In previous posts, we discussed plantwide overhead rates and departmental overhead rates to allocate overhead costs to cost objects. Another method for applying overhead is activity-based costing (ABC).
Activity-based costing is a more precise way to allocate costs to cost objects. Plantwide rates are the easiest to apply but can cause cost distortion because all overhead resources are treated as though they are equally consumed by all cost objects. Departmental rates were more refined because at least we were breaking costs down by department and applying overhead based on the actual activity a cost object used in each department.
ABC goes one step further. Rather than just looking at each department, with ABC we are breaking down activities within the production process and calculating a rate for each activity. This allows a very refined allocation of overhead to the cost objects.
In order to use ABC, we first must identify the activities that make up the processes important to our cost object. It is important to note that ABC can be used by any type of business. Even service companies can benefit from using ABC, especially in competitive markets. Activities could include things like machine setup, inspecting, packaging, sending statements, and providing technical support.
Once the company has identified the activities, the company should identify the estimated cost of each of these activities. The cost of each activity is called an activity cost pool. These cost pools are used to accumulate costs associated with each activity.
Next, select an allocation base or activity that best acts as a driver for each activity cost pool. If machine set up is one of your activity cost pools, the allocation base could be the number of setups that will be done over the year. For inspections, it makes sense to use the number of inspections that are done. For packaging, we could use the number of items to be packaged or the cubic feet of product to be packaged. Sending statements would be based on the number of statements sent. Technical support could be based on the number of calls received by tech support or on time.
Now that you have your allocation bases set for each activity, estimate the quantity for each allocation base.
The next step is to calculate the rate for each activity, using the estimated cost of each activity cost pool and the estimated quantity for each allocation base. At this point, this should start to look familiar because we did this using plantwide rates and departmental rates. To calculate the ABC rate:
Total estimated activity cost pool / Total estimated activity allocation base = ABC rate
This is the exact same formula we used for plantwide rates and departmental rates. Total cost divided by total activity equals rate. The only thing that is different about ABC rates is that you will have more of them. With plantwide rates we had one rate for the entire company. For departmental rates, we had one for each department. For ABC, we will have one rate for each activity that has been identified.
It is extremely important to label each of your rates. If you are calculating the rate for machine setups, label your rate “$/setup”. This makes it much easier when you are applying your rates. Don’t skip this step. When students make mistakes, the mistakes are made in the application of the rates because students use the wrong driver to apply the rates. When you label your rates, it is so much easier to apply the rates because you don’t need to think about which rates to use for each activity. If the problem states that there are 15 setups, look at your rates for the one that is marked “$/setup” and use that one.
To apply the rates, multiply the actual amount of activity by the rate for that activity. Again, that is very similar to what we did for plantwide rates and departmental rates. Just like departmental rates, once you get the amount for each activity, you will need to add up the applied cost for each activity to get the total overhead applied to your cost object.
Steps for using Activity-Based Costing
- Identify the activities that are associated with your cost object and allocate estimated costs to each of the activities using an activity cost pool.
- Identify the allocation base for each of your activities and estimate the quantity for each allocation base.
- Calculate the rate for each activity: estimated activity cost pool / estimated activity allocation base.
- Apply the ABC rates using actual quantity for each activity.
- Add the cost of all your activities to calculate the total overhead cost for your cost object.
Activity-Based Costing – Allocating Cost to Cost Pools
Activity-Based Costing – Calculating activity rates and applying rates