Managerial Accounting - Learning Objective 4.2: Activity-Based Costing (ABC)

Introduction to Activity-Based Costing (ABC)

• ABC (Activity-Based Costing): A method to compute predetermined overhead allocation rates and allocate indirect costs.
• More accurate than plant-wide and departmental rates.
• Widely used in modern companies due to advances in software.
• It helps in cost accounting by handling small and large numbers accurately.

Activity-Based Management (ABM)

• ABM (Activity-Based Management): Focuses on primary activities performed by a business to enhance profits.
• Uses cost information for decision-making.
• ABC is a part of ABM to determine the cost of activities.

Identifying Activities

• Activities: Tasks that are performed within the company, not product-specific (e.g., Quality Inspection, Warranty, Shipping).
• Build up overhead cost pools by activity.

Cost Pools and Allocation

• Overhead Cost Pools: Separate pools for each activity (Quality Inspection, Warranty, Shipping, etc.).
• Allocate overhead from these pools to each product.
• More specific than departmental rates due to different rates of activities within departments.

Allocation Base and Cost Drivers

• Each activity has an allocation base (e.g., number of inspections for Quality Inspection).
• Cost Driver: Direct logical connection to total activity cost (typically volume-related).

Steps to Develop an ABC System

1. Identify Activities: Estimate total indirect costs.
2. Identify Allocation Base: Estimate total quantity of each allocation base.
3. Compute Predetermined Overhead Allocation Rate by Activity: Instead of by department or plant-wide.
4. Allocate Overhead to Cost Objects: Use the predetermined rates to allocate costs to products (e.g., premium and standard tablets).

Example Calculation

• Activities: Setup, Production, Testing.
• Setup Allocation: $400 per batch (e.g., 20 batches for standard, 25 batches for premium).
• Production Allocation: 1.76 per direct labor hour.
• Multiply the allocation base by the actual quantity used (20 batches for standard tablet = $8,000 setup overhead).

Per Unit Cost Calculation

• Standard Tablet: $268.80 per unit.
• Premium Tablet: $428.80 per unit.
• These values differ from previous plant-wide and departmental rate calculations.

Comparison of Costing Methods

• ABC is the most accurate, followed by departmental rates, and then plant-wide rates.
• Using incorrect methods can result in over or under costing, affecting pricing and profit projections.

Additional Example

• Review allocation rates and overhead for different product lines (e.g., regular and super products).

Conclusion

• ABC provides detailed and accurate cost allocation, crucial for precise costing and pricing strategies.