Activity Based Costing with Four Activities

Let’s add two more activities to our example: procurement and material handling. The costs of these two activities are not caused by—nor do they correlate with—machine hours. Rather, we will assume that both of these activities are related to the physical weight of the direct material used in making the product.

The company determines that $300,000 of its annual manufacturing overhead is associated with procurement and material handling. As a result, the company removes $300,000 from the manufacturing overhead that will be allocated via machine hours, and instead plans to allocate the $300,000 to the products based on the weight of the materials used. The company expects that during the year it will procure and handle 3,000,000 pounds of material. Under activity based costing, the company will assign $0.10 ($300,000 divided by 3,000,000 pounds) per pound of product weight to each unit manufactured. The end result is that the heavier parts will not only have more direct material cost, they will also be assigned more factory overhead than the lighter parts. By assigning some manufacturing overhead to a product based on the product’s weight, the remaining manufacturing overhead assigned via machine hours will be reduced. These points are illustrated in the following table:

	With ABC	Without ABC
Mfg overhead costs assigned to setups	$200,000	$–0–
Number of setups	400	Not applicable
Mfg overhead cost per setup	$500	$–0–
Mfg O/H costs caused by procurement/handling	$300,000	$–0–
Pounds of material in products	3,000,000	Not applicable
Mfg O/H per pound of product material	$0.10	$–0–
Mfg O/H costs caused by producing the items:
Total manufacturing overhead costs	$2,000,000	$2,000,000
Less: Cost traced to machine setups	– 200,000	$–0–
Less: Costs traced to procurement/handling	– 300,000	$–0–
Mfg costs to be allocated on machine hours	$1,500,000	$2,000,000
Machine hours (MH)	100,000	100,000
Mfg overhead costs allocated per MH	$15	$20
Mfg Overhead Cost Allocations	$500 setup cost per batch + $0.10 per lb. + $15 per MH	$20 per MH

In the table below we can see how ABC would assign costs to the following:

1. A product that weighs 0.5 pound and is produced in a batch of 50,000 units at a rate of 50 per hour.
2. A product that weighs 1.5 pounds and is produced in a batch of 50,000 units at a rate of 50 per hour.
3. No activity based costing allocations—all manufacturing overhead costs are allocated entirely via machine hours.

	(1.) ABC	(2.) ABC	(3.) No ABC
Mfg overhead for setting up machine	$500	$500	$–0–
No. of units in batch	50,000	50,000	Not applicable
Mfg O/H caused by Setup – Per Unit	$0.01	$0.01	Not applicable
Mfg overhead costs per lb. of product	$0.10	$0.10	Not applicable
Lbs of material in product	0.5	1.5	Not applicable
Mfg O/H caused by Weight – Per Unit	$0.05	$0.15	Not applicable
Mfg overhead costs per machine hour	$15	$15	$20
No. of units produced per machine hour	50	50	50
Mfg O/H caused by Production – Per Unit	$0.30	$0.30	$0.40
Total Mfg O/H Allocated – Per Unit	$0.36	$0.46	$0.40

If the manufacturing overhead costs are caused by a number of activities such as setup, procurement, handling, and production, then using the activity based costing method of determining costs will give you a result that is closer to the true costs. As you can see, the product that weighs 0.5 pound is assigned $0.36 of manufacturing overhead, while the product weighing 1.5 pounds is assigned $0.46 of manufacturing overhead. Under the traditional costing allocations the procurement and handling costs would be assigned on production hours. Keep in mind that whenever manufacturers have a diverse lineup of products, allocating costs on a single basis (such as machine hours) will result in inaccurate per-unit manufacturing overhead costs.

If you want to learn more about overhead and activity based costing, we have prepared a short list of books that we have read and found to be very helpful. You can view our listing of recommended books by going to the following page: Recommended Books.

Because the material covered here is considered an introduction to this topic, many complexities have been omitted. You should always consult with an accounting professional for assistance with your own specific circumstances.

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