropriate where the majority of costs are direct.
What are Indirect Costing Systems?
Traditional costing systems: Use unsophisticated methods to allocate indirect costs to cost objects.
ABC systems: Use sophisticated methods to allocate indirect costs to cost objects.
Trade-off of Sophistication of Cost Systems
Different cost information is required for inventory valuation and decision-making but most companies use a single database and extract different costs for different purposes.
Companies can choose to maintain their database using costing systems that vary on a continuum from simplistic to sophisticated (the choice should be based on costs
A Comparison of Traditional and ABC Systems, what are some similarities and differences?
Both use two-stage allocation process.
* First stage - traditional systems allocate costs to departments; ABC to activities
* Second stage - traditional systems rely on a small number of volume-based cost drivers
- ABC systems use only cause-and-effect cost drivers
- ABC - separate cost driver rates for support departments
The major distinguishing features of ABC systems are that within the two-stage allocation process they rely on:
1. A greater number of cost centres.
2. A greater number and variety of second stage cost drivers.
By using greater number of cost centres and different types of cost drivers that cause activity resource consumption and assigning costs to cost objects on the based of cost driver usage, ABC systems more accurately measure the resources consumed by cost objects.
Traditional cost systems tend to report less accurate costs because they use cost drivers where no cause-and-effect relationships exist to assign support costs to cost objects.
When are traditional systems appropriate?
Traditional systems are appropriate when:
Direct costs were the dominant costs.
Indirect costs were relatively small (small fraction).
Information costs were high.
There is a lack of intense global competition.
A limited (narrow) range of products was produced.
What are Volume-based and Non-Volume Based Cost Drivers?
In contrast to traditional costing systems, ABC systems use both volume-based and non-volume-based cost drivers.
Volume-based cost drivers assume that a product’s consumption of overhead resources is directly related to units produced.
Typical volume-based cost drivers include units of output, direct labour hours and machine hours.
Appropriate for measuring the consumption of expenses such as machine energy costs, depreciation related to machine usage, indirect labour employed in production centres etc.
Non-Volume-based drivers: not performed each time a unit of the product or service is produced.
Consider, for example, two activities – setting up a machine and reengineering products.
The number of set-ups does not depend on number of units.
Re-engineering costs may depend on the number of engineering work orders and not the number of units produced.
Appropriateness is justified because activities are performed each time a unit of product/service.
Traditional costing systems use volume-based second stage drivers (e.g., direct labour and machine hours), but if volume bases are not the cause of indirect costs reported costs will be misleading.
Thus, using volume-based cost drivers to assign non-volume related overhead costs can result in the reporting of distorted product costs.
The extent of distortion depends: (1) on what proportion of total overhead costs the non-volume overheads represent and (2) the level of product diversity.
Hence, two conditions are therefore necessary for product cost distortion:
1. Non-volume related overhead costs are a large proportion of total overhead costs; and
2. Product diversity applies.
Where these conditions exist, traditional product costing systems can result in the over costing of high volume products and undercosting of low volume products.
Products HV (a high-volume product) and LV (a low-volume product) are two of several products produced by a company. HV is made in large batches and LV is made in small batches. HV consumes 30% of (Direct Labour Hours) DLHs and LV consumes 5% but each product consumes 15% of the batch-related indirect costs. The traditional system uses DLHs as the cost driver and the ABC system uses the number of batches processed. All overheads (total = £1m) are batch-related.
How do you design ABC systems?
- Identify the major activities that take place in an organization.
reasonable level of aggregation based on cost versus benefit criteria.
influenced by total cost of activity centre and ability of a single cost driver to provide a satisfactory determinant of the cost of the activity.
- Assign costs to cost pools/cost centres for each activity.
Include direct and indirect costs.
Resource cost drivers used to assign indirect costs.
Reliability of cost information will be reduced if arbitrary allocations are used
- Identify the cost drivers for each activity.
Activity drivers should:
(a) provide a good explanation of costs of each activity pool.
(b) be easily measurable
(c) the data should be easy to obtain and identifiable with the product.
Transaction and duration drivers.
- Assign the cost of activities to products according to the product’s demand for activities.
What are the classifications of manufacturing activities?
Unit-level activities:
1. Each time a unit is produced.
2. Consumed in proportion to the number of units produced or sold.
Batch-related activities:
1. Each time a batch of goods is produced.
2. Vary with the number of batches made.
Product/service sustaining activities:
1.Performed to enable the production of individual products or services.
Facility-sustaining activities:
1. Performed to support the organization as a whole.
2. Common to all products and services.
Consumption Rates:
What is the Consumption ratio?
Activity Rates
Activity-Based Unit Costs
ABC and Traditional Costs side by side (see answer)
