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Accounting Principles II – Activity-Based Costing

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    Study Guide Accounting Principles II – Activity - Based Costing 1. Activity - Based Costing (ABC) Activities How overhead is usually assigned (traditional way) In traditional costing systems — like job order costing and process costing — companies usually assign (allocate) overhead costs using one simple basis such as: • Direct labor hours • Machine hours • Direct labor dollars This works well in many businesses. However, in modern factories, things have changed. Why traditional overhead allocation may not work today Many 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 called Activity - Based Costing (ABC). What is Activity - Based Costing (ABC)? Activity - Based Costing (ABC) is a system that assigns overhead costs based on what actually causes 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 Guide 1. Key ABC Terms You Must Know 1. Activity cost pools ABC groups overhead costs into categories called activity cost pools . An activity cost pool is a “bucket” of overhead costs for a specific activity (like ordering materials or setting up machines). 2. Cost drivers A cost driver is 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 customers So, if a company places more orders, the purchasing department becomes busier and costs rise. How ABC Calculates the Cost Per Unit In ABC, you calculate an activity rate (cost per unit of activity) like this: ABC finds the cost per unit of activity by dividing: Total cost of the activity pool ÷ Total number of activity units This gives the activity cost per unit .

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    Study Guide Example: Lady Trekkers, Inc. Let’s say a company called Lady Trekkers, Inc. identifies its cost pools and cost drivers. Some companies may have only five or six activities, while others may have hundreds . Computers make it much easier for companies to use ABC, even if there are many activities. 2. Lady Trekkers’ Activity Cost Pools and Drivers This 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 calculated To find the per - unit cost for each activity, the company divides: Total dollars in the activity cost pool ÷ Number of activity driver units

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    Study Guide Example: Purchasing Department To calculate the cost per unit for the purchasing department , the company divides: Total purchasing department costs ÷ Number of purchase orders Combining activity pools when they share the same driver Lady Trekkers found that both: • Purchasing Department costs • Receiving Department costs are driven by the number of purchase orders . Since both use the same cost driver, the company can: combine these two cost pools and compute one cost per purchase order . Assigning overhead to products using ABC Once all activity costs per unit are calculated: 1. The company adds up the activity costs. 2. Then it multiplies the activity cost per unit by the number of activity units used. 3. This assigns overhead costs to products more accurately. In simple terms: More activity used = more overhead assigned 3. Activity Categories in ABC ABC recognizes that not all overhead costs happen the same way. Some costs happen for every unit , while others happen per batch , or for an entire product line. To improve accuracy, ABC places activities into four categories :

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