Question

Imagine the activities involved in making a product like cupcakes. Which costing method (process costing, activity based costing, or job costing) would best fit the product?

Answer 1

Activity based costing

In a traditional costing method, we calculate one plantwide allocation rate or we could calculate an overhead allocation rate for each department. We have a three step process:

Step 1: Determine the basis for allocating overhead or indirect costs. These can be anything a company decides but most common are direct labor cost, direct labor hours, direct material usage or machine hours.

Step 2: Calculated a predetermined overhead rate using estimates. This is typically calculated at the end of the year to be used during the following year. The formula we use for this is:

Predetermined overhead rate(POHR)= Estimated overhead /Estimated base

Step 3: Apply overhead throughout the period using the actual amount of our base and the predetermined overhead rate (POHR) calculated in step 2. We calculate this as:

Applied overhead = Actual amount of base x POHR

Activity-based costing requires accountants to use the following four steps:

1. Identify the activities that consume resources and assign costs to those activities. Purchasing materials would be an activity, for example.
2. Identify the cost drivers associated with each activity. A cost driver is an activity or transaction that causes costs to be incurred. For the purchasing materials activity, the cost drivers could be the number of orders placed or the number of items ordered. Each activity could have multiple cost drivers.
3. Compute a cost rate per cost driver unit. The cost driver rate could be the cost per purchase order, for example.
4. Assign costs to products by multiplying the cost driver rate times the volume of cost driver units consumed by the product. For example, the cost per purchase order times the number of orders required for Product A for the month of December would measure the cost of the purchasing activity for Product A for December.