ACCTG 231 Lecture 7 Ch. 3Outline of Current Lecture I. Assigning Overhead Costs to ProductsII. Plantwide Overhead RateIII. Departmental Overhead RatesIV. Activity-Based Costing (ABC)V. Designing an Activity-Based Costing SystemVI. Hierarchy of ActivitiesVII. Shifting of Overhead CostVIII. Targeting Process ImprovementsIX. Benefits of Activity-Based CostingX. Limitations of Activity-Based CostingXI. Activity-Based Costing Critical AssumptionXII. Modifying the ABC ModelCurrent LectureI. Assigning Overhead Costs to Products- When cost systems were developed in the 1800s, the emphasis was on simplicity because:o Cost and activity data had to be collected by hand and all calculations were done with paper and pencilo Most companies produced a limited variety of similar products, so therewas little difference in the overhead costs consumed by each productII. Plantwide Overhead Rate- Plantwide Overhead Rate: A single overhead rate used throughout an entire factory- Direct labor has often been used as the allocation base for overhead because:o Direct labor information was already being recordedo Direct labor was a large component of product costso Managers believed direct labor and overhead costs were highly correlated- Today, direct labor may no longer be a satisfactory base for allocation of overheado Most companies sell a large variety of products that consume differing amounts of overheadThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.o As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of these growing overhead costs may not be correlated with direct laboro Technology advancements have reduced the cost and complexity of gathering diverse sources of data- A plantwide overhead allocation system may not be optimal for many companies in today’s business environment.III. Departmental Overhead Rates- Many companies have a system in which each department has its own overhead rate- The allocation base depends on the nature of the work performed in each department- In the matching department, overhead may be based on machine-hours, but in the assembly department, overhead may be based on labor-hourso Matching departmentassembly departmentshipping department- Departmental rates will not correctly assign overhead in situations where a company has a range of products and complex overhead costs- The department approach relies exclusively on volume-related allocation bases while some overhead costs may be caused by factors that are not related to the volume of production- Activity-based costing is required to account for these other factorsIV. Activity-Based Costing (ABC)- A number of allocation bases are used for assigning costs to products- Cost Objects (e.g., products and customers)ActivitiesConsumption of ResourcesCost- ActivityAn event that causes the consumption of overhead resources- Examples of Activitieso Setting up machineso Admitting hospital patientso Billing customerso Opening a bank account- Activity Cost Pool A “cost bucket” in which costs related to a particular activity are accumulated- Activity measureExpresses how much of the activity is carried out and is used as the allocation base for applying overhead costs- Activity RateA predetermined overhead rate for each activity cost pool- For each activity in isolation, this system works exactly like the job-order costing system- A predetermined overhead rate is computed for each activity and then applied tojobs and products based on the amount of activity consumed by the job or productV. Designing an Activity-Based Costing System- The challenge is to select a reasonably small number of activities that explain thebulk of the variation in overhead costs- Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization’s resources- Related activities are frequently combined to reduce the amount of detail and record-keeping costso Ex: several actions may be involved in handling and moving raw materials, but these may be combined into a single activity titled material handling- An activity dictionary defines each of the activities that will be included in the activity-based costing system and how the activities will be measuredVI. Hierarchy of ActivitiesLevel Activities Activity MeasureUnit-level Processing units on machinesProcessing units by handConsuming factory suppliesMachine-hoursDirect labor-hoursUnits ProducedBatch-level Processing purchase ordersProcessing production ordersSetting up equipmentHandling materialsPurchase orders processedProduction orders processedNumber of setupsPounds of material handledProduct-level Testing new productsAdministering parts inventoriesDesigning productsHours of testing timeNumber of part typesHours of design timeFacility-level General factory administrationPlant building and groundsDirect labor-hoursDirect labor-hoursVII. Shifting of Overhead Cost- When a company implements activity-based costing, overhead cost often shifts from high-volume to low-volume products with a higher unit product cost resulting for the low-volume products- Production Orders Activity Cost Pool (a batch-level cost pool)- The ABC system assigns different amounts of Production Order-related overhead costs to each product. This fact can be illustrated in a two-step processo Compute the number of units processed per production order for each producto Compute production order cost per unit for each productVIII. Targeting Process Improvements- An ABC system can help identify areas where the company can benefit from improving its current processes- Activity-Based Management: Focuses on managing activities to eliminate waste and reduce delays and defects- The first step in any improvement program is deciding what to improveo The Theory of Constraints approach targets the highest impact improvement opportunitieso Activity rates can be used to target areas where costs seem excessively higho Benchmarketing can be used to compare activity cost information with world-class standards of performance achieved by other organizationsIX. Benefits of Activity-Based Costing- ABC improves the accuracy of product costing by:o Increasing the number of cost pools used to accumulate overhead costso Using activity