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ACG 4361
Allocating Indirect Costs:
Simple Costing & ABC
Prepared by
Diane Tanner
University of North Florida
2-2
Stage 2 Cost Allocation
Stage 2. Allocate Production Cost Pools to
Cost Objects
Support
Department #1
Direct
and
Indirect
Costs
Support
Department #2
Support
Department #3
Production
Department #1
Production
Department #2
Stage 1. Allocate Support
Costs to Cost Pools
Cost
Object A
Cost
Object B
Allocation of Indirect Costs to Cost Objects
 Allocation method depends on how managers ‘group’
overhead costs
 Groups of overhead costs are cost pools
 Methods of allocating indirect product costs to products
(Variations of normal costing)
 Simple (traditional) cost allocation
 A single “plant-wide” overhead rate used for entire factory
 Dual cost allocation
 Separation of indirect costs into two pools…one for fixed
and one for variable costs
 Activity based costing
 Multiple overhead rates—one for each activity
Simple Costing vs. ABC
•
Simple costing
• Also known as ‘Traditional’ cost allocation and peanut-
butter costing
• Often acceptable for companies with
• Limited variety of goods
• Small amounts of indirect costs
• Activity-based costing
• Multiple cost pools
• Allocation of indirect costs is based on what
‘drives’ the costs
• Relatively expensive to implement
• More refined
Simple Costing
 All indirect costs (manufacturing overhead) are
grouped into one cost pool
 Allocations are based on activities that are volumebased




Direct labor hours
Direct labor cost
Machine hours
Number of units produced
Overhead rate =
Estimated MOH
Estimated Activity
Allocated overhead = Overhead Rate × Actual Activity
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Activity-Based Costing
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 Indirect costs are separated into multiple cost pools
 Typically 5 to 8 pools
 Based on activities that drive costs rather than on
volume-based denominators
 Primarily used to allocate manufacturing overhead
 Sometimes used to allocate support or other common
costs
Overhead Rate = Estimated MOH
Estimated Activity
Multiple Rates
and Allocations
Allocated overhead = Overhead Rate × Actual Activity
Underlying Premise ….Activities underlie costs.
Cost Hierarchies
ABC uses a 4-level cost structure to determine how far down the
production cycle costs should be allocated (i.e., the cost drivers).
Facility-level
activities
• Factory costs that impact all the products produced in
a factory, such as depreciation on the factory building,
factory insurance, factory janitors, factory supplies
Product-level
activities
• Costs specific to particular products such as training
employees how to produce it, quality control on a
product, etc.
Batch-level
activities
• Costs specific to particular batches of products such
as machine setup for a particular product, machine
maintenance between each batch, etc.
Unit-level
activities
• Costs performed every time a product is produced.
They are usually variable and correlate to the number
of products produced, such as packaging, sanding a
product edge, printing labels, etc.
Signals that Suggest that ABC
Implementation Could Help a Firm
 Significant indirect costs are allocated using one
or two cost pools
 Most or all overhead is considered unit-level
 Has products that consume different amounts of
resources
 Has products that consistently show small profits
(though the products should be profit makers)
 Operations staff disagree with accounting over
manufacturing and marketing costs
Setting Up an ABC System
Step 1: Determine the cost object.
Step 2: Form cost pools.
 Group the costs of performing a particular activity
together.
 All costs in a pool should have the same cause.
 The costs will differ in nature; i.e., can include indirect
wages, depreciation, maintenance, supplies, etc.
Step 3: Select a cost driver that has a cause-and-effect
relationship with the costs to be allocated.
 Considerations in selecting a cost driver
 Experience
 Industry practices
 Cost-benefit analysis of each option under
consideration
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How to Perform ABC
Step 1: Calculate the rate for each cost pool.
Estimated Cost / Estimated Activity = Rate
Step 2: Multiply each cost pool rate times the
respective actual activity to determine
allocated costs.
Step 3: Total the allocated costs from step 2. This
results in the allocated (applied) overhead cost.
Step 4: Add the allocated costs to the direct costs
of each cost object to obtain the total cost of
the cost objects.
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Capacity Considerations of ABC
 Activity can be measured on practical capacity,
actual capacity, or other estimate
 Practical capacity preferred over actual capacity
because
 Does not hide the cost of idle capacity within
product costs
 Gives a truer cost of activities used to produce the
product
Comparing ABC and Traditional Costing
 Advantages of ABC over traditional costing
 More accurate costing
 Helps managers control costs better
 ABC mitigates product cross-subsidization
 Disadvantages of ABC over traditional
 Very expensive to implement
 No separation of fixed and variable costs which
makes incremental analysis difficult
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Product Cross-Subsidization
 Occurs when costs are allocated to all units equally
Undercosting
Overcosting
Overhead allocated under
ABC is greater than if
traditional is used
Overhead allocated under
ABC is less than if
traditional is used
A product consumes a
relatively high level of
resources but is reported
to have a relatively low
total cost
A product consumes a
relatively low level of
resources but is reported
to have a relatively high
total cost
Recent Trends That Affect Choice of
Allocation Method
 Increase in product diversity
 Some products use more resources than others
 Increase in indirect costs
 Machines (depreciation) replace workers (direct labor)
 Advances in information technology
 Direct labor not needed
 Competition in foreign markets
 Costs must be reduced to stay competitive
ABC Implementation Issues
 After switching to ABC, companies may find that
only 10 to 15% of their products are profitable
 Causes management to alter the product mix by
minimizing unprofitable products
 Profits usually increase
 Implementation mirrors the complexity of the
organization
 Complete conversion to ABC requires auditors to
accept the system when used for financial
reporting
Activity-Based Management
 A tool in which managers analyze activities that
cause indirect costs of products or services
 Goal is to improve efficiency and effectiveness of
the activities in order to reduce costs
 Serves as the basis for numerous process
improvement programs of companies
 Helps focus managerial attention on what is most
important among the activities performed to
create value for customers
The End
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