Activity-Based Costing: A Tool to Aid
Solutions to Questions
Activity-based costing differs from traditional costing systems in a number of ways. In activity-based costing, nonmanufacturing as well as manufacturing costs may be assigned to products. And, some manufacturing costs—including the costs of idle capacity--may be excluded from product costs. An activity-based costing system typically includes a number of activity cost pools, each of which has its unique measure of activity. These measures of activity often differ from the allocation bases used in traditional costing systems.
When direct labor is used as an allocation base for overhead, it is implicitly assumed that overhead cost is directly proportional to direct labor. When cost systems were originally developed in the 1800s, this assumption may have been reasonably accurate. However, direct labor has declined in importance over the years while overhead has been increasing. This suggests that there is no longer a direct link between the level of direct labor and overhead. Indeed, when a company automates, direct labor is replaced by machines; a decrease in direct labor is accompanied by an increase in overhead. This violates the assumption that overhead cost is directly proportional to direct labor. Overhead cost appears to be driven by factors such as product diversity and complexity as well as by volume, for which direct labor has served as a convenient measure.
Employees may resist activity-based costing because it changes the “rules of the game.” ABC changes some of the key measures, such as product costs, used in making decisions and may affect how individuals are evaluated. Without top management support, employees may have little interest in making these changes. In addition, if top managers continue to make decisions based on the numbers generated by the traditional costing system, subordinates will quickly conclude that the activity-based costing system can be ignored.
Unit-level activities are performed for each unit that is produced. Batch-level activities are performed for each batch regardless of how many units are in the batch. Product-level activities must be carried out to support a product regardless of how many batches are run or units produced. Customer-level activities must be carried out to support customers regardless of what products or services they buy. Organization-sustaining activities are carried out regardless of the company’s precise product mix or mix of customers.
Organization-sustaining costs, customer-level costs, and the costs of idle capacity should not be assigned to products. These costs represent resources that are not consumed by the products.
In activity-based costing, costs must first be allocated to activity cost pools and then they are allocated from the activity cost pools to products, customers, and other cost objects.
Since people are often involved in more than one activity, some way must be found to estimate how much time they spend in each activity. The most practical approach is often to ask employees how they spend their time. It is also possible to ask people to keep records of how they spend their time or observe them as they perform their tasks, but both of these alternatives are costly and it is not obvious that the data would be any better. People who know they are being observed may change how they behave.
In traditional cost systems, product-level costs are indiscriminately spread across all products using direct labor-hours or some other allocation base related to volume. As a consequence, high-volume products are assigned the bulk of such costs. If a product is responsible for 40% of the direct labor in a factory, it will be assigned 40% of the manufacturing overhead cost in the factory—including 40% of the product-level costs of low-volume products. In an activity-based costing system, batch-level and...
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