Treatment of Costs Under Activity Based Costing (ABC) System:
Learning Objectives:
- How manufacturing, non-manufacturing and
idol capacity costs are treated under activity based costing system?
Contents:
-
Non-manufacturing costs and activity based costing
-
Manufacturing costs and activity based costing
-
Costs of idle capacity and activity based costing
In traditional
cost accounting system, only
manufacturing costs are assigned to products. Selling, general, and
administrative expenses are treated as period costs and are not assigned to
products. However, many of these non-manufacturing costs are also part of the
costs of producing, selling, distributing, and servicing products. For
example commissions paid to salespersons, shipping costs, and warranty repair
costs can be easily traced to individual products. The term overhead is usually
used to refer non-manufacturing costs as well as indirect manufacturing costs
under an ABC system. In activity based costing, products are assigned all of
the costs-manufacturing as well as non-manufacturing-that they can reasonably be
supposed to have caused. The entire cost of the product is determined rather than just
its manufacturing cost.
In traditional
cost accounting, all manufacturing costs
are assigned to products-even manufacturing costs that are not caused by the
products. For example, a portion of the factory security guard's wages would be
allocated to each product even though the guards wages are totally unaffected by
which products are made or not made during a period. In activity based costing, cost is assigned to a product only if there is a good reason to believe
that the cost would be affected by decisions concerning the product.
Plant wide Overhead Rate:
Normally overhead rate, called plant
wide overhead rate or
predetermined overhead rate, is used throughout an entire factory and that the allocation
base is direct labor hours or machine hours. This simple approach to overhead
assignment can result in distorted unit product costs when it is used for
decision making purposes.
When cost systems were collected in
1800s, cost and activity data had to be collected by hand and all calculations
were done with paper and pen. Consequently, the emphasis was on simplicity.
Companies often established a single overhead cost pool for an entire facility
or department. Direct labor was the obvious choice as an allocation base for
overhead costs. Direct labor hours were already being recorded for the purposes
of determining wages and direct labor time spent on tasks was often closely
monitored. In the labor-intensive production processes of that time, direct
labor was a large component of product costs--larger than it is today. Moreover,
managers believed direct labor and overhead costs were highly correlated. (Two
variables, such as direct labor and overhead costs, are highly correlated if
they tend to move together.) And finally most companies produced a very limited
variety of products that required similar resources to produce, so in fact there
was probably little difference in the overhead costs attributable to different
products. Under these conditions, it was not cost effective to use a more
elaborate costing system.
Conditions have changed. Many
companies now sell a large variety of products and services that consume
significantly different overhead resources. Consequently, a costing system that
assigns essentially the same overhead cost to every product may no longer be
adequate. Additionally, many managers now believe that overhead overhead costs
and direct labor are no longer highly correlated and that other factors drive
overhead costs.
On an economy wide basis,
direct labor and overhead costs have been moving in opposite directions for a long
time. As a percentage of total cost, direct labor has been declining, whereas
overhead has been increasing. Many tasks that used to be done by hand are now
done with largely automated equipment--a component of overhead. Companies are
creating new products and services at an ever-accelerating rate that differ in
volume, batch size and complexity. Managing and sustaining this product
diversity requires many more overhead resources such as production schedulers
and production design engineers, and may of these overhead resources have no
obvious connection with direct labor. Finally, computers, bar code readers, and
other technology have dramatically reduced the cost of collecting and
manipulating data--making more complex (and accurate) costing systems such as
activity based costing much less expensive to build and maintain.
Nevertheless,
direct labor remains a
viable base for applying overhead to products in some companies--particularly
for external reports. Direct labor is an appropriate allocation base for
overhead when overhead costs and
direct labor are highly correlated. And indeed,
most companies throughout the world continue to base overhead allocations on the
direct labor or machine hours. However if factory wide costs do not move in
tandem with factory wide direct labor or machine hours, some other means of
assigning overhead costs must be found or product costs will be distorted.
Departmental Overhead Rates:
Rather than use a plant wide
overhead rate (predetermined
overhead rate), many companies have a system in which each department has
its own overhead rate (multiple
predetermined overhead rates). The nature of the work performed in each
department will determine the department's allocation base. For example,
overhead costs in machining department may be allocated on the basis of the
machine-hours incurred in that department. In contrast, the overhead costs in an
assembly department may be allocated on the basis of direct labor-hours incurred
in that department.
Unfortunately, even departmental
overhead rates will not correctly assign overhead costs in situations where a
company has a range of products that differ in volume, batch size, or complexity
of production. The reason is that the departmental approach usually relies on
volume as the factor in allocating overhead cost to products. For example, if
the machining department's overhead is applied to products on the basis of
machine-hours, it is assumed that the department's overhead costs are caused by,
and are directly proportional to, machine-hours. However, the department's
overhead costs are probably more complex than this and are caused by a variety
of factors, including the range of products processed in the department, the
number of batch setups that are required, the complexity of the products, and so
on. Activity based costing is a technique that is designed to reflect these
diverse factors more accurately when costing products. It attempts to accomplish
this goal by identifying the major activities such as batch setups, purchase
order processing, and so on, that consume overhead resources and thus cause
costs. An activity is any event that causes the consumption of overhead
resources. The costs of carrying out these activities are assigned to the
products that cause the activities.
In traditional cost accounting, predetermined overhead
rates are computed by dividing budgeted overhead costs by a measure of budgeted
activity such as budgeted direct labor hours. This results in applying the costs
of unused, or idle capacity to products, and it results in unstable unit
product cost. In contrast to traditional cost accounting, in activity
based costing system, products are charged for the costs of capacity they use and not
for the costs of capacity they do not use. The costs of idle capacity is not
charged to products in activity based costing system. This results in more
stable unit costs and is consistent with the objective of assigning only those
costs to products that are actually caused by the products. Instead of assigning
the costs if idle capacity to products, in activity based costing system these
costs are considered to be
period costs that flow through to the
income
statement as an expense of the current period. This treatment highlights the
cost of idle capacity rather than burying it in inventory and
cost of goods sold.
Real Business Example:
In Business |
Activity Based Costing (ABC) Changes the Focus
Euclid Engineering makes parts and
components for the big automobile manufacturers. As a result of its ABC
study, Euclid's managers "discovered that the company was spending more
in launching new products than on direct labor expenses to produce
existing products. Product development and launch expenses were 10% of
expenses, where as direct labor costs were only 9%. Of course, in the
previous direct labor cost system, all attention had been focused on
reducing direct labor costs. . . Product development and launch costs
were blended into the factory overhead rate applied to products based on
direct labor costs. Now Euclid's manager realized that they had a major
cost reduction opportunity by attacking the production launch cost
directly."
The new information produced by the ABC
study also helped Euclid in its relations with customers. The detailed
breakdown of the costs of design and engineering activities helped
customers to make trade-offs, with the result that they would often ask
that certain activities whose costs exceeded their benefits be skipped.
Source: Robert S. Kaplan and Robin
Cooper, Cost & Effect: Using Integrated Cost Systems to Drive
Profitability and Performance (Boston: Harvard Business School Press,
1998), pp. 219-222. |
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