Traditionally, overhead costs are assigned based arbitrarily on the rate of either direct labor or direct materials associated with production. This makes sense when companies only make a few products, production processes are simple, and overhead costs are less pervasive. However, today production processes are more complex, companies make a wider array of products, and fewer costs are directly traceable to units of production. To address this, companies use activity-based costing (ABC).

Specifically, activity-based costing identifies and traces costs and expenses to activities and then to specific products. ABC uses multiple factory overhead rates based on activities. Activities are the types of work, or actions, involved in a manufacturing process or service activity. For example, assembly, inspection, and engineering design are activities.

The estimated activity costs are allocated to products using an activity rate. Activity rates are determined as follows: Activity Rate = Estimated Activity Cost / Estimated Activity Base Usage

Illustrated Example of Activity-Based Costing

Comparing Two Products under Traditional and Activity-Based Costing

Compare two projects under development by the same company. The following are a few aspects of each products development process relevant to costs.

Product A		Product B
Requires 3,840 hours of testing		Requires 960 hours of testing
Requires 5,320 units of computing power		Requires 2,280 units of computing power
Requires 25 developer hours to implement		Requires 75 developer hours to implement

Cost Items	Cost of Each Activity
Testing:	$30,240
Computing power:	$44,840
Developer hourly cost:	$12 per hour

Traditional Costing

Traditional costing would take the proportion of a direct cost, such as direct labor hours, and use it as the basis for allocating overhead costs, such as computing power and testing. In the following table, use developer hours as the basis for assigning overhead costs (computing and developer costs) to each project If required, round your answers to the nearest dollar.

Product A			Product B
Percentage of developer hours	25%		Percentage of developer hours	75%
Testing cost	$		Testing cost	$
Computing cost	$		Computing cost	$
Developer cost	$		Developer cost	$
Total cost	$		Total cost	$

Percentage of developer hours

- Percentage of developer hours for Product A (25%)

Allocation basis for Product A: The amount of labor hours associated directly with Product A, as a percentage of all developer hours worked (regardless of product). The amounts for overhead to be allocated are multiplied by this value to determine the overhead to be assigned to Product A under the traditional costing method.

25

(25+75)

+ Percentage of developer hours for Product B (75%)

Seeing how many resources each product (A and B) requires for production compared to the costs calculated under traditional costing, does traditional costing serve as an accurate gauge of costs? SelectYesNoNot enough informationCorrect 9 of Item 1

Activity-Based Costing

Using the data above for products A and B, calculate the costs using activity-based costing. Allocate the costs of testing, computing, and development based on the rates of activity consumed by each product's development process. If required, in your computations, round per unit costs to the nearest cent. Round your final answers to the nearest dollar.

Cost	Activity Base
Testing	Hours of testing
Computing cost	Units of computing power
Developer cost	Development hours

Product A			Product B
Testing cost	$		Testing cost	$
Computing cost	$		Computing cost	$
Developer cost	$		Developer cost	$
Total cost	$		Total cost	$

Activity-based costing for varying batch production

A manufacturing company has the following two activities associated with completion of products:

The setting up of machines for running batches of products

The actual production of units produced

The company has annual manufacturing overhead costs of $2,000,000, of which $200,000 is directly involved in setting up machines for batch runs. During the year, the company expects to perform 400 machine setups, one setup per batch for a total of 400 batches of production. Assume that the batch sizes vary considerably, but the work involved in setting up the machines is not appreciably different from one job to the next.

If the company estimates that the $200,000 costs associated with setups will yield 400 setups this year, the cost associated directly with each setup will be $ per setup. Because each job will require its own setup, setup costs are viewed as batch costs. Because $200,000 of the $2,000,000 are costs associated with setups, this means that costs associated directly with the production of units equal $.

APPLY THE CONCEPTS: Calculate the batch-level cost

Determine what batch-level costs will be, both with activity-based costing (ABC) and without, to understand the method and compare and contrast both approaches. Assume that overhead not associated with setup costs is caused by production activities associated with the companys 100,000 machine hours. If an amount is zero, enter "0". Round unit costs to the nearest cent.

	With ABC		Without ABC
Total setup costs	$		$0
Number of setups	400		Not applicable
Overhead costs per setup	$		$
Total manufacturing overhead costs	$2,000,000		$2,000,000
Less: Cost traced to machine setups	$		$
Overhead costs allocated on machine hours	$		$2,000,000
Machine hours	100,000		100,000
Overhead costs per machine hour	$		$
Formula for allocating manufacturing O/H costs	$	setup cost per batch + $ per machine hour	$	per machine hour

The effect of batch-level costs spread among varying levels of production

APPLY THE CONCEPTS: Assign the costs at the unit level (small batch)

Now that you've determined what the cost calculation is at the batch level, extrapolate this down to the unit level to see precisely how much each unit is costing for any given-sized batch of production. For this purpose, assume that the company is considering taking on a contract for 5,000 units and it currently produces 50 units per machine hour. Assign costs with and without activity-based costing. If an amount is zero, enter "0". Round unit costs to the nearest cent.

	With ABC	Without ABC
Overhead for setting up machine	$	$
Number of units in batch		Not applicable
Manufacturing overhead caused by batch setup per unit	$0.10	Not applicable
Manufacturing overhead costs per machine hour	$	$
Number of units produced per machine hour
Manufacturing overhead caused by production per unit	$	$
Total manufacturing overhead allocated per unit	$	$

APPLY THE CONCEPTS: Assign costs at the unit level (large batch)

If the company manufactures 50,000 units and produces 50 units per machine hour, how would the costs look at this batch level?

	With ABC	Without ABC
Overhead for setting up machine	$	$
Number of units in batch		Not applicable
Manufacturing overhead caused by batch setup per unit	$0.01	Not applicable
Manufacturing overhead costs per machine hour	$	$
Number of units produced per machine hour
Manufacturing overhead caused by production per unit	$	$
Total manufacturing overhead allocated per unit	$	$

What is the reason for the lower per-unit cost when the batch contains more units? SelectThe batch-level costs decrease with a larger batch size due to increased effectiveness in the production process.The batch-level costs decrease with a smaller batch size due to increased efficiency in the production process.There is no difference in the per-unit cost for different batch sizes under activity-based costing.When the batch-level costs are spread across a greater number of units, the cost per unit decreases.