Question

Companies can choose from different costing methods: process/product costing and activity-based costing. Think about a company you know and answer the following:

What are the differences between the two costing methods, and how do these apply to your company?

What are some ABC cost drivers the company might use?

How could the costs differ if one method is chosen over the other?

Which method would you recommend for your company, and why?

Answer 1

1. What are the differences between the two costing methods, and how do these apply to your company?

Product-based costing

Product-based Costing is also known as traditional costing. This Method Seeks to allocate all costs down to individual unit of finished goods. The rationale behind product-based costing is that each unit produced caused a curtain percentage of both Fixed and variable expenses the company incurred. Direct cost such as Raw Materials are allocated per unit and overhead costs are allocated either equally across all units produced or on a weighted basis derived from variable such as direct labor hours.

Disadvantage of Product costing

Product-based costing provides little flexibility in the way that overhead costs are allocated to finished goods. Even if costs are allocated to products in a weighted fashion based on a variable-like cycle time or direct labor, the system is not robust enough to accurately reflect the complicated flow of product in a plant that produces multiple products of different complexity. This can lead to either over-costing or under-costing -- allocating too much or too little overhead to an individual product -- and can also mask inefficiencies in the production system due to its broad application.

Activity –Based costing

Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. This accounting method of costing recognizes the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than traditional costing methods. However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product.

Activity-based costing steps

To use activity-based costing, you must understand the process for assigning costs to activities.

First, identify which activities are necessary to create a product.

Then, separate each activity into its own cost pool, which is a group of individual costs associated with an activity. Determine the total overhead of each cost pool. For example, purchasing could be its own cost pool.

Next, assign activity cost drivers to each cost pool. Cost drivers are things (e.g., units, hours, parts, etc.) that control the changes in costs. For example, purchasing costs are driven by the number of parts purchased.

Divide the total overhead in each cost pool by the total cost drivers to get your cost driver rate.

Lastly, compute how many hours, parts, units, etc. that the activity used and multiply it by the cost driver rate.

ABC systems can be complicated. Check out this example to help further illustrate the process.

Example

Let’s figure out how much you are spending on utilities to create a product. To do this, you estimate that your total utility bill is $20,000 for the year.

You determine that the cost driver impacting your utility bill is the number of direct labor hours worked. The number of direct labor hours worked totaled 1,000 hours for the year.

Divide your total utility bill by your cost driver (the number of hours worked) to get your cost driver rate. Your overhead application rate is $20 ($20,000 / 1,000 hours).

For this particular product, you used utilities for 3 hours. Multiply the hours by the cost driver rate of $20 to get $60.

What are some ABC cost drivers the company might use?

Under the ABC system, an activity can also be considered as any transaction or event that is a cost driver. A cost driver, also known as an activity driver, is used to refer to an allocation base. Examples of cost drivers include machine setups, maintenance requests, consumed power, purchase orders, quality inspections, or production orders.

There are two categories of activity measures: transaction drivers, which involves counting how many times an activity occurs, and duration drivers, which measure how long an activity takes to complete.

Unlike traditional cost measurement systems that depend on volume count, such as machine hours and/or direct labor hours to allocate indirect or overhead costs to products, the ABC system classifies five broad levels of activity that are, to a certain extent, unrelated to how many units are produced. These levels include batch-level activity, unit-level activity, customer-level activity, organization-sustaining activity, and product-level activity.

How could the costs differ if one method is chosen over the other?

Activity-based costing determines all activities associated with production, assigns a cost to those activities and then determines the cost of the product. The other method is Products based costing, which assigns costs to products based on an average overhead rate.

Which method would you recommend for your company, and why?

I will recommend to use activity based costing method to my company. As Activity-based costing (ABC) enhances the costing process in three ways. First, it expands the number of cost pools that can be used to assemble overhead costs. Instead of accumulating all costs in one company-wide pool, it pools costs by activity.

Second, it creates new bases for assigning overhead costs to items such that costs are allocated based on the activities that generate costs instead of on volume measures, such as machine hours or direct labor costs.

Finally, ABC alters the nature of several indirect costs, making costs previously considered indirect—such as depreciation, utilities, or salaries—traceable to certain activities. Alternatively, ABC transfers overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume products.