Tag Archives | costing

Activity Based Costing

See Also:
Activity-based Costing (ABC) vs Traditional Costing

Activity Based Costing

Activity based costing is a system that attempts to accurately trace indirect costs to products by allocating indirect costs to activities and then to products based on their usage of the activities. ABC is optimal when accuracy is very important and when indirect costs comprise a large proportion of total costs compared to direct costs.

ABC is commonly used in the manufacturing sector. A reason why it is so useful for the manufacturing sector is fairly obvious, by allocating indirect costs to products based on usage, a company can more accurately see where the resources and energy is going in their company. By figuring out where the money and energy is going, efforts can be focused upon those products that are eating up the most time and energy. This will eventually lead to a drop in cost, in theory, as efforts will be made to reduce the costs on the bulk of the products. Activity based costing is all about efficiency. Efficiency is paramount to success and growth within a company and that is why activity based costing is an effective way to allocate indirect costs within a company to products.

Activity Based Costing Steps

Th four following steps include the activity based costing process:

1. Identify and classify all of the activities in the value chain related to the production of the product.

2. Estimate a total cost for each of the activities identified.

3. Compute a cost-driver rate for each activity based on a cost allocation base that has a causal link to the cost of the activity.

4. Apply activity costs to products using the appropriate cost-driver rate.

Activity-Based Costing Example

For example, a company identifies and classifies machine maintenance as an indirect cost activity. Based on historical data, the company estimates machine maintenance costs to be $1,000 per month. The company determines that batches of product produced on the machine are an appropriate cost-driver allocation base for machine maintenance costs. The machine typically produces 500 batches per month. Thus, the cost-driver rate would be $1,000/500 batches, or $2/batch. So, for each batch of product produced, the company would apply $2 of indirect cost for machine maintenance.

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Absorption Cost Accounting

See Also:
Semi Variable Costs
Standard Costing System
Variable vs Fixed Cost

Absorption Cost Accounting

Absorption cost accounting (also known as the “Cost-Plus” approach), is a method that is centered upon the allocation of Manufacturing Cost to the product. This method is important for situations when a company needs to decide if it can be competitive in a market, or when the company has control over the pricing in general. This means that Direct Labor, Direct Materials, as well as fixed and variable Overhead Definition are all “absorbed” into product pricing as well as product costing.

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Absorption Cost Per Unit

Because absorption cost accounting is a “per-unit” method, it is necessary to understand how to determine the absorption cost per unit. So the fair question remains: What is the absorption cost approach? Ultimately, all of the calculations are done on a Per-Unit basis. For example, Wintax Company creates 5,000 products with Variable Cost per unit being $60 direct materials, $110 direct labor, and $40 variable overhead. In addition to the per-unit costs, the fixed overhead is $100,000. In order to obtain the product cost under absorption costing, first the per-unit costs are added together (direct labor, direct materials, variable overhead). After that, per-unit costs need to be obtained from the fixed overhead so that the per-unit overhead can be applied to the per-unit cost. Adding the overhead to the per-unit costs completes what is absorption costing per unit. See how to work out the problem below.

Solution

Per-Unit Costs Fixed-overhead per-unit
(direct labor + direct materials +variable overhead) + (fixed overhead / number of units)
($210) + ($20)
Absorption cost per unit: $230

Absorption Cost Unit Pricing

In addition to determining the overall cost of a singular product, absorption cost accounting gives one the ability to determine the appropriate selling price of a unit as well. As long as there is a target profit, the absorption costing method can calculate the appropriate price. For example, Bizzo Company desires a profit of $180,000 while producing 10,000 products. In addition, each product costs $150 to produce in total. In order to determine the appropriate selling price, first, divide profit by the number of products. Add that number to the original product cost in order to achieve the correct product price. Check out the solution worked out below.

Solution

((Desired Profit) / (Number of Units)) + (Product Cost Per-Unit)
( $180,000 / 10,000 ) + ( $150 )
Target Product Price= $168

Absorption Costing Formulas

(Absorption Cost per-unit) = (Per-Unit Variable Costs) + (Per-Unit Fixed Overhead)
Sales Price = (Manufacturing Cost Per-Unit) + (Sales and Administrative Cost Per-Unit) + (Profit Markup)

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Absorption Cost Accounting

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Implementing Activity Based Costing

All of us have used cost allocation as part of our Financial Services offerings since it is required by GAAP. Cost allocation is the process of assigning common costs to ending inventory and cost of goods sold (COGS). Our goal has been to either reduce taxes or increase reported earnings, but this all depends on our client’s needs and circumstances. But what about cost allocation’s other uses? Are we shortchanging our clients by not offering services in this area (usually referred to as cost or management accounting services)?

Implementing Activity Based Costing

Managers’ use cost allocation for a number of reasons. First and foremost, cost allocation provides a methodology for assigning overhead costs of various activities, usually support departments, to products or services being produced and/or sold allowing upper management to assess and analyze their profitability.

By knowing what the true “cause-and-effect” relationship is, managers can more accurately assess the true cost of a product or service. Then they can determine if carrying certain products and/or services contributes to overall profitability given the demand for and price these products/services sell for. This is especially important as it pertains to both operational decisions and capital/long-term decisions.

Some of the operational decisions include the following:

  • Calculating the maximum price a firm can charge, especially for a “commodity” product
  • Determining the maximum cost a firm is willing to pay to provide this product or service
  • In making special order and transfer pricing decisions

Some of the capital/long-term decisions include the following:

Cost Allocation

You can also use cost allocation to reduce wasteful spending and/or promote more efficient use of resources (especially PP&E). Accomplish this by evaluating needs and uses for the year to come as part of the planning/budgeting process. Managers can then be evaluated on their planning effectiveness, leading to better communication, sharing of resources, and cost efficiency. You can also use it to manage product and process design. As one breaks down and/or determines allocations, the use of resources becomes transparent from a process standpoint. This allows managers to improve operations as needed….

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Implementing Activity Based Costing, Cost Allocation

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