Activity-Based vs Traditional Costing

Assume the Busy Ball Company makes two types of bouncing balls; one has a hollow center and
the other has a solid center. The same equipment is used to produce the balls in different runs.
Between batches, the equipment is cleaned, maintained, and set up in the proper configuration
for the next batch. The hollow center balls are packaged with two balls per package, and the solid
center balls are packaged one per package. During the year, Busy Ball expects to make 1,000,000
hollow center balls and 2,000,000 solid center balls. The overhead costs incurred have been
allocated to activity pools as follows:

By analyzing the activity pools, the accountants and production managers have identified the
cost drivers, estimated the total expected units for each product, and calculated the unit cost for
each cost driver.

The activity by product is shown in the following table.

To calculate the per unit overhead costs under ABC, the costs assigned to each product are
divided by the number of units produced. In this case, the unit cost for a hollow center ball is
$0.52 and the unit cost for a solid center ball is $0.44.

Under the traditional method of allocating overhead based on direct labor dollars, the total costs
for all balls would be divided by total direct labor dollars for all balls to determine the per unit
cost. Estimated direct labor costs for the year are $1,512,000, of which $378,000 is for hollow
center balls and $1,134,000 is for solid center balls. The per unit direct labor costs are $0.38 for
hollow center balls ($378,000 1,000,000) and $0.57 for solid center balls ($1,134,000
2,000,000). The per unit cost to produce balls is calculated in two steps:

Calculate the predetermined overhead rate by dividing total overhead costs by total direct
labor dollars.
Allocate overhead to each type of product by multiplying the overhead cost per direct
labor dollar by the per unit direct labor dollars for hollow center balls and for solid center
balls.

A comparison of the overhead per unit calculated using the ABC and traditional methods often
shows very different results:

In this example, the overhead charged to the hollow ball using ABC is $0.52 and much higher
than the $0.35 calculated under the traditional method. The $0.52 is a more accurate cost for
making decisions about pricing and production. For the solid center ball, the overhead calculated
is $0.44 per unit using the ABC method and $0.53 per unit using the traditional method. The
reason for the differences is the traditional method determines the cost allocation using direct
labor dollars only, so a product with high direct labor dollars gets allocated more of the overhead
costs than a product with low direct labor dollars. The number of orders, setups, or tests the
product actually uses does not impact the allocation of overhead costs when direct labor dollars
are used to allocate overhead.
ABC provides a way to allocate costs more accurately when overhead costs are not incurred at
the same rate as direct labor dollars. The more activities identified, the more complex the costing
system becomes. Computer systems are needed for complex ABC systems. Some companies
limit the number of activities used in the costing system to keep the system manageable. While
this approach may result in some allocations being arbitrary, using ABC does provide a more
accurate estimate of costs for use in making management decisions.