Activity Based Costing Overview

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Questions and Answers

What is the primary focus of Activity-Based Costing (ABC)?

Allocating costs based on direct labor hours only

Determining profit margins based exclusively on batch-level activities

Tracing costs to activities and then to products (correct)

Assigning overhead costs per unit produced

Which characteristic is most significant for a company to effectively utilize Activity-Based Costing?

High overhead costs that do not correlate with unit volume (correct)

Reliance on manual labor for all production processes

Production of a single product only

Low overhead costs relative to unit volume

In Activity-Based Costing, what are unit-level activities?

Activities performed for each unit produced (correct)

Activities that support batches of products

Activities that occur each time a new product is introduced

Activities unrelated to the production process

Which of the following describes product-sustaining activities?

Activities incurred to support the production of a product different from what is currently produced Signup and view all the answers

What is a key difference between traditional costing and Activity-Based Costing?

Traditional costing relies on one allocation basis for overhead costs Signup and view all the answers

How does Activity-Based Costing handle overhead costs in a highly automated production environment?

It uses machine hours as the allocation base Signup and view all the answers

Which of the following is a facility-sustaining activity?

Maintaining security services for the factory Signup and view all the answers

What occurs at the beginning of a period in a traditional costing system?

An allocation rate is determined based on the selected allocation basis Signup and view all the answers

What is a significant benefit of using Activity-Based Costing (ABC) over traditional volume-based costing?

It provides a more accurate allocation of indirect costs per unit. Signup and view all the answers

Which of the following is a requirement for effective implementation of Activity-Based Costing?

Identification of relevant cost drivers is essential. Signup and view all the answers

Which of these activities could be considered a typical cost driver in an ABC framework?

Machine maintenance frequency Signup and view all the answers

Which statement correctly reflects a limitation of Activity-Based Costing?

It is difficult to allocate a majority of overhead costs to specific activities. Signup and view all the answers

How do you calculate a cost driver rate in the ABC system?

Activity cost / Total cost driver volume Signup and view all the answers

What is a common misconception about Activity-Based Costing?

It can only be used for manufacturing costing. Signup and view all the answers

What role does the concept of 'cost pool' play in Activity-Based Costing?

It groups activities that consume resources and incur overhead costs. Signup and view all the answers

Which statement reflects one of the major advantages of implementing ABC?

It improves management's understanding of overhead cost drivers. Signup and view all the answers

What is the first step in the process of calculating production costs using ABC?

Group production overheads into activities based on cost drivers. Signup and view all the answers

Which of the following is NOT a disadvantage of Activity-Based Costing?

It is overly simplistic for complex businesses. Signup and view all the answers

Study Notes

Activity Based Costing

Activity based costing (ABC) assigns costs to products based on activities required to produce, perform, distribute or support those products.
ABC traces costs to activities first, then to products.
ABC works best when companies:
- Produce or perform a variety of products or services
- Have high overhead costs not proportional to product volume
- Have significant automation making it difficult to allocate overhead using traditional methods
- Have difficult to explain profit margins
- Produce difficult-to-make, high-profit products alongside easy-to-make, low-profit products.

Categories of Activities

Unit-level activities: Occur for each unit produced (e.g., hours of work, inspection)
Batch-level activities Occur each time a batch is produced (e.g., machine setup, purchasing, scheduling, material handling, inspection)
Product-sustaining activities: Support the production of different products (e.g., product design, engineering changes)
Facility-sustaining activities: Support general production (e.g., security, maintenance, plant management)

Traditional Costing vs. Activity-Based Costing

Traditional Costing:
- Allocates overhead costs to products using one allocation basis (e.g., machine hours, direct labor hours, number of components)
- Uses a predetermined allocation rate based on the chosen allocation basis
Activity-Based Costing:
- Identifies cost drivers (activities causing costs)
- Allocates costs to activities and calculates a cost driver rate for each (e.g., cost per move, cost per machine breakdown)
- Provides more accurate allocation of indirect costs and overhead compared to traditional volume-based systems

Calculating Full Production Cost Using ABC

Step 1: Group overhead costs into activities (cost pools), identifying cost drivers for each activity
Step 2: Identify cost drivers for each activity
Step 3: Calculate a cost driver rate for each activity (activity cost / total cost driver volume)
Step 4: Allocate activity costs to products
Step 5: Calculate total production cost per unit

Advantages of ABC

More accurate cost per unit, improving pricing, sales strategy, performance management, and decision making
Better insight into overhead cost drivers
Recognizes that overhead costs are not always related to production and sales volume
Facilitates overhead cost control by managing cost drivers
Applicable to all overhead costs, not just production overheads
Applicable to service costing as well as product costing

Disadvantages of ABC

Limited benefit if overhead costs are mainly volume-related or a small proportion of overall cost
Difficult to allocate all overhead costs to specific activities
Choice of activities and cost drivers might be inappropriate
Can be complex to explain to stakeholders
Benefits might not justify the costs
In some cases, ABC might not provide significantly different information than traditional costing

Conclusion

Overhead absorption techniques require careful consideration before implementation.
ABC can improve cost allocation accuracy and provide valuable insights for businesses.

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Description

Explore the fundamental concepts of Activity Based Costing (ABC) and how it assigns costs to products based on specific activities. This quiz covers the types of activities—unit-level, batch-level, and product-sustaining—and the conditions that make ABC particularly effective for companies. Test your understanding of how ABC can optimize cost allocation and profit margins.