Activity Based Costing (abc) Accounting Help

In we illustrated how manufacturing overhead costs may be applied to. production using an overhead application rate based on a single cost driver (such as direct labor hours). This’ approach works well for many companies, especially if all products are manufactured in a similar manner, But now consider, a company that uses very different processes us manufacturing different products. The factors that drive overhead costs may vary greatly among different  product lines. Such companies may benefit from ‘activity-based costing (called ABC).

In ABC. many different activity bases (or cost drivers) are used in applying overhead costs to products. Thus ABC recognizes the special overhead considerations of each product line. Overhead allocations tend to be more useful. In addition. ABC provides management with information about the cost of performing various overhead activities.

How’ ABC Works The first step in ABC is to subdivide overhead costs into a number of activity cost pools.

Each cost pool represents a type of overhead activity. such as building maintenance, purchasing materials, heating the factory, and machinery repairs. The overhead costs in each pool then are applied to production separately. In short, ABC  separately identifies and makes use of the most appropriate cost driver for applying each category of overhead costs. The Benefits of ABC Measurement of unit costs may assist managers in several ways.

For example, it helps them in setting sales prices and in evaluating the profitability of each product line. ABC also helps managers to better understand what activities drive overhead costs. This understanding may inspire them to develop new operating procedures that may reduce overhead costs. ABC Versus a Single Application Rate:

A Comparison Assume that Master File, Inc., makes two lines of file cabinets: (I) metal file cabinets. sold through office supply outlets for commercial use, and (2) wooden file cabinets, sold .through fine furniture stores for home use. In a typical year, the company produces and sells approximately 42,000 metal cabinets and 9,000 wooden cabinets. Total manufacturing .overcloud ut this level of production averages $249,600 per year and is currently allocated to products at a rate of $/.60 per direct labor hour (DLH).us computed below. sets its selling prices /60% of total manufacturing costs, Thus the company chinchillas fur $61.12 lotus unit cost of $3H.20 X 160%) und its wooden fur unit cost of $’ 17.80 X 160’if). At these prices, the metal cub per unit than comparable cabinets sold by Muster File’s comp However, the price of wooden cabinets uvcr41gcs $10 more per unit on the market. ” Cilen Brown. M.lstci marketing director, believes Hill sales of the wooden cab have sulfured result of the competency’s pricing policy. He recently hired u con evaluate how prices urc set. Scott drafted the following memo summarize

Assume that Master File decides to implement ABC as suggested by the consultant. Remember that the company’s total overhead costs at normal levels of production aver- , age $249,600 per year. Let us assume that these overhead costs fall into two broad categories: (I) Maintenance Department costs and (2) utilities costs. The diagram on the following page illustrates how these costs may be allocated to Master File’s product lines using ABC.’ Maintenance Department Costs The Maintenance Department incurs approximately $180.000 of Master File’s total overhead costs. The department has five full-time employs,

Three employees arc responsible for repair work, such as fixing the large cutling and bending machines used to manufacture metal file cabinets. The other two employees are responsible for set-up activities, such as adjusting machinery prior to each production run.Using ABC, ,Master· File identifies repair activities and set-up activities as separate activity cost pools: Thus each pool is assigned a portion of the department’s $180.000 in total costs.

Management believes that the number of employees engaged in each activity is the most-significant cost driver of the Maintenance Department’s total costs sing the number of employees as an activity base, $108,000 is assigned to the repair cost 11:72.000 is assigned to the set-up cost pool, OJ’ computed below.

The costs assigned to each cost pool must now he allocated to Master File’s two product lines. Management has determined that the number {~f work orders is the most appropriate activity base for allocating the repair (‘OS! pool to each product line. The Maintenance Department receives approximately 250 repair work orders each year, Of these, about 200 are related to the metal cabinet line, and 50 are related to the wooden.

Cabinet line, In The number of production runs is determined to be the most significant driver of setup costs. Thus production runs will serve as the activity base for allocating the set-up cost pool to each product line. Master File schedules approximately 200 production runs each year. Of these, about 150 are for metal cabinets, and.50 are for wooden cabinets. Thus. in  atypical year. the metal cabinets are allocated ‘approximately $54,000 from the set-up cost pool. whereas wooden cabinets are allocated about $18,000, computed below.

Posted on November 23, 2015 in Accounting Systems for Measuring Costs

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