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chapter
26(11)
Cost Allocation and
Activity-Based Costing
______________________________________________
OPENING COMMENTS
Chapter 26(11) deals with the distortion that can occur in product costing if overhead is not applied
properly. It presents three methods for allocating overhead: (1) a single plantwide factory overhead rate,
(2) multiple production department factory overhead rates, and (3) activity-based costing (ABC). As you
cover these methods, stress that they represent a trade-off between accuracy and complexity. While ABC
After studying this chapter, your students should be able to:
2. Use a single plantwide factory overhead rate for product costing.
4. Use activity-based costing for product costing.
6. Use activity-based costing in a service business.
KEY TERMS
activities
activity base
activity rates
activity-based costing (ABC) method
engineering change order (ECO)
multiple production department factory overhead rate method
462 Chapter 26(11) Cost Allocation and Activity-Based Costing
product costing
production department factory overhead rate
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?
OBJECTIVE 1
Identify 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 Example Exercises and Exhibits
Chapter 26(11) Cost Allocation and Activity-Based Costing 463
SUGGESTED APPROACH
TM 26(11)-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
Use 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
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 Example Exercises and Exhibits
SUGGESTED APPROACH
In this objective, the text reviews the method for allocating overhead that was used in Chapter 17(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
17(2) 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.
464 Chapter 26(11) Cost Allocation and Activity-Based Costing
GROUP LEARNING ACTIVITY—Plantwide Overhead Rate
TM 26(11)-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
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
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 Example Exercises and Exhibits
• Example Exercise 26(11)-2 Multiple Production Department Factory Overhead Rates
Chapter 26(11) Cost Allocation and Activity-Based Costing 465
• Exhibit 3 – Comparison of Single Plantwide Rate and Multiple Production Department Rate
Methods
• 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
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
DEMONSTRATION PROBLEM—Multiple Production Department Factory
Overhead Rates
TM 26(11)-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.
466 Chapter 26(11) Cost Allocation and Activity-Based Costing
Production Dept. #2:
$340,000 $34.00 per machine hour
10,000 =
On TM 26(11)-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.
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
Chapter 26(11) Cost Allocation and 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.
Relevant Example Exercises and Exhibits
• Example Exercise 26(11)-3 Activity-Based Costing: Factory Overhead Costs
• Exhibit 7 – Multiple Production Department Factory Overhead Rate Method vs. Activity-Based
Costing
• Exhibit 8 – Activity Bases—Ruiz Company
SUGGESTED APPROACH
TM 26(11)-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 illustration in TM 26(11)-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:
1. ABC changes only the way overhead costs are allocated. Direct materials and direct labor costs are
468 Chapter 26(11) Cost Allocation and Activity-Based Costing
2. When identifying the activities needed to manufacture their product, many companies find
inefficiencies that they didn’t know existed. These inefficiencies can be eliminated, reducing the
product’s cost.
LECTURE AID—The Need for Activity Based Costing
The following real-world example illustrates how traditional cost systems can understate the cost of
complex products.
A manufacturer of surgical gloves traditionally made gloves in one color: white. The company received a
request from one of its customers to make each size glove a different color. The customer wanted small
gloves to be pink, medium to be yellow, and large to be green.
Every time the manufacturer would start to produce a colored glove, the machines would have to be shut
down while colored dye was pumped into them. At the end of the production run, workers had to clean
the machines to remove the remaining dye. The special setup and cleaning caused the company to spend
more on labor to make the colored gloves.
Another example (used by Cooper and Kaplan) is two pen factories—one that sells only blue pens and
one that sells pens of all colors. Both sell 100,000 pens per month. Assume you walk into the multicolor
pen factory, but you’re colorblind. How would you know you are in the factory that makes a variety of
pen colors? Answer: There would be more activities than in the blue pen factory, such as color cleanouts,
additional materials requisitions and purchasing, more quality checks and rework, etc.
Chapter 26(11) Cost Allocation and Activity-Based Costing 469
For example, assume that a manufacturing company identifies the following activities as necessary to
make a product:
2. Receive and inspect materials.
4. Set up machines to make the product.
6. Inspect the finished product.
7. Pack and ship the product to the customer.
Step 2: Trace overhead costs to activity cost pools. The company would start this step by determining the
overhead costs it incurs to order materials (the first activity). Assume that these costs total $80,000 and
include such items as the salaries of the purchasing agent(s) and staff, supplies used by the purchasing
department, and depreciation on office equipment used by the purchasing department.
Step 3: Select an activity base. A means to allocate the cost of each activity to the product must be
chosen. This is known as selecting an activity base (also called an activity driver). The activity base for
any activity should be the event that causes costs to be incurred. For example, placing an order causes
purchasing costs to be incurred.
Step 4: Calculate an activity rate and allocate costs to products. Assume that the purchasing department
places 10,000 orders per year. The cost to place an order is calculated as follows:
470 Chapter 26(11) Cost Allocation and Activity-Based Costing
OBJECTIVE 5
Use activity-based costing to allocate selling and administrative expenses to products.
SYNOPSIS
Learning Objective 5 presents an overview of how activity-based costing can be applied to selling and
administrative (S&A) expenses. For reporting purposes, S&A costs are simply expensed in full in the
period incurred. However, for managerial decision making, S&A costs are often allocated to products,
Relevant Example Exercises and Exhibits
• Example Exercise 26(11)-4 Activity-Based Costing: Selling and Administrative Expenses
• Exhibit 13 – Selling and Administrative Activity Product Differences
SUGGESTED APPROACH
Objective 5 presents an overview of how activity-based costing can be applied to selling and
administrative expenses. Use the group learning activity below to turn these concepts into something
concrete.
GROUP LEARNING ACTIVITY—ABC Applied to Selling and Administrative
Costs
Exhibit 13 in the text lists the selling and administrative activities for two products, Ipso and Facto. These
products consume dramatically different amounts of selling and administrative attention. TM 26(11)-5
presents hypothetical dollar amounts for each of those activities.
Activity Possible Activity Base
Post-Sale Technical Support Hours Spent Training Customers
Number of Training Sessions Provided to Customers
Time Spent Assisting Customers on a 1-800 Technical
Support Hotline
Chapter 26(11) Cost Allocation and Activity-Based Costing 471
OBJECTIVE 6
Use activity-based costing in a service business.
SYNOPSIS
Learning Objective 6 points out that service businesses can benefit from ABC just like manufacturing
companies as services, like products, can be over- or under-costed. This section introduces Hopewell
Hospital and demonstrates the ABC costing of five different services provided by the hospital. Exhibit 14
Relevant Example Exercises and Exhibits
• Example Exercise 26(11)-5 Activity-Based Costing for a Service Business
• Exhibit 14 – Activity-Based Costing Method—Hopewell Hospital
• Exhibit 15 – Hopewell Hospital Overhead Costs Allocated to Mia Wilson
• Exhibit 16 – Customer Profitability Report—Hopewell Hospital
SUGGESTED APPROACH
The steps necessary to implement activity-based costing explained under Objective 4 can be applied to
WRITING EXERCISE—ABC in a Service Business
In Exhibit 14, the text divides the operations of a hospital into five activities and assigns a cost to each of
these activities. As a result, each customer is assigned only the costs of the hospital services (activities) he
or she uses.
472 Chapter 26(11) Cost Allocation and Activity-Based Costing
Ask your students to select another type of service business and list the activities that that business would
perform in providing its services to customers. Next, ask your students to write a memo to the owner of
Type Item Description LO(s) Difficulty
Time
Est
BUSPROG AICPA ACBSP - APC Bloom's EE Excel GL SMH FAI Service Real World Writing Ethics Internet Group
DQ 1 1 Easy 5 min. Analytic Measurement Managerial Accounting Features/Costs Application
PE 4B Activity-based costing: selling and administrative expenses 5 Easy 15 min. Analytic Measurement Managerial Accounting Features/Costs Application x
PE 5A Activity-based costing for a service business 6 Easy 10 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
PE 5B Activity-based costing for a service business 6 Easy 10 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
EX 1 Single plantwide factory overhead rate 2 Easy 10 min. Analytic Measurement Managerial Accounting Features/Costs Application
EX 2 Single plantwide factory overhead rate 2 Moderate 15 min. Analytic Measurement Managerial Accounting Features/Costs Application
EX 3 Single plantwide factory overhead rate 2 Moderate 20 min. Analytic Measurement Managerial Accounting Features/Costs Application
EX 4 Product costs and product profitability reports, using single plantwide factory overhead rate 2 Moderate 25 min. Analytic Measurement Managerial Accounting Features/Costs Application x x x
EX 5 Multiple production department factory overhead rate method 3 Moderate 25 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
EX 6 Single plantwide and multiple production department factory overhead rate methods and product cost distortion 2,3 Moderate 25 min. Analytic Measurement Managerial Accounting Features/Costs Application x
EX 7 Single plantwide and multiple production department factory overhead rate methods and product cost distortion 2,3 Easy 25 min. Analytic Measurement Managerial Accounting Features/Costs Application x
EX 16 Single plantwide rate and activity-based costing 2,4 Moderate 35 min. Analytic Measurement Managerial Accounting Features/Costs Application x x x
EX 17 Evaluating selling and administrative cost allocations 5 Moderate 30 min. Analytic Measurement Managerial Accounting Features/Costs Application x
EX 18 Construct and interpret a product profitability report, allocating selling and administrative expenses 5 Moderate 40 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
EX 19 Activity-based costing and customer profitability 5 Moderate 40 min. Analytic Measurement Managerial Accounting Features/Costs Application x x x
EX 20 Activity-based costing for a service company 6 Moderate 30 min. Analytic Measurement Managerial Accounting Features/Costs Application x x x
EX 21 Activity-based costing for a service company 5,6 Moderate 40 min. Analytic Measurement Managerial Accounting Features/Costs Application x x x x
PR 1A Single plantwide factory overhead rate 2 Moderate 35 min. Analytic Measurement Managerial Accounting Features/Costs Application
PR 2A Multiple production department factory overhead rates 3 Moderate 35 min. Analytic Measurement Managerial Accounting Features/Costs Application
PR 3A Activity-based and department rate product costing and product cost distortions 3,4 Challenging 45 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
PR 4A Activity-based product costing 4 Moderate 40 min. Analytic Measurement Managerial Accounting Features/Costs Application x x
CP 3 Activity-based costing for a service company 4 Moderate 30 min. Analytic Measurement Managerial Accounting Features/Costs Synthesis x x x
CP 4 Using a product profitabiity report to guide strategic decisions 4 Moderate 40 min. Analytic Measurement Managerial Accounting Features/Costs Application x
CP 5 Product cost distortion 4 Moderate 30 min. Analytic Measurement Managerial Accounting Features/Costs Synthesis x
CP 6 Allocating administrative costs for a service company 4 Moderate 30 min. Analytic Measurement Managerial Accounting Features/Costs Synthesis x
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