Question

You have just taken a job at a manufacturing company and have discovered that they use one predetermined overhead rate to apply manufacturing overhead costs. You would like to introduce them to activity based costing and explain to them why this costing method can be used and why it is helpful.

Compose a short email - 2 to 3 short paragraphs because the president it too busy to read anything longer than that - proposing an activity based costing system and what that might mean for product costs and management decisions. You could give a brief example if you feel that is necessary for your explanation to the president.

Answer 1

Activity-based costing (ABC) is an accounting method that identifies and assigns costs to overhead activities and then assigns those costs to products. An activity-based costing (ABC) system recognizes the relationship between costs, overhead activities, and manufactured products, and, through this relationship, it assigns indirect costs to products less arbitrarily than traditional methods.

Some costs are difficult to assign through this method of cost accounting. Indirect costs, such as management and office staff salaries, are sometimes difficult to assign to a product. For this reason, this method has found its niche in the manufacturing sector.

There are two categories of activity measures: transaction drivers, which involves counting how many times an activity occurs, and duration drivers, which measure how long an activity takes to complete.

How Activity-Based Costing Improves the Costing Process

Activity-based costing enhances the costing process in three ways. First, it expands the number of cost pools that can be used to assemble overhead costs. Instead of accumulating all costs in one company-wide pool, it pools costs by activity. Second, it creates new bases for assigning overhead costs to items such that costs are allocated based on the activities that generate costs instead of on volume measures, such as machine hours or direct labor costs. Finally, ABC alters the nature of several indirect costs, making costs previously considered indirect - such as depreciation, inspection, or power - traceable to certain activities. Alternatively, ABC transfers overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume products.