Overview
This lecture introduces activity-based costing (ABC) and compares it to traditional overhead allocation methods, highlighting their use in estimating product or service costs.
Overhead Allocation Challenges
- Direct materials and labor can be easily traced to products/services.
- Overhead (indirect materials and labor) cannot be directly traced and must be allocated.
- Allocating overhead helps estimate the true cost of products and services.
- Allocation methods only provide the best estimate, not the exact cost.
Allocation Methods Summary
- There are three main methods to allocate overhead: plantwide rate, departmental rates, and activity-based costing (ABC).
- The choice of allocation method affects accuracy and usefulness depending on the business environment.
Plantwide Rate
- Uses a single overhead rate for the entire plant.
- Rate is based on a volume-based cost driver: direct labor hours, direct labor cost, or machine hours.
- This method was used in job order costing.
Departmental Rates
- Uses two or more rates for different departments.
- Still relies on volume-based cost drivers (e.g., direct labor or machine hours).
- More refined than a plantwide rate but still generalized.
Activity-Based Costing (ABC)
- Uses multiple rates—more than plantwide or departmental methods.
- Allocates costs based on identified activities that drive overhead (e.g., number of batches, setups, pounds of materials).
- Each activity has its own predetermined overhead rate, calculated using estimated activity amounts.
Key Terms & Definitions
- Direct Materials/Labor — Costs that can be directly traced to a product or service.
- Overhead (Factory Overhead) — Indirect costs (materials, labor, other expenses) not directly traceable to products/services.
- Cost Driver — A factor that causes overhead costs to be incurred.
- Plantwide Rate — A single overhead rate used for the entire production facility.
- Departmental Rates — Multiple overhead rates, one for each department.
- Activity-Based Costing (ABC) — An allocation method where costs are assigned to products based on activities and their respective cost drivers.
Action Items / Next Steps
- Review and compare the three overhead allocation methods.
- Prepare for further discussion on detailed ABC procedures in upcoming lectures.