Acctg 23 Links for Week 2-3 topics

Week 2

Actual Costing
In accounting, Actual Cost refers to the amount of money that was paid to acquire a
product or asset. This could be the historical, past, or present-day cost of the
product. This is not the budgeted or forecasted costs that management has
anticipated as they might include vendor expenses like the costs of delivery, set up
and testing. These costs also reflect factors like vendor discounts or price
increases.

When recorded in financial recorded the actual cost of an asset is listed as a fixed
asset.

The actual approach and the use of estimates are blended together. Budget costs
and compared to actual costs to create a variance. Variances can be used to better
manage operations and improve the accuracy of future estimates and forecasts.

For example, an auto repair shop may estimate that vehicle repairs will cost $1100,
but the actual cost may actually be $1200. A customer might not be aware of the
actual cost until the expenses are incurred during the repairs.

What is Actual Costing?

Costing accounting that uses actual cost, direct-cost rates and actual qualities used
in production to determine the cost of specific products is called Actual Costing.

With actual costing system, usually direct costs to a cost object or something that
has a measurable cost is traced. This allows managers to go back to the source of
the costs (cost objects) like labor and materials. Through analyzing how many
hours of manufacturing time a product requires, managers can calculate the actual
costs of producing that product.

What Is the Actual Cost Formula?

Actual cost can be calculated with the following formula:

Actual Cost = Direct Costs + Indirect Costs + Fixed Costs + Variable

Costs + Sunken Costs

As you can see above, the actual cost formula factors in several types of project
costs.

1. Direct Costs: Obvious costs directly related to your projects like fixed costs
and variable costs.
2. Indirect Costs: Additional cost that supports your project but is not easily
measured like administrative services.
3. Fixed Costs: Costs that remain consistently the same throughout the
project, such as cost to rent equipment.
4. Variable Costs: Changing costs during the course of the project. An
example the hours of anticipated labor for a project might be greater than the
actual time it took for labor to be complete.
5. Sunken Costs: These are costs that have incurred due to an error or
change of scope that must be included in the total cost of the project.

What Is a Cost Variance?

Cost variance is the difference between the actual cost and the budgeted or
planned costs.

For example, if a company had repairs done for $1150 but the budget amount was
$800, the company had a cost variance of $350.

Since the actual cost is more than the budgeted amount, the cost variance is
considered to be unfavorable. When the actual cost is less than the budgeted cost,
the variance is considered favorable.

https://www.freshbooks.com/hub/accounting/actual-cost

Normal Costing

What is Normal Costing?

Normal costing is used to derive the cost of a product. This approach applies actual direct costs
to a product, as well as a standard overhead rate . It includes the actual cost of materials, the
actual cost of labor, and a standard overhead rate that is applied using the product's actual usage
of whatever allocation base is being used (such as direct labor hours or machine time).

If there is a difference between the standard overhead cost and the actual overhead cost, you can
either charge the difference to the cost of goods sold (for smaller variances) or prorate the
difference between the cost of goods sold and inventory.

When to Use Normal Costing

Normal costing is designed to yield product costs that do not contain the sudden cost spikes that
can occur when actual overhead costs are used; instead, it uses a smoother long-term estimated
overhead rate.

It is acceptable under the generally accepted accounting principles and international financial
reporting standards accounting frameworks to use normal costing to derive the cost of a product
for financial reporting purposes.

Normal Costing vs. Standard Costing

Normal costing varies from standard costing , in that standard costing uses entirely
predetermined costs for all aspects of a product, while normal costing uses actual costs for the
materials and labor components.

For a more accurate view of the direction in which product costs are headed, it is better to use
actual costs, since they match the current amount of actual overhead costs. Standard costs are
the least usable from a management perspective, since the costs used may not equate to actual
costs. The accuracy level of normal costs is between actual costs and standard costs.

https://www.accountingtools.com/articles/what-is-normal-costing.html

Standard Costing
 What is Standard Costing?

Standard costing is the practice of substituting an expected cost for an actual cost in the
accounting records. Subsequently, variances are recorded to show the difference between the
expected and actual costs. This approach represents a simplified alternative to cost layering
systems, such as the FIFO and LIFO methods, where large amounts of historical cost
information must be maintained for inventory items held in stock.

Standard costing involves the creation of estimated (i.e., standard) costs for some or all
activities within a company. The core reason for using standard costs is that there are a number
of applications where it is too time-consuming to collect actual costs, so standard costs are used
as a close approximation to actual costs. This results in significant accounting efficiencies.

Since standard costs are usually slightly different from actual costs, the cost accountant
periodically calculates variances that break out differences caused by such factors as labor rate
changes and the cost of materials. The cost accountant may periodically change the standard
costs to bring them into closer alignment with actual costs.
Advantages of Standard Costing

Though most companies do not use standard costing in its original application of calculating the
cost of ending inventory, it is still useful for a number of other applications. In most cases, users
are probably not even aware that they are using standard costing, only that they are using an
approximation of actual costs. Here are some potential uses:

 Budgeting. A budget is always composed of standard costs, since it would be impossible to

include in it the exact actual cost of an item on the day the budget is finalized. Also, since a key
application of the budget is to compare it to actual results in subsequent periods, the standards
used within it continue to appear in financial reports through the budget period.

 Inventory costing. It is extremely easy to print a report showing the period-end inventory
balances (if you are using a perpetual inventory system), multiply it by the standard cost of each
item, and instantly generate an ending inventory valuation. The result does not exactly match
the actual cost of inventory, but it is close. However, it may be necessary to update standard
costs frequently, if actual costs are continually changing. It is easiest to update costs for the
 highest-dollar components of inventory on a frequent basis, and leave lower-value items for
occasional cost reviews.

 Overhead application. If it takes too long to aggregate actual costs into cost pools for allocation
to inventory, then you may use a standard overhead application rate instead, and adjust this rate
every few months to keep it close to actual costs.

 Price formulation. If a company deals with custom products, then it uses standard costs to
compile the projected cost of a customer’s requirements, after which it adds a margin. This may
be quite a complex system, where the sales department uses a database of component costs that
change depending upon the unit quantity that the customer wants to order. This system may also
account for changes in the company’s production costs at different volume levels, since this
may call for the use of longer production runs that are less expensive.

Nearly all companies have budgets and many use standard cost calculations to derive product
prices, so it is apparent that standard costing will find some uses for the foreseeable future. In
particular, standard costing provides a benchmark against which management can compare
actual performance.

Problems with Standard Costing

Despite the advantages just noted for some applications of standard costing, there are
substantially more situations where it is not a viable costing system. Here are some problem
areas:

 Cost-plus contracts. If you have a contract with a customer under which the customer pays you
for your costs incurred, plus a profit (known as a cost-plus contract), then you must use actual
costs, as per the terms of the contract. Standard costing is not allowed.

 Drives inappropriate activities. A number of the variances reported under a standard costing
system will drive management to take incorrect actions to create favorable variances. For
example, they may buy raw materials in larger quantities in order to improve the purchase price
variance, even though this increases the investment in inventory. Similarly, management may
schedule longer production runs in order to improve the labor efficiency variance, even though
it is better to produce in smaller quantities and accept less labor efficiency in exchange.
 Fast-paced environment. A standard costing system assumes that costs do not change much in
the near term, so that you can rely on standards for a number of months or even a year, before
updating the costs. However, in an environment where product lives are short or continuous
improvement is driving down costs, a standard cost may become out-of-date within a month or
two.

 Slow feedback. A complex system of variance calculations is an integral part of a standard

costing system, which the accounting staff completes at the end of each reporting period. If the
production department is focused on immediate feedback of problems for instant correction, the
reporting of these variances is much too late to be useful.

 Unit-level information. The variance calculations that typically accompany a standard costing
report are accumulated in aggregate for a company’s entire production department, and so are
unable to provide information about discrepancies at a lower level, such as the individual work
cell, batch, or unit.

The preceding list shows that there are many situations where standard costing is not useful, and
may even result in incorrect management actions. Nonetheless, as long as you are aware of
these issues, it is usually possible to profitably adapt standard costing into some aspects of a
company’s operations.

Standard Cost Variances

A variance is the difference between the actual cost incurred and the standard cost against
which it is measured. A variance can also be used to measure the difference between actual and
expected sales. Thus, variance analysis can be used to review the performance of both revenue
and expenses.

There are two basic types of variances from a standard that can arise, which are the rate
variance and the volume variance. Here is more information about both types of variances:

 Rate variance. A rate variance (which is also known as a price variance) is the difference
between the actual price paid for something and the expected price, multiplied by the actual
quantity purchased. The “rate” variance designation is most commonly applied to the labor rate
variance, which involves the actual cost of direct labor in comparison to the standard cost of
 direct labor. The rate variance uses a different designation when applied to the purchase of
materials, and may be called the purchase price variance or the material price variance.

 Volume variance. A volume variance is the difference between the actual quantity sold or
consumed and the budgeted amount, multiplied by the standard price or cost per unit. If the
variance relates to the sale of goods, it is called the sales volume variance. If it relates to the use
of direct materials, it is called the material yield variance. If the variance relates to the use of
direct labor, it is called the labor efficiency variance. Finally, if the variance relates to the
application of overhead, it is called the overhead efficiency variance.

Thus, variances are based on either changes in cost from the expected amount, or changes in the
quantity from the expected amount. The most common variances that a cost accountant elects to
report on are subdivided within the rate and volume variance categories for direct materials,
direct labor, and overhead. It is also possible to report these variances for revenue.

It is not always considered practical or even necessary to calculate and report on variances,
unless the resulting information can be used by management to improve the operations or lower
the costs of a business. When a variance is considered to have a practical application, the cost
accountant should research the reason for the variance in detail and present the results to the
responsible manager, perhaps also with a suggested course of action.

How to Create Standard Costs

At the most basic level, you can create a standard cost simply by calculating the average of the
most recent actual cost for the past few months. In many smaller companies, this is the extent of
the analysis used. However, there are some additional factors to consider, which can
significantly alter the standard cost that is used. They are:

 Equipment age. If a machine is nearing the end of its productive life, it may produce a higher
proportion of scrap than was previously the case.

 Equipment setup speeds. If it takes a long time to setup equipment for a production run, the cost
of the setup, as spread over the units in the production run, is expensive. If a setup reduction
plan is contemplated, this can yield significantly lower overhead costs.
 Labor efficiency changes. If there are production process changes, such as the installation of
new, automated equipment, then this impacts the amount of labor required to manufacture a
product.

 Labor rate changes. If you know that employees are about to receive pay raises, either through
a scheduled raise or as mandated by a labor union contract, then incorporate it into the new
standard. This may mean setting an effective date for the new standard that matches the date
when the cost increase is supposed to go into effect.

 Learning curve. As the production staff creates an increasing volume of a product, it becomes
more efficient at doing so. Thus, the standard labor cost should decrease (though at a declining
rate) as production volumes increase.

 Purchasing terms. The purchasing department may be able to significantly alter the price of a
purchased component by switching suppliers, altering contract terms, or by buying in different
quantities.

Any one of the additional factors noted here can have a major impact on a standard cost, which
is why it may be necessary in a larger production environment to spend a significant amount of
time formulating a standard cost.

https://www.accountingtools.com/articles/standard-costing

Job Order Costing

Job order costing is a costing method which is used to determine the cost of

manufacturing each product. This costing method is usually adopted when the

manufacturer produces a variety of products which are different from one another

and needs to calculate the cost for doing an individual job. Job costing includes the

direct labor, direct materials, and manufacturing overhead for that particular job.

Importance of job order costing

To determine the profitability of the job
Job order costing is useful for determining if a job is profitable. It helps the company

make estimates about the value of materials, labor, and overhead that will be spent

while doing that particular job. Efficient job order costing helps companies to create

quotes that are low enough to be competitive but still profitable for the company.

To make data-driven decisions

Over time, a job order costing system becomes a valuable database holding the details

and costs of doing jobs. The information that is stored can be used as empirical

data to help the company evaluate its own efficiency and reduce costs by changing its

procedures, methods, or staffing.

To monitor machine usage

Job order costing helps companies see how much they’re using their fixed assets, such

as manufacturing equipment. Since machine costs are distributed amongst different

jobs, the identification of this cost is important to know the cost of the job. This helps

determine the amount of overhead allocated to each asset and distribute it fairly

between the company’s jobs.

What are the elements of cost?

 The elements of cost include all the different expenses which are incurred during the

production of an item and should be included in its final price. These include:

1. Material cost

2. Direct labor cost

3. Direct expenses

4. Factory overhead

Material cost
The material cost is the cost incurred for purchasing materials that are essential for the

manufacturing process. These costs are classified as direct or indirect costs based

on their traceability to the product. They’re direct costs if the raw material used to

manufacture the product is one of the essentials and is directly used in the

product. For example, wood pulp is a direct cost for paper manufacturing, because it

is the primary raw material used in the process. Indirect costs are any materials that

are needed to supplement the production process. For example, the oil and

coolant used in the paper-making machinery to keep it running and cooled during the

production process would be an indirect cost.

Direct labor
Direct labor is the cost of the employees who are directly involved in

the product’s production process. It includes their wages and any other benefits they

are offered while working on the product. For example, the person who

collects wood pulp and sends it for processing into paper, and the person who

monitors the whole production process from start to finish are both considered direct

labor. Whereas the guards or the janitors who are employed to supervise and assist

during the production process are indirect laborers and are not included as a part of

direct labor.

Direct expenses
Direct expenses are the costs that can be traced back to the spending of a specific

department. These include expenses like design costs, tool maintenance and

purchasing equipment that is directly used to manufacture the product.  They’re listed

under the COGS (Cost of Goods Sold) section in the income statement.

Factory overhead
Factory overhead is any other manufacturing cost, besides direct labor and materials,

incurred during the manufacture of the product. It includes expenses like the

electricity bill, janitorial supplies, depreciation of the machines used, depreciation

of the land where the manufacturing facility is located, and property taxes. Factory

 overheads are all added together is included in the cost sheet at the end and is charged

to the finished items.

How to calculate job order costs

Job order costing is used to measure the revenue gained against the expenses incurred

during the production process so that we can determine the profit for every

unique job which is being manufactured. Job order costing is calculated in six steps:

1. Identifying the job

2. Calculating the costs

3. Choosing the allocation base

4. Receiving the order

5. During manufacturing: Maintaining job cost sheets

6. After manufacturing: Revising the cost sheets

Identifying the job

The first step is to identify the job and its requirements.This is done by analyzing the

factors and outcomes which will be affected by taking up this job. This is a very

essential step because it helps you decide on an estimate for the job that you will be

undertaking. For example, when manufacturing paper, you need to know how many

sheets of paper the customer needs, the number of trees that need to be cut down, the
span of time required to produce this paper, the personnel who need to be assigned to

this job, the capacity of your machines, and the electricity they consume.

Calculating the costs

The next step is to identify the costs associated with doing this job. This cost should

be broken down into direct and indirect costs. For example, while manufacturing

paper, your wood pulp, water, glue, bleaching agents, and directly involved factory

personnel are direct material and labor costs. The security personnel deployed at the

manufacturing unit, and the oil and coolants required to ensure the smooth functioning

of the machines, are indirect material and labor costs. Adding all of these together will

give you an idea of the total cost that will you incur while performing this activity for

your client.

Choosing the allocation base

The incurred indirect costs should be allocated to the job based on previous examples.

In other words, the cost for this job is assigned based on the costs incurred in the

past while doing a similar job. They’re provided as an estimate, and should be

adjusted in the final stages of production based on any additional indirect costs which

add up during the production process. These costs include the cost of manufacturing

equipment, the electricity used to run the equipment, utility bills, and depreciation of

machines.
Receiving the order
Once the direct and indirect costs are calculated, they’re added together and submitted

to the client to give a quote for the job. If the customer is satisfied with the quote they

can place the order and the production can begin. During the manufacturing process,

each job is assigned a unique production number and will be identified by this

number until the job is completed.

Maintaining job cost sheets

While the job is being performed, you need to maintain a job cost sheet to

track the actual material and labor being used. This sheet will help you evaluate if the

actual cost of doing the job differs from your estimate. If they differ a lot, it means

that either your estimation process or your manufacturing process can be improved.

This can be due to incorrect estimation or inefficient implementation of the job. Since

every cost incurred in this job can be tracked, it is easy to find out where the mistake

or excessive consumption has occurred so that it can be rectified.

Revising the costs

Once the job is completed, you need to revise the actual cost by adding the additional

costs which might be incurred while doing the job with respect to the estimate given

to the customer. This helps to remove over or under applied costs and revise them in
accordance with the completed job. This step will help identify the true cost of

completing the job and arriving at its final cost.

Job order costing helps you calculate the entire cost of the job in a step by step. This

method enables you to find out errors, decide if the job is profitable, finding areas for

process improvement, monitoring fixed asset usage and creating more accurate quotes

for future jobs. It is a highly efficient costing method for a manufacturer who

produces a multitude of products different from one another.

https://www.zoho.com/inventory/guides/what-is-job-order-costing.html

Process Costing
What is a Process Costing System?

A process costing system accumulates costs when a large number of identical units are being
produced. In this situation, it is most efficient to accumulate costs at an aggregate level for a
large batch of products and then allocate them to the individual units produced. The assumption
is that the cost of each unit is the same as that of any other unit, so there is no need to track
information at an individual unit level.

Who Uses Process Costing?

Any large-scale manufacturer that produces large quantities of identical goods will use a
process costing system. The classic example of a process costing environment is a petroleum
refinery, where it is impossible to track the cost of a specific unit of oil as it moves through the
refinery.
Accounting for Process Costs

A process costing system accumulates costs and assigns them at the end of an accounting
period. At a very simplified level, the process is noted below.
Direct Materials Costs

Using either a periodic or perpetual inventory system, we determine the amount of materials
used during the period. We then calculate the number of units begun and completed during the
period, as well as the number of units begun but not completed (work-in-process units). We
generally assume that materials are added at the beginning of the production process, which
means that a work-in-process unit is the same as a completed unit from the perspective of
assigning material costs. We then assign the amount of direct materials used based on the total
of fully and partially produced units.

Direct Labor Costs

Labor is accumulated by units throughout the production process, so it is more difficult to

account for than direct materials. In this case, we estimate the average level of completion of all
work-in-process units, and assign a standard direct labor cost based on that percentage. We also
assign the full standard labor cost to all units that were begun and completed in the period. If
there is a difference between the actual direct labor cost and the amount charged to production
in the period, the difference can be charged to the cost of goods sold or apportioned among the
units produced.

Overhead Costs

Overhead is assigned in a manner similar to what was just described for direct labor, where we
estimate the average level of completion of all work-in-process units, and assign a standard
amount of overhead based on that percentage. We then assign the full standard amount of
overhead to all units that were begun and completed in the period. As was the case with direct
labor, any difference between the actual overhead cost and the amount charged to production in
the period is either charged to the cost of goods sold or apportioned among the units produced.

Presentation of Process Costs

 Cost assigned to units produced or in process are recorded in the inventory asset account, where
it appears on the balance sheet. When the goods are eventually sold, the cost is shifted to the
cost of goods sold account, where it appears on the income statement.

Alternatives to the Process Costing System

If a process costing system does not mesh well with a company's cost accounting systems, there
are two other systems available that may be a better fit. The job costing system is designed to
accumulate costs for either individual units or for small production batches. The other option is
a hybrid costing system, where process costing is used part of the time and job costing is used
the rest of the time; it works best in production environments where some of the manufacturing
is in large batches, and other work steps involve labor that is unique to individual units.

https://www.accountingtools.com/articles/what-is-a-process-costing-system.html

Backflush (JIT) Costing

What is Backflush Costing?

Backflush costing is an accounting method that records costs after a good is sold or a
service is completed. Backflush costing is common among companies that use a Just-
in-Time inventory management system. It avoids the costly and complicated reporting of
all expenses as they occur, and instead “flushes” all expenses in a single entry once the
production process is completed.

Summary

 Backflush costing is an accounting method that records costs after a good is sold or a
service is completed.
 The backflush costing method uses a standard cost per unit and multiplies this cost by
the number of units produced to determine the expense amount.
 Backflush costing is especially valuable to companies with many costs involved in
production; however, it isn’t suited to companies that sell customizable products.
How it Works

Companies will estimate the cost to produce each unit of a particular product, assigning
a standard cost per unit. At the end of a production cycle, the number of units produced
will be multiplied by the standard cost to determine the expense journal entry. The
journal entry will be recorded once at the end of the production cycle.
For example, a manufacturer who estimates a standard cost of $5 per product and
produces 1,000 units during the production cycle will make an expense journal entry of
$5,000 at the end of the cycle.

When is Backflush Costing Used?

Backflush costing is generally used by companies that keep low levels of inventory and
experience high turnover in inventory. It is because costs are still recorded relatively
close to the day they are incurred. Companies with slow inventory turnover tend to
record costs as they are incurred, as the product may remain unsold for a longer
duration of time.

The backflush costing method works particularly well, where many different costs go
into the production of a good. In such an instance, it can simplify the accounting
process significantly. As a result, many manufacturing companies with complex
production processes use backflush costing. However, companies that sell more
customized products are less suited to a backflush costing method, as the unit cost will
vary.

Advantages and Disadvantages of Backflush Costing

Backflush costing allows companies to easily assign costs to corresponding inventory.

Only one journal entry needs to be made at the end of the production process to
account for all costs designated to the product. Such a process saves companies time
needed to record costs during the production process, which lowers accounting costs.

However, companies with slower inventory turnover often can’t use a backflush costing
system, as the cost will be recorded too long after it was incurred. Such a costing
method often doesn’t conform to GAAP, and therefore can’t always be used.
Additionally, it can make a company more difficult to audit.

If an auditor is trying to determine all of the costs linked to a specific product, backflush
costing will not be able to provide the information in enough detail. Companies that use
the costing method will typically assign a standard cost to each unit of production. The
standard cost can vary from reality and may need to be reconciled in future accounting
entries.

Journal Entry

The journal entry for backflush costing is a single entry at the end of the production
period based on a standard cost and the number of units produced.
The entry below shows how using other accounting methods can be much more time-
consuming. The entries would continue over the life of the production process as costs
arise.

Example

A cellular device manufacturer wants to use the backflush costing method to record
costs for the development of a new cellphone model. On the first day of the year, they
purchase $1,000 of Component A, and $500 of Component B. The labor to assemble
the phones is $1,000 over the course of the month. The units are shipped to the
wholesaler on January 31st.

Using backflush costing, a debit of $2,500 to expenses and $2,500 to cash would be
recorded on January 31st.

https://corporatefinanceinstitute.com/resources/accounting/backflush-costing/
 Activity-based Costing

Not sure what activities your overhead costs are going towards? With activity-
based costing, product-focused businesses can get into the nitty-gritty details
to better allocate expenses. That means you can more accurately analyze
your spending—and price your products.

Activity-based costing is a complex subject. Read on to learn the basics of

what activity-based costing is, how to find it, and how it can help your
business.

What is activity-based costing?

Activity-based costing (ABC) is a system you can use to find production costs.
It breaks down overhead costs between production-related activities. The
ABC system assigns costs to each activity that goes into production, such as
workers testing a product. 

Manufacturing businesses with high overhead costs use activity-based costing

to get a clearer picture of where money is going. Because ABC gives specific
production cost breakdowns, you can see which products are actually
profitable. 

By using activity-based costing, you can:

 Take into consideration both the direct and overhead costs of creating each
product
 Recognize that different products require different indirect expenses
 More accurately set prices
 See which overhead costs you might be able to cut back on

Activity-based costing vs. traditional

costing 
ABC provides an alternative to traditional costing. Traditional costing applies
an average overhead rate to direct production costs based on a cost driver
(e.g., hours or volume). 
 But, some production-related activities use more overhead expenses than
others. As a result, traditional costing can give an inaccurate cost of making
each product.

Traditional costing is simpler but less specific than activity-based costing. You
might consider going with traditional costing if you only make a few products. 

You may also use traditional costing for reporting externally (e.g., to investors)
and activity-based costing for reporting internally (e.g., to managers). 

Benefits and drawbacks of activity-based

costing 
Although an activity-based costing system gives you accurate production cost
details, it can be difficult to implement. That’s why you should consider the
pros and cons before deciding if it’s right for your business. 

Benefits of activity-based costing 

ABC costing can help with:

 Budgeting
 Overhead decisions
 Product pricing

Budgeting 
When creating your budget for the year, you probably try to get as specific as
possible when it comes to your incoming and outgoing money. 

Activity-based costing can help you to set an accurate budget that breaks
down exactly where your money is going—and which products are the most
profitable. 

Overhead decisions
The ABC system shows you how you use overhead costs, which helps you
determine whether certain activities are necessary for production.
 Activity-based costing helps you identify where you’re wasting money. If you
find that some activities cost more than they should, you can find new
methods to do something. Or, you can cut out steps (and even products)
entirely.

Product pricing 
Another benefit of ABC is accurate product pricing. Pricing products can be
one of the most difficult decisions you make in business. 

Failing to take all of your costs into consideration could result in setting your
prices too low. As a result, you might not wind up with a healthy profit margin. 

With an ABC system, you can assign costs to each activity in the production
process. This shows you all the costs that go into producing a specific
product. You can use this data to set a price that more accurately accounts for
how much it costs you to create the product.

Drawbacks of an ABC system 

Before implementing this type of costing method, consider the cons:

 Complex
 Not 100% accurate

Complex
Activity-based costing is more complicated than traditional costing. Instead of
general overhead costs and production-related activities, you need to be
specific. 

How much time is Employee A spending on Activity XYZ? What about

electricity—how should you split up utility costs by activity?  

Getting into the weeds can make it difficult to track data without an elaborate
(and tried and true) system. Not to mention, some businesses don’t have the
job positions and resources to manage an ABC system. 
Not 100% accurate 
Unfortunately, there isn’t a costing method that gives you a completely
accurate breakdown of your costs. So although an ABC system is more
accurate and detailed than traditional costing, it isn’t 100% accurate. 

For example, the ABC system requires employees to track how much time
they spend on each activity (e.g., research, production, etc.). Your employees
might miscalculate or even exaggerate their time spent working on an activity. 

Activity-based costing calculation

Interested in using the ABC system in your business? To use this costing
system, you need to understand the process of assigning costs to activities. 

Take a look at an activity-based costing formula you can use:

(Overhead for Cost Pool / Cost Drivers) X Amount of Activity Cost

Driver  

Now, let’s take a step back and go over what exactly this means. 

A cost pool is a group of individual costs associated with an activity. You can
create cost pools by identifying the activities that go into creating a product.
Once you’ve grouped your costs into a pool, find the total overhead. Keep in
mind that there’s no set number of groups you need to have. 

A cost driver is something that controls changes in the cost of an activity.

Examples of cost drivers include units, labor or machine hours, and parts.
Assign cost drivers (you can have more than one) to each cost pool. 

When you divide the total overhead in a cost pool by your total cost drivers,
you get a cost driver rate.  

Step-by-step breakdown
Here’s a breakdown of the steps that go into activity-based costing:

1. Identify all the activities that go into creating a product (tip: if you spend
money on it, add it in!)
 2. Separate each activity into groups (e.g., product line) 
3. Find the total overhead for each cost pool 
4. Assign activity cost drivers (units, hours, parts, etc. that control
changes in costs) to each group
5. Divide the total overhead in each group by the total activity cost drivers
to get your cost driver rate
6. Multiply the cost driver rate by the amount of activity cost drivers 

Let’s say you allocate $10,000 in overhead to setting up 4,000 machines (your
cost drivers). Your cost driver rate would be $2.50 ($10,000 / 4,000). Now,
you want to know how much goes toward Product XYZ. Two hundred of the
machines you set up were Product XYZ. Your overhead costs for Product
XYZ were $500 ($2.50 X 200).  

Stay on top of your business’s finances by updating your books. With Patriot’s
online accounting software, tracking your expenses and income doesn’t have
to be difficult. Get your free trial today!   

https://www.patriotsoftware.com/blog/accounting/activity-based-costing-small-business/

Week 3
See Cost Accounting Book Chapter 2 Cost Terminology & Cost Behavior

Cost Classifications/Categories

The Conversion Process in a Manufacturing Company

Components of Product Cost
Cost behavior
Product Cost
Accumulation and Allocation of Overhead

Recording Transactions in a Manufacturing Business

Cost of Goods manufactured and Sold

Income Statement of a Manufacturing Business