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uses broad averages for assigning the cost of resources uniformly to cost objects when the individual product might not use resources in the same way.
*historically companies used a simple costing system because they did not have such a variety of products so indirect cost could be allocated evenly amongst products. Now that has changed
Broad averaging can lead to:
Product undercosting: a product consumes a high level of resources but is reported to have a low cost per unit
Product overcosting: product consumes a low level of resources but is reported to have a high cost per unit.
*splitting a dinner 4 ways evenly when cost of individual dinner is not evened out.
if a company overcosts one of its units, it will undercost another and vis versa.
*if meal is divided evenly amongst parties some parties are paying more for their meal while other parties are paying less for what their direct meal costs.
Simple Costing System
allocates indirect cost using a single indirect cost rate:
- Step 1: Identify the Products that are the chosen cost objects
- Step 2: Identify the Direct cost of the products (direct materials and direct manufacturing labor)
- Step 3: Select the Cost-Allocation Bases to use for allocating Indirect Cost (overhead) (direct manufacturing labor hours)
- Step 4: Identify the indirect cost that correlate to the allocation bases (step 3)
- Step 5: Compute the rate/unit of each cost allocation base: total indirect costs/ total cost-allocation base = indirect cost rate
- Step 6: Compute the Indirect Cost allocated to the Products (Step 5 x Step 1)
- Step 7: Add all indirect cost (step 6) to direct costs.
5 Step Decision Making
- 1.) Identify the problem
- 2.) Obtain information
- 3.) Make predictions about the future
- 4.) Make decisions by choosing among alternatives
- 5.) Implement decision evaluate the performance and learn
Refining Cost System
reduce the use of broad averages for assigning the cost of resources to cost objects and provides a better measurement of the costs of indirect resources used by different cost objects.
* example is activity based costing abc
Reasons for Refining a Costing System
- Increase in product diversity
- Increase in indirect costs
- Competition in product markets
Guideline for Refining a Costing System
- Direct-cost tracing
- Indirect-cost pools
- Cost allocation bases
Activity Based Costing:
refines a cost system by identifying individual activities as the fundamental cost object.
In ABC an activity is an even task or unit of work with a specified purpose. Must be a verb
Ex: designing products, setting up machines distribution and operating machines
*activities must be defined and account for a good amount of indirect costs and combines activities that have the same cost drivers
Identify all indirect costs possible to reduce the amount of cost classified as indirect.
A guideline when refining a costing system
Indirect cost pool
expand the number of indirect cost pools until each pool is similar (ie single cost driver for each pool and narrow focused cost)
A guideline when refining a costing system
use the cost driver as an allocation bases for each similar indirect cost pool
categorizes various activity cost pools on the basis of different types of cost drivers/cost allocation bases.
- Four Levels
- 1. Output unit-level costs
- 2. Batch-level costs
- 3. Product sustaining costs
- 4. Facility sustaining costs
Output unit-level costs
the costs of activities performed on each individual unit of a product or service
cost of activities related to a group of units of a product or service rather than each individual unit of product or service.
Product sustaining costs
the costs of activities under taken to support the individual product or services regardless of the number of units or batches in which the units are produced.
cost of activities that cannot be traced to individual product or services but that support the organization as a whole.
In order to apply ABC approach to a costing system a company must follow
the seven-step approach to costing and the three guidelines for refining costing systems.
Signs of when ABC system will provide the most benefits:
-large amounts of indirect costs are allocated using only one or two cost pools
-the majority of indirect costs are identified as output unit-level
-products make a diverse demand on resources b/c of differences in volume steps, batch size or complexity
-products that a company is well suited to make and sell show small profits and vis versa
-operations staff has substantial disagreement w/ the reported costs of manufacturing and marketing products and services
uses ABC information to improve customer satisfaction and profitability
- -pricing and product mix decisions
- -cost reduction and process improvement decisions
- -design decisions
- -planning and managing activities
the detailed data from ABC with a value-added analysis by adding customer-perceived value of each activity. ABM identifies value-added and non-value-added activities, and gives managers opportunities to enhance value-added activities and to reduce non-value-added activities.
are important to the customer. From the customer’s perspective they add actual or perceived value, e.g. quality materials,excellent product design.
are not perceived by the customer to add value to the product or service, e.g. defective units, manufacturing equipment breakdowns, completing a firm’s corporate income taxes or weekly staff meetings.