The setup process (cost pool) costs the organization $28,800 in overhead (with probably no direct labor or direct machine hours because the product isn’t being made yet), and the cost driver was batches of purses (80 units per batch). Based on 3,760 purses, that would be 47 batches. Total cost in the pool divided by the total number of activities = $600 per batch.

For the production function, we determined that the cost driver would be machine hours and the rate would be $7.50 per direct labor hour, computed as follows:

In reality, as a managerial accountant, you might want to create two activities out of this one, since assembly and finishing have different cost drivers. However, in order to keep the example simpler, we’ll assume one activity with one cost driver.

The third activity in our example is the quality assurance department. Management has asked that department to test 18% of the basic purses and 65% of the deluxe purses (quality control is stricter because they sell at a high price). The cost driver is tests, and so the calculation is as follows:

Once you have the rates per activity, you can apply them to the activities per product line:

With total overhead allocated between each style of product, we can determine the per purse overhead cost:

Which will give us a total per purse cost when we add allocated overhead to direct costs (rounding the basic purse overhead allocation to the nearest penny):

This will also allow us to calculate the gross profit per unit:

And, to check our work, because accountants always want a check figure to be sure all calculations have been completed correctly, we can reconcile our per-unit gross margin to the gross margin per the financial statements:

* Actual gross profit per unit Basic is $245.00 – $182.50 – $42.0375 = $20.4625

$20.4625 * 3,200 units = $65,480

Now, let’s compare our per-unit cost computations under ABC to our other computations:

If we came to the conclusion that our Activity-Based Costing calculations were the best representation of the actual cost of the items, we might then conclude that our company should focus more on the basic purse because it has a higher gross margin and therefore contributes more to the bottom line. We might even take ABC one step further though, and separate the production activity into a few more component activities that reflect the differences between the labor-driven aspects of production (finishing) and the automated aspects (assembly). In fact, research might show us even more cost pools; however, there will be a limit to the effectiveness of any allocation system. At some point, the cost of collecting data and computing product cost will exceed the added value of the information received.

In addition, we will want to consider production capacity and how that affects the overall costs. It is possible that a decision to drop the entire deluxe line would have adverse effects that we have not yet considered. For instance, if some of the machines are specifically tooled up to produce deluxe purses, they may not be available for the basic purse and will therefore sit idle, possibly consuming resources (and still adding to depreciation expense, and overhead item) without producing any revenue.

In other words, determining the cost of an item is one tool in the cost accountant’s toolbox, and will not answer every question.

Here is a quick review of the ABC allocation process:

You can view the transcript for “Activity Based Costing (Part 2) 2nd Stage Allocation” here (opens in new window).

Now check your understanding of the ABC process.