Finance Academy: Cost Structure and Profitability Analysis
Benefits of Activity-Based Costing
Benefits of Activity-Based Costing
Insurance Industry
The following example illustrates overhead allocation using activity-based costing.
An insurance company sells four policies: A, B, C, and D. They also make costly sales promotions for each policy. The
following table contains the data for each policy.
Policy Reference
Number of Policies Sold
Direct Labor Hours Per Policy
Sales Promotions Made
A
B
10
1
2
C
10
3
2
D
100
1
5
1,000
3
5
Total
1,120
3,140
14
The direct labor cost is $10 per hour. Overhead costs are $62,800, which consist of $22,000 spent on sales
promotions and $40,800 spent on policy handling costs. Determine the overhead to be allocated to each policy using
activity-based costing.
Solution
In activity-based costing, overhead is assigned based on cost drivers.
Sales promotion overhead assignment rate = Sales promotion overhead / Total number of promotions
= $22,000 / 14
= $1571.43 per promotion
Policy handling overhead assignment rate = Policy handling promotion overhead / Total number of policies
= $40,800 / 1,120
= $36.43 per policy
Policy Reference
Direct Labor Cost ($)
Sales Promotions Cost ($)
Policy Handling Cost ($)
Total Cost ($)
Number of Policies
Cost Per Policy ($)
A
B
100
3,143
364
3,607
10
360.70
C
300
3,143
364
3,807
10
380.70
D
30,000
7,857
36,430
74,287
1,000
74.29
1,000
7,857
3,643
12,500
100
125
Total
31,400
22,000
40,800
94,200
1,120
Now let’s now compare conventional and activity-based costing.
Policy Reference
Cost Per Policy: Conventional Costing ($)
Cost Per Policy: Activity-Based Costing ($)
Difference ($)
A
30
360.70
(330.70)
B
C
90
380.70
(290.70)
D
30
125
(95)
90
74.29
15.71
You find that under conventional costing, D got charged more than its share of overhead. D consumed more direct
labor hours, because it was high volume and so it got assigned more than its share of sales promotion and policy
handling costs. On the other hand, A―which was low volume and had relatively few direct labor hours―got assigned
very little overhead even though A still consumed sales promotions and had policy handling costs.
Based on conventional costing, you might, therefore, incorrectly conclude that D was unprofitable because it got
assigned too much overhead. Under more precise overhead allocation using activity-based costing, you need to check
whether as much overhead spending on promotions and policy handling costs for A, B, and C is justified given that
they are low volume, and therefore, very costly.
Finance Academy: Cost Structure and Profitability Analysis