Posted by: Maj Gatungay
Category: Bookkeeping

Certain activities, such as maintenance or quality control, can oftentimes be accounted for in multiple levels of activity-based costing. Service industries also have cost drivers and can benefit from analyzing what drives their costs. The sales price was set after management reviewed the product cost with traditional allocation along with other factors such as competition and product demand. The current sales price, cost of each product using ABC, and the resulting gross profit are shown in Figure 6.9.

This information shows how valuable ABC can be in many situations for providing a more accurate picture than traditional allocation. Robin Cooper and Robert S. Kaplan, proponents of the Balanced Scorecard, brought notice to these concepts in a number of articles published in Harvard Business Review beginning in 1988. Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management systems. These traditional costing systems are often unable to determine accurately the actual costs of production and of the costs of related services. The number of activities a company has may be small, say five or six, or number in the hundreds. Assume Lady Trekkers, Inc., has identified its activity cost pools and cost drivers (see the following table).

  1. ABC systems and traditional systems often result in vastly different product costs.
  2. With activity-based costing, you take into consideration both the direct and overhead costs of creating each product.
  3. Manufacturing overhead includes all other expenses incurred during the manufacture of a product that cannot be directly allocated to that product.
  4. Imagine having 15 cost pools (activities), each with a predetermined overhead rate used to assign overhead costs to the company’s 80 products—not an unrealistic example for a large company.

Activity-based costing identifies all of the specific overhead operations related to the manufacture of each product. Batch-level activities are work actions that are classified within an activity-based costing accounting system, often used by production companies. Examples of these batch-level cost drivers can often include machine setups, maintenance, purchase orders, and quality tests. For the year, there were 2,500 labor hours worked, which in this example is the cost driver. Calculating the cost driver rate is done by dividing the $50,000 a year electric bill by the 2,500 hours, yielding a cost driver rate of $20.

We have discussed three different methods of allocating overhead to products—plantwide allocation, department allocation, and activity-based costing. The costs of unit‐level, batch‐level, and product‐line activities are easily allocated to a specific product, either directly as a unit‐level activity or through allocation of a pooled cost for batch‐level and product‐line activities. The way in which companies will structure the schedule by which machines are set up is an example of how batch-level activity accounting can influence the practices of a manufacturer.

Some of the overhead related to monitoring a patient’s health status may overlap, but most of the overhead related to diagnosis and treatment differ from each other. The predetermined overhead rate found in step four is applied to the actual level of the cost driver used by each product. As with the traditional overhead allocation method, the actual overhead costs are accumulated in an account called manufacturing overhead and then applied to each of the products in this step. In such companies, activity‐based costing (ABC) is used to allocate overhead costs to jobs or functions.

Example of Batch-Level Activities

Look at the overhead rates computed for the four activities in the table below. Note that the total overhead for current year is $2,000,000 using activity-based costing, just as it was using a traditional costing method. The total amount of overhead should be the same whether using activity-based costing or traditional methods of cost allocation to products.

It is more suited to businesses with high overhead costs that manufacture products, rather than companies that offer services. Companies that manufacture a large number of different products prefer an activity-based system because it gives more accurate costs of each product. With activity-based allocation of overhead costs, it is easier to identify areas where expenses are being wasted on unprofitable products. A per unit cost is calculated by dividing the total dollars in each activity cost pool by the number of units of the activity cost drivers.

The Service Industries and Their Use of the Activity-Based Costing Allocation Method

The companies that used activity-based costing (ABC) had higher overhead costs as a percent of total product costs than companies that used traditional costing. The complexity of production processes and products tended to be higher for those using ABC, and ABC companies operated at capacity more frequently. With activity-based https://simple-accounting.org/ costing, you take into consideration both the direct and overhead costs of creating each product. By assigning both direct and overhead expenses to each product, you can more accurately set prices. And, the activity-based costing process shows you which overhead costs you might be able to cut back on.

Batch-level activities are related to costs that are incurred whenever a batch of a certain product is produced. However, these costs are accounted for regardless of the related production run’s size. When using ABC, the total cost of each activity pool is divided by the total number of units of the activity to determine the cost per unit. These levels include batch-level activity, unit-level activity, customer-level activity, organization-sustaining activity, and product-level activity.

Historical Perspective on Determination of Manufacturing Overhead Allocation

However, the service industry can apply the same principles to improve its cost management. Direct material and direct labor costs range from nonexistent to minimal in the service industry, which makes the overhead application even more important. The number and types of cost pools may be completely different in the service industry as compared to the manufacturing industry. For example, the health-care industry may have different overhead costs and cost drivers for the treatment of illnesses than they have for injuries.

Kohler found that a traditional form of managerial accounting was not going to suffice in properly and accurately accounting for the costs that were being incurred by the TVA in the process of carrying out their duties. Kohler introduced the concept of accounting for the costs of these processes by accurately assessing the activities involved in carrying them out. A classic example is the cost to set up a production run; this cost is then assigned to the units produced as a result of that setup. An example of a batch activity is the setting up of a machine to produce a batch of 1,000 identical items. The loss on each sale of the Solo product was not discovered until the company did the calculations for the ABC method, because the sales of the other products were strong enough for the company to retain a total gross profit. Kohler defined an activity as a portion of work done by a specific part of the company.

The other levels of activity that are accounted for by activity-based costing are unit-level activities, customer-level activities, production-level activities, and organization-sustaining activities. A fundamental difference between traditional costing and ABC costing is that ABC methods expand the number of indirect cost pools that can be allocated to specific products. The traditional method takes one pool of a company’s total overhead costs to allocate universally to all products. Activity-based costing focuses on identifying the activities required to make products, on forming cost pools for each activity, and on allocating overhead costs to the products based on their use of each activity. ABC systems and traditional systems often result in vastly different product costs.

Batch-level activities — AccountingTools

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What Are Batch-Level Activities?

Assigning costs to activities takes time, as does identifying and tracking cost drivers. And assigning costs to products requires a significant amount of time in the accounting department. Imagine having 15 cost pools (activities), each with a predetermined overhead rate used to assign overhead costs to the company’s 80 products—not an unrealistic example for a large company. The accounting costs incurred to maintain batch level activity such a system can be prohibitively high. The ABC column represents overhead costs allocated using the activity-based costing shown back in Figure 3.5 “Allocation of Overhead Costs to Products at SailRite Company”. Traditional costing adds an average overhead rate to the direct costs of manufacturing products and is best used when the overhead of a company is low compared to the direct costs of production.

In activity-based costing (ABC), an activity cost driver influences the costs of labor, maintenance, or other variable costs. Cost drivers are essential in ABC, a branch of managerial accounting that allocates the indirect costs, or overheads, of an activity. Labor and materials costs are considered direct costs if they are incurred during the manufacture of a product and can be directly allocated to that product. Manufacturing overhead includes all other expenses incurred during the manufacture of a product that cannot be directly allocated to that product.

Maj Gatungay