UAL2-U3-L03 · University Accounting Level 2
Overhead allocation and activity-based costing
Learning goals
- Diagnose cross-subsidization from one broad overhead rate.
- Create activity pools and cost-driver rates.
- Compare traditional and ABC product costs and make a cautious recommendation.
Prerequisite check
An allocation base should explain resource consumption. Labour hours may work in a labour-intensive shop but mislead when setups, engineering changes, or purchase orders drive most overhead.
Vocabulary
- Activity-based costing (ABC): assigns resource costs to activities then to cost objects using drivers.
- Cost pool: group of costs sharing a driver.
- Cost driver: measurable factor causing or closely relating to cost.
- Unit-level/batch-level activity: performed per unit or per batch.
- Cross-subsidization: one product receives too much allocated cost and masks another's consumption.
Core idea
ABC improves allocation when products consume non-volume activities differently. It does not make every cost causal or every decision automatic. The model should be only as detailed as decisions and data quality justify.
Why this treatment makes sense
A low-volume customized product may require many setups and engineering hours despite few machine hours. One plantwide rate can undercost it and overcost a simple high-volume product, leading to poor prices and product choices.
A repeatable method
- Define cost objects and decisions the model must support.
- Interview operations and map major activities.
- Group costs with similar drivers; separate facility-sustaining costs when appropriate.
- Calculate pool rate = budgeted pool cost/budgeted driver quantity.
- Assign cost = rate × cost-object driver use.
- Reconcile assigned pools to total overhead.
- Compare with current model and test sensitivity before acting.
Worked example
Waterloo Sensor Works has $600,000 overhead. Traditional allocation uses 30,000 machine hours = $20/MH. Product S uses 8,000 MH for 4,000 units, so gets $160,000 or $40/unit.
ABC separates:
| Pool | Cost | Driver quantity | Rate | S use | S assigned |
|---|---|---|---|---|---|
| Machine support | $300,000 | 30,000 MH | $10/MH | 8,000 | $80,000 |
| Setups | $180,000 | 120 setups | $1,500/setup | 60 | $90,000 |
| Engineering | $120,000 | 2,000 hours | $60/hour | 900 | $54,000 |
| Total S | — | — | — | — | $224,000 |
ABC overhead is $56/unit, $16 more than traditional. S's customization burden was hidden. Before raising price, verify driver data, customer value, unused capacity, and competitor response.
Journal, ledger, and statement connection
ABC is often a management submodel; external inventory still reconciles to the general ledger and applicable costing rules. Pool totals must tie to overhead accounts, while driver transactions need controlled source data and versioned definitions.
Common mistakes
- Creating one pool for every account and making the model unmaintainable.
- Choosing drivers because data are easy rather than causally useful.
- Treating allocated facility cost as avoidable in a short-run decision.
- Raising price immediately without checking demand or capacity.
Guided practice
Inspection pool $96,000 over 1,200 inspections = $80 each. Product A uses 350 inspections, so receives $28,000. If A makes 2,000 units, inspection cost is $14/unit.
Independent practice
Level 1 — rate: Setup cost $240,000 and 160 setups. Find rate.
Level 2 — assign: Rates are $12/MH and $900/setup. Product B uses 3,000 MH and 25 setups for 1,500 units. Find assigned overhead and per-unit amount.
Level 3 — design: Recommend drivers for purchasing, quality testing, and facility rent, and identify which allocation is least likely to be causal.
Self-check and solutions
Level 1: $1,500 per setup.
Level 2: $36,000 + $22,500 = $58,500; $39/unit.
Level 3: Purchase orders or supplier lines; tests/hours or inspections; floor area may allocate rent but is often facility-sustaining and not avoidable for product decisions. State purpose and limitations.
Retrieval practice
- State the pool-rate formula.
- What pattern makes ABC especially useful?
- Does allocation prove avoidability?
Answers: pool cost/driver quantity; diverse products consuming non-volume activities differently; no.
Exam-style application
Reallocate three overhead pools to two products, identify cross-subsidization, and recommend a pricing/process response with one sensitivity test and one data control.
Lesson summary
ABC exposes activity consumption hidden by broad volume rates, but model purpose, driver quality, reconciliation, and decision relevance remain essential.