Chapter 18: Product Costing Allocation Methods

Single Plantwide Factory Overhead Rate

Allocated Overhead = (Overhead Cost ÷ Total Direct Machine Hours) x Hours for Hoses

• factory overhead costs = productions costs excluding direct materials and direct labour
• allocation/activity base = labour hours or machine hours

Product Costing Allocation Methods

Product Costing Allocation Methods

• methods of allocating factory overhead using predetermined factory overhead rates are:

- Single plantwide factory overhead rate method

- Multiple production department factory overhead rate method

- Activity-based costing method

• the allocation affects the product cost.

Single Plantwide Factory Overhead Rate Method

• Factory overhead costs are allocated to products using only one rate.

• The budgeted allocation base is a measure of operating activity in the factory.

• Common allocation bases: direct labor hours, direct labor dollars, and machine hours.

Single Plantwide Factory Overhead Rate Method

Multiple Production Department Factory Overhead Rate Method

• When production departments differ significantly in their manufacturing processes, factory

• Uses different rates for each production department to allocate factory overhead costs to
products.
Comparison of Single Plantwide Rate and Multiple Production Department Rate Methods

Distortion of Product Costs

• The single plantwide factory overhead rate distorts product cost of both the snowmobile and
riding mower.

- That is, the snowmobile is not allocated enough cost and, thus, is undercosted by $138.

- In contrast, the riding mower is allocated too much cost and is overcosted by $138
($800 – $662).

• The preceding cost distortions are caused by averaging the differences between the high factory
overhead costs in the Fabrication Department and the low factory overhead costs in the
Assembly Department.

• Using the single plantwide rate, it is assumed that all factory overhead is directly related to a
single allocation base for the entire plant. However, this assumption is not realistic for Ruiz.

- Thus, using a single plantwide rate distorted the product costs of snowmobiles and
riding mowers.

• Condition one exists for Ruiz because the factory overhead rate for the Fabrication Department
is $103 per direct labor hour, whereas the rate for the Assembly Department is only $57 per
direct labor hour.

• Condition two also exists for Ruiz because the snowmobile consumes 8 direct labor hours in the
Fabrication Department, whereas the riding mower consumes only 2 direct labor hours.

The ratios of allocation base usage for the Fabrication and Assembly departments:
Activity-Based Costing Method

• The activity-based costing (ABC) method provides an alternative approach for allocating factory
overhead that uses multiple factory overhead rates based on different activities.

- Activities are the types of work, or actions, involved in a manufacturing or service

• Under activity-based costing, factory overhead costs are initially budgeted for activities,
sometimes called activity cost pools, such as machine usage, inspections, moving, production
setups, and engineering activities.

• In contrast, when multiple production department factory overhead rates are used, factory
overhead costs are first accounted for in production departments.

Multiple Production Department Factory Overhead Rate Method versus Activity-Based Costing

Activity Rates

• Activity rates: Budgeted activity costs are assigned to products using factory overhead rates for
each activity.

• The term activity base, rather than allocation base, is used because the base is related to an
activity.

Allocating Costs

• Overhead costs of each activity rate are allocated to a product.

• The estimated total factory overhead for a product = the sum of the product’s individual activity
allocations.

- The factory overhead cost per unit is determined by the following formula:
Activity-Based Costing for Selling and Administrative Expenses

• Generally accepted accounting principles (G A A P) require that selling and administrative

• However, selling and administrative expenses may be allocated to products for managerial
decision making.

- One method of allocating selling and administrative expenses to the products is based
on sales volume.

◦ However, products may consume activities in ways that are unrelated to their
sales volumes.

• When this occurs, activity-based costing may be a more accurate

Activity-Based Costing in Service Businesses

• In service companies, the use of single and multiple department overhead rate methods may
lead to distortions to those of manufacturing firms. Thus, many service companies use activity-
based costing for determining the cost of services.

Activity-Based Costing Method— Hopewell Hospital

Activity-Based Costing in Service Businesses

• Assume that the budgeted costs for radiological testing are $960,000 and the total estimated
activity-base usage is 3,000 images.

• The activity rate per radiological image is computed as follows:

• The activity rates for the other activities are determined in a similar manner.
Analysis for Decision Making

• Activity-based costing can be used to improve the cost of a product.

• The activity cost reduction can be accomplished by:

- Improving operations so that the activity-base usage per unit is either reduced or
eliminated.

- Changing the classification of employees doing an activity and thereby decreasing the
activity rate.