How Is Overhead Allocated In An Abc System

The Activity-Based Costing (ABC) system offers a more refined approach to allocating overhead costs compared to traditional methods. Instead of applying overhead based on volume-related measures like direct labor hours or machine hours, ABC focuses on identifying and costing activities that drive overhead costs. This article delves into how overhead is allocated in an ABC system, covering the steps involved, the underlying principles, and the benefits of this methodology.

Understanding Activity-Based Costing (ABC)

Activity-Based Costing (ABC) is a costing method that identifies activities within an organization and assigns the cost of each activity to products and services based on actual consumption. It recognizes that overhead costs are not always directly related to production volume but are often driven by activities necessary to support production.

Key Concepts in ABC

• Activities: These are the actions or tasks performed within an organization, such as order processing, machine setup, or quality control.
• Cost Drivers: These are the factors that cause activities' costs. For example, the number of purchase orders might drive the cost of the purchasing department.
• Cost Pools: These are groupings of overhead costs associated with a specific activity.
• Activity Rate: This is the cost per unit of the cost driver.

Steps in Overhead Allocation Using ABC

The allocation of overhead in an ABC system involves several key steps:

1. Identify Activities: The first step is to identify all the significant activities that consume overhead resources within the organization.
2. Assign Costs to Activity Cost Pools: The next step is to assign overhead costs to the identified activities, creating cost pools for each activity.
3. Identify Cost Drivers: Once the cost pools are established, identify the cost driver for each activity.
4. Calculate Activity Rates: Calculate the activity rate for each cost pool by dividing the total cost in the cost pool by the total amount of the cost driver.
5. Allocate Costs to Products or Services: Finally, allocate the overhead costs to products or services based on their consumption of each activity.

Let's explore each of these steps in more detail.

1. Identify Activities

The identification of activities is a crucial step in the ABC system. It involves analyzing the organization's processes to determine the significant activities that consume overhead resources.

• How to Identify Activities:

  • Process Mapping: Create detailed process maps to visualize the flow of work and identify key activities.
  • Employee Interviews: Conduct interviews with employees at different levels to gather insights into their tasks and responsibilities.
  • Document Review: Review documents such as process manuals, work instructions, and organizational charts to identify activities.

• Examples of Activities:

  • Order Processing: Receiving and processing customer orders.
  • Machine Setup: Preparing machines for production runs.
  • Quality Control: Inspecting products for defects.
  • Material Handling: Moving materials within the facility.
  • Engineering Design: Designing and developing new products.
  • Customer Support: Providing assistance to customers.

2. Assign Costs to Activity Cost Pools

Once the activities are identified, the next step is to assign overhead costs to each activity, creating cost pools. This involves determining how much of each overhead cost is consumed by each activity.

• Methods for Assigning Costs:

  • Direct Tracing: If possible, directly trace costs to activities. For example, the salary of a quality control inspector can be directly traced to the quality control activity.
  • Driver Tracing: Use cost drivers to allocate costs to activities. For example, electricity costs might be allocated to activities based on machine hours.
  • Allocation: If direct tracing or driver tracing is not possible, allocate costs based on a reasonable basis, such as employee headcount or square footage.

• Creating Cost Pools:

  • Group overhead costs associated with each activity into a cost pool. For example, the cost pool for order processing might include salaries of order entry clerks, costs of order processing software, and related expenses.

3. Identify Cost Drivers

A cost driver is a factor that causes the cost of an activity. Identifying appropriate cost drivers is essential for accurately allocating overhead costs.

• Characteristics of a Good Cost Driver:

  • Causality: The cost driver should have a clear causal relationship with the activity cost.
  • Measurability: The cost driver should be easily measurable and quantifiable.
  • Availability: The data for the cost driver should be readily available.

• Examples of Cost Drivers:

  • Order Processing: Number of orders
  • Machine Setup: Number of setup hours
  • Quality Control: Number of inspections
  • Material Handling: Number of material moves
  • Engineering Design: Number of engineering hours
  • Customer Support: Number of customer calls

4. Calculate Activity Rates

The activity rate is the cost per unit of the cost driver. It is calculated by dividing the total cost in the cost pool by the total amount of the cost driver.

• Formula for Activity Rate:

  • Activity Rate = Total Cost in Cost Pool / Total Amount of Cost Driver

• Example:

  • Suppose the total cost in the machine setup cost pool is $50,000, and the total number of setup hours is 1,000.
  • The activity rate for machine setup is $50,000 / 1,000 = $50 per setup hour.

5. Allocate Costs to Products or Services

The final step is to allocate the overhead costs to products or services based on their consumption of each activity. This involves multiplying the activity rate by the amount of the cost driver consumed by each product or service.

• Formula for Allocating Costs:

  • Allocated Cost = Activity Rate x Amount of Cost Driver Consumed

• Example:

  • Suppose Product A requires 10 setup hours.
  • The allocated cost for machine setup for Product A is $50 (activity rate) x 10 (setup hours) = $500.

Example of Overhead Allocation in ABC System

Consider a manufacturing company that produces two products, Product X and Product Y. The company has the following overhead costs:

• Salaries: $200,000
• Rent: $50,000
• Utilities: $30,000
• Depreciation: $20,000
• Total Overhead Costs: $300,000

The company identifies the following activities:

• Order Processing
• Machine Setup
• Quality Control

The company assigns the overhead costs to the activities as follows:

The company identifies the following cost drivers:

• Order Processing: Number of Orders
• Machine Setup: Number of Setup Hours
• Quality Control: Number of Inspections

The company gathers the following data:

Now, let’s calculate the activity rates:

• Order Processing: $115,000 / 500 = $230 per order
• Machine Setup: $97,000 / 1,000 = $97 per setup hour
• Quality Control: $88,000 / 1,000 = $88 per inspection

Finally, let’s allocate the overhead costs to Product X and Product Y:

In this example, Product X is allocated $164,900 in overhead costs, while Product Y is allocated $135,100.

Comparison with Traditional Overhead Allocation Methods

Traditional overhead allocation methods, such as using direct labor hours or machine hours, often lead to inaccurate cost allocations because they do not reflect the actual consumption of overhead resources.

• Traditional Method: Overhead is allocated based on a single cost driver, such as direct labor hours.
• ABC Method: Overhead is allocated based on multiple activities and their associated cost drivers.

Example: Traditional vs. ABC

Let’s compare the ABC method with a traditional method using direct labor hours as the allocation base. Suppose the total direct labor hours for Product X is 2,000 and for Product Y is 3,000.

Total direct labor hours = 2,000 + 3,000 = 5,000

Overhead rate = Total overhead costs / Total direct labor hours = $300,000 / 5,000 = $60 per direct labor hour

Comparing the results:

• ABC Method: Product X = $164,900, Product Y = $135,100
• Traditional Method: Product X = $120,000, Product Y = $180,000

As you can see, the ABC method provides a more accurate allocation of overhead costs compared to the traditional method.

Advantages of Using ABC

The Activity-Based Costing (ABC) system offers several advantages over traditional costing methods:

• More Accurate Costing: ABC provides a more accurate allocation of overhead costs, leading to better product costing and pricing decisions.
• Improved Decision Making: With more accurate cost information, managers can make better decisions regarding product mix, pricing, and process improvements.
• Better Understanding of Costs: ABC helps managers understand the activities that drive costs, allowing them to focus on cost reduction and efficiency improvements.
• Enhanced Cost Control: By identifying the cost drivers, ABC enables managers to control costs more effectively.
• Support for Process Improvement: ABC highlights areas where processes can be improved to reduce costs and increase efficiency.

Disadvantages of Using ABC

Despite its advantages, the ABC system also has some drawbacks:

• Complexity: ABC can be complex and time-consuming to implement and maintain.
• Cost: Implementing ABC requires significant resources, including time, money, and expertise.
• Subjectivity: Identifying activities and cost drivers can be subjective and may require judgment.
• Data Collection: Collecting the data required for ABC can be challenging and time-consuming.
• Resistance to Change: Employees may resist the implementation of ABC, especially if it results in changes to their roles and responsibilities.

Implementing ABC Successfully

To implement ABC successfully, organizations should consider the following:

• Top Management Support: Obtain support from top management to ensure that the necessary resources are available and that the implementation is taken seriously.
• Cross-Functional Team: Form a cross-functional team to ensure that all relevant perspectives are considered.
• Training: Provide training to employees to ensure that they understand the principles of ABC and how it will affect their work.
• Pilot Project: Start with a pilot project to test the ABC system and identify any issues before implementing it across the entire organization.
• Continuous Improvement: Continuously monitor and improve the ABC system to ensure that it remains accurate and relevant.

Practical Applications of ABC

ABC can be applied in various industries and functions to improve cost management and decision-making.

• Manufacturing: ABC can be used to allocate overhead costs to products, allowing manufacturers to determine the true cost of each product and make informed pricing decisions.
• Healthcare: ABC can be used to allocate costs to different medical procedures and services, helping healthcare providers understand the profitability of each service and make decisions about resource allocation.
• Banking: ABC can be used to allocate costs to different banking products and services, such as loans and checking accounts, helping banks understand the profitability of each product and make decisions about pricing and product mix.
• Service Industries: ABC can be used to allocate costs to different service offerings, allowing service providers to understand the profitability of each service and make decisions about pricing and resource allocation.

The Future of Activity-Based Costing

The future of Activity-Based Costing (ABC) is closely tied to advancements in technology and data analytics. As organizations generate more data, they can leverage sophisticated tools to enhance the accuracy and efficiency of ABC systems.

• Integration with ERP Systems: Integrating ABC with Enterprise Resource Planning (ERP) systems can streamline the data collection process and improve the accuracy of cost allocations.
• Big Data Analytics: Using big data analytics techniques can help identify patterns and relationships in data, leading to a better understanding of cost drivers and more accurate cost allocations.
• Artificial Intelligence (AI): AI can be used to automate the ABC process, reducing the time and effort required to implement and maintain the system.
• Cloud-Based Solutions: Cloud-based ABC solutions offer scalability and flexibility, allowing organizations to easily adapt their ABC systems to changing business needs.

Conclusion

In conclusion, the Activity-Based Costing (ABC) system offers a more refined approach to allocating overhead costs compared to traditional methods. By focusing on activities and their associated cost drivers, ABC provides a more accurate and detailed understanding of costs, leading to better decision-making and improved cost control. While ABC can be complex and time-consuming to implement, the benefits of more accurate costing and improved decision-making often outweigh the costs. Organizations that successfully implement ABC can gain a competitive advantage by making better-informed decisions about product mix, pricing, and process improvements.