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Product and Activity Based Costing: Two Activity Example

Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities.

Let's discuss activity based costing by looking at two products manufactured by the same company. Product 124 is a low volume item which requires certain activities such as special engineering, additional testing, and many machine setups because it is ordered in small quantities. A similar product, Product 366, is a high volume product--running continuously--and requires little attention and no special activities. If this company used traditional costing, it might allocate or "spread" all of its overhead to products based on the number of machine hours. This will result in little overhead cost allocated to Product 124, because it did not have many machine hours. However, it did demand lots of engineering, testing, and setup activities. In contrast, Product 366 will be allocated an enormous amount of overhead (due to all those machine hours), but it demanded little overhead activity. The result will be a miscalculation of each product's true cost of manufacturing overhead. Activity based costing will overcome this shortcoming by assigning overhead on more than the one activity, running the machine.

Activity based costing recognizes that the special engineering, special testing, machine setups, and others are activities that cause costs-they cause the company to consume resources. Under ABC, the company will calculate the cost of the resources used in each of these activities. Next, the cost of each of these activities will be assigned only to the products that demanded the activities. In our example, Product 124 will be assigned some of the company's costs of special engineering, special testing, and machine setup. Other products that use any of these activities will also be assigned some of their costs. Product 366 will not be assigned any cost of special engineering or special testing, and it will be assigned only a small amount of machine setup.

Activity based costing has grown in importance in recent decades because (1) manufacturing overhead costs have increased significantly, (2) the manufacturing overhead costs no longer correlate with the productive machine hours or direct labor hours, (3) the diversity of products and the diversity in customers' demands have grown, and (4) some products are produced in large batches, while others are produced in small batches.

Activity Based Costing with Two Activities
Let's illustrate the concept of activity based costing by looking at two common manufacturing activities: (1) the setting up of a production machine for running batches of products, and (2) the actual production of the units of product.

We will assume that a company has annual manufacturing overhead costs of $2,000,000â?"of which $200,000 is directly involved in setting up the production machines. During the year the company expects to perform 400 machine setups. Let's also assume that the batch sizes vary considerably, but the setup efforts for each machine are similar.

The cost per setup is calculated to be $500 ($200,000 of cost per year divided by 400 setups per year). Under activity based costing, $200,000 of the overhead will be viewed as a batch-level cost. This means that $200,000 will first be allocated to batches of products to be manufactured (referred to as a Stage 1 allocation), and then be assigned to the units of product in each batch (referred to as Stage 2 allocation). For example, if Batch X consists of 5,000 units of product, the setup cost per unit is $0.10 ($500 divided by 5,000 units). If Batch Y is 50,000 units, the cost per unit for setup will be $0.01 ($500 divided by 50,000 units). For simplicity, let's assume that the remaining $1,800,000 of manufacturing overhead is caused by the production activities that correlate with the company's 100,000 machine hours.

For our simple two-activity example, let's see how the rates for allocating the manufacturing overhead would look with activity based costing and without activity based costing:

With ABC
Without ABC

Mfg overhead costs assigned to setups
$200,000
$0

Number of setups
400
Not applicable

Mfg overhead cost per setup
$500
$0

Total manufacturing overhead costs
$2,000,000
$2,000,000

Less: Cost traced to machine setups
200,000
0

Mfg O/H costs allocated on machine hours
$1,800,000
$2,000,000

Machine hours (MH)
100,000
100,000

Mfg overhead costs per MH
$18
$20

Mfg Overhead Cost Allocations
$500 setup cost per batch + $18 per MH
$20 per MH

Next, let's see what impact these different allocation techniques and overhead rates would have on the per unit cost of a specific unit of output. Assume that a company manufactures a batch of 5,000 units and it produces 50 units per machine hour, here is how the cost assigned to the units with activity based costing and without activity based costing compares:

With ABC
Without ABC

Mfg overhead for setting up machine
$500
$0

No. of units in batch
5,000
Not applicable

Mfg O/H caused by Setup â?" Per Unit
$0.10
Not applicable

Mfg overhead costs per machine hour
$18
$20

No. of units produced per machine hour
50
50

Mfg O/H caused by Production â?" Per Unit
$0.36
$0.40

Total Mfg O/H Allocated â?" Per Unit
$0.46
$0.40

If a company manufactures a batch of 50,000 units and produces 50 units per machine hour, here is how the cost assigned to the units with ABC and without ABC compares:

With ABC
Without ABC

Mfg overhead for setting up machine
$500
$0

No. of units in batch
50,000
Not applicable

Mfg O/H caused by Setup Per Unit
$0.01
Not applicable

Mfg overhead costs per machine hour
$18
$20

No. of units produced per machine hour
50
50

Mfg O/H caused by Production â?" Per Unit
$0.36
$0.40

Total Mfg O/H Allocated Per Unit
$0.37
$0.40

As the tables above illustrate, with activity based costing the cost per unit decreases from $0.46 to $0.37 because the cost of the setup activity is spread over 50,000 units instead of 5,000 units. Without ABC, the cost per unit is $0.40 regardless of the number of units in each batch. If companies base their selling prices on costs, a company not using an ABC approach might lose the large batch work to a competitor who bids a lower price based on the lower, more accurate overhead cost of $0.37. Its also possible that a company not using ABC may find itself being the low bidder for manufacturing small batches of product, since its $0.40 is lower than the ABC model of $0.46 for a batch size of 5,000 units. With its bid price based on manufacturing overhead of $0.40 but a true cost of $0.46 the company may end up doing lots of production for little or no profit.

Our example with just two activities (production and setup) illustrates how the cost per unit using the activity based costing method is more accurate in reflecting the actual efforts associated with production. As companies began measuring the costs of activities (instead of focusing on the accountant's departmental classifications), they began using ABC cost information to practice activity based management. For example, with the cost of setting up a machine now being measured and discussed, managers began to ask questions such as:

Please answer the following in detail

Why is the cost of setting up a production machine so expensive? What can be done to reduce the setup cost? If the setup costs cannot be reduced, are the selling prices adequate to cover all of the companys costs including the setup cost that was previously buried in the overall machine-hour overhead rate?

Elaborate your solution describing how Activity Based Costing can benefit companies. You may wish to give an example of a company where activity based costing could be applied. Describe in detail how this company could benefit from Activity based costing.

Solution expectations:

The following items will be evaluated in particular:

Identify strengths and weaknesses of ABC
Discuss the differences between traditional product costing and ABC
Explain why the inclusion of fixed costs in the product will lead to poor internal decision making.

Solution Preview

Activity based costing system:
Meaning:

Activity-Based Costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to products and services according to the actual consumption by each in order to arrive at the actual cost of products and services.

In Activity based costing costs of all organization's resources are assigned to the products and services that the organization manufacture/render. The main intention behind the assignment of resource cost to the product/services is to find out the cost of the product and the resultant profitability.

Purpose:

The main purpose of Activity Bases costing is the elimination of unprofitable activities in the organization. Further, to identify the overpriced activities in order to lower the prices of those activities. It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing and identification and measurement of process improvement initiatives.
Following are the steps to be followed in ABC.

1. Identify cause and effect relationships of all the activities to assign costs to the activities.

2. Costs of the activities are to be computed.

3. Then the cost of each activity is assigned to each product/service to the extent that the product/service uses the activity.

4. Then the products with high overhead costs are to be identified and the efforts need to be made to reduce the costs of the costs.
Identify strengths and weaknesses of ABC:
Strengths:
Following are the strengths:
1. Traditional costing does not show the cause of arisen costs. However, in ABC costing the each transaction is coded and cost can be easily controlled by tracing the excess cost to the activities involved. Therefore, organization should have sound coding system to allocate the costs to the resources in ABC costing.

2. ABC provides a system to allocate costs more accurately when overhead costs are not incurred at the same rate as direct labor dollars. The more activities identified the more complex the costing system becomes. Therefore, the organization should have the computer system to manage ABC costing and should limit the number of activities to the manageable extent. ABC provides a more accurate estimate of costs for use in making management decisions than the overhead cost system.

3. When the organization is having high organizational complexity and changes, ABC costing is better than overhead ...

Solution Summary

The solution discusses product and activity based costing

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