Week 6 note.docx - Week 7 Activity based costing 1 Problems...

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Week 7 Activity based costing 1. Problems with conventional product costing system • Problems 1: Features of conventional product costing systems – Direct material and direct labour costs are traced to products – Manufacturing overhead costs are allocated to products using a predetermined overhead rate (plant wide or departmental) – Manufacturing overhead rate is calculated using some measure of production volume – Non-manufacturing costs are not assigned to products • Problems 2: Failure to adapt to the changing business environment – Manufacturing overhead is increasing as a proportion of total manufacturing costs. – Increasing levels of non-volume-driven manufacturing overhead costs. – Increasing proportions of non-manufacturing costs. – Causes of changes in costs include: increased automation, increasing product diversity, increased customer demand for improved service, quality and customer support. Indicators of Problems with a Product Costing System – Conventional product costing systems are likely to result in inaccurate product costs when: ▪ the proportion of direct labour costs decreases. ▪ the proportion of manufacturing overhead costs increases. ▪ the proportion of manufacturing overhead costs, not related directly to production volume, increases. ▪ non-manufacturing costs that are product-related become substantial. ▪ product diversity increases. • Problems 3: Costing in service firms: – Service firms tend to use firm-wide, volume-based overhead rates ▪ Overhead costs are increasing and are increasingly non-volume driven. – Customers are demanding a more diverse range of higher quality services ▪ Increases in service diversity and quality increase the level of non-volume-driven overhead costs. ▪ Service costs derived from conventional product costing systems may be inaccurate. 2. Activity based costing A methodology that can be used to measure both the cost of cost objects and the performance of activities. Can help solve problems such as – Distorted product costs – Poor cost control Activity Based Costing Model: The costing view - measures the cost of activities & assigns activity costs to products.

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