Uploaded by Ibrahim Mohamed



Activity-Based Costing

Cost Allocation

The basic approach in product costing is to allocate costs in the cost pools to the individual cost objects, which are the products or services of interest.

We assign, or allocate, these costs to the individual cost objects by using appropriate cost allocation bases or cost drivers.

Plantwide Allocation method

LO 1 Compare and contrast plantwide and department allocation methods.

Plantwide allocation method

All overhead costs are recorded in one cost pool and applied to products using one overhead allocation rate.

One cost pool for the entire plant

The cost pool is the entire plant.

This method uses one overhead allocation rate, or one set of rates, to allocate overhead to products for all departments in a particular plant.

Companies using a single plantwide rate generally use an allocation base related to the volume of output, such as direct labor-hours, machine-hours, units of output, or materials costs.

Department allocation method

Department allocation method

Overhead costs are traced to separate departments and applied to products using a department allocation rate.

One cost pool for each department

A company has a separate cost pool for each department. The company establishes a separate overhead allocation rate for each department.

Each production department is a separate cost pool.

Example: Plantwide Vs. Department allocation

Main Street Ice Cream Company uses a plantwide allocation method to allocate overhead based on direct labor-hours at a rate of $3 per labor-hour. Strawberry and vanilla flavors are produced in

Department SV. Chocolate is produced in Department C. Sven manages Department SV and Charlene manages Department C. The product costs (per thousand gallons) follow:


a. If the number of hours of labor per 1,000 gallons is 50 for strawberry, 55 for vanilla, and 75 for chocolate, compute the total cost of 1,000 gallons of each flavor using plantwide allocation. b.Charlene’s department uses older, outdated machines. She believes that her department is being allocated some of the overhead of Department SV, which recently bought state-of-the-art machines.

After she requested that overhead costs be broken down by department, the following information was discovered:

Using machine-hours as the department allocation base for Department SV and labor-hours as the department allocation base for Department C, compute the allocation rate for each.

c. Compute the cost of 1,000 gallons of each flavor of ice cream using the department allocation rates computed in requirement ( b ) if the number of machine-hours for 1,000 gallons of each of the three flavors of ice cream are as follows: strawberry, 50; vanilla, 55; and chocolate, 150. Direct labor hours by product remain the same as in requirement a.

Solution: Plantwide Vs. Department allocation b.

Department SV has an overhead allocation rate of $4.20 per machine-hour ($105,840 ÷ 25,200 machine hours). Department C has an overhead allocation rate of $1.32 per labor-hour ($23,760

÷ 18,000 labor-hours). c.

a$210 = 50 machine-hours x $4.20 per machine-hour. b$231 = 55 machine-hours x $4.20 per machine-hour. c$99 = 75 labor-hours x $1.32 per labor-hour.

Choice of Allocation Methods

Which method is appropriate?

The choice of whether to use a plantwide rate or departmental rates depends on the products and the production process.

If the company manufactures products that are quite similar and that use the same set of resources, the plantwide rate is probably sufficient.

If multiple products use the manufacturing facilities in many different ways, departmental rates provide a better picture of the use of manufacturing resources by the different products.

Managers need to make a decision about plantwide versus departmental rates based on the costs and benefits of the information inherent in each system.

Selecting more complex allocation methods requires more time and skill to collect and process accounting information. Such incremental costs of additional information must be justified by an increase in benefits from improved decisions.

Two-Stage Cost Allocation

First stage:

Allocate overhead costs to departments.

Second stage:

Allocate department overhead costs to the products or services.

Activity-Based Costing (ABC)

Assume that you are thinking about going into business offering music to be downloaded

(legally) over the Internet.

One of the first steps is to develop a business plan that includes a financial analysis.

One aspect of the financial analysis is estimating the cost of downloads to help you assess the profitability of your venture.

Because you are not now in the business, you have no accounting records to use to help you.

Instead, you need to use the engineering approach to estimate cost. You would probably proceed by identifying the activities that you would need to perform.

The activities would include:

obtaining permission from various artists and studios to include their songs in your catalog.

Negotiating a royalty payment for each download would be necessary.

Buying and maintaining a Web site,

processing orders, collecting payments,

keeping records, and so on.

Once you had identified each activity that you would have to accomplish, you would estimate the cost of completing each one.

In this description of the process you would follow, the italicized words are actions that represent tasks that you would complete to make the product (service) available for sale. You

do not attempt to determine what department or what overhead account would be used. You use activities.

Applying this approach to the two-stage cost allocation system, you assign costs to activities, not departments or buildings, in the first stage. In the second stage, you “allocate” costs to your single product, downloads, using the appropriate cost drivers for each activity.

LO 2

Explain how activity-based costing and a two-stage product system are related.

ABC is a costing method that first assigns costs to activities and then assigns them to products based on the products’ consumption of activities.

Stage 1:

Assign costs to activities.

Stage 2:

Assign costs to products based on the use of each activity

Why ABC?

Step 1: Identify the activities that consume resources and assign costs to them.

Step 2: Identify the cost driver(s) associated with each activity.

Step 3: Compute a cost rate per cost driver unit or transaction.

Step 4: Assign costs to products by multiplying the cost driver rate by the volume of cost driver units consumed by the product.

Identifying Activities That Use Resources

Often the most interesting and challenging part of the exercise is identifying activities that use resources because doing so requires understanding all the activities required to make a product.

Example, the activities involved in making a bottle of water:


 receiving and inspecting materials;

 bottling the water;

 packing the cases;

 shipping the cases.

Choosing Cost Drivers

Cost drivers are factors that cause or “drive” an activity’s costs.

The best cost driver is one that is

causally related to the cost being allocated

Computing a Cost Rate per Cost Driver

In general, predetermined rates for allocating indirect costs to products are computed as follows:

Costs are allocated to a product by multiplying each activity’s predetermined rate by the volume of activity used in making it.

In the ABC two-stage cost system, the first stage consists of activities, not departments. Instead of a department rate, activity-based costing computes a cost driver rate for each activity center.

Assigning Costs to Products

The final step in the activity-based costing system is to assign the activity costs to products.

We multiply the cost driver rates by the number of units of the cost driver in each product.

Cost Hierarchies

This is the classification of cost drivers into general levels of activity; volume, batch, product, and so on.

LO 3 Compute product costs using activity-based costing.

Janis, she’s the cost accountant at Joplin—interviews the production managers to determine the major activities used to produce cameras in the Port Arthur facility. She learns that the Assembly building has three major activities—setting up, handling material, and assembling—and that the

Packaging building has two major activities—inspecting and packing, and shipping.

Step 1: Identify the activities that consume resources and assign costs to them.

 setting up

 handling material

 assembling

 inspecting and packing

 shipping.

Step 2: Identify the cost driver(s) associated with each activity.

Step 3: Compute a cost rate per cost driver unit or transaction.

Step 4: Assign costs to products by multiplying the cost driver rate by the volume of cost driver units consumed by the product.

Cost Flow Diagram – ABC System

Match each of the following activities with the appropriate category


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