4 2 Activity Based-Costing Method Managerial Accounting

The total amount of overhead should be the same whether using activity-based costing or traditional methods of cost allocation to products. The primary difference between activity-based costing and the traditional allocation methods is the amount of detail; particularly, the number of activities used to assign overhead costs to products. In practice, companies using activity-based costing generally use more than four activities because more than four activities are important. Management accounting uses an activity cost driver to allocate overhead costs to produced goods or services.

Under an activity-based costing system, we identify four activities that make up overhead costs. These activities are product design, orders, order size, and customer relations. We estimate that each activity will cost $25,000 for a total of $100,000 in overhead https://kelleysbookkeeping.com/what-is-bad-debts-expense/ costs. Once we identify the cost drivers, we then must estimate the volume of cost driver activity. Next, we find the application rates for each activity by dividing the estimated cost for the activity by the volume of cost driver activity for each activity.

Chapter 4: Activity-Based Costing

For example, management estimated the company would purchase 100,000 pieces of materials that would require overhead costs of $200,000 for the year. These overhead Activity Cost Driver costs included salaries of people to purchase, inspect, and store materials. Setting up machines for a new product would need 400 setups and overhead of $800,000.

The longer the production runs, the more wear on the machines, and more maintenance is needed. This video will discuss the differences between the traditional costing method and activity based costing. Generally, the cost driver for short term indirect variable costs may be the volume of output/activity; but for long term indirect variable costs, the cost drivers will not be related to volume of output/activity. The Activity Based Costing (ABC) approach relates indirect cost to the activities that drive them to be incurred.

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(See the exhibit “Profitable Decisions at Banta Foods.”) Its performance has led to the distinction of being named “Innovator of the Year” by the industry journal, Institutional Distributor. Many companies’ ERP systems already store data on order, packaging, distribution method, and other characteristics. These order- and transaction-specific data enable the particular time demands for any given order to be quickly determined using a calculation like the one above. Let’s say that if the chemical is already packaged in a way that meets standard requirements, it should take 0.5 minutes to prepare it for shipment. If the item requires a new package, however, the manager estimates, either from experience or from making several observations, that an additional 6.5 minutes will be required to supply the new packaging.

If the customer were new, 15 more minutes would be required to set up the customer in the company’s computer system. This approach works well in the limited setting in which it was initially applied, typically a single department, plant, or location. Difficulties arise, however, when you try to roll this approach out on a large scale for use on an ongoing basis.