There are three methods of overhead allocation
1. The single plant wide overhead rate method (as discussed in Chapter 2) Single overhead rate = Total budgeted overhead for the plant / Total budgeted base With base being direct labor cost, direct labor hours or machine hours 2. The departmental overhead rate method
Each department will calculate its own overhead rate based on department’s overhead and its own base 3. The activity-based costing method.
Overhead rate is calculated base on each activity or task.
Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities.
Let’s look at two products manufactured by the same company. Product 123 is a low volume item which requires certain activities such as special engineering, additional testing, and many machine setups because it is ordered in small quantities. A similar product, Product 789, is a high volume product—running continuously—and requires little attention and no special activities. If this company used traditional costing, it might allocate or "spread" all of its overhead to products based on the number of machine hours. This will result in little overhead cost allocated to Product 123, because it did not have many machine hours. However, it did demand lots of engineering, testing, and setup activities. In contrast, Product 789 will be allocated an enormous amount of overhead (due to all those machine hours), but it demanded little overhead activity. The result will be a miscalculation of each product's true cost of manufacturing overhead. Activity based costing will overcome this shortcoming by assigning overhead on more than the one activity, running the machine.
Activity based costing recognizes that the special engineering, special testing, machine setups, and others are activities that cause costs-they cause the company to consume resources. Under ABC, the company will calculate the cost of the resources used in each of these activities. Next, the cost of each of these activities will be assigned only to the products that demanded the activities. In our example, Product 123 will be assigned some of the company's costs of special engineering, special testing, and machine setup. Other products that use any of these activities will also be assigned some of their costs. Product 789 will not be assigned any cost of special engineering or special testing, and it will be assigned only a small amount of machine setup.
Activity based costing has grown in importance in recent decades because: (1) manufacturing overhead costs have increased significantly, (2) the manufacturing overhead costs no longer correlate with the productive machine hours or direct labor hours, (3) the diversity of products and the diversity in customers' demands have grown, and (4) some products are produced in large batches, while others are produced in small batches.
Example of ABC
Let’s take a look at a product with just two common manufacturing activities: (1) the setting up of a production machine for running batches of products, and (2) the actual production of the units of product.
Let’s assume that a company has annual manufacturing overhead costs of $2,000,000—of which $200,000 is directly involved in setting up the production machines. During the year the company expects to perform 400 machine setups. Let’s also assume that the...