Activity Rates for Activity-Based Costing

One function of activity-based costing is to determine a method for assigning the indirect costs to specific cost objects. Managers set up activity-based costing using activity pools that are assigned to the activity. An activity cost pool is a combination of all the expenses related to a specific task, such as making a product or providing a service. The manager then uses these costs to calculate how much it costs to perform the activity. Unlike traditional costing, activity-based costing allocates indirect costs to the production of products or services.

In activity-based costing, managers use activity rates to calculate the overhead cost and to analyze the costs of producing the products. An activity rate is the ratio of manufacturing overhead and total indirect costs, divided by a cost driver to determine a rate. Activity rates come directly from activity drivers.

In a simple analogy for drivers and rates, a normal automatic car will go a certain distance before it needs maintenance. In this particular example, $46 worth of maintenance will happen every 2,000 miles. The cost driver is driving an automatic car, and the activity rate is $0.02 per mile. This is a simple example, but it could also include other typical expenses related to driving a car, such as purchase price, gas, parking, and so forth.

Since a NASCAR race car gets maintenance periodically throughout its races, applying this same activity rate to a NASCAR race car would be inaccurate, resulting in a gross underestimation of the costs. Applying this analogy to manufacturing, it is important for managers to consider the circumstances of activity cost pools and activity cost drivers as they calculate activity rates.

Megalith Manufacturing needs to clean its machines after every 180,000 machine-hours. Cleaning the machines costs $750,000. The activity would be machine maintenance, and the amount would be $750,000. The cost driver would be 180,000 machine-hours. The activity rate for this activity would be $4 per machine-hour. Since the activity rate gives the measure for each hour, it is a transaction driver. A transaction driver tallies up the number of times an event occurs.

There are several steps a manager takes to perform activity-based costing. First, the manager looks for activities required to complete the product. Next, the manager assigns overhead costs to those activities. After that, the manager identifies costs and calculates predetermined overhead rates. The manager then allocates the overhead costs to products.

During the first step, when looking for activities required to complete the product, the manager divides tasks into activity cost pools. For example, Megalith Manufacturing might have activity cost pools such as production, purchasing, shipping, research and development, and sales and marketing.

Once the manager has established activity cost pools, they can focus more closely on each pool and find activity cost drivers within it. A driver is anything that triggers a change. The activity cost driver is the component that changes expenses related to labor, maintenance, and variable costs.

It is important for a manager to identify the activity cost driver in order to accurately calculate the activity rate and then use it for allocating cost to products. An important point about calculating an activity rate is that the activity rate for an activity cost pool, rather than for each product, must be calculated at this stage.

Activity-based costing recognizes that activities are ultimately difficult to assign directly to a product at its start. Direct costs are relatively straightforward to assign to a product. One product may take two hours to make at $10 per hour and use $4 of material. In that case, the total cost is $24 per product. However, overhead, or operating costs or expenses such as rent, electricity, or taxes, are not so straightforward to assign. For instance, Megalith Manufacturing needs an employee law poster for every 100 employees. These posters have a cost, and that cost goes into an overhead pool. The number of employees ultimately depends on the number of products. However, at this point, it would be costly and useless to calculate overhead costs for these posters down to the product level.

Megalith Manufacturing spends $1,200,000 for 12,000 hours of inspection, $4,700,000 for 180,000 hours of machine usage, and $240,000 for 275,000 hours of assembly time. It costs $1,750,000 to deliver 120,000 pallets of the product. After 180,000 machine-hours, the company has spent a total of $750,000 on machine maintenance.

Machine maintenance is a product-level activity. It is related to the number of units produced but cannot be linked directly to a specific unit.

Shipping is a batch-level activity, or an activity that depends on the number of batches run rather than on the number of units in the batch. In this example, the shipping cost is the same if there is 1 unit in the batch or 100.

Megalith produces two products, Product A and Product B. Product A is more complex than Product B so it requires more usage of several of the activities. Product A uses 1.5 hours of inspection time, 21 hours per unit of machine run time, 22 hours per unit of machine maintenance time, 38 hours per unit of assembly, and 12 batches of shipping per unit. Product B uses 0.9 hours of inspection time per unit, 15 hours of machine run time, 14 hours of machine maintenance, 17 hours of assembly, and 12 batches of shipping.

The usage for each activity for each product is multiplied times the cost for that activity in order to assign overhead to the product. For example, Product A uses 1.5 hours of inspection time per unit and inspection costs $100 per hour. This makes the cost of inspection for one unit of Product A $150. This calculation is done for every activity and each product in order to arrive at the total cost per unit of each product. For example, Product A is assigned $150 for inspection, $548.33 for machine run time, $91.67 for machine maintenance, $33.16 for assembly, and $175 for shipping for total overhead per unit of $998.16. Since Product A is more complex and uses more of various activities, the total per unit overhead cost of Product A is more than the per unit overhead cost of Product B using activity-based costing.