ALLOCATTION OF OVERHEAD COSTS

Let's look at overhead allocation in more detail.

When you need to allocate overhead cost objects, 
like products, it might be helpful to think of that process in 4 steps.
Step 1 is to determine the total amount of overhead cost that need to be allocated. 
You might decide to divide the total amount of overhead cost 
into several cost pools to be treated separately. 
But for now, let's just assume that we have one pool of overhead costs. 
This would be the $26,000 for the t-shirt example we just looked at.
Step 2 is to choose a basis for allocating those overhead costs. 
For the t-shirt example we just looked at, we used units as the allocation base.
Step 3 is to calculate an overhead rate that will be used to allocate 
the overhead. 
That rate is calculated as the relation between overhead to be allocated and 
the allocation base.
Step 4 is to use that overhead rate to allocate overhead 
as products are being made.
Now let's talk a little bit more about step 3, calculating that allocation rate.
In determining this overhead allocation rate, 
organizations typically use budgeted information. 
Now why would they do that? 
Well, take a look.
Here, we have the beginning of the period, like a year, and 
the organization has an estimate or 
a budget of the overhead costs that it expects to incur during the upcoming year.
And then here, we have the end of the period. 
And it's only at that time that we know how much actual overhead has been 
incurred.
We could wait until that point and allocate actual overhead to the products. 
However, managers need to make 
good management decisions during this timeframe. 
For example, it's really hard to know what price to set 
if you don't know what the product's cost is. 
So, we typically allocate overhead 
based on estimates by using information from the budget.
Now as a side note, we hope our estimates are relatively accurate, but no doubt, 
there'll be some differences between the actual and the budgeted amounts. 
So for financial accounting purposes, once we know the actuals, we must correct for 
the difference between actuals and estimates in the books. 
Doing that particular accounting correction is beyond the scope of this 
particular course. But in this meantime, as long as we have relatively good
estimates, we can use those estimates to make management decisions.

So back to the process of allocating overhead. 

Let me amend our previous picture to note that we determine a budgeted 
overhead allocation rate based on the relation between budgeted overhead and 
the budgeted amount of the allocation base.
Okay, let's go back to our t-shirt maker. 
Step 1 is to determine the amount of overhead costs that need to be allocated. 
That's the $26,000. 
Step 2 is to choose a basis for allocating that overhead.
We'll talk about how to choose one of these later. 
But for now, rather than units in our previous example, let's assume that 
the company decided to use direct labor costs as its overhead allocation base. 
Then step 3 is to calculate an overhead rate based on the relation 
between the overhead to be allocated and the allocation base.
The amount of overhead to be allocated is $26,000. 
And the amount of the allocation base direct labor costs is also $26,000. 
Now how did I know that? 
How did I know that it was $26,000? 
Well, we have an estimated 10,000 basic 
t-shirts times the $2 direct labor per shirt.
And then for the deluxe t-shirts, 
we have an estimated 2,000 t-shirts times the,
$3 in direct labor per shirt. 
And that gives us our $26,000 in estimated direct labor cost. 
So then dividing the 26,000 in estimated overhead by the 26,000 
in estimated direct labor cost gives us an overhead rate of 100%. 
So in other words, for every $1 in direct labor that a t-shirt requires, 
it will be allocated $1 in overhead. 
So finally, step 4 is to use that overhead rate 
to allocate overhead as the t-shirts are being made. 
Since a basic t-shirt requires $2 in direct labor,
It is allocated $2 in overhead.
And since the deluxe t-shirt requires $3 in direct labor, 
It is allocated $3 in overhead. 
So the total cost of the basic t-shirt here is $8, and 
the total cost of the deluxe t-shirt is $11. 
And at this point, management has estimates of the cost of each 
t-shirt that it can use in making decisions throughout the year. 
DESIGNING COST ALLOCATION SYSTEM

Recall our four steps to allocating overhead.

Notice that the first two steps, determining the pools of overhead costs 
and the allocation base, involved choices that management makes.
And the last two steps are purely mathematical calculations 
that result from the choices made in the first two steps. 
So, there are two choices we must make in designing a cost system, 
pool and base. It's important to make good choices about cost pools and about
allocation bases, because the estimated product or service cost that result from those
choices in the cost system we will design, will be used in making management
decisions. And we want to make sure we're making good, not poor, management
decisions.
Traditionally, manufacturing organizations that must allocate manufacturing 
overhead to products in compliance with financial accounting requirements, 
have used relatively simple allocation systems. 
Two common traditional choices are allocating overhead 
with a plantwide allocation rate, and 
then allocating overhead with a departmental allocation base.
With a planetwide approach, you have just one cost pool that contains all the
manufacturing overhead cost. And it's allocated using a relatively simple, 
volume-driven allocation base like direct labor or machine hours. 
Our T-shirt maker was an example of this type of allocation system. 
All 26,000 in manufacturing overhead cost were placed into that one cost pool and 
allocated to the T-shirts based on direct labor costs. With a planetwide approach, you
have just one cost pool that contains all the manufacturing overhead cost. And it's
allocated using a relatively simple, volume-driven allocation base like direct labor or
machine hours. Our T-shirt maker was an example of this type of allocation system. 
All 26,000 in manufacturing overhead cost were placed into that one cost pool and 
allocated to the T-shirts based on direct labor costs.

With a departmental approach, you have a cost pool for 

each department that contains all the overhead costs in that department. 
And overhead in each department is allocated separately, but again, 
using a relatively simply allocation base. 
For companies that have more than one department in which overhead is consumed 
in different ways, this approach often leads to product costs that 
more accurately reflect the manufacturing process to make those products.
Your Turn: Allocating Overhead Costs Problem 1
Now it's your turn. I’m going to give you the opportunity to calculate 
overhead rates and allocate overhead to some products. How exciting?

Now it's your turn. I’m going to give you the opportunity to calculate 
overhead rates and allocate overhead to some products. How exciting?

 
All right, the first one let's take a look. The company makes two products, 
product A and product B. The company uses a plant wide allocation method to allocate 
manufacturing overhead costs of $90,000. We have some data here about product A. 
We have some data about Product B. And then we have some data about the total of
these two. I'm asking you to determine how much manufacturing overhead per unit is
allocated to each product A and B if the company uses the following as the allocation
base? So, first you would do an allocation assuming that they're 
using units as the allocation base. Then second, you would do another allocation
separate from that assuming they use direct labor dollars as the allocation base. 
And then finally, a third allocation separate from the first two, 
assuming they use machine hours as the allocation base. 
Take a few minutes, give it a try, then come back and we'll see how you do it? 
And I will meet you at that light board
Okay, here we are at the light board. How did you do? 
Let's take a look. We’re allocating overhead to product A and product B, 
and we're asked to use three different allocation bases and see what we come up with. 
So, let's start with the first base which is the number of units, and let's determine what
our allocation rate would be. So, the allocation rate is going to be determined by taking 
our overhead costs divided by the expected amount of the allocation base. 
And here in this case, we've got the number of units, 3,000 units. 
So, our allocation rate would be $30 per unit. It's pretty straightforward to determine how
much goes to A and how much goes to B, each unit gets $30. That one's pretty
straightforward. Now let's step it up a little bit. We've got again the $90,000 in
overhead, and the expected amount of the allocation base, the allocation base is direct
labor costs, $50,000 in direct labor cost. And so, that allocation rate would be 180
percent of direct labor cost. So, let's go over and do our allocations to A and B. All right,
A incurs direct labor of $20. So, because it has $20 of direct labor, we're going to
allocate 180 percent of that as overhead. So, the amount of overhead that product A
would get would be $36, which is 180 percent times the $20 in direct labor. 
And then, Product B would get 180 percent times $15 in direct labor, 
which would be let's say $27. And the third allocation base we were asked to work with
is machine hours. So, let's develop our rate. Again, we start with our expected overhead
of $90,000, and we divide that by the expected amount of the allocation base, machine
hours. And we see an allocation rate of $36 per machine hour. 
So, let's allocate the overhead to the products. Now we've got a rate, A uses a half of
machine hour per unit. So, a half of machine hour times our $36 per machine hour is an
allocation of 18 dollars going to A. So, let's move on to B. B uses, each unit uses one
machine hour. So, we would allocate one machine hour times hour rate of $30 per
machine hour. So, we'd see an allocation of $36. So hopefully things went well with the
calculations. I just want to point out one thing. Notice that the amount of overhead that
product A gets allocated differs based on the allocation base that we've chosen to use. 
The amount of overhead that product B gets allocated differs 
based on the allocation base that we have chosen to use. 
What does that tell us? That tells us it's really important to think about 
that allocation base when we start allocating overhead because the choice that we
make can make a difference.

Your Turn: Allocating Overhead Costs Problem 2

Okay. Take a second turn. Here's the situation. Consider the same company, 
the information we just had with the prior Your Turn, but now we have some additional
information.

We have some information about Product A, additional information to the prior Your
Turn example. We have some additional information about Product B and we have
some additional total information. Now notice we're being given some information about
what happens in Department One and Department Two with direct labor. And we're
being given some information about what happens in Department One and Department
Two with manufacturing overhead. So, your task is to determine how much
manufacturing overhead per unit has allocated to each Product A and B, 
if the company uses a departmental allocation method and direct labor dollars is the
allocation base. Take a few minutes, give it a try and then come on back, 
and we'll see how you did. I'll be waiting for you over there at the white board.
Hello again. How did it go? 
I bet you're getting great at this. We're going to allocate the manufacturing overhead of
each department separately, to Product A and Product B and we're using as the
allocation base direct labor costs. 
Let's get started. 
Department One, we have overhead of $30,000. So, we're going to take the $30,000 in 
overhead and divide by the estimated amount of the allocation base, that's $20,000 in
direct labor cost. So, we have an allocation rate of 150 percent of direct labor cost. 
In Department Two, we have overhead of $60,000 and the estimated amount of the
allocation based direct labor is $30,000. So, we're taking our estimated overhead of 
60,000 and we're dividing by the estimated amount of the allocation base $30,000 and
we see a rate 200% of direct labor cost. So, we're going to use those rates to allocate
the overhead in each department separately, to Product A and to Product B. So, let's
start with Department One overhead allocating it to Product A. We're going to take 150
percent times the amount of direct labor that Product A incurs in Department One, $10. 
So that will give us a $20 allocation of overhead, that's not correct, is it? 
Now, that would give us a $15 allocation of overhead to Product A from Department
One. And then, to Product B, we'd see 150 percent times the amount of labor in
Department One for Product B. So, 150 percent times the $5 of direct labor is a 750. 
So that's the allocation of overhead from Department One to Products A and B. 
Let's move the Department Two, where our allocation rate is 200% of direct labor. 
To allocate to Product A, we're going to take the allocation rate of 200% and we'll 
multiply that times the direct labor that Product A incurs in department two. 
So that looks to me like that would be $20. Now let's allocate to product B. 
We have the allocation rate 200% times the amount of labor that Product B incurs in
Department two, so that's $20 to Product B as well. So, then the total amount of
overhead that gets allocated to Product A from Department One and Department Two is
$35. And the total amount that product B is allocated if we add Department One and
Department Two 27.50. 
Great job.

Traditional Cost Allocation Systems

Traditional allocation systems, like the plant-wide and departmental approaches, have

their advantages. They meet financial reporting requirements for determining the costs
to assign the inventory as product cost. And they're simple to use, which is a good
thing. And they're based on information that's really easy to obtain. 
And for some companies, they may actually result in estimated product cost that 
accurately capture the cost of manufacturing those products. 
But for other companies, they may not.
Now note that using these approaches to allocate overhead makes a couple of 
inherent assumptions.

First, they assume that over time, overhead costs, either at the plant-wide level or the
departmental level, depending on which traditional system you're using, 
change with changes in the allocation base, such as direct labor costs.
Now think about that.
If overhead is comprised primarily of costs associated with supervision and human
resource management and administration, that assumption may be a valid one.
In other words, it's likely that as a company has more direct labor cost 
over time, it probably does end up having more supervisory and 
human resource and administrative costs. So direct labor costs likely do drive those
types of overhead costs. So, products that use more direct labor probably 
do cause more of these overhead costs to be incurred.
However, if overhead cost are comprised primarily of costs associated with processing
customers’ orders, setting up the equipment to produce a new batch of products
associated with those orders, and shipping the resulting orders of products made, then
that the assumption may not be as valid. In that case, as the company accepts more
and more orders as it grows, those overhead costs will probably be larger.
So, the number of orders likely drives those type of overhead costs and 
would be a more appropriate allocation base.
The second assumption that these approaches to allocating overhead makes is 
that all products in the organization are equally responsible for the overhead costs that
are incurred. Or they use overhead in the same proportions. 
And you can imagine though that some products are more complex to make or maybe
made in smaller batch sizes. In cases like this, the assumption that all products use
overhead in the same proportions may not be a valid one.

 
It's also worth noting that over time the composition of costs, 
particularly in manufacturing organizations, has changed. 
Decades or more ago, manufacturing processes were very labor intensive. 
With little automation, little computerization, little technology. 
So indirect costs were a very small proportion of total manufacturing costs. 
So, the bottom line was that the choices about overhead allocation didn't 
really affect the overall estimated product cost too much.
Decades or more ago, manufacturing processes were very labor intensive. 
With little automation, little computerization, little technology. 
So indirect costs were a very small proportion of total manufacturing costs. 
So, the bottom line was that the choices about overhead allocation didn't 
really affect the overall estimated product cost too much. But in recent times, we've
seen increasingly more automation, and indirect costs now represent a much higher
proportion of total costs. So, choices in how you allocate overhead can change
dramatically the estimated cost of a product. In other words, it can be harder to get
accurate estimates of the cost of our products.
In addition, over the past several decades competition has become more global, 
it's become more intense. So, the implications of not having accurate estimates of the
cost to make your product or offer your service have become more pronounced. 
So, it's more important than ever to design good cost systems.

Activity-Based Costing
In discussing cost systems, a term called activity-based costing comes into play. 
Activity-based costing is a method of allocating overhead that focuses on activities. 
Its underlying principle is that the activities that are performed in a process is what
causes costs to be incurred. With activity-based costing, we determine what activities
are being performed, determine the cost of those activities, and then allocate the cost of
those activities to cost objects or products based on the cost objects use of those
activities. So, for example, if a product is responsible for 40% of a particular activity, 
ordering material from suppliers, for example, then that product will be allocated 40% of
the cost of ordering material from suppliers. The idea here is that activities, and here
we've got ordering material was our activity, uses resources. In this example,
purchasing department personnel, and those resources have costs, purchasing
department salaries and other costs in that department. And the products that cause
those activities ordering the material should be allocated the cost of using those
resources. 

Let's apply our four steps for allocating overhead to activity-based costing. 
And remember, step one is to identify groups or pools of overhead costs. With the plant
wide allocation approach, that was easy, there was one pool and it consisted of all the
indirect manufacturing cost. So how do we do that with activity-based costing? 
Well, we start by identifying the key activities that take place in the production process. 
Activities include things like maintaining equipment, setting up equipment to make a
batch of a product, taking orders from customers, ordering material from suppliers, 
shipping finished products, and I could go on and on and on. But then, what we do is we
put the cost of each activity group into a cost pool.
Now, recall that step two in the allocation process is to choose an allocation base for
each cost pool. With activity-based costing, we want to choose an allocation base that 
has a causal relationship with the cost in the cost pool. We use the term cost driver to
refer to the allocation base and an activity-based costing system because it's something
that drives those costs to be incurred.
For example, if purchasing costs are in a cost pool, then we might choose the number
of orders placed with the supplier as an allocation base. If we place more orders over
time, we would expect purchasing department costs to be higher, or if we place less
orders over time, we would expect the purchasing department costs to be lower. 

Remember, in designing cost allocation systems, we have to make those two choices,
pool and base. And it's the process of making those choices that makes 
activity-based costing different from the traditional allocation systems. 
We get to the third and fourth steps. 
They're no different than we've seen before. We just calculate an allocation rate for
each cost pool and we use that allocation rate to assign overhead costs to our cost
objects.

 
Let's go back to the T-shirt maker. Suppose that after studying the activities required to
make the T-shirts, we observe that many activities are taking place in that work space
but most of them are driven primarily by one of two things, either by running the
equipment to make the T-shirts or by performing work-related orders from customers. 
Now activities driven by running the equipment would include things like operating the
equipment itself, using the electricity, maintaining the equipment, and things like that. 
So, we group the cost related to all those things into one cost pool. Now let's just say
that they total to $13,000, and we use machine hours because it seemed like the cost
driver here as an allocation base to allocate that cost pool. And activity is driven by
taking orders. Taking orders from customers include things like purchasing 
material from suppliers once the order from the customer has been received, 
receiving the material when it arrives, packing and shipping the order when it's finished, 
setting up the equipment to make a new order of T-shirts. So, we group the costs
related to all of those things into one cost pool. And let's say they total to the remaining
$13,000, and we use the number of orders because it seems like the cost driver here as
an allocation base to allocate that cost pool. So, what we've done is divide the $26,000
in manufacturing overhead cost into two cost pools, here they happen to be $13,000
each, and we allocate one pool based on machine hours and the other pool based on
customer orders.

Next, of course, we calculate an allocation rate for each pool. 

For the first pool, we divide the $13,000 pool of the overhead cost by the 3,000 machine
hours to obtain a rate of $4.33 per machine hour. And then for the second pool, we
divide that $13,000 pool of overhead cost by the 130 orders to obtain a rate of $100 per
order. And then we use those rates to allocate each pool to the T-shirts.
Let's allocate the first $13,000 pool of overhead, the one that's based on machine
hours. Since basic T-shirts require 2,310 machine hours, they're allocated $10,000 from
the first pool. This is how we get that. $4.33 per machine hour, the allocation rate, and
they require 2,310 machine hours, and there's 10,000 basic T-shirts so that's one dollar
per shirt. This numerator was $10,000. So, we get $1 per shirt. And since deluxe T-
shirts require 690 machine hours, they're going to be allocated $4.33 per machine hour
times 690 machine hours and there's 2,000 of those, so that's $1.50 per shirt. Okay?
Now, let's allocate the second cost pool based on orders. Since the basic T-shirts
require 50 orders, they're going to be allocated $5,000 from the second pool, the order
related cost. $100 per order times 50 orders, and again, there's 10,000 basic T-
shirts, so we're at 50 cents per shirt. And since deluxe T-shirts require 80 orders, we're
going to allocate $100 per order times the 80 orders, there's 2,000 of those T-shirts, so
that's $4 per shirt. So, with this system, the total manufacturing cost of a basic T-shirt is
$7.50 and the total manufacturing cost of the deluxe T-shirt is $13.50.
Now it's important to note that this compares to $8 under the traditional system, that
prior traditional system, where we allocated all $26,000 overhead based on direct
labor. Notice that when we went from the traditional to the activity-based costing
system, the cost of the basic T-shirt went down under the activity-based costing system
while the cost of the deluxe T-shirt went up. Why the change? Well, just think about it
this way. The basic T-shirt is responsible for 77% of direct labor costs. So those basic
T-shirts were assigned 77% of the overhead costs under the previous system where we
used direct labor as the allocation base. How did I get the 77%? Is that what you're
wondering? So, what I did is I recognized that the direct labor in total is $2 per shirt for
the basic T-shirts, there's 10,000 basic T-shirts, the direct labor per shirt is $3 for a
deluxe T-shirt, and there's 2,000 deluxe T-shirts, the basic T-shirt direct labor divided
by this total direct labor is 77%. Okay. They're also responsible for 77% of the machine
hours. And remember, machine hours are used as the allocation base under the
activity-based costing system. All right. How did I get that? Let's take a look. Basic T-
shirts use 2,310 machine hours. The total machine hours used are the basic plus the
$6.90 for deluxe. So, 77% of the machine hours are being used by the basic T-shirts. 
But, here's the catch. They're responsible for only 38% of the orders, 50 orders divided
by 130 orders. And remember, this was also used as an allocation base in the activity-
based costing system. So, under the ABC system, they're allocated 77% of half the
overhead costs that are driven by machine hours and they're allocated 38% of the other
half of the overhead costs that are driven by customer orders. So, customer orders was
used to allocate half of the overhead under the ABC system. So, naturally, the allocation
of overhead to the basic T-shirts would go down and the allocation to 
deluxe T-shirts would go up when we consider that it's the deluxe T-shirt 
that's causing most of that portion of the overhead to be incurred.
Beyond Manufacturing Costs

We've spent a lot of time talking about allocating manufacturing overhead to products. 
But why did we do that? Well, recall that manufacturing companies must allocate the
manufacturing costs to its products, to place an inventory for financial accounting
purposes. So naturally, that's a good place to illustrate concepts in cost allocation. 
But, it's important to realize that the concepts we discussed and the techniques that we
used are equally applicable to some other settings. And I'd like to talk about three of
these: non-manufacturing cost, service organizations, and cost objects other than
products and services such as customers. Let's start with non-manufacturing cost. 
We'll return again to our T-shirt maker. In addition to the manufacturing overhead costs 
we've addressed in our allocation system thus far, suppose that the company incurs
non-manufacturing overhead cost as well. Examples can include selling, 
administrative or other general costs. It could be the case that some products cause
more of these non-manufacturing overhead cost to be incurred. And if so, then knowing
that may affect some of the management decisions we make regarding our products, 
in this case, the two T-shirt models. Let's take a look. Let's assume that the company
incurs $7,800 of selling costs and that those costs seem to be driven by customer
orders. The sales rep visits the customer to generate orders and then does the paper
work necessary to get those orders into the company's system so the process of making
them can begin. And let's assume that the company incurs $5,200 of other general and
administrative costs that are primarily related to human resource type functions like
administering benefit plans, performance reviews, and the like. 
So, it seems natural to separate those costs into two different pools. And we would
allocate the $7,800 of selling cost based on customer orders because that's what drives 
that cost and the $5,200 cost based on something like direct labor cost because that's
what drives those costs. 

Doing so results in an allocation of selling cost of ¢30 per shirt to 

basic T-shirts and $2.40 per shirt to deluxe t-shirts. Remember how many orders the
deluxe T-shirts require compared to the basic T-shirts. And it results in an allocation of
general and administrative cost of ¢40 per shirt for the basic shirts and ¢60 per shirt to
the deluxe T-shirts. Notice that after considering just the manufacturing costs, 
deluxe T-shirts seemed quite a bit more costly to make than basic T-shirts. 
Well, that difference is even more striking when we consider the additional non-
manufacturing overhead costs associated with those shirts. This may be an important
decision when pricing the two models. The company should ensure that it prices the
deluxe shirt high enough to cover those higher costs.
Now let's consider the applicability of activity-based costing to service firms. Let's take
as an example an accounting firm that provides three basic types of services: filing tax
returns for businesses, performing audit of financial statements for businesses, 
and doing basic bookkeeping work like accounting and payroll and the like on an
ongoing basis for businesses. It might want to assess the profitability of each of those
types of services and assess the cost of each as it considers pricing decisions with new
clients. Each of these types of services will have direct costs associated with them. 
For example, the firm may assign an accountant team service that works only on that
particular service. You know, accountants often specialize in tax, 
audit, or general accounting. And it may be able to trace supplies used directly to those
services and luckily, there are some other direct costs as well. But then there will be
indirect costs that are not easily traced to each type of service. They may include the
cost of management to the extent that management doesn't focus solely on one type of
service and of course, the general and administrative cost fall here as well. 
As a final extension, let's consider the application of activity-based costing to the
assessment of customer profitability. Many of you have experience working with a wide
variety of customers. Some are easier to work with than others I bet. Some require less
time, less special orders, less expediting, less revision to orders placed, they'll accept
more product and fewer shipments or deliveries, or they're closer to your location so
delivery costs may be lower and I could just go on and on and on. But an activity-based
costing approach to understanding what it costs to service each of your customers can
be extremely valuable. Take as an example a wholesale distributor. That distributor has
many customers, many of whom purchase virtually identical products from the
distributor. If the company compared the revenues, it receives and the cost of the
products that the customers purchase, many of its customers may appear to be roughly
equally profitable. However, extending its review to include customer service, 
delivery, and other similar costs may tell a different picture. Understanding which
customers are more resource intensive and how much more resource intensive they are
will allow you to make better decisions as you work with them. You may decide to
charge more for expedited deliveries, or to charge for those expedited situations if
you've never been charging for them before, or you may realize a need to refine 
customer service processes to make them more efficient. You may even realize that
there are some customers you would prefer to discontinue a relationship with. Either
way, applying the activity-based costing concept to assess customer profitability will
undoubtedly ensure you're making more informed decisions in relating to your
customers.
Your Turn: Activity-Based Costing Problem 1
Now it's your turn. 
I'm going to give you the opportunity to calculate overhead rates and allocate 
overhead to some products using an activity-based costing system. 
Here's the information.

. 
A company makes two types of Go-Karts, a basic version and a deluxe version. 
It's expecting to make 5,000 basic, and 1,000 deluxe Go-Karts in the upcoming
year. And to allocate manufacturing overhead, it uses an activity-based costing system
with three cost pools and their associated cost drivers. So, the cost pools or the cost of
equipment, which might be depreciation, the setup of machines and the receiving and
handling of materials. So, we have three cost pools. And the company feels like that the
cost of equipment is driven by machine hours. How many hours the machines are being
run? The setup of the machines and its associated costs is driven by how many times
they have to set them up, and the receiving and handling of materials is driven 
by how many parts that they're doing that activity for. We have information for the basic
Go-Kart and the deluxe Go-Kart for each of those cost drivers. So, I'm asking you to
figure out what is the allocation rate for each cost pool? And then, how much of the total
overhead cost will be allocated to each product line? The basic and the deluxe. 
And then, what is the overhead cost per unit for the basic model and the deluxe model?
back at the light board, having a great time. 
We're going to use activity-based costing concepts to allocate overhead cost to the
basic and deluxe Go-Kart models. We have three cost pools, we have the cost driver, 
we know how much of the cost driver basic and deluxe models use, and so we'll use all
this information to do our allocations. So we have our three pools here. Let's calculate
our allocation rate for each of our cost pools. With the equipment, we have a cost pool
that totals $70,000. So our expected overhead $70,000, and the cost driver's machine
hours, the total machine hours that we're expecting is 3500. And so that would make an
allocation rate of $20 per machine hour. Now let's move to setup. Setup, we have a cost
pool that's $30,000. The driver, cost driver, is the number of setups we would expect a
total of 300 setups. So our allocation rate would be, let's say, $100 per setup. And now,
we're in the receiving and handling, and we have an overhead cost of 39,000 in that
cost pool. And the cost drivers, the number of parts, we're expecting 130,000 parts. 
So that gives us a rate of 30 cents per part. So we've got our allocation rates for each of
our cost pools, now let's take those rates and allocate the overhead in each pool 
to the basic and the deluxe Go-Kart models. So our basic model, let's start with the
equipment cost pool. We're going to allocate $20 per machine hour. And we're
expecting 2,500 machine hours for basic. And then we have all of that, we're going to
be dividing by the total number of basic Go-Karts that we expect to have to get a per
unit amount for what's allocated to the basic Go-Kart, and that would be let's say I
believe that's a $10 per Go-Kart. Yes, so we're allocating $5,000 in total overhead that's
being incurred by the basic model, and we're dividing that by our 5,000 unit. Still the
same thing for the deluxe model. Deluxe model we've, again, we’re going to allocate
$20 per machine hour, and we're expecting 1,000 machine hours. So we would be
allocating to $20,000 here. I'm just noticing here that I said 5,000 here, but I believe
we're looking at $50,000 that get allocated to the basic model, and 20,000 of that gets
allocated to the deluxe model. And of course, that makes sense. Sometimes, it's nice to
make a little mess up because you can actually learn something from it. The 50,000 that
goes to basic plus the 20,000 that goes to deluxe would give us our 70,000 in the cost
pool, so we're right on track. So $20 per machine hour, and we're expecting 1,000
machine hours for the deluxe model, and there's a 1,000 units that we are expecting to
make. And so that would give us $20 per deluxe model. Perfect. Now, let's move to
setup. Setup, we've got a rate of $100 per setup. So let's see what we're going to
allocate to the basic model. How many setups are we expecting? A hundred for the
basic model, and then that's going to be spread over the 5,000 units. And then, let's
move over here to the deluxe model and do something similar. $100 per setup times the
number of setups, 200 setups, and that's 1,000 units. And so, if we take a look at this, 
that's going to be 10,000 that gets allocated over to the basic product line, 
and that's going to be 20,000 that gets allocated over to the deluxe line. 
That makes sense because the total that's being allocated is the $30,000 from our cost
pool. Things are working out great. And so that puts us at two dollars per unit here for
the basic model, and it puts us at $20 per unit for the deluxe model. A lot more setups
going to the deluxe model for a lot fewer number that we're making, and so each unit is
going to be allocated a lot more setup costs than for the basic model. All right, great!
We're on a roll, let's go to receiving and handling. We've got 30 cents per part. 
And we've got 100,000 parts that we're expecting to use for the basic model, 
and of course, 5,000 units. We'll do the same thing over here for our deluxe model. 
Thirty cents per part times the number of parts, 30,000, divided by the 1,000 units. 
That would give us a, let's see, I believe that's six dollars for the basic model, 
and then that would be nine dollars for the deluxe model. 
Looking good. If we total these, it looks like the deluxe model is going to be allocated a
total of $49 in overhead, and it looks like the basic model is going to be allocated a total
of $18 an overhead. Is that making sense? 
Probably so, because we have a deluxe model that we're selling a lot fewer units of, 
but it's using a lot of activity compared to 
the basic model that we're selling a whole lot more units to.
Your Turn: Activity-Based Costing Problem 2
0:01
Now it's time to take a second turn. 
We're going to look at the use of activity-based costing in a service example.
We're looking at a medical clinic that performs two types of surgery, 
general surgery and specialty surgery. 
It estimates that it's going to perform 800 general surgeries, 
400 specialty surgeries in the upcoming year. 
It uses an activity-based costing system with four cost pools and 
the following associated cost drivers to allocate its costs.
Cost pools, or rent, cost of equipment, cost of patient service, and the physician
salaries. They feel that rent and the equipment cost are driven by 
how many square feet each of the types of surgery occupies? Patient services is driven
by the number of patients served, and physicians salaries are driven by physician hours
spent on each respective type of surgery. We have some information about each of the
cost drivers for our general surgery and our specialty surgery. You're being asked to
determine the allocation rate for each cost pool. Determine how much total cost will be
allocated to general cost will be allocated to general surgery and to specialty surgery,
and then determine the average cost per patient for general surgery and specialty
surgery. Take some time. Give it a try. When you're ready, come on back and we'll
tackle it together at the lightboard. Welcome back to the lightboard once again. 
Still using activity-based costing. We're going to try to determine how much overhead to
allocate to the general surgery patient, and how much to the specialty surgery patient. 
We have four cost pools. We have cost drivers, and 
we'll be able to go through the process of doing that allocation. Before we do any
numbers, I want to point out one thing. You'll notice that two of these cost pools have as
their cost driver square footage. When the company decides that the cost driver for
more then one pool is the same thing, it would be possible if we wanted to combine
these two pools into one. We can call it Rent and Equipment. The pool would be
$150,000. And we would allocate the pool of $150,000 to square feet. We'll keep them
separate from that for now. We'll get more practice doing the allocation rates and the
allocation. But know that we could, because these costs are driven by the same driver,
combine them into one pool.
Let's take a look here. Rent, let's determine the allocation rate for the cost pool for
rent. We've got overhead costs of $50,000. We are going to divide that by the
estimated amount of the cost driver which is square footage. We have a total square
footage of 2,500 square feet. So if we take our $50,000 and divide that by 2,500 square
feet, we have an allocation rate of $ 20 per square foot.

Let's do the same thing for the equipment cost pool. We have a pool of $100,000. 
We have a total estimated square feet of 2,500. So that gives us an allocation rate for
that pool of $40 per square foot. Now of course if we had combined these two together
into one pool, rather than having a $20 and a $40 dollar rate we would've had a $60
per 
square foot rate to allocate the dollars in the rent and equipment pool. 
That would've totaled $150,000.
Lets go to Patient Services. We have a pool of $60,000.
The cost driver the company has decided is the number of patients. 
And the total number of patients expected is 1200, and so we're going to get 
a per patient rate, the allocation rate would be $50 per patient. 
And then finally, the largest cost pool the physician salaries, 
$3,200,000. And the cost driver here is the number of hours the physicans work. 
We have 16,000 hours. So we have a rate per physician hour
to use as our allocation rate of, I believe that's going to be 200, 
yeah 200, per physician hour. Now let's allocate these costs to each of these two types
of procedures, the general and the specialty surgery. $20 per square foot.
And we're going to multiply that by the 1,000 square feet that general surgery occupies. 
So that gives us $200,000, I think. $20,000. And that $20,000 is going to be spread over
a total of 800, I'll call it units. So that's how many patients we have okay? 
And so that will give us for general surgery $25. So $25 of rent will be allocated to each
unit of general surgery. If we look at the specialty surgery, we'd be allocating $20 
per square foot times the 1500 square feet that specialty surgery occupies. 
And that's going to be spread over the 400 units which will 
give us a rate of $75 allocated to a specialty surgery.
Let's do the same thing with equipment. We've got a rate per square foot and 
we're going to multiply that times the number of square feet. Divide by our 800 units of
general surgery to give us a cost per surgery. Let's see, $50. 
And then do the same thing here for specialty, $40 per square foot 
times 1,500 square feet over the 400 units, gives us 150.Doing well, doing well. Let's
move to patient services. We have $50 per patient and we're expecting 800 patients.
And we're dividing that by the 800 units, or 800 patients, so that would be $50 for a
general surgery. Likewise for the specialty surgery, 50 per patient, we're expecting 400
patients, divide that by 400 units or 400 patients, 50.So our patient services would be
the same thing and it would be allocated the same amount for general and specialty
surgery. And then we'll get to the physician hours here. We've got 200 per hour, we're
expecting 4,000 physician hours devoted to general surgery and we'll spread that over
our 800 surgeries and that would be $1,000 for a general surgery. If we do the same for
our specialty, 200 per hour, we're expecting a lot more hours, more complicated
procedures. Spread that over our 400 patients and we've got $6,000 per patient. So we
can total these. Let's see if we can add these in our head. That's $1,125 overhead
allocated to each general surgery experience. And then let's see. It's 125, 275, 6,275
that would be allocated to a specialty surgery.

To Use Activity-Based Costing or Not?

Activity-based costing has many advantages. It results in a more accurate allocation of
overhead costs to the cost objects in question. And in turn, this of course can result
in better management decisions around issues like pricing, better cost control, and a
keener focus on the parts of the process that matter, or for which we can take actions
that make a difference. On the downside though, activity-based costing systems are not
cost less. They can be costly to implement, and they can be costly to maintain. So if
we're going to use them, we need to continue to assess whether the benefits that they
offer in the way of better management decisions are sufficient to outweigh the costs of
having a more detailed system.