How costs are classified in different types of organisations

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Costs are associated with all types of organizations business, non-business, manufacturing, retail and service. Generally, the kinds of costs that are incurred and the way in which these costs are classified depend on the type of organization involved.

In your assignment you should explain with examples (use dollar value in your examples):

How to measure cost behaviour (cost measurement)?

In management accounting, the classification and measurement of fixed and variable cost is based on a body of knowledge that involves a number of assumptions. In many cases, the usefulness of fixed and variable cost data depends on the validity of these assumptions. In order to avoid poor operating results and faulty decision-making that is likely to occur when false cost assumptions are made, the ability to recognize and measure cost behavior is essential. Various theories of Cost behavior are as follows :

Variable Cost - varies proportionately in total but remains constant on a per unit basis.

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a. True variable costs - proportionately variable (ex. Raw material) amount used directly increases as production increases by the same percentage.

b. Step variable costs - costs obtainable in large segments (ex. Labor costs of maintenance workers) and that increase or decrease in response to fairly wide changes in activity levels. NOTE: these costs are constant for a certain activity level (relevant range) and then vary in a step like fashion as volume increases.

2. Fixed Costs - remain constant in total but vary inversely on a per unit basis (if production increases, then per unit cost decreases; if production decreases, then per unit cost increases)

a. Committed fixed costs - relate to the investment in plant, equipment and the basic organizational structure of the firm (ex. Depreciation of building and equipment, real estate taxes, insurance, management salaries, etc.)

- are long term in nature

- cannot be reduced immediately over a short period of time without seriously impairing either the profitability or the long run goals of a firm.

b. Discretionary Fixed Costs ( Managed Fixed Costs )

- arise form annual decisions by management to spend in certain fixed costs areas (ex. Advertising, research, management development programs)

- short term in nature, usually a single year

- possible to cut back on certain costs for short periods of time with minimum disruptions to long term goals.

c. Semi variable or Mixed Costs - contains both variable and fixed costs elements

- at certain levels of activity mixed costs display the same characteristics as a fixed cost

- at certain levels they display same characteristic as a variable cost

- (examples: electricity, heat, telephone, maintenance, car rental,copy machine rental)

3. Direct or Indirect Costs

a. Direct Costs - can be physically traced to the particular segment under consideration (product line, sales territory, division, etc.)

b. Indirect Costs - must be allocated in order to be assigned to the segment under consideration (indirect cost is manufacturing overhead). NOTE: Indirect Costs are also called Common Costs.

4. Additional Cost Terms

a. Controllable Costs - if management at a certain level as the power to authorize and influence the cost

b. Noncontrollable Costs - if management at a certain level is unable to influence the incurrence of the cost.

c. Differential Cost - present under one alternative but is absent under an alternative course of action.

NOTE: Differential costs are also known as incremental costs.

d. Opportunity Cost - potential benefit that is lost or sacrificed whenzselecting one course of action makes it necessary to give up a different

course of action.

Opportunity cost is not recorded in the books of an organization, but is

considered in every decision.

e. Sunk Cost - already incurred and cannot be changed by any decision made now or in the future. An irrelevant cost in decision-making.

The econometrical model which is used to analyze costs is a model in which explanatory variable represents total costs and endogenous variables represent factors that influence their level. Production quantity is the most important factor which determines the level of total costs. Total costs consist of two parts:

total fixed costs, which appear independently of the production quantity (when production level is zero)

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total variable costs, which are dependent only on the production quantity

Cost Function :

K = F + VX

(Where K is total cost, F is Fixed Cost , V is Variable Cost and X is volume)

 What is cost accounting system and cost allocation? (Managerial Accounting)

Sol:Cost accounting is linked to tax accounting, financial accounting and managerial accounting because it is an important component of each discipline as cost accounting involves determining the cost of something, such as a product, a service, an activity, a project, or some other cost object. These costs are needed for several purposes. For example, the costs of products and services produced and sold are needed for both tax and external financial statements. In other words, tax and financial accounting depend on cost accounting to provide cost information. Information about costs is also needed for a variety of management decisions. For example, cost estimates are needed to determine whether or not a product or service can be produced and sold at a profit. Unit costs of a product (or service) are also needed for product pricing and product discontinuance decisions. In addition, accurate cost information is required to determine whether or not a company should make (produce) or buy the raw materials, parts and subassemblies that become part of its major products and services. From this perspective, cost accounting is perhaps underrated as a discipline since none of the other disciplines including tax accounting, financial accounting or managerial accounting could exist without cost accounting.

The costs associated with a manufacturing firm are separated into two broad categories. These include manufacturing costs and selling and administrative costs. This functional separation is important because each category of cost is treated differently in the accounting records. The different treatments are required to obtain proper matching.

Manufacturing Costs

There are three types of manufacturing costs. These include: 1) direct material or raw material, 2) direct labor, and 3) indirect manufacturing costs, or factory overhead. Direct material becomes the product, or becomes a part of the product. Direct labor converts the direct material into a finished product. Factory overhead represents all the other factory costs that cannot be directly identified with a particular product. This indirect category includes a variety of costs that are discussed in more detail in subsequent chapters. These three types of costs are also referred to as product costs, or inventorial costs, because they are capitalized in (or charged to) the inventory, i.e., they become assets.

Matching

Accountants capitalize manufacturing costs to obtain proper matching. The matching concept is pervasive in accrual accounting and requires that costs and benefits are matched or brought together on the income statement. In a production setting, the idea is to match the costs of producing a product (or service) against the benefits, i.e., revenue derived from the sale. When the inventory is sold, these costs are charged to an expense account referred to as cost of goods sold. At the end of the accounting period, cost of goods sold is closed to the income summary where, theoretically, matching takes place. Remember that unexpired costs represent assets. Expired costs represent expenses. When the inventory is sold, we say these costs have expired, i.e., the benefits to be obtained (from the effort that generated the costs) have been recognized. Thus, manufacturing costs become expenses when they reach cost of goods sold, but represent assets until the sale takes place.

Selling and Administrative Costs

In traditional accounting systems, selling and administrative costs are expensed in the period in which they are incurred. Theoretically, if there are future benefits associated with a cost, the cost should be capitalized as an asset rather than expensed. Certainly there are some future benefits associated with costs such as research and development, training, market promotion and advertising. However, these costs are expensed as incurred because it is difficult if not impossible to relate them to the future benefits. As a result, these costs are referred to as period costs.

COST BEHAVIOR AND PREDICTION

In addition to separating costs into categories such as direct and indirect and manufacturing and non-manufacturing, costs are also frequently identified by their behavior in relation to changes in an activity level. This separation is helpful for planning and budgeting purposes. The major types of costs, in terms of cost behavior, are: 1) variable costs, and 2) fixed costs, 3) semi-variable costs and 4) semi-fixed costs. These concepts are illustrated graphically in Exhibit 1-3 and discussed individually below.

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Variable Costs

Variable costs are those costs that vary with changes in the level of activity. Variable costs tend to increase at various rates that generate linear (straight line) or a variety of non-linear cost functions when the costs are plotted on a graph. The major activity that affects manufacturing costs is production volume, i.e., producing output. Production volume is frequently measured in terms of units produced, direct labor hours used, machine hours used, materials costs or some other production volume related measure. However, other activities that are not related to production volume might also be important in analyzing cost behavior. The recognition that non-production volume related activities also cause, or drive costs is a fundamental idea associated with activity based costing (ABC)

Fixed Costs

Fixed costs are defined as those costs that do not vary with changes in the activity level. However, this does not mean that fixed costs remain constant. If a production volume based measure is used as the activity, a cost that changes for some reason other than a change in production activity is considered fixed. This simply means that the cost is driven by a non-production volume related phenomenon. For example, property taxes are considered fixed in traditional cost accounting systems that are typically based on production volume related activities. However, property taxes change when the taxing authority changes the tax rate or reassesses the property. The idea to grasp is that the designation of a particular cost as fixed or variable can change when it is analyzed in relation to a different activity. It is also important to understand that the notion of fixed and variable costs is a short run concept. All costs tend to be variable in the long run.

Semi-Variable and Semi-Fixed Costs

Semi-variable costs are part fixed and part variable. There is a minimum cost (the fixed portion) and a variable portion that increases as activity increases. There are also semi-fixed costs that do not change continuously as the level of activity changes, but do increase in steps as activity increases beyond various levels. These costs are sometimes referred to as step cost and step functions. For example, a single production supervisor (who's salary normally represents a fixed cost) might be adequate until production reaches a certain level, then a second supervisor would need to be hired. Supervisory costs might be driven by the number of production shifts.

Cost accounting system requires five parts that include: 1) an input measurement basis, 2) an inventory valuation method, 3) a cost accumulation method, 4) a cost flow assumption, and 5) a capability of recording inventory cost flows at certain intervals. These five parts and the alternatives under each part are summarized in Exhibit 2-1. Note that many possible cost accounting systems can be designed from the various combinations of the available alternatives, although not all of the alternatives are compatible. Selecting one part from each category provides a basis for developing an operational definition of a specific cost accounting system.

1) INPUT MEASUREMENT BASES

The basis of a cost accounting system begins with the type of costs that flow into and through the inventory accounts. There are three alternatives including: pure historical costing, normal historical costing and standard costing.

Pure Historical Costing

In a pure historical cost system, only historical costs flow through the inventory accounts. Historical costs refers to the costs that have been recorded. The term actual costs is sometimes used instead, but the term "actual" seems to imply that there is one true cost associated with a particular output. But determining the cost of a product, or service requires many cost allocations, e.g., allocating the cost of fixed assets to time periods, and allocating indirect manufacturing costs, or overhead to products. Since there are many alternative allocation methods, (e.g., straight line or accelerated depreciation) the calculated cost of a unit of product or service simply represents an attempt to approximate the true cost.

Normal Historical Costing

Normal historical costing uses historical costs for direct material and direct labor, but overhead is charged, or applied to the inventory using a predetermined overhead rate per activity measure. Typical activity measures include direct labor hours, or direct labor costs. The amount of factory overhead charged to the inventory is determined by multiplying the predetermined rate by the actual quantity of the activity measure. The difference between the applied overhead costs and the actual overhead costs represents an overhead variance.

Standard Costing

In a standard cost system, all manufacturing costs are applied, or charged to the inventory using standard or predetermined prices, and quantities. The differences between the applied costs and the actual costs are charged to variance accounts as shown symbolically in the enlarged graphic below. The variances provide the basis for the concept of accounting control, that is somewhat different from the statistical control concept

2) FOUR INVENTORY VALUATION METHODS

The four inventory valuation methods that appear in Exhibit 2-1 are arranged in the order of the amount of cost that is traced to the inventory. The throughput method involves tracing the least amount of cost to the inventory, while the activity based method includes tracing the greatest amount of costs to the inventory. In direct (or variable) costing, a greater amount of cost is traced than in the throughput method, but a lesser amount than in the full absorption method. Direct costing and full absorption costing are the traditional methods, while the throughput and activity based methods are relatively new. These inventory valuation methods are very important because they control the manner in which net income is determined. As we shall see is this chapter and subsequent chapters, the amount of net income can vary substantially for different inventory valuation methods.

The Throughput Method

The throughput method was developed to complement a concept referred to as the theory of constraints. In this method only direct material costs are charged to the inventory. All other costs are expensed during the period. The concept is symbolized in the enlargement below. Sales, less direct material costs is referred to as throughput which reflects how the method got its' name. The throughput method does not provide proper matching (as defined by GAAP) because all manufacturing cost, other than direct material are expensed when incurred rather than capitalized in the inventory. Therefore, the throughput method is not acceptable for external reporting although advocates argue that it provides many advantages for internal reporting.

The Direct or Variable Method

In the direct (or variable) method, only the variable manufacturing costs are capitalized, or charged to the inventory. Fixed manufacturing costs flow into expense in the period incurred. This method provides some advantages and some disadvantages for internal reporting. However, it does not provide proper matching because the current fixed costs associated with producing the inventory are charged to expense regardless of whether or not the output is sold during the period. For this reason direct costing is not generally acceptable for external reporting.

The Full Absorption Method

Full absorption costing (also referred to as full costing and absorption costing) is a traditional method where all manufacturing costs are capitalized in the inventory, i.e., charged to the inventory and become assets. This means that these costs do not become expenses until the inventory is sold. In this way, matching is more closely approximated. All selling and administrative costs are charged to expense. Technically, full absorption costing is required for external reporting, although many companies apparently use something less than a pure full absorption costing system. The full absorption method is also frequently used for internal reporting. The second major section of this chapter compares the income statements for full absorption costing with those used for direct costing because they are by far the dominant methods.

The Activity Based Method

Activity based costing is a relatively new type of procedure that can be used as an inventory valuation method. The technique was developed to provide more accurate product costs. This improved accuracy is accomplished by tracing costs to products through activities. In other words, costs are traced to activities (activity costing) and then these costs are traced, in a second stage, to the products that use the activities. The concept of ABC is illustrated in the enlarged graphic below. Another way to express the idea is to say that activities consume resources and products consume activities. Essentially, an attempt is made to treat all costs as variable, recognizing that all costs vary with something, whether it is production volume or some non-production volume related phenomenon. Both manufacturing costs and selling and administrative costs are traced to products in an ABC system. Note that treating selling and administrative costs in this way is not acceptable for external reporting.

3) FOUR COST ACCUMULATION METHODS

Cost accumulation refers to the manner in which costs are collected and identified with specific customers, jobs, batches, orders, departments and processes. The center of attention for cost accumulation can be individual customers, batches of products that may involve several customers, the products produced within individual segments during a period, or the products produced by the entire plant during a period. The company's cost accumulation method, or methods are influenced by the type of production operation and the extent to which detailed cost accounting information is needed by management.

Job Order

In job order costing, costs are accumulated by jobs, orders, contracts, or lots. The key is that the work is done to the customer's specifications. As a result, each job tends to be different. For example, job order costing is used for construction projects, government contracts, shipbuilding, automobile repair, job printing, textbooks, toys, wood furniture, office machines, caskets, machine tools, and luggage. Accumulating the cost of professional services (e.g., lawyers, doctors and CPA's) also fall into this category. Chapter 4 illustrates a cost accounting system that includes normal historical costing as the basic cost system, full absorption costing as the inventory valuation method and job order costing as the cost accumulation method.

Process

In process costing, costs are accumulated by departments, operations, or processes. The work performed on each unit is standardized, or uniform where a continuous mass production or assembly operation is involved. For example, process costing is used by companies that produce appliances, alcoholic beverages, tires, sugar, breakfast cereals, leather, paint, coal, textiles, lumber, candy, coke, plastics, rubber, cigarettes, shoes, typewriters, cement, gasoline, steel, baby foods, flour, glass, men's suits, pharmaceuticals and automobiles. Process costing is also used in meat packing and for public utility services such as water, gas and electricity.

Back Flush

Back flush costing is a simplified cost accumulation method that is sometimes used by companies that adopt just-in-time (JIT) production systems. However, JIT is not just a technique, or collection of techniques. Just-in-time is a very broad philosophy, that emphasizes simplification and continuously reducing waste in all areas of business activity. JIT systems were developed in Japan and depend on the communitarian concepts of teamwork and continuous improvement. In fact, many of the assumptions, attitudes and practices of communitarian capitalism are included in the JIT philosophy.

One of the many goals of JIT systems is zero ending inventory. In a backflush cost system, manufacturing costs are accumulated in fewer inventory accounts than when using the job order or process cost methods. In fact, in extreme backflush systems, most of the accounting records are eliminated. The production facilities are also arranged in self contained manufacturing cells that are dedicated to the production of a single, or similar products. In this way more of the manufacturing costs become direct product costs and fewer cost allocations are necessary. Thus, more accurate costing is obtained in spite of the fact that the cost accumulation method is simplified. The just-in-time philosophy and related accounting methods are discussed in Chapter 8.

Hybrid, or Mixed Methods

Hybrid or mixed systems are used in situations where more than one cost accumulation method is required. For example, in some cases process costing is used for direct materials and job order costing is used for conversion costs, (i.e., direct labor and factory overhead). In other cases, job order costing might be used for direct materials, and process costing for conversion costs. The different departments or operations within a company might require different cost accumulation methods. For this reason, hybrid or mixed cost accumulation methods are sometime referred to as operational costing methods.

4) FOUR COST FLOW ASSUMPTIONS

A cost flow assumption refers to how costs flow through the inventory accounts, not the flow of work or products on a production line. This distinction is important because the flow of costs is not always the same as the flow of work. The various types of cost flow assumptions include: specific identification (e.g., by job), first in, first out, last in, first out and weighted average.

Costs flow through the inventory accounts by the job in a job order cost system which represents an example of specific identification. The requirements of the various jobs determines the timing of the cost flows. Simple jobs tend to move through the system faster than more complex jobs. The first-in, first-out (FIFO) and weighted average cost flow assumptions are used in process costing. Since costs are accumulated by the process or department in a process cost environment, a cost flow assumption is needed to determine the treatment of the beginning inventory. When FIFO is used, it is assumed that the units of product in the beginning inventory are finished first and transferred to the next department before any of the units that are started during the period. The group of units in the beginning inventory maintain their separate identity and prior period costs. However, when the weighted average cost flow assumption is used, the beginning inventory units lose their separate identity because they are lumped together with the units of product started during the period. Process costing tends to be fairly challenging, therefore you may find these introductory concepts to be confusing.

Although last-in, first-out (LIFO) is frequently used for tax reporting purposes, it is not normally used in the accounting records. For this reason, we consider the FIFO and weighted average cost flow assumptions in Chapter 5, but leave the LIFO cost flow assumption for courses that emphasize financial and tax reporting.

5) RECORDING INTERVAL CAPABILITY

Inventory records can be maintained on a perpetual or a periodic basis. Conceptually, the perpetual inventory method provides a company with the capability of maintaining continuous records of the quantities of inventory and the costs flowing through the inventory accounts. The periodic method, on the other hand, requires counting the quantity of inventory before inventory records can be updated. In the past, manufacturers tended to keep perpetual inventories, while retailers used the periodic method. However, today a variety of modern point of sale devices and dedicated microcomputer software are readily available to provide any company with perpetual inventory capability.

Cost allocation is the assigning of a common cost to several cost objects. For example, a  company might allocate or assign the cost of an expensive computer system to the three main areas of the company that use the system. A company with only one electric meter might allocate the electricity bill to several departments in the company.Allocation implies that the assigning of the cost is somewhat arbitrary. Some people describe the allocation as the spreading of cost, because of the arbitrary nature of the allocation. Efforts have been made over the years to improve the bases for allocation. In manufacturing, the overhead allocations have moved from plant-wide rates to departmental rates, from direct labor hours to machine hours to activity based costing. The goal is to allocate or assign the costs based on the root causes of the common costs instead of merely spreading the costs.

Direct costs can be physically traced to each department.Indirect costs must be allocated. Many companies develop allocation methods to assign service department costs to the producing departments. All organizations accumulate costs for their products or services for financial reporting purposes. An accounting system will assign to a department's output all its direct costs plus all the indirect costs allocated to it. A cost driver that has a logical, cause-effect relationship to the cost will be used as a cost-allocation base.

Linking costs with cost objectives is accomplished by selecting cost drivers.When used for allocating costs, a cost driver is often called a cost-allocationbase. Major costs, such as newsprint for a newspaper and direct professionallabour for a law firm, may each be allocated to departments, jobs, and projects on an item-by-item basis, using obvious cost drivers such as tonnes of newsprint consumed or direct-labour-hours used. Other costs, taken one at a time, are not important enough to justify being allocated individually. These costs are pooled and then allocated together.

A cost pool is a group of individual costs that is allocated to cost objectives using a single cost driver. For example, building rent, utilities cost, and janitorial services may be in the same cost pool because all are allocated on the basis of square metres of space occupied. Or a university could pool all the operating costs of its registrar's office and allocate them to its colleges on the basis of the number of students in each faculty. In summary, all costs in a given cost pool should be caused by the same factor. That factor is the cost driver. Many different terms are used by companies to describe cost allocation in practice. You may encounter terms such as allocate, attribute, reallocate, trace, assign, distribute, redistribute, load, burden, apportion, and reapportion, which can be used interchangeably to describe the allocation of costs to cost objectives.

The allocation of costs is necessary when the linkage between the costs and the cost objective is indirect. In this case, a basis for the allocation, such as direct-labour-hours or tonnes of raw material, is used even though its selection is arbitrary. A cost allocation base has been described as incorrigible, since it is impossible to objectively determine which base perfectly describes the link between the cost and the cost objective. Given this subjectivity in the selection of a cost-allocation base, it has always been difficult for managers to determine "When should costs be allocated?" and "On what basis should costs be allocated?" The answers to these questions depend on the principal purpose or purposes of the cost allocation.

Costs are allocated for three main purposes:

1. To obtain desired motivation. Cost allocations are sometimes made to influence management behaviour and thus promote goal congruence and managerial effort. Consequently, in some organizations there is no cost allocation for legal or internal auditing services or internal management consulting services because top management wants to

encourage their use. In other organizations there is a cost allocation for such items to spur managers to make sure the benefits of the specified services exceed the costs.

2. To compute income and asset valuations. Costs are allocated to products and projects to measure inventory costs and cost of goods sold. These allocations frequently service financial accounting purposes. However, the resulting costs are also often used by managers in planning, performance evaluation, and to motivate managers, as described above.

3. To justify costs or obtain reimbursement. Sometimes prices are based directly on costs, or it may be necessary to justify an accepted bid. For example, government contracts often specify a price that includes reimbursement for costs plus some profit margin. In these instances, cost allocations become substitutes for the usual working of the marketplace in setting prices.

.

 What is activity based costing? (ABC system)?

Sol :

In the past, the vast majority of departments used direct labour hours as the only cost driver for applying costs to products. But direct labour hours is not a very good measure of the cause of costs in modern, highly automated departments. Labour-related costs in an automated system may be only 5 percent to 10 percent of the total manufacturing costs and often are not related to the causes of most manufacturing overhead costs. Therefore, many companies are beginning to use machine-hours as their cost-allocation base. However, some managers in modern manufacturing firms and automated service companies believe it is inappropriate to allocate all costs based on measures of volume. Using direct labour hours or cost-or even machine hours-as the only cost driver seldom meets the cause/effect criterion desired in cost allocation. If many costs are caused by non volume-based cost drivers, Activity-Based Costing (ABC) should be considered

Activity Based Costing (ABC) is an economic model that identifies the cost pools or activity centers in an organization and assigns costs to cost drivers based on the number of each activity used. It identifies activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption by each: it assigns more indirect costs (overhead) into direct costs.In this way, an organization can precisely estimate the cost of individual products and services so they can identify and eliminate those that are unprofitable and lower the prices of those that are overpriced.

In a business organization, the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers. It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing, identification and measurement of process improvement initiatives.

Activity-based costing (ABC) systems first accumulate overhead costs for each of the activities of an organization, and then assign the costs of activities to the products, services, or other cost objects that caused that activity. To establish a cause-effect relationship between an activity and a cost object, cost drivers are identified for each activity. Consider the following activities and cost drivers for the Belmont manufacturing plant department of a major appliance producer:

ACTIVITY COST DRIVER

Production set-up : Number of production runs

Production control : Number of production process changes

Engineering : Number of engineering change orders

Maintenance : Number of machine hours

Power : Number of kilowatt hours

Cost-driver activity is measured by the number of transactions involved in the activity. For example, in this case, engineering costs are caused by change orders (a document detailing a production change that requires the attention of the engineering department). Therefore, engineering costs are assigned to products in proportion to the number of engineering change orders issued for each product. If the production of microwave ovens caused 18 percent of the engineering change orders, then the ovens should bear 18 percent of the costs of engineering. Because transactions are often used for assigning costs of activities to cost objects, activity-based costing is also called transaction-based accounting or transaction costing.

Cost drivers are related to the activities, they occur on several levels :

Unit level drivers which assume the increase of the inputs for every unit that is being produced.

Batch level drivers which assume the variation of the inputs for every batch that is being produced.

Product level drivers which assume the necessity of the inputs to support the production of each different type of product.

Facility level drivers are the drivers which are related to the facility's manufacturing process. Users of the ABC system will need to identify the activities which generate cost and then match the activities to the level bases used to assign costs to the products.

While using the ABC system, the activities which generate cost must be determined and then should be matched to the level drivers used to assign costs to the products. The implementation of the ABC system has the following steps:

Identifying the activities such as engineering, machining, inspection…etc.

Determining the activity costs

Determining the cost drivers such as machining hours, number of setups, engineering hours…,etc.

Collecting the activity data

Computing the product cost

Advantages of Activity Based Costing :  Traditional costing methods divide costs into product costs and period costs.  The period costs include selling, general, and administrative items and are charged against income in the period incurred.  Product costs are the familiar direct materials, direct labor, and factory overhead, these costs are traced/allocated to production under both job and process costing techniques.  However, some managers reject this methodology as conceptually flawed.  For example, it can be argued that the cost of a finished product should include not only the cost of direct materials, but also a portion of the administrative cost necessary to buy the raw materials (e.g., many companies have a separate administrative unit in charge of all purchasing activity, like writing specifications, obtaining bids, issuing purchase orders, and so forth).  Conversely, the cost of a plant security guard is part of factory overhead, but some managers fail to see a correlation between that activity and a finished product; after all, the guard will be needed no matter how many units are produced.

Activity-based costing attempts to overcome the perceived deficiencies in traditional costing methods by more closely aligning activities with products.  This requires abandoning the traditional division between product and period costs, instead seeking to find a more direct linkage between activities, costs, and products.  This means that products will be charged with the costs of manufacturing and nonmanufacturing activities.  It also means that some manufacturing costs will not be attached to products.  This is quite a departure from traditional thought.

Another benefit of ABC is that a product is only charged with the cost of capacity utilized.  Idle capacity is isolated and not charged to a product or service.  Under traditional approaches, some idle capacity may be incorporated into the overhead allocation rates, thereby potentially distorting the cost of specific output.  This may limit the ability of managers to truly understand and identify the best business decisions about product pricing and targeted production levels. 

Limitations of Activity Based Costing :  One limitation of ABC is that external reporting must be based on traditional absorption costing methods.  Absorption costing requires the traditional division between product costs and period costs, with inventory absorbing all of the manufacturing costs and none of the period costs.  As a result, ABC may produce results that differ from those required under generally accepted accounting principles (GAAP).  Therefore, ABC is usually viewed as supplemental in nature.  It is used for internal management decision making, but it may not be suitable for public reporting (note: when the aggregate financial statement results do not differ materially between ABC and other methods, ABC can be used for both internal and external purposes).

The fact that ABC is not GAAP usually means that a company that wishes to benefit from ABC must develop two costing systems -- one for external reporting and one for internal management.  Some companies feel they have enough to do without working through two costing methods!  Another disadvantage of ABC is that it is usually more involved than other approaches.  Rather than applying all factory overhead on some simple basis such as labor hours, it requires the development of numerous cost pools that must be individually allocated.  In other words, ABC is a more intensive technique, and the costs to implement it may not be worth the trouble.

The Reality of Activity Based Costing:  Despite the limitations of ABC, many companies utilize the method.  A quick internet search will reveal millions of references to the approach, including various management consultant groups praising its merits.  As you might suspect, many important business decisions about the fate of a product are based on assessment of profitability, and profitability boils down to comparing sales price to cost.  Because the sales price is pretty well set, the "decision" about how to determine a product's cost is obviously quite significant in assessing the bottom-line profitability for an individual product or service.

Now, for a single-product company with fairly stable inventory levels, this is much to do about nothing.  Traditional and ABC methods will get to about the same end point.  But, for multi-product/service firms, the arbitrary allocation of costs can pretty much "make or break" the perceived profitability of each product or service.  As companies have grown larger and more diverse in output, there has been an accompanying concern about how costing occurs.  Arguably, product diversification has been a major contributing factor into the management accountant's pursuit of alternative costing devices like ABC.

Another driver of ABC-type approaches has been the advent of computer technology.  Before modern information systems, it was very expensive to manipulate data.  Most firms were perfectly content to live with simple approaches that allocated factory overhead on a single basis.  The ease with which data can be managed under a sophisticated information system greatly reduces the cost and error rate associated with ABC.  It is not surprising that the method's popularity is inversely related to data processing costs.

You are required to

(a) calculate the total costs for each product if all overhead costs are absorbed on a labour hour basis;

(b) calculate the total costs for each product, using activity based costing;

Sol :

Traditional direct labour hours basis

The direct labour hour rate is $10, calculated by dividing the total overheads by the total number of direct labour hours:

total overheads

total number of direct labour hours

3,375,000

337,500

$10 per dlh

Since we are using the direct labour hour rate method for the absorption of all overheads, the product costs per unit must be:

The overheads recovered are, of course:

Direct labour hour rate x number of direct labour hours per product

For product A, for example, the calculation is:

$10 per dlh x 2.5 dlh = $25

ABC method

As we said above, to apply the ABC method, we need to identify cost drivers for two stages:

1 cost drivers tracing the costs of inputs into cost pools; and

2 cost drivers tracing the cost pools into product costs

The workings that follow illustrate clearly how such cost drivers work through the ABC system in these two stages: an initial overhead rate or amount being further subdivided according the needs of the situation.

workings:

The calculations for each of the rates to be used are:

The machine hour rate is the only rate that is what we might call a traditional rate. All of the other rates we are about to use involve a two stage process. We will see the elements of these two stages as we get to them.

machine hour overhead rate

$1,000,000

= $1.5326

652,500 machine hours

This rate is used as normal.

For the set up costs, we first devise a rate to tell us the cost per set up: total set up overheads divided by the number of set ups: in this case, this is

$75,000

= $1,153.85

65 production runs

We will return to this rate shortly.

All of the other rates are calculated similarly. Hence they will be presented now without further comment.

Receiving rate

$900,000

= $1,097.56

 

820 receipts

 

Packing rate

$650,000

= $8,666.67

 

75 deliveries

 

Engineering rate

$750,000

= $5,769.23

 

130 production orders

 

All of this information can now be put together into a cost per unit statement as follows.

The final stage in the whole ABC procedure, as far as product cost determination is concerned is to find out the costs per unit. The cost per unit statement follows, and then we will work through the calculations.

Machine overheads are found by multiplying the machine hour rate by the number of machine hours per product per unit:

machine hour rate $1.5326 x

machine hours

5

3

7.5

gives

$7.6628

4.5977

11.4943

The set up costs rate we have already is the rate per machine set up, the cost per unit is calculated by multiplying the rate per set up by the number of set up per product and then dividing the results by the total number of units per product:

Set up cost per set up $1153.85 x

No of set ups

5

10

50

gives

$0.0010

0.0059

0.0592

Set up cost per set up $1,153.85 x

No of set ups

5

10

50

gives

$5,769.25

11,538.50

57,692.50

these values are then divided by the number of units per product to give us the cost per unit:

$0.0641

0.3846

3.8462

Thus , according to my opinion Activity Based costing method scores over the traditional methods as it gives a more realistic absorption of indirect cost as it uses the activity as base which is major contributor to the costs concerned unlike the traditional cost which uses a single base which may or may not have any relation with the costs incurred for a particular activity. Traditional method assumes that all costs incurred in proportion to the machine hour or labor hour which tends to give misappropriate allocation of cost. In traditional method, it might happen that a particular Product does not consume a particular activity, but it costs might get appropriated over it. In ABC it will not happen. Thus, ABC is better approach as it gives proper allocation of costs which in result leads to better decision making by the management.