Managerial Accounting 3.3 (part 2 of 2): Overhead allocation using ABC - YouTube

This is Kurt Heisinger, accounting professor  at Sierra College and author of Managerial  

Accounting. This video extends our discussion of  activity-based costing, it is the part two video  

related to activity-based costing, and here we  are going to discuss not only how the product  

cost information can be used when compared to  other approaches to allocating overhead, but also  

it gets in to the advantages and disadvantages of  using activity-based costing and what the entries  

look like in an activity-based costing system. At  the very end of the part one video we established  

what the product cost would be, which you see down  here toward the bottom, what the product cost would  

be for each of our products, the Basic sailboat  and the Deluxe sailboat, using activity-based  

costing. And so that's what I've outlined here. It is  really this section right here. Now with this slide,  

the extension of this discussion, we're going to  take a look at how this compares to the  

plantwide costing approach and what the profit  looks like for each of these approaches. Let me  

set up this comparison a little bit further. Let's  assume that our company, SailRite, which produces  

two sailboats that you see here the Basic and  the Deluxe, used to use the plantwide costing  

approach, that is this here, and as a result we were  allocating overhead based on direct labor hours in  

one rate plantwide, based on direct labor hours. The result of that allocation is shown here for  

overhead, that overhead line item, and that was what  we came up with as our overhead cost per unit for  

each of those products that we produce. You will  notice too that the direct materials and direct  

labor costs are above the overhead cost and are  the same for both examples. If you go down to the  

bottom part you will see it there as well. Going  back to the plantwide costing approach you will  

see that our total product cost per unit, for the  Basic boat, was $2,880 and for the Deluxe sailboat  

is $3,650. We also now have the sales price in  here, that is this line item right here, and the  

sales price for the Basic sailboat is $3,200 the  sales price for the Deluxe sailboat is $4,500  

per-unit. As a result our profit according to  our records back using this plantwide costing  

approach, the resulting profit was  $320 for the Basic sailboat, and $850 per unit  

for the Deluxe sailboat. To continue to build this  example, let's assume that management based on our  

plantwide costing information, decided to push  the sales of the Deluxe sailboat, because the  

profits of the Deluxe sailboat at $850 per unit  are clearly higher than the profit for the Basic  

sailboat of $320 per unit. The problem was as the  company continued then to push the sales of Deluxe  

sailboats, perhaps offering higher commissions to  our salespeople if they sell that Deluxe boat, as  

we push that and increased our sales of the Deluxe  sailboat, our overall company profits went down. So  

something strange happen, right if we increase the  sales of our Deluxe sailboat it has the highest  

profit per unit but our overall profit goes down,  something is going on here. And management then  

came to us, we are the managerial accountants,  and asked us to reevaluate what our product  

costs are. We know the sales prices are accurate  but we are not entirely sure about the product cost,  

particularly overhead, because overhead is that  one product cost that is not easily traced to  

our individual products. After going through the  activity-based costing process, as was shown in the  

part 1 video related to activity-based costing, we  identified our overhead costs and established our  

overhead costs at $1,004 for the Basic sailboat per  unit, and $2,980 for the Deluxe sailboat per unit.  

And you will see as a result then, that our product  costs per unit were significantly different than  

what we saw with the plantwide approach, and that  then when subtracted from the sales price gave us  

an entirely different profit amount per unit. So  for the Basic sailboat our profits actually were  

higher than we initially thought. We initially  thought our profits were $320

per unit, but after activity-based costing  it looks like those profits are $596 per unit. And  

our Deluxe sailboat, instead of being $850 per  unit in profit, we actually have a $530 loss for  

unit we sell. So now that starts to explain  why our overall company profits went down  

when we were pushing the sales of the Deluxe sail  boat. This leads right into our next slide which  

outlines the advantages of using activity-based  costing. First of all, activity-based costing if  

done correctly, tends to provide more accurate  cost information. And with more accurate cost  

information hopefully we will see improved  decisions being made by management, so it  

leads to better decisions. Now I say hopefully,  that's not always the case, it is really up to  

the managers to make those better decisions, but  if they do use the information correctly it should  

lead to at least more informed decisions. Secondly,  looking at the second bullet point here, secondly,  

if we use activity-based costing, it increases  our knowledge of the production activities that  

are involved in producing our products. Perhaps we  didn't know about all these different activities,  

or at least how costly these activities were, so  using activity-based costing provides us with  

that information. And with that information,  hopefully we'll see some improvement in the  

process, in the production process, and as a result  reduce costs. What are some of the disadvantages  

of using activity-based costing. Obviously not all  companies use this approach to allocating overhead  

to products. Well first of all, the activity-based  costing systems tend to be costly. We have to  

have accounting personnel who know what they are  doing, who have that expertise, and that is costly  

to hire those folks. The second consideration when  implementing an activity-based costing system, is  

understanding that unitizing fixed costs can be  misleading, so we have to be careful about that.  

What that means is, once we establish a cost per  unit at a certain level of production, if there  

are fixed costs in there, that cost per unit is  only good at that level of production. If we start  

to change our level of production, then our cost  per unit changes. That is the classic definition  

of a fixed cost. It stays the same in total but as  we change the level of activity than the per unit  

amount of that fixed cost changes. And that is explained further in a separate video  

having to do with cost behavior identification. So we have to be careful about unitizing fixed  

costs and providing perhaps misleading information. We have to make sure that whoever is using that  

information understands that fixed costs are being  unitized. The third potential disadvantage of using  

activity-based costing, is that the benefits may  not outweigh the costs. It may be that we put a  

lot of work into an activity-based costing system  and a lot of resources, meaning money, and it turns  

out that the information that we get from that  analysis and from that system doesn't really  

help us, the benefits from that  information really doesn't help us in a way  

that outweighs the costs that we incur to  obtain that information. What we talked about on  

the first slide, the differences between using  the plantwide approach and the activity-based  

costing approach with these two sailboats and  the fact that we had vastly different results,  

that doesn't always happen. It could be that we  implement activity-based costing after having  

used the plantwide approach and find that we don't  have vastly different information. So the benefits  

may not outweigh the costs. How are overhead costs  recorded when using activity-based costing. Well  

first of all, it is important to understand that the  flow of costs for a job costing system, it is the  

same whether we're using a plantwide approach for  allocating overhead, a departmental approach for  

allocating overhead, or activity-based costing for  allocating overhead, it is really the same approach.  

The costs flow through all the same accounts  and so you might want to take a look at the  

job costing videos that have been posted because  that is where it is explained in detail how these  

costs flow through the accounts. The second  bullet point here, the cost flows are the same, as  

I mentioned, but now we're using several different  rates, with activity-based costing instead of just  

one rate using a plantwide approach for the  entire plant, or a couple or a few rates related  

to each department within our production facility,  if we are using the departmental allocation approach. So  

we are just going to use several rates, instead  of one, or two, or three, and we have a rate for  

each activity when we're using activity-based  costing. And then with this last bullet point,  

it is just sort of a quick review to show  you the entry that we make when we do apply  

overhead costs to products, whatever system we  are using. So once the overhead amount is  

calculated, again whether it's using a plantwide  approach or the departmental approach, or  

the activity-based costing approach, once we get  the dollar amount, we are going to debit work in  

process inventory, it's an asset account, it's going  up, and we are going to credit the manufacturing  

overhead account. So that entry is consistent  regardless of the allocation method that we use.