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Allocating Overhead in Activity-Based Costing Systems

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  • 0:03 Activity-Based Costing
  • 1:14 Cost Pools & Cost Drivers
  • 1:53 Calculating Overhead Formula
  • 2:28 Examples
  • 4:16 Lesson Summary
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Lesson Transcript
Instructor: Yuanxin (Amy) Yang Alcocer

Amy has a master's degree in secondary education and has taught math at a public charter high school.

In this lesson, you'll learn how you can calculate your overhead by figuring out the cost of each activity you do to make a product. You'll also read about dividing your costs into batch-related costs and per-unit costs.

Activity-Based Costing (ABC)

Imagine that you are the general manager of a company that makes storage bins for small things such as beads, ribbons, and other craft items. To make your products, machines need to be set up, and then time and materials are needed to make each finished product. In order to accurately price each item, you need to know how much your overhead costs are. Your overhead costs are the costs associated with making your products.

There are several different methods that businesses use to calculate their overhead. In this lesson, we'll take a look at the activity-based costing method. This method takes into account the various activities that go into the making of a product. It can be as simple as just a few activities, or it can be complicated, with hundreds of activities.

To calculate the overhead per product by using the activity-based costing method, follow these steps:

  1. Identify your cost pools and cost drivers. Calculate the totals of each cost pool.
  2. Divide the cost of each cost pool by the number of products made.
  3. Add each of these divided costs to find the overhead per product.

Cost Pools and Cost Drivers

Each of the activities that go into the making of a product is also referred to as a cost pool. You can include the machine setup activity, along with a research and development activity. You can also include a personnel activity to account for wages paid to employees. Each business will have its own unique list of cost pools.

For your craft storage bins business, you may have the cost pools of:

  • Machine setup
  • Personnel
  • Materials

Your cost drivers are the reasons behind your cost pools. For example, the cost pool machine setup has a cost driver of the cost to a company in terms of time and supplies to set up a certain machine.

Calculating Overhead Formula

To calculate your overhead using the activity-based costing method, you take each cost pool that you've listed and figure out the cost of each. You then divide this number by the total number of products you've made. Some of these cost pools are per batch, while others are per product. For example, the machine set up cost pool is a per batch cost, while the personnel and materials cost pools are per product. For each cost pool, you'll follow this formula:

Activity-based Cost per Unit = (Total Activity Cost) / (Total Number of Products Produced)

Examples

Let's go ahead and make a couple overhead calculations for your craft storage bin business. Each one is for a different manufacturing scenario. We'll see how your overhead per product changes with each scenario.

Scenario #1: Making a batch of 500

For scenario #1, you'll be making a batch of 500 bins. We see that your overhead per product in this case is $250 per batch for machine setup, $500 for personnel, and $50 for materials.

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