Cost Accounting TopClass

Activity Based Costing and Indirect Manufacturing Costs

Direct Costs

Some manufacturing costs are directly traceable to products. For example, consider a company that makes golf clubs and tennis rackets by assembling components purchased from suppliers.

Golf clubs and tennis rackets are made from the following components.

For golf clubs the costs of the club heads, shafts and grips can be traced and accounted for as raw material costs. For tennis rackets the costs of the frames, grips and strings can also be traced and accounted for as raw material costs. So direct raw material costs can be traced to the product lines of golf clubs and tennis rackets.

Similarly, the direct labor costs of assembling golf clubs and tennis rackets can be traced to the product lines of golf clubs and tennis rackets. The time cards of factory workers can identify how many hours each worker spent on each product line.

Indirect Costs

Imagine that the assembly of golf clubs and tennis rackets takes place in a rented facility. The costs of this facility are rent, insurance, security, cleaning, water, electric power, telephone, postage and delivery, and depreciation of machinery and equipment. These combined costs are known as manufacturing overhead [1] . Most of these costs are fixed, meaning that they do not increase or decrease according to the level of manufacturing activity.

It is very difficult to trace these manufacturing overhead costs to the product lines of golf clubs and tennis rackets. For example, it is hard to know how much of the telephone expense relates to golf clubs and how much to tennis rackets. It is even harder to distinguish the telephone expense for golf clubs with steel shafts versus graphite shafts, or tennis rackets with gut strings versus nylon strings.

So direct product costs like raw materials and factory labor can readily be traced to product lines. But indirect product costs cannot be traced to product lines. Therefore indirect product costs must be allocated to product lines. The term “allocated” means assigned to product lines either by some formula or by arbitrary means.

Traditional cost systems allocate manufacturing overhead costs to individual product lines in an arbitrary manner, usually by means of a single allocation base, such as direct labor hours. For example, imagine that manufacturing overhead costs total $800,000 for the month of May. Direct labor hours in May total 6,450, of which 2,560 hours are for tennis rackets and 3,890 hours are for golf clubs. Then manufacturing overhead costs are allocated as follows:

Allocation of Manufacturing Overhead to Tennis Rackets and Golf Clubs

It is typically unknown whether or not this allocation is accurate. In fact, it can only be accurate if manufacturing overhead costs are actually driven by direct labor hours. This seems unlikely, because direct labor hours vary according to the level of manufacturing activity, but manufacturing overhead costs tend to include fixed costs as well as variable costs. So manufacturing overhead costs do not vary according to the level of manufacturing activity because they include fixed costs. Therefore traditional cost allocations are frequently inaccurate and unreliable. As a result, product decisions by management can likewise be inaccurate and unreliable.

Activity Based Costing

In order to provide more accurate and reliable allocations of manufacturing overhead costs, activity based costing was developed. Instead of a single allocation base, activity based costing uses separate cost pools and allocation bases for different activities. Each cost pool is allocated to individual product lines based on whatever driver causes the costs in each pool to be incurred by each individual product line.

For example, one cost pool may consist of all costs relating to machinery and equipment, such as maintenance and depreciation of machinery and equipment, plus a share of the rent, insurance, and electric power costs. Assume that all machinery and equipment is used to assemble golf clubs, and that tennis rackets are gripped and strung completely by hand. Then clearly, all machinery and equipment costs will be allocated to golf clubs, and none to tennis rackets. This is a more accurate allocation than traditional costing can provide. Under traditional costing, using direct labor hours to allocate manufacturing overhead costs to product lines, machinery and equipment costs would partly be allocated to golf clubs, and partly to tennis rackets – which would be incorrect.

Activity based costing is more accurate and reliable than traditional costing because:

· It uses multiple cost pools,

· Based on different activities,

· To allocate costs to product lines,

· Using appropriate cost drivers.

Summary

Costs of direct materials and direct labor are not difficult to trace to different product lines. But indirect manufacturing overhead costs are very difficult to trace to different product lines. Traditional cost systems use arbitrary single allocators (like direct labor hours) to assign indirect manufacturing overhead costs to different product lines. The resulting allocations are often inaccurate and unreliable.

Activity based costing is more accurate and reliable than traditional costing in allocating indirect manufacturing overhead costs to different product lines. Therefore, the greater the proportion of indirect manufacturing overhead costs to direct material and labor costs, the greater the need for activity based costing. And, since indirect manufacturing overhead costs tend to be fixed costs, the greater the proportion of fixed costs to variable costs, the greater the advantage of activity based costing over traditional costing.

[1]  Note that manufacturing overhead does not include Selling, General or Administrative expenses, and does not include interest expense or income tax expense. Only manufacturing costs are allocated to products.