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Accounting Principles II: Activity-Based
Costing
Complete Study Guide
Activity-Based Costing Activities
Traditionally, in a job order cost system and process cost system, overhead is allocated to a job or function based on direct labor hours, machine hours, or direct labor dollars. However, in some companies, new technologies have changed the manufacturing environment such that the number of hours worked or dollars earned by employees are no longer good indicators of how much overhead will be needed to complete a job or process products through a particular function. In such companies, activity‐based costing (ABC) is used to allocate overhead costs to jobs or functions. Activity‐based costing assumes that the steps or activities that must be followed to manufacture a product are what determine the overhead costs incurred. Each overhead cost, whether variable or fixed, is assigned to a category of costs. These cost categories are called activity cost pools. Cost drivers are the actual activities that cause the total cost in an activity cost pool to increase. The number of times materials are ordered, the number of production lines in a factory, and the number of shipments made to customers are all examples of activities that impact the costs a company incurs. When using ABC, the total cost of each activity pool is divided by the total number of units of the activity to determine the cost per unit. The number of activities a company has may be small, say five or six, or number in the hundreds. Computers make using ABC easier. Assume Lady Trekkers, Inc., has identified its activity cost pools and cost drivers (see the following table).
A per unit cost is calculated by dividing the total dollars in each activity cost pool by the number of units of the activity cost drivers. As an example to calculate the per unit cost for the purchasing department, the total costs of the purchasing department are divided by the number of purchase orders. Lady Trekkers, Inc., has determined that both the purchasing and receiving departments' costs are based on the number of purchase orders; therefore, the two departments' costs may be added together so that one per unit cost is calculated for these departments. Once the per unit costs are all calculated, they are added together, and the total cost per unit is multiplied by the number of units to assign the overhead costs to the units. Activity categories While using cost drivers to assign overhead costs to individual units works well for some activities, for some activities such as setup costs, the costs are not incurred to produce an individual unit but rather to produce a batch of the same units. For other costs, the costs incurred might be based on the number of product lines or simply because there is a manufacturing facility. To assign overhead costs more accurately, activity‐based costing assigns activities to one of four categories:
By analyzing the activity pools, the accountants and production managers have identified the cost drivers, estimated the total expected units for each product, and calculated the unit cost for each cost driver.
The activity by product is shown in the following table.
Under the traditional method of allocating overhead based on direct labor dollars, the total costs for all balls would be divided by total direct labor dollars for all balls to determine the per unit cost. Estimated direct labor costs for the year are $1,512,000, of which $378,000 is for hollow center balls and $1,134,000 is for solid center balls. The per unit direct labor costs are $0.38 for hollow center balls ($378,000 ÷ 1,000,000) and $0.57 for solid center balls ($1,134,000 ÷ 2,000,000). The per unit cost to produce balls is calculated in two steps: Calculate the predetermined overhead rate by dividing total overhead costs by total direct labor dollars. Allocate overhead to each type of product by multiplying the overhead cost per direct labor dollar by the per unit direct labor dollars for hollow center balls and for solid center balls.
A comparison of the overhead per unit calculated using the ABC and traditional methods often shows very different results: In this example, the overhead charged to the hollow ball using ABC is $0.52 and much higher than the $0.35 calculated under the traditional method. The $0.52 is a more accurate cost for making decisions about pricing and production. For the solid center ball, the overhead calculated is $0.44 per unit using the ABC method and $0.53 per unit using the traditional method. The reason for the differences is the traditional method determines the cost allocation using direct labor dollars only, so a product with high direct labor dollars gets allocated more of the overhead costs than a product with low direct labor dollars. The number of orders, setups, or tests the product actually uses
