4.4: Activity-based costing for a manufacturing business to estimate factory overhead

Example

Recall that the simplest method for estimating factory overhead is to use the same predetermined rate in all departments, for all activities, and for all products in a manufacturing facility. Two amounts must be estimated for the calculation, as follows:

\(\ \frac{\text{Total budgeted factory overhead}}{\text{Total budgeted activity base (such as direct labor hours, machine hours, etc.)}}\)

The single factory overhead rate is a very loose estimate because it relies on one fixed dollar amount to assign factory overhead costs across the many facets, various segments, and different activities involved in the manufacturing process. It is unlikely that one rate can capture all the diversity of what goes on in a factory with reliable precision.

Activity-based costing (ABC) is a more specific and more accurate way of assigning factory overhead to manufactured goods versus using single factory or departmental rates. An activity is a unit of work that consumes resources when performed by a company. A cost object (in the case of manufacturing, the item produced) is the target of the activity. Cost objects include products, jobs, services, projects, clients, patients, customers, and contracts.

In a factory, ABC identifies activities within the manufacturing process that occur repeatedly, such as purchasing, production scheduling, setups, moves, inspections, testing, clean-ups, and invoicing. Each activity has its own activity base to measure usage. The following list matches common activities of a manufacturing company with their respective activity bases.

Accounting reports	Number of accounting reports
Customer return processing	Number of customer returns
Electric power	Kilowatt hours used
Human resources	Number of employees
Inventory control	Number of inventory transactions
Invoice and collecting	Number of customer orders
Machine depreciation	Number of machine hours
Materials handling	Number of material moves
Order shipping	Number of customer orders
Payroll	Number of payroll checks processed
Production control	Number of production orders
Production setup	Number of setups
Purchasing	Number of purchase orders
Quality control	Number of inspections
Sales order processing	Number of sales orders

A factory overhead rate for each routinely-performed activity is calculated by dividing the total budgeted cost amount for the activity for a period by the budgeted activity base quantity over the same time frame. The fraction for each activity is similar to the one used for the predetermined single factory rate, except at a more micro level.

There may still be some factory overhead costs that are not associated with any particular activity for the cutting and assembly processes. These may include factory expenses such as utilities, maintenance, insurance, and depreciation. These general overhead costs must be applied to jobs on an estimated (or “budgeted”) basis. In this example, machine hours and direct labor hours will be used as the activity base for cutting and assembly, respectively. Factory overhead amounts for the cutting and assembly processes will be less than those under the single rate or departmental rate methods since the costs for identifiable activities have already been separated out.

The following information lists a company’s six production activities and a fraction for each that is used to determine the activity rate in the right column. The denominator for each fraction is the activity base used. The amounts in the Calculation column are estimates that are given, presumably prepared by management using available company data.

Activity	Fraction	Calculation	Activity Rate
Setups	\(\ \frac{\text{Budgeted total cost of setups }}{\text{Budgeted number of setups }}\)	\(\ \frac{\$ 1,700}{34}\)	$ 50 per setup
Moves	\(\ \frac{\text{Budgeted total cost of moves}}{\text{Budgeted number of moves}}\)	\(\ \frac{\$ 450}{30}\)	$ 15 per move
Inspections	\(\ \frac{\text{Budgeted total cost of inspections}}{\text{Budgeted number of inspections}}\)	\(\ \frac{\$ 7,500}{300}\)	$ 25 per inspection
Clean-ups	\(\ \frac{\text{Budgeted total cost of clean-ups}}{\text{Budgeted number of clean-ups}}\)	\(\ \frac{\$ 1,450}{145}\)	$10 per cleanup
Cutting	\(\ \frac{\text{Budgeted total general cutting costs}}{\text{Budgeted machine hours}}\)	\(\ \frac{\$ 39,000}{1,300}\)	$30 per machine hour
Assembly	\(\ \frac{\text{Budgeted total general assembly costs}}{\text{Budgeted direct labor hours}}\)	\(\ \frac{\$ 4,500}{300}\)	$15 per direct labor hour

The following example will illustrate ABC for estimating factory overhead for a custom furniture manufacturer whose production takes place in its Cutting and Assembly departments. Identifiable activities include setups, moves, inspections, and cleanups.

The company uses ABC to estimate factory overhead for two jobs. Job 1 is a batch of 300 identical nine-drawer wood dressers. Job 2 is a batch of 160 identical free-standing wood clothing closets.

The usage amounts of these activities for each job are given in the following table. For each job, the number of times each activity occurs is multiplied by the overhead rate for that activity. The sum of all the activity costs is the amount of factory overhead applied to the job.

Activity	Activity Rate (calculated above)	Dresser Usage	Dresser Costs	Closet Usage	Closet Costs
Setups	$50 per setup	24 setups	$50 x 24 = $1,200	10 setups	$50 x 10 = $500
Material transfers	$15 per move	20 moves	$15 x 20 = 300	10 moves	$15 x 10 = 150
Inspections	$25 per inspection	140 inspections	$25 x 140 = 3,500	160 inspections	$25 x 160 = 4,000
Cleanups	$10 per cleanup	85 cleanups	$10 x 85 = 850	60 cleanups	$10 x 60 = 600
Cutting	$30 per machine hour (mh)	950 mh	$30 x 950 = 28,500	350 mh	$30 x 350 = 10,500
Assembly	$15 per direct labor hour (dlh)	210 dlh	$15 x 210 = 3,150	90 dlh	$15 x 90 = 1,350
			$ 37,500		$17,100

The journal entry to apply factory overhead of $54,600 ($37,500 + $17,100) to the two jobs using ABC is as follows:

Account	Debit	Credit
Work in Process	54,600		▲ Work in Process is an asset (inventory) account that is increasing
Factory Overhead		54,600	▼ Factory Overhead is an expense account that is decreasing