Ch 4 Activity Based Costing
Activity Based Costing
Accounting 2020
Professor Richard McDermot
Traditional Costing Systems
• Product Costs
– Direct labor
– Direct materials
– Factory Overhead
• Period Costs
– Administrative expense
– Sales expense
Appear on the income statement when goods are sold, prior to that time they are stored on the balance sheet as inventory.
Appear on the income statement in the period incurred.
Traditional Costing Systems
• Product Costs
– Direct labor
– Direct materials
– Factory Overhead
• Period Costs
– Administrative expense
– Sales expense
Direct labor and direct materials are easy to trace to products.
The problem comes with factory overhead. Traditional Costing Systems
• Typically used one rate to allocate overhead to products. • This rate was often based on direct labor dollars or direct labor hours.
• This made sense, as direct labor was a major cost driver in early manufacturing plants.
Problems with Traditional Costing
Systems
• Manufacturing processes and the products they produce are now more complex.
• This results in over-costing or under-costing.
– Complex products are not allocated an adequate amount of overhead costs.
– Simple products get too much.
Today’s Manufacturing Plants
•
•
•
•
Are more complex
Are often automated
Often make more than one product
Use proportionately smaller amount of direct labor making direct labor a poor allocation base for factory overhead.
When the manufacturing process is more complex:
• Then multiple allocation bases should be used to allocate overhead expense.
• In such situations, managers need to consider using activity based costing
(ABC).
ABC Definitions
• Activity based costing is an approach for allocating overhead costs.
• An activity is an event that incurs costs.
• A cost driver is any factor or activity that has a direct cause and effect relationship with the resources consumed.
ABC Steps
• Overhead cost drivers are determined.
• Activity cost pools are created.
– A activity cost pool is
Accounting 2020
Professor Richard McDermot
Traditional Costing Systems
• Product Costs
– Direct labor
– Direct materials
– Factory Overhead
• Period Costs
– Administrative expense
– Sales expense
Appear on the income statement when goods are sold, prior to that time they are stored on the balance sheet as inventory.
Appear on the income statement in the period incurred.
Traditional Costing Systems
• Product Costs
– Direct labor
– Direct materials
– Factory Overhead
• Period Costs
– Administrative expense
– Sales expense
Direct labor and direct materials are easy to trace to products.
The problem comes with factory overhead. Traditional Costing Systems
• Typically used one rate to allocate overhead to products. • This rate was often based on direct labor dollars or direct labor hours.
• This made sense, as direct labor was a major cost driver in early manufacturing plants.
Problems with Traditional Costing
Systems
• Manufacturing processes and the products they produce are now more complex.
• This results in over-costing or under-costing.
– Complex products are not allocated an adequate amount of overhead costs.
– Simple products get too much.
Today’s Manufacturing Plants
•
•
•
•
Are more complex
Are often automated
Often make more than one product
Use proportionately smaller amount of direct labor making direct labor a poor allocation base for factory overhead.
When the manufacturing process is more complex:
• Then multiple allocation bases should be used to allocate overhead expense.
• In such situations, managers need to consider using activity based costing
(ABC).
ABC Definitions
• Activity based costing is an approach for allocating overhead costs.
• An activity is an event that incurs costs.
• A cost driver is any factor or activity that has a direct cause and effect relationship with the resources consumed.
ABC Steps
• Overhead cost drivers are determined.
• Activity cost pools are created.
– A activity cost pool is