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DQ 1

Activity Based Costing


What is activity-based costing? What are some main elements of activity-based costing? How
does this method differ from a more traditional costing method?

Activity-based costing (ABC) An overhead cost-allocation system that allocates overhead to


multiple activity cost pools and assigns the activity cost pools to products or services by means
of cost drivers that represent the activities used (Weygandt, Kieso, & Kimmel, 2010, pp 153).
So in simple terms, it is an approach that matches costs with activities that cause those cost.
Products consume Activities > Activities consumes Resources. The activities (not the products)
consume the resources and are the cost drivers. Furthermore, activities are not necessarily based
on the output of production.
Some elements of the activity based costing is: (Overhead Costs > Activity Cost Pools > Cost
Drivers > Products)
allocating overhead costs to activity cost pools,
use cost drivers to determine the costs to assign to the individual products (Weygandt, et
al, 2010, pp 154).
Activity based accounting provides greater detail on the overhead cost than the normal
traditional costing method. Instead of allocating cost to manufacturing or marketing, like
traditional method, ABC allocates direct and indirect cost to activities, such as machining,
assembling, and supervising. Therefore, the use of ABC and the segregation of costs leads to a
more accurate cost per product or activity.
Reference
Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2010). Managerial Accounting Tools for
Business Decision Making (5th ed.). Hoboken, NJ: John Wiley & Sons, Inc..

DQ 2
Cost Drivers
What are cost drivers? How do cost drivers relate to cost pools? What are some cost pools?
Name two or three different cost drivers for each of these cost pools.
"A cost driver is any factor or activity that has a direct cause-effect relationship with the
resources consumed" (Weygandt, Kieso, & Kimmel, 2010, pp 153).
"An activity cost pool is the overhead cost attributed to a distinct type of activity (e.g., ordering
materials or setting up machines)" (Weygandt, et al, 2010, pp 153).

The cost drivers are used to allocate the activity cost pools to the products. The cost drivers
measure the number of individual activities undertaken or preformed to product a product or
service.
Material Management (Functional areas)
Issue of purchase orders (Activity)
Number of Purchases orders (Cost Driver)
Inspection of materials (Activity)
Number of Purchase orders (Cost Driver)
Personnel pool (Functional area)
Recruitment of employees (Activity)
Number of employees recruited (Cost Driver)
Maintenance of leave records & attendance (Activity)
Number of employees (Cost Driver)
Reference
Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2010). Managerial Accounting Tools for
Business Decision Making (5th ed.). Hoboken, NJ: John Wiley & Sons, Inc..
DQ 3

Overhead Allocation
In tracking overhead costs, cost drivers can help allocate overhead costs to cost pools, activities, end
products, and services. How might this computation and allocation process differ between allocating costs
to an end product for a manufacturing concern and a cost activity for a service provider? Provide specific
examples.

Using ABC in production is no difference on providing a service. The general approach to


costing is the same: analyze operations, identify activities, accumulate overhead costs by activity
cost pools, and identify and use cost drivers to assign the cost pools to the services.
When working for a bank the overhead cost pools can be ordering materials (office supply (pen,
paper etc.), operation supply (example: brochure; tellers cash in tickets, stop payment paper).
This week the focus was on cost pool and cost drivers. It was hard for me to understand about the
cost pool and cost drivers. It took a couple of times of reading the material for me to understand
what exactly the cost drivers where. Also I have better understanding how important this
information is to managers and companies. Furthermore, if the scorekeeping is more realistic and
more accurate, managers should be able to better understand cost behavior and overall
profitability.
Reference
Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2010). Managerial Accounting Tools for
Business Decision Making (5th ed.). Hoboken, NJ: John Wiley & Sons, Inc..

(Weygandt, Kimmel, & Kieso, 2010).


(Weygandt, et al, 2010).
DQ 4

Value Add
What are value-added processes? How do you determine if a process adds value? How does
identifying value-added processes help a company run more efficiently and effectively?

"Value-added activities increase the worth of a product or service to customers" (Weygandt,


Kimmel, & Kieso, 2010, pp 163). They involve resource usage and related costs that customers
are willing to pay for. Value-added activities are the activities of actually manufacturing a
product or performing a service.
Value-added can be determined by assessing the activity to see if it is a part of the actual
manufacturing of a product or performing a service.
Companies often use activity flowcharts to help identify the ABC activities. When a company
identifies the value-added activities it provides managers the areas of concentration on
continuous improvement of operations and activates. When managers recognize the nonvalueadded characteristic of these activities, they are motivated to minimize them as much as
possible" (Weygandt, et al, 2010, pp 164).
Examples of value-added activities in a manufacturing operation are engineering design,
machining, assembly, painting, and packaging. Examples of value-added activities in a service
company would be performing surgery, providing legal research for legal services, or delivering
packages by a delivery service.
Reference
Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2010). Managerial Accounting Tools for
Business Decision Making (5th ed.). Hoboken, NJ: John Wiley & Sons, Inc..
(Weygandt, Kimmel, & Kieso, 2010, pp 163).
(Weygandt, et al, 2010, pp 164).

Benefits of ABC
The primary benefit of ABC is more accurate product costing. Here's why:
1. ABC leads to more cost pools being used to assign overhead costs to products
2. ABC leads to enhanced control over overhead costs
3. ABC leads to better management decisions

Activity-based costing does not change the amount of overhead costs. What it does do is allocate
those overhead costs in a more accurate manner. Furthermore, if the scorekeeping is more
realistic and more accurate, managers should be able to better understand cost behavior and
overall profitability.
Limitations of ABC
Although ABC systems often provide better product cost data than traditional volume-based
systems, there are limitations:
1. ABC can be expensive to use.
2. Some arbitrary allocations continue Even though more overhead costs can be assigned directly
to products through ABC's multiple activity cost pools, certain overhead costs remain to be
allocated by means of some arbitrary volume-based cost driver such as labor or machine hours
Reference
Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2010). Managerial Accounting Tools for
Business Decision Making (5th ed.). Hoboken, NJ: John Wiley & Sons, Inc
BENEFITS OF ABC
The primary benefit of ABC is more accurate product costing. Here's why:
1. ABC leads to more cost pools being used to assign overhead costs to products.
Instead of one plant wide pool (or even departmental pools) and a single cost
driver, companies use numerous activity cost pools with more relevant cost
drivers. Costs are assigned more directly on the basis of the cost drivers used
to produce each product.
2. ABC leads to enhanced control over overhead costs. Under ABC, companies
can trace many overhead costs directly to activitiesallowing some indirect
costs to be identified as direct costs. Thus, managers have become more
aware of their responsibility to control the activities that generate those costs.
3. ABC leads to better management decisions. More accurate product costing
should contribute to setting selling prices that can help achieve desired
product profitability levels. In addition, more accurate cost data could be
helpful in deciding whether to make or buy a product part or component, and
sometimes even whether to eliminate a product.
Activity-based costing does not change the amount of overhead costs. What it does
do is allocate those overhead costs in a more accurate manner. Furthermore, if the
scorekeeping is more realistic and more accurate, managers should be able to
better understand cost behavior and overall profitability.
LIMITATIONS OF ABC
Although ABC systems often provide better product cost data than traditional
volume-based systems, there are limitations:
1. ABC can be expensive to use. The increased cost of identifying multiple
activities and applying numerous cost drivers discourages many companies
from using ABC. Activity-based costing systems are more complex than

traditional costing systemssometimes significantly more complex. So


companies must ask, is the cost of implementation greater than the benefits of
greater accuracy? Sometimes it may be. For some companies there may be no
need to consider ABC at all because their existing system is sufficient. If the
costs of ABC outweigh the benefits, then the company should not implement
ABC.
2. Some arbitrary allocations continue. Even though more overhead costs can be
assigned directly to products through ABC's multiple activity cost pools, certain
overhead costs remain to be allocated by means of some arbitrary volumebased cost driver such as labor or machine hours.

Traditional costing is distorted.