-Rather than use a plantwide overhead rate (POHR), many companies use departmental overhead rates with a different predetermined overhead rate in each production department. The nature of the work performed in a department will determine the department's allocation base -Ex. Overhead costs in a machining department may be allocated on the basis of machine-hours. In contrast, the overhead costs in an assembly department may be allocated on the basis of direct labor-hours
-Like POHR can often overapply or underapply overhead, departmental overhead rates will not correctly assign overhead costs ins situations where a company has a range of products and complex overhead costs. The reason is that the departmental approach usually relies on a single measure of activity as the base for allocating overhead cost to products.
-Activity based costing seeks to account for the departmental overhead rate's shortcomings. Activity-Based Costing (ABC) is a technique that attempts to assign overhead costs more accurately to products than the simpler methods discussed thus far. -Ex. If Nordstrom orders a line of women's skirts from Calvin Klein, a production order is generated, patterns are created, materials are ordered, textiles are cut to pattern and then sewn, and the finished products are packed for shipping. These activities consume resources. Ordering the appropriate materials consumes clerical time--a resource the company must pay for. In activity-based costing, an attempt is made to trace these costs directly to the products that cause them.
-Rather than a single allocation base such as direct labor-hours or machine-hours, in activity-based costing a company uses a number of allocation bases for assigning costs to products. Each allocation base in an activity-based costing system represents a major activity that causes overhead costs.
-An activity in an ABC is an event that causes the consumption of overhead resources.
-An activity cost pool is a "cost bucket" in which costs related to a particular activity measure are accumulated.
-The activity measure expresses how much of the activity is carried out and it is used as the allocation base for applying overhead costs to products and services. -Ex. The number of patients admitted is a natural choice of an activity measure for the activity admitting patients to the hospital
-An activity rate is a predetermined overhead rate in an ABC system. Each activity has its own activity rate that is used to apply overhead costs to cost objects -Ex. Setting up machines to process a batch would have its own activity cost pool. Products are ordinarily processed in batches.
Developing an ABC system - Hierarchy of Activities
Level| Activities| Activity Measures|
Unit-level| Processing units on machines
Processing units by hand
Consuming factory supplies| Machine-hours
Batch-level| Processing purchase orders
Processing production ordersSetting up equipmentHandling Material| Purchase orders processed Production orders processed
Number of setups; setup hours
Pounds of material handled; number of times material moved| Product-level| Testing new products
Administering parts inventoriesDesigning products| Hours of testing time Number of part types
Hours of design time|
Facility-level| General factory administration
Plant building and grounds| Direct labor-hours*
*Facility-level costs cannot be traced on a cause-and-effect basis to individual products. Nevertheless, these costs are usually allocated to products for external reports using some arbitrary allocation basis such as direct labor-hours
-Unit-level activities- are performed each time a unit is produced. The costs of unit-level activities should be proportional to the number of units produced. -Ex. Providing power to run processing equipment is a unit-level activity because power tends to be...