An action analysis report shows what costs have been assigned to the cost object, such as a product or customer, and how difficult it would be to adjust the cost if there is a change in activity. Note that the Red margin at the bottom ofExhibit 7A–5, ($49,500), is exactly the same as the product margin for the custom compass housings inExhibit 7–10in the chapter. The activity rates that will be used for assigning overhead costs to products and customers are computed inExhibit 7–6. The ABC team determined the total activity for each cost pool that would be required to produce the company’s present product mix and to serve its present customers. For example, the ABC team found that400new product designs are required each year to serve the company’s present customers. The activity rates are computed by dividing thetotalcost for each activity by itstotalactivity.
It is often very difficult to change a company’s accounting system because it is deeply embedded within complex computer programs that have evolved over many years. The product margins for stanchions and compass housings would be a negative three hundred sixty dollars and three hundred eighty seven dollars, respectively.
A particularly high cost for an activity may trigger efforts to improve the way the activity is carried out in the organization. Implementing an activity-based costing system is a major project that requires substantial resources. And once implemented, an activity-based costing system is more costly to maintain than a traditional costing system—data concerning numerous activity measures must be periodically collected, checked, and entered into the system. The benefits of increased accuracy may not outweigh these costs. Third, an ABC system such as the one described in this chapter does not conform to generally accepted accounting principles . It is possible to adjust the ABC data at the end of the period to conform to GAAP, but that requires more work.
The results of the interviews at Classic Brass are displayed inExhibit 7–4. For example, factory equipment depreciation is distributed20%to Customer Orders,60%to Order Size, and20%to the Other cost pool. According to the estimates made by the production manager, 60% of the total available machine time was used to actually process units to fill orders. Each customer order requires setting up, which also requires machine time. This activity consumes 20% of the total available machine time and is entered under the Customer Orders column.
Advantages of Activity Based Costing System
This is a unit-level activity because each unit requires some of these resources. The process by which overhead costs are assigned to activity cost pools in an activity-based costing system. A per unit cost is calculated by dividing the total dollars in each activity cost pool by the number of units of the activity cost drivers. As an example to calculate the per unit cost for the purchasing department, the total costs of the purchasing department are divided by the number of purchase orders. Once the per unit costs are all calculated, they are added together, and the total cost per unit is multiplied by the number of units to assign the overhead costs to the units.
- The ABC system assigned product design costs to a product only if it required product design work.
- This underscores the importance of top management support and the full participation of line managers, as well as the accounting staff, in any activity-based costing initiative.
- These costs would have to be eliminated or the resourcesshifted to the constraintto have any benefit to the company.
- The action analysis report makes it clear where costs would have to be adjusted in the organization as a result of an action.
All 400 product designs related to custom compass housings; none related to standard stanchions. Producing 30,000 standard stanchions required 17,500 machine-hours and producing 1,250 custom compass https://business-accounting.net/ housings required 2,500 machine-hours, for a total of 20,000 machine-hours. As the regulation ended in the banking industry, costing became more important as banks competed with one another.
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The “Other” activity cost pool consists of the costs of idle capacity and organizationsustaining costs. You have been asked to complete the firststage allocation of costs to the activity cost pools. Activity rates in activitybased costing are computed by dividing costs from the firststage allocations by the activity measure for each activity cost pool. The next step in preparing an action analysis report is to label each cost using an ease of adjustment code. Green costs adjust more or less automatically to changes in activity level without any action by managers. For example, direct materials cost would automatically change in response to changes in activity level without management action.
- The Customer Relations activity is a customer-level activity and the Other activity is an organization-sustaining activity—neither activity is caused by products.
- They felt that the benefits of increased accuracy would not be great enough to justify the higher cost of implementing and maintaining the more detailed costing system.
- Activity-based costing attempts to trace through these relationships to identify how products and customers affect costs.
- Theease of adjustment codereflects how easily the cost could be adjusted to changes in activity.4“Green” costs are those costs that would adjust more or less automatically to changes in activity without any action by managers.
- Activity‐based costing assumes that the steps or activities that must be followed to manufacture a product are what determine the overhead costs incurred.
This chapter extends that idea to show how activity-based costing can be used to aid decisions that potentially affect fixed costs as well as variable costs. In the secondstage allocation in activitybased costing, activity rates are used to apply costs to products, customers, and other cost objects. The cost of opening an account at the Avon branch is much higher than at the lowest cost branch ($35 versus $24). On the other hand, the cost of processing deposits and withdrawals is lower than at the lowest cost branch ($2 versus $2). And the cost of processing other customer transactions is somewhat higher at the Avon branch ($57 versus $48). The other branches may have something to learn from Avon concerning processing deposits and withdrawals and Avon may benefit from learning about how some of the other branches open accounts and process other transactions.
Traditional Costing Vs. Activity-Based Costing
Determine the unit product costs of the Deluxe and Standard products under the activity-based costing system. Prepare an action analysis report showing the profitability of the Peregrine Golf Club. Include direct materials and direct labor costs in the report. Classify each of the costs or activities above as unit-level, batch-level, product-level, customer-level, or organization-sustaining. In this case, customers are golf courses, products are models of the golf cart, a batch is a specific order from a customer, and units are individual golf carts. The company just completed a single order from CineMax Entertainment Corporation for 2,400 custom seats. The selling price was $137.95 per seat, the direct materials cost was $112.00 per seat, and the direct labor cost was $14.40 per seat.
This suggests that there is no longer a direct link between the level of direct labor and overhead. Indeed, when a company automates, direct labor is replaced by machines; a decrease in direct labor is accompanied by an increase in overhead. This violates the assumption that overhead cost is directly proportional to direct labor. Overhead cost appears to be driven by factors such as product diversity and complexity as well as by volume, for which direct labor has served as a convenient measure. Whenever possible, directly trace overhead costs to activities and cost objects. The manufacturing and nonmanufacturing overhead costs for Classic Brass are as shown on your screen. Notice, the shipping costs can be directly traced to customer orders.
ABC data should be linked to how people are evaluated and rewarded. If traditional non-ABC data continues to be used to evaluate employee performance, it sends the signal that ABC data is unimportant and can even be ignored. ABC assigns both manufacturing and nonmanufacturing costs to products. Traditional cost systems assign only manufacturing costs to products. For example, ABC systems can assign sales commissions, shipping costs, and warranty repair costs to specific products.
Exhibit 7–4and many of the other exhibits in this chapter are presented in the form of Excel spreadsheets. All of the calculations required in activity-based costing can be done by hand. It is unlikely that any other company would use exactly the same activity cost pools and activity measures that were selected by Classic Brass.
However, many of these nonmanufacturing costs are also part of the costs of selling, distributing, and servicing specific products. For example, commissions paid to salespersons, shipping costs, and warranty repair costs can be easily traced to individual products. In this chapter, we will use the termoverheadto refer to nonmanufacturing costs as well as to indirect manufacturing costs. In activity-based costing, products are assigned all of the overhead costs—nonmanufacturing organization-sustaining activities is another term for as well as manufacturing—that they can reasonably be supposed to have caused. In essence, we will be determining the entire cost of a product rather than just its manufacturing cost. The focus inChapters 3and4was on determining just the manufacturing cost of a product. The fourth step in the implementation of activity-based costing is calledsecond-stage allocation.In thesecond-stage allocation, activity rates are used to apply overhead costs to products and customers.
- For example, if a custom product requires additional phone support staff to take customer orders, then this cost should be included as part of the product cost.
- The costs of idle capacity should not be assigned to products in activity-based costing.
- However, note that100%of the factory building lease has been assigned to the Other cost pool.
- Using these data and the data fromExhibit 7–9, the design team created the customer profitability report shown inExhibit 7–11.
- They believed that ABC created a “turkeys queuing for Christmas syndrome” because they were expected to volunteer information to help create a cost system that could eventually lead to their demise.
- Exhibit 7A–6summarizes all of the steps required to create both an action analysis report as illustrated in this appendix and an activity analysis as shown in the chapter.
- The process by which overhead costs are assigned to activity cost pools in an activity-based costing system.