In previous posts, we discussed plantwide overhead rates and departmental overhead rates to allocate overhead costs to cost objects. Another method for applying overhead is activity-based costing (ABC).
Activity-based costing is a more precise way to allocate costs to cost objects. Plantwide rates are the easiest to apply but can cause cost distortion because all overhead resources are treated as though they are equally consumed by all cost objects. Departmental rates were more refined because at least we were breaking costs down by department and applying overhead based on the actual activity a cost object used in each department.
ABC goes one step further. Rather than just looking at each department, with ABC we are breaking down activities within the production process and calculating a rate for each activity. This allows a very refined allocation of overhead to the cost objects.
In order to use ABC, we first must identify the activities that make up the processes important to our cost object. It is important to note that ABC can be used by any type of business. Even service companies can benefit from using ABC, especially in competitive markets. Activities could include things like machine setup, inspecting, packaging, sending statements, and providing technical support.
Once the company has identified the activities, the company should identify the estimated cost of each of these activities. The cost of each activity is called an activity cost pool. These cost pools are used to accumulate costs associated with each activity.
Next, select an allocation base or activity that best acts as a driver for each activity cost pool. If machine set up is one of your activity cost pools, the allocation base could be the number of setups that will be done over the year. For inspections, it makes sense to use the number of inspections that are done. For packaging, we could use the number of items to be packaged or the cubic feet of product to be packaged. Sending statements would be based on the number of statements sent. Technical support could be based on the number of calls received by tech support or on time.
Now that you have your allocation bases set for each activity, estimate the quantity for each allocation base.
The next step is to calculate the rate for each activity, using the estimated cost of each activity cost pool and the estimated quantity for each allocation base. At this point, this should start to look familiar because we did this using plantwide rates and departmental rates. To calculate the ABC rate:
Total estimated activity cost pool / Total estimated activity allocation base = ABC rate
This is the exact same formula we used for plantwide rates and departmental rates. Total cost divided by total activity equals rate. The only thing that is different about ABC rates is that you will have more of them. With plantwide rates we had one rate for the entire company. For departmental rates, we had one for each department. For ABC, we will have one rate for each activity that has been identified.
It is extremely important to label each of your rates. If you are calculating the rate for machine setups, label your rate “$/setup”. This makes it much easier when you are applying your rates. Don’t skip this step. When students make mistakes, the mistakes are made in the application of the rates because students use the wrong driver to apply the rates. When you label your rates, it is so much easier to apply the rates because you don’t need to think about which rates to use for each activity. If the problem states that there are 15 setups, look at your rates for the one that is marked “$/setup” and use that one.
To apply the rates, multiply the actual amount of activity by the rate for that activity. Again, that is very similar to what we did for plantwide rates and departmental rates. Just like departmental rates, once you get the amount for each activity, you will need to add up the applied cost for each activity to get the total overhead applied to your cost object.
Steps for using Activity-Based Costing
- Identify the activities that are associated with your cost object and allocate estimated costs to each of the activities using an activity cost pool.
- Identify the allocation base for each of your activities and estimate the quantity for each allocation base.
- Calculate the rate for each activity: estimated activity cost pool / estimated activity allocation base.
- Apply the ABC rates using actual quantity for each activity.
- Add the cost of all your activities to calculate the total overhead cost for your cost object.
Activity-Based Costing – Allocating Cost to Cost Pools
Activity-Based Costing – Calculating activity rates and applying rates
Sometimes a single predetermined overhead rate causes costs to be misallocated.
Imagine you are renting an apartment with three friends. The rent is $600 per month, cable is $150 per month, and groceries are $450 per month. You decide to take the $1,200 cost and divide it evenly by the four of you. That would be $300 each. After a few months, you and your friends become annoyed with this scenario. You don’t watch TV so you don’t think it’s fair you have to pay for cable. One of your friends rarely eats at home so he thinks it is unfair to pay for groceries. Clearly, the $300 per person rate is not working. You feel that too much of the cost of cable is being allocated to you and your friend feels that too much of the cost of groceries is being allocated to him. Your other two roommates are underpaying for the resources that they are consuming.
There needs to be a better way and there is.
In managerial accounting, rather than using one overhead rate to allocate all of the overhead costs, we can break up overhead costs by department. By using departmental overhead rates, we have the flexibility to use a different activity or cost driver for each department. Some departments rely heavily on manual labor but other departments rely heavily on machinery. Direct labor hours might been a good indicator of cost in some departments but machine hours might work better for others.
The process for calculating the rates is exactly the same as when we calculated predetermined overhead rates. The only difference here is that it is important to pay attention to which driver is being used in each department. Because you are working with multiple drivers, it is really important to label your rates here. If you do a calculation based on machine hours label your rate as $x/MH. That tells you that the rate is dollars per machine hour. That way when you go to apply the rates, you’ll know to use machine hours and not something else.
When calculating and departmental overhead rates:
1. Calculate the rate for each department using the correct driver:
Departmental overhead rate = Estimated overhead for the department / Estimated activity for the department
2. Label the rate so you know which activity you used to calculate each rate.
3. Apply overhead to jobs or activities using the rate for each department and the actual activity:
Applied overhead for each department = Departmental overhead rate x Actual activity (using the same driver used to calculate the rate)
If you used estimated machine hours to calculate the rate, use actual machine hours. If you used direct labor hours to calculate the rate, use actual direct labor hours.
4. Add up the overhead from each department to calculate the total overhead applied.
The related video shows an example problem and the calculations required. It also shows how plantwide overhead rates can skew the numbers.
Calculating and Applying Departmental Overhead Rates
When overhead is overapplied or underapplied, there are two different ways to allocated the variance. In the previous post, we allocated all of the variance to cost of goods sold. However, that is not a very accurate way to allocate the variance.
Think back to the calculation of cost of goods sold in our discussion of inventory. There are three different inventory accounts: Raw materials, work-in-progress, and finished goods. If you think back to the calculations for these accounts, overhead was added during the calculation of work-in-progress.
That means that overhead is applied to work-in-progress, finished goods, and cost of goods sold. When the variance is calculated, that variance exists in each of these accounts, not just cost of goods sold. Therefore, in order to make sure that each of these accounts is accurate, the variance should be allocated to each of these accounts.
In order to do this, we need to look at what percentage of the applied overhead is in each of the accounts and allocate the variance based on those percentages.
Let’s look at an example.
K’s Kustom Furniture has applied overhead of $1,300,000. The $1,300,000 is allocated to the following accounts:
Finished goods $150,000
Cost of goods sold $950,000
The balances in the accounts are as follows:
Finished goods $525,000
Cost of goods sold $3,500,000
Actual overhead is $1,450,000
Calculate the amount of the overhead variance and allocate the variance to work-in-progress, finished goods, and cost of goods sold.
We have $1,300,000 in applied overhead currently sitting in the three accounts. We need to determine what percentage of the applied overhead is in each of the accounts. Divide the applied overhead balance in each account by the total amount of applied overhead.
Work-in-progress $200,000 / $1,300,000 = 15.38%
Finished goods $150,000 / $1,300,000 = 11.54%
Cost of goods sold $950,000 / $1,300,000 = 73.08%
Now calculate the variance. We know that overhead is underapplied because the applied overhead is lower than the actual overhead. Not enough overhead has been applied to the accounts. The variance is:
$1,300,000 – $1,450,000 = $150,000 underapplied.
Multiply the $150,000 by each of the percentages.
Work-in-progress $200,000 / $1,300,000 = 15.38% X $150,000 = $23,070 underapplied in work-in-progress
Finished goods $150,000 / $1,300,000 = 11.54% X $150,000 = $17,310 underapplied in finished goods
Cost of goods sold $950,000 / $1,300,000 = 73.08% X $150,000 = $109,620 underapplied in cost of goods sold
We know how much overhead has been underapplied in each account, so we now must adjust each of the account. When overhead is underapplied, there is not enough overhead in each of the accounts. We must add the variance to each of the account balances. Add the variance to the total amount in each account.
Work-in-progress $675,000 + $23,070 variance = $698,070 adjusted Work-in-progress
Finished goods $525,000 + $17,310 variance = $542,310 adjusted Finished goods
Cost of goods sold $3,500,000 + $109,620 = $3,609,620 adjusted Cost of goods sold
When allocating the overhead variance among multiple accounts, look at the amount of applied overhead in each of the accounts: work-in-progress, finished goods, and cost of goods sold. Calculate the percentage of total applied overhead in each of the accounts. Then use that percentage to calculate the amount of the variance that should be allocated to each account. If the overhead is underapplied, add the amount of variance to each of the accounts. If the overhead is overapplied, add the amount of variance to each of the accounts.
Allocating overhead using a predetermined overhead rate
In the previous post, we discussed using the predetermined overhead rate to apply overhead to jobs. This applied overhead is an approximation. What about actual spending for overhead costs? Let’s review how we got applied overhead.
First, we calculated the predetermined overhead rate by dividing estimated overhead by estimated activity.
Then we multiplied the predetermined overhead rate by the actual activity to calculate applied overhead.
So far, we haven’t used a single actual overhead figure in our calculations. Actual overhead is the amount that the company actually incurred. Imagine that there are two groups of accountants inside a company. One group is applying overhead based on the actual activity and the predetermined overhead rate. These accountants are adding direct materials, direct labor and applied overhead to jobs to calculate the cost of goods sold on every job that is sold. The second group of accountants is recording actual bills and totalling up actual overhead costs. Except these actual overhead costs are not included in cost of goods sold. They are held off to the side. At the end of the year, the applied accountants and the actual accountants come together to reconcile cost of goods sold to ensure that the actual numbers are what ends up in cost of goods sold at the end of the year.
Overapplied or Underapplied?
What do we do when we have the actual overhead numbers? We need to compare the actual overhead incurred to the applied overhead that is currently attached to our jobs. We need to see if we applied too much overhead or too little overhead to our jobs.
If too much overhead has been applied to the jobs, we say that overhead is overapplied. If too little overhead has been applied to the jobs, we say that overhead is underapplied. I like to figure this out before I even calculate the dollar figure. Compare applied overhead to actual overhead. Have you applied too much or too little? Remember that applied overhead is what is in cost of goods sold right now. We need to adjust cost of goods sold to actual at the end of the year.
Once you have determined if overhead is underapplied or overapplied, Calculate the difference between applied overhead and actual overhead. This is the amount that you must adjust cost of goods sold to bring it to the actual cost.
If overhead is overapplied, meaning you have too much overhead in cost of goods sold, subtract the amount that is overapplied.
If overhead is underapplied, meaning you have too little overheard in cost of goods sold, add the amount that is underapplied.
Let’s look at an example to help clarify all this.
K’s Kustom Furniture estimated overhead at the beginning of the year to be $567,000. Over the course of the year, K’s applied $578,000 worth of inventory to it’s jobs. At the end of the year, actual overhead incurred was $572,000. Calculate the amount of overhead that was overapplied or underapplied. How much cost of goods sold should be reported if unadjusted cost of goods sold is $2,134,000?
We’ve got a lot of figures for such a short problem. We have three overhead figures. This is why knowing the terminology is really important. If you have the terminology clear, this problem is easy. First, let’s review the terminology.
Estimated overhead is budgeted at the beginning of the year and used to calculate the predetermined overhead rate. Applied overhead is the amount that is added to jobs as work is completed. This is done during the year as work is completed using the predetermined overhead rate and actual activity. Actual overhead is the amount of overhead cost that the company actually incurred.
When determining if overhead has been overapplied or underapplied, we have to compare how much overhead has been applied to how much was actually incurred. Applied overhead is $578,000. Actual overhead is $572,000. Estimated overhead is not used here. Remember that estimated overhead is ONLY used to calculate the predetermined overhead rate.
First determine if overhead is overapplied or underapplied. Actual overhead is what should be in cost of goods sold. Applied overhead is what is currently in the account. So right now, there is $578,000 in the account but there should be $572,000. Is there too much overhead or too little overhead? There is too much overhead. If we do the math, there is $6,000 too much in cost of goods sold.
Therefore, overhead is $6,000 overapplied.
That also means that cost of goods sold is $6,000 too high. When overhead is overapplied, we must subtract the amount from cost of goods sold. Cost of goods sold is currently overstated.
$2,134,000 – $6,000 overapplied overhead = $2,128,000 adjusted cost of goods sold.
This post may seem like overkill, but I can’t tell you how many times I’ve seen students get these problems wrong because they did not know the terminology. I often see students confuse estimated and applied overhead. Make sure you know the terminology and the rest of this is easy.
Allocating overhead using a predetermined overhead rate
We have previously discussed cost objects and assigning costs to cost objects. One object that is used frequently by job costing.
Job costing is a cost allocation method used by companies that make custom products. Imagine a cabinet maker who makes custom cabinets for homes. Each cabinet is custom built based on measurements made inside the customer’s home. All jobs require different amounts of material, labor, and overhead. Therefore, each job has a unique total cost.
Direct costs are easy to assign to jobs. It is easy to calculate the total cost of direct materials based on the materials used in the job. Companies use job cost sheets to record the cost of materials used on the job.
Direct labor is easy to calculate as we know how much each of the employees earns per hour and how many hours the employees worked on the job. Employees track which jobs they are working on throughout the week so that direct labor costs can be added to the job cost sheets.
Overhead can cause problems for organizations that use job costing. Without allocating overhead to jobs, we do not have an accurate idea of the cost of the job. Since overhead is such a large part of the cost of operating a business, we cannot ignore it. So how do we allocate it?
We could wait until the end of the year, when we know actual numbers but that does not help us determine if our jobs are profitable when they are completed. If we waited until we had all the overhead spending calculated for the year, it would be January of 2017 before we know if jobs completed in 2016 were profitable or not. We can’t wait that long if we want to determine if we are making profit on our jobs.
We could use overhead costs for the current or previous month and apply those costs to the job, but what if our overhead costs vary greatly from month to month. For example, what if we get the annual renewal for our insurance policies in March. Those insurance policies cost $100,000. Is it ethical to allocate that $100,000 only to the jobs that are completed in March or April? No, those costs should be allocated to all jobs completed throughout the year, not just those unlucky customers who happened to place in order with our company in March or April.
If we don’t know the actual costs, how can we allocate overhead fairly to all of our jobs? We are going to use estimates.
Most businesses complete budgets prior to the beginning of each year. These budgets include estimated overhead and estimated activity. We can use those estimates to calculated a rate that we can apply to our jobs. We call this rate the predetermined overhead rate.
Predetermined overhead rate = Estimated Overhead / Estimated Activity
The company can choose any activity it believes will most accurately apply the overhead costs. Most companies use direct labor hours or machine hours to allocate overhead costs.
K’s Premier Cabinets uses job costing to calculate the cost of jobs as they are completed. The company estimates that it will have $1,250,000 in overhead costs in 2015. The company believes that employees will work 200,000 hours and that 150,000 machine hours will be used during 2015. Calculate the predetermined overhead rate assuming that the company uses direct labor hours to allocate overhead to jobs.
Predetermined overhead rate is estimated overhead divided by estimated activity. The example states that estimated activity is 200,000 direct labor hours.
$1,250,000 / 200,000 direct labor hours = $6.25 per direct labor hour (don’t forget to label your numbers)
Applying the predetermined overhead rate to jobs
Alright, so we have a rate. Now what?
We must apply the rate to our jobs. The rate from our example above is $6.25 per direct labor hour. How do we apply this to our jobs? Based on the direct labor hours worked on the job. For each direct labor hour worked, we will add $6.25 of overhead to the job.
Applied overhead is overhead added to a job by taking the predetermined overhead rate multiplied by the actual activity. Applied overhead is added to direct materials and direct labor to calculate total job cost.
Total Job Cost = Direct Materials + Direct Labor + Applied Overhead
Every time a job is completed, overhead is applied to the job. The total cost of all the jobs completed over the course of the year is cost of goods sold.
K’s Premier Cabinets completes job #322 on July 7. The job used 45 direct labor hours and 30 machine hours. The job consumed $1,800 worth of materials. The average direct labor rate is $18.00 per hour and the company uses the predetermined overhead rate calculated in Example #1. Calculate the total cost of job #322.
There are three components of job cost: direct materials, direct labor and applied overhead.
We are told that direct materials are $1,800.
We must calculate total direct labor cost. Direct labor is a variable cost. Our rate is $18.00 per direct labor hour. Our driver is 45 hours. If we calculate rate x activity, our total direct labor cost for job #322 is:
$18.00 per direct labor hour X 45 direct labor hours = $810
Lastly, we just apply overhead to the job. Overhead is applied by taking our predetermined overhead rate and multiplying it by activity. We are given activity for direct labor hours and for machine hours. Which one do we use? Remember when I said to label your answer? This is precisely why it is so important to label your rate! So what was our rate?
$6.25 per direct labor hour
Therefore, we are going to apply the rate based on direct labor hours.
$6.25 per direct labor hour X 45 direct labor hours = $281.25
We now have the components of job cost. Now to add them up and see what the total cost of the job is.
Direct materials = $1,800
Direct labor = $810
Applied overhead = $281.25
Total job cost = $2,891.25
One of the most important pieces of advice I can give you about allocating overhead using a predetermined overhead rate is keeping the terminology straight in your mind.
Estimated overhead is calculated at the beginning of the year before any work begins. Applied overhead is calculated throughout the year as jobs are completed and added to the cost of the jobs.
First calculate your predetermined overhead rate using estimates and LABEL YOUR ANSWER! Then apply overhead to jobs by using the predetermined overhead rate and actual activity.
Allocating overhead using a predetermined overhead rate
Job cost for service companies