Comprehensive Study Notes: Plant Overhead Allocation, Broad Averaging, Product Cross-Subsidization, and Activity-Based Costing (ABC)

Plant Overhead Allocation Principles

• Overhead Application Concept: Plant overhead is applied to production units in a rational, systematic manner utilizing averaging mechanisms.

• Trade-Offs in System Design: Overhead allocation methods involve trade-offs between operational simplicity and accounting realism:

  • Simple Methods: Utilize mechanisms such as Predetermined Overhead Rates ($\text{POHR}$). While straightforward to implement and maintain, simple methods can produce highly inaccurate product cost data.

  • Complex Methods: Utilize Activity-Based Costing ($\text{ABC}$) and multi-tiered allocation structures. These refined cost systems provide greater tracking accuracy but demand significantly higher administrative complexity.

Broad Averaging and "Peanut-Butter Costing"

• Historical Context:

  • Historically, manufacturing organizations produced a limited variety of standardized goods.

  • Indirect costs represented a relatively small proportion of total manufacturing expenses.

  • Cost allocation was straightforward: overhead was assigned uniformly across products using broad averages, regardless of how resources were actually consumed during production.

• Definition of "Peanut-Butter Costing":

  • Describes the practice of using broad averages to allocate costs uniformly across all product lines, spreading indirect costs evenly across output units like peanut butter on bread.

• Distortions Caused by Broad Averaging:

  • Low-Resource Products: Products that consume fewer resources are systematically overcosted.

  • High-Resource Products: Products that consume more resources are systematically undercosted.

Product Cost Cross-Subsidization

• Fundamental Rule: If one product is undercosted, at least one other product must be overcosted by an offsetting amount.

• Mechanics of Overcosting:

  • An overcosted product absorbs an excessive proportion of overhead costs.

  • Effect: Overcosting reduces reported margins, making the product appear less profitable than it actually is.

• Mechanics of Undercosting:

  • An undercosted product is assigned an insufficient proportion of overhead costs.

  • Effect: Undercosting inflates reported margins, making the product appear more profitable than it actually is.

Refined Costing Structure: Plastim Activity-Based Costing (ABC)

• Seven-Step ABC Implementation Process:

  • Step 1: Identify Cost Objects

    • Primary Cost Objects: Simple Lenses ($\text{S3}$) and Complex Lenses ($\text{C5}$).

  • Step 2: Identify Direct Costs of the Products

    • Direct Materials

    • Direct Manufacturing Labor

    • Mold Cleaning and Maintenance

  • Step 3: Select Cost-Allocation Bases (Cost Drivers)

  • Step 4: Identify Indirect-Cost Pools Associated with Each Allocation Base

  • Step 5: Compute the Allocation Rate per Unit of Cost Driver

    • Design Activity Pool:

      • Total Indirect Cost Pool: $\$450,000$

      • Cost Allocation Base / Driver: $100\,\text{Parts-Square feet}$

      • Activity Allocation Rate: $\frac{\$450,000}{100} = \$4,500\,\text{per part-square foot}$

    • Molding Machine Setup Activity Pool:

      • Total Indirect Cost Pool: $\$300,000$

      • Cost Allocation Base / Driver: $2,000\,\text{Setup-Hours}$

      • Activity Allocation Rate: $\frac{\$300,000}{2,000} = \$150\,\text{per setup-hour}$

    • Molding Machine Operations Activity Pool:

      • Total Indirect Cost Pool: $\$637,500$

      • Cost Allocation Base / Driver: $12,750\,\text{Molding Machine-Hours}$

      • Activity Allocation Rate: $\frac{\$637,500}{12,750} = \$50\,\text{per molding machine-hour}$

    • Shipment Setup Activity Pool:

      • Total Indirect Cost Pool: $\$81,000$

      • Cost Allocation Base / Driver: $200\,\text{Shipments}$

      • Activity Allocation Rate: $\frac{\$81,000}{200} = \$405\,\text{per shipment}$

    • Distribution Activity Pool:

      • Total Indirect Cost Pool: $\$391,500$

      • Cost Allocation Base / Driver: $67,500\,\text{Cubic Feet Delivered}$

      • Activity Allocation Rate: $\frac{\$391,500}{67,500} = \$5.80\,\text{per cubic foot delivered}$

    • Administration Activity Pool:

      • Total Indirect Cost Pool: $\$255,000$

      • Cost Allocation Base / Driver: $39,750\,\text{Direct Manufacturing Labor-Hours}$

      • Activity Allocation Rate: $\frac{\$255,000}{39,750} = \$6.4151\,\text{per direct manufacturing labor-hour}$

  • Step 6: Compute the Indirect Costs Allocated to the Products

    • Multiply calculated activity allocation rates by actual driver volumes consumed by $\text{S3}$ and $\text{C5}$.

  • Step 7: Compute the Total Cost of the Products

    • Sum all direct costs (Step 2) and allocated indirect activity costs (Step 6).