4.1: Introduction to Activity-Based Costing
Companies must accurately determine the costs of their products and services to make sound management decisions, such as determining their selling prices to customers. A manufacturer’s product costs consist of direct materials, direct labor, and factory overhead. The materials and labor are direct costs that can be identified and traced to the product. Factory overhead, however, are indirect and must be allocated to the product cost on an estimated basis.
We have already looked at applying factory overhead to work in process using a predetermined factory overhead rate in the discussion of job order costing. We used a single factory overhead rate based on direct labor hours, total direct labor, or machine hours.
The following journal entry is an example of allocating $2,100 of factory overhead to work in process.
|
Account |
Debit |
Credit |
|
|
Work in Process |
2,100 |
▲ Work in Process is an asset (inventory) account that is increasing |
|
|
Factory Overhead |
2,100 |
▼ Factory Overhead is an expense account that is decreasing |
|
The issue we address now is how precise the estimate of $2,100 actually is. Three different ways of allocating factory overhead will be looked at, as follows:
- Single factory-wide rate – the same rate based on the same activity base for all departments
- Departmental rates – different rates for different departments, but a single rate within a department
- Activity-based costing – different rates for different processes and activities, regardless of department
An example of two different orders of custom wood furniture will be used to illustrate the three methods. Both the direct materials and direct labor costs are known for each job; only the factory overhead must be estimated. Assume jobs are manufactured in a factory with two departments, Cutting and Assembly.