2AGENDADifference between ABC and Traditional Costing ApproachDesign and Implementation of ABC Costing SystemLimitations of ABC
3Activity Based Costing (ABC)The objective of activity-based costing is to understand overhead and the profitability of products and customers.ABC is agood supplement to our traditional cost systemI agree!
4Traditional Costing Systems vs. ABCTraditional cost systems were created when manufacturing processes were labor intensive.A single company-wide overhead rate based on, say direct labor hours may be used to allocate overhead to products in these labor intensive processes.
5Traditional Costing Systems vs. ABC (cont’d)Job1Job2Labor Hours 2 6OH allocationOverhead will be allocated to jobs using direct labor hours. If total overhead is $120, how much will be allocated to each job?Job1Job2Labor Hours 2 6OH allocation $30$90Why?
6Traditional Costing Systems vs. ABC(cont’d)Now, the company introduces automated machinery. Total overhead rises from $120 to $420, while the labor time needed for Job2 falls from 6 hours to 1 hour. Now allocate the $420 OH to the two jobs.Job1Job2Labor Hours 2 1OH allocationDo you see the problem with traditional costing system?280 140
7Traditional Costing Systems vs. ABC(cont’d)The automation process benefits only Job2. But most of the additional overhead cost resulted from automation was allocated to Job1. Clearly it is NOT a reasonable costing method. We need look for another cost driver.ABC system makes it possible.
8How Costs are Treated UnderActivity–Based CostingABC does not assign all manufacturing costs to products.ManufacturingcostsNonmanufacturingcosts“Best practice” ABC differs from traditional costing in five ways.Traditionalproduct costingABCproduct costingAllSomeABC assigns both types of costs to products.
9ABC differs from traditional cost accounting in five ways. 1.ABC assigns both manufacturing and nonmanufacturing costs to products. Traditional cost systems assign only manufacturing costs to products. However, ABC systems can assign sales commissions, shipping costs, and warranty repair costs to specific products. 2.ABC systems do not assign all manufacturing costs to products, while traditional cost systems do assign all manufacturing costs to products. ABC only assigns a cost to a product if decisions concerning that product will cause changes in the cost.
10How Costs are Treated UnderActivity–Based CostingPlantwideOverheadRateDepartmentalOverheadRatesActivity–BasedCostingNumber of cost poolsLevel of complexity“Best practice” ABC differs from traditional costing in five ways.ABC cost pools are created to correspond to the activities performed in an organization that cause the consumption of overhead resources. The total number of ABC cost pools will definitely exceed one and it is likely to exceed the number of departments within a company since more than one activity is often performed within each department.