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I'm Larry Walther, this is Principles of Accounting.com,
Chapter 20 and we're looking at Process Costing and Activity-Based Costing.
And in this module we will begin to look at activity based costing systems.
Now, our activity-based costing systems are alternatives to traditional
costing systems, they arise out of frustrations with the arbitrary
allocations that are part of the traditional costing model.
For example, it can be argued that a finished product should include not only
the cost of direct materials.
But also a portion of the administrative costs necessary to acquire those
materials.
In a traditional costing model, the administrative costs are charged to
expense in the period, they don't get assigned to a particular product.
Conversely, you may have the cost of a plant security guard.
In a traditional costing model, that guard Is part of factory overhead,
which is allocated to all of our production.
However, it can be argued that the guard will be needed whether or
not any production occurs, and thus there's a question about why assign, or
try to determine the cost of that for our productive output, that there's some kind
of mismatch that may occur and cause some distorted decision making as a result.
So activity-based costing, it seems like it's a fairly complex process.
And indeed, this first video may leave you a bit confused.
The second video,
when we start to introduce an actual example of activity-based costing,
we'll probably clarify the concepts introduced in this particular video.
But for now, just follow along as best as you're able.
Activity-based costing divides production into core activities.
It defines costs for each of those activities.
It allocates those costs to products based on the consumption of the activities.
Products are charged with the cost of manufacturing and
non-manufacturing activity.
And some manufacturing costs don't get assigned to production at all.
Therefore a product is only charged with the cost of the capacity utilized.
External reporting must continue to be based on traditional
costing methods where inventory observes all of the manufacturing cost, and
none of the period costs.
Therefore activity-based costing or ABC may produce results that
differ from those required under generally accepted accounting principles.
Therefore ABC is supplemental to external reporting and
used primarily for internal decision making purposes.
Activity-based costing is in all likelihood,
more involved than traditional costing methods.
The process of engaging in activity-based costing is at least simplified by computer
technology of course.
For a single-product company, there's probably very little difference between
traditional costing and activity-based costing.
It's where we get into multi-product settings where we have some differences
that may result in our assessed costs for products and the decisions that follow.
The arbitrary allocation of cost can make or break the perceived profitability of
each product or service therefore a proper and full cost assessment process such as
may be prevalent in an ABC system becomes quite important.
This is a simply a slide reviewing traditional costing,
there's nothing new here.
On the left are resources, material, labor, and overhead, which are traced or
allocated to our products and services, and as a reminder,
are non-factory selling and administrative costs.
They are period expenses in each period as incurred.
This will be in direct contrast to the method we used for activity-based costing.
Activity-based costing entails engagement with certain terminology.
Cost objects, first of all, are broadened to include not only products and
services but other things such as customers, markets served and so forth.
Cost objects consume activities.
And the activity driver is the event that causes the consumption of an activity.
We'll see how this works here in a moment.
Activities drives the needs for resources and are thus said to be resource drivers.
For example, each customer may receive a catalog.
Preparation and distribution of the catalog is the activity
that is being driven by the number of customers.
So customers are cost object.
The activity is the preparation and
distribution of the catalog to those customers.
So here is a representation of essentially our cost pool again on the left,
our resources in other words.
Factory overhead, selling and administrative costs, material, and labor.
And we look at our cost objects on the right, whether it's a product,
a service, a customer, or any number of a litany of other items.
The products and services are consuming certain activities,
such as machine set up, product design, and so forth.
And those activities are consuming our resources.
Some cost, in this case for example, material and
labor, they're drawn or traced directly into the product or service.
They're really not an activity related to that, but product or
service actually entails or encapsulates those particular resources.
A business may have dozens of cost objects, hundreds of activities and
numerous resource pools.
A diagram of the interconnectivity can reveal multiple cost
objects feeding off of many shared activities that pull on various resources,
meaning this can become fairly complex.
And so the steps to setting up an ABC system first begins with a study of
a business' processes and costs.
We look at our activities, we identify the activities we have.
Activities can be subdivided into categories such as unit-level activities,
where there's a one-to-one correspondence with a unit of output.
Batch-level activities, which would like to one or more units together, product
level activities which are carried out at the product level no matter the level of
production, customer level activities relate to each customer independent of
the volume of goods and services provided by the specific customer.
Market level activities relate to the number of markets in which an entity
operate independent of the number of products for customers in that market.
Entity-sustaining activities relate to an entity's ability to operate,
independent of business volume.
Activities are usually combined logically within each level.
So, we could refine and further refine our activities, but
this is a good general framework.
By themselves, those terms my not have much context to you yet.
What I would suggest is perhaps why didn’t tell after you view the next video and
seen an example of this and then go back and review this again following along in
the textbook and each of these activities will then begin to make sense.
Or the descriptions that attach will make much more sense, okay?
The next step is to identify traceable costs.
That is, costs that are directly traced that don't need to be allocated to
a product such as direct material and labor in an end product, or
the printing and postage associated with a catalog.
Those costs are assigned to a related activity cost.
We would assign the remaining cost activities for example,
the cost of an industrial engineering group that just sets up machines would be
assigned to the machine set-up activity, which is then reallocated to the products.
Some costs may not be allocated at all.
They shouldn't be ignored but
they don't need to be allocated to a particular product or cost object.
And that the next step is determine the per-activity allocation rate.
For example, if the cost pool for
catalog preparation includes $500,000, and 200,000 catalogs were produced,
we would finally come up with a cost of $2.50 per catalog.
We apply those costs to objects in a very logical fashion,
utilizing that activity allocation rate that we just calculated.
And here's a diagram now of the steps to setting up an ABC system.
Study our processes, thinking about the cost we're incurring and
the activities we're engaged in.
The cost we will then assign if they're attributable to a specific activity,
we'll assign those costs to the activity pool to be matched with the activities.
To come up with our per activity cost allocation which flows to the cost object.
Certain other costs are directly traceable to the cost object,
such as material and labor.
And other costs we're not able to trace or allocate at all.
And I say they're unattached but not to be forgotten.
And so this is the general framework,
this is the step, this is the model of activity-based costing.
In the next video, it'll begin to make far more sense when we look at an actual
example of this in practice.
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