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Activity-based costing

Activity-based costing. Introduction. In the past, overhead costs were relatively small, and the problems arising from inappropriate overhead allocations were not so significant

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Activity-based costing

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  1. Activity-based costing

  2. Introduction • In the past, overhead costs were relatively small, and the problems arising from inappropriate overhead allocations were not so significant • But nowadays, factories are highly automated, resulting in increasing depreciation charges, maintenance cost and machinery set-up cost • Errors in overhead absorption may seriously affect the management decisions

  3. The Activity-based costing (ABC) system is developed to provide better approach for assigning overheads to products and computing product costs

  4. Limitation of traditional costing • Traditional systems adopt volume-relatedallocation bases e.g. direct labour hour and machine hour. However, different resources are used in non-volume related support activities e.g. materials ordering, machinery set-up, production scheduling and first-item inspection

  5. Traditional systems allocate overheads to products in proportion to their productionvolumes. High overheads are allocated to the high-volume products. As a result, the high-volume simple products may be over-costed while the low-volume complex products may be under-costed

  6. Introduction to Activity-based costing • The activity-based costing system asserts that products create demand for activities and activities bring about the costs to be incurred

  7. What steps? • Identity major activities performed by the business • Calculate the total cost of each activity over the period (i.e. cost centre or cost pool) • Determine the cost driver for each activity. Cost drivers are the factors which cause the activity cost pool to increase • Calculate the cost driver rate (i.e. total cost in a cost pool/ no. of cost driver) • Assign the cost-centre overheads to the products according to their cost driver rates

  8. Example

  9. Martin Ltd. Manufactures tow products. Product A is a high- Volume product while Product B is a low-volume product. Details of production are shown as follows: Product A Product B Materials cost per unit $130 $130 Direct Labour cost per hour $50 $50 Direct machine hour per unit 4 hrs 4 hrs Direct labour hour per unit 2 hrs 2 hrs Output 10 100 No. of purchase orders 3 4 No. of set up 40 80 Overhead costs are shown as follows: $ Factory power 6600 Machinery set-up costs 4800 Materials handling and dispatch 2100 13500

  10. Required Calculate the product costs using: (a) Absorption costing based on machine hour (b) Activity-based costing

  11. (a) Absorption costing based on machine hour Product A Product B $ $ Direct Materials 130 130 Direct labour 100 100 Overheads ($13500*4/440) 123 123 Product cost per unit 353 353 4*10+100*4

  12. (b) Activity based Costing Product A Product B $ $ Direct Materials 130 130 Direct labour 100 100 Overheads Factory power (6600*4/440) 60 60 Machinery set-up cost (4800*40/120*1/10) 160 (4800*80/120*1/10) 32 Materials handling & dispatch (2100*3/7*1/10) 90 (2100*4/7*1/100) 12 Product cost per unit 540 334

  13. Cost driver analysis • Traditional costing systems assume that all overheads increase in proportion to the number of units produced • In a complex manufacturing environment, a greater number of cost drivers are used for cost accumulation

  14. Costs are incurred for each unit • Produced. For example, • Direct materials • Direct labour • Factory power Unit-level activities Cost per unit • Costs are incurred for each batch • produced. For example, • Purchase orders • Production runs • Number of inspection Batch-level activities Cost per unit in batch • Costs are incurred to support a product • Types or process. For example, • Engineering change orders • Product development • Process design • Test routines Production -level activities Cost per unit in batch

  15. Advantages of Activity-based costing • More realistic cost assignment • Better decision-making • Better control over cost

  16. Limitation of Activity-based costing • Difficult to apportion common costs • Difficult to implement • Inconsistent with the generally accepted accounting principles (GAAP)

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