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Overhead Costs
Ordering
Setting Inspecting
and Assem- Super-
Up Machining and Painting
Receiving bling vising
Machines Cost Pool Testing Cost Pool
Materials Cost Pool Cost Pool Cost Pool
Cost Pool
Cost Pool
Products
Illustration of Traditional Costing versus ABC
*Predetermined overhead rate times direct labor hours (Rs. 30 x 1 hr. = Rs. 30)
Unit Costs under ABC
Activity-based costing involves the following steps:
1 Identify the major activities that pertain to the
manufacture of specific products and allocate
manufacturing overhead costs to activity cost pools.
2 Identify the cost drivers that accurately measure each
activity’s contributions to the finished product and
compute the activity-based overhead rate.
3 Assign manufacturing overhead costs for each activity
cost pool to products using the activity-based overhead
rates (cost per driver).
Identifying Activities
A well designed activity-based costing system starts with
an analysis of the activities performed to manufacture a
product. This analysis should identify all resource-
consuming activities.
Estimated
Activity Cost Pools Overhead
Setting up machines Rs.300,000
Machining 500,000
Inspecting 100,000
Total Rs.900,000
Identifying Cost Drivers
After costs are allocated to the activity cost pools, the cost
drivers for each activity cost pool must be identified. To
achieve accurate costing, a high degree of correlation must
exist between the activity cost driver and the actual
consumption of the activity cost pool.
• The cost drivers identified by Atlas and their total expected
use per activity cost pool are shown below:
Atlas Company
Expected Use of
Cost Drivers
Activity Cost Pools Cost Drivers per Activity
Setting up machines Number of setups 1,500 setups
Machining Machine hours 50,000 machine hours
Inspecting Number of inspections 2,000 inspections
Computing Overhead Rates
Expected Use of
Estimated Cost Drivers
Activity Cost Pools
Setting up machines
Overhead
Rs.300,000
per Activity
1,500 setups
= Activity-Based
Overhead Rates
Rs.200 per setup
Machining 500,000 50,000 machine hours Rs.10 per machine hour
Inspecting 100,000 2,000 inspections Rs.50 per inspection
Total Rs.900,000
Assigning Overhead Costs to Products under
ABC
Expected Use
of Cost Drivers
Expected Use of
per Product
Cost Drivers
Activity Cost Pools Cost Drivers per Activity The Boot The Club
Setting up machines Number of setups 1,500 setups 500 1,000
Machining Machine hours 50,000 machine hours 30,000 20,000
Inspecting Number of inspections 2,000 inspections 500 1,500
Assigning Overhead Costs to Products under
ABC
To assign overhead costs to each product, the activity-
based overhead rates are multiplied by the number of cost
drivers expected to be used per product.
• The assignment of Atlas Company’s estimated annual
overhead cost to The Boot is shown below. Estimated
overhead assigned to The Club is shown on the next slide.
Atlas Company: The Boot
Expected Use Activity-Based
of Cost Drivers Overhead Cost
x = Assigned
Activity Cost Pools per Product Rates
Setting up machines 500 Rs.200 Rs.100,000
Machining 30,000 Rs. 10 300,000
Inspecting 500 Rs. 50 25,000
Total assigned costs (a) Rs.425,000
Units produced (b) 25,000
Overhead cost per unit (a) (b) Rs.17
Assigning Overhead Costs to Products under
ABC
Atlas Company: The Club
Expected Use Activity-Based
of Cost Drivers Overhead Cost
x = Assigned
Activity Cost Pools per Product Rates
Setting up machines 1,000 Rs.200 Rs.200,000
Machining 20,000 Rs. 10 200,000
Inspecting 1,500 Rs. 50 75,000
Total assigned costs (a) Rs.475,000
Units produced (b) 5,000
Overhead cost per unit (a) (b) Rs.95
You are required to calculate the over head cost per unit of each
product A & B based on:
•Traditional method of charging overhead
•ABC Method
• Industrial Tools Ltd. produces four products A, B, C and D. The
following information is related to a particular period:
Particulars A B C D
Outputs(units) 100 200 500 2000
No. Of production runs 2 3 6 20
No. Of set ups 2 4 6 8
Labour hour per unit 1 2 1 2
Machine hour per unit 1 3 2 1
Material cost per unit (Rs.) 100 300 200 400
Direct Labour hour cost per 25 25 25 25
unit(Rs.)
Calculate the total cost per unit for each of the four products
using ABC.
Benefits of ABC
The primary benefit of ABC is more accurate product
costing because:
• ABC leads to more cost pools used to assign overhead
costs to products. Instead of one pool and one driver,
numerous activity cost pools with more relevant cost
drivers are utilized.
• ABC leads to enhanced control over overhead costs.
Many overhead costs can be traced directly to activities.
Thus, managers become more aware of their
responsibility to control the activities that generate costs.
Benefits of ABC
• ABC leads to better management decisions. More
accurate product costing helps in setting selling prices
and in deciding to whether make or buy components.
Activity-based costing does not, in and of itself, change
the amount of overhead costs, but it does in certain
circumstances allocate those costs in a more accurate
manner. And, if the score-keeping is more realistic,
more accurate, and better understood, managers
should be able to better understand cost behavior and
overall profitability.
Limitations of ABC
Although ABC systems often provide better product cost data
than traditional volume-based systems, there are limitations.
• ABC can be expensive to use. ABC systems are more complex
than traditional costing systems. There is a cost to identifying
multiple activities and applying numerous cost drivers.
• Some arbitrary allocations continue. Even though more
overhead costs can be assigned directly to products, certain
overhead costs remain to be allocated by means of some
arbitrary volume-based cost driver.