Traditional Costing method

In a traditional costing method, we calculate one plantwide allocation rate or we could calculate an overhead allocation rate for each department.  We have a three step process:

Step 1:  Determine the basis for allocating overhead or indirect costs.  These can be anything a company decides but most common are direct labor cost, direct labor hours, direct material usage or machine hours.

Step 2:  Calculated a predetermined overhead rate using estimates.  This is typically calculated at the end of the year to be used during the following year.  The formula we use for this is:

Step 3:  Apply overhead throughout the period using the actual amount of our base and the predetermined overhead rate (POHR) calculated in step 2.  We calculate this as:

This video will discuss the differences between the traditional costing method and activity based costing.

Traditional costing method example

Assume High Challenge Company makes two products, touring bicycles and mountain bicycles. The touring bicycles product line is a high-volume line, while the mountain bicycle is a low-volume, specialized product.

High Challenge Company allocated manufacturing overhead costs to the two products for the month of January.  Department A had estimated overhead of $2,000,000 and used 20,000 machine hours.  High Challenge has decided to allocate overhead on the basis of machine hours.

• The predetermined overhead rate of $100 per machine hour is calculated as:

• At the end of January, High Challenge had used 1,500 machine hours for the Touring bicycle product line and 500 machine hours for the Mountain bicycle product line.   Overhead would be allocated to each product as follows (use the POHR calculated above at $100 per machine hour):

Methods used for activity-based costing

Activity-based costing requires accountants to use the following four steps:

1. Identify the activities that consume resources and assign costs to those activities. Purchasing materials would be an activity, for example.
2. Identify the cost drivers associated with each activity. A cost driver is an activity or transaction that causes costs to be incurred. For the purchasing materials activity, the cost drivers could be the number of orders placed or the number of items ordered. Each activity could have multiple cost drivers.
3. Compute a cost rate per cost driver unit. The cost driver rate could be the cost per purchase order, for example.
4. Assign costs to products by multiplying the cost driver rate times the volume of cost driver units consumed by the product. For example, the cost per purchase order times the number of orders required for Product A for the month of December would measure the cost of the purchasing activity for Product A for December.

The next section describes these four steps.

Step 1 is often the most interesting and challenging part of the exercise. This step requires people to understand all of the activities required to make the product. Imagine the activities involved in making a simple product like a pizza—ordering, receiving and inspecting materials, making the dough, putting on the ingredients, baking, and so forth. Or imagine the activities involved in making a complex product such as an automobile or computer.

One of the lessons of activity-based costing has been that the more complex the business, the higher the indirect costs. Imagine that each month you produce 100,000 gallons of vanilla ice cream and your friend produces 100,000 gallons of 39 different flavors of ice cream. Further, assume your ice cream is sold only in one liter containers, while your friend sells ice cream in various containers. Your friend has more complicated ordering, storage, product testing (one of the more desirable jobs, nevertheless), and packing in containers. Your friend has more machine setups, too. Presumably, you can set the machinery to one setting to obtain the desired product quality and taste. Your friend has to set the machines each time a new flavor is produced. Although both of you produce the same total volume of ice cream, it is not hard to imagine that your friend’s overhead costs would be considerably higher.

In Step 2, we identify the cost drivers.  In the table below, we present several examples of the cost drivers companies use. Most cost drivers are related to either the volume of production or to the complexity of the production or marketing process.

In deciding which cost drivers to use, managers consider these three factors:

• Causal relation. Choosing a cost driver that causes the cost is ideal. For example, suppose students in biology classes are messier than students in history classes. As a result, the university does more maintenance per square foot in biology classrooms and labs than in history classrooms. Further, it is possible to keep track of the time maintenance people spend cleaning classrooms and labs. The university could assign maintenance costs based on the time spent in history classrooms and in biology classrooms and labs, respectively, to the history and biology departments.
• Benefits received. Choose a cost driver so costs are assigned in proportion to benefits received. For example, if the physics department in a university benefits more from the university’s supercomputer than the German department does, the university should select a cost driver that recognizes such differences in benefits. The cost driver could be the number of faculty and/or students in each department who use the computer.
• Reasonableness. Some costs that cannot be linked to products based on causality or benefits received are assigned on the basis of reasonableness.

For step 3, we need to calculate the activity rates.  These are calculated using the same formula for predetermined overhead rate (POHR) that we used for traditional costing.  In general, predetermined rates for allocating indirect costs to products are computed as follows:

This formula applies to all indirect costs, whether manufacturing overhead, administrative costs, distribution costs, selling costs, or any other indirect cost.

In Step 4, we first define the notion of an activity center. An activity center is a unit of the organization that performs some activity. For example, the costs of setting up machines would be assigned to the activity center that sets up machines. This means that each activity has associated costs. When the cost driver is the number of inspections, for example, the company must keep track of the cost of inspections.

Workers and machines perform activities on each product as it is produced. Accountants allocate costs to products by multiplying each activity’s indirect cost rate by the volume of activity used in making the product.  The formula we will use for each activity is:

Activity-based costing example

Assume High Challenge Company makes two products, touring bicycles and mountain bicycles. The touring bicycles product line is a high-volume line, while the mountain bicycle is a low-volume, specialized product.

In using activity-based costing, the company identified four activities that were important cost drivers and a cost driver used to allocate overhead. These activities were (1) purchasing materials, (2) setting up machines when a new product was started, (3) inspecting products, and (4) operating machines.

Accountants estimated the overhead and the volume of events for each activity. For example, management estimated the company would purchase 100,000 pieces of materials that would require overhead costs of $200,000 for the year. These overhead costs included salaries of people to purchase, inspect, and store materials. Setting up machines for a new product would need 400 setups and overhead of $800,000.  The company would have 4,000 inspections and overhead of $400,000.  Finally, running machines would cost $600,000 for 20,000 machine hours.

These estimates were made last year and will be used during all of the current year. In practice, companies most frequently set rates for the entire year, although some set rates for shorter periods, such as a quarter.

Look at the overhead rates computed for the four activities in the table below. Note that the total overhead for current year is $2,000,000 using activity-based costing, just as it was using a traditional costing method. The total amount of overhead should be the same whether using activity-based costing or traditional methods of cost allocation to products. The primary difference between activity-based costing and the traditional allocation methods is the amount of detail; particularly, the number of activities used to assign overhead costs to products. Traditional allocation uses just one activity, such as machine-hours. Activity-based costing used four activities in this case. In practice, companies using activity-based costing generally use more than four activities because more than four activities are important. We used four to keep the illustration as simple as possible.

The activity cost rates (predetermined overhead rates) are calculated as follows:

For January, the High Challenge Company has the following information about the actual number of cost driver units for each of the two products:

Multiplying the actual activity events for each product times the predetermined rates computed earlier resulted in the overhead allocated to the two products:

Now we can compare the overhead allocated to the two product lines using the traditional method and activity-based costing, as follows:

Notice how the total overhead for the month of January is the same at $200,000 but the amount allocated to each product is different.

Analysis More overhead is allocated to the lower volume mountain bicycles using activity-based costing. The mountain bicycles are allocated more overhead per unit primarily because activity-based costing recognizes the need for more setups for mountain bicycles and for as many inspection hours for the more specialized mountain bicycles as for the higher volume touring bicycles. By failing to assign costs to all of the activities, touring bicycles were subsidizing mountain bicycles. Many companies have found themselves in similar situations. Activity-based costing has revealed that low-volume, specialized products have been the cause of greater costs than managers had realized.

Here is a video example of activity based costing: