Calculating an accurate manufacturing cost for each product is a vital piece of information for a company’s decision-making. For example, knowing the cost to produce a unit of product affects not only how a business budgets to manufacture that product, but it is often the starting point in determining the sales price.
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An important component in determining the total production costs of a product or job is the proper allocation of overhead. For some companies, the often less-complicated traditional method does an excellent job of allocating overhead. However, for many products, the allocation of overhead is a more complex issue, and an activity-based costing (ABC) system is more appropriate.
Another factor to consider in determining which of the two major overhead allocation methods to use is the cost associated with collecting and analyzing information. When making their decision regarding which method to use, the company must consider these costs, both in time and money. (Figure) compares overhead in the two systems. In many cases, the ABC method is more expensive in terms of time and other costs.
The difference between the traditional method (using one cost driver) and the ABC method (using multiple cost drivers) is more complex than simply the number of cost drivers. When direct labor is a large portion of the product cost, the overhead costs tend to be consistently driven by one cost driver, which is typically direct labor or machine hours; the traditional method appropriately allocates those costs. When technology is a large portion of the product cost, the overhead costs tend to be driven by multiple drivers, so using multiple cost drivers in the ABC method allows for a more precise allocation of overhead.
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| Overhead assigned | Single cost driver | Multiple cost drivers |
| Optimal usage | When direct labor is a large portion of the product cost | When technology is a large portion of the product cost |
| Orientation | Cost driven | Process driven |
As shown with Musicality’s products, not only are there different costs for each product when comparing traditional allocation with an activity-based costing, but ABC showed that the Solo product creates a loss for the company. Activity-based costing is a more accurate method, because it assigns overhead based on the activities that drive the overhead costs. It can be concluded, then, that the cost and subsequent gross loss for each unit’s sales provide a more accurate picture than the overall cost and gross profit under the traditional method. (Figure) compares the cost per unit using the different cost systems and shows how different the costs can be depending on the method used.
(Figure)Carlton’s Kitchens makes two types of pasta makers: Strands and Shapes. The company expects to manufacture 70,000 units of Strands, which has a per-unit direct material cost of $10 and a per-unit direct labor cost of $60. It also expects to manufacture 30,000 units of Shapes, which has a per-unit material cost of $15 and a per-unit direct labor cost of $40. It is estimated that Strands will use 140,000 machine hours and Shapes will require 60,000 machine hours. Historically, the company has used the traditional allocation method and applied overhead at a rate of $21 per machine hour. It was determined that there were three cost pools, and the overhead for each cost pool is shown:
(Figure)Carlton’s Kitchen’s three cost pools and overhead estimates are as follows:
The estimated overhead for the material cost pool is estimated as $12,500, and the estimate for the machine setup pool is $35,000. Calculate the allocation rate per unit of brass and per unit of gold using:
The traditional allocation methodThe activity-based costing method(Figure)Portable Seats makes two chairs: folding and wooden. This information was obtained to review the decision to consider ABC:
(Figure)Casey’s Kitchens makes two types of food smokers: Gas and Electric. The company expects to manufacture 20,000 units of Gas smokers, which have a per-unit direct material cost of $15 and a per-unit direct labor cost of $25. It also expects to manufacture 50,000 units of Electric smokers, which have a per-unit material cost of $20 and a per-unit direct labor cost of $45. Historically, it has used the traditional allocation method and applied overhead at a rate of $125 per machine hour. It was determined that there were three cost pools, and the overhead for each cost pool is as follows:
(Figure)Casey’s Kitchens’ three cost pools and overhead estimates are as follows:
The estimated overhead for the material cost pool is estimated as $45,000, and the estimate for the machine setup pool is $55,000. Calculate the allocation rate per unit of silver and per unit of gold using:
The traditional allocation methodThe activity-based costing method(Figure)Portable Seats makes two chairs: folding and wooden. This information was obtained to review the decision to consider ABC:
Compute the overhead assigned to each product under:
The traditional allocation methodThe activity-based costing method(Figure)Cape Cod Adventures makes foam noodles with sales of 3,000,000 units per year and retractable boat oars with sales of 50,000 pairs per year. What information would Cape Cod Adventures need in order to change from traditional to ABC costing? What are the limitations to activity-based costing?