Summary

6.1 Calculate Predetermined Overhead and Total Cost under the Traditional Allocation Method

• Manufacturing overhead is estimated for the upcoming period.
• An activity base is selected to allocate overhead. This is traditionally direct labor hours, direct labor cost, or machine hours.
• A predetermined overhead rate is calculated by dividing the estimated overhead by the allocation base.
• Overhead is allocated to each product based on the estimated predetermined overhead rate and the number of units in the selected activity base.

6.2 Describe and Identify Cost Drivers

• Overhead costs are analyzed and grouped based on similar activity bases. A cost driver, such as inspections, machine setups, or order taking, is selected for each cost grouping.
• Analysis of cost drivers allows for better selection of true overhead cost drivers and more appropriate allocation of overhead.

6.3 Calculate Activity-Based Product Costs

• Costs can be traced to the unit level or batch level.
• There are five steps in the ABC process:
  • identify activities needed for production
  • assign overhead expenses
  • assign a cost driver for each expense
  • determine a predetermined overhead rate
  • allocate overhead to each product

6.4 Compare and Contrast Traditional and Activity-Based Costing Systems

• Traditional allocation assigns overhead based on a single overhead rate, while ABC assigns overhead based on several cost pools and the activities that drive costs.
• Traditional allocation is optimal when the manufacturing process is labor driven and overhead increases based on traditional activity bases, such as direct labor hours, direct labor dollars, or machine hours.
• ABC costing is optimal when the manufacturing process is technology driven and overhead increases based on various activities that differ for each product.

6.5 Compare and Contrast Variable and Absorption Costing

• Absorption costing assigns all manufacturing costs to products, whereas variable costing only assigns variable costs to the products.
• Income statements from both methods can be reconciled by starting with the net income or loss using variable costing and adding the amount of fixed costs included in ending inventory and subtracting the fixed costs included in beginning inventory.
• Variable costing is not considered GAAP compliant but lends itself to cost-volume-profit analysis.