When companies produce few products and production is similar across product lines, managers could limit their focus to a broad business function, such as production, and use a single plantwide rate or multiple department rates to allocate manufacturing overhead costs to their inventory. But today’s business environment involves complex production processes and personalization of products to customers’ specifications which calls for more refined cost accounting. This is especially important when production includes manufacturing products that require different resources or different amounts of the various resources.
Smart Touch Learning is now facing this situation—its two primary products require different amounts of the resources. As we stated previously, the premium model of the touch screen tablet computer requires the calibration setup to be performed by higher- paid workers with specialized skills, and the operating system testing process takes longer than testing the standard model due to the specialized configuration. Additionally, the premium model is produced in smaller batches because the quantity of sales is lower than the standard model (500 units compared with 2,000 units).
Companies like Smart Touch Learning, with diverse products, can obtain better cost- ing information by using activity-based costing and activity-based management. Activity- based management (ABM) focuses on the primary activities the business performs, determines the costs of the activities, and then uses the cost information to make decisions that will lead to improved customer satisfaction and greater profits. The costs of the activi- ties (rather than the overhead costs of the plant or departments) become the building blocks for allocating indirect costs to products and services. An activity is a task, operation, or procedure such as quality inspection, warranty services, or shipping. The process of first determining the costs of the activities to then determine the cost of products and services is called activity-based costing (ABC).
Learning Objective 2 Use activity-based costing (ABC) to
compute predetermined overhead allocation rates and allocate indirect costs
Activity-Based Management (ABM) Using activity-based cost information to make decisions that improve customer satisfaction while also increasing profits.
Activity A task, operation, or procedure.
Activity-Based Costing (ABC) Focuses on the costs of activities as
the building blocks for allocating indirect costs to products and services.
Try It!
The Santos Shirt Company manufactures shirts in two departments: Cutting and Sewing. The company allocates manufacturing overhead using a single plantwide rate with direct labor hours as the allocation base. Estimated overhead costs for the year are
$500,000, and estimated direct labor hours are 200,000. In June, the company incurred 17,500 direct labor hours.
1. Compute the predetermined overhead allocation rate.
2. Determine the amount of overhead allocated in June.
The Santos Shirt Company has refined its allocation system by separating manufacturing overhead costs into two cost pools—
one for each department. The estimated costs for the Cutting Department are $200,000. They will be allocated based on direct labor hours, which are estimated to be 125,000 hours for the year. The estimated costs for the Sewing Department are $300,000.
Those costs will be allocated based on machine hours, which are estimated to be 150,000 hours for the year. In June, the company incurred 10,000 direct labor hours in Cutting and 12,500 machine hours in Sewing.
3. Compute the predetermined overhead allocation rates for each department.
4. Determine the total amount of overhead allocated in June.
Check your answers online in MyAccountingLab or at http://www.pearsonhighered.com/Horngren.
For more practice, see Short Exercises S19-1 and S19-2. MyAccountingLab
Exhibit19-3 | Examples of Activities and Allocation Bases
Quality Inspection––Inspecting raw materials or finished products
Warranty Services––Providing service for defective products
Shipping––Shipping finished products to customers
Setup––Setting up machines for production
Number of inspections
Number of service calls
Number of pounds of product shipped
Number of batches Machining––Machine usage
Purchasing––Purchasing raw materials
Number of machine hours Number of purchase orders
Activity Allocation Base
You go to a restaurant with three of your friends, and the waiter brings one bill for $100. You had the special and ordered water to drink. The meal you ordered cost only $15. Your friends ordered appetizers and drinks with their meals. How do you split the bill? Because four of you had
dinner together, do you pay 1/4 of the bill, $25, or do you pay based on the cost of what you ordered, $15? Paying based on what you ordered is the key to activity-based costing. Production
costs are allocated based on the amount of each activity of production that the products use.
An activity-based costing system is developed in four steps. Let’s look at these four steps for Smart Touch Learning.
Step 1: Identify Activities and Estimate Their Total Indirect Costs The first step in developing an activity-based costing system is to identify the activities that will be used to allocate the manufacturing overhead. Analyzing all the activities required for a product or service forces managers to think about how each activity might be improved—
or whether it is necessary at all.
The Smart Touch Learning management team has carefully analyzed the production process. It has determined there are three activities in the production process (setup, pro- duction, and testing) that incur the majority of the manufacturing overhead costs. There- fore, Smart Touch Learning will create three cost pools to accumulate the overhead costs.
Cost pools are a collection of costs. The first activity is setup. Before a batch of tablets can be manufactured, the machines must be properly calibrated. After the setup activity is In ABC, each activity has its own (usually unique) allocation base, often called a cost driver. Exhibit 19-3 shows some representative activities and allocation bases.
looked at the manufacturing overhead costs incurred by these three activities and estimated each activity would incur the following overhead costs during the next year:
Activity Estimated Overhead Costs
Setup $ 15,000
Production 65,000
Testing 20,000
Total $ 100,000
Exhibit 19-4 illustrates how manufacturing overhead is allocated to the tablets at Smart Touch Learning.
Exhibit19-4 | ABC System
Standard Model Number of
Batches Direct Labor
Hours Number of
Tests Activities
Allocation Bases
Cost Objects
Manufacturing Overhead
Premium Model
Setup Production Testing
Step 2: Identify the Allocation Base for Each Activity and Estimate the Total Quantity of Each Allocation Base
Because there are multiple activities that require different resources, Smart Touch Learning will use a different allocation base for each activity. In ABC systems, ideally the allocation base is the primary cost driver, the factor that causes the cost to increase or decrease. For example, Smart Touch Learning has determined that the allocation base for setups is the number of batches. Step 2 must be completed for each activity.
Setup
Smart Touch Learning has determined that the allocation base for setup is the number of batches. The standard model is normally produced in batches of 50 units. Therefore, the production of 2,000 units would require 40 batches (2,000 units / 50 units per batch). The premium model is normally produced in batches of 25 units. Therefore, the production of 500 units would require 20 batches (500 units / 25 units per batch).
Production
Smart Touch Learning has determined that the allocation base for production is direct labor hours. Note that the company is not using direct labor costs but direct labor hours. Analysis of the process indicated that the overhead costs were related to the time it took to process the units through the activity, not how much the workers were paid. Both models require an average of five hours of labor to assemble. Therefore, the standard model is expected to require 10,000 labor hours during the next year (2,000 units * 5 hours per unit) and the premium model is expected to require 2,500 hours (500 units * 5 hours per unit).
Testing
Smart Touch Learning has determined that the allocation base for testing is the number of testing operations performed. Units are randomly selected for testing, with the premium units tested more often than the standard units due to their complexity. Based on the num- ber of units to be produced, the production manager estimates the standard model units to have 7,750 tests during the year and the premium model to have 2,250 tests, for a total of 10,000 tests.
Exhibit 19-5 summarizes the data for each allocation base.
Exhibit19-5 | Smart Touch Learning—Allocation Base Summary
Standard Model Allocation Base
Activity Premium Model Total
60 batches 12,500 DLHr 10,000 tests 10,000 DLHr
7,750 tests 40 batches Number of batches
Direct labor hours (DLHr) Number of tests
20 batches
2,250 tests 2,500 DLHr Setup
Production Testing
Step 3: Compute the Predetermined Overhead Allocation Rate for Each Activity
The formula to compute the predetermined overhead allocation rate for each activity is the same as the formula used for the other methods. The process is repeated for each activity.
The predetermined overhead allocation rates for Smart Touch Learning are:
Predetermined overhead allocation rate
= Total estimated overhead costs
Total estimated quantity of the overhead allocation base
Setup: +15,000 total estimated overhead costs
60 batches = +250.00 per batch Production: +65,000 total estimated overhead costs
12,500 direct labor hours = +5.20 per DLHr Testing: +20,000 total estimated overhead costs
10,000 tests = +2.00 per test
Step 4: Allocate Indirect Costs to the Cost Object
The fundamental cost pools of an activity-based costing system are the activities. Now that we have determined the cost of each activity and computed a predetermined overhead allocation rate for each activity, we can use the rates to allocate overhead costs from the cost pools to the units. The following table shows the allocation of overhead costs and the cal- culation of overhead cost per unit for each model:
PREMIUM
Setup =
=
=
×
×
× Production
Testing
Total manufacturing overhead
÷ Number of units
Manufacturing overhead cost per unit
$250.00 per batch 20 batches $ 5,000 13,000 4,500
$ 22,500
÷ 500 units
$ 45.00 2,500 DLHr
2,250 tests
$ 5.20 per DLHr
$ 2.00 per test STANDARD
Setup =
=
=
×
×
× Production
Testing
Total manufacturing overhead
÷ Number of units
Manufacturing overhead cost per unit Predetermined
overhead allocation rate
Actual quantity of the allocation
base used
Allocated manufacturing
overhead cost
$250.00 per batch 40 batches $ 10,000
52,000 15,500
$ 77,500
÷ 2,000 units
$ 38.75 10,000 DLHr
7,750 tests
$ 5.20 per DLHr
$ 2.00 per test
The total production cost of each model, including direct materials, direct labor, and manufacturing overhead costs, is shown below:
Premium Model Standard Model
Direct materials cost per unit Direct labor cost per unit
Manufacturing overhead cost per unit Total cost per unit
88.00
$ 150.00
38.75
$ 276.75
148.00
$ 200.00
45.00
$ 393.00
Traditional Costing Systems Compared with ABC Systems Let’s compare the estimated cost per unit calculated with the three different systems.
Premium Model
Multiple department allocation rates Direct materials cost per unit Direct labor cost per unit
Manufacturing overhead cost per unit Total cost per unit
Activity-based allocation rates Direct materials cost per unit Direct labor cost per unit
Manufacturing overhead cost per unit Total cost per unit
Standard Model Single plantwide allocation rate
Direct materials cost per unit Direct labor cost per unit
Manufacturing overhead cost per unit Total cost per unit
$ 200.00 148.00 51.84
$ 399.84
$ 200.00 148.00 45.00
$ 393.00
$ 200.00 148.00 59.20
$ 407.20
$ 150.00 88.00 37.04
$ 275.04
$ 150.00 88.00 38.75
$ 276.75
$ 150.00 88.00 35.20
$ 273.20
With each refinement of the costing system, from a single plantwide allocation rate to multiple department allocation rates to activity-based allocation rates, the cost per unit of the standard model increased while the cost per unit of the premium model decreased. Activity- based costs are more accurate because ABC considers the resources (activities) each product actually uses. Allocating overhead based on labor costs distorted the cost of the premium units. This happened because the laborers working on premium units are paid more due to their advanced skills, which increased the cost of the direct labor on the pre- mium models. However, the higher direct labor cost does not have a direct cause-and-effect relationship on the overhead costs. Other factors, such as the number of batches and the number of tests, do have an effect.
It is important to note that the total overhead cost did not change, only the allocation of the total overhead to the two different types of tablets. Total
overhead allocated in all three methods is $100,000.
Now that we know the indirect costs of the standard and premium models of touch screen tablet computers, let’s see how Smart Touch Learning’s managers use the ABC cost information to make better decisions.
Which cost calculation is most accurate?