Treatment of Costs Under Activity
Based Costing (ABC) System:
Non-manufacturing Costs and
Activity Based Costing (ABC) System:
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.
Manufacturing Costs and Activity
Based Costing (ABC):
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.
The Cost of Idle Capacity and
Activity Based Costing (ABC)
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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