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1 ACG 4361 Allocating Indirect Costs: Simple Costing & ABC Prepared by Diane Tanner University of North Florida 2-2 Stage 2 Cost Allocation Stage 2. Allocate Production Cost Pools to Cost Objects Support Department #1 Direct and Indirect Costs Support Department #2 Support Department #3 Production Department #1 Production Department #2 Stage 1. Allocate Support Costs to Cost Pools Cost Object A Cost Object B Allocation of Indirect Costs to Cost Objects Allocation method depends on how managers ‘group’ overhead costs Groups of overhead costs are cost pools Methods of allocating indirect product costs to products (Variations of normal costing) Simple (traditional) cost allocation A single “plant-wide” overhead rate used for entire factory Dual cost allocation Separation of indirect costs into two pools…one for fixed and one for variable costs Activity based costing Multiple overhead rates—one for each activity Simple Costing vs. ABC • Simple costing • Also known as ‘Traditional’ cost allocation and peanut- butter costing • Often acceptable for companies with • Limited variety of goods • Small amounts of indirect costs • Activity-based costing • Multiple cost pools • Allocation of indirect costs is based on what ‘drives’ the costs • Relatively expensive to implement • More refined Simple Costing All indirect costs (manufacturing overhead) are grouped into one cost pool Allocations are based on activities that are volumebased Direct labor hours Direct labor cost Machine hours Number of units produced Overhead rate = Estimated MOH Estimated Activity Allocated overhead = Overhead Rate × Actual Activity 5 Activity-Based Costing 6 Indirect costs are separated into multiple cost pools Typically 5 to 8 pools Based on activities that drive costs rather than on volume-based denominators Primarily used to allocate manufacturing overhead Sometimes used to allocate support or other common costs Overhead Rate = Estimated MOH Estimated Activity Multiple Rates and Allocations Allocated overhead = Overhead Rate × Actual Activity Underlying Premise ….Activities underlie costs. Cost Hierarchies ABC uses a 4-level cost structure to determine how far down the production cycle costs should be allocated (i.e., the cost drivers). Facility-level activities • Factory costs that impact all the products produced in a factory, such as depreciation on the factory building, factory insurance, factory janitors, factory supplies Product-level activities • Costs specific to particular products such as training employees how to produce it, quality control on a product, etc. Batch-level activities • Costs specific to particular batches of products such as machine setup for a particular product, machine maintenance between each batch, etc. Unit-level activities • Costs performed every time a product is produced. They are usually variable and correlate to the number of products produced, such as packaging, sanding a product edge, printing labels, etc. Signals that Suggest that ABC Implementation Could Help a Firm Significant indirect costs are allocated using one or two cost pools Most or all overhead is considered unit-level Has products that consume different amounts of resources Has products that consistently show small profits (though the products should be profit makers) Operations staff disagree with accounting over manufacturing and marketing costs Setting Up an ABC System Step 1: Determine the cost object. Step 2: Form cost pools. Group the costs of performing a particular activity together. All costs in a pool should have the same cause. The costs will differ in nature; i.e., can include indirect wages, depreciation, maintenance, supplies, etc. Step 3: Select a cost driver that has a cause-and-effect relationship with the costs to be allocated. Considerations in selecting a cost driver Experience Industry practices Cost-benefit analysis of each option under consideration 9 10 How to Perform ABC Step 1: Calculate the rate for each cost pool. Estimated Cost / Estimated Activity = Rate Step 2: Multiply each cost pool rate times the respective actual activity to determine allocated costs. Step 3: Total the allocated costs from step 2. This results in the allocated (applied) overhead cost. Step 4: Add the allocated costs to the direct costs of each cost object to obtain the total cost of the cost objects. 10 Capacity Considerations of ABC Activity can be measured on practical capacity, actual capacity, or other estimate Practical capacity preferred over actual capacity because Does not hide the cost of idle capacity within product costs Gives a truer cost of activities used to produce the product Comparing ABC and Traditional Costing Advantages of ABC over traditional costing More accurate costing Helps managers control costs better ABC mitigates product cross-subsidization Disadvantages of ABC over traditional Very expensive to implement No separation of fixed and variable costs which makes incremental analysis difficult 12 Product Cross-Subsidization Occurs when costs are allocated to all units equally Undercosting Overcosting Overhead allocated under ABC is greater than if traditional is used Overhead allocated under ABC is less than if traditional is used A product consumes a relatively high level of resources but is reported to have a relatively low total cost A product consumes a relatively low level of resources but is reported to have a relatively high total cost Recent Trends That Affect Choice of Allocation Method Increase in product diversity Some products use more resources than others Increase in indirect costs Machines (depreciation) replace workers (direct labor) Advances in information technology Direct labor not needed Competition in foreign markets Costs must be reduced to stay competitive ABC Implementation Issues After switching to ABC, companies may find that only 10 to 15% of their products are profitable Causes management to alter the product mix by minimizing unprofitable products Profits usually increase Implementation mirrors the complexity of the organization Complete conversion to ABC requires auditors to accept the system when used for financial reporting Activity-Based Management A tool in which managers analyze activities that cause indirect costs of products or services Goal is to improve efficiency and effectiveness of the activities in order to reduce costs Serves as the basis for numerous process improvement programs of companies Helps focus managerial attention on what is most important among the activities performed to create value for customers The End 17