It’s as simple as….
A B C
A
B
C

Direct Materials are easy to accurately assign to products
Direct Labor is easy to accurately assign to product.
Overhead is often difficult to accurately assign to products.

Total OH Cost
# of Units Made
= OH Cost per Unit

• Think back to Your House / My House
MY HOUSE - #1
YOUR HOUSE - #3
HOUSE #2

You told me that you didn’t want to divide the overhead between the three houses.
Why?
Because My House used more overhead than Your House.

BIG Overhead $$$$ =
Semi-sensible Cost Driver
Potentially misleading OH rate

When you go to a fancy restaurant doesn’t it make you nervous when there are no prices on the menu?
You want to know how much your meal is going to cost before you order.

Companies want to know the cost of the product before it is produced.
Companies have to estimate their costs.

Estimate Overhead Costs & Cost Driver
Amounts.
This provides the companies with a predetermined overhead rate.
The companies then “apply” the overhead.
At the end of the period, they will compare
“actual” to “applied” – we will discuss this in Chapter 8.

Overhead needs to be allocated in “some logical way”
Historically, the most common “logical” way to assign overhead was to use direct labor hours as a cost driver.

In the “old days” most things were made with a lot of
Direct Labor Hours was a good way to allocate overhead
Many companies used direct labor hours as the sole base for establishing a companywide allocation rate.

Traditional cost systems were created when manufacturing processes were labor intensive.
A single company-wide overhead rate, based on direct labor hours, is used to allocate overhead to products in these labor intensive processes.

Overhead is allocated to jobs using direct labor hours. If overhead is $120, how much overhead is allocated to each job?

Overhead Rate = $120 ÷ 8 direct labor hours
Overhead Rate = $15 per direct labor hour
Job 1 = 2 hours × $15 per hour = $30
Job 2 = 6 hours × $15 per hour = $90

Labor Intensive Process
 Overhead costs are relatively small.
 Overhead allocations may be inaccurate, but the amounts are relatively insignificant.
Automated Process
 Overhead costs are relatively large.
 Inaccurate overhead allocation can lead to questionable product cost information.

Automation increases overhead from $120 to $420 and reduces the Job 2 labor hours from 6 to 1. Allocate the $420 overhead to the two jobs using direct labor.

Overhead Rate = $420 ÷ 3 direct labor hours
Overhead Rate = $140 per direct labor hour
Job 1 = 2 hours × $140 per hour = $280
Job 2 = 1 hour × $140 per hour = $140

Is this reasonable?
Automation benefited Job 2, but Job 1 is allocated more overhead. Clearly, we need another cost driver to allocate overhead.

• Today automation has cut down on the number of direct labor hours used.
• So, direct labor hours is not the best allocation base to use.

Martinez Furniture Company (MFC) makes desks and chairs. Desks require 5 hours of direct labor per unit and chairs require 2 hours per unit . Each month MFC normally uses 500,000 hours of direct labor making desks and 300,000 hours of direct labor making chairs in the course of starting and completing work on 100,000 desks and 150,000 chairs . The company incurs $1,088,000 of materials handling cost each month.

What is the most appropriate allocation base?
• Labor Hours or Units
• Total Direct Labor Hours is most appropriate allocation base = 800,000 hrs
• What needs to be allocated?
• $1,088,000 – Materials Handling Cost
• The allocation is rate is:
• $1,088,000 / 800,000 hrs = $1.36 / DLH
Desks = $1.36 * 500,000 = $680,000
Chairs = $1.36 * 300,000 = $408,000
$1,088,000

OVERHEAD
$1,088,000
DESKS
$608,000
CHAIRS
$408,000

• Direct labor hours is a good allocation base as long as both products are labor intensive.
• What happens if the production of one of the two products become automated?

• MFC can now make one desk in 0.4 hrs
40,000 DL hrs to make 100,000 desks
300,000 DL hrs to make 150,000 chairs
• Still have $1,088,000 of overhead
• Allocate materials using DL hrs

• DLH is now 340,000 ( 40,000 + 300,000 )
• Allocation Rate is:
– $1,088,000 / 340,000 DLH = $3.20
DLH
• Allocated Overhead Costs:
– Desks: $3.20
* 40,000 = $128,000
– Chairs: $3.20
* 300,000 = $960,000

Before Automation
Desks = $680,000 Allocated Overhead
Chairs = $408,000 Allocated Overhead
After Automation
Desks = $128,000 Allocated Overhead
Chairs = $960,000 Allocated Overhead
The desks still require the same amount of materials after automation as they did before automation.
So does this seem correct?

This caused a shift of $552,000 of overhead cost to the chairs, even though desks still require more materials handling than chairs.
Chairs are overcosted
Desks are undercosted
What happens if this isn’t fixed?
Chairs will be sold for too much
Desks will be sold for too little

A
B C
Activity-based costing (ABC) is a two-stage allocation process that employs a variety of cost drivers.

C
• 2-stage process
• 1 st – Costs are assigned to pools based on the activities that cause the costs to be incurred
Note: Costs are pooled by activity centers
• 2 nd – Costs in the activity cost pools are allocated to products using a variety of cost drivers
• GOAL – Calculate costs in a sensible & accurate manner

• Must identify essential activities and the costs of performing the activities
• Activities
– Acquire Raw Materials
– Transform Raw Materials
– Deliver Products to the Customers

OVERHEAD
$900,000
ACQUIRE RAW
MATERIALS
$300,000
TRANSFORM RAW
MATERIALS
$300,000
DELIVERY OF
PRODUCTS
$300,000
PRODUCT A
$300,000
PRODUCT B
$300,000
PRODUCT C
$300,000

MFC
• Mgmt identified the following activities associated with the materials handling cost
– Locating a supplier
– Placing an order
– Transporting materials from supplier
– Inspecting materials for defects
– Storing materials in a warehouse
– Preparing production requisitions
– Issuing materials to the production department

Step 1 Allocation
All Overhead
$1,088,000
Production
Requisitions
Storage
Placing an Order
Issuing Materials
Locating a Supplier
Step 2 Allocation
Product A Product B
Product C

It’s the # of Production
Requistitions
• After analysis MFC concludes it’s the number of production requisitions prepared that is the primary activity that drives the cost of handling materials.
• After counting – 4,000 requisitions a month
• 2,500 for materials for desks
• 1,500 for materials for chairs

• Now let’s use the # of requisitions as the allocation base
• Allocation Rate:
– $1,088,000 / 4,000 = $272 / req.
• Allocated Materials Handling Cost
– Desks: $272 * 2,500 = $680,000
– Chairs: $272 * 1,500 = $408,000
• These allocations are more accurate

OVERHEAD
$1,088,000
PURCHASE
REQUISITIONS
$1,088,000
DESKS
$680,000
CHAIRS
$408,000

• Using Direct Labor Hours
– Desks = $128,000
– Chairs = $960,000
• Using # of Purchase Requisitions
– Desks = $680,000
– Chairs = $408,000

• MFC’s mgmt team found that the cost incurred by storing materials in a warehouse was a non-value added activity
• MFC implemented a Just-in-Time inventory system
• This eliminated inventory storage costs such as warehouse rental cost, reporting cost, costs of lost and damaged materials, and processing costs

Monthly Materials Handling Cost
Fell from $1,088,000 to $816,000
• MFC filed 5,000 purchase orders / month
– 3,000 for materials for desks
– 2,000 for materials for chairs
• Allocation Rate:
– $816,000 / 5,000 orders = $163.20 / order
• Allocate Materials Handling Cost
– Desks: 3,000 * $163.20 = $489,600
– Chairs: 2,000 * $163.20 = $326,400

• Assign resource costs to resource users.
As an example, when you go out to eat, the person who orders steak should pay more than the person who orders soup…splitting the bill is unfair.

Putting What We’ve Learned Into
Perspective
• Traditional costing systems (aka functional-based systems) often work well.
• Traditional systems can lead to poor decisions…if you think a product is a money-loser, you disfavor it.
• Activity-based costing (ABC) systems improve decision making ability…but ABC systems are costly to operate.