What\'s the whole idea behind ABC? It provides a company with a different (perha

Question

What's the whole idea behind ABC? It provides a company with a different (perhaps smarter) way of allocating some or all of its overhead costs (i.e., cost pools) across the various product lines or services (cost objectives) it sells to customers. I'm going to make up an easy example with some simple numbers for us to think about. Let's say we own a toy factory and it's comprised of five different production areas for separately producing five different product lines: yoyos, frisbees, hula hoops, rubber balls and Ouija boards (if you even know what a Ouija board is). In a typical month, we produce 200 units of each of these different products (200 yoyos, 200 frisbees, 200 hula hoops, 200 rubber balls and 200 Ouija boards) for a total of 1000 units of all of our products. Our production supervisors know exactly how much DM and DL expense go into each of these different toys, but separate from that, our overall factory operation has $1000 in manufacturing overhead each month covering expenses for maintenance and equipment tear-downs, security and custodial staff, quality inspections, supervision, etc. Using a traditional approach, one way of allocating these total manufacturing overhead costs to each product could be to simply use volume as a base, so in this case our mfg OH costs might ultimately be "spread like peanut butter" across all of the products we produce. This might mean that we've simply allocated $1 in mfg OH to the cost of each yoyo, frisbee, hula hoop, rubber ball and Ouija board ($1000 allocated over all 1000 units each month). This $1 is then added into the product cost of each unit (recall that Product Cost = DM + DL + Mfg OH). However, can you envision some business or manufacturing scenarios where maybe we should not be attributing our overhead so simplistically across all of the products we produce or the services we provide? Does the above scenario bother you in any way? Does it seem that it would be "fair" (for lack of a better word) in all cases that every one of these products should receive the same allocation of the overhead? If not, then how might allocation of overhead costs using ABC differ from a traditional approach of allocating these costs to each product? Any general thoughts on this?

Explanation / Answer

Assume that the Total Overhead per month is $1000 And we consider some activities that consume the   resoursec and act as cost drivers . We shall try to allocate   the major Overhead costs as per the resources consumed Les Us assume the following facts Overheads Amt $ Cost Dricer Total Actvity in A month Rate /Activty Maintenace Expenses                        300 Maintenance dept Man Hours                             50 $               6.00 Quality Inspection Tests                        200 No of Inspections made                           100 $               2.00 Machine Set up                          200 No of Set ups                             75 $               2.67 Supervision                          300 No of Manpower in Prodcution                             80 $               3.75                    1,000 So these are the major overheads categories and the cost   drivers and the rate per activity of each overhead. Now we shall see how much of these activities each product consumes and how the total overhead gets allocated Details yoyo Frisbees Hula Hoops Ouija Boards Total Manitenance Department Man hours spent                             5                                       20                             10                       15                     50 Activity Rate per Maint Man hour                             6                                         6                               6                          6 Maintenance Cost Allocated                            30                                    120                             60                       90                   300 No Of Quality Inspections made                            20                                       25                             45                       10                   100 Activity Rate per No Of Inspections made                               2                                         2                               2                          2 Cost Of Quality Expense allocated                          40                                       50                             90                       20                   200 No of set Ups made                          15                                       25                             10                       25                     75 Activity rate per set Ups made                       2.67                                   2.67                         2.67                    2.67 Cost Of Machine set Up Allocated                          40                                       67                             27                       67                   200 No Of manpower in production                            15                                       20                             25                       20                     80 Supervision cost per No Of manpower in production                         3.75                                   3.75                         3.75                    3.75 Supervision cost Allocated                            56                                       75                             94                       75                   300 Total Overhead expense allocated                        166                                    312                           270                     252               1,000 No of units produced                        200                                    200                           200                     200                   800 Overhead per unit   $                  0.83 $                               1.56 $                     1.35 $               1.26 So it is clear that ABC method allocates overheads   according to the amount of resource consume , not at a flat or predetermined single basis of allocation. So ABC method of allocation is more accurate and correct.

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