Managerial Accounting: Activity Based Rates

{Assign Manufacturing Overhead via Activity-Based Rate} Product costs are the total of direct materials, direct labor and indirect manufacturing overhead. Recall that direct costs, like direct materials and direct labor, are traced to the finished products, whereas indirect costs, like manufacturing overhead, are allocated to the finished product. There are three common ways to allocate manufacturing overhead to products. The most common is the plant-wide rate. This is what we earlier described as the predetermined overhead rate. Another method is departmental rates. Finally, the most refined method is activity-based costing. This video will focus on the activity-based rate method. Direct materials is a concept most understand, because they end up in product or product packaging. Direct labor is also fairly understandable because it is the labor costs to directly assemble or manufacture the products. Manufacturing overhead is slightly more complicated. In short, it is all the costs in a manufacturing plant that aren’t either direct materials or direct labor. Examples include depreciation, utilities, maintenance, supplies, insurance, and indirect labor like supervision, setup, cleanup, and testing. Many companies choose to refine, or improve, their method of overhead allocation to try to achieve more accurate product costs. This is because plant-wide rate method does not do a good job of matching the cost of overhead resources with the products. Additionally, more simple allocation systems result in “overcosting” or “undercosting” their products. We call this is called cost distortion. So rather than have one pool of overhead to allocate with a plant-wide rate, or breaking out the overhead by departments, we can refine our overhead allocation, by using the activity-based rates. With activity-based rates, we divide manufacturing overhead into groupings of activities. Ideally, these are the activities which cause a business to incur overhead costs in the first place. You can see in my example that the activities are: Machine Set up, Milk Processing, Filling, and Packaging & Labeling. So when determining overhead allocation with activity-based rates, the first step is to identify the activity, and how much of the overhead is related to each one. Notice that the total of the overhead is still $2,500,000. That is the same amount that we allocated with the plant-wide rate and departmental rates. The next step is to identify the cost driver of overhead and estimate the number of activities that will occur for the period. A cost driver is the activity that most likely causes the overhead to occur for that function. As you can see here, the number of times a machine needs to be set up is the cost driver for the overhead associated with the set up activity. The third step is to calculate the overhead allocation rate for each activity. If you want to think of this as a predetermined overhead rate for each activity, that is perfectly fine, because that is what we are doing. So the estimated overhead cost per activity divided by the estimated number of cost driver activities equals the overhead allocation rate per activity. Another way to look at the third step is to put the information into a table as I’ve shown here. Then we enter the actual numbers of activity used by a certain product or product line. The fifth step is to allocate overhead to products based on the amount of actual activity they have used. For example, products that use more of the packaging and labeling activity will be allocated more of the overhead from that function. So in this example, gallons of milk are allocated $1,770,000 of the $2,500,000 of overhead. Assuming we manufactured 10,000,000 gallons of milk, then each gallon of milk would be allocated 17.7 cents of overhead. We would repeat step 4 and 5 for our other products. In this case, these numbers are assumed to be the usage for half gallons. Notice the activity cost allocation rates don’t change. The only thing that changes is how much of each activity is being used to manufacture half gallons of milk Once we complete the table, we can see that half gallons were allocated $730,000 of the $2,500,000 of overhead. Assuming that we manufactured 2,000,000 gallons, each half gallon would be allocated 36.5 cents of overhead. This is one of the reasons why half gallons aren’t 50% of the cost of gallons. So with a more refined overhead allocation method, you can see that gallons ended up being allocated more overhead than with the less refined methods. This means that using a plant-wide rate or departmental rates we overcosted half gallons and undercosted gallons.

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