Solutions to Assignments
MMPC - 004 - Accounting for Managers
Solutions to Question No. 2
Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities.
Let's discuss activity based costing by looking at two products manufactured by the same company. Product 124 is a low volume item which requires certain activities such as special engineering, additional testing, and many machine setups because it is ordered in small quantities. A similar product, Product 366, is a high volume product—running continuously—and requires little attention and no special activities. If this company used traditional costing, it might allocate or "spread" all of its overhead to products based on the number of machine hours. This will result in little overhead cost allocated to Product 124, because it did not have many machine hours. However, it did demand lots of engineering, testing, and setup activities. In contrast, Product 366 will be allocated an enormous amount of overhead (due to all those machine hours), but it demanded little overhead activity. The result will be a miscalculation of each product's true cost of manufacturing overhead. Activity based costing will overcome this shortcoming by assigning overhead on more than the one activity, running the machine.
Activity based costing recognises that the special engineering, special testing, machine setups, and others are activities that cause costs—they cause the company to consume resources.
Under ABC, the company will calculate the cost of the resources used in each of these activities. Next, the cost of each of these activities will be assigned only to the products that demanded the activities. In our example, Product 124 will be assigned some of the company's costs of special engineering, special testing, and machine setup. Other products that use any of these activities will also be assigned some of their costs. Product 366 will not be assigned any cost of special engineering or special testing, and it will be assigned only a small amount of machine setup.
How to determine the cost under ABC
Activity-based costing includes the following steps:
- Identify activities that are required to complete a product.
- Trace costs to activities and objects and then assign them to different pools.
- Assign specific drivers to each pool, like an hour or unit.
- Calculate cost driver's rates by dividing overhead costs by total cost drivers.
- Divide the total overhead of each pool by total cost drivers to get the cost driver rate of each.
- Multiply your cost driver rate by the number of cost drivers.
Benefits of ABC
1. It gives you a realistic and more accurate production cost of specific items
Activity-based costing gives managers more accurate production costs. This can help businesses make more informed decisions about which products to produce or help them find cheaper methods of production. It can also help when determining pricing for individual products.
In addition to having a clearer understanding of the manufacturing costs, the process of gathering the data is also easy with activity-based costing. Most management members can identify the costs of each activity once they have the necessary data. This may also help with making production decisions that affect pricing.
2. It allows you to assign specific overhead costs to more expensive products
Instead of assigning an equal value to all products, you can allocate the necessary budget in each area when using activity-based costing. Some products may be costlier to produce, depending on their indirect costs. This can also help with identifying costs that apply to more than one pool of manufacturing products, which can make resources more valuable.
3. It allows you to evaluate the efficiency of productions and make improvements
This method allows managers to assign value to indirect costs, treating them as if they were direct costs. By breaking down the indirect cost of each activity, they can make improvements. Managers can use the activity-based costing method to evaluate things like management influence, efficient processes and the overall cost of different departments.
4. It gives you more accurate data for profit margins
Because activity-based costing accounts for non-manufacturing costs or indirect costs that you may not have otherwise considered, it can help with improving profit margins. Having more accurate profit margins can help business leaders make important decisions. It can also help reduce or transfer production costs, allowing management to improve their profit margins even further with effective pricing strategies.
Managers can easily identify products of little to no value when using activity-based costing. They can use this information to remove products from inventory and to allocate those manufacturing resources to more profitable items. It also makes it easier to identify products that can be wasteful when it comes to required resources. Some products may not only be of low value but also use necessary resources.
5. It provides benefits in industries that other methods don't work
Traditional costing methods don't always work in certain industries, such as the service industry. This is because service industries have minimal direct costs. However, you can use activity-based costing in these industries since you apply the cost directly to the type of service. This means you can use it to improve results and pricing in industries that are otherwise left out.
