Week 2 Discussion

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Activity-Based Costing (ABC) Activity-Based Costing (ABC). Activity-Based Costing (ABC) has grown in popularity over the years and is believed to be a more accurate way to cost a product in many situations. By having accurate cost a company can better plan their strategy going forward. Under traditional costing, manufacturing overhead was assigned usually using one type of activity such as direct labor hours, machine hours or direct labor costs. Under ABC costing, numerous cost pools are used and each pool will have its own measure of activity in order to get the assigned rate. Under ABC we define five different levels of activities. Number 1, Unit level activities – these activities occur each time a unit is produced so direct labor would be an example of this. Number 2, Batch level activities – these activities happen each time a group or batch is processed. A machine setup is one of the most common examples of this, because it won't matter how many units pass through, we just set up one time per process. Number 3, Product level activities – these activities are unique to the specific product. Research and development would be an example of this. Number 4, Customer level activities – these activities are customer driven and relate to specific customers in helping keep the customer satisfied and interested in our products. Number 5, organization sustaining activities – these activities are done regardless of the number of products or customers a company has. The janitor cleaning the building would be an example of this.

Activity-Based Costing (ABC)

In order to use ABC efficiently in a business, certain steps need to be followed:

Define activities, activity cost pools, and activity measures.

Assign overhead costs to activity cost pools.

Calculate activity rates.

Assign overhead costs to cost objects using the activity rates and activity measures.

Prepare management reports.

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Variable Costing Variable Costing. As you have been learning about costing of jobs, you have primarily been doing absorption costing, which is treating all manufacturing cost variable and fixed as product cost. Another name for absorption costing is full costing because it considers all types of manufacturing costs. An alternative to absorption costing is variable costing which only considers variable cost as product cost. This will normally include direct materials, direct labor and variable manufacturing overhead. Under variable costing, fixed manufacturing overhead will not be included as a product cost but instead it will be like a period cost and deducted all in the period incurred. Due to this treatment cost of goods sold will normally be a lower number as well as value of ending inventory. It is important to note that when we say variable cost we are only referring to variable product cost. So, other types of variable cost that are normal period cost will remain period cost. The formula is direct materials plus direct labor plus variable manufacturing overhead equals unit production cost. The difference is that fixed manufacturing overhead under variable costing will no longer be considered as part of the cost of the product.

Variable Costing

So, for example, if we produced 100 units that had $8 in direct materials, $9 in direct labor, $5 in variable manufacturing overhead, and $1,000 of total fixed costs for the period, the unit product cost would be calculated like this:

Direct Material $8

+ Direct Labor $9

+ Variable Manufacturing Overhead $5

= Unit Product Cost $22

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Standard Costs

Standard Cost. A standard is considered a benchmark. This is used for measuring performance. It is a budgeted amount of something we would expect so we could have a standard price we expect to pay for materials or standard number of hours we would expect a unit to take or standard rate we pay our employees.

There are several standards that a company can set to help keep production on track and to evaluate how supervisors are doing. When we set standards for different areas, we need to make sure to consider the entire cost. For example, the standard price of materials should include all cost that go into getting that material ready for its intended use.

That would include the purchase price plus freight less any discounts that might be applicable. When we set standards for labor, we should include the entire cost of an employee per hour so that could include employer taxes and fringe benefits.

When we are setting standards for quantity, we might also have to consider an allowance for waste or rejects which would need to be added to the normal material requirements to get an overall standard al lowed per finished product.

Standard Costs

Accountants, engineers, purchasing, and production managers combine efforts to set standards that en courage efficient production. Two types of standards are commonly used—quantity standards that show how much quantity should be used and price standards that specify how much should be paid for each unit of input.

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Overhead Variances Overhead Variances. In the variable overhead performance report, you will look at both the spending variance and the efficiency variance that is used in standard cost systems. The spending variance looks at how our spending was when comparing our budget to our actual base on the same activity level. The efficiency variance compares cost at the actual activity used such as machine hours to the cost at the budgeted activity level used. It is important to note that we are comparing the budgeted activity level at the actual production. So, for example, we might budget 10,000 hours, but because we produced 5200 units that are estimated to take 2 hours each, that means our standard allow for actual output is 10,400 for 5200 units. And if our actual is 10,300, then we are comparing numbers at the 10,400 level to the 10,300 level and disregarding the 10,000 hours’ budget to begin with because these were budgeted at different levels of activity. That is a major difference. There are two fixed overhead variances. The first is the budget variance and it is calculated actual fixed overhead minus budgeted fixed overhead equal budget variance. So, if actual fixed overhead is $230,000 and the budgeted is $200,000, that would be a $30,000 variance that is unfavorable because actual is higher than the budget. The other variance for fixed cost is the volume variance and it is calculated fixed predetermined overhead rate times level of activity minus standard hours allowed.

Overhead Variances

If we had a rate of $10 per machine hour and we had the budgeted level of activity set at 20,000 machine hours and 23,000 hours were allowed for the actual level of output, the for mula would look like this:

$10 (20,000 MHs – 23,000 MHs) = $30,000 F