Activity Based Costing Step by step

Summary

In this managerial accounting episode, Michael McLaughlin explores activity-based costing (ABC), contrasting it with traditional costing methods. ABC provides a more accurate cost allocation by identifying activities that drive overhead costs and using activity rates for allocation. Despite its accuracy, ABC's implementation can be challenging due to the need for maintaining dual cost systems, extensive data analysis, and potential resistance from employees. The video humorously illustrates these concepts with a Santa's toy factory example, highlighting the importance of accurate costing for business decision-making.

Takeaways

• 🔍 Activity-Based Costing (ABC) is a cost system that measures the cost of providing goods or services, calculates product line profitability, and performs customer profitability analysis.
• 📊 Traditional cost systems use a single volume-based cost driver like machine hours or direct labor hours to allocate overhead, which can distort product costs if the cost driver isn't correlated with overhead.
• 🚀 ABC stands out for its accuracy by identifying activities that cause overhead and allocating costs based on cause and effect relationships, rather than a single arbitrary cost driver.
• 📈 With ABC, overhead is grouped into cost pools based on activity types, activity rates are calculated for each pool, and these rates are used to assign overhead costs to products, customers, or departments.
• 🎯 ABC allows for a more accurate comparison of product profitability by considering the specific activities that drive overhead costs for each product.
• 🛠️ The implementation of ABC can be complex and time-consuming, requiring interviews with employees to identify cost pools and activities.
• 💼 Companies may choose not to use ABC due to the cost and effort of maintaining two cost systems, the potential for employees to overstate their activity times, and the large amount of data that needs to be analyzed.
• 📋 ABC might include non-manufacturing costs or exclude certain manufacturing costs from product costs, which is not typically allowed in financial statements under U.S. GAAP or IFRS.
• 👮‍♂️ Manufacturers adopting ABC may need to maintain two separate cost systems: one for external reporting and another for internal decision-making.
• 🚫 Despite its benefits, some executives may not find ABC worth the hassle due to the challenges in implementation and data management.

Q & A

What is Activity-Based Costing (ABC)?

Activity-Based Costing (ABC) is a cost system used to measure the cost of providing a good or service, calculate the profitability of a company's product lines, and perform customer profitability analysis. It stands out for its accuracy in allocating overhead costs based on cause and effect relationships rather than a single volume-based cost driver.

Why might traditional cost systems provide distorted product costs?

Traditional cost systems might provide distorted product costs because they rely on a single volume-based cost driver like machine hours or direct labor hours to allocate overhead, which can lead to inaccuracies if these drivers aren't closely related to actual overhead costs.

How does automation affect the relevance of traditional cost systems?

Increased automation means that overhead accounts for a greater proportion of companies' costs. This makes the traditional cost systems less relevant as they are less effective in accurately allocating overhead costs, which are now a significant part of total costs.

What is the main difference between ABC and traditional cost systems?

The main difference is that ABC identifies the activities that cause overhead to be incurred, groups overhead into cost pools based on activity type, calculates activity rates for each cost pool, and then uses these rates to assign overhead costs to cost objects. Traditional systems, on the other hand, use a single cost driver to allocate overhead.

Can you provide an example of how ABC is applied?

Yes, in the script, Santa's toy manufacturing company uses ABC to allocate overhead costs to teddy bears and dolls. It identifies activities causing overhead, assigns costs to cost pools, calculates activity rates, and then allocates costs to products, revealing that dolls are more expensive to produce than teddy bears.

What is a two-stage allocation in the context of ABC?

A two-stage allocation in ABC involves first allocating costs to cost pools and then using activity rates to allocate the costs of products. This method ensures that costs are assigned based on the activities that drive them, rather than a single arbitrary cost driver.

Why might a company choose to include non-manufacturing costs in ABC?

A company might include non-manufacturing costs in ABC to get a more accurate and relevant cost per unit of a product. For example, warranty costs or sales commissions might be included to reflect the true cost of producing and selling a product.

Why would a manufacturer need to maintain two separate cost systems?

A manufacturer might need to maintain two separate cost systems to comply with financial reporting standards like U.S. GAAP or IFRS for external reporting, while using ABC for internal decision-making to get more accurate cost information.

What are some reasons companies might not adopt ABC?

Companies might not adopt ABC due to the cost of maintaining two cost systems, the time-consuming process of identifying cost pools, potential overstatement of time spent on activities by employees, the large amount of data generated that requires analysis, and the difficulty of implementing ABC, especially if there is resistance from employees.

What is the significance of the phrase 'never give your bank password to someone dressed as Santa' in the context of the script?

The phrase is a humorous way to conclude the script and emphasize the importance of accurate cost information. It serves as a reminder to be cautious and not to be fooled by appearances, just as one should not rely on inaccurate cost systems for business decisions.

How does ABC help in pricing products accurately?

ABC helps in pricing products accurately by providing a more precise allocation of overhead costs to products. This ensures that the cost figures used for pricing are meaningful and reflect the true cost of production, avoiding situations where products are priced at a loss.