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.