Tahmina Ahmed

Instructor
Cost Accounting
1
Traditional Allocation
Method
Indirect costs allocated to cost
object based on usually labor hours
$10,000,000 total indirect cost = $25 per hour rate
400,000 total labor hours

A product consuming 6 labor hours would be charged

$150 of indirect costs

This made sense, as direct labor was a major cost

driver in early manufacturing plants.

2
Todays Manufacturing
Plants
Are more complex
Are often automated
Often make more than one product
Use proportionately smaller
amount of direct labor making
direct labor a poor allocation base
for factory overhead.
When the manufacturing
process is more
Then multiple allocation bases
complex:
should be used to allocate
overhead expense.
In such situations, managers need
to consider using activity based
costing (ABC).
Overview of ABC
Identifies activities required to
produce the product or service
Determines the cost of the
activities
Allocates costs to the cost object
based on the objects consumption
of activities

5
 Traditional allocation method

Costs Products

Activity-based allocation method

Costs Activities Products

First stage Second stage

6
Operation of an ABC
System
Step 1: Identify activities used by
products and determine their
cost drivers
Step 2: Assign costs to activity
pools
First stage allocation
Identify the costs incurred to
perform various activities

7
Operation of an ABC
System
Step 3: Reclassify and combine
Activity costs
Step 4: Collect data on the use of
cost drivers and determine the
overhead cost per driver.

8
Operation of an ABC
System
Step 5: Assign costs to
products/services based on
consumption of activities or use of
cost driver
Second stage allocation
A Traditional Overhead
Calculation
X Co. manufactures 85,000 units of Spade and
800 units of Mower. The company currently
uses direct-labor cost to assign overhead
costs to products. The company estimates
that it will incur $40,000,000 in
manufacturing overhead and estimates that
labor cost will be $8,000,000. Compute the
predetermined overhead rate.
$40,000,000 $5 per labor dollar
=
$8,000,000
One unit of Spade uses $1.08 direct-labor
cost per unit while one unit of Mower uses
$15.00 direct-labor cost per unit. Use the
following information to compute each
products total unit cost:
Spade Mower
Direct materials $1.80 Direct materials $60.00
Direct labor 1.08 Direct labor 15.00

Mfg. Overhead Mfg. Overhead

1.08 DL$ x $5 = 5.40 15 DL$ x $5 = 75.00
$8.28 $150.00
ABC: Expand the number of activity-cost
pools until each of these pools is
homogeneous.
 The First Stage Allocation
Overall Overhead
Cost Pool
$40,000,000

Setup Material Equipment

Costs Handling Deprec. Other
$4,000,000 $2,000,000 $10,000,000 $24,000,000
Identify the preferred cost-allocation base
(cost driver) for each indirect cost pool.

Number of Number of Number of Number of

Setups Material Machine Hours workstations
Requisitions used
Manufacturing Activities
Annual Per 85,000 Per 800
Activity Center Total Spades Mowers
Number of setups 1,000 2 5
Number of requisitions 2,000 3 50
Number of machine hrs. 20,000 40 100
Number of workstations 3,000 1 15
The Second Stage Allocation - Spades
Machine Material Machine Work-
Setups Req. Hours stations
$4,000,000/ $2,000,000/ $10,000,000/ $24,000,000/
1,000 = 2,000 = 20,000 = 3,000 =
$4,000 $1,000 $500 $8,000

$4,000 $1,000 $500 $8,000

x2 x3 x 40 x1

$8,000 $3,000 $20,000 $8,000

$39,000 / 85,000 units = 0.46 per unit

The Second Stage Allocation - Mowers
Machine Material Machine Work-
Setups Req. Hours stations
$4,000,000/ $2,000,000/ $10,000,000/ $24,000,000/
1,000 = 2,000 = 20,000 = 3,000 =
$4,000 $1,000 $500 $8,000

$4,000 $1,000 $500 $8,000

x5 x 50 x 100 x 15

$20,000 $50,000 $50,000 $120,000

$240,000 / 800 units = $300 per unit

Product Unit Cost
Comparison
Traditional Costing Activity-Based Costing
Spade (85,000 units) Spade (85,000 units)
Direct materials $1.80 Direct materials $1.80
Direct labor 1.08 Direct labor 1.08
Mfg overhead 5.40 Mfg overhead .46
Unit cost $8.28
Unit cost $3.34
Mower (800 units)
Direct materials $ 60.00 Mower (800 units)
Direct labor 15.00 Direct materials $ 60.00
Mfg overhead 75.00 Direct labor 15.00
Unit cost $150.00 Mfg overhead 300.00

Unit cost $375.00

 End of Lecture