ACCT5996 Chap.3 Overhead Allocation and Activity-Based Costing
Overhead Allocation and Activity-Based Costing
Indirect costs reach products and services through cost pools and allocation bases. This chapter compares plant-wide, departmental and activity-based costing, explains unit, batch, product and facility activity levels, and diagnoses cross-subsidy when one volume driver ignores support complexity.
Original examples reconcile every pool and connect revised cost information to pricing, design and process decisions.
Refinement is treated as a decision about information economics, not a claim that more pools are always superior. A useful system groups resources with a shared causal driver, measures consumption consistently and makes the direction of any cross-subsidy explainable.
The chapter distinguishes a reporting reallocation from an avoidable cash saving: changing the assigned amount does not remove resources. Managers must link revised product or customer cost to process redesign, capacity release, service changes or pricing action before the model creates economic value.
What this chapter covers
- 01
Indirect costs, cost pools and allocation bases
- 02
Cause-and-effect driver selection
- 03
Plant-wide overhead rates
- 04
Departmental two-stage allocation
- 05
Activity-based costing
- 06
Unit, batch, product and facility activities
- 07
Cross-subsidy, data cost and behavioural effects
Worked example · free
Compare one rate with activity-based allocation
- +1Plant-wide rate is $360,000 divided by 18,000, giving $20 per machine hour.
- +1Plant-wide allocation is $300,000 to Standard and $60,000 to Custom.
- +1ABC machine rate is $10 per hour and setup rate is $1,800 per setup.
- +1ABC allocation is $186,000 to Standard and $174,000 to Custom, reconciling to $360,000.
- +1Standard was overcosted by $114,000 and Custom undercosted by $114,000 because Custom consumed most setups.
Key terms
- Cost pool
- A collection of indirect costs grouped for allocation through a common base.
- Allocation base
- The factor used to distribute pooled indirect cost to cost objects.
- Plant-wide rate
- One overhead rate applied across an entire production operation.
- Departmental rate
- A rate specific to one department and its selected cost driver.
- Activity-based costing
- A method that assigns significant activity pools through causal activity drivers.
Overhead Allocation and Activity-Based Costing FAQ
Why does one overhead rate distort product cost?
A single volume base ignores differences in setup, inspection and product-support consumption. Complex low-volume products can be undercosted while simple high-volume products are overcosted, distorting pricing and product decisions.
How is a good driver selected?
Prefer a measurable factor with a credible cause-and-effect relationship to resource consumption. Also consider data cost, operational interpretability, and whether the measure invites unhelpful behaviour or manipulation.
Does activity-based costing save money?
It changes cost visibility, not total cost by itself. Savings require managers to remove or redeploy resources after redesigning products, batches, inspections or customer service.
How many activity pools should a system use?
Use enough pools to separate materially different resource-consumption patterns, but stop when another pool costs more to measure and maintain than the decisions it improves. Combine activities that share a credible driver and similar behaviour. Split a pool when products consume its components differently and that difference could alter pricing, design, sourcing or service decisions.
Why can activity data create behavioural problems?
People may reduce, relabel or batch recorded events to lower an allocation even when the underlying work or customer impact does not improve. Review driver definitions, controls and operational outcomes together. A falling setup count is valuable only if setup resources, capacity, quality or flow also improve; otherwise the measure may simply have changed what employees report.
Exam move
Draw the two-stage flow from resources to pools and from pools to cost objects. Calculate each driver rate, allocate by consumption and reconcile to the pool total. Compare the refined result with the original system, then explain the operational reason for the shift. End with a decision that could change resource use rather than merely changing reported margin.
Label every driver as unit, batch, product or facility level and test whether its denominator uses practical, budgeted or actual capacity. For a cross-subsidy question, write which object was overcosted, which was undercosted and which support activity caused the direction. Separate capacity cost that remains committed from spending that a proposed process change can actually avoid.
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