Course: Introduction to Management Accounting, University of Minnesota Twin Cities Source: ICE #6 (In-Class Exercise 6) Difficulty: Intermediate Prerequisites: Understanding of product costing basics, direct vs indirect costs, and how overhead is applied to products.
Every manufactured product carries both direct costs (materials, labour) and indirect costs (overhead). The question is how to split that overhead fairly across different products. This topic compares two approaches: the traditional plantwide overhead rate, which uses a single allocation base, and activity-based costing (ABC), which traces overhead to multiple activity cost pools before assigning it to products.
This matters because the method you choose can flip a product from profitable to unprofitable on paper. If you have covered direct vs indirect costs and know what manufacturing overhead is, you are ready for this material.
Traditional costing spreads all manufacturing overhead using one rate (here, $2 per direct labour dollar). Activity-based costing breaks overhead into separate pools (machining, setups, product-sustaining) and assigns each pool using its own driver. In this exercise, switching from traditional to ABC shifts the T500 from a $136,300 profit to a $29,200 loss, revealing that traditional costing was hiding the T500's true cost.
Plantwide overhead rate (predetermined overhead rate)
A single rate used to apply all manufacturing overhead to products, calculated as total manufacturing overhead divided by the total of a single allocation base (e.g. direct labour dollars or machine hours).
In simple terms, one number that spreads the entire overhead pot across every product using the same measure.
Activity-based costing (ABC)
A costing method that identifies individual activities (machining, setups, product support) as cost pools and assigns overhead to products based on how much of each activity the product actually consumes.
Think of it as splitting the overhead bill into several smaller bills, each charged according to its own usage metric.
Activity cost pool
A grouping of overhead costs tied to a single activity. Each pool has its own cost driver.
In simple terms, a bucket of costs that all happen for the same reason (e.g. every cost related to setting up machines goes in the "setups" pool).
Activity measure (cost driver)
The unit used to measure how much of an activity each product consumes: machine hours for machining, setup hours for setups, number of products for product-sustaining costs.
Think of it as the meter that tracks each product's share of that activity.
Product margin
Sales revenue minus all costs traced or allocated to the product. Under traditional costing this includes direct materials, direct labour, and applied MOH. Under ABC it may also include directly traceable non-manufacturing costs like advertising.
In simple terms, what is left over from a product's sales after you subtract everything you can reasonably charge to it.
Organisation-sustaining costs
Overhead costs that support the business as a whole and cannot be meaningfully traced to any individual product (e.g. general admin, facility-level costs).
Think of it as the cost of keeping the lights on, which benefits everything and belongs to nothing specific.
Applied manufacturing overhead (applied MOH)
The amount of overhead charged to a product using the predetermined overhead rate times the product's actual usage of the allocation base.
In simple terms, the product's share of overhead according to the formula.
How the plantwide rate works
Calculate one overhead rate for the entire factory:
Overhead Rate = Total Manufacturing Overhead / Total Allocation Base
Here: $608,000 / $304,000 direct labour = $2 per direct labour dollar
Apply that rate to each product based on its direct labour cost:
B300 applied MOH: $200,000 x $2 = $400,000
T500 applied MOH: $104,000 x $2 = $208,000
Product margin calculation (traditional)
B300 | T500 | |
|---|---|---|
Sales | $1,400,000 | $700,000 |
Direct materials | ($436,300) | ($251,700) |
Direct labour | ($200,000) | ($104,000) |
Applied MOH | ($400,000) | ($208,000) |
Total cost | ($1,036,300) | ($563,700) |
Product margin | $363,700 | $136,300 |
Under this method, both products appear profitable. The B300 earns a larger margin in absolute terms, and the T500 looks comfortably in the black.
Step 1: Identify activity cost pools and compute activity rates
The ABC team broke manufacturing overhead ($608,000) into four pools:
Activity pool | Cost | Driver | Total driver units | Rate |
|---|---|---|---|---|
Machining | $213,500 | Machine hours | 152,500 | $1.40 per machine hour |
Setups | $157,500 | Setup hours | 375 | $420 per setup hour |
Product-sustaining | $120,000 | Number of products | 2 | $60,000 per product |
Organisation-sustaining | $117,000 | N/A | N/A | Not allocated to products |
Notice that the $117,000 organisation-sustaining cost is not allocated to either product. ABC leaves costs unassigned when no cause-and-effect link to a product exists.
Step 2: Trace non-manufacturing costs where possible
The ABC implementation team also found that $50,000 of advertising was directly traceable to B300 and $100,000 to T500. The remaining selling and administrative expenses were organisation-sustaining.
Step 3: Assign activity costs to each product
B300 machining: 90,000 hours x $1.40 = $126,000
T500 machining: 62,500 hours x $1.40 = $87,500
B300 setups: 75 hours x $420 = $31,500
T500 setups: 300 hours x $420 = $126,000
Both products: 1 product each x $60,000 = $60,000 each
Product margin calculation (ABC)
B300 | T500 | |
|---|---|---|
Sales | $1,400,000 | $700,000 |
Direct materials | ($436,300) | ($251,700) |
Direct labour | ($200,000) | ($104,000) |
Advertising | ($50,000) | ($100,000) |
Machining | ($126,000) | ($87,500) |
Setups | ($31,500) | ($126,000) |
Product-sustaining | ($60,000) | ($60,000) |
Total cost | ($903,800) | ($729,200) |
Product margin | $496,200 | ($29,200) |
Under ABC, the B300 margin rises from $363,700 to $496,200, and the T500 swings from a $136,300 profit to a $29,200 loss. The T500 was being subsidised under the traditional system.
The traditional system uses one allocation base (direct labour dollars) for all overhead. That single base assumes every overhead cost behaves in proportion to labour. In reality, the T500 consumes a disproportionate share of setup activity (300 of 375 total setup hours, or 80%) while using only about 34% of direct labour dollars.
The traditional rate buries this by averaging. ABC exposes it by matching each cost pool to the activity that actually drives the cost.
Key drivers of the difference in this exercise:
Setup-intensive T500: 300 setup hours vs 75 for B300. Under ABC, setups cost the T500 $126,000 instead of being averaged away.
Advertising traced directly: The T500 carries $100,000 in directly traceable advertising (vs $50,000 for B300). Traditional costing ignored this cost in the product margin entirely.
Organisation-sustaining costs excluded: ABC does not force $117,000 of organisation-sustaining overhead onto products, which removes distortion rather than adding it.
Traditional overhead rate
\text{Plantwide OH Rate} = \frac{\text{Total Manufacturing Overhead}}{\text{Total Allocation Base}}In this exercise: $608,000 / $304,000 = $2 per direct labour dollar.
Activity rate (for each ABC cost pool)
\text{Activity Rate} = \frac{\text{Cost Pool Total}}{\text{Total Activity Measure}}Examples from this exercise:
Machining: $213,500 / 152,500 machine hours = $1.40 per machine hour
Setups: $157,500 / 375 setup hours = $420 per setup hour
Product-sustaining: $120,000 / 2 products = $60,000 per product
Product margin
\text{Product Margin} = \text{Sales} - \text{Total Costs Traced to Product}This is exactly the kind of analysis companies use when deciding whether to keep, drop, or reprice a product line. A manufacturer that relies on a single plantwide rate might unknowingly subsidise a loss-making product for years. ABC is used in industries from automotive to healthcare to identify which products, services, or customers actually consume resources, and to set prices that reflect true cost.
"ABC allocates all overhead to products." It does not. Organisation-sustaining costs (here, $117,000) are deliberately left unallocated because no cause-and-effect link to a specific product exists.
"The traditional system is wrong because it uses one rate." The traditional system is not wrong in its arithmetic. The issue is that a single allocation base can misrepresent how products actually consume overhead. When products use overhead resources in very different proportions, one rate averages away those differences.
"ABC always shows the low-volume product is more expensive." Not necessarily. ABC reveals cost based on actual activity consumption. A low-volume product that is simple to produce (few setups, little machining) could look cheaper under ABC. In this exercise the T500 happens to be both low-volume and setup-intensive, which is why it looks worse.
"Product margin under ABC should equal net operating income." Product margins under ABC do not sum to net operating income because organisation-sustaining costs and unallocated selling and administrative expenses are excluded from product-level margins.
⚠️ You will very likely be asked to compute product margins under both systems for the same scenario. Practise the full calculation until it is mechanical.
⚠️ Expect a question asking you to explain why the margins differ. The answer centres on the number of cost pools and the choice of allocation base, not on whether one system is "better."
⚠️ Watch for the treatment of organisation-sustaining costs. Under ABC these are not allocated to products. If an exam question asks for product margin under ABC, do not include organisation-sustaining costs.
⚠️ Non-manufacturing costs (like advertising) can be traced to products under ABC when a direct link exists. Traditional costing typically excludes them from product cost entirely.
True or false: Under ABC, all manufacturing overhead is allocated to products. (False: organisation-sustaining costs are not allocated.)
Fill in the blank: The traditional overhead rate in this exercise is ______ per direct labour dollar. (Two dollars)
True or false: The T500 is profitable under both costing systems. (False: it shows a loss under ABC.)
Fill in the blank: The activity rate for setups is ______ per setup hour. (Four hundred and twenty dollars)
True or false: ABC uses a single cost driver for all overhead. (False: ABC uses a separate driver for each activity cost pool.)
Q: What is the plantwide overhead rate and how is it calculated in this scenario?
A: Total manufacturing overhead (608,000) divided by total direct labour dollars (304,000) equals 2 per direct labour dollar.
Q: Under the traditional system, what is the product margin for the B300?
A: Sales of 1,400,000 minus total costs of 1,036,300 equals a product margin of 363,700.
Q: Under ABC, what is the product margin for the T500, and what does it reveal?
A: Sales of 700,000 minus total costs of 729,200 equals a product margin of negative 29,200. This reveals the T500 is unprofitable once overhead is traced using activity-specific drivers.
Q: Why does the T500 absorb so much setup cost under ABC?
A: The T500 uses 300 of the total 375 setup hours (80%), so it receives 80% of the setup cost pool. Under the traditional system, setup costs were spread based on direct labour, which hid the T500's disproportionate use of setup resources.
Q: Why are organisation-sustaining costs excluded from product margins under ABC?
A: Organisation-sustaining costs (such as general administration) cannot be meaningfully traced to individual products because they support the business as a whole. Including them would reintroduce the distortion that ABC is designed to remove.
Q: A classmate says the traditional system overcharges the B300 for overhead. Explain whether this is correct.
A: Yes. Under the traditional system the B300 absorbs 400,000 in overhead. Under ABC, the B300's share of machining, setups, and product-sustaining costs totals only 217,500. The difference arises because the plantwide rate over-allocates setup and product-sustaining costs to the B300 based on its larger labour base, even though the T500 is the heavier user of setup resources.
This material connects directly to job-order costing, where overhead application using a plantwide rate is the standard approach. ABC is the refinement that addresses the limitations of that single-rate system.
It also ties into cost-volume-profit (CVP) analysis: if you are using distorted product costs in your break-even calculations, your break-even volume will be wrong. Getting costs right at the product level feeds into pricing, make-or-buy decisions, and segment profitability analysis later in the course.
Activity-based costing, ABC costing, traditional costing, plantwide overhead rate, predetermined overhead rate, cost driver, activity cost pool, activity measure, manufacturing overhead allocation, product margin, product profitability analysis, cost distortion, cross-subsidisation, organisation-sustaining costs, facility-level costs, setup costs, machining costs, product-sustaining costs, direct labour allocation base, absorption costing income statement, Hi-Tek Manufacturing, management accounting, cost accounting