- Activity-based overhead rate
Overhead rate = Total Cost for each poolTotal estimated cost driver for the pool
- Market analysis:
Overhead rate = Total Cost of market analysis Total estimated number of hours of analysis
= $70/hour of analysis
- Product design:
Overhead rate = Total Cost of product deisgn Total estimated number of designs
- Product development:
Overhead rate = Total Cost of product development Total estimated number of products
- Prototype testing:
Overhead rate = Total Cost of testing Total estimated number of tests
- Total cost to in-house manufacturing department
Market analysis [1,800 × 70] 126,000
Product design [280 × 940] 263,200
Product development [40,000 × 10] 400,000
Prototype testing [2,800 × 92] 257,600
Total cost 1,046,000
- Total cost for R &D with an outside company
Market analysis [1,800 × 70] 56,000
Product design [280 × 940] 167,320
Product development [40,000 × 10] 120,000
Prototype testing [2,800 × 92] 196,000
Total cost 539,320
- Benefits of Activity-Based Costing
Activity-based costing is a technique that assigns overheads to products, departments or activities based on their consumption of cost drivers. At Ideal Manufacturing, the total cost of a contract is mostly composed on non-volume related services. For instance, market analysis is not related to any volume of production (Heisinger, 2010). Identifying the cost driver for each of the activity ensures that the overhead costs are accurately allocated. In addition, identifying cost pools and the corresponding drivers is important in determining the accurate cost of a contract. The total cost for activities are determined by different drivers thus allocating overhead costs based on a single basis as in traditional costing would be misleading. For example, what drives the cost of market analysis (hours of analysis) and what drives the cost of prototype testing are completely different. Activity-based costing ensures that the accurate absorption rate is used to determine the total cost of each of the activities for every contract.
Accurate determination of the cost for a given contract is critical to Ideal manufacturing. It ensures that it charges an appropriate price for a contract. Appropriate price covers all the costs involved plus an additional profit margin. If overhead costs are not allocated appropriately, the cost of the contract may be less than the total cost incurred hence the firm will make losses. In addition, allocation of overheads using inappropriate bases may lead to an unreasonably high price (Heisinger, 2010). Charging exorbitant prices on a contract affects the competitiveness of the firm. Clients prefer firms that charge reasonable prices for their contracts. Inappropriate pricing would be costly for Ideal Manufacturing in the highly competitive market. Moreover, accurate cost determination is critical to sound decision making by the company. Through ABC, the company can determine the accurate cost of a contract, and this helps in choosing between undertaking a contract through its in-house manufacturing department or outsourcing it to an outside manufacturing firm.
Activity-based costing identifies cost pools thereby giving the total cost for each activity or process. This allows the management of Ideal Manufacturing to control costs effectively. The cost for a contract can easily be classified as market analysis, prototype testing, product design and product development. Since, the cost drivers for each of these activities are known; it is easier to control contract costs. Furthermore, for every contract, the company can identify the activities that consume a lot of resources and design measures to reduce their costs (Heisinger, 2010). Activity-based costing also helps the company to classify activities as value-added and non-value added activities. This involves determining the value an activity adds to the overall value of the contract. To reduce contract costs, activities that do not add much value to the contract may be eliminated or reduced. Effective cost control and management allows the company to reduce the total contract costs making the company more competitive in the market.
Activity-based costing enables Ideal Manufacturing to allocate resources efficiently. Identification of value-added and non-value added services helps in determining the amount of resources to allocate to a given service. This method also helps in planning since the overhead absorption rate is based on budgeted/predetermined estimates. This assists the company to determine the total cost for a contract before its execution.
In addition, the process of applying ABC involves a detailed examination of overheads in the business. All overheads are studied and cost pools are identified after which activities are studied in order to identify the cost driver for each cost pool (Heisinger, 2010). This detailed analysis of overheads enhances better understanding of the company’s overhead costs by the management. Better understanding of overheads assists the management to establish appropriate cost control and management systems.
Heisinger, K. (2010). Essentials of managerial accounting (International ed.). Mason, OH: Southern-Western Cengage Learning.