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n07 - Chapter 8 Notes Page 1 Activity-Based Costing Cost...

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Chapter 8 Notes Page 1 Please send comments and corrections to me at [email protected] Activity-Based Costing Cost Pools As we mentioned in Chapter 3, in a manufacturing situation, there are three components to cost: Direct Labor, Direct Materials, and Manufacturing Overhead. As noted previously, it is relatively easy to allocate Direct Labor and Direct Materials to the products produced, but it is difficult to allocate Manufacturing Overhead costs. Because of this, we have Normal Costing and the allocation of Manufacturing Overhead using Predetermined Overhead Rates. In Chapter 3, we used a single, Predetermined Overhead Rate to allocate the Manufacturing Overhead costs to the products being produced. If all of the products are similar, this approach may produce a fairly accurate allocation of Manufacturing Overhead. On the other hand, if you have widely diversified product lines and production operations, then a Plant-Wide Application Rate may not be very accurate. You may find that some products are being under-costed and others are being over-costed. In this case, you might obtain more accuracy in the allocation of Manufacturing Overhead to the units that generated it by using more than one overhead cost pools. The number of cost pools to use always involves a cost-benefit analysis, because of the additional record keeping involved. Why should you care whether your products being over-costed or under-costed? Having more accurate cost information can lead to an improvement in your bidding process. If you base your customer bid prices on your costs, you could charge the wrong amounts. If you charge more than your competitors, then you will lose business. If you charge less than your competitors, you will get more business, but your profits will be less than you expected because you are not charging your customers enough. Having more accurate cost information could improve a firm’s product mix. Even if your prices are not based on your costs ( e.g. , set by the free market), you still may have problems. For example, you may not actively go after certain business because you don't think it is very profitable when that business actually is profitable. Similarly, you may go after other business that you believe is very profitable, when it is not profitable or less profitable than you believe. Another way that over-costing or under-costing can affect a business is in the decision whether to offer a product or discontinue a product. Having misinformation on the
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Chapter 8 Notes Page 2 Please send comments and corrections to me at [email protected] profitability of a product may cause a product to be improperly discontinued (or retained when it should be discontinued). For example, a firm may incorrectly outsource the manufacture of a part or product because it wrongly believes that it is cheaper to purchase the part or product rather than manufacture it.
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