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There are two common methods for allocating indirect costs to products. Both of these methods
assess overhead costs and then attach these costs to products based on certain cost drivers.
ABC can be used when one or more of the following conditions are present:
Activity-based costing should be used when accuracy is crucial, because it is the most precise.
Although it is costly to implement, it should be used for:
Times when overhead is high, because small changes in each product cost can make a
large difference overall. This method makes it easy to visualize and understand all
indirect costs and activities.
Internal use, because decision-makers will be able to see all relevant spending and can
document all indirect costs accurately. This method is good for finding areas of wasteful
spending.
Absorption or Traditional costing should be considered when time is limited or when accuracy
wont be affected much by production activities. Traditional costing is most effective for:
Times when overhead is low compared to the direct costs, because this is when it will
be the most accurate. This works well when there are a large number of similar items (or
a single item) being produced.
External use, because it will be easier for outsiders to determine the value of products.
Identify and classify all of the activities in the value chain related to the production of the
product.
Compute a cost-driver rate for each activity based on a cost allocation base that has a
causal link to the cost of the activity.
Cost drivers: A cost driver is any factor or activity that has a direct cause and effect
relationship with the resources consumed. The costs of an activity are caused by factors
known as cost drivers. Thereby management should be able to control the amount of
costs by controlling the amount of cost drivers, for example, the cost of ordering is driven
by the amount of orders placed. If the monthly cost of ordering is $12 000 and there are
1000 orders placed in a month, then the cost per order is $12. Products are then
assigned the costs of an activity on the basis of the number of cost drivers the products
generate. For example, if product A requires 5 orders to be placed then the cost of
ordering for product A is $60 (5 x $12).
Example 1:
OJW Company manufactures two types of widgets - Widget A and Widget B. The company has
to evaluate its process expenses to determine its activity cost pools. The following information is
given:
Expenses:
Payroll taxes
Fringe benefits
Electricity
Factory rent
Equipment maintenance
Factory maintenance
The first step to creating activity cost pools is to determine what drives each individual cost; that
is, what factor influences how much is spent in that expense category. For example, the amount
spent on electricity depends on how many hours a machine is running. Therefore, the cost
driver for electricity would be machine hours. The drivers for each of the above expenses are
listed below:
Once the cost drivers are determined, the expenses influenced by the same cost drivers are
grouped into activity cost pools.
Payroll taxes
Fringe benefits
Electricity
Equipment maintenance
Factory rent
Factory maintenance
OJW Company will need three activity cost pools for the following cost drivers: direct labor
hours, machine hours, and number of square feet.
Example 2:
Two years later, OJW Company has added a third widget to its production - Widget C. The
manufacturing process is now more complex and the company has asked you to reevaluate its
process expenses to determine its activity cost pools. The following information is given:
Expenses:
Purchasing labour
Inspector labour
Payroll taxes
Fringe benefits
Electricity
Factory rent
Purchasing supplies
Inspecting supplies
Equipment depreciation
Equipment maintenance
Factory maintenance
As in the first example, the first step to creating activity cost pools is to determine what drives each individual cost.
The drivers for each of the above expenses are listed below:
Benefits:
ABC provides a more accurate cost per unit. As a result, pricing, sales
strategy, performance management and decision making should be improved.
It provides much better insight into what drives overhead costs.
ABC recognizes that overhead costs are not all related to production and sales volume.
In many businesses, overhead costs are a significant proportion of total costs, and
management needs to understand the drivers of overhead costs in order to manage the
business properly. Overhead costs can be controlled by managing cost drivers.
ABC can be applied to all overhead costs, not just production overheads.
Limitations:
ABC will be of limited benefit if the overhead costs are primarily volume related or if the
overhead is a small proportion of the overall cost.
It is impossible to allocate all overhead costs to specific activities.
ABC can be more complex to explain to the stakeholders of the costing exercise.
The benefits obtained from ABC might not justify the costs.
Other systems may need to be changed - for example, how variances are calculated.
WORKSHEET
3. Ferris Corporation makes a single product - a fire resistant commercial filing cabinet - that it
sells to office furniture distributors. The company has a simple ABC system that it uses for
internal decision making. The company has two overhead departments whose costs are listed
below:
The company's activity based costing system has the following activity cost pools and activity measures:
Costs assigned to the "other" activity cost pool have no activity measure; they consist of the costs of
unused capacity and organization-sustaining costs - neither of which are assigned to products, orders or
customers. Ferris Corporation distributes the costs of manufacturing overhead and of selling and
administrative overhead to the activity cost pools based on employee interviews, the results of which
are reported below:
100
Total activity 1,000 units 250 orders -- --
customers
Required:
(a) Perform the first stage allocation of overhead costs to the activity cost pools.
(c) OfficeMart is one of the Ferris Corporation's customers. Last year OfficeMart ordered filing
cabinets four different times. OfficeMart ordered a total of 80 cabinets during the year.
Construct a table showing the overhead costs of these 80 units and four orders.