Chapter 18 (ACCT 203)

Singe Plantwide Factory Overhead Rate Method

-A company use a predetermined factory overhead rate to allocate factory overhead costs to products. Under the *single plantwide factory overhead rate method*, factory overhead costs are allocated to products using only one rate. Single Plantwide Factory Overhead Rate=Total Budgeted Factory Overhead/Total Budgeted Plantwide Allocated Base -The budgeted allocation base is a measure of operating activity in the factory. Common allocation bases would include direct labor hours, direct labor dollars, and machine hours. -The primary advantage of using the single plantwide overhead rate method is that it is simple and inexpensive to use. However, the single plantwide rate assumes that the factory overhead costs are consumed in the same way by all products. -The preceding assumption may be valid for companies that manufacture one or a few products. However, if a company manufactured products that consumer factory overhead costs in different ways, a single plantwide rate may not accurately allocate factory overhead costs to the products.

Activity-Based Costing Method

-As illustrated in the preceding section, product costs may be distorted when a single plantwide factory overhead rate is used. However, product costs may also be distorted when multiple production department factory overhead rates are used. Activity-based costing further reduces the possibility of product cost distortions. -The *activity-based costing (ABC) method* provides an alternative approach for allocating factory overhead that uses multiple factory overhead rates based on different activities. *Activities* are the types of work, or actions, involved in a manufacturing or service process. -Under activity-based costing, factory overhead costs are initially budgeted for activities, sometimes called activity cost pools, such as machine usages, inspections, moving, production setups, and engineering activities. In contrast, when multiple production department factory overhead rates are used, factory overhead costs are first accounted for in production departments.

Product Costing Allocation Methods

-Determining the cost of product is termed *product costing*. Product costs consist of direct materials, direct labor, and factory overhead. The direct materials and direct labor that can be traced to the product. -The most common methods of allocating factory overhead using predetermined factory overhead rates are: >Single plantwide factory overhead rate method >Multiple production department factory overhead rate methods >Activity-based costing method -The choice of allocation method is important to managers because the allocation affects the product cost. Managers are concerned about the accuracy of product costs, which are used for decisions such as determining product mix, establishing product price, and determining whether to discontinue a product line.

Department Overhead Rate and Allocation

-Each *production department factory overhead rate* is computed as follows: Production Department Factory Overhead Rate=Budgeted Department Factory Overhead/Budgeted Department Allocation Base

Activity-Based Costing for Selling and Administrative Expenses

-Generally accepted accounting principles (GAAP) require that selling and administrative expenses be reported as period expenses on the income statement. However, selling and administrative expenses may be allocated for analyzing product profitability.

Allocating Costs

-Overhead costs of each activity are allocated to a product by multiplying the product's activity-base usage by the activity rate, as follows: Activity Overhead Allocated=Activity-Base Usage*Activity Rate -The estimated total factory overhead cost for a product is the sum of the product's individual activity allocations. The factory overhead cost per unit is computed by dividing the product's total factory overhead cost by the total units of estimated production, as follows: Factory Overhead Cost per Unit=Total Factory Overhead Cost/Total Units of Estimated Production

Activity-Based Costing in Service Businesses

-Service companies need to determine the cost of their services so that they can making pricing, promoting, and other decisions. The use of single and multiple department overhead rate methods may lead to distortions similar to those of manufacturing firms. Thus, many service companies use activity-based costing for determining the cost of services.

Activity Rates

-The budgeted activity costs are assigned to products using factory overhead rates for each activity. These rates are called *activity rates* because they are related to activities. Activity rates are computed as follows: Activity Rate=Budgeted Activity Cost/Total Activity-Base Usage -The term *activity base*, rather than allocation base, used because the base is related to an activity.

Product Distortions

-The following conditions indicate that a single plantwide factory overhead rate may cause product distortions: >Condition 1: Differences in production department factory overhead rates. Some departments have high rates, whereas others have low rates. >Condition 2: Differences among products in the ratios of allocation base usage within a department and across departments. Some products have a high ratio of allocation base usage within departments, whereas other products have a low ratio of allocation base usage within the same departments.

Multiple Production Department Factory Overhead Rate Method

-When production departments differ significantly in their manufacturing processes, factory overhead costs are normally incurred differently in each department. In such cases, factory overhead costs may be more accurately using multiple production department factory overhead rates. -The *multiple production department factory overhead rate method* uses different rate for each production department to allocate factory overhead costs to products. In contrast, the single plantwide rate method uses only one rate to allocate factory overhead costs.