For any one of the companies from the previous chapters, discuss the following:
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Question
For any one of the companies from the previous chapters, discuss the following: A) What overhead costs do you believe would have to be allocated to either jobs or products? MB) How would these costs be allocated under 1) Traditional accounting methods 2) Activity-based costing Be sure to include examples and the include a discussion of what you believe would be appropriate cost drivers. For any one of the companies from the previous chapters, discuss the following: A) What overhead costs do you believe would have to be allocated to either jobs or products? MB) How would these costs be allocated under 1) Traditional accounting methods 2) Activity-based costing Be sure to include examples and the include a discussion of what you believe would be appropriate cost drivers.Explanation / Answer
Some of the costs that would typically be included in overhead include:
Material handlers (forklift operators who move materials and units).
People who set up the manufacturing equipment to the required specifications.
People who inspect products as they are being produced.
People who perform maintenance on the equipment.
People who clean the manufacturing area.
People who perform record keeping for the manufacturing processes.
Factory management team.
(Note: For the seven items above, the company will incur costs for salaries, wages, Social Security and Medicare taxes, unemployment compensation tax, worker compensation insurance, health insurance, holiday pay, vacation pay, sick pay, pension or retirement plan, seminars and training, and perhaps more.)
Electricity, natural gas, water, and sewer for operating the manufacturing facilities and equipment
Example of traditional costing
With the traditional method one assumes that there is a relationship between the cost and a volume based measure. i.e. overhead costs are ultimately driven by production volume.
Example: An organization knows its Overhead cost is $200,000 per annum. It also knows that it uses 5,000 hrs of direct labour per annum.
It manufactures a product that has these costs:
Materials: $10.50
Labour: 2 hours at $55 per hour: $110
Total direct costs: $120.50
Indirect costs: allocate on the basis of direct labour hours:
2 hours x 200,000/5,000 = $80
Total cost: $200.50
How realistic is this cost calculation? The answer is usually - no one knows! A competitor sells the same product for $160. Are they selling at a loss, or do they have a better understanding on what drives the cost of their product? OR: A competitor sells the same product for $1,000. Are they overpricing their product, or do they realize something about overhead allocation that is unknown to you? You need to understand costs to make an informed decision on how to price services and products.
Traditional techniques tend to give wrong costings because they use simple methods to allocate cost to products. This can lead to some products being penalized because of the unfair basis of allocation chosen. A result of bad costing information can be management taking wrong business decisions and losing business.
* Activity based costing (ABC)
Today, for many organizations indirect overheads are much bigger than direct costs.
The contribution of the overhead component in costing is today very significant. Many businesses do not understood the components of their overhead costs and what drives them. Activity based costing is a well recognized technique that is used for this purpose. It enables organizations to assign indirect overhead costs to products or services much more realistically than was done in the past.
ABC recognizes that many of the overheads are unaffected by changes in production volume. These overheads (indirect costs) are incurred in service support functions like order entry, accounting, purchasing materials, planning production, quality control etc. Different products require different volumes of these activities. For example, small lots of new products might use more resources than large lots of existing products. It is the volume of these activities (not the volume of product) which uses the resources and thus incurs the cost..
The basis of Activity Based Costing is: look at the activities required to produce the cost of the product or service. The activities consume resources and the cost of these can be calculated. The amount of activity required for each product and service is determined, hence the real cost can be determined.
What's what in ABC
* The activity is the work that is done.
* The resource is what the activity uses to do the work eg people, equipment, services. Resources cost money.
* The cost of the activity depends on the quantity of resources used to accomplish the activity.
* The cost driver for an activity is the factor that influences the amount of the resources that will be consumed by this activity.
Example: the activity is delivering goods. The costs of this activity include the truck drivers%u2019 wages, fuel, depreciation of the truck, insurance, etc. The quantity of the resources that will be consumed by this activity are influenced by the number of deliveries made per year. Hence the cost driver could be the number of deliveries. A cost driver is designed to allocate the delivery activity cost pool to the cost objects.
(Note: The software has the facility to enter and change the cost drivers as better information becomes available).
* The activity driver measures how much of the activity is used by the cost object. Example: Product A is delivered once a month, whereas product B is delivered once a week. Products A and B require a different number of deliveries, hence the cost of the delivery activity should be assigned to each product on the basis of the number of deliveries each uses.
* The cost object is whatever it is you wish to cost. It could be a product, service, process, job or customer.
While traditional costing arbitrarily allocates overhead costs, ABC traces overhead costs by looking at the activities that each product and service calls upon. With ABC the products consume the activities. It is the activities that cost money.
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