Explanation for Recording of Activity-Based Costs
Managers develop a costing report for activity-based costing so they can identify the specific expenses associated with the development of a product and consider ways to improve product development. The report lists each activity pool separately so that managers can analyze it. Therefore, managers need to a way to identify, assign, and analyze costs. Identifying and assigning costs to specific overhead activities and then assigning those costs to products can be a challenge, so managers need an internal method of keeping track of the costs.
A manager can take certain steps to prepare reports for activity-based costing. First, the manager should identify activities and activity pools within the company, department, or process. Next, they should trace and determine the activities related to the process. After that, the manager can assign costs to the activity cost pools and calculate them to arrive at cost driver rates. Finally, the manager can assign the costs and prepare the report. By examining the report, the organization can determine profitability and consider what is working and what needs improvement.
Within an activity-based costing report, the level, activity, and activity measures need to be broken down. For example, there may be unit, batch, product, and facility levels for a manufacturing company. Then the manager would need to break down each level into activities that relate to each level and then find out activity measures for each of the activities. This information ties into the greater financial reports that justify pricing and inventory valuation.
For example, a manager works for Megalith Manufacturing, which produces widgets. The manager should first look at the unit level for producing the widgets. This level may include the process of creating the widgets on machines or by hand and the factory supplies needed to do so. The resulting measurements may include the actual machine-hours, the direct labor hours, and the units produced. Each of these amounts goes on the income statement as an expense and is used in managerial decision-making.Traditional costing and activity-based costing will yield different information based on the allocation of overhead. Under traditional costing, overhead will be part of a general expense, but activity-based costing will move this expense to cost of goods sold. This will change the fiscal analysis of the financial statements between the two systems. Applying costs at the cost-of-goods-sold level will decrease the gross profit of the company, giving a more accurate analysis as compared to traditional costing.
Reconciliation of Activity-Based Costs to Traditional Cost Accounting
The choice to use activity-based costing over traditional costing can affect the reporting of the company's profit (called gross margin), the assignment of value to inventory, and the amount of money used to pay fixed costs (called contribution margin). Therefore, the manager will need to reconcile earnings reports and financial statements in order to use benchmarking practices, in which the company compares production levels to its historic amounts and to competitors. Benchmarking is the process of measuring the quality of a company's products, performance, or processes against specific standards. These standards could include the company's previous performance, a rival's performance, industry standards, or government requirements. Most benchmarking standards are based on traditional costing overhead or, in some cases, groups of cost drivers. Traditional costing brings costs to the product level, but activity-based costing may not do this. To make proper comparisons, managers will need to adjust their reports to capture the appropriate overhead cost data.
Managers need to determine the overhead rate for each activity before allocating the overhead cost to the product that is being produced. Managers must evaluate the overhead costs of products, because the costs of the activities are related to specific overhead costs. An example is the calculation of hours that are needed to produce a product. The hours are considered the cost driver and, thus, a controller of overhead, such as electric power use or even maintenance costs. Managers must reconcile the various cost drivers in order to determine the appropriate costs for developing the product. Traditional costing will only tell the total amount of electricity that is used by the company. Activity-based costing will give a more accurate report, breaking down the costs by usage for an activity. Activity-based costing will be more accurate for costs that are associated with manufacturing but not related to managing the company.
A relationship can exist between the costs, overhead activity, and product that is being produced. Reconciling activity-based costing requires information such as the activity, the amount of time spent, an assigned cost, the activity quantity, and the cost driver rate. An example of this is the process of credit evaluation. Many companies hire employees to review credit applications from businesses and individuals and decide whether to allow that business or individual to buy from that company on credit. When analyzing the work of credit evaluators, a manager starts by determining the time spent on each activity. The manager must then determine the assigned cost, the quantity produced, and the cost driver rate. For this example, it would be the amount per each credit evaluation.
As an additional example, Megalith Manufacturing sells about $1 million of its product on credit. It has two employees who perform credit evaluation. One of these employees spends all of their time doing this for the Grand Widget product line. The other splits their time between Grand Widgets and Petit Widgets. Each employee makes $60,000 annually. It takes Grand Widgets applicants six months to be processed, but Petit Widgets takes only three months.
The reporting will depend on the analysis that needs to be performed. If the benchmark is given in total credit overhead, then traditional standards will work, and the total overhead is $120,000. If the analysis is specific to Grand Widgets applicants, then the activity rate is 1.5 for the amount of time spent by the total employee for Grand Widgets. The second credit evaluation analyst will bounce back and forth, using the reporting standard that gives the most information and reconciling all of the data at the end for consistency.
Managers also use reconciliation as an efficiency analysis tool. If overhead costs under traditional costing are $100,000 and the company makes two products with equal volume, it would make sense that the overhead would be allocated 50-50 between the two product lines. If, under activity-based costing, managers discover that one product line is taking 80% of the overhead, then this would indicate a lack of efficiency in that product line. For some reason, that product line is requiring more overhead, probably in the form of supervisors' salaries. Analyzing the reconciliation report of the two systems will highlight this problem so that it can be addressed.