# Introduction to Activity Based Costing

Description: The focus of the following article mainly concentrates on the key point of activity based costing. The content will show us the concept of Activity Based Costing which can also be called ABC activity-based costing. We can see some more detailed analyses of it from reading the material below.

Today we’re going to be looking at activity-based costing, we call this ABC activity-based costing, in our previous class, we looked at populating a predetermined overhead rate, this was the traditional approach with a plant-wide approach where we get one single rate.

So we get this predetermined overhead rate, we took our estimated overhead, we asked me to what our overhead would be for the year or the time period and divided it by the estimated activity-based activity for that same time period.

So for example, let’s say that our estimated overhead is \$30,000 for this time period, we put a dollar sign there and our activity base is going to be labor hours, how many hours hour laborers are physically working on the product?

We estimate there’s going to be 5,000 labor hours in this time period, what will take the 30,000 divided by the 5,000 labor hours or we’ll get a rate of six dollars per labor hour? So every time that somebody works an hour on a job will allocate six dollars overhead to that job.

So if they work three hours on a job \$18.00 overhead will be allocated to the job along with the labor rate and the materials, the traditional approach is one rate for the whole company, some textbooks though they talk about dept rates, so each department could do their own single rate.

So there could be an assembly Department and assembly may have their own overhead and they could calculate a rate for that department and may be machining, it might have a different rate, but it would still be a single rate for each department separately.

But typically what we have is one single rate for the whole company, when we use the traditional approach one single rate versus activity-based costing activity-based costing, we’re going to have multiple rates, so what we do is that we take this overhead here.

We’re going to divide it into different pools groupings of cots, so I’m going to give an example here, we have a janitorial area, we have a machining rate and we’re going to have an assembly assembly now,so let’s say that this 30,000 is broken out this way, janitor janitorial tied costs are \$10,000 machining costs are five thousand dollars and our assembly overhead costs.

These are all over estimated overhead cost, so we’re doing the same formula here, we’re doing it multiple times, we’re going to take this 30,000 and break it down between ten five and fifteen, so we looked at the individual cost and this is where they fell now janitorial.

Let’s say that the best way to allocate janitorial services is based off of square footage, let’s say there are 20,000 square feet in this plan, so each area then gets allocated overhead for janitorial services based off of how many square feet they’re using in the plan.

So 10,000 dollars divided by 20,000 square feet gives us a rate of 50 cents per square foot, let’s assume that there are going to be 5000 machine hours, so the machines are going to be, we estimate they’re going to run for 5,000 hours, so every time the machine runs a dollar per hour will be allocated to that job and assembly.

Let’s assume the assembly will use 5000 labour outlets, they’re not the same, these machining hours and labor hours are different of issues from the same dollar amount though it, so this gets us three dollars every time, somebody works an hour in the assembly area.

Three dollars of overhead will be allocated to that job, so now this is five thousand labor hours that should be the same, that’s where I got this five thousands of labor hours over here, we have one rate here for the traditional approach, the activity based approach, we have multiple rates.

I show three weights, there could be more than three rates, there could be four rates vibrates, however, many rates you want to use to allocate overhead typically, the more rates you have, the better you are at allocating those cost correctly to each job.

Because you’re more specific on how you want to allocate them, the advantage is that you’re going to be more accurate, the disadvantages that it’s a little bit harder, I mean because you’re doing multiple rates, you would not do this way, making sure you understand that companies either use the traditional approach or the single rate approach or the plant right approach or you use the activity-based costing approach which is going to be more accurate.

So let’s continue on with this example here, let’s say that we have job number, we’re going to make this up job number 457 and let’s say that they have a thousand square feet, so this job is using a thousand square feet area, let’s say they have five hundred machine hours and they have 400 labour hours.

So this is what’s taking place here, so every square foot gets 50 cents, so we’re going to take a thousand times 50 cents which gives us obviously five hundred dollars and then for the machine hours each machine hour gets allocated \$1 of overhead, so that’s another 500, so the 500 machine hours times the dollar rate.

Now for the assembly, we’re going to take 400 labor hours times \$3 which equals \$1,200, so that gets us \$2,200 of overhead, this is how much overhead will go into JA 457 and then Plus will calculate the labor rate, so there’ll also be labor and materials that go into job 457.

But this is how much over it, then we’re going to allocate to this job, if this company wasn’t using activity-based costing and instead it was using the traditional approach they would use, I told you before that our activity base on this one was labor hours.

So there were 400 labor hours times, the rate \$6 which gets us 2,400 miles, so under this approach, they’d be allocated more overhead, this one generally is going to be more accurate, because we’re breaking down our overhead into more specific pools and allocating on a better cost driver whatever is driving this in a better activity base than one huge pot of money.

We’re using several separate activity bases that are used that are better useful in allocating the overhead in that area class, I think you’ll probably need to watch this video a couple of times, it’s not hard stuff, it’s easy stuff, but students do get a little bit confused between activity-based costing and traditional approach, but it’s not too bad, keep reviewing this in the chapter and you should get it quickly, thank you.