Activity-Based Accounting and Product Costing

Introduction

Over the last few years, many companies have been using activity-based costing methods when accounting for overheads. Companies are shifting from the traditional method of allocating overheads due to a considerable increase in overhead costs, increased customer demands, batch size variation, and a lack of correlation between machine hours and direct labor hours. Activity-based costing allocates overhead costs in a logical manner; first to activities contributing to the overhead and then to products using the activities. It gives a better understanding of overhead costs by articulating each of the activities contributing to overhead costs, thus is easy to understand for everyone in the company.

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Activity-Based Costing

Unlike the traditional method of allocating manufacturing overheads that rely on machine-hours, activity-based costing recognizes that there are various activities contributing to manufacturing overhead (Needles, Crosson, &Powers, 2008, p.287). Activity-based accounting helps to avoid miscalculations of a product’s actual manufacturing overhead. The traditional method may cause an understatement of product manufacturing overhead.

Activity-based costing uses unit cost unlike traditional methods, which use total cost when allocating overhead costs to products. The traditional method of calculating overhead costs may cause a company to offer low bids for a contract compared to its competitors. However, the company with low bids may get the contract only to manufacture a product at zero or considerably low profit.

Activity-based costing helps management to evaluate what drives the cost of all activities contributing to manufacturing overhead. Using activity-based management, management finds ways of reducing costs thus reducing overall manufacturing overhead costs (Hansen, Mowen, & Guan, 2009, p.85). It supports performance management and the establishment of scorecards for all activities contributing to manufacturing overheads.

Activity-based costing reports do not conform to the Generally Accepted Accounting Principles (GAAP’s), thus can only be used for internal purposes. The organization has to maintain two accounting systems in order to accommodate activity-based accounting.

The activity-based accounting system is expensive to implement in a company and requires substantial resources to maintain after implementation. According to Baker (1998), the costs associated with activity-based reporting include the cost of collecting data on various activities contributing to manufacturing overheads (p.1). The data collected helps managers in assessing how the costs for each of the activities can be minimized thus reducing overall manufacturing overhead costs. Manufacturing costs are all other costs incurred during the manufacturing process other than direct labor and material costs. According to Cokins (2001), not all costs are relevant when making decisions in an organization (p.11). Managers should, therefore, be extremely careful when using activity-based accounting reports to make decisions.

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The bread manufacturing process involves a long process before the final product is ready for market. The process includes preparation of ingredients, dough-mixing process, dough fermentation, rounding, and molding, panning, baking, cooling, and packaging. If a manufacturing company, bases its selling price on the cost of manufacturing each loaf of bread, the company must take into consideration the direct labor hours, direct material cost, and overhead costs. To obtain the actual cost of production per loaf of bread, the activity-based costing method would be more appropriate. The activities contributing to the overheads include the cooling process, panning, machine setup cost, dough mixing process, slicing, and packaging. The accounting department should establish the total overhead costs. The total overhead cost should be divided among the activities contributing to overhead costs to get the manufacturing overhead cost per loaf of bread.

The activity-based costing method will help the bread manufacturing company when pricing its product by avoiding understatement of overhead costs in a bid to make profits; the core objective in any business. The company will perform activity-based management to establish how to reduce the cost of the activities contributing to overheads.

Fixed costs do not vary with the level of production, they occur once over a defined period. Fixed costs are all costs in an organization other than the cost of goods sold; for example, rent, cost of purchase of equipment and machinery for use in the organization. When calculating the cost of goods sold, management should only consider direct material direct labor and direct overhead cost. The cost of goods sold varies with the operation of the organization. Inclusion of fixed cost, in the cost of goods sold, will be a poor internal decision because the fixed costs are incurred whether a company is producing one unit of a product or one thousand units. The cost of goods sold is a determining factor when pricing the goods of a company thus if the fixed costs are included in the calculation of product cost, it will lead to overpricing (Warren, Reeve, & Duchac, 2008, p.1186). Since fixed costs are incurred once over a long period, the inclusion of the fixed cost in each unit produced will be impossible because production level is determined by market demand and cannot be added arbitrarily without a tangible demand forecast.

Conclusion

Many companies have adopted activity-based accounting over the years as a method of calculating manufacturing overheads. Activity-based accounting helps an organization to articulate manufacturing overheads thus avoiding miscalculation when calculating the selling price of a product.

References

Baker, J. (1998). Activity-based costing and activity-based management for health care. USA: Aspen Publishers

Cokins, G. (2001). Activity-based cost management: an executive’s guide. New York: Wiley and sons.

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Hansen, R., Mowen, M., & Guan, L. (2009).Cost management: accounting & control. USA: Cengage learning

Needles, B. E., Powers, M., & Crosson, S. (2008).Principles of Accounting. USA: Cengage learning.

Warren, C. S., Reeve, J. M., & Duchac, J. (2008). Financial and Managerial Accounting. USA: Cengage learning

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Paperroni. 2022. "Activity-Based Accounting and Product Costing." June 9, 2022. https://paperroni.com/activity-based-accounting-and-product-costing/.

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