Module 3 Part 1 – Factory Overhead

and Activity-Based Costing

The Nature of Factory Overhead

Factory overhead is generally defined as indirect materials, indirect labor, and all
other factory costs that cannot be conveniently identified with or charged directly
specific jobs, products, or final cost objectives. Other terms used for factory
overhead are:
 factory burden,
 manufacturing expense,
 manufacturing overhead,
 factory expense, and
 indirect manufacturing cost.
Factory overhead has two characteristics:
 The first characteristic requires the consideration if products are to be
charged with a reasonable amount of this cost. These characteristics deal
with overhead’s relationships to the product and to the volume of production.

Unlike direct materials and direct labor, overhead is an invisible part of the
finished product. There is no materials requisition or labor time ticket to
indicate the amount of overhead that enters into a job or product. So far
overhead is as much a part of a product’s manufacturing cost as direct
materials and direct labor. Because automation has increased, overhead has
become a larger percentage of total product cost, while direct labor’s
percentage has declined.

 The second characteristic of overhead deals with how different items of

overhead change in response to a change in production volume. Overhead
can be fixed, variable, semi variable, step-variable or semi-fixed (or step-
fixed).

Fixed overhead remains relatively constant regardless of changes in the

level of output, within the relevant range; another way of stating that
relationship is that fixed overhead per unit of output varies inversely with
production volume.

Variable overhead changes proportionately with production volume, within

the relevant range; in other words, variable overhead per unit of output is
constant.

Semi-variable overhead is neither fixed nor variable; its amount changes,

but not in proportion to production volume. As volume changes, the different
overhead cost behavior patterns cause per-unit manufacturing cost to
fluctuate considerably. As a result, some method is needed to stabilize the
amount of overhead charged to the units produced.
 Step-variable overhead some costs are nearly variable, but increase in
few small steps instead of continuously. Such costs, called step-variable
overhead costs, usually include inputs that are purchased and used
relatively small increments. It shows a pattern of cost behavior that fits
neither the fixed-variable classification scheme nor the pattern of a typical
mixed cost.

Semi-fixed overhead (or step-fixed overhead) have large steps is a

cost that increases in lumps of cost with changes in output or activity. Semi-
fixed costs are predominately fixed but change in peso lumps at some point
within the relevant range

Use of a Predetermined Overhead Rate

A predetermined overhead rate permits a consistent and logical allocation to

each unit of output. In both job order and process cost accumulation, predetermined
overhead rates provide the only feasible method of computing product overhead
costs promptly enough to serve management’s needs for product cost fluctuations
that would otherwise appear in reported unit costs.

Factors Considered in Selecting Overhead Rules

Types of overhead rates differ not only from one company to another, but also from
one department, cost center, or cost pool to another within the same company. At
least three major factors influence the selection of overhead rates. The three factors
are summarized as follows:

I. Use of a Single Rate or Several Rates/Activity Rates

A. Traditional/Conventional
1. Plantwide or blanket rate (Single rate)
Based to be Used
a. Units produced/Physical-output/Unit-level drivers
b. Direct materials cost
c. Direct labor cost
d. Direct labor hours
e. Machine hours

2. Departmental rates (Several rates) – Producing or Service/Support

Departments – refer to Chapter 5 for detailed discussions

3. Sub-departmental – refer to Chapter 5

B. Activity-Based Costing (ABC) – Several activity rates
II. Activity Level Selection – refer to Chapter 3

A. Theoretical capacity
B. Practical capacity
C. Expected actual capacity
D. Normal capacity
E. Idle capacity versus excess capacity
F. Effect of capacity on overhead rates
 III. Including or Excluding Fixed Overhead

A. Absorption/Full/Traditional costing – refer to Chapter 2

B. Variable/Direct costing
ESTIMATING
FACTORY Budgeted /Estimated total factory
OVERHEAD overhead Budgeted Factory overhead
=
Budgeted/Estimated activity application rate
(e.g., direct labor/machine hours)

ACCOUNTING Factory Overhead Applied Factory Work in Process—

FOR Control/Actual Overhead Factory Overhead Finished Goods
FACTORY Actual Applied Goods Completed
OVERHEAD charges: factory completed goods
Indirect with transferre
materials overhea factory d
Indirect d overhead to cost
labor (rate x based on of goods
Utilities pre- sold
Maintenance capacity determine
Depreciation utilized, d
Property tax i.e., rate
etc. actual

activity)

Over-/
Underapplied
Factory Overhead

FIGURE 4–1 Factory Overhead

Prime costs (direct materials and direct labor) are assigned using direct
tracing depending on their respective activity driver. On the other side, factory
overhead rates depends on the selected activity driver.

Choice of Cost Allocation Methods: A Cost-Benefit Decision

The choice of whether to use a plantwide rate or departmental rates depends on the
products and the production process. If the company manufactures products that
are quite similar and that use the same set of resources, the plantwide rate is
probably sufficient.

Use of a Single Rate (Plantwide/Blanket) or Several Rates (Departmental) /

Activity Rates

Plantwide or departmental predetermined overhead rates are used to assign or

apply overhead costs to production as the actual production activity unfolds. The
total overhead assigned to actual production at any point in time is called applied
overhead. Applied overhead is computed using the following formula:
Applied Factory Overhead = Actual Driver/Activity Usage x Factory Overhead Rate

As soon as, the applied factory overhead is assigned, the unit cost is computed by
dividing the total applied overhead by the total units produced.

Traditional/Conventional: Plantwide or Blanket Rate (Single Rate)

In the plantwide allocation method, the cost pool is the entire plant. A single
predetermined overhead rate for an entire factory called a plantwide overhead
rate. This is a fairly common practice—particularly in smaller companies. But in
larger companies, multiple predetermined overhead rates are often used.

This method uses one overhead allocation rate, or one set of rates, to allocate
overhead to products for all departments in a particular plant. the term “plant” to
refer to an entire factory, store, hospital, or other multidepartment segment of a
company. The key word in the definition is all; that is, a single rate or set of rates is
used for every department.

Although it is called plantwide allocation, this allocation concept can be used in

both:

 manufacturing and
 nonmanufacturing organizations.

For example, in a hospital, overhead could be applied to different wards, patients,

or treatments using just one overhead rate for the entire hospital. Although it refers
to the costs that are being allocated as overhead costs, the concepts apply to any
indirect cost allocation.

Plantwide allocation is the single-stage approach:

 Accounting for overhead is simple.

 All actual overhead costs are recorded in one cost pool in the Factory
Overhead Control account for the plant without regard to the department or
activity that caused them.
 A single overhead rate is used to apply overhead to products, crediting
Applied Factory Overhead.

For example, if overhead is applied using a predetermined rate per machine-hour,

the amount of the credit to the Applied Factory Overhead account and the amount
of the debit to Work in Process for overhead costs equal the rate per machine-hour
times the total number of machine-hours worked. Companies using a single
plantwide rate generally use an allocation base related to the volume of output,
such as direct labor-hours, machine-hours, units of output, or materials costs

All budgeted overhead costs are assigned to a plantwide pool (first-stage cost
assignment). Next, a plantwide rate is computed using a single unit-level driver,
which is usually direct labor hours. Finally, overhead costs are assigned to
products by multiplying the rate by the actual total direct labor hours used by each
product (second-stage assignment).

Assigning the cost of direct materials and direct labor to products poses no
particular challenge. These costs can be assigned to products using direct tracing,
and most functional-based costing systems are designed to ensure that this tracing
takes place.

Overhead costs, on the other hand, pose a different problem. The physically
observable input-output relationship that exists between direct labor, direct
materials, and products is simply not available for overhead. Thus, assignment of
overhead must rely on driver tracing and perhaps allocation.

Base to Be Used
The factor measured in the denominator of an overhead rate is called the
overhead rate base, the overhead allocation base, or simply the base.
Selection of the base is important if a cost system is to provide meaningful cost
data.

1. The primary objective in selecting a base is to ensure the application of

overhead in a reasonable proportion to the indirect factory resources used by
the jobs, products, or work performed.

Ordinarily the base should be closely related to functions represented by the

overhead cost being applied.
 If overhead is mostly labor oriented, dominated by costs such as
supervision and fringe benefits, then the proper base is probably direct
labor cost or direct labor hours.
 If overhead items are predominantly technology oriented, resulting from
the ownership and operation of machinery, then a machine-hour base is
probably most appropriate.
 If overhead is mainly materials oriented, dominated by costs associated
with procuring and handling materials, then materials cost may be
suitable as the base. Correlation analysis, discussed in Chapter 3, is useful
in selecting the base.

2. A second objective in selecting a base is minimization of clerical cost and

effort. When two or more bases result in approximately the same applied
factory overhead costs for each job or product, the simplest, most easily
measured base should be used.

Labor hour and machine hour bases generally entail additional clerical work
due to extra effort required to collect the data.

Calculation of a Predetermined Overhead Rate

The first step in calculating the overhead rate is determining the activity level to
be used for the base selected. Then each individual overhead cost item is
estimated or budgeted at that activity level, arriving at the total estimated
factory overhead.

 Units produced/Physical Output/ Unit-level drivers (refer to further

discussions below). Physical output or units of production is the simplest base
for applying factory overhead. The rate is computed by dividing total
estimated overhead by total estimated units of production as follows:
Budgeted/Estimated factory
overhead = Budgeted Factory Overhead per
*Budgeted/Estimated units of Unit
production
*normal capacity for a longer period of time (refer to chapter 3)
  Direct Materials Cost Base. In some companies, a study of past costs
reveals a high correlation between direct materials cost and overhead. This is
plausible, for example, when much of the production work consists of
receiving, inspecting, storing, retrieving, and handling many lots of costly
materials. In such cases, a rate based on materials cost may be appropriate.
The rate is computed by dividing total estimated overhead by total estimated
direct materials cost as follows:
Budgeted/Estimated factory
overhead × 100% = Budgeted Factory Overhead as a percentage
Budgeted/Estimated direct of Actual Direct Materials Cost
materials cost
 Direct Labor Cost Base. Using a direct labor cost base for applying factory
overhead to jobs or products entails dividing estimated overhead by
estimated direct labor cost to compute a percentage:
Budgeted/Estimated factory
overhead × 100% = Budgeted Factory Overhead as a percentage
Budgeted/Estimated direct labor of Actual Direct Labor Cost
cost
 Direct Labor Hour Base. The direct labor hour base is designed to
overcome the second disadvantage of using the direct labor cost base. The
factory overhead rate based on direct labor hours is computed as follows:
Budgeted/Estimated factory
overhead × 100% = Budgeted Factory Overhead per
Budgeted/Estimated direct labor Actual Direct Labor hour
hours
 Machine Hour Base. When machines are used extensively, machine hours
may be the most appropriate basis for applying overhead. This method is
based on time required to perform identical operations by a machine or
group of machines. Total machine hours expected to be used are estimated,
and a machine hour rate is determined as follows:
Budgeted/Estimated factory
overhead × 100% = Budgeted Factory Overhead per
Budgeted/Estimated machine Actual Machine hour
hours

Traditional/Conventional: Departmental Rates (Several rates) – Producing

or Support Departments (refer to Chapter 5 for detailed discussions)

In a multiple (departmental) predetermined overhead rate system, normally

used for production or service/support, wherein they may have its own
predetermined overhead rate. Such a system, while more complex, is more
accurate because it can reflect differences across departments in how overhead
costs are incurred.

Using the department allocation method, a company has a separate cost pool for
each department. The company establishes a separate overhead allocation rate for
each department. Each production department is a separate cost pool.

In contrast, the plantwide allocation method considers the entire plant as

one cost pool. For example, in departments that are relatively labor intensive
overhead might be allocated based on direct labor-hours and in departments that
are relatively machine intensive overhead might be allocated based on machine-
hours.

When multiple predetermined overhead rates are used, overhead is applied in each
department according to its own overhead rate as jobs proceed through the
department.

Illustrative Example 4-1: Plantwide and Departmental Rates - A company

with a plant that produces two products: AA and BB. The two producing
departments are Cutting and Finishing. Cutting is responsible for producing Product
AA, and Finishing is responsible for producing Product BB.

Cutting is composed of 2 workers and 25 machines, and Finishing has 25 workers

and 3 machines. One of the company’s products passes through both departments
and uses the following quantities of direct labor and machine time:
Cutting Finishin
g
Machine hours per unit 10.00 0.30
Direct labor hours per unit 0.50 2.0

Following are the budgeted overhead costs and volumes for each department for
the upcoming year:
Cutting Finishin
g
Estimated overhead P317,67 P162,00
0 0
Estimated machine hours (MH) 36,000 4,650
Estimated direct labor hours (DLH) 2,400 24,000

Plantwide

The plantwide rate for overhead application rate (based either on machine hours or
direct labor hours) for the upcoming year and the amount of overhead assigned to
each unit using the selected applicable overhead rate would be as follows:

Based on Machine Hours:

Cutting Finishin Total
g
Estimated overhead P317,67 P162,00 P479,67
0 0 0
Estimated machine hours (MH) 36,000 4,650 __40,65
0
Plantwide – Factory Overhead Rate per MH P
11.80
x: Machine hours (MLH) per unit 10.00 0.30 ___10.30
Applied factory overhead per unit P
121.54

Based on Direct Labor Hours:

Cutting Finishin Total
 g
Estimated overhead P317,67 P162,00 P479,67
0 0 0
Estimated direct labor hours (DLH) 2,400 24,000 __26,40
0
Plantwide – Factory Overhead Rate per DLH P 18.17
x: Direct labor hours (DLH) per unit .50 2.0 ___2.50
Applied factory overhead per unit P
45.43

Departmental

The company’s applied the more appropriate basis to determine overhead rates
and use machine hours in Cutting and direct labor hours in Finishing. The
department rates for overhead application for the upcoming year and the amount of
overhead will be assigned to each unit using the applicable rate would be as
follows:
Cutting Finishin Total
g
Estimated overhead P317,67 P162,00
0 0
Estimated machine hours (MH) 36,000
Estimated direct labor hours (DLH) ________ __24,00
0
Plantwide – Factory Overhead Rate P P
8.82 6.75
x: Machine hours (MLH) per unit 10.00
Direct labors (DLH) per unit ________ ____2.00
Applied factory overhead per unit P P P
88.20 13.50 101.70

Limitations of Traditional: Plantwide and Departmental Overhead Rates

Plantwide and departmental rates have been used for decades and continue to
be used successfully by many organizations. In some settings, however, they do not
work well and may actually cause severe product cost distortions. Causing a
significant cost distortion, overhead costs must be a significant percentage of total
manufacturing costs.

For some manufacturers, overhead costs are a small percentage (e.g., 5 percent or
less), and the system in which these costs are assigned is not a major issue. In this
case, using a very simple, uncomplicated approach such as plantwide rates is
appropriate.

Assuming, however, that the overhead costs are a significant percentage of total
manufacturing costs, at least two major factors can impair the ability of the unit-
based plantwide and departmental rates to assign overhead costs accurately:
1. the proportion of non-unit-related overhead costs to total overhead costs
is large, and
2. the degree of product diversity is great.
Non-Unit-Related Overhead Costs

The use of either plantwide rates or departmental rates assumes that a product’s
consumption of overhead resources is related strictly to the units produced.

But what if there are overhead activities that are unrelated to the number of units
produced like setup costs, product engineering costs. Both these examples illustrate
the existence of non-unit-based drivers. Non-unit-based drivers are factors, other
than the number of units produced, that measure the demands that cost objects
place on activities.

Thus, unit-level drivers cannot assign these costs accurately to products. In fact,
using only unit-level drivers to assign non-unit-related overhead costs can create
distorted product costs.

Product Diversity

The severity of this distortion depends on what proportion of total overhead costs
these non-unit-based costs represent. Significant non-unit overhead costs will not
cause product cost distortions provided products consume the non-unit overhead
activities in the same proportion as the unit-level overhead activities.

Product diversity, on the other hand, can cause product cost distortion. Product
diversity simply means that products consume overhead activities in different
proportions. Product diversity is caused by such things as differences in product
size, product complexity, setup time, and size of batches.

The proportion of each activity consumed by a product is defined as the

consumption ratio. The way that non-unit overhead costs and product diversity can
produce distorted product costs (when only unit-level drivers are used to assign
overhead costs).

Selection of Capacity-Level

In calculating a predetermined overhead rate, a great deal depends on the capacity-

level selected. The numerator of the overhead rate is an estimate of overhead at a
certain capacity-level, and the denominator is an estimate of the allocation base at
that same level of activity.The greater the assumed capacity-level, the lower the
predetermined overhead rate; this relationship exists because factory overhead
consists of fixed and variable portions. The higher the capacity-level, the smaller
the fixed portion of the factory overhead rate, because fixed factory overhead is
being spread over a greater number of units of activity. The variable portion of the
rate tends to remain constant at different activity levels within the relevant range.

The different activity levels include (refer to Chapter 2).:

 theoretical capacity,
 practical capacity,
 expected actual capacity, and
 normal capacity

Effect of Capacity on Factory Overhead Rates. The effect of the various

capacity levels on predetermined overhead rates is illustrated in Figure 4–2. If the
75% capacity level (normal capacity) is selected, the factory overhead rate is P2.40
per machine hour. At higher capacity levels, the rate is lower because the fixed
factory overhead is spread over more machine hours.

Figure 4-2:
Effect of Various Capacity Levels on
Predetermined Factory Overhead Rates
Theoretic
Normal Expected Practical al
Item Capacity Actual Capacity Capacity Capacity
Percentage of theoretical
capacity 75% 80% 85% 100%
Machine
hours……………………... 7,500hrs 8,000hrs 8,500hrs 10,000hrs
Budgeted factory overhead:
Fixed…………………………….
.. P 12,000 P 12,000 P 12,000 P 12,000
Variable
………………………… 6,000 6,400 6,800 8,000
Total
…………………………….. P 18,000 P 18,400 P 18,800 P 20,000
Fixed factory overhead rate
per
machine hour
…………………... P 1.60 P 1.50 P 1.41 P 1.20
Variable factory overhead rate
per machine hour
……………… .80 .80 .80 .80
Total factory overhead rate per
machine hour
…………………... P 2.40 P 2.30 P 2.21 P 2.00

After the activity level and the overhead cost have been estimated, overhead rates
can be computed. Assuming the machine hour base is used and machine hours for
the coming year are expected (budgeted) to be 20,000 for, the estimated/budgeted
factory overhead rate at this selected activity level is:
Estimated factory P300,00
Factory overhead rate overhead 0 = P15.00 per machine
=
= Estimated machine hours 20,00 hour
0

This rate is used to charge factory overhead to jobs, products or work performed.
Amounts applied are first entered in subsidiary ledgers such as job order cost
sheets or cost of production reports. The machine hours actually used will
determine the amount of factory overhead chargeable to each job, product, or
department.

The factory overhead rate can be divided into fixed and variable components as
follows:
P125,000 estimated fixed factory
overhead = P 6.25 fixed portion of the factory overhead rate
20,000 estimated machine hours
P175,000 estimated variable factory
= 8.75 variable portion of the factory overhead
overhead
rate
20,000 estimated machine hours
Total factory overhead rate = P15.00 per machine hour
Including or Excluding Fixed Factory Overhead

Ordinarily cost accounting applies all factory costs to the output of a period. Under
this approach, called absorption costing, conventional costing, or full costing,
both fixed and variable costs are included in factory overhead rates.

Another method of costing, termed direct costing or variable costing, is not

allowed for external reporting but is sometimes used for internal management
purposes. Under this method, only variable factory overhead is included in overhead
rates. The fixed portion of factory overhead cost does not become a product cost. It
is instead treated as a period cost, meaning that it is charged off in total each
period, as are marketing and administrative expenses. It is not included in either
work in process or finished goods inventories.

Absorption costing and direct costing are the results of two entirely different cost
concepts with respect to product cost, period cost, gross profit, and operating
income. Although the two methods result in different inventory costs and different
period profits, each of the various bases discussed for applying factory overhead
can be used with absorption costing or direct costing. Factory overhead variances
due to idle capacity do not arise under variable/direct costing (refer to Chapters 2
and 9).

Actual Factory Overhead

Determining the base and the activity level, estimating total overhead, and
calculating the overhead rate take place prior to incurring or recording actual costs.
Factory overhead may be applied each week or month, as soon as the necessary
data––such as the predetermined rate and the actual machine hours––are available.
However, some actual factory overhead costs are recorded when incurred, as
transactions are journalized and posted to general and subsidiary ledgers; this
recording is independent of the application of the factory overhead.

A basic objective of accumulating factory overhead is to provide information for

control. Control requires first reporting costs to the individual department heads
responsible for them, and then making comparisons with amounts that would be
budgeted for the level of activity actually achieved. Collecting overhead cost data
relies on the chart of accounts, which indicates the accounts to which various
overhead transactions are to be charged.

Applied Factory Overhead and the Over- or Under-applied Amount

At the end of the month or year, applied factory overhead and actual factory
overhead are compared. Actual factory overhead is the amount of indirect cost
incurred, while applied factory overhead is the amount of cost allocated to
output.

Applying Factory Overhead

A predetermined factory overhead rate of P15 per machine hour was calculated
previously using estimated/budgeted factory overhead and estimated machine
hours. To continue that illustration, assume the actual machine hours totaled
18,900 and actual factory overhead totaled P292,000.
The factory overhead applied during the period is 18,900 x P15 = P283,500. The
general journal entry summarizing factory overhead applied is:
Work in Process ……………………………………. 283,500
Applied Factory Overhead
…………….......... 283,500

The debit to the work in process control account brings into the general ledger the
total applied factory overhead for the period, usually a month. Charges to subsidiary
records (job order cost sheets or departmental cost of production reports) list
details of the applied factory overhead charged to each job or department.

The applied factory overhead account subsequently is closed to the factory

overhead control account at the end of the year by the following entry:
Applied Factory Overhead 283,500
……………..................
Factory Overhead Control
……………….......... 283,500

It is common practice to use an applied factory overhead account because it keeps

applied costs and actual costs separate. This separation facilitates monthly
comparison with budgeted factory overhead. These comparisons are necessary to
evaluate the appropriateness of the predetermined overhead rate.

If actual experience diverges substantially from the budget, and if the reasons for
the divergence are not expected to be offset later in the period, then the overhead
rate should be adjusted to avoid misstating product costs during the year and avoid
a large over- or under-applied factory overhead amount at year-end.

After the preceding entries are recorded, the factory overhead control for DeWitt
Products appears as follows:
Factory Overhead Control/Actual Factory Overhead
Dec. 292,00 Dec. 31 (18,900 x 283,50
31 0 P15.00) 0

Total Actual Overhead Overhead Applied

Incurred During Period During Period

Factory overhead costs are normally charge to Work in Progress, but in a just-in-
time environment (backflush costing), factory overhead costs may be charged
directly to Cost of Goods Sold. As end-of-period entry is then made, adjusting the
inventory accounts for the portion of factory overhead and other manufacturing
costs appropriate to the units in inventory. The offsetting entry is made to the cost
of goods sold account, using backflush costing as discussed in Chapter 7.

Over- or Under-applied Factory Overhead

Debits to the factory overhead control account reflect actual factory overhead costs
incurred during the period, while credits reflect applied amounts. There may also be
credit adjustments (e.g., for the return of supplies to the storeroom) that reduce the
total actual factory overhead. Because the debits and credits are seldom equal,
there is usually a debit or credit balance in the account.
A debit balance indicates that factory overhead has been underapplied; a credit
balance means that factory overhead has been overapplied. These over- or
underapplied balances are a source of much information needed by management
for controlling and judging the efficiency of operations and the use of available
capacity, and for calculating predetermined factory overhead rates in subsequent
periods.

In the previous illustration, applied factory overhead for the period is P8,500 less
than actual factory overhead incurred, so factory overhead for the period is P8,500
underapplied.

Cost
Actual Factory Overhead/Factory Overhead P292,000
Control……………………..
Less: Applied Factory 283,500
Overhead……………………………………………...
Overhead Variance – P 8,500
underapplied………………………………………….

Disposition of Over- or Underapplied Amount

Disposition of the over- or underapplied factory overhead is usually quite simple. At

the end of the accounting period, it can be either treated as:

 a period expense – i.e. closed to cost of goods sold or directly to

Income Summary or
 allocated between inventories and the cost of goods sold.

If the amount of over- or underapplied factory overhead is:

 Immaterial/Insignificant, it should be closed:

a. Directly to Income Summary or to Cost of Goods Sold as a period

expense. Insignificance in this sense refers to an amount so small that
the effect on income of expensing all of it, rather than allocating part to
inventories, is immaterial; that is, it is so small that the difference is not
expected to affect the decisions of a reader of the financial statements.

This practice is justified on the basis of immateriality, the same principle

used to justify expensing the entire cost of a product in the period
acquired rather than allocating (through depreciation) its cost over the life
of the product.

In that case, the entry to dispose of underapplied factory overhead on the

books is as follows:
Income Summary ………………….................. 8,500
Factory Overhead Control ………………... 8,500
or
Cost of Goods Sold ……………….................. 8,500
Factory Overhead Control ………………... 8,500

In the second entry, the P8,500 becomes a part of the cost of goods sold
account balance, which subsequently is closed into the income summary
account. In either event, the over- or underapplied factory overhead
amount can be reported as an adjustment in the income statement as
shown in Figure 4–3.

Figure 4-3:
Name of Company
Income Statement
For Year Ending December 31, 20––
Sales ………………………………………………....... P1,600,000
Less: Cost of goods sold, actual costing:
Cost of goods sold, normal costing…………. P
1,193,500
Add: Underapplied factory overhead……… 8,50 1,202,000
0
Gross profit, actual costing…………………………. P 398,000
Less: Marketing expense …………………………… P
150,000
Administrative expense………………………. ___100,000 ___250,000
Operating income …………………………………….. P 148,000

Alternatively, over- or underapplied factory overhead can be reported to

as an adjustment in the cost of goods sold statement. This statement and
the income statement then appear as shown in Figure 4-4.

The treatment of the adjustment may be based on management

responsibility for the over- or underapplied factory overhead:

 if a responsibility of manufacturing managers, it is reported in the

cost of goods sold statement;
 if a responsibility of general management, it is reported in the
income statement as illustrated previously.

Figure 4-4:
Name of Company
Costs of Goods Sold Statement
For Year Ending December 31, 20––
Direct materials used P 400,000
…………………………………………………
Direct labor used 500,000
………………………………………………………
Applied factory overhead 283,500
……………………………………………..
Manufacturing cost P1,183,500
………………………………………………..
Less: Increase in work-in-process inventory 20,000
………………………
Cost of goods manufactured P1,163,500
………………………………………….
Add: Decrease in finished goods inventory ____30,000
……………………….
Cost of goods sold, normal costing P1,193,500
………………………………….
Add: Underapplied factory overhead 8,500
………………………………
 Adjusted Cost of goods sold, actual P1,202,000
costing………………………..
Name of Company
Income Statement
For Year Ending December 31, 20––
Sales ………………………………………………....... P1,600,000
Less: Cost of goods sold, actual costing:
Cost of goods sold, normal costing…………. P
1,193,500
Add: Underapplied factory overhead……… 8,50 1,202,000
0
Gross profit, actual costing…………………………. P 398,000
Less: Marketing expense …………………………… P
150,000
Administrative expense………………………. ___100,000 ___250,000
Operating income …………………………………….. P 148,000

 Material/Significant, it is allocated among work-in-process inventory,

finished goods inventory and cost of goods sold in proportion to the overhead
applied during the current period in ending balances. This allocation is an
attempt to restate all applied factory overhead at amounts approximating
actual factory overhead.

It is required for financial reporting purposes if its effect on the financial

statements are material.

Expensing a large underapplied factory overhead balance, for example,

generally overstates the cost of goods sold, understates income, and
understates inventory on the balance sheet.

To illustrate, the allocation of over-or-underapplied factory overhead

between inventories and cost of goods sold, suppose ReSA Company in all
previous years had treated over- or underapplied factory overhead as an
adjustment to income or expense.

At the end of the current year the company had P8,000 of underapplied
factory overhead, and the balances in inventories and cost of goods sold
were:
Work-in- Finished Cost of Goods
Process Goods Sold
Direct materials ………… P 30,000 P 14,000 P 56,000
Direct labor ……………… 10,000 38,000 152,000
Applied factory overhead 10,000 38,000 152,000
Year-end balance ………. P 50,000 P 90,000 P 360,000

The purpose of allocating the underapplied factory overhead is to revise all

the amounts of factory overhead that were applied during the year. The
revision is achieved by adjusting the three accounts shown, because all
applied factory overhead amounts are contained in the year-end balances of
those three accounts.

The materials inventory account is not involved, because it contains no

applied factory overhead. (This illustration also assumes that the beginning
balances of Work in Process and Finished Goods were very small compared to
Cost of Goods Sold. When beginning inventories are significant, the
appropriate disposition standard cost variances, discussed in Chapter 8).

The over-or underapplied factory overhead usually is allocated to the three

accounts in proportion to their balances. The calculation is as follows:
Account Percentag
Balance e
of Total
Work in Process
P 50,000 10%
……………………………….
Finished goods
90,000 18
…………………………………
Cost of goods sold
360,000 72__
……………………………..
Total ………………………………….. P 500,000 100%

The P4,000 of underapplied factory overhead is then allocated to the three

accounts based on the three percentages calculated. The journal entry to
dispose of ReSA’s underapplied factory overhead is as follows:
Work in Process (10% of P8,000) ………… 800
Finished goods (18% of P8,000) ………….. 1,440
Cost of goods sold (72% of P8,000) ………. 5,760
Factory overhead control ………......... 8,000

If factory overhead had been overapplied, the two inventories and Cost of
Goods Sold would be credited and Factory Overhead Control would be
debited.

Often the work in process inventory consists mostly of direct material cost
and relatively little overhead, so the approach just illustrated attributes too
much of the adjustment to Work in Process.

Because only the overhead components of the three accounts need to be

restated, the allocation should be in proportion to the amounts of
applied factory overhead contained in the three accounts.

Using this approach, the calculation and the journal entry to dispose of the
underapplied factory overhead are as follows:

Applied Percentag
Overhea e
d of Total
Work in Process ………………………………. P 10,000 5%
Finished goods ………………………………… 24,000 19%
Cost of goods sold …………………………….. 152,000 76%
Total ………………………………….. P 200,000 100%

Work in Process (5% of P8,000) ……… 400

Finished goods (19% of P8,000)
1,520
……….
Cost of goods sold (76% of P8,000)
6,080
……
 Factory overhead control …………. 8,000

Under either approach, the inventories are reported on the balance sheet at
their adjusted amounts, and Cost of Goods Sold is adjusted on either the Cost
of Goods Sold Statement or the Income Statement, as illustrated previously.
At the beginning of the next year, the portions of the journal entry that
involve inventories are reversed.

Changing Overhead Rates

Overhead rates usually are reviewed periodically. Changes in production methods,

prices, efficiencies, and sales forecasts make review and possible revision of
overhead rates necessary at least annually. The extent to which a company revises
its overhead rates depends on the frequency of changes, on factors that affect
overhead rates, and on management’s need and desire for current cost data.

An overhead rate can be incorrect because of misjudgments regarding estimated

overhead or anticipated activity. A large over- or underapplied factory overhead
figure does not necessarily mean that the overhead rate was wrong. When the
overhead rate is based on expected actual conditions, seasonal variations can result
in large interim amount of over or under absorbed overhead that will even itself out
during a full year.

Cost Management Systems: Traditional and Activity-Based Costing

Systems

Cost management systems can be broadly classified as:

 traditional (unit-based or unit-level driver) or

 activity-based

Both of these systems are found in practice. Currently, the traditional-based cost
management systems are more widely used than the activity-based systems. Firms
operating in an advanced manufacturing environment, the traditional-based cost
management system may not work well. More relevant and timely cost information
is needed for these organizations to build a sustainable long-term competitive
advantage.

Traditional (Unit-Based or Unit-Level Driver) Product Costing

The unit-based product costing systems use traditional product cost definitions and
use only unit-based activity (refer to Illustration 4-1 above) drivers to assign
overhead to products.

Unit-based product costing assigns only manufacturing costs to products. Figure 4-5
shows the general functional-based product costing model. Assigning the cost of
direct materials and direct labor to products poses no particular challenge. These
costs can be assigned to products using direct tracing, and most functional-based
costing systems are designed to ensure that this tracing takes place.

Direct Materials Direct Labor Overhead

 Direct Tracing
Driver Tracing
Allocation
Direct Direct
Tracing Tracing
Plant/Departmental
Cost Pools

Unit-Based
Drivers

PRODUCTS

Figure 4-5: Unit-Based Product-Costing (refer to Chapter 2 on Cost

Assignment Summarized)

Overhead costs, on the other hand, pose a different problem. The physically
observable input-output relationship that exists between direct labor, direct
materials, and products is simply not available for overhead. Thus, assignment of
overhead must rely on driver tracing and their allocation.

Unit-based costing first assigns overhead costs to a unit, creating either plant or
departmental cost pools. Next, these pooled costs are assigned to products using
predetermined overhead rates based on unit-level drivers.

Predetermined rates are used because overhead and production often are incurred
non-uniformly throughout the year, and it is not possible to wait until the end of the
year to calculate the actual overhead cost assignments (managers need unit
product cost information throughout the year).

A cost system that uses predetermined overhead rates and actual costs for direct
materials and direct labor is referred to as a normal cost system (refer to
Chapter 2).

Budgeted overhead is simply the firm’s best estimate of the amount of overhead
(utilities, indirect labor, depreciation, etc.) to be incurred in the coming year. The
estimate is often based on last year’s figures, adjusted for anticipated changes in
the coming year.

Transaction Base. A group of costs may be associated with particular activity in a

manner not adequately represented by any of the bases previously discussed. For
example, setup costs can be assigned more appropriately to products by a rate per
setup.
Each setup is thus viewed as a transaction, with costs assigned to a product or
batch of products based on the number of transactions required. This transaction
approach can also apply to activities such as scheduling, inspections, materials
movements, and changes in products and processes.

The transactions-based approach to overhead allocation is popularly referred

to as activity-based costing (ABC). ABC recognizes that significant overhead
costs may not be caused by volume of output. Rather, in modern multiproduct
factories, overhead cost can be caused more by the complexity of the product line
and by the handling required for special, low volume items than by the total volume
of production.

To the extent that overhead cost is driven by transactions that are not proportional
to output volume, the use of a volume-of-output base tends to over cost the high-
volume products and under cost the low-volume products. Use of the transactions
base can correct this misallocation.

Total overhead of P250,000 allocated alternatively:

Traditional/
P150,000 Conventional
P75,000
P25,000 Overhead
Allocation
(amounts
assumed)
Standard Moderate Premium
Product Product Product

P150,000 Activity-based
P75,000 Costing (ABC)
P25,000
Overhead
Allocation
Premium
(amounts
Standard Moderate
Product Product Product
Figure 4-6: Traditional versus ABC Overhead Allocations

Thus, activity-based costing typically shifts a substantial amount of overhead cost

from standard, high-volume products to premium special-order, low-volume
products, as shown in Figure 4-6. The ABC costs of moderate products and services
(those that are neither extremely simple nor complex, nor produced in extremely
low or high volumes) tend to remain approximately the same as the costs
calculated using traditional costing methods. Many companies use an activity-based
costing system to allocate corporate overhead costs to their revenue-producing
units based on the number of reports, documents, customers, or other reasonable
measures of activity.

Activity-Based Costing (ABC)

Activity-based costing (ABC) is defined as a cost accounting system that focuses

on the various activities performed in an organization and collects costs on the
basis of the underlying nature and extent of those activities. This costing method
focuses on attaching costs to products and services based on the activities
conducted to produce, perform, distribute, or support those products and services.

Compared to traditional cost accounting, ABC represents a more thorough

application of cost tracing. Traditional product costing traces only direct material
and direct labor to each unit of output. In contrast, ABC recognizes that many other
costs are in fact traceable - not to units of output, but to the activities required to
produce output.

The three fundamental components of activity-based costing (ABC):

1. Recognizing that several levels of costs exist accumulating costs into related
cost pools,
2. Using multiple cost drivers to assign costs to products
3. Using multiple cost drivers to assign costs to services

An activity-based cost accounting system offers greater product costing accuracy

but at an increased cost. The justification for adopting an activity-based costing
approach must rely on the benefits of improved decisions resulting from materially
different product costs. It is important to understand that a necessary condition for
improved decisions is that the accounting numbers produced by an activity-based
costing system must be significantly different from those produced by a traditional
costing system.

The theoretical premise of activity-based costing is that it assigns costs according to

the resource consumption pattern of products. If this is true, then activity-based
costing should produce more accurate product costs if there is product diversity
simply because unit-based drivers cannot capture the full consumption pattern of
products. There is a need to choose among a plantwide cost pool, departmental
cost pools, or activity cost pools.
In reality, if there is no product diversity and a plantwide cost pool is chosen, all
what is needed is the cost of overhead resources taken from the general ledger
accounts: depreciation, salaries, utilities, rent, etc.

On the other hand, departmental cost pools require more detail and less
aggregation because costs must be assigned to every producing department.
Finally, activity-based costing requires the most detail and the least aggregation
because each activity performed and its associated costs must be identified.

Activity-based costing is useful in companies having the following characteristics:

1. the production or performance of a wide variety of products or services;
2. high overhead costs that are not proportional to the unit volume of individual
products;
3. significant automation that has made it increasingly more difficult to assign
overhead to products using the traditional direct labor or machine-hour
bases;
4. profit margins that are difficult to explain; and
5. hard-to-make products that show big profits and easy-to-make products that
show losses.
Companies having the above characteristics may want to reevaluate their cost
systems and implement activity-based costing.

As Figure 4-7 illustrates, an activity-based costing (ABC) system first traces costs to
activities and then to products and other cost objects. The underlying assumption is
that activities consume resources, and products and other cost objects consume
activities.

Figure 4-7: Activity-Based Costing Model

Cost of Resources/Cost Objects

(e.g. products and customers)

Costs assigned using

driver tracing and direct
tracing

Activities

Costs assigned using

activity drivers

Consumption of Resources
 Product Costs

In designing an ABC system, there are six essential steps:

1. Identify, define, and classify activities and key attributes.
2. Assign the cost of resources to activities / directly trace costs to activities and
cost objects.
3. Assign the cost of secondary activities to primary activities / assign cost to
activity pools.
4. Identify cost objects and specify the amount of each activity consumed by
specific cost objects.
5. Calculate primary activity rates.
6. Assign activity costs to cost objects.
Activity Identification, Activity Definition and Classification

Activity Identification. Identifying activities is a logical first step in designing an

activity-based costing system. Activities represent actions taken or work performed
by equipment or people for other people. Identifying an activity is equivalent to
describing action taken—usually by using an action verb and an object that receives
the action.

A simple list of the activities identified is called an activity inventory. The following
are samples of activity inventory for a manufacturer involving electronics are as
follows:
1. Developing test programs 7. Inserting dies
2. Making probe cards 8. Providing utilities
3. Testing products 9. Providing space
4. Setting up lots 10. Purchasing materials
5. Collecting engineering data 11. Receiving materials
6. Handling wafer lots 12. Paying for materials

Activity Definition. Once an inventory of activities exists, then activity attributes

are used to define activities.
 Activity attributes are financial or quantitative and nonfinancial or qualitative
information items that describe individual activities.
 An activity dictionary lists the activities in an organization along with desired
attributes. The attributes selected depend on the purpose being served.

Figure 4-8: Cost Flow Diagram: Activity-Based Costing System

Manufacturing
overhead

First stage

Step 1:
Setting up Handling Machining Machining
2:
3: machines material (machine-hours) (machine-hours)
(setup hours) (production
Step 4: runs)

₱ per ₱ per ₱ per ₱ per

setup production machine- production
Step 5:
hour run hour run
Examples of activity attributes with a product costing objective include tasks that
describe the activity, types of resources consumed by the activity, amount
(percentage) of time spent on an activity by workers, cost objects that consume the
activity, and a measure of activity consumption (activity driver). Activities are the
building blocks for both product costing and continuous improvement.

An activity dictionary provides crucial information for activity-based costing as well

as activity management. It is a key source of information for building an activity-
based database that is discussed later in the chapter.

Activity Classification. Attributes define and describe activities and, at the same
time, become the basis for activity classification. Activity classification facilitates
the achievement of key managerial objectives such as product or customer costing,
continuous improvement, total quality management, and environmental cost
management.

For example, for costing purposes, activities can be classified as primary or

secondary:

 A primary activity is an activity that is consumed by a final cost object such

as a product or customer.
 A secondary activity is one that is consumed by intermediate cost objects
such as primary activities, materials, or other secondary activities.

Recognizing the difference between the two types of activities facilitates product
costing. Figure 4-7 indicates that activities consume resources.

Thus, in the first stage of activity-based costing, the cost of resources is assigned to
activities. Figure 4-7 also reveals that products consume activities—but only
primary activities. Thus, before assigning the costs of primary activities to products,
the costs of the secondary activities consumed by primary activities must be
assigned to the primary activities. Many other useful activity classifications exist.

In designing an activity costing system, the desired attributes and essential

classifications need to be characterized up front so that the necessary data can be
collected for the activity dictionary.

Gathering the Necessary Data

Interviews, questionnaires, surveys, and observation are means of gathering data

for an ABC system.

 Interviews with managers or other knowledgeable representatives of

functional departments are perhaps the most common approach for
gathering the needed information. In structuring an interview, the questions
should reveal certain key attributes.
 Interview questions can be used to identify activities and activity attributes
needed for costing or other managerial purposes. The information derived
from interview questions serves as the basis for constructing an activity
dictionary and provides data helpful for assigning resource costs to individual
activities.
 Interview questions should be structured to provide answers that allow the
desired attributes to be identified and measured. An example is perhaps the
 best way to show how an interview can be used to collect the data for an
activity dictionary.
Activity Dictionary

Based on the answers to the interview, an activity dictionary can now be prepared.
The activity dictionary names the activity (typically by using an action verb and an
object that receives the action), describes the tasks that make up the activity,
classifies the activity as primary or secondary, lists the users (cost objects), and
identifies a measure of activity output (activity driver).

For example, the supervising activity is consumed by the following primary

activities: treating patients, providing hygienic care, responding to patient requests,
and monitoring patients. The three products—intensive care patients, intermediate
care patients, and normal care patients - in turn, consume the primary activities.

Assigning Costs to Activities

After identifying and describing activities, the next task is determining how much it
costs to perform each activity. The cost of an activity is simply the cost of the
resources consumed by each activity.

Activities consume resources such as labor, materials, energy, and capital:

 The cost of these resources is found in the general ledger, but how much is
spent on each activity is not revealed.
 Resource costs must be assigned to activities using direct and driver tracing.
 For labor resources, a work distribution matrix is often used. A work
distribution matrix simply identifies the amount of labor consumed by each
activity and is derived from the interview process (or a written survey).

Interviews, survey forms, questionnaires, and timekeeping systems are examples of

tools that can be used to collect data on resource drivers.

Assigning costs to activities completes the first stage of activity-based costing:

 In this first stage, activities are classified as primary and secondary.

 If there are secondary activities, then intermediate stages exist. In an
intermediate stage, the cost of secondary activities is assigned to those
activities (or other intermediate cost objects) that consume their output.

Once the costs of primary activities are determined, these costs can then be
assigned to products or other cost objects in proportion to their usage of the
activity, as measured by activity drivers.

However, before any assignment is made, the cost objects must be identified and
the demands these objects place on the activities must be measured. Many
different cost objects are possible: products, materials, customers, distribution
channels, suppliers, and geographical regions are some examples.

Classifying Activities or Activity Drivers or Levels of Costs

In ABC, the bases used to allocate overhead costs are called drivers. A resource
driver is a base used to allocate the cost of a resource to the different activities
using that resource. The name resource driver is new, but the idea is not.
For example:

 Most traditional accounting systems allocate some plant-wide costs to

departments based on each department’s number of employees or square
footage occupied. Square footage and number of employees are called
allocation bases in that context.
 If an ABC system allocates the cost of a resource to several activities based
on the square footage or number of employees devoted to each activity, then
square footage and number of employees are called resource drivers.

An activity driver is a base used to allocate the cost of an activity to products.

Customers, or other final cost objects. The word final refers to the last step in cost
allocation, the nature and variety of activity drivers is what distinguishes ABC from
traditional costing.

ABC recognizes activities, activity costs, and activity drivers at different levels of
aggregation within a production environment. The four levels commonly identified
are the unit, batch, product, and organizational or facility or plant. Figure 4–9
provides examples of activities, costs, and activity drivers at each of these four
levels.

Figure 4-9: Examples of Activities, Costs and Activity Drivers Based on

Four Levels

Levels and Examples of Activities, Costs, and Activity Drivers

Unit Batch Product Organization/Factory/
Plant
Examples of activities
Cutting Scheduling designing Heating
Soldering setting up developing Lighting
Painting Blending prototyping Cooling
Assembling Moving advertising Providing security
Packaging warehousing

Example of Costs
portions of salaries of salaries of depreciation
electricity and schedulers, designers and insurance
indirect setup programmers taxes on buildings
materials personnel, or advertising fees
material costs of patents
handlers

Examples of Activity Drivers

units or number of number of square footage
pounds batches, products, occupied
of output setups, design.
direct labor material changes, or
hours moves, or design hours
machine production
hours orders

The different levels are simply different degrees of data aggregation:

 A batch is the sum, or aggregation, of the identical units that make it up.
 A product is an aggregation of many batches.
 A plant can be thought of as an aggregation of all its products.
Persons who have studied mathematics will recognize the level of aggregation as
being parallel to the concept of a subset: a unit is subset of batch; a batch is a
subset of the total output of a product; a product is a subset of the total output of a
plant.

To help identify activity drivers and enhance the management of activities,

activities are often classified into one of the following four general activity
categories:

1. unit-level,
2. batch-level,
3. product-level, and
4. organizational or facility or plant-level

Classifying activities into these general categories facilitates product costing

because the costs of activities associated with the different levels respond to
different types of activity drivers.

Activity-based costing systems improve product costing accuracy by recognizing

that many of the so-called fixed overhead costs vary in proportion to changes other
than production volume. Level classification also provides insights concerning the
root causes of activities and thus can help managers in their efforts to improve
activity performance.

By understanding what causes these costs to increase or decrease, they can be

traced to individual products

These broader-based activity levels have successively wider scopes of influence on

products and product types. The categories are classified as batch, product or
process, and organizational or facility levels. Examples of the kinds of costs that
occur at the various levels are given in Exhibit 4-10.

Unit-level activities/drivers are measures of activities that that are performed

each time and vary with the number of units produced and sold. They are only costs
that always can be assigned accurately in proportion to volume. All unit-level
drivers are proportional to the volume of output; they are the only volume-related
allocation bases used in ABC. Drivers at all the other levels are not necessarily
proportional to volume.

Examples:
 grinding, polishing, and assembly are examples of unit-level activities.
 unit-level drivers/activities are direct labor hours, direct labor cost, machine
hours, direct material weight, direct material cost, direct material pieces,
total prime costs, total direct costs, and units produced. All of those examples
are also used as overhead allocation bases in traditional (non-ABC) costing
systems.
 unit-level costs include electricity cost of electrically powered machinery is
used in producing each unit, heating costs if each unit is heat-treated, and
inspection labor if each unit requires inspection. These costs are purely
variable and theoretically can be treated as direct costs but usually are
accounted for as indirect costs. Technically, direct materials and direct labor
 fit the definition of unit-level costs, but because ABC is a system for assigning
indirect costs, assignment of direct material and direct labor costs are
outside the subject matter of ABC. Apart from the question of unit-level costs
however, direct labor dollars and direct material dollars are good examples of
unit-level drivers.

Figure 4-10: Level of Costs

Classification Type of Necessity of Cost

Levels Costs
o Direct material Once for each unit
o Direct labor produced
Unit-Level Costs o Some machine costs,
if traceable

o Purchase order Once for each batch

o Setup produced
o Inspection
Batch-Level Costs o Movement
o Scrap, if related to
the batch

o Engineering change Supports a product type or

orders a process
o Equipment
Product/Process maintenance
Level Costs o Product development
o Scrap, if related to
product design

o Engineering change Supports the overall

Organizational or orders production or service
Facility or Plant o Equipment process
Level Costs maintenance
o Product development
o Scrap, if related to
product design

The distinctions between batch- and unit-level costs are not lost when a batch
consists of one unit. Batch-level costs still are those that would not increase if one
or more units were added to the batch.

Batch-level costs are influenced by the number of batches, independent of the

number of units. Producing another unit does not necessarily require another batch.
Similar distinctions exist among all four levels of costs.

Batch-level activities/drivers are measures of activities that that are performed

each time and vary with the number of batches produced and sold. The costs of
batch-level activities vary with the number of batches but are fixed (and, therefore,
independent) with respect to the number of units in each batch.

Examples:
 Setups (setup costs, setup hours), receiving and inspection (inspection costs,
inspection hours if done by sampling units from a batch), production or work
 orders and purchasing orders, and materials requisition and handling
(handling costs)

If the first unit produced in each batch is inspected, this in process inspection cost is
a batch-level cost. Significant batch-level costs also exist outside the production
function.

Examples:
 if a product is not kept in stock but instead a batch is produced for each
customer order, then batch-level costs include some marketing and
administrative costs of accounting and billing.

Product-level activities/drivers are those activities performed wherein costs

incurred to support the number different or various products of a company to be
produced and sold. These activities and their costs tend to increase as the number
of different products increases. They are not necessarily influenced by the
production and sale of one more batch or one more unit.

Examples:
 product design or engineering changes (to products), design hours, and the
number of different kinds of parts needed (called “number of part numbers”)
 developing product-testing procedures, introducing new products, and
expediting goods are examples of product-level activities. They are not
necessarily influenced by the production and sale of one more batch or one
more unit.
 product prototyping, and production engineering. If workers need additional
training before producing a particular product, then the cost of this training is
a product-level cost. If special tools are needed in producing a particular
product, or if some machinery is used exclusively for one product, then the
costs of such tooling and machinery are product-level costs. If some materials
are unique to one product and are not ordered separately for each batch
produced, then the costs of procuring, receiving, and inspecting those
materials are product-level costs.

Significant product-level costs also can exist outside the factory.

Examples:
 the costs of patents, market research, and product promotions are product-
level costs
 product-level cost in a service business is a consulting firm’s cost of acquiring
new computer software to provide a new kind of service to clients.

Organizational or facility or plant--level activities/drivers are those that

sustain a factory’s general manufacturing processes. Several levels of costs and
drivers can exist above the product level.

These include the product line level, process level, department level, and plant
level.

Most applications of ABC recognize only one of these, organizational or facility the
plant level. Floor space occupied is referred to often as the organizational or facility
or plant-level driver for assigning plant-level costs.
However, this stretches the idea of a driver, because it is rare that the total floor
space devoted to each product or unit can be identified. A notable exception is
found in some factories subdivided into work cells or sub-plants.

This subdivision is sometimes called single product, then the fraction of the total
plant floor space occupied by that cell can be assigned unambiguously to that
product, along with that same fraction of total plant-level costs.

In most cases, assignment of plant-level costs to products, batches, or units is an

arbitrary allocation. Even in ABC systems, plant-level costs often are allocated to
output using unit-level allocation bases, despite the fact that plant-level costs are
very different from unit-level costs.

Examples:
 unit-level measures used to allocate plant-level costs to products in ABC are
total conversion costs (also called value added), the number of units and total
direct costs.
 depreciation, property taxes, and insurance of the factory building.
 providing facilities, maintaining grounds, and providing plant security

Two-Stage/Step Cost Allocation

The basic approach in product costing is to allocate costs in the cost pools to the
individual cost objects, which are the products or services of interest. Assign, or
allocate, these costs to the individual cost objects by using appropriate cost
allocation bases or cost drivers. Cost pools and cost drivers should be considered.

The two-stage approach allowed us to separate plant, or manufacturing, overhead

into two or more cost pools based on the account in which the costs were recorded.

1. The first-stage, activity cost pools are formed when resource costs are
allocated to activities based on resource drivers. Costs having the same
driver/activity are accumulated in pools reflecting the appropriate level of
cost incurrence (unit, batch, or product or process). Overhead costs have to
be assigned to the two or more intermediate cost pools/drivers. Cost objects
are the overhead accounts, such as supplies, depreciation, and so
on.
The allocation in the first stage, although simple, allowed us then to select
multiple cost pools/drivers— direct labor costs (labor-related) and machine-
hours (machine-related), for example—that were used to allocate costs to
products.
2. The second stage, costs of activities are allocated from activity cost pools to
products or other final cost objects. Grouped overhead accounts with similar
patterns of variability into first-stage cost pools that could be allocated to
products using a common cost driver. Another common choice is to use
departments within the plant.
After accumulation, costs are allocated out of the activity center cost pools
and assigned to products and services by use of a second type of activity
driver. Overhead costs from each of the intermediate cost pools/drivers are
allocated to the products using a specified allocation base.
Figure 4.12 is a cost flow diagram that shows how this is done.
Reducing the Size and Complexity of an ABC System
In principle, ABC requires an activity rate for each activity. An organization may
have hundreds of different activities and, thus, hundreds of activity rates. Although
information technology certainly is capable of handling this volume, there is merit
to reducing the number of rates if it can be done without suffering a significant
decrease in the accuracy of the cost assignments. After all, increased accuracy of
cost assignments is the source of the decision benefits and the justification for using
ABC.
Figure 4-11: Determining Product Profitability and Company Profit

Product Unit Selling Price × Product Unit Volume = Total product revenue (1)

UNIT-LEVEL COSTS Allocate over Cost

 Direct material number of units per
 Direct labor produced unit
 Machine energy

BATCH-LEVEL COSTS
 Machine setup
 Purchasing/ Allocate over Cost per
ordering number of units unit in
 Material handling in batch batch

+
Allocate over
PRODUCT/
PROCESS-LEVEL number of units
COSTS expected to be Cost per
Engineering changes produced in unit in
Product development
related product product
Product design line
line

=
Total product
cost per unit
Total Product Cost per Unit × Product Unit Volume = Total product cost (2)
Total product revenue (1 above) -
Total product cost (2 above)
= Net product
margin
± All other net product
margins*
ORGANIZATIONAL-or FACILITY-
LEVEL or
PLANT-LEVEL COSTS**
 Corporate/divisional
administration
 Facility/Plant
depreciation
 -

= Company profit or loss

*Calculations are made for each product line using the same method as above.
**Some of these costs may be assignable to specific products or services and would be
included in determining product cost per unit.
Figure 4-12: Tracing Costs in an Activity-Based Costing System

COST INITIALLY
COST DRIVER ACTIVITY DRIVER
RECORDED ACTIVITY
(Used to assign (Used to assign
(By department and CENTER COST COST OBJECTS
costs to cost costs to cost
general ledger POOL
pools) objects)
accounts) Number of setups
Number of setups
₱ Setup Cost hours

Overhead Number of Processing time

Pesos Machine Power
Consumed machine runs Cost per unit

Square footage Storage time per

Warehouse
of occupied square foot
Cost occupied
space
resulting from

Individual
products
Value- Non-Value-
added added
activities activities

Work to eliminate or reduce

Figure 4-13: Cost Flow Diagram: Two-Stage Cost Allocation System

Cost Manufacturing
Direct Materials Direct Labor
pools overhead

First stage
Direct Direct
costs costs
Machine-related Direct labor-
Cost allocation costs related costs
rule
 Indirect costs Indirect
(allocated by costs
machine (allocated
hours) by direct
Second
stage

Cost
objec
ts C-888s C-999s
Figure 4-14: Two-Stage Cost Allocation: First-Stage Allocation to
Departments
Manufacturing
overhead

First stage

Department 1 Department 2
(e.g. fabrication) (e.g. assembly)
Cost driver 2
Cost driver 1
Second (e.g. labor-
(e.g. machine-
hours, labor
hours)
costs)

Products

Grouped overhead accounts with similar patterns of variability into first-stage cost
pools that could be allocated to products using a common cost driver; however, we
are not limited to this choice. Another common choice is to use departments within
the plant.

In Figure 4–11 illustrates how costs collected at the unit, batch, and product/process
levels can be used to generate a total product cost. Each product cost would be
multiplied by the number of units sold and that amount of cost of goods sold would
be subtracted from total product revenues to obtain a product line profit or loss
item.

These computations would be performed for each product line and summed to
determine net product income or loss from which the unassigned organizational
level costs would be subtracted to find company profit or loss for internal
management use. In this model, the traditional distinction between product and
period costs can be and is ignored.

The emphasis is on refining product profitability analysis for internal management

purposes, rather than for external financial statements. Because the product/period
cost distinction required by generally accepted accounting principles is not
recognized, the model presented in Figure 4–11 is not currently acceptable for
external reporting.

Comparison of ABC and Traditional Costing

The costs of the products under the ABC and are different from the costs computed
under the old traditional costing system. Following are the differences:

Activity-based Costing (ABC) Traditional Costing

Collection of Notice that any ABC systems Regardless of the number of
financial and necessarily uses multiple overhead different departments, overhead
operational cost pools, but not every multiple- cost pools and allocation bases
data pool system is an ABC system. For used, traditional costing systems
example, a florist shop might cost are characterized by their
its floral arrangements by exclusive use of volume-related,
separately calculating the per- or unit-level, measures as bases
 minute costs of cutting, arranging, for allocating overhead to output.
and decorating. For this reason, traditional
systems are also called unit-
based systems.

Activity driver The number of overhead cost pools Traditional systems used a single
/ cost pool and allocation bases tends to be cost pool or a single based for all
higher in ABC systems cost pools
ABC attaches costs to products
based on the activities (cost
drivers) performed to produce,
distribute, or support those
products.
This distinction is not universal. A system can use very large numbers of overhead cost
pools and allocation bases, but if all the bases are at the unit level, the system is a
traditional, unit-based system.
Homogeneity ABC requires both calculating an Same cannot be said of most
of costs activity cost pool and identifying an traditional systems
within an activity driver for each significant,
activity driver costly activity. The usual result is
/ cost pool that all the costs within an activity
cost pool are very much alike in
their logical relationship to the
activity driver
Cost All ABC systems are two-stage Traditional systems maybe one-
allocation (step) costing systems or two-stage. uses two stages
only if departments or other cost
centers are created. Resource
costs are allocated to cost centers
in the first stage and are then
allocated from the cost centers to
products in the second stage.
Some traditional systems are
single-stage because they do not
use separate cost centers, but
there is no such thing as a single-
stage ABC system.
Selection of ABC systems can use a large Traditional costing system
activity number of activity cost pools and identified only the total of all
drivers many different activity drivers overhead and allocated it based
on one activity

Illustrative Example 4-2: ABC Costing Versus Traditional/Conventional

Costing

Factory Maintenance Department: The company’s conventional/traditional system

assigns the personnel costs of this department to products using direct labor hours
(DLHs); the department has 10 employees and incurred P1,880,000 of factory
personnel costs in the current year or P188,000 per employee. Expected/budgeted
DLHs are 25,000.
Stage 1: Trace costs from general ledger and subsidiary ledger accounts to
activity center pools according to number of employees:
 Quality machine control – uses 5 employees; P1,000,000 is allocated to this
 activity center; second stage allocation is based on machine hours (MH)
 Setups – uses 3 employees; P540,000 is allocated to this activity; second-stage
allocation to be based on number of setups (SU)
 Materials handling – uses 2 employees; P340,000 is allocated to this activity;
second stage allocation is based on pounds (LBS) of materials used
Stage 2: Allocate activity center cost pools to products using cost drivers
chosen for each cost pool. Expected/budgeted activity of second-stage
drivers:
10,000 hours machine hours;
2,000 setups,
1,000 pounds
Step Allocate cost per unit of activity of second-stage cost drivers
1:
Quality Machine Setups Materials handling
Control
Expected OH Costs P 1,000,000 P 540,000 P 340,000
Divided by:
Expected/Budget
ed 10,000 MH 2,000 SU 1,000 lbs
activity drivers
OH Cost per P 100 per MH P 270 per P 340 per lb
activity SU
Step Allocate costs to products using quantity of second-stage cost drivers
2: consumed in making these products based on Product ReSA: 8,000 MHs;
1,800 SU; 750 lbs. and 12,000 DLHs. Four thousand (4,000) units were
manufactured during the year.

Traditional/Conventional Allocation to Product ReSA

Costs
Estimated/budgeted overhead (personnel) P 1,880,000
…………………………..
Divided by: Expected/budgeted 25,000
DLH…………………………………
Factory overhead per P 75.20
DLH……………………………………………..
Multiplied by: Number of actual 12,000
DLH………………………………..
Total allocated factory overhead P 902,400
costs……………………………….
Divided: Number of Units 4,000
Produced………………………………….
Cost per P 225.60
unit………………………………………………………………

Activity-Based Costing Allocation to Product ReSA

Quality Machine Setups Materials handling
Control
OH Cost per P 100 per MH P 270 per P 340 per lb
activity SU
Multiplied by:
Actual activity 8,000 MH ___1,800 SU _____750 lbs.
ABC Allocation to
Product ReSA P800,000 P 486,000 P 255,000
 Costs
Quality Machine Control………………………………………………. P 800,000
Setups…………………………………………………………………….. 486,000
Materials handling……………………………………………………… 255,000
Total allocated factory overhead P 1,541,000
costs……………………………….
Divided: Number of Units 4,000
Produced…………………………………
Cost per unit…………………………………………………………….. P 385.25

Strengths and Weaknesses of ABC

ABC produces more credible product cost information but is nonetheless a system
of allocation.

Particularly for:
 Plant-level costs, ABC has little or no advantage over traditional costing. All
product costing systems arbitrarily allocate plant-level costs to products.
Further, in a year of low volume both ABC and traditional costing report
higher unit costs.

A partial solution to this problem is simply to allocate no plant-level costs to

products, batches, or units, and instead to treat plant-level costs as period
costs. Direct (variable) costing offers a similar solution, in which fixed costs
are treated as period costs. However, the fixed costs in direct costing
typically include much of the cost that ABC identifies at the batch- and
product-level activities. Traditional absorption costing allocates these costs
using unit-level allocation bases that can distort product costs. Direct costing
treats them as period costs with the result that they are never assigned at all
to products, batches, or units. ABC is conceptually superior to both systems,
because management has the option of viewing ABC’s plant-level costs as
period costs but can still allocate to products their shares of batch- and
product-level costs.

 ABC shows how much batch-level and product-level activity is devoted to

each product, not how much less money will be spent if fewer products or
bathes are produced. If ABC shows a low-volume product is a money-loser,
the entire loss cannot be avoided by discontinuing the product because some
costs assigned to the product may not be avoidable.

 Finally, ABC requires data-gathering efforts beyond those needed to satisfy

external reporting requirements. Traditional costing systems are sufficient for
financial and tax reporting, so new systems such as ABC must be justified by
the benefits they generate. In companies with a long history of success in
relying on traditional costing, it can be hard to convince management that a
new costing system is needed.

A solution to this final problem is to continue with the familiar traditional

system and experiment with ABC separately, using it initially for only one
product line, one facility, or one category of costs such as the costs of service
departments. If important new insights are gained from the experiment,
managers may become convinced that ABC deserves wide application.
 Note also that it is not necessary to replace the traditional system with ABC
to get ABC’s benefits. Both systems can be operated, the traditional system
for financial and tax reporting and ABC for occasional special studies

Criticisms of ABC

Activity-based costing, although it typically provides better information than was

generated under the traditional overhead allocation process, is not a solution for
all managerial concerns. The following are some of this method’s
shortcomings:

 First, ABC requires a significant amount of time and, thus, cost to implement.
If implementation is to be successful, substantial support is needed
throughout the firm. An environment for change must be created that
requires overcoming a variety of individual, organizational, and
environmental barriers.

Individual barriers are typically related to (1) fear of the unknown or shift in
status quo, (2) potential loss of status, or (3) a necessity to learn new skills.

Organizational barriers are often related to “territorial,” hierarchical, or

corporate culture issues. Environmental barriers are often built by employee
groups (including unions), regulatory agencies, or other stakeholders of
interest. To overcome these barriers, a firm must first recognize that these
barriers exist; second, investigate their causes; and, third, communicate
information about the “what,” “why,” and “how” of ABC to all concerned
parties. Top management must be involved with and support the
implementation process. Lack of commitment or involvement by top
management will make any meaningful progress slow and difficult.
Additionally, employees and managers must be educated in some
nontraditional techniques that include new terminology, concepts, and
performance measurements.

 Another problem with ABC is that it does not conform specifically with
generally accepted accounting principles (GAAP). ABC would suggest that
some non-product costs (such as those in research and development) be
allocated to products, whereas certain other traditionally designated product
costs (such as factory building depreciation) not be allocated to products.

Therefore, most companies have used ABC for internal reporting, while
continuing to maintain their general and subsidiary ledger accounts and
prepare their external financial statements on the basis of a more
“traditional” system—requiring two product costing systems and causing
even more costs to be incurred. As ABC systems become more widely
accepted, more companies may choose to refine how ABC and GAAP
determine product cost to make those definitions more compatible and,
thereby, eliminate the need for two costing systems.

 One final criticism that has been leveled at activity-based costing is that it
does not promote total quality management (TQM) and continuous
improvement.
 Companies attempting to implement ABC as a cure-all for product failures,
volume declines, or financial losses will quickly recognize. However,
companies can implement ABC and its related management techniques in
support of and in conjunction with TQM, JIT, or any of the other world-class
methodologies. Companies doing so will provide the customer with the best
variety, price, quality, service, and lead time of which they are capable. Not
coincidentally, they should find their businesses booming.

Attribute-Based Costing (ABC II), an extension of activity-based costing,

employs detailed cost–benefit analyses relating to information on customer needs
(in terms of performance attributes of a product such as reliability, durability,
responsiveness, and so forth) and the costs of the incremental improvements
necessary to obtain these attributes.

ABC II employs planned costs rather than past costs because, as discussed
earlier, such a high percentage of a product’s life-cycle costs are locked-in
during the product’s development stage. The approach focuses on satisfying
customer needs by searching for the optimum enhancement of customer utility
through comparisons of alternatives for attribute enhancements relative to the
costs of producing those enhancements

Duration-Based Costing (DBC), is a before-the-fact simplification method that

eliminates the need for Stage 1 of ABC and dramatically simplifies Stage 2. In fact,
DBC is a simple as a traditional unit-based costing approach but has the same
accuracy as a comprehensive ABC system that uses duration-based drivers.

The cost assignment under DBC requires four items of information:

1. the cycle for time each product (cost object);
2. the practical capacity for each product;
3. the total overhead cost; and
4. the total time of all primary activities.
The first three items are observable and found within an organization’s cost
accounting information system. Total time of all primary activities is derived from
the cycle time and practical capacity for each product.

Cycle time is the length of time required (in hours) to produce one unit of product
(time/units). Every activity consumed by a product contributes to its cycle time.
Thus the expected total time (hours) spent with primary activities for a single
product.

Before-the-Fact Simplification: TDABC

Time-Driven Activity Based Costing (TDABC) is a before-the-fact simplification

method that simplifies Stage 1 by eliminating the need for detailed interviewing and
surveying to determine resource drivers. Activities still must be identified.

However, TDABC assigns resource costs to activities in a very simple and

straightforward way:

 First, it calculates the total operating cost of a department or process for

supplying resource capacity (cost of all resources such as equipment,
personnel, materials, etc.).
  Second, it calculates a capacity cost rate by dividing the total resource cost
by the practical capacity (as measured by resource time used in the
department) of the resources supplied:
Capacity cost rate = Cost of resources supplied/Practical capacity of resources applied

 Third, it estimates the time to perform one unit of activity. One unit of activity
is one unit of an activity driver; thus, multiplying the capacity cost rate by the
time to perform one unit of activity and then by the total activity output (as
measured by the activity driver) yields the activity cost:
Activity cost
= Capacity cost rate × Time to perform one unit of activity
× Total activity output
= Activity rate × Total activity output

In practical terms, the resource cost can be driven directly to products without
formally calculating the activity cost. Since by multiplying the capacity cost rate by
the time it takes to perform one unit of activity yields the activity rate, resource
costs can be assigned to individual products by simply multiplying the activity rate
by the amount of activity consumed by each product.