The cost object of the plantwide overhead rate method is

Activity-Based Costing and Analysis

Chapter 17

Wild and Shaw

Financial & Managerial Accounting

8th Edition

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Chapter 17 Learning Objectives

CONCEPTUAL

C1 Distinguish between the plantwide overhead rate method, the departmental overhead rate method, and the activity-based costing method.

C2 Explain cost flows for activity-based costing.

C3 Describe the four types of activities that cause overhead costs.

ANALYTICAL

A1 Identify and assess advantages and disadvantages of the plantwide overhead and departmental overhead rate methods.

A2 Identify and assess advantages and disadvantages of activity-based costing.

PROCEDURAL

P1 Allocate overhead costs to products using the plantwide overhead rate method.

P2 Allocate overhead costs to products using the departmental overhead rate method.

P3 Allocate overhead costs to products using activity-based costing.

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Distinguish between the plantwide overhead rate method, the departmental overhead rate method, and the activity-based costing method.

Learning Objective C1

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Assigning Overhead Costs (1 of 2)

Goods in Process

Cost of Goods Sold

Labor

Materials

Indirect

Indirect

Finished Goods

Factory Overhead

Direct

Direct

Allocate

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Learning Objective C1: Distinguish between the plantwide overhead rate method, the departmental overhead rate method, and the activity-based costing method.

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Product cost consists of direct materials, direct labor, and overhead (indirect costs). Because direct materials and direct labor can be traced to units of output, assigning these costs to products is straightforward.

Overhead costs, however, are not directly related to production and cannot be traced to units of product like direct materials and direct labor can. We must use an allocation system to assign overhead costs.

Assigning Overhead Costs (2 of 2)

Overhead can be assigned to production in one of three ways:

Single plant-wide overhead rate

Departmental overhead rates

Activity-based costing

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Learning Objective C1: Distinguish between the plantwide overhead rate method, the departmental overhead rate method, and the activity-based costing method.

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There are three methods of overhead allocation: the single plantwide overhead rate method; the departmental overhead rate method; and the activity-based costing method.

Alternative Methods of Overhead Allocation

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Exhibit 17.1

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Learning Objective C1: Distinguish between the plantwide overhead rate method, the departmental overhead rate method, and the activity-based costing method.

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The plantwide overhead rate method and the departmental overhead rate method use volume-based measures such as direct labor hours or machine hours to allocate overhead costs to products. The plantwide method uses a single rate and the departmental rate uses at least two rates.

Activity-based costing focuses on activities and their costs. Rates based on these activities are used to assign overhead to products in proportion to the amount of activity required to produce them. Activity-based costing typically uses more overhead allocation rates than the plantwide and departmental methods.

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Allocate overhead costs to products using the plantwide overhead rate method.

Learning Objective P1

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Plantwide Overhead Rate Method

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Learning Objective P1: Allocate overhead costs to products using the plantwide overhead rate method.

Exhibit 17.2

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For this method, the target of the cost assignment, or cost object, is the unit of product. The overhead rate is determined using a volume-related measure such as direct labor hours or machine hours, which are readily available in most manufacturing settings.

Under the single plantwide overhead rate method, total budgeted overhead costs are divided by the chosen allocation base, such as total direct labor hours, to arrive at a single plantwide overhead rate. This rate then is applied to assign overhead costs to all products based on their actual usage of the allocation base.

Let’s look at the Exhibit 17.3 and Exhibit 17.4 as an example.

Plantwide Overhead Rate Method Illustration (1 of 4)

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Exhibit 17.3

Learning Objective P1: Allocate overhead costs to products using the plantwide overhead rate method.

Exhibit 17.4

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Let’s look at an example. KartCo. manufactures two models of go-karts, standard and custom. They use a plantwide rate and use direct labor hours as the allocation base To calculate total direct labor hours, multiply the number of product units by direct labor hours per unit per product. Kartco’s budgeted overhead cost consists of indirect labor costs of $4,000,000 and factory utilities of $800,000 for a total of $4,800,000. This number will also be needed to calculate the plantwide overhead rate.

Plantwide Overhead Rate Method Illustration (2 of 4)

Plantwide overhead rate

=

Total budgeted overhead costs

Total budgeted DLH

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Learning Objective P1: Allocate overhead costs to products using the plantwide overhead rate method.

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Plantwide overhead rate is equal to total budgeted overhead cost divided by total budgeted direct labor hours.

Plantwide Overhead Rate Method Illustration (3 of 4)

Plantwide overhead rate

=

$4,800,000

100,000 DLH

=

$48/DLH

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Overhead allocated to each unit produced =

$48 × DLH per unit

Learning Objective P1: Allocate overhead costs to products using the plantwide overhead rate method.

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Dividing $4,800,000 by 100,000 hours gives us a plant overhead rate of $48 per DLH (direct labor hour). This plantwide overhead rate is then used to allocate overhead cost to products based on the number of direct labor hours required to produce each unit as follows.

Overhead allocated to each product unit = Plantwide overhead rate × DLH per unit.

Plantwide Overhead Rate Method Illustration (4 of 4)

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Learning Objective P1: Allocate overhead costs to products using the plantwide overhead rate method.

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Using the overhead rate of $48 per direct labor hour KartCo can determine the amount of factory overhead to allocate to each go-kart. They can then use this information to determine the total unit cost of each go-kart.

Allocate overhead costs to products using the departmental overhead rate method.

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Learning Objective P2

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Departmental Overhead Rate Method

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Learning Objective P2: Allocate overhead costs to products using the departmental overhead rate method.

Exhibit 17.6

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Exhibit 17.6 shows a four-step process for allocating costs under the departmental overhead rate method.

Assign overhead costs to departmental cost pools.

Select an allocation base for each department.

Compute overhead allocation rates for each department.

Use departmental overhead rates to assign overhead costs to cost objects (products).

The departmental overhead rate method uses several departments and several overhead rates. This allows each department to have its own overhead rate and its own allocation base.

Departmental Overhead Rate Method: First Step

Overhead Cost

$4,800,000

Machining Dept.

$4,200,000

Assembly Dept.

$600,000

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Learning Objective P2: Allocate overhead costs to products using the departmental overhead rate method.

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Let’s return to KartCo and calculate their departmental overhead rates. KartCo has two production departments, machining and assembly.

The first step requires that KartCo assign its $4,800,000 overhead cost to its two production departments. KartCo determines that $4,200,000 of its overhead costs are traceable to its machining department and the remaining $600,000 are traceable to its assembly department.

Departmental Overhead Rate Method: Second Step (1 of 2)

Product 1

Product 2

Product 3

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Machining Dept.

Overhead Rate based on machine hours (MH)

Assembly Dept.

Overhead Rate based on direct labor hours (DLH)

Learning Objective P2: Allocate overhead costs to products using the departmental overhead rate method.

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The second step requires each department to determine an allocation base. For KartCo, the Machining Department uses machine hours (MH) to allocate its overhead and the Assembly Department uses direct labor hours to allocate its overhead.

Departmental Overhead Rate Method: Second Step (2 of 2)

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Learning Objective P2: Allocate overhead costs to products using the departmental overhead rate method.

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Here is the budgeted departmental information about KartCo’s machining and assembly departments. They will be using machine hours as the allocation base in Machining, and direct labor hours in Assembly.

Departmental Overhead Rate Method: Third Step (1 of 2)

Departmental Overhead Rate

=

Total budgeted departmental overhead costs

Total amount of departmental allocation base

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Learning Objective P2: Allocate overhead costs to products using the departmental overhead rate method.

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In the third step, each department computes its own overhead rate using this formula:

Departmental overhead rate = Total budgeted departmental overhead costs / Total amount of departmental allocation base.

Departmental Overhead Rate Method: Third Step (2 of 2)

Machining Department Overhead Rate

=

$4,200,000

70,000 MH

=

$60/MH

Assembly Department Overhead Rate

=

$600,000

30,000 DLH

=

$20/DLH

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Learning Objective P2: Allocate overhead costs to products using the departmental overhead rate method.

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For KartCo, it’s departmental overhead rates are computed as follows:

Machining department overhead rate = $4,200,000 / 70,000 MH = $60 per MH

Assembly department overhead rate = $600,000 / 30,000 DLH = $20 per DLH

Departmental Overhead Rate Method: Fourth Step

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Learning Objective P2: Allocate overhead costs to products using the departmental overhead rate method.

Exhibit 17.7

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Exhibit 17.8

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Step 4 applies overhead costs to each product using departmental overhead rates. Because each standard go-kart requires 10 MH from the Machining Department and 5 DLH from the Assembly Department, the overhead cost allocated to each standard go-kart is $600 from Machining Department (10 MH × $60/MH) and $100 from the Assembly Department (5 DLH × $20/DLH). The same procedure is applied for its custom go-kart. Next, we can compare the allocated overhead costs for standard and custom go-karts under the single plant wide overhead rate and the departmental overhead rate methods. The overhead cost allocated to each standard go-kart decreased from $720 under the plant wide overhead rate method to $700 under the departmental overhead rate method, whereas overhead cost allocated to each custom go-kart increased from $1,200 to $1,300. These differences occur because the custom go-kart requires more hours in the machining department (20 MH) than the standard go-kart requires (10 MH).

Identify and assess advantages and disadvantages of the plantwide overhead and departmental overhead rate methods.

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Learning Objective A1

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Plantwide Overhead Rate Method Advantages and Disadvantages

Advantages

Information is readily available

Easy to implement

Consistent with GAAP and can be used for external reporting

Disadvantages

With many different products, assumptions may not be reasonable.

Overhead costs may not bear a relationship with direct labor hours

All products may not use overhead costs in the same proportion

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Learning Objective A1: Identify and assess advantages and disadvantages of the plantwide overhead and departmental overhead rate methods.

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The usefulness of the single plantwide overhead rate depends on two assumptions: 1) overhead costs change with the allocation base such as direct labor hours; and 2) all products use overhead costs in the same proportions.

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Departmental Overhead Rate Method Advantages and Disadvantages

Advantages

More accurate overhead allocations

More refined than the plantwide overhead rate method

Disadvantages

Assumes that products are similar in volume, complexity, batch size

Assumes that departmental overhead costs are proportional to the allocation base

Can distort product costs

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Learning Objective A1: Identify and assess advantages and disadvantages of the plantwide overhead and departmental overhead rate methods.

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The departmental overhead rate method assumes that 1) different products are similar in volume, complexity, and batch size, and 2) departmental overhead costs are directly proportional to the department allocation base such as direct labor hours or machine hours.

Explain cost flows for activity-based costing.

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Learning Objective C2

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Cost Flows Under Activity-Based Costing

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Learning Objective C2: Explain cost flows for activity-based costing.

Exhibit 17.9

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Activity-based costing (ABC) attempts to more accurately assign overhead costs by focusing on activities.

The basic principle underlying activity-based costing is that activities, which are tasks, operations, or procedures, are what cause costs to be incurred. An activity cost pool is a collection of costs that are related to the same or similar activity. Pooling costs to determine an activity overhead (pool) rate for all costs incurred by the same activity reduces the number of cost assignments required.

The four basic steps to the ABC method are:

Identify activities and the overhead costs they cause.

Trace overhead costs to cost pools.

Determine activity rates.

Use the activity overhead rates to assign overhead costs to cost objects (products).

Let’s take a closer look at the four basic steps of activity based costing.

Allocate overhead costs to products using activity-based costing.

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Learning Objective P3

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Applying Activity-Based Costing

4 STEPS:

Identify activities and the costs they cause.

Trace overhead costs to cost pools.

Determine activity rates.

Assign overhead costs to cost objects (products).

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Learning Objective P3: Allocate overhead costs to products using activity-based costing.

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ABC differs from using multiple departmental rates in how overhead cost pools are identified and in how overhead cost in each pool is allocated.

This involves four steps:

1. Identify activities and the costs they cause.

2. Trace overhead costs to cost pools.

3. Determine activity rates.

4. Assign overhead costs to cost objects.

Step 1: Identify Activities and the Costs They Cause (1 of 2)

Machine setup

Machine repair

Factory

maintenance

Engineer

salaries

Assembly

line power

Heating and

lighting

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Learning Objective P3: Allocate overhead costs to products using activity-based costing.

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Step 1 in applying ABC is to identify activities and the costs they cause. This is one of the biggest challenges. This is done mainly through discussions with employees in the production departments and reviewing production activities. However, tracking too many activities makes the system cumbersome and costly to maintain. The aim of this first step is to understand actions performed in the organization that drive costs.

Step 1: Identify Activities and the Costs They Cause (2 of 2)

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Learning Objective P3: Allocate overhead costs to products using activity-based costing.

Exhibit 17.10

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Recall that a premise of ABC is that operations are a series of activities that cause costs to be incurred. Instead of combining costs from different activities into one plant wide pool or multiple departmental pools, ABC focuses on activities as the cost object in the first step of cost assignment. We are then able to trace costs to a cost object and then combine activities that are used by products in similar ways to reduce the number of cost allocations.

KartCo has total overhead cost of $4,800,000 consisting of $4,000,000 indirect labor costs and $800,000 factory utilities cost. After reviewing activities with production employees, KartCo identifies the activities and their costs as shown in Exhibit 17.10.

Step 2: Trace Overhead Costs to Activity Cost Pools (1 of 2)

Overhead Cost

Activity

Cost Pool (Craftsmanship)

Activity

Cost Pool (Setup)

Activity

Cost Pool (Design Modification)

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Activity

Cost Pool (Plant Services)

Learning Objective P3: Allocate overhead costs to products using activity-based costing.

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Step 2 in applying ABC is to assign activities and their overhead costs to activity cost pools. KartCo management assigns its overhead costs into four activity cost pools: Craftsmanship, Setup, Design modification and Plant Services

Step 2: Trace Overhead Cost to Activity Cost Pools (2 of 2)

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Learning Objective P3: Allocate overhead costs to products using activity-based costing.

Exhibit 17.11

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Exhibit 17.11 shows how KartCo’s management assigned its overhead costs into the four activity cost pools. To form cost pools we look for costs that are caused by the same activities within each activity level. For KartCo, there is only one activity driver within each activity pool, but that is not always the case. It is common to see several different activity drivers within each level of activity pool. We pool only those costs that are related to the same driver.

The exhibit above shows that $600,000 of its overhead costs are assigned to the craftsmanship activity pool, $2,000,000 to the set-up cost pool, $1,200,000 to the design modification cost pool, and $1,000,000 to the plant services cost pool. The use of cost pools reduces the potential number of overhead rates from six (one for each of its six activities) to four (one for each pool).

Step 3: Determine Activity Rates (1 of 4)

Step 3 is to compute the activity rates used to assign overhead costs to final cost objects such as products.