Topic 6 Chapter 5 - Activity Based Coating (ABC) System Notes

Topic 6: Chpt 5 (mco, sect B & C) Activity-based costing (ABC) system Relatively low-level significant costs Follow a three-stage procedure to assign overhead costs to products Stage 1: Identify activities, assign costs to activities, and identify cost drivers Tasks as associated with the ABC system Identification of cost pools Identification of cost drivers Calculation of cost driver rates Four broad categories of activity Unit-level activity: Any activity that is carried out for each unit of production. The cost incurred increases in proportion to the number of units produced. Batch-level activity: Any activity that is carried out for each batch of products. The cost incurred increases with the number of batches, but not necessarily in proportion to the number of units in each batch. Product-sustaining activity: This category encompasses activities that are required to support an entire product line but are not directly related to individual units or batches. Facility-level activity: These activities are not directly linked to specific products or batches but are necessary for the overall operation of the facility. Examples include depreciation, property taxes, plant maintenance, and insurance. Stage 2: Identify the unit-level, batch-level, product-sustaining, and facility-level drivers Unit-level drivers: Direct labor hours, machine hours Batch-level drivers: Number of setups, number of inspections Product-sustaining drivers: Number of products, number of parts Facility-level drivers: Square footage, number of employees Stage 3: Assign overhead costs to products Calculate the cost driver rate for each activity Multiply the cost driver rate by the number of cost drivers used by each product Add the overhead costs assigned to each product to determine the total product cost Why traditional volume- and system-based cost drivers distort product costs Inaccuracies in the use of a single volume-based cost driver Ignoring activity-based costing (ABC) Non-value-added activities are operations that are either unnecessary or inefficient Activity-based costing systems often reveal processes that are inefficient or wasteful Over costing by traditional systems If combining manufacturing overhead costs using a single cost driver like direct labor hours, with the ABC system, more accurate product costs can be determined The company's high sales products are overcosted Product diversity creates costing problems because diverse products tend to utilize manufacturing activities in different ways   Overhead costs that are not incurred at the unit level create costing problems because such costs do not vary with traditional allocation bases like direct labor hours or machine hours   Product line diversity & a large proportion of manufacturing overhead Compared with traditional systems, activity-based costing is preferred when a company has a lowest degree of correlation ABC can be used to analyze issues like product variety, special packaging and handling, and shipping and collecting Order processing, machine processing, and product inspection costs of a Standard unit and an Enhanced unit Activity Standard Enhanced Order processing $50,000 $60,000 Machine processing $252,000 $320,000 Product inspection $8,000 $12,000 Total $310,000 $392,000 The company, which uses activity-based costing, has identified five activities and related cost drivers. Each activity, its budgeted cost, and related cost driver is identified below:   Activity Cost Cost Driver Order processing $250,000 Number of orders Machine processing $1,400,000 Machine hours Product inspection $80,000 Number of inspections Setup $360,000 Number of setups General factory $440,000 Direct labor hours   The following information pertains to the three product lines for next year: Product Orders Machine hours Inspections Setups Standard 2,000 30,000 200 65 Enhanced 3,000 40,000 300 80 Deluxe 4,000 50,000 400 100 Cost driver rates for activity-based costing: Order processing cost per order = $250,000 / 9,000 orders = $27.78 per order Machine processing cost per machine hour = $1,400,000 / 120,000 machine hours = $11.67 per machine hour Product inspection cost per inspection = $80,000 / 900 inspections = $88.89 per inspection Setup cost per setup = $360,000 / 145 setups = $2,482.76 per setup General factory cost per direct labor hour = $440,000 / 120,000 direct labor hours = $3.67 per direct labor hour Unit product cost of Standard: Order processing cost = 2,000 orders * $27.78 per order = $55,560 Machine processing cost = 30,000 machine hours * $11.67 per machine hour = $350,100 Product inspection cost = 200 inspections * $88.89 per inspection = $17,778 Setup cost = 65 setups * $2,482.76 per setup = $161,479.40 General factory cost = 36,000 direct labor hours * $3.67 per direct labor hour = $132,120 Total unit product cost of Standard = $717,037.40 / 2,000 units = $358.52 per unit Unit product cost of Enhanced: Order processing cost = 3,000 orders * $27.78 per order = $83,340 Machine processing cost = 40,000 machine hours * $11.67 per machine hour = $466,800 Product inspection cost = 300 inspections * $88.89 per inspection = $26,667 Setup cost = 80 setups * $2,482.76 per setup = $198,620.80 General factory cost = 48,000 direct labor hours * $3.67 per direct labor hour = $176,160 Total unit product cost of Enhanced = $951,588.80 / 3,000 units = $317.19 per unit Unit product cost of Deluxe: Order processing cost = 4,000 orders * $27.78 per order = $111,120 Machine processing cost = 50,000 machine hours * $11.67 per machine hour = $583,500 Product inspection cost = 400 inspections * $88.89 per inspection = $35,556 Setup cost = 100 setups * $2,482.76 per setup = $248,276 General factory cost = 60,000 direct labor hours * $3.67 per direct labor hour = $220,200 Total unit product cost of Deluxe = $1,200,652 / 4,000 units = $300.16 per unit Comparison of traditional costing and ABC: Product Traditional cost per unit ABC cost per unit Standard $181 $358.52 Enhanced $198 $317.19 Deluxe $230 $300.16 Conclusion: The Enhanced product is overcosted by the traditional costing system, while the Standard product is undercosted. ABC provides a more accurate picture of product profitability.