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In a traditional, volume-based product-costing system, only a single predetermined overhead rate is used. All manufacturing-overhead costs are combined into one cost pool, and they are applied to products on the basis of a single cost driver that is closely related to production volume. The most frequently used cost drivers in traditional product-costing systems are direct-labor hours, direct-labor dollars, machine hours, and units of production.
Management was being misled by the traditional product-costing system, because the high-volume product lines were being overcosted and the low-volume product line was being undercosted. The high-volume products essentially were subsidizing the low-volume line. The traditional product-costing system failed to show that the low-volume products were driving more than their share of overhead costs. As a result of these misleading costs, the company's management was mispricing its products.
An activity-based costing system is a two-stage process of assigning costs to products. In stage one, activity-cost pools are established. In stage two a cost driver is identified for each activity-cost pool. Then the costs in each pool are assigned to each product line in proportion to the amount of the cost driver consumed by each product line.
A cost driver is a characteristic of an event or activity that results in the incurrence of costs by that event or activity. In activity-based costing systems, the most significant cost drivers are identified. Then a database is created that shows how these cost drivers are distributed across products. This database is used to assign costs to the various products depending on the extent to which they use each cost driver.
The four broad categories of activities identified in an activity-based costing system are as follows:
Unit-level activities: Must be done for each unit of production.
Batch-level activities: Must be performed for each batch of products.
Product-sustaining activities: Needed to support an entire product line.
Facility-level (or general-operations-level) activities: Required for the entire production process to occur.
An activity-based costing system alleviated the problems management was having under its traditional, volume-based product-costing system by more accurately assigning costs to products. Products were assigned costs based on the extent to which they used various cost drivers that were determined to be closely related to the incurrence of a variety of overhead costs.
Product-costing systems based on a single, volume-based cost driver tend to overcost high-volume products, because all overhead costs are combined into one pool and distributed across all products on the basis of only one cost driver. This simple averaging process fails to recognize the fact that a disproportionate amount of costs often is associated with low-volume or complex products. The result is that low-volume products are assigned less than their share of manufacturing costs, and high-volume products are assigned more than their share of the costs.
In traditional, volume-based costing systems, only direct material and direct labor are considered direct costs. In contrast, under an activity-based costing system, an effort is made to account for as many costs as possible as direct costs of production. Any cost that can possibly be traced to a particular product line is treated as a direct cost of that product.
The pool rate is calculated by dividing the budgeted amount of an activity cost pool by the budgeted total quantity of the associated cost driver. The pool rate is the cost of a particular activity that is expected per unit of the associated cost driver.
Two factors that tend to result in product cost distortion under...
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