Manufacturing companies rely on product cost data to set product sales prices and determine if products are producing profits. This lesson covers activity-based costing and describes how to assign overhead costs to products using this method.

Product Costing

Manufacturing companies create products to be sold to customers. In order to make a profit on their products, these companies must accurately determine how much it costs to manufacture each product. Companies do this through product costing.

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Product costing is the process of determining the business expenses associated with the manufacture of a product. Associated expenses include direct labor and materials and manufacturing overhead.

Labor and materials costs are considered direct costs if they are incurred during the manufacture of a product and can be directly allocated to that product. Manufacturing overhead includes all other expenses incurred during the manufacture of a product that cannot be directly allocated to that product. This might include factory rent, payroll taxes on direct labor wages, and machine maintenance. These costs are also known as indirect costs. Manufacturing overhead must be accurately allocated to a product’s cost for manufacturing companies to set product sales prices and determine if products are producing profits.

Traditional vs. Activity-Based Costing

Traditional costing systems allocate manufacturing overhead by dividing total indirect costs by a cost driver to obtain one rate to be used to allocate overhead to different products. A cost driver is an activity that controls the amount of costs incurred.

For example, in a factory, the number of hours a machine runs determines how much electricity is used and how much will have to be spent on maintenance. In this example, the number of machine hours is the cost driver that controls how much electricity is used and the cost of maintenance. The fewer the number of machine hours, the less the cost of electricity and maintenance; whereas, the higher the number of machine hours, the more the cost of electricity and maintenance. The number of machine hours is a typical cost driver used in traditional costing systems, as is direct labor hours. Traditional costing systems are simple, but can result in over-costing or under-costing, as the manufacture of products is generally complex and influenced by more than one cost driver.

Activity-based costing systems allocate manufacturing overhead by assigning indirect costs to several different cost pools and dividing each cost pool by its associated cost driver to obtain several different rates that can then be used to allocate overhead to different products. A cost pool is a group of individual costs. Activity-based costing systems allow manufacturing companies to more accurately allocate overhead expenses to specific products, as multiple cost drivers are used. Like traditional costing systems, machine hours and direct labor hours are typical cost drivers used. Other examples include square footage used per product to allocate factory rent and maintenance and number of purchase orders to allocate purchasing department expenses.

Formula

An activity-based costing rate is calculated by assigning indirect costs to a cost pool, adding the costs included in that cost pool together, then dividing the cost pool total by the cost driver.

Cost pool total ; Cost driver

The result will be a dollar amount that can then be multiplied by the number of products manufactured to obtain a total product cost for that cost pool. By calculating the activity-based costing rate for multiple cost pools, a manufacturing company can more accurately determine product cost.

Examples

Now let’s look at a couple of examples.

Example 1: Traditional Costing

Rio Group LLC manufactures two types of widgets: Widget A and Widget B. The company has asked you to allocate its overhead to each product using traditional costing and direct labor hours as the cost driver. You have been given the following information:

Expenses:

Payroll taxes: $2,000
Factory maintenance: $5,000
Purchasing labor: $3,500
Purchasing supplies: $500
Electricity: $7,000
Factory rent: $4,500
Equipment depreciation: $3,000
Fringe benefits: $1,500

Other Information:

Direct labor hours: 500 Widget A; 700 Widget B
Machine hours: 350 Widget A; 450 Widget B
Purchase orders: 75 Widget A; 45 Widget B
Square feet used: 5,000 Widget A; 2,000 Widget B

Under the traditional costing system, we’d add all of these expenses together, then divide them by the total direct labor hours to obtain an application rate:

$2,000 + $5,000 + $3,500 + $500 + $7,000 + $4,500 + $3,000 + $1,500 = $27,000 total manufacturing overhead$27,000 ; (500 hours Widget A + 700 hours Widget B) = $22.50 application rate

The $22.50 application rate represents the manufacturing overhead expense to be allocated to each direct labor hour incurred during production. To complete the project for Rio Group LLC, the application rate must be multiplied by the number of direct labor hours incurred during production of Widget A and Widget B to obtain total manufacturing overhead allocated to each:

$22.50 application rate x 500 hours = $11,250 overhead to Widget A$22.50 application rate x 700 hours = $15,750 overhead to Widget B

Upon completion of the calculations, you will be able to tell Rio Group LLC to allocate $11,250 of overhead to Widget A and $15,750 of overhead to Widget B.

Example 2: Activity-Based Costing

Using the same expenses and information from Example 1, Rio Group LLC has asked you to allocate its overhead to each product using activity-based costing. The first step would be to group the expenses into different cost pools, depending on the factors that drive the costs.

Payroll taxes and fringe benefits are driven by direct labor hours and will be included in one cost pool. Factory maintenance and factory rent are driven by the number of square feet used per widget and will be included in another cost pool. Purchasing labor and supplies are driven by the number of purchase orders and will be included in yet another cost pool. And, finally, electricity and equipment depreciation are driven by machine hours and will be included in the final cost pool.

  • Adding $2,000 payroll taxes to $1,500 fringe benefits results in a $3,500 labor cost pool total
  • Adding $5,000 factory maintenance to $4,500 factory rent gives you a $9,500 factory cost pool total
  • Adding $3,500 purchasing labor to $500 purchasing supplies equals a $4,000 purchasing cost pool total
  • And adding $7,000 in electricity costs to $3,000 in equipment depreciation totals a $10,000 equipment cost pool total

Next, the application rate must be calculated for each cost pool by dividing each pool by the associated cost driver:

$3,500 labor cost pool total ; (500 hours Widget A + 700 hours Widget B) = $2.92 labor application rate
$9,500 factory cost pool total ; (5,000 square feet Widget A + 2,000 square feet Widget B) = $1.36 factory application rate
$4,000 purchasing cost pool total ; (75 purchase orders Widget A + 45 purchase orders WIdget B) = $33.33 purchasing application rate
$10,000 equipment cost pool total ; (350 machine hours Widget A + 450 machine hours Widget B) = $12.50 equipment application rate

Finally, the application rates must be multiplied by the cost driver for each of the widgets and added together to obtain total manufacturing overhead allocated to each. The application rates above have been rounded to two decimal places. The following calculations use the complete application rates to eliminate rounding differences.

Widget A

($2.92 labor application rate x 500 direct labor hours) + ($1.36 factory application rate x 5,000 square feet) + ($33.33 purchasing application rate x 75 purchase orders) + ($12.50 equipment application rate x 350 machine hours) = $15,120 overhead to Widget A

Widget B

($2.92 labor application rate x 700 direct labor hours) + ($1.36 factory application rate x 2,000 square feet) + ($33.33 purchasing application rate x 45 purchase orders) + ($12.50 equipment application rate x 450 machine hours) = $11,880 overhead to Widget B

Upon completion of the calculations, you will be able to tell Rio Group LLC to allocate $15,120 of overhead to Widget A and $11,880 of overhead to Widget B.

Analysis

  • The traditional costing method results in allocation of $11,250 of overhead to Widget A and $15,750 of overhead to Widget B.
  • The activity-based costing method results in allocation of $15,120 of overhead to Widget A and $11,880 of overhead to Widget B.

As shown by these figures, the traditional costing method results in under-allocation of $3,870 of overhead costs to Widget A and over-allocation of the same amount to Widget B. By using activity-based costing, Rio Group LLC will be able to more accurately price its widgets and determine if each widget is creating a profit.

Lesson Summary

Product costing is the process of determining the business expenses associated with the manufacture of a product. Business expenses are costs incurred in the manufacture of products and include direct costs, which are costs that can be directly associated with a product, and manufacturing overhead costs, which are costs that cannot be directly associated with a product. Manufacturing overhead costs are also known as indirect costs.

Traditional costing systems allocate manufacturing overhead by dividing total indirect costs by a cost driver to obtain one rate to be used to allocate overhead to different products, while activity-based costing systems allocate manufacturing overhead by assigning indirect costs to several different cost pools, then dividing each cost pool by its associated cost driver, to obtain several different rates. A cost driver is an activity that controls the amount of costs incurred. Cost pools are groups of individual indirect costs.

Activity-based costing is more complex than traditional costing, but provides more accurate overhead allocation, as multiple cost drivers are used. This decreases the risk of over- or under-costing a product.

Key Terms

Work Force in a Factory

Product costing – the process of determining the business expenses associated with the manufacture of a product

Direct costs – costs incurred during the manufacture of a product which can be directly allocated to that product

Manufacturing overhead – all other expenses incurred during the manufacture of a product that cannot be directly allocated to that product

Indirect costs – another term for manufacturing overhead

Traditional costing systems – systems that allocate manufacturing overhead by dividing total indirect costs by a cost driver to obtain one rate to be used to allocate overhead to different products

Cost driver – an activity that controls the amount of costs incurred

Activity-based costing systems – systems that allocate manufacturing overhead by assigning indirect costs to several different cost pools then dividing each cost pool by its associated cost driver to obtain several different rates that can then be used to allocate overhead to different products

Cost pool – a group of individual costs

Learning Outcomes

Watching this video lesson on activity-based costing can help you gather information you’ll need to subsequently:

  • Contrast direct and indirect costs as they relate to product costing
  • Compare traditional and activity-based costing systems
  • Use a formula to calculate an activity-based costing rate
  • Analyze your results