030110 - CH 7 Activity-based Costing (ABC) Traditional...

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CH 7 Activity-based Costing (ABC) What’s wrong with traditional methods? Why is ABC better? How does ABC work? Kattelus -Spring 2010 1 Traditional Absorption Costing supplemented by Activity- Based Costing
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Recall: Traditional Absorption Costing Allocates manufacturing overhead to products based on a predetermined overhead rate (either a single plant-wide rate, or one rate per department) Rates are usually based on some volume measure , e.g., direct labor hours or machine hours Products that use a high volume of direct labor or machine hours get a greater share of overhead whether they “caused” it or not Kattelus -Spring 2010 2
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When a company has a lot of overhead and produces a variety of products, ABC can deliver more useful information about product costs than traditional costing A single plant-wide overhead rate based on a volume measure results in over -costing products – those that use more hours get more overhead whether or not they “caused” it In modern factories, a trend has been to become highly automated resulting in less labor costs. Distortions to product costs can result when traditional absorption costing is used. Why use ABC? Kattelus -Spring 2010 3
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Advantages of ABC Managers following lean production concepts desire to weed out non-value adding activities in a business (production) process Focus on the costs of activities uncovers those steps that do not add value Cost data supports manager’s activity- based management (strategic) decisions to eliminate unprofitable product lines , cut other non-value added costs, change product-mix, set prices Kattelus -Spring 2010 4
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Limitations of ABC Expensive system to implement and maintain Desire to fully allocate all costs to products Resistance to unfamiliar numbers and reports Potential to misinterpret unfamiliar numbers Does not conform to GAAP, so two costing systems are needed. Kattelus -Spring 2010 5
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Most companies do not use ABC for external reporting because : 1. External reports are less detailed than internal reports. 2. It may be difficult to make changes to the company’s  accounting system. 3. ABC does not conform to GAAP. 4. Auditors may be suspect of the subjective allocation  process based on interviews with employees.
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030110 - CH 7 Activity-based Costing (ABC) Traditional...

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