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26

Cost Allocation and Activity-Based

Costing

Student Version

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1

Identify three methods used for allocating factory overhead costs to products.

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Most companies have accounting systems that trace revenues to individual product lines. In addition, they need to subtract the cost of manufacturing their product from revenues in order to determine the profit from sales. Determining the cost of the product is termed product costing.

Product Costing

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Product Costing Allocation Methods

1

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2

Use a single plantwide factory overhead rate for product costing.

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Ruiz Company Illustration

Ruiz Company manufactures two products, snowmobiles and lawnmowers. Both products are manufactured in a single factory. There is $1,600,000 of factory overhead budgeted for the period.

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2

Ruiz Company Illustration

Each product is budgeted 10,000 direct labor hours as shown below:

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Total budgeted factory overhead costsTotal budgeted plantwide allocation

base

Computing Single Plantwide Factory Overhead

$80 per direct labor hour=

$1,600,00020,000 direct labor hours

(1,000 × 10 dlh) + (1,000 × 10 dlh)

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Snowmobile:$80 per dlh × 10 direct labor hours = $800

Lawnmower: $80 per dlh × 10 direct labor hours = $800

Factory Overhead

Cost per Unit

Factory Overhead

Cost per Unit

2

Computing Single Plantwide Factory Overhead

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3

Use multiple production department factory overhead rates for product costing.

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Production Department Factory Overhead Rates and Allocation

Fabrication Department Overhead Rate:

$1,030,00010,000 direct labor hours

= $103 per dlh

Assembly Department Overhead Rate:

$570,00010,000 direct labor hours

= $57 per dlh

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Allocating Factory Overhead to Products—Ruiz CompanyExhibit 3

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Exhibit 4Multiple Production Department Rate Method—Ruiz Company

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Distortion of Product Costs

The differences in factory overhead for each product using the two methods are shown below:

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In general, the following conditions may indicate that a single plantwide factory overhead rate will lead to distorted product costs.

Condition 1: Differences in production department factory overhead rates.

(continued)

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Condition 2: Differences among products in the ratios of allocation base usage within a department and across departments.

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Exhibit 5Conditions for Product Cost Distortion—Ruiz Company

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4

Use activity-based costing for product costing.

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The activity-based costing (ABC) method focuses on the cost of activities and then allocates these costs to products using a variety of activity bases.

Activity-Based Costing (ABC) Method

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Fabrication $ 530,000Assembly 70,000Setup 480,000Quality control inspections 312,000Engineering changes 208,000 Total budgeted factory overhead costs $1,600,000

Activity Cost PoolAmount

Ruiz Company Example

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Activity Rates

The activity cost pools are assigned to products, using factory overhead rates for each activity. These rates are called activity rates.

Activity Rate =Budgeted Activity Cost

Activity Base

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Additional Data About the Two Products

(continued)

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Additional Data About the Two Products

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Exhibit 7 Activity Bases—Ruiz Company

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Exhibit 8 Activity Rates—Ruiz Company

Snowmobile 8,000 $53 $424,000Lawnmower 2,000 53 106,000 Total 10,000 $530,000

Fabrication: DL Hours Rate Total

4

(continued)

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Snowmobile 2,000 $7 $14,000Lawnmower 8,000 7 56,000 Total 10,000 $70,000

Assembly: DL Hours Rate Total

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Exhibit 8 Activity Rates—Ruiz Company

(continued)

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Exhibit 8 Activity Rates—Ruiz Company

Snowmobile 100 $4,000 $400,000Lawnmower 20 4,000 80,000 Total 120 $480,000

Setup: Setups Rate Total

(continued)

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4

Exhibit 8 Activity Rates—Ruiz Company

(continued)

Snowmobile 100 $3,000 $300,000Lawnmower 4 3,000 12,000 Total 104 $312,000

Quality Control: Inspts. Rate Total

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4

Exhibit 8 Activity Rates—Ruiz Company

Snowmobile 12 $13,000 $156,000Lawnmower 4 13,000 52,000 Total 16 $208,000

Engineering: Changes Rate Total

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Exhibit 9Activity-Based Product Cost Calculations

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Additional Data About the Two Products

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5

Use activity-based costing to allocate selling and administrative expenses to products.

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The selling and administrative expenses of Abacus Company are allocated to its two products, Ipso and Facto, on the basis of warranty claims. Abacus Company has a budgeted cost of $150,000. One hundred warranty claims are estimated for the period.

Abacus Company Example

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Warranty Claim Activity

Rate

=

Budgeted Warranty Claim

ExpensesEstimated Warranty

ClaimsWarranty

Claim Activity Rate

=$150,000

100 claims

Warranty Claim Activity

Rate

= $1,500 per claim

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