Chapter 2 Learnsmart Managerial Accounting Chapter Learnsmart Questions Costs

a measure such as direct labor hours

These five cost pools and the activity measurements associated with each cost pool appear in Exhibit 7-5. It is possible to have several overhead rates, where overhead costs are split into different cost pools and then allocated using different allocation measures. For example, fixed benefit costs could be allocated based on the cost of direct labor incurred, while equipment maintenance costs could be allocated based on machine hours used. This approach results in more fine-tuned allocations, but is more time-consuming to compile. Chan Company estimates that annual manufacturing overhead costs will be $500,000. Chan allocates overhead to jobs based on machine hours, and it expects that 100,000 machine hours will be required for the year. The first step involves recording all the indirect costs of your business.

  • Prime Cost is nothing but the total of direct materials and direct labor cost of your business.
  • Activity-based costing factors these complexities into the overall equation.
  • Managers prefer to know the cost of a job when it is completed—and in some cases during production—rather than waiting until the end of the period.
  • Restated in reverse order, the ABC logic is that resources generate costs, activities consume resources and products consume activities.

Using these estimates, the predetermined overhead rate equals estimated total annual overhead costs divided by estimated total annual operating activity. Activity‐based costing assumes that the steps or activities that must be followed to manufacture a product are what determine the overhead costs incurred. Each overhead cost, whether variable or fixed, is assigned to a category of costs. Cost drivers are the actual activities that cause the total cost in an activity cost pool to increase. The number of times materials are ordered, the number of production lines in a factory, and the number of shipments made to customers are all examples of activities that impact the costs a company incurs. When using ABC, the total cost of each activity pool is divided by the total number of units of the activity to determine the cost per unit. An allocation base is a measure such as direct labor hours DLH or machine hours from MGT 11B at University of California, Davis.

The ABC cost classification scheme helps emphasize the difference between traditional costing and activity based costing. In assigning cost to products, traditional costing treats all manufacturing costs as unit level costs, therefore they are referred to as production volume based , or unit based allocations. In addition, traditional costing treats marketing, distribution and customer service costs as period costs, while ABC traces, or attempts to trace, these product level and customer level costs to products and customers. The number of direct labor hours is frequently used in traditional cost systems as the basis for allocating overhead costs to products. As a result, accountants frequently say that direct labor time is the cost driver.

Product A is a complex product with more than 50 purchased parts and several different types of raw material. During the year, the 1,000 units were assembled in 10 different production runs requiring 200 purchased parts shipments and 50 different raw material shipments. Product A incurs $2,875 in inventory control overhead ($10 × 200 + $12.50 × 50 + $25 × 10) to produce the 1,000 units, or $2.88 of inventory control costs per unit. It is easy to calculate the total cost of direct materials based on the materials used in the job. Companies usejob cost sheets to record the cost of materials used on the job. Another approach to calculating a single or plantwide overhead rate uses direct cost as a basis, rather than direct labor hours.

Cost Accounting

Companies that make many different products each period use ______________ – ______________ costing. Terms and conditions, features, support, pricing, and service options subject to change without notice. Behavior refers to the change in the cost with respect to the change in the volume of the output. You need to incur various types of costs for the smooth running of your business. These costs depend upon the type and the nature of your business. The examples in this paper of the valve manufacturer and the building supplies company were drawn from work originally done by William Boone, president of Strategic Systems Group.

Batch‐level activities are costs incurred every time a group of units is produced or a series of steps is performed. Purchase orders, machine setup, and quality tests are examples of batch‐level activities.

With four low- to medium-volume products , the overhead cost estimate increased by 100% or more. For the two highest volume products , the overhead cost declined.

These costing methods thus suggest that it is in manufacturers’ interest to run, within the limits of plant design, at high capacity levels. Fixed costs are those costs that are invariant with respect to changes in output and would accrue even if no output were produced.

a measure such as direct labor hours

The Cola Company produces two products, regular cola, RC and clear cola, CC. RC is Cola Company’s main product and CC is a specialty product. Describe how activity measures are chosen when using the ABC approach.

At first, this may appear to be a fair and accurate way to allocate overhead. However, since Company A produces ten times as many V2’s as V1’s, traditional PVB costing assigns ten times as much overhead costs to V2 as it assigns to V1. More specifically, V2 receives ten elevenths (1,000/1,100) or 90.9% of the overhead, while V1 receives only one eleventh (100/1,100) or 9.1%. The resulting unit cost distortions are summarized in Exhibit 7-9 where ABC and PVB unit costs are compared.

Traditional Costing Systems

Activity costs are still perfectly correlated to the activity measures chosen for the ABC system. A variety of illustrations could be provided to show how product cost distortions occur in traditional production volume based costing and how these distortions are eliminated when activity based costing is used.

Emphasize resources whose consumption varies significantly by product and product type; look for diversity. You are provided with the cost data from twelve observations of electricity, a semi-variable cost. This notes could have been completely helpful to me if posting of material, labour and overhead was included. It is relatively easy to implement and provides flexibility to account for the changing needs of particular business. These costs must be included in the stock valuation of finished goods and work in progress.

The Need For Predetermined Overhead Rate:

Total of direct material or direct labour will give you manufacturing cost. Therefore, you would multiply that rate with direct labour since the company uses direct labour cost as allocation base. To calculate the plantwide overhead rate, first divide total overhead by the number of direct labor hours used to find the overhead per labor hour. Next, multiply the overhead per normal balance labor hour by the number of labor hours used to produce each unit. Calculate the unit costs of products V1, V2 and V3 using a traditional cost system where overhead costs are allocated on the basis of direct labor hours. Calculate the unit costs of products V1 and V3 using a traditional cost system where overhead costs are allocated on the basis of direct labor hours.

a measure such as direct labor hours

As per this method, you charge overheads to production based on the number of machine-hours used on a particular job. Now, you must remember that factory overheads only include indirect factory-related costs. These do not include costs such as General Administrative Expenses, Marketing Costs, and Financing Costs. As the name suggests, the semi-variable costs are the expenses that are partially fixed and partially variable. That is, these expenses remain fixed only up to a certain level of output.

Outline three additional steps required to obtain ABC product costs. Describe the two main problems that tend to occur when companies use traditional costing.

Smith expects to spend about 500,000 labor hours and 100,000 machine hours. To understand the difference between the activity measure and the activity driver, consider the following example. The number of purchase orders might be chosen to represent the volume of work performed by the purchasing a measure such as direct labor hours department, but the number of purchase orders is driven by whatever drives the purchasing activity. Thus, to say that the number of purchase orders is the driver for purchasing costs tends to confuse the issue. Although ordering causes costs, the number of purchase orders is secondary.

Calculate The Total Manufacturing Overhead

Cost allocation is used for financial reporting purposes, to spread costs among departments or inventory items. You need more than labor and raw materials to manufacture products. Manufacturing units need factory supplies, electricity and power to sustain their operations. Examples of product‐line normal balance activities are engineering changes made Accounting Periods and Methods in the assembly line, product design changes, and warehousing and storage costs for each product line. Many small businesses find that calculating their overhead rate yearly is sufficient. However, businesses with an active manufacturing component may find it helpful to calculate their overhead rate quarterly to make more timely adjustments if needed.

This means that for every dollar of direct labor, Joe’s manufacturing company incurs $1.21 in overhead costs. Cost accounting is a form of managerial accounting that aims to capture a company’s total cost of production by assessing its variable and fixed 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. K’s Premier Cabinets uses job costing to calculate the cost of jobs as they are completed.

The cost driver rate is used in activity-based costing to calculate the amount of overhead and indirect costs related to a particular activity. The more challenging product component to track is manufacturing overhead. Overhead consists of indirect materials, indirect labor, and other costs closely associated with the manufacturing process but not tied to a specific product. Examples of other overhead costs include such items as depreciation on the factory machinery and insurance on the factory building. Bookkeeping is simplified by using a predetermined overhead rate. So, the overhead rate is nothing but the cost that you as a business allocate to the production of a good or service. Such an allocation is done to understand the total cost of producing a product or service.


If a job is not completed at the year-end, however, overhead should be applied to value the work in process inventory. An allocation base is a measure of activity that is used to assign overhead Accounting Periods and Methods costs to products. Manufacturing overhead costs are divided by the allocation base to determine the amount of manufacturing overhead that should be assigned to each unit of production.

The second section outlines the steps involved in using the ABC technique and provides two related examples that illustrate and compare ABC with traditional costing. Sections three and four include a discussion of the CAM-I organization’s involvement in the development and implementation of ABC concepts and a short discussion of a controversial issue concerning how ABC should be used. The last section relates the emergence of activity based costing to the dichotomy of capitalism framework discussed in Chapter 1.

We believe that only two types of costs should be excluded from a system of activity-based costing. First, the costs of excess capacity should not be charged to individual products. To use a simplified example, consider a one-product plant whose practical production capacity is one million units per year. This is the unit product cost the company should use regardless of the plant’s budgeted production volume. The cost of excess or idle capacity should be treated as a separate line item—a cost of the period, not of individual products.

Figure 2.6 “Overhead Applied for Custom Furniture Company’s Job 50” shows the manufacturing overhead applied based on the six hours worked by Tim Wallace. Notice that total manufacturing costs as of May 4 for job 50 are summarized at the bottom of the job cost sheet. The average direct labor rate is $18.00 per hour and the company uses the predetermined overhead rate calculated in Example #1. ABC designers normally use interviews with knowledgeable managers to define activities, cost pools and cost driver relationships. Although the statistical tools discussed in Chapter 3 might also be used to aid in this process, there are some serious problems that limit their usefulness for this purpose. First, analyzing short run data may produce very misleading results. This is because performing correlation analysis with short run data is not likely to reveal the drivers of long run variable costs, i.e., the costs identified as fixed costs in traditional costing.

While both the overhead rate and direct costs can impact final product cost, along with your balance sheet and income statement, they are two different things. If you’re using accounting software for your business, you can obtain this information directly from your financial statements or other system reports.

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