Cost Accounting
Allocation of Overhead
MB-664 May 2009
Managerial Cost Concepts
1. Direct materials: raw materials physically
associated with the final product
2. Direct labor: employees physically and
directly associated with the final product
3. Overhead: variable manufacturing overhead
tied directly to the final product while fixed
manufacturing overhead is not.
4. Selling and administrative: Marketing
expenses, office expenses and managerial
salaries and benefits.
Budgets and Financial Statements
Sales Budget
Production Budget
Direct Materials
Budget
Direct Labor
Budget
Overhead
Budget
Selling and Administrative
Expense Budget
Cash Budget
Budgeted Income
Statement
Budgeted Cash
Flow Statement
Capital
expenditures
Budgeted
Balance Sheet
Enterprise Budgets and The Master Budget
Enterprise #1
•Unit sales and expected price
•Unit production and inventory
•Direct materials used
•Direct labor used
•Manufacturing overhead
Sales Budget
Production Budget
Direct Materials
Budget
Enterprise #n
•Unit sales and expected price
•Unit production and inventory
•Direct materials used
•Direct labor used
•Manufacturing overhead
Direct Labor
Budget
Overhead
Budget
Enterprise Budgets and The Master Budget
Enterprise #1
•Unit sales and expected price
•Unit production and inventory
•Direct materials used
•Direct labor used
•Manufacturing overhead
Sales Budget
Production Budget
Direct Materials
Budget
Enterprise #n
•Unit sales and expected price
•Unit production and inventory
•Direct materials used
•Direct labor used
•Manufacturing overhead
Direct Labor
Budget
Overhead
Budget
Enterprise Budgets and The Master Budget
Enterprise #1
•Unit sales and expected price
•Unit production and inventory
•Direct materials used
•Direct labor used
•Manufacturing overhead
Examples of direct materials:
•Purchase of corn.
•Purchase of natural gas.
•Purchase of other inputs used in
the ethanol production process.
Examples of manufacturing overhead:
•Variable manufacturing overhead
examples include utilities, repairs and
maintenance.
•Fixed manufacturing overhead
examples include property taxes, rent,
insurance premiums, depreciation and
legal and professional charges.
Use of ABC Accounting
1. Identify and classify activities and
allocate overhead to cost pools.
2. Identify cost drivers – correlation
between driver and use.
3. Calculate overhead rates or ABC rates.
4. Assign overhead costs to products – use
of cost drivers.
5. Allocate overhead to individual products.
Activity Based Cost Allocation
Overhead Costs
Activity Based Cost Allocation
Overhead Costs
Ordering
and
Receiving
Materials
Cost Pool
Setting
Up
Machines
Cost
Pool
Machining
Cost
Pool
Assembly
Cost
Pool
Inspecting
and
Testing
Cost
Pool
These are activity cost pools
Painting
Cost
Pool
Activity Based Cost Allocation
Overhead Costs
Activity cost pools:
Ordering
and
Receiving
Materials
Cost Pool
Setting
Up
Machines
Cost
Pool
Machining
Cost
Pool
Assembly
Cost
Pool
Inspecting
and
Testing
Cost
Pool
Painting
Cost
Pool
# of
Purchase
orders
# of
Setups
# of
Machine
hours
# of
Parts
# of
Tests
# of
Direct
hours
These are cost drivers
Activity Based Cost Allocation
Overhead Costs
Activity cost pools:
Ordering
and
Receiving
Materials
Cost Pool
Setting
Up
Machines
Cost
Pool
Machining
Cost
Pool
Assembly
Cost
Pool
Inspecting
and
Testing
Cost
Pool
Painting
Cost
Pool
# of
Machine
hours
# of
Parts
# of
Tests
# of
Direct
hours
Cost drivers:
# of
Purchase
orders
# of
Setups
Products
Example of ABC Accounting
Step 1: calculate the ABC Overhead rate:
Activity Cost Pool
Setting up machines
Machining
Inspecting
Total
Process
overhead
$300,000
$500,000
$100,000
$900,000
Driver
activity
1,500 setups
50,000 hours
2,000 inspection
AB overhead
rate
$200/setup
$10/hour
$50/inspection
Divide the process overhead by level of driver activity
to calculate the ABC overhead rate.
Example of ABC Accounting
Step 2: Assigning overhead driver activity to products:
Activity Cost Pool
Cost driver
Setting up machines
Machining
Inspecting
# setups
Hours
# inspections
Driver
activity
1,500
50,000
2,000
Product 1 Product 2
500
30,000
500
1,000
20,000
1,500
Allocate the activity levels to the 2 products. For example,
500 of the setups are associated with product 1.
Example of ABC Accounting
Step 2: Assigning overhead driver activity to products:
Activity Cost Pool
Cost driver
Driver
Product 1 Product 2
activity
Setting up machines
# setups
1,500
500
1,000
Machining
Hours
50,000
30,000
20,000
Inspecting
# inspections
2,000
500
1,500
Step 3: Partitioning of process overhead:
Overhead
Product 1
Product 2___
Setting up machines
$300,000
(33%) $100,000 (67%) $200,000
Machining
$500,000
(60%) $300,000 (40%) $200,000
Inspecting
$100,000
(25%) $25,000 (75%) $75,000
500/1,500 x $300,000 or 500 units x $200/setup
Example of ABC Accounting
Step 2: Assigning overhead driver activity to products:
Activity Cost Pool
Cost driver
Driver
Product 1 Product 2
activity
Setting up machines
# setups
1,500
500
1,000
Machining
Hours
50,000
30,000
20,000
Inspecting
# inspections
2,000
500
1,500
Step 3: Partitioning of process overhead:
Overhead
Product 1
Product 2___
Setting up machines
$300,000
(33%) $100,000 (67%) $200,000
Machining
$500,000
(60%) $300,000 (40%) $200,000
Inspecting
$100,000
(25%) $25,000 (75%) $75,000
1,000/1,500 x $300,000 or 1,000 x $200/setup
Example of ABC Accounting
Step 2: Assigning overhead driver activity to products:
Activity Cost Pool
Cost driver
Driver
Product 1 Product 2
activity
Setting up machines
# setups
1,500
500
1,000
Machining
Hours
50,000
30,000
20,000
Inspecting
# inspections
2,000
500
1,500
Step 3: Partitioning of process overhead:
Overhead
Product 1
Product 2___
Setting up machines
$300,000
(33%) $100,000 (67%) $200,000
Machining
$500,000
(60%) $300,000 (40%) $200,000
Inspecting
$100,000
(25%) $25,000 (75%) $75,000
30,000/50,000 x $500,000 or 30,000 x $10/hour
Example of ABC Accounting
Step 2: Assigning overhead driver activity to products:
Activity Cost Pool
Cost driver
Driver
Product 1 Product 2
activity
Setting up machines
# setups
1,500
500
1,000
Machining
Hours
50,000
30,000
20,000
Inspecting
# inspections
2,000
500
1,500
Step 3: Partitioning of process overhead:
Overhead
Product 1
Product 2___
Setting up machines
$300,000
(33%) $100,000 (67%) $200,000
Machining
$500,000
(60%) $300,000 (40%) $200,000
Inspecting
$100,000
(25%) $25,000 (75%) $75,000
20,000/50,000 x $500,000 or 20,000 x $10/hour
Example of ABC Accounting
Step 2: Assigning overhead driver activity to products:
Activity Cost Pool
Cost driver
Driver
Product 1 Product 2
activity
Setting up machines
# setups
1,500
500
1,000
Machining
Hours
50,000
30,000
20,000
Inspecting
# inspections
2,000
500
1,500
Step 3: Partitioning of process overhead:
Overhead
Product 1
Product 2___
Setting up machines
$300,000
(33%) $100,000 (67%) $200,000
Machining
$500,000
(60%) $300,000 (40%) $200,000
Inspecting
$100,000
(25%) $25,000 (75%) $75,000
500/2,000 x $100,000 or 500 x $50/inspection
Example of ABC Accounting
Step 2: Assigning overhead driver activity to products:
Activity Cost Pool
Cost driver
Driver
Product 1 Product 2
activity
Setting up machines
# setups
1,500
500
1,000
Machining
Hours
50,000
30,000
20,000
Inspecting
# inspections
2,000
500
1,500
Step 3: Partitioning of process overhead:
Overhead
Product 1
Product 2___
Setting up machines
$300,000
(33%) $100,000 (67%) $200,000
Machining
$500,000
(60%) $300,000 (40%) $200,000
Inspecting
$100,000
(25%) $25,000 (75%) $75,000
1,500/2,000 x $100,000 or 1,500 x $50/inspection
Example of ABC Accounting
Step 3: Partitioning of process overhead:
Overhead
Product 1
Setting up machines
$300,000
$100,000
Machining
$500,000
$300,000
Inspecting
$100,000
$25,000
Total
$900,000
$425,000
Step 4: Process overhead costs per unit:
Units produced
25,000
Process overhead cost per unit
$17
Product 2
$200,000
$200,000
$75,000
$475,000
5,000
$95
$17 = $425,000 / 25,000
$95 = $475,000 / 5,000
Example of ABC Accounting
Step 3: Partitioning of process overhead:
Overhead
Product 1
Setting up machines
$300,000
$100,000
Machining
$500,000
$300,000
Inspecting
$100,000
$25,000
Total
$900,000
$425,000
Product 2
$200,000
$200,000
$75,000
$475,000
Step 4: Process overhead costs per unit:
Units produced
25,000
Process overhead cost per unit
$17
5,000
$95
Traditional process overhead cost per unit
$30
$30
$30 = $900,000 / (25,000 + 5,000)
Example of ABC Accounting
Product 1 Product 2
COP unit costs with ABC costing:
Direct materials
Direct labor
ABC manufacturing overhead
Total unit costs
$40
$12
$17
$69
$30
$12
$95
$137
COP unit costs with traditional costing:
Direct materials
Direct labor
Traditional manufacturing overhead
Total unit costs
$40
$12
$30
$82
$30
$12
$30
$72
Traditional overhead costing suggests
that Product 2 is cheaper to produce
than Product 1, which is not true!