Managerial Accounting - Discussion Assignment Unit Using activity-based accounting (ABC) to allocate overhead costs Briefly describe the five (5) steps used to implement activity-based costing (ABC). What are the advantages of using ABC? State some disadvantages. Activity-Based Costing (ABC) is a costing method primarily employed in the manufacturing industry to pinpoint an organization's overhead and indirect cost activities, subsequently allocating these costs to the products or jobs that engage in these activities, specifically non-direct costs (excluding direct materials and direct labor) (Woodruff, 2019). The implementation of Activity- Based Costing involves a systematic process consisting of five key steps: 1.Identifying costly activities required to complete products, 2.Assigning overhead costs to the activities identified in the first step 3. Identifying the cost driver for each activity, 4.Calculating a predetermined overhead rate for each activity, 5.and finally, allocating overhead costs to products. (Heisinger, & Hoyle, 2012). Implementing ABC involves several steps: I will discuss another example, this time in the context of a manufacturing company called Precision Parts Inc. that produces precision-engineered components for the aerospace industry. Step #1. Identifying Costly Activities in Precision Parts Inc. In the aerospace component manufacturing industry, Precision Parts Inc. understands the importance of identifying costly activities to implement Activity-Based Costing effectively. Here's how they begin. Precision Parts Inc. recognizes that the initial setup activities for each production run involve significant costs. This includes preparing machines, tools, and materials for a specific order. For example, when they receive an order to manufacture a batch of specialized aircraft components, the setup activities are essential but resource-intensive. Given the strict quality standards in the aerospace industry, Precision Parts
Inc. allocates substantial resources to quality control activities. They identify inspection, testing, and compliance checks as activities that contribute significantly to their overall production costs. Ensuring that every component meets stringent safety and quality requirements is a priority. Step #2. Assigning overhead costs to the activities identified in step 1, In the case of Precision Parts Inc., after identifying the critical activities, the next step in implementing activity-based costing (ABC) is allocating overhead costs to each of these activities. Overhead Costs Breakdown Precision Parts Inc. conducts a detailed review of their annual expenses. They determine that machine maintenance costs amount to $300,000, while quality control expenses total $200,000 for the year. These costs are categorized as overhead expenses. Assigning Costs to Activities Precision Parts Inc. proceeds to allocate these overhead costs to the specific activities identified in step 1, which, in this case, are machine maintenance and quality control. Activity Estimated annual Overhead Cost Machine Maintenance $300,000 Quality Control $200,000 Total $500,000 Step #3. Identifying the cost driver for each activity Another crucial phase involves the identification of cost drivers specific to each activity. To illustrate this, let's focus on our two activities, machine maintenance and quality control, For machine maintenance, a pertinent cost driver could be the number of machine hours utilized throughout the year, which, in this instance, amounts to 2,000 hours. In contrast, quality inspection costs may be closely correlated with the number of inspection checkpoints conducted during production, resulting in a cost driver represented by the count of these inspections (Heisinger & Hoyle, 2012) Step #4. Identifying the cost driver for each activity Another significant stride in the process entails identifying the specific cost drivers for each activity. To illustrate this, let's delve into our two activities: machine maintenance and quality control. For machine maintenance, a pertinent cost driver can be discerned in the form of the number of machine
hours utilized, with an example figure of 2,000 hours. On the other hand, quality inspection costs might correlate with the frequency of inspection checkpoints carried out during production, making the count of these inspections an applicable cost driver (Woodruff, 2019) Activity Cost Estimated cost Estimated cost Predetermine Overhead cost driver activity Overhead rate Machine Machine hrs $600.00 $2, 000 600,000/2,000 Maintenance used =300per M.hr Quality Number of $200,000 $2,000 200,000/2,000 Control inspection =100 per inspection Step #5. Allocating overhead costs to products The final phase in executing activity-based costing within the production process revolves around allocating overhead costs to products. This allocation is achieved by applying a predetermined overhead rate to the relevant cost driver activity. Predetermine Cost driver Overhead allocated Overhead rate activity 300 per machine hr 2,000 300*2,000=$600,000 100 per 2,000 100*2,000=$200,000 inspection Advantages of ABC ABC provides a more accurate allocation of indirect costs compared to traditional costing methods. It considers the specific activities that drive costs, leading to more precise cost assignment. With a clearer understanding of the costs associated with various activities, organizations can make
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