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ACTIVITY BASED COSTING AND ANALYSIS

Because overhead cannot be applied to the units of production in the same manner that direct labor and direct materials can, we assign overhead costs by using one of three allocation methods. The three different methods of assigning overhead costs are a single plantwide overhead rate, departmental overhead rates, and activity-based costing (ABC) rates. A plantwide overhead rate is the easiest and cheapest method to implement because it uses just one single rate to apply overhead to production. The other two methods, however, use multiple rates and are therefore more difficult to implement. While a single plantwide overhead rate is the simplest allocation system, it can distort the cost of a particular product. In fact, if there is more than one type of unit being produced, it will almost certainly distort the overhead cost per unit at least to some extent. In the plantwide overhead rate system, the total budgeted overhead costs are all merged into a single overhead cost pool. It is then divided by the selected allocation base a volume-related measure such as direct labor hours or machine hours to become a single overhead rate. This rate is applied to all products based off of this chosen allocation base. The problem with this method is that it assumes all of the factory overhead costs correspond exactly with the single overhead rate. When different products are produced, the overhead used to produce each product will appear the same under the plantwide allocation method, which distorts the true costs of each product. This is because some products require expensive machinery and/or more labor to produce, while others may require cheaper machinery or less labor to produce, for example. Therefore, the more diverse a companys products are, the greater the distortion will be.