Question

Activity-based costing (ABC) conforms to GAAP and because of that most companies use ABC for external repo Select one: True O False

Answer 1

Hi There,

Here is my answer to the question asked.

The statement is " FALSE "

ABC costing DO NOT conforms to GAAP ( genrally accepted accounting principles).

What is activity-based costing?

The activity-based costing (ABC) system is a method of accounting you can use to find the total cost of activities necessary to make a product. The ABC system assigns costs to each activity that goes into production, such as workers testing a product.With activity-based costing, you take into consideration both the direct and overhead costs of creating each product. You recognize that different products require different indirect expenses. 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.

ABC costing Non Conformity with GAAP :

  Activity-based costing systems, known as ABC systems in practice, are not compliant with generally accepted accounting principles. However, this does not mean that ABC systems aren't useful. ABC systems provide valuable information for managerial decision-making. However, knowing the similarities between ABC systems and GAAP-compliant systems can help you decide if the extra expense of keeping two systems is worthwhile for your small business.

REASONS ARE :

Since activity based costing (ABC) system generally provides more accurate product costs than traditional costing methods, why isn't it used for external reports?

Some companies do use activity based costing in their external reports, but most do not. There are a number of reasons for this. First, external reports are less detailed than internal reports prepared for decision making. On the external reports, Individual product costs are not reported. Cost of goods sold and inventory valuations are disclosed, but their is no breakdown of these accounts by product. If some products are under-costed and some are over-costed, the errors tend to cancel each other when the product costs are added together.

Second, it is often very difficult to make changes in a company's accounting system. The official cost accounting system in most large companies are usually embedded in complex computer programs that have been modified in-house over the course of many years. It is extremely difficult to make changes in such computer programs without causing numerous bugs.

Third, an ABC costing system does not conform to generally accepted accounting principles (GAAP). Product cost computed for external reports purposes must include all of the manufacturing costs and only manufacturing costs; but in ABC system products costs exclude some manufacturing costs and include some non-manufacturing costs. It is possible to adjust the ABC data at the end of the period to conform to GAAP but it requires more work.

Fourth, the auditors are likely to be uncomfortable with allocation that are based on interviews with the company's personnel. Such objective data can be easily manipulated by management to make earnings and other key variables look more favorable.

For all of these reasons, most companies confine their ABC efforts to special studies for management, and they do not attempt to integrate activity based costing into their formal cost accounting system.

ADDITIONAL REASONS ARE :

Manufacturing Costs

One of the major reasons that ABC is not compliant with GAAP is that ABC systems do not assign all manufacturing costs to products. Organization-sustaining costs, such as expenses related to factory security, heating and air conditioning and building rent, will be incurred regardless of the level of production. As such, ABC systems do not assign these costs to products. The thinking here is that if a cost doesn't change based upon what is going on in the factory, then the cost isn't relevant to decision-making. While this makes sense from a managerial decision-making standpoint, this is in violation of GAAP.

Non-manufacturing Costs

ABC systems assign some specific non-manufacturing costs to products, even though this process is not allowed under GAAP. ABC principles dictate that all costs that are relevant to the product should be included in product cost. For example, if a custom product requires additional phone support staff to take customer orders, then this cost should be included as part of the product cost. Even though this isn't a manufacturing cost, if the phone personnel did not take these calls, there would be no product orders. In addition, if the company discontinued the custom product, the phone employees could be eliminated.

Cost Pools

In contrast with traditional costing systems, ABC systems use multiple cost pools to allocate overhead to products. Cost pools are "buckets" where costs are accumulated to be assigned to products. These cost pools are related to specific activities that occur in the company. For example, a small business may produce more than one product and need to set up machinery when switching from manufacturing one product or another. The overhead costs incurred due to switching products would be accounted for as part of the job setup cost pool. The disparity between this method and traditional costing systems is that traditional costing systems use a plant-wide or departmental rate to allocate all overhead costs as part of one large "bucket."

Traceable Costs

Traditional costing systems and ABC systems treat traceable costs in the same manner. Traceable costs, those costs that can be easily and cost-effectively directly traced to products, are directly applied to products under both systems. For small businesses, these costs are most often related to materials and labor costs. For example, if an employee works 8 hours at a rate of $20 per hour and manufactures a batch of 160 products, each product would be traced $1 of this employee's labor cost.