Accounting Principles II – Activity-Based Costing - Quick Guides

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Study GuideAccounting PrinciplesII–Activity-Based Costing1.Activity-Based Costing (ABC) ActivitiesHow overhead is usually assigned (traditional way)In traditional costing systems—likejob order costingandprocess costing—companiesusuallyassign (allocate) overhead costs using one simple basis such as:•Direct labor hours•Machine hours•Direct labor dollarsThis works well in many businesses. However, in modern factories, things have changed.Why traditional overheadallocation may not work todayMany companies now use advanced machines and technology. Because of this:•Workers may spend fewer hours directly making products.•Direct labor costs may not be the main reason overhead costs increase.So,labor hours or labor cost may not accurately represent how much overhead is used.That is why some companies switch to a better method calledActivity-Based Costing (ABC).What is Activity-Based Costing (ABC)?Activity-Based Costing (ABC)is a system that assigns overhead costs based on what actuallycauses those costs.ABC is based on a simple idea:Activities create costs.So, the more activities a product uses, the more overhead cost it should receive.

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Study Guide1.Key ABC Terms You Must Know1. Activity cost poolsABC groups overhead costs into categories calledactivity cost pools.Anactivity cost poolis a “bucket” of overhead costs for a specific activity (like ordering materials orsetting up machines).2. Cost driversAcost driveris the activity that causes the cost in a cost pool to increase.Examples of cost drivers include:•Number of materials ordered•Number of production lines•Number of shipments to customersSo, if a company places more orders, the purchasing department becomes busier andcosts rise.How ABC Calculates the Cost Per UnitIn ABC, you calculate an activity rate (cost per unit of activity) like this:ABC finds thecost per unit of activityby dividing:Total cost of the activity pool ÷ Total number of activity unitsThis gives theactivity cost per unit.

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Study GuideExample: Lady Trekkers, Inc.Let’s say a company calledLady Trekkers, Inc.identifies its cost pools and cost drivers.Some companies may have onlyfive or sixactivities, while others may havehundreds.Computers make it much easier for companies to use ABC, even if there are many activities.2.Lady Trekkers’ Activity Cost Pools and DriversThis table shows examples of:•Activity cost pools(like Purchasing Department, Setup, Inspection)•Cost drivers(like Number of Purchase Orders, Number of Setups)How the per-unit activity costs are calculatedTo find theper-unit costfor each activity, the company divides:Total dollars in the activity cost pool ÷ Number of activity driver units

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Study GuideExample: Purchasing DepartmentTo calculate the cost per unit for thepurchasing department, the company divides:Total purchasing department costs ÷ Number of purchase ordersCombining activity pools when they share the same driverLady Trekkers found that both:•Purchasing Department costs•Receiving Department costsare driven by thenumber of purchase orders.Since both use the same cost driver, the company can:combine these two cost poolsand computeone cost per purchase order.Assigning overhead to products using ABCOnce all activity costs per unit are calculated:1.The companyadds upthe activity costs.2.Then it multiplies the activity cost per unit by the number ofactivity units used.3.This assigns overhead costs to products more accurately.In simple terms:More activity used = more overhead assigned3.Activity Categories in ABCABC recognizes that not all overhead costs happen the same way.Some costs happenfor every unit, while others happenper batch, or for an entire product line.To improve accuracy, ABC places activities intofour categories:

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