Difficulty: Intermediate | Prerequisites: Understanding of fixed vs variable costs, contribution margin, and basic overhead concepts.
Overhead allocation determines how much of a firm's indirect costs get assigned to each product. Traditional systems use a single volume-based driver (usually labour hours or machine hours), which can seriously distort product costs when products consume resources in different proportions. Activity-based costing (ABC) fixes this by using multiple cost drivers matched to the activities that actually cause costs. Target costing flips the question entirely: instead of computing cost and adding a margin, it starts with the market price and works backwards to a cost the product must hit.
Traditional costing allocates all overhead using one volume-based rate, which cross-subsidises products. ABC uses multiple cost pools and drivers (batch-level, product-level) to assign overhead more accurately. Target costing starts from the market price and subtracts the required profit to find the allowable cost, making it most useful for products with well-defined, discrete features.
Traditional cost system (volume-based costing)
A system that allocates all overhead costs using a single unit-level cost driver, such as direct labour hours or machine hours. Simple to operate but prone to cost distortion.
Activity-based costing (ABC)
A costing method that identifies the activities a firm performs and assigns overhead costs to products based on each product's consumption of those activities, using activity-specific cost drivers.
Think of it as matching costs to the things that actually cause them, rather than spreading everything by volume.
Cost driver
A factor that causes or influences the level of cost for an activity. Examples: number of setups (batch-level), number of labour hours (unit-level), number of purchase orders (batch-level).
Unit-level cost driver
A driver that changes with each unit produced (e.g. labour hours, machine hours, materials consumed). Traditional systems rely solely on these.
Batch-level cost driver
A driver that changes with each batch or production run, regardless of the number of units in the batch (e.g. number of setups, number of inspections, number of purchase orders).
Cost distortion (cross-subsidisation)
The misallocation of overhead that makes some products appear more profitable than they are and others less so. Typically, high-volume products subsidise low-volume ones under traditional costing.
Overhead rate
Total overhead cost divided by total driver volume. Under traditional costing, this is a single plant-wide rate. Under ABC, there is a separate rate for each activity cost pool.
Target costing
A pricing and cost management approach that starts with a target selling price (set by the market), subtracts the desired profit margin, and derives a maximum allowable cost. Product design is then managed to hit that cost.
In simple terms, the market tells you the price; you work backwards to what you can afford to spend.
Order entry cost
The cost of processing a customer order, often calculated using time-driven activity-based costing. The cost depends on the time required for each activity (entering customer info, entering line items) multiplied by the cost per unit of time.
Traditional systems use unit-level cost drivers (typically labour hours or machine hours) to allocate all overhead. The problem: many overhead costs are not driven by unit volume. Setup costs, for example, depend on the number of production runs, not the number of units in each run.
When a company makes both high-volume and low-volume products, the high-volume product absorbs a disproportionate share of batch-level and product-level costs under a single rate. The low-volume product, which may require many setups relative to its unit count, appears cheaper than it really is.
The correct answer from the exam: traditional systems distort costs because they use unit-level cost drivers to allocate overhead costs to products. The reliance on unit-level drivers is the root cause of distortion.
ABC identifies separate cost pools for different types of activities and assigns a driver to each. A firm might have one pool for labour-related overhead (driven by labour hours) and another for batch-related overhead (driven by number of batches). Each product then absorbs overhead in proportion to its actual consumption of each activity.
Acme makes three product lines:
Hand-Held | Lawn Sprinklers | Estate Sprinklers | |
|---|---|---|---|
Units | 1,000,000 | 2,000,000 | 40,000 |
Price per unit | $9.00 | $8.50 | $15.00 |
Variable cost per unit | $2.00 | $4.00 | $4.50 |
Labour hours per unit | 2.2 | 1.9 | 2.1 |
Batch size | 10,000 | 5,000 | 1,000 |
Total overhead: $12,776,400. Total labour hours: 6,084,000.
Part A: Traditional (single rate based on labour hours)
Overhead rate = $12,776,400 / 6,084,000 = $2.10 per labour hour
Hand-Held | Lawn | Estate | |
|---|---|---|---|
Contribution margin per unit | $7.00 | $4.50 | $10.50 |
Allocated overhead (hours x $2.10) | $4.62 | $3.99 | $4.41 |
Profit margin per unit | $2.38 | $0.51 | $6.09 |
Total profit | $2,380,000 | $1,020,000 | $243,600 |
Under the traditional system, estate sprinklers look highly profitable at $6.09 per unit.
Part B: ABC (two cost pools, labour + batch)
Labour-related overhead: $7,300,800 at $1.20 per labour hour.
Batch-related overhead: $5,475,600 across 540 total batches at $10,140 per batch.
Batches: Hand-Held 100 (1,000,000 / 10,000), Lawn 400 (2,000,000 / 5,000), Estate 40 (40,000 / 1,000).
Hand-Held | Lawn | Estate | |
|---|---|---|---|
Contribution margin per unit | $7.00 | $4.50 | $10.50 |
Labour overhead per unit (hours x $1.20) | $2.64 | $2.28 | $2.52 |
Batch overhead per unit | $1.01 | $2.03 | $10.14 |
Total allocated overhead | $3.65 | $4.31 | $12.66 |
Profit margin per unit | $3.35 | $0.19 | ($2.16) |
Total profit | $3,346,000 | $384,000 | ($86,400) |
The result flips the story. Estate sprinklers are actually unprofitable once batch-level costs are properly assigned. Their small batch size (1,000 units) means each unit bears a heavy share of the $10,140 per-batch cost. Total profit across all products remains the same ($3,643,600) because ABC reallocates costs, it does not create or destroy them.
Time-driven ABC uses a single rate (cost per unit of time) and estimates the time each activity consumes.
Worked example:
Cost rate: $56.00 per hour
Basic customer info entry: 0.1 hours
Per line item entry: 0.02 hours
A manual order with 10 line items: (0.1 + 10 x 0.02) x $56 = 0.30 x $56 = $16.80
Target costing works backwards from the market:
Target cost = Market price - Desired profit
It is most effective in firms offering products with well-defined and discrete features, because the firm can make trade-offs among price, quality, and functionality for each feature. It is less effective for commodity products, where there is little scope to differentiate by features.
Traditional overhead rate:
Overhead rate = Total overhead / Total driver volume (e.g. labour hours)
Allocated overhead per unit (traditional):
Allocated overhead = Overhead rate x Driver units per product unit
ABC overhead rate per activity:
Activity rate = Activity cost pool / Total activity driver volume
Time-driven ABC cost:
Cost = (Time for activity 1 + Time for activity 2 + ...) x Cost per unit of time
Target cost:
Target cost = Target selling price - Desired profit margin
ABC is widely used in manufacturing firms with diverse product lines, where overhead is a large share of total cost. A contract manufacturer producing both high-volume smartphone components and low-volume speciality sensors would find that a single overhead rate masks the true cost of the speciality line.
Target costing originated in Japanese manufacturing (notably Toyota) and is standard practice in automotive and consumer electronics, where the market effectively sets the price and the engineering team must design to a cost budget.
Students often think ABC creates or destroys profit. It does not. Total profit across all products is the same under both methods. ABC merely redistributes overhead, so individual product profitability changes.
A common error on the Acme-style problem is dividing batch-level costs per unit by batch size incorrectly. The batch cost per unit = (cost per batch) / (units per batch), or equivalently, (number of batches x cost per batch) / total units.
Students sometimes confuse target costing with cost-plus pricing. Cost-plus starts with cost and adds a margin to get a price. Target costing starts with a price (set by the market) and subtracts a margin to get a cost. They run in opposite directions.
When calculating order entry cost, students sometimes forget to add the base time (entering customer info) to the per-line-item time. Both components must be included.
⚠️ The Acme-style problem (traditional vs ABC profitability) is a high-point question. Practise setting up the two-pool calculation quickly, especially the batch count (total units / batch size for each product).
⚠️ Know the reason traditional systems distort costs: reliance on unit-level cost drivers. This is tested as both a multiple-choice concept question and as the interpretive part of worked problems.
⚠️ Target costing effectiveness: the exam tests the condition. It works best for products with well-defined, discrete features. Commodity products offer little scope for feature trade-offs.
⚠️ Order entry cost calculations are straightforward arithmetic but easy to rush. Write out the time equation explicitly.
True or False: ABC changes the total profit a company earns. (False. ABC reallocates the same total overhead across products differently.)
Fill in the blank: Traditional cost systems distort product costs because they rely on ________ cost drivers. (Unit-level)
True or False: Target costing is most effective for commodity products. (False. It is most effective for products with well-defined, discrete features.)
Fill in the blank: Target cost = Target selling price - ________. (Desired profit margin)
True or False: Under ABC, a low-volume product made in small batches will typically show higher per-unit costs than under traditional costing. (True. The batch-level costs are spread over fewer units.)
Q: A firm produces two products. Product A makes 100,000 units in batches of 10,000 (10 batches). Product B makes 5,000 units in batches of 500 (10 batches). Total batch-level overhead is $200,000 and total units are 105,000. Under a traditional unit-based system, how much batch overhead is allocated per unit? Under ABC?
A: Traditional: $200,000 / 105,000 = $1.90 per unit for both products. ABC: 20 total batches, so $10,000 per batch. Product A: ($10,000 x 10) / 100,000 = $1.00 per unit. Product B: ($10,000 x 10) / 5,000 = $20.00 per unit. The traditional system significantly understates Product B's batch costs.
Q: An order entry employee costs $50 per hour. Entering basic customer information takes 0.15 hours. Each line item takes 0.03 hours. What is the cost of a manual order with 8 line items?
A: (0.15 + 8 x 0.03) x $50 = (0.15 + 0.24) x $50 = 0.39 x $50 = $19.50.
Q: A firm's market research shows customers will pay $80 for a product. The firm wants a 20% profit margin on sales. What is the target cost?
A: $80 - (20% x $80) = $80 - $16 = $64.
Q: Under traditional costing, Product X shows a profit of $5 per unit. After implementing ABC, Product X shows a loss of $2 per unit. Did the firm's total profit change?
A: No. Total profit across all products is unchanged. ABC reallocated overhead from other products to Product X, revealing that it was being cross-subsidised.
ABC connects to variance analysis because ABC-derived cost pools can be used to set more accurate budgets and standards. A flexible budget built on ABC drivers (setups, inspections) gives a cleaner picture than one built solely on labour hours.
Target costing connects to the balanced scorecard through the internal business process perspective, which measures how well a firm designs and delivers products. Meeting a target cost is an internal process metric.
The cost distortion problem ties into the transfer pricing topic: if Division A uses a traditional cost system to set transfer prices, the prices may misrepresent the true cost of the product, leading to poor decisions by Division B.
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