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chapter
18(4)
Activity-Based Costing
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OPENING COMMENTS
provides a more accurate means to trace overhead costs to products, it is also more complex and more
expensive to implement. However, with global competition squeezing the prices many businesses can
After studying this chapter, your students should be able to:
1. Describe three methods used for allocating factory overhead costs to products.
2. Illustrate the use of a single plantwide factory overhead rate for product costing.
3. Use multiple production department factory overhead rates for product costing.
4. Use activity-based costing for product costing.
5. Use activity-based costing to allocate selling and administrative expenses to products.
6. Use activity-based costing in a service business.
ADM: Describe and illustrate the use of activity-based costing information in decision making.
KEY TERMS
activities
activity base
activity rates
activity-based costing (ABC) method
engineering change order (ECO)
multiple production department factory overhead rate method
product costing
production department factory overhead rate
Chapter 18(4) Activity-Based Costing 462
setup
single plantwide factory overhead rate method
STUDENT FAQS
Which of the three methods for allocating factory overhead cost to products is better?
Why would someone choose the multiple production department FOH rate method when it is more
complicated to calculate than the single plantwide rate?
How is the selection of the allocation base for a production department made?
How does the activity-based costing method differ from the single plantwide and the multiple
production department FOH rate methods?
Which of the three methods for allocating costs of products can lead to significant product cost
distortions?
Can activity-based costing be used in service businesses? If so, how?
Why are selling and administrative expenses often allocated by an activity-based costing method
rather than sales volume?
How are activity-based rates determined?
What is an activity base?
OBJECTIVE 1
Describe three methods used for allocating factory overhead costs to products.
SYNOPSIS
Learning Objective 1 reminds us that factory overhead is an indirect cost (cannot be traced directly to
units of output) and therefore must be allocated to products. As shown in Exhibit 1, there are three
common allocation methods in use: a single plantwide overhead rate method, a departmental overhead
rate method, and an activity-based overhead rate method.
Key Terms and Definitions
Product Costing—Determining the cost of a product.
Relevant Check Up Corner and Exhibits
Exhibit 1- —Allocation of Factory Overhead Costs
Chapter 18(4) Activity-Based Costing 463
SUGGESTED APPROACH
TM 18(4)-1 lists the three overhead allocation methods presented in this chapter: (1) a single plantwide
factory overhead rate, (2) multiple production department factory overhead rates, and (3) activity-based
costing (ABC). It also shows that these methods vary in complexity and accuracy.
OBJECTIVE 2
Illustrate the use of a single plantwide factory overhead rate for product costing.
SYNOPSIS
Learning Objective 2 introduces Ruiz Company, which manufactures snowmobiles and riding mowers. In
this learning objective, the company’s overhead is allocated to the two products using a single factory
overhead rate. In later objectives, departmental and activity-based allocation rates are used. Plantwide
overhead rates are found by dividing the company’s total budgeted overhead cost by its total budgeted
allocation base. The allocation base is a measure of the factory’s operating activity. Direct labor hours,
direct labor costs, and machine hours are common allocation bases. The primary advantage of a plantwide
overhead rate is that it’s simple and inexpensive to use but its use does imply that overhead costs are
consumed in the same way by all products. Plantwide overhead rates are common in companies that
produce a single product because there is no concern that the overhead system will over-cost some
products while under-costing others. Exhibit 2 summarizes the allocation of overhead to Ruiz Company’s
products using a single plantwide overhead rate.
Key Terms and Definitions
Single Plantwide Factory Overhead Rate Method—A method that allocates all factory
overhead to products by using a single factory overhead rate.
Relevant Check Up Corner and Exhibits
Exhibit 2 —Single Plantwide Factory Overhead Rate Method—Ruiz Company
Check Up Corner 18(4)-1 – Single Plantwide Factory Overhead Rare
SUGGESTED APPROACH
In this objective, the text reviews the method for allocating overhead that was used in Chapter 16(2) with
job order costing. The single plantwide overhead rate is calculated as follows:
Single Plantwide Total Budgeted Factory Overhead Costs
Factory Overhead Rate = Total Budgeted Allocation Base
Point out that this is the same formula as was used to calculate a predetermined overhead rate in Chapter
16 and that this single rate will be used by all departments to allocate overhead costs to the company’s
various products, such as snowmobiles and riding mowers in the case of Ruiz Company.
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GROUP LEARNING ACTIVITY—Plantwide Overhead Rate
TM 18(4)-2 asks your students to calculate a single plantwide overhead rate and use that rate to apply
overhead to products. By working in groups to solve this problem, your students will review this basic
overhead allocation method. You may want to refer them to the formula for calculating a predetermined
overhead rate in Chapter 16(2) to emphasize the correlation between the concepts in Chapters 16(2) and
17(3). The solution to this problem is presented on TM 18(4)-3. Be sure to emphasize that the plantwide
system makes no distinction as to where the direct labor hours are worked. Prepare them for the next
learning objective by raising the possibility that the overhead costs in one department might be impacted,
or driven, by a different cost driver than the overhead costs in another department.
OBJECTIVE 3
Use multiple production department factory overhead rates for product costing.
SYNOPSIS
The plantwide overhead rate system ignores the possibility that production departments may differ
significantly in terms of the types and amounts of overhead support required. In those cases, departmental
overhead rates may more accurately allocate overhead to a company’s products. Learning Objective 3
describes the development of multiple department overhead rates. First, Exhibit 3 provides a graphical
comparison of the single vs. multiple overhead rate methods. Then Ruiz Company data is used to develop
department overhead rates that are then used to allocate overhead to the company’s two products,
snowmobiles and riding mowers. Exhibit 4 presents the overhead that would be assigned to the two
products using departmental rates. A comparison of that exhibit to Exhibit 2 reveals that the departmental
rate system assigns more overhead to snowmobiles than the plantwide system but less overhead to the
riding mower. Exhibit 5 just presents a different view of the data presented in Exhibit 4. Finally, Learning
Objective 3 explains that the plantwide system can distort product costs (for example in the case of Ruiz
Company, the snowmobile was under-costed while the riding mower was over-costed). Yes, the two
overhead allocation methods allocate overhead differently but how do we know which system is
distorting costs? The plantwide rate method can distort cost when either of the two following conditions
exist: (1) differences in department overhead rates from department to department and (2) differences
among products in the ratios of allocation base usage within a department and across departments. Exhibit
6 illustrates these conditions for the Ruiz Company data.
Key Terms and Definitions
Multiple Production Department Factory Overhead Rate Method—A method that allocated
factory overhead to product by using factory overhead rates for each production department.
Production Department Factory Overhead Rate—Rates determined by dividing the budgeted
production department factory overhead by the budgeted allocation base for each department.
Relevant Check Up Corner and Exhibits
Exhibit 3—Comparison of Single Plantwide Rate and Multiple Production Department Rate
Methods
Chapter 18(4) Activity-Based Costing 465
Exhibit 4—Allocating Factory Overhead to Products—Ruiz Company
Exhibit 5—Multiple Production Department Rate Method—Ruiz Company
Exhibit 6—Conditions for Product Cost Distortion—Ruiz Company
Check Up Corner 18(4)-2 – Multiple Production Department Factory Overhead Rates
SUGGESTED APPROACH
When production departments differ significantly in their costs and operations, multiple production
department factory overhead rates may yield a more accurate product cost than the single plantwide
factory overhead rate. Under the multiple department rate method, overhead costs are traced to each
production department and applied to products based on the departmental resources consumed. The
demonstration problem below will assist you in illustrating this method.
DEMONSTRATION PROBLEM—Multiple Production Department Factory
Overhead Rates
TM 18(4)-2 presented information for Franklin Manufacturing. Use this TM as a basis for illustrating the
multiple production department rate method.
Franklin Manufacturing had traced its factory overhead costs to the company’s two production
departments. These costs are:
Production Dept. #1—$160,000
Production Dept. #2—$340,000
You may want to point out that, although the text does not show an example where plantwide overhead
costs are allocated to production departments, this is a necessary step for most companies using
departmental overhead rates. This additional complexity is omitted from the chapter in order to simplify
the discussion.
Once the overhead costs have been assigned to each production department, the company must choose the
basis for allocating overhead to products. Assume that overhead costs will be allocated based on direct
labor hours in Dept. #1 (a labor-intensive department) and machine hours in Dept. #2 (a more automated
department). Budgeted direct labor and machine hours for these departments are:
Production Dept. #1—12,000 direct labor hours
Production Dept. #2—10,000 machine hours
The departmental overhead rates would be calculated as follows:
Production Dept. #1:
$160,000 $13.33 per direct labor hour
12,000
Production Dept. #2:
$340,000 $34.00 per machine hour
10,000
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On TM 18(4)-2, your students were asked to calculate the overhead allocated to a product using a single
plantwide factory overhead rate. Now, instruct your students to calculate the overhead allocated to that
same product using departmental overhead rates, assuming the product used 2 direct labor hours in Dept.
#1 and 4 machine hours in Dept. #2.
Overhead Allocated in Dept. #1: 2 direct labor hours × $13.33/hr. = $ 26.66
Overhead Allocated in Dept. #2: 4 machine hours × $34.00/hr. = 136.00
Total $162.66
Ask your students to comment on the differences in overhead allocated to Franklin’s product using the
single plantwide rate and multiple department rates. With the single plantwide rate, all overhead is
allocated based on direct labor hours even though the overhead costs in Dept. #2 are machinery related.
By allocating Dept. #2 costs based on machine hours, the products that use the most machine time will be
allocated the most overhead, which is rational for a highly automated department. The single rate
averages all factory overhead costs together, rather than reflecting the departmental resources consumed.
OBJECTIVE 4
Use activity-based costing for product costing.
SYNOPSIS
Learning Objective 4 presents an alternative approach for allocating factory overhead based on activities.
Activities are the types of work, or actions, involved in a manufacturing or service process. In this system,
overhead costs are first traced to the various production activities. This tracing results in the creation of
activity cost pools. The importance of these multiple cost pools is the ability to select cost allocation
bases (i.e., cost drivers) that are highly correlated with the activity costs in each pool. Exhibit 7 illustrates
how activity-based costing differs from a departmental rate system. Next, the chapter illustrates the
development and use of activity-based costing in Ruiz Company. Exhibit 8 identifies the allocation base
(cost driver) for each activity and shows the calculation of the total usage for each activity. Exhibit 9
presents the calculation of the activity rates (Total budgeted activity cost pool amount/Total budgeted cost
driver usage = Activity rate). Exhibit 10 presents the overhead assigned to snowmobiles and riding
mowers under activity-based costing. Note the accuracy of the activity-based system. For example,
because snowmobiles require five times as many setups as the riding mower, snowmobiles are assigned
five times as much setup costs. Exhibit 11 presents graphically how the overhead costs are traced from
cost pools to product. Exhibit 12 highlights the significant differences in the overhead assigned to each
product using the activity-based costing, department, and plantwide methods. Finally, the chapter
discusses one of the most significant dangers of product cost distortion which is under– or over-pricing of
the company’s products. This occurs because of the common practice of setting selling prices on a cost–
plus basis. Cost-plus pricing will be discussed in Chapter 24.
Chapter 18(4) Activity-Based Costing 467
Key Terms and Definitions
Activities—The types of work, or actions, involved in a manufacturing process or service
activity.
Activity Base—A measure of activity that is related to changes in cost. Used in analyzing and
classifying cost behavior. Activity bases are also used in the denominator in calculating the
predetermined factory overhead rate to assign overhead costs to cost objects.
Activity Rates—The estimated activity cost divided by estimated activity-base usage.
Activity-Based Costing (ABC) Method—An alternative approach for allocating factory
overhead that uses multiple rates based on the activities that are required to produce the product.
Engineering Change Order (ECO)—The document that initiates changing a product or process.
Setup—An overhead activity that consists of changing tooling in machines in preparation for
making a new product.
Relevant Check Up Corner and Exhibits
Exhibit 7—Multiple Production Department Factory Overhead Rate Method vs. Activity-Based
Costing
Exhibit 8—Activity Bases—Ruiz Company
Exhibit 9—Activity Rates—Ruiz Company
Exhibit 10—Activity-Based Product Cost Calculations
Exhibit 11—Activity Bases—Ruiz Company
Exhibit 12—Overhead Cost Allocation Methods: Ruiz Company
Check Up Corner 18(4)-3 – Activity-Based Costing
SUGGESTED APPROACH
TM 18(4)-4 illustrates the allocation of overhead in an ABC system. In an ABC system, management
must identify all the activities necessary to manufacture a product. Overhead costs are then allocated to
these activities, forming activity cost pools. For example, one activity that absorbs overhead costs is
machine setup. Under ABC, all costs incurred in setting up machines would be allocated to the setup
activity cost pool.
The goal of ABC is to allocate overhead to products based on the activities they consume in the
manufacturing process. After defining an activity cost pool, an activity base is selected to link the
overhead costs to the product. Continuing with the machine setup example, the total setup cost pool could
be linked to products based on the number of times they require machines to be set up for production.
The illustration in TM 18(4)-4 assumes a simple manufacturing process with only three activities.
Therefore, there are only three activity cost pools from which to allocate costs to the five products
produced.
While discussing ABC, stress the following points:
still traced to products.