Activity Based Costing (Part 1) Cost Pools and 1st Stage Allocation

in this video we're going to talk about

activity-based costing I think it's best

that we just jump right into an example

of an actual firm and why activity-based

costing would be useful so let's say

that you start a company that makes

bicycles and skateboards you manufacture

them you sell them to bike shops to

skate shops so that's what you do with

your company and let's say that in the

past when you think about allocating

your manufacturing overhead which I'll

just abbreviate here so your

manufacturing overhead you would just

say okay well we'll just allocate that

based on something like machine hours so

you'll just say whatever your

manufacturing overhead is so let's say

it's X you just divide that by the

number of machine hours and then you get

a certain amount per machine hours $13 a

machine hours something like that in

each time you have machine hours you go

ahead and you allocate that to the

products that you're making but but

there's a thing here that bears

mentioning is okay so machine hours is

just one measure of what might drive

overhead right there are a lot of things

that might have an effect on your

overhead that have nothing to do with

the number of machine hours right we

just pick machine hours because it's

just an easy just an easy proxy right

just something we can just plug in and

say let's do this but what if there were

four or five or ten things that we're

driving manufacturing overhead and what

if your product costs we're actually

also driven by things like you know SGA

customer support things that don't fall

into manufacturing overhead but

nonetheless you know you might have more

customer support costs for the bicycles

than you would for the skateboards maybe

the people with the bicycles that you

sell them to they complain more about

the quality of the bicycles that's

driving more of these costs which in a

traditional costing system we wouldn't

be allocating that because SGA costs or

period costs are not part of

manufacturing overhead so activity-based

costing of what we're what we're doing

is we're going to say okay well we're

going to take all the overhead and step

one of active activity-based costing

implementing the system or take all the

overhead now this overhead can include

this could be manufacturing over

head and it could also be SG an a-type

overhead right like those customer

support costs we're just going to take

it all we're going to dump it in this

bucket here right and say that it's to a

2.5 million dollars right so that's

that's what you've you've got for your

firm now of course if you wanted to you

could actually break it out and say okay

well we're actually going to two

separate lines here we're gonna have one

for manufacturing overhead and then one

for SGA and we'll do that separately in

this case I'm just going to make it

simple we're going to lump them both in

and say we've got two million five

hundred thousand dollars here okay

so this is the overhead this is what we

want to be allocating and in the past we

just have that that one plant-wide rate

right based on machine hours labor hour

or something like that that has to do

the manufacturing overhead but with

activity-based costing we're actually

going to come up with multiple rates

which is really the core difference

between traditional costing and ABC so

now that we've got what our overhead

bucket is here we need to create

something called cost pools and with

cost pools what we're essentially doing

let me actually hold off on going down

there we're actually saying out of this

two and a half million dollars how does

this break out in terms of different

activities they're actually driving this

overhead right we know it's not just

machine hour so what is it so let's say

that we think about this we interview

our employees and we find that there are

multiple things and and one thing is

assembly right so as we assemble units

as we assemble bicycles and in

skateboards we're incurring some

overhead and so that's one of the

drivers of that that two and a half

million dollars and beyond assembly we

say well actually when we've assembled

the unit we have to process the orders

right so we've got some processing of

the orders that's actually going to

drive some of the overhead and then

we've got support costs and that we're

talking about the customer support

people are complaining that might not

believe manufacturing but that is

something that we want to take into

consideration when we're costing out

these bicycles in these skateboards and

then we'll have a fourth category where

we just say well this is this is other

this is actually things that really


into these categories maybe it's

something like the lease on the factory

where we actually manufacture the bikes

and the skateboards so these are called

cost pools right so what it is is we're

saying that this big bucket that two and

a half million dollars goes into these

different pools right so it's going to

be divvied up among those four pools and

now actually I've wrote out a little

table here and and this is basically it

has the same information as as above

right here we've got those four cost

pools and just got them assembly

processing support and other those are

our four cost pools and now we're just

going to basically dump this two and a

half million dollars we're going to

spread it across these four pools right

that that's what we're going to be doing

now and that's actually known as the

first stage allocation right they're

actually going to be two stages and

we'll get into the second stage in our

second video the first stage allocation

is we're taking this two and a half

million dollars and spreading it across

the four cost pools now you say well how

do we do that how do we know how much is

in assembly how much is processing and

so forth well again we have to interview

our employees and say okay what percent

of this overhead do you think has to do

with actually assembling the units has

to do a processing orders and so forth

and so we're going to come up with

percentages and then we're going to use

those percentages to actually calculate

the numbers that are going to go in this

first stage allocation so let's say that

after interviewing people you found that

assembly really accounts for 60% of this

overhead and then processing the orders

that's about 10% and then support would

be 25% and then this other category is

5% right now again the this is your cost

system at your firm you design it how

you feel is appropriate you might have

an additional cost pool that's not in

here or you might not have one of these

depends on what you feel is relevant and

you just basically get this information

from your employees so it's upset

subjective in that sense but it's going

to be more accurate than just saying

well let's just take machine hours right

so we're looking at all these activities

and how they drive the cost in this


bakit so now we just say okay well we've

got 60% is this assembly so we take 60%

of two and a half million dollars and

we're going to put that right here so

that's going to be if you do the math

we've got 1 million five hundred

thousand dollars again that's just that

60% of the two and a half million okay

now we've got this other thing here you

might be wondering well what is this

activity measure why do I have that

written in there well we've got our

activity assembling units and then we've

got the amount of cost that is going to

come into the assembly of the unit's

borgund we're ultimately shooting for a

rate right which we're going to get into

that's our kind of our last step in this

video I don't want to get ahead of

myself too much but to have a rate we

need to have some kind of measure right

we're going to need to say okay we've

got here's the cost we've dumped into

this bucket but cost according to what

well assembly the costs in that assembly

are driven in our opinion by the amount

of units that we actually assemble right

if we assemble more bicycles and more

skateboards we're going to have more

assembly overhead costs right so we just

say okay well we're just going to take

this 1.5 million dollars but we need to

have some kind of to get a rate

ultimately which is what we're shooting

for we need some kind of measure of how

we go about calculating these class and

we'll say okay well we plan to produce

let's say 500,000 units and when I say

units we're talking about is a number of

bicycles and skateboards right so we're

saying okay we've got this 1.5 million

and then we're going to spread it across

the 500,000 units right now with

processing now we're at our next cost

pool we're just going to follow the same

process we're going to say okay well we

know if we talk to our employees is 10%

of that two and a half million dollars

is going to go here in our first stage

allocation that's how much you get

dumped in that bucket and that's two

hundred and fifty thousand dollars okay

so this is we're saying 250 thousand

dollars of that overhead has to do and

is driven by our employees processing

the orders so how will we go about

thinking about a measure for processing

those orders what we can say well the


of orders right the number of orders

that we have if we have more orders

we're going to have more overhead costs

related to processing those orders right

so we'll just say okay well we'll go

ahead and say how many orders we're

going to have and then we'll use that to

calculate our rate later and so let's

say we say well you know what we think

we're going to have a thousand orders

okay so we just plug that in right here

so now our customer support cost is next

that's our next cost pool we just follow

the same plan we say okay look we we've

talked to our employees twenty-five

percent of this amount here of that two

and a half million has to do it's driven

by customer support costs so we multiply

that out and we get six hundred and

twenty five thousand and again that's

just twenty five percent of that two and

a half million dollars right so now we

need an activity measure for the

customer support cost so we might think

of a lot of different ways that we

measure how well how would customer

support cost be driven maybe by the

number of emails that we get from

customers maybe by the number of phone

calls we'll just say by the number of

customers right we'll just say that

that's an easy way to count and we'll

say okay there's there's 200 customers

and so the more customers there are the

more customer support costs there will

be related to overhead yep now with our

final cost pool this other again we

talked about this others just is five

percent of this two and a half million

and we're saying that that really

doesn't fit in to any of our other cost

pools that might be the lease on the

factory or something like that and it's

we're just going to calculate that out

say it's one hundred and twenty five

thousand dollars and then we're not

going to have an activity activity

measure so I've just got an A here

because because that's not important

actually we're really not going to even

even focusing on this that's not

relevant to us it's something we don't

want to be thinking about because we

don't really think is a clause driver in

the sense of something we can measure

with a rate so now we can say okay

step three and I should have said so

this first stage allocation going ahead

and finding how much to dump in each of

those buckets right we're basically

taking that two-and-a-half million and

spreading it across those four cost

pools that's that's technically step two

right so now step three

is we're actually going to calculate our

activity rate so again now you see we're

going to have multiple rates here right

we're going to have multiple different

rates we're not just going to have one

plant-wide overhead rate this is okay

$13 a machine hour whatever it is we're

actually going to have multiple rates

and then apply those based on these

different activities so now we just say

this is actually a pretty simple part we

just say okay how much do we allocate in

the first stage allocation right how

much of this bucket went down here right

so we've got 1.5 million and then we

just divide that by the number of units

right so that's going to come out to $3

a unit that's our activity rate for

assembly overhead costs right now when

we think of the processing we again just

take this number and divide it by this

number we have 250,000 divided by a

thousand orders that's going to be two

hundred and fifty dollars in order and

then now for support we just take the

six hundred twenty-five thousand and

divide it by two hundred customers and

that's going to give us three thousand

one hundred and twenty-five dollars per

customer and then of course now we don't

have any kind of activity measure for

other so we really don't want to even be

thinking about that so we'll just say

n/a because when we go to do our

activity-based costing we use the rates

we really want to be looking at these

three cost pools right here and how they

drive the costs that end up in this big

bucket of two and a half million dollars

now you can see that because we've got

multiple activity measures because we

said well actually let's look at what

really drives that two and a half

million dollars let's look at the

assembly let's look at the processing

let's look at the support since we're

doing this we're going to come up with

more precise more accurate cost numbers

when we think of the different product

lines when we think costing out how much

it is to produce a bicycle how much it

is to produce a skateboard then we would

if we just did traditional costing and

use that one rate of based on machine

hours or labor hours now again bear in

mind alcohol we're allocating overhead


now right now even though it includes

sgna and we're not just talking about

manufacturing overhead this is not

counting for things like direct

materials and direct labor so there's

actually more costs they're going to be

involved than just what we're talking

about with the activity rate but those

costs are traceable directly to the

bicycles directly to the skateboards so

we don't need to allocate those what

we're trying to do is take those

difficult to measure costs that end up

in this overhead bucket and say can we

find more precise rates to go ahead and

measure them so we can allocate them to

the products