25-04-2021

Choosing Cost Drivers Activity Based Costing

  1. Read this article on Questia. Academic journal article The Government Accountants Journal Practical Issues in Cost Driver Selection for Managerial Costing Systems.
  2. Activity-Based Costing (ABC) and Activity Based Management. Managerial Accounting Chapter 10. For each cost pool, choose cost driver that has strongest casual.
  3. PART I INTRODUCTION TO COST MANAGEMENT Activity-Based Costing and Management. Issa Is-haka Ngwali. Download with Google Download with Facebook or download with email. PART I INTRODUCTION TO COST MANAGEMENT Activity-Based Costing and Management. PART I INTRODUCTION TO COST MANAGEMENT Activity-Based Costing and Management.
  4. Implementing Activity-Based Costing Step 3: Select the cost-allocation bases to use in allocating indirect costs to the products. Activities identified Cost drivers H-level 1 Design design hours 3 2 Machine setups # of setups 2 22 3 Manufacturing operations units 1 4 Shipment set up # of orders 2 5 Distribution # of orders 2 6 Administration 4.

Each activity has an associated cost pool and requires a cost driver rate using the formula above. • The second stage in a two-stage system using activity-based costing allocates costs to products by multiplying the cost driver rates by the number of units of the cost driver (i.e., volume of activities) consumed in each product. Exhibit 9.11 illustrates such a process.

If you make and sell products, you want the best information available for the major decisions you need to make, including setting sale prices for your merchandise. One management strategy that gives you more accurate decision-making information is activity-based costing. This costing practice lets you assign expenses to your products to give you an accurate picture of what it costs to make each individual item of your inventory.

Activity Based Costing Notes

Traditional Costing vs. Activity-Based Costing

A traditional costing system uses a flat rate to help distribute expenses that are shared among several product lines. So if you make three products, you might allocate:

  • 50% of costs to Product A
  • 30% to Product B
  • 20% to Product C

If your total monthly expenses are $10,000, $5,000 of this expense is your cost of making Product A.

Activity-based costing lets you use multiple rates for different expenses. Traditional costing groups all your costs together, but that might not be an accurate measure. For example:

Activity Based Costing Vs Traditional Costing

Drivers
  • Part of the costs for Products A, B and C include hiring a consultant who spends a total of 10 hours helping you develop all three products.
  • Under the traditional costing system, you see 50% of the costs are associated with Product A.
  • However, your consultant only spends two hours helping develop that product, which would make allocating 50% of the costs to Product A off balance.

Choosing Cost Drivers Activity Based Costing

Activity-based costing lets you set a different rate for each type of expense, so you know the exact cost for each product. In the consulting example, 20% of the consultant’s bill goes toward making Product A, instead of 50%. If you use 10% of your office’s square footage to make Product A, you should assign 10% of your rent as a cost of the product. Rather than using one flat rate when assigning costs, you choose multiple rates based on different activities.

Different Cost Drivers Make Activity-Based Costing Work

Cost drivers are variables that explain why costs happen. Activity-based costing works because you choose multiple cost drivers. Going back to the consultant example, the number of hours the consultant works and your office’s square footage are both cost drivers.

Activity Based Costing Example

Traditional costing systems use just one cost driver. Under activity-based costing, you control how many drivers you use. You make your expense tracking system as complex or simple as you want. That way, you’re more detailed when looking at your costs and you’re getting better information about your goods.

Why Use Activity-Based Costing?

If you can’t directly trace your costs to a product, it’s a good time for activity-based costing. Say you make wooden chairs and dressers and your accountant asks you, “How much does it cost to make a product?

You know the cost of making a chair includes the wood and your labour, but you can’t determine other costs so easily. How much of the overhead cost of your wood glue, nails, paint or finish that you use for both products should you assign to the chair? You don’t have a way of telling exactly how much you used, or maybe it’s not efficient for you to track the costs. You do know that dressers use up more of these materials, so it’s only fair that you assign more of the costs to dressers.

You can’t do this under a traditional costing system. By using an activity-based costing system, you can:

  • See what expenses you should assign to your inventory, and
  • Figure out a closer estimate of the true cost of each item you sell.

Activity-based costing gives you better information, so you price your goods correctly

Using activity-based costing for your products and having that data handy helps you set the right prices to maximize your profit margins. Keep your books accurate and up-to-date automatically. Change the way you manage your finances with Quickbooks Online now.

26 Cards in this Set

  • Front
  • Back
Managers often estimate cost functions based on 2 assumptions:
1. Variations in the level of a single activity (the cost driver) explain the variations in the related total costs.
2. Cost behavior is approximated by a linear cost function within the relevant range. For a linear cost function represented graphically, total cost versus the level of a single activity related to that cost is a straight line within the releveant range.
A particular cost item could be variable with respect to one cost object and fixed with respect to another cost object.
Whether a cost is fixed or variable depends on the time horizon being considered in the decision situation. The longer the time horizon all things equal, the more likely that the cost will be variable.
to measure a relationship based on data from past costs and the related level of an activity. Managers are interested in estimating past cost behavior functions primarily because these estimates can help them make more accurate cost predictions or forecasts about future costs.
Estimates cost functions by analyzing the relationship between inputs and outputs in physical terms. Very thorough and detailed way to estimate a cost function when there is a physical relationship between inputs and outputs. But it can be very time consuming and physical relationships can be hard to specify for some items such as indirect manufacturing costs.
Estimates cost functions on the basis of analysis and opinions about costs and their drivers gathered from various departments of a company (purchasing, process engineering, manufacturing, employee relations and so on) Encourages interdepartmental cooperation. Pooling of expert knowledge from different business functions of the value chain gives the conference method credibility. Because it does not require detailed analysis of data cost functions and cost estimates can be developed quickly. However, emphasis on opinion rather than systematic estimation means that the accuracy of the cost estimates depends largely on the care and skill of ppl providing the inputs.
Estimates cost function by classifying various cost accounts as variable, fixed, or mixed with respect to identified level of activity. Managers use qualitative rather than quantitative analysis when making these cost classification decisions. The account analysis approach is widely used because it is reasonably accurate, cost effective, and easy to use. The goal is to use account analysis to estimate a linear cost function for indirect manufacturing labor costs with number of machine hours as the cost driver. Cost analyst uses experience and judgment to separate total indirect manufacturing labor costs into costs that are fixed and costs that are variable.
Uses a formal mathematical method to fit cost functions to past data observations. There are 6 steps to this method.
1. Choose the dependent variable.
2. Identify the independent variable, or cost driver.
3. Collect data on the dependent variable and the cost driver.
4. Plot the data.
5. Estimate the cost function.
6. Evaluate the cost driver of the estimated cost function.
Simplest form of quantitative analysis to 'fit' a line to data points is the high low method. It uses only the highest and lowest observed values of the cost driver within the relevant range and their respective costs to estimate the slope coefficient and the constant of the cost function. The estimated cost function is a straight line joining the observations with the highest and lowest values of the cost driver. There is a danger of relying on only 2 observations to estimate a cost function. The advantage is that it's simple to compute and easy to understand; it gives a quick, initial insight into how the cost driver - number of machine hours - affects indirect manufacturing labor costs. The disadvantage is that it ignores information from all but 2 observations when estimating the cost function.
Difference between costs associated with highest and lowest observations of the cost driver / difference between the highest and lowest observations of the cost driver.
= highest cost - (slope coefficient x cost driver)
Statistical method that measures the average amount of change in the dependent variable associated with a unit change in one or more independent variables. The regression line is derived using the least squares technique. The least squares determines the regression line by minimizing the sum of the squared vertical differences from the data points to the regression line. The vertical difference called residual term, measures the distance between actual costs and estimated costs for each observation. The smaller the residual terms, the better the fit between actual cost observations and estimated costs. More accurate than high low because we have info from all observations. Accurate cost estimation helps managers predict future costs and evaluate the success of cost reduction initiative.
How does a company determine the best cost driver when estimating a cost function?
In many cases, the choice of a cost driver is aided substantially by understanding both operations and cost accounting.
What guidance do the cost estimation methods provide for choosing among cost drivers?
The industrial engineering method relies on analyzing physical relationships between cost drivers and costs, relationships that are difficult to specify in this case, The conference method and the account analysis method use subjective assessments to choose a cost driver and to estimate the fixed and variable components of a cost function., Managers rely on their best judgement. The major advantage of a quantitative method are that they are objective- a given data set and estimation method result in a unique estimated cost function- and managers can use them to evaluate different cost drivers.
Describe three criteria used to evaluate and choose cost drivers
1. Economic plausibility
2. Goodness of fit.
3. Significance of independent variable.
What happens if managers fail to identify the proper cost drivers?
Management would be misled into believing the new style is more profitable than it actually is. Incorrectly estimating would also have repercussions for cost management and cost control.
Focus on individual activities such as product design, machine setup, materials handling, distribution, and customer service as the fundamental cost object. The manager collects cost data on materials handling and the quantities of the two competing cost drivers over a reasonably long period. Why a long period? Because in the short run, materials handling costs may be fixed and therefore, will not very with changes in the level of the cost driver. In the long run, however, there is a clear cause-and-effect relationship between materials handling costs and the cost driver. ABC systems have a great number and variety of cost drivers and cost pools. They require many cost relationships to be estimated. The manager must pay careful attention to the cost heiarchy.
cost function for which the graph of total costs is not a straight line within the relevant range. Even direct material costs are not always linear variable costs because of quantity discounts on direct material purchases.
A cost function in which the cost remains the same over various ranges of the level of activity, but the cost increases by discrete amounts--that is increases in steps as the level of activity increases from one range to the next. If the relevant range is considered to be from 0-60,000 production units the cost function is nonlinear.
What is the main difference between a step variable cost function and a step fixed cost function
The cost in a step fixed cost function remains the same over wide ranges of the activity in each relevant range.
A function that measures how labor hours per unit decline as units of production increase because workers are learning and becoming better at their jobs. As a result of improved efficiency, unit costs decrease as productivity increases and the unit cost function behaves nonlinearly.
A function that measures the decline in cost per unit in various business functions of the value chain--marketing, distribution, and so on--as the amount of these activities increases.
Declines by a constant percentage each time the cumulative quantity of units produced doubles.
Incremental time needed to produce the last unit declines by a constant percentage each time the cumulative quantity of units produced doubles.
The ideal database for estimating cost functions quaantitatively has two characteristics.
1. The database should contain numerous reliably measured observations of the cost driver ( independent variable) and the related costs (the cost driver)
2. The database should consider many values spanning a wide range for the cost driver.
Frequently encountered data problems and the steps the cost analyst can take to overcome these problems:
1. The time period for measuring the dependent variable doesn't properly match the period for measuring the cost driver. This often arises when records aren't kept on an accrual basis.
2. Fixed costs are allocated as if they are variable. The danger is to regard these costs as variable rather than fixed. They seem to be variable because of the allocation methods used. So analyst should carefully distinguish fixed from variable and not treat allocated fixed cost per unit as variable cost.
3. Data are either not available for all observations or are not uniformly reliable. Cost analyst should design data collection reports that regularly and routinely obtain required data and follow up immediately whenever there's missing data.
4. Extreme values of observation occur from errors recording costs (for example, a missed decimal place), from nonrepresentative periods or from onbservations outside the relevant range.
5. There is no homogenous relationship between the cost driver and the individual cost items in the dependent variable cost pool.
6. The relationship between the cost driver and the cost is not stationary. The underlying process that generated the observation has not remained stable over time. One way to test is to split the sample into 2 parts and estimate separate cost relationships--one for the period before the technology was introduced and one for the period after the technology was introduced.
7. Inflation has affected costs, cost driver, or both. Analyst should remove purely inflationary price effects from the data by dividing each cost by the price index on the date the cost was incurred.