Allocating Overhead Using ABC

Learning Outcomes

  • Allocate costs to cost objects using Activity Based Costing

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.

Setup $  28,200.00 total
Cost driver = batches 80 units per batch
3200 units basic  = 40.00 batches
560 units deluxe  = 7.00 batches
Single Line 47.00Double line total
$28,200 / 47 setups = $600.00 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:

Production $141,000.00 total
Cost driver = direct labor hours
3200 units basic  = 13,200.00 hours
560 units deluxe  = 5,600.00 hours
Single Line 18,800.00Double line total
$141,000 / 18,800 DLH = $7.50 per DLH

 

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, so the calculation is as follows:

Quality Assurance $  18,800.00 total
Cost driver = tests 18.00% of basic units are tested
3200 units basic  =           576.00 tests
65.00% of deluxe units are tested
560 units deluxe  =           364.00 tests
Single Line 940.00Double line total
$18,800 / / 940 tests = $      20.00 per test

 

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

Predetermined overhead allocation rate times Quantity = Allocation
Basic
  Setup $ 600.00 per batch 40 batches $24,000.00
  Production $7.50 per Direct Labor Hour 13,200 DLHs $99,000.00
  Quality Assurance $20.00 per test 576 tests $11,520.00
Single Line$134,520.00Double line

 

Predetermined overhead allocation rate times Quantity = Allocation
Deluxe
  Setup $ 600.00 per batch 7 batches $4,200.000
  Production $7.50 per Direct Labor Hour 5,600 DLHs $42,000.000
  Quality Assurance $20.00 per test 364 tests $7,280.000
Single Line$53,480.00Double line

 

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

Description Amount Divided by Quantity Total Rate
Overhead allocation to basic purse line $134,520.00 divided by 3200 purses = $42.0375 per purse
Overhead allocation to deluxe purse line $53,480.00 divided by 560 purses = $95.5000 per purse
Total overhead allocated Single Line$ 188,000.00Double line

 

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):

Description Amount (product 1) Amount (product 2)
Activity-based costing Basic Deluxe
  Direct Materials $        100.00 $        210.00
  Direct Labor $          82.50 $        200.00
  Manufacturing Overhead $          42.04 $          95.50
Single Line$        224.54Double line Single Line$        505.50Double line

 

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

Description Amount (product 1) Amount (product 2)
Activity-based costing
Sales Price $        245.00 $        515.00
Less: Direct Variable Costs 182.50 410.00
Single Line62.50 Single Line105.00
Less: Allocated Fixed Costs 42.04 95.50
Gross profit per unit Single Line$          20.46Double line Single Line$            9.50Double line

 

And, to check our work, because accountants always want a check figures 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:

Description Product 1 Product 2 Total
Basic Deluxe
Gross profit per unit* $         20.46 $          9.50
Times number of units sold             3,200                 560
Total gross profit Single Line          $     65,480Double line Single Line      $      5,320Double line
Total gross profit – basic $   65,480.00
Total gross profit – deluxe 5,320.00
Total gross profit, all products Single Line$   70,800.00Double line

 

* 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:

Product Basic Deluxe
Production level 3,200 560
Subcategory, Simple Average
Sales Price $        245.00 $        515.00
Less: Direct Variable Costs $        182.50 $        410.00
Single Line$          62.50 Single Line$        105.00
Less: Allocated Fixed Costs $          50.00 $          50.00
Gross profit per unit Single Line$          12.50Double line Single Line$          55.00Double line
Subcategory, Single Allocation Rate (DMH)
Sales Price $        245.00 $        515.00
Less: Direct Variable Costs 182.50 410.00
Single Line62.50 Single Line105.00
Less: Allocated Fixed Costs 36.00 130.00
Gross profit per unit Single Line$          26.50Double line Single Line$        (25.00)Double line
Subcategory, Single Allocation Rate (DL$)
Sales Price $        245.00 $        515.00
Less: Direct Variable Costs 182.50 410.00
Single Line62.50 Single Line105.00
Less: Allocated Fixed Costs 41.25 100.00
Gross profit per unit Single Line$          21.25Double line Single Line$            5.00Double line
Subcategory, Multiple Allocation Rates based on departments
Sales Price $        245.00 $        515.00
Less: Direct Variable Costs 182.50 410.00
Single Line62.50 Single Line105.00
Less: Allocated Fixed Costs 37.31 122.50
Gross profit per unit Single Line$          25.19Double line Single Line$        (17.50)Double line
Subcategory, Activity-based costing
Sales Price $        245.00 $     515.00
Less: Direct Variable Costs 182.50 410.00
Single Line62.50 Single Line105.00
Less: Allocated Fixed Costs 42.04   95.50
Gross profit per unit Single Line$          20.46Double line Single Line$         9.50Double line

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, so they may not be available for the basic purse and will therefore sit idle, possibly consuming resources (and still adding to depreciation expense, an 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.

Practice Question