Using a plant-wide or single overhead rate when a business manufactures or produces a single product or provides a single service is feasible and generally accurate. However, in a business with multiple departments and manufacturing sections, a much more accurate overhead rate can be calculated through cost allocation per department. For example, in a business that produces dozens of products, it is essential to know the cost of producing each product.
One reason to know the exact cost relates to the price, but unless the product or service is priced on a cost-plus basis, it’s really the market (consumers) that sets the price based on competition and the free-market system in most cases. However, knowing the exact cost of an item can help a business determine whether or not to continue producing an item.
However, there are some instances when producing a product at a loss is done in order to make a profit on complementary items. For instance, a company may be willing to lose money making printers in order to make a profit selling toner and ink cartridges.
If we go back to our original example of parsing out costs, where the Sales Manager, the Production Manager, and the Cost Accountant went out to dinner, we can see the direct costs (dinners, wine) and the indirect (shared) costs, like dessert and the appetizer, and even the variable overhead costs, which would be the tip in this example, and how a cost accountant would take more time and effort to allocate costs as accurately as possible, rather than just splitting the cost evenly. However, the cost accountant would also be aware that some costs might be unavoidable and allocated differently if the “product mix” (the diners) was different. For instance, if the Product Manager had not shown up, the appetizer and dessert would be allocated differently (assuming they are unavoidable costs).
| Description | Item Price | SM | PM | CA |
|---|---|---|---|---|
| Steak Dinner | Single Line$ 50.00 | Single Line$ 50.00 | Single Line | Single Line |
| Pasta Special | $ 30.00 | $ 30.00 | ||
| Caesar Salad | $ 16.00 | $ 16.00 | ||
| Appetizer | $ 24.00 | $ 4.00 | $ 4.00 | $ 16.00 |
| Wine – glass | $ 30.00 | $ 30.00 | ||
| Wine – glass | $ 30.00 | $ 30.00 | ||
| Wine – glass | $ 30.00 | $ 30.00 | ||
| Dessert | $ 15.00 | $ 5.00 | $ 5.00 | $ 5.00 |
| Subtotal | Single Line$ 225.00 | Single Line$ 119.00 | Single Line$ 69.00 | Single Line$ 37.00 |
| Tip | $ 45.00 | $ 23.80 | $ 13.80 | $ 7.40 |
| Total | Single Line$ 270.00Double line | Single Line$ 142.80Double line | Single Line$ 82.80Double line | Single Line$ 44.40Double line |
Also, assume that the group also went bowling, or went to a movie, or included other activities. You should be able to identify the different cost pools and cost drivers related to the different activities you are familiar with on a personal basis, and that will help you identify activities, cost pools, and cost drivers in a production process or even a service organization.
As a final note, the use of costing accounting issues like this span a wide variety of organizations, from production to sales to not-for-profit to government. For instance, click here for an in-depth analysis of how the air force uses activity-based costing.
