Treatment of Costs Under Activity Based Costing (ABC) System


Treatment of Costs Under Activity Based Costing (ABC) System

Learning Objectives:

  1. How manufacturing, non-manufacturing and idol capacity costs are treated under activity based costing system?

Contents:

  1. Non-manufacturing costs and activity based costing

  2. Manufacturing costs and activity based costing

  3. Costs of idle capacity and activity based costing

Non-manufacturing Costs and Activity Based Costing (ABC) System:

In traditional cost accounting system, only manufacturing costs are assigned  to products. Selling, general, and administrative expenses are treated as period costs and are not assigned to products. However, many of these non-manufacturing costs are also part of the costs of  producing, selling, distributing, and servicing products. For example commissions paid to salespersons, shipping costs, and warranty repair costs can be easily traced to individual products. The term overhead is usually used to refer non-manufacturing costs as well as indirect manufacturing costs under an ABC system. In activity based costing, products are assigned all of the costs-manufacturing as well as non-manufacturing-that they can reasonably be supposed to have caused. The entire cost of the product is determined rather than just its manufacturing cost.

Manufacturing Costs and Activity Based Costing (ABC):

In traditional cost accounting, all manufacturing costs are assigned to products-even manufacturing costs that are not caused by the products. For example, a portion of the factory security guard’s wages would be allocated to each product even though the guards wages are totally unaffected by which products are made or not made during a period. In activity based costing, cost is assigned to a product only if there is a good reason to believe that the cost would be affected by decisions concerning the product.

Plant wide Overhead Rate:

Normally overhead rate, called plant wide overhead rate or predetermined overhead rate, is used throughout an entire factory and that the allocation base is direct labor hours or machine hours. This simple approach to overhead assignment can result in distorted unit product costs when it is used for decision making purposes.

When cost systems were collected in 1800s, cost and activity data had to be collected by hand and all calculations were done with paper and pen. Consequently, the emphasis was on simplicity. Companies often established a single overhead cost pool for an entire facility or department. Direct labor was the obvious choice as an allocation base for overhead costs. Direct labor hours were already being recorded for the purposes of determining wages and direct labor time spent on tasks was often closely monitored. In the labor-intensive production processes of that time, direct labor was a large component of product costs–larger than it is today. Moreover, managers believed direct labor and overhead costs were highly correlated. (Two variables, such as direct labor and overhead costs, are highly correlated if they tend to move together.) And finally most companies produced a very limited variety of products that required similar resources to produce, so in fact there was probably little difference in the overhead costs attributable to different products. Under these conditions, it was not cost effective to use a more elaborate costing system.

Conditions have changed. Many companies now sell a large variety of products and services that consume significantly different overhead resources. Consequently, a costing system that assigns essentially the same overhead cost to every product may no longer be adequate. Additionally, many managers now believe that overhead overhead costs and direct labor are no longer highly correlated and that other factors drive overhead costs.

On an economy wide basis, direct labor and overhead costs have been moving in opposite directions for a long time. As a percentage of total cost, direct labor has been declining, whereas overhead has been increasing. Many tasks that used to be done by hand are now done with largely automated equipment–a component of overhead. Companies are creating new products and services at an ever-accelerating rate that differ in volume, batch size and complexity. Managing and sustaining this product diversity requires many more overhead resources such as production schedulers and production design engineers, and may of these overhead resources have no obvious connection with direct labor. Finally, computers, bar code readers, and other technology have dramatically reduced the cost of collecting and manipulating data–making more complex (and accurate) costing systems such as activity based costing much less expensive to build and maintain.

Nevertheless, direct labor remains a viable base for applying overhead to products in some companies–particularly for external reports. Direct labor is an appropriate allocation base for overhead when overhead costs and direct labor are highly correlated. And indeed, most companies throughout the world continue to base overhead allocations on the direct labor or machine hours. However if factory wide costs do not move in tandem with factory wide direct labor or machine hours, some other means of assigning overhead costs must be found or product costs will be distorted.

Departmental Overhead Rates:

Rather than use a plant wide overhead rate (predetermined overhead rate), many companies have a system in which each department has its own overhead rate (multiple predetermined overhead rates). The nature of the work performed in each department will determine the department’s allocation base. For example, overhead costs in machining department may be allocated on the basis of the machine-hours incurred in that department. In contrast, the overhead costs in an assembly department may be allocated on the basis of direct labor-hours incurred in that department.

Unfortunately, even departmental overhead rates will not correctly assign overhead costs in situations where a company has a range of products that differ in volume, batch size, or complexity of production. The reason is that the departmental approach usually relies on volume as the factor in allocating overhead cost to products. For example, if the machining department’s overhead is applied to products on the basis of machine-hours, it is assumed that the department’s overhead costs are caused by, and are directly proportional to, machine-hours. However, the department’s overhead costs are probably more complex than this and are caused by a variety of factors, including the range of products processed in the department, the number of batch setups that are required, the complexity of the products, and so on. Activity based costing is a technique that is designed to reflect these diverse factors more accurately when costing products. It attempts to accomplish this goal by identifying the major activities such as batch setups, purchase order processing, and so on, that consume overhead resources and thus cause costs. An activity is any event that causes the consumption of overhead resources. The costs of carrying out these activities are assigned to the products that cause the activities.

The Cost of Idle Capacity and Activity Based Costing (ABC)

In traditional cost accounting, predetermined overhead rates are computed by dividing budgeted overhead costs by a measure of budgeted activity such as budgeted direct labor hours. This results in applying the costs of unused, or idle capacity to products, and it results in unstable unit product cost. In contrast to traditional cost accounting, in activity based costing system, products are charged for the costs of capacity they use and not for the costs of capacity they do not use. The costs of idle capacity is not charged to products in activity based costing system. This results in more stable unit costs and is consistent with the objective of assigning only those costs to products that are actually caused by the products. Instead of assigning the costs if idle capacity to products, in activity based costing system these costs are considered to be period costs that flow through to the income statement as an expense of the current period. This treatment highlights the cost of idle capacity rather than burying it in inventory and cost of goods sold.

Real Business Example:

In Business | Activity Based Costing (ABC) Changes the Focus
Euclid Engineering makes parts and components for the big automobile manufacturers. As a result of its ABC study, Euclid’s managers “discovered that the company was spending more in launching new products than on direct labor expenses to produce existing products. Product development and launch expenses were 10% of expenses, where as direct labor costs were only 9%. Of course, in the previous direct labor cost system, all attention had been focused on reducing direct labor costs. . . Product development and launch costs were blended into the factory overhead rate applied to products based on direct labor costs. Now Euclid’s manager realized that they had a major cost reduction opportunity by attacking the production launch cost directly.”

The new information produced by the ABC study also helped Euclid in its relations with customers. The detailed breakdown of the costs of design and engineering activities helped customers to make trade-offs, with the result that they would often ask that certain activities whose costs exceeded their benefits be skipped.

Source: Robert S. Kaplan and Robin Cooper, Cost & Effect: Using Integrated Cost Systems to Drive Profitability and Performance (Boston: Harvard Business School Press, 1998), pp. 219-222.

You may also be interested in other relevant articles from “activity based costing system” chapter:

  1. Definition and Explanation of Activity Based Costing System
  2. Treatment of Manufacturing, Non-manufacturing and Idle Capacity Costs Under Activity Based Costing System
  3. Activity Based Costing And Top Management
  4. Activity Based Costing System and External Reports
  5. Designing and Implementing Activity Based Costing System
  6. Targeting Process Improvements (Activity Based Costing + Activity Based Management)
  7. Advantages or Benefits | Disadvantages or Limitations of Activity Based Costing System
  8. Activity Based Costing Example

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