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Understanding Activity-Based Costing

To create an activity-based costing (ABC) product line income statement, you attempt to trace the overhead cost directly to products or services. For example, suppose that in the case of an imaginary hot dog stand business, the rent expense is necessary because you need an electrical hookup to keep the pot of chili heated. Perhaps you also need an electrical hookup to run the can opener that you use (surreptitiously) to open the cans of chili needed to refill the pot. This means, then, that the rent expense really can’t be split between regular hot dogs and chilidogs. It needs to be allocated to chilidogs.

You can treat the supplies expense in a very similar way. Suppose also that, based on your observations, a regular hot dog customer grabs two napkins for his hot dog, whereas a chilidog customer grabs eight napkins for his chilidog. In this case, you can use this information to better allocate the supplies expense.

Using this napkin usage information, you can calculate which percentage of the supplies expense is used by regular hot dog customers and chilidog customers. If regular hot dog customers use 4,000 out of a total of 20,000 napkins, 20 percent of the napkins are going to regular hot dog customers. So you can allocate $200 of the $1,000 supplies expense to regular hot dogs, and the remaining $800 of supplies expense should be allocated, or traced, to the chilidog product line.

All you’re trying to do is trace overhead costs, or operating expenses, to product lines.

The wages expense of $4,000 probably works in a very similar fashion. Suppose that all the $4,000 of wages expense goes to serving customers hot dogs. Furthermore, suppose that the process of serving a regular hot dog to a customer requires two steps.

These steps are known as cost drivers. The term cost drivers simply suggests that the number of steps an employee takes to serve a customer is a good base on which to allocate the wages expense that comprises the activity of serving.

By looking at the total number of steps required to serve regular hot dogs and the total number of steps required to serve chilidogs, you can trace the wages expense to the individual product lines. For example, if you sell 2,000 regular hot dogs and each hot dog requires two steps, regular hot dogs require 4,000 steps in total. If you sell 2,000 chilidogs and each chilidog requires five steps, the chilidog product line requires 10,000 steps.

To calculate the percentage of the wages expense that goes into preparing regular hot dogs, you make the following calculation:

4,000 (the number of steps required for regular hot dogs) / 14,000 (the total number of steps) x $4,000

This calculation returns the value $1,143.00.

In a similar fashion, you can use the steps information to allocate wages expense to the chilidog product line.

10,000 (the number of steps to prepare chilidogs) / 14,000 (the total steps) x $4,000

This calculation returns the value $2,857.00.

An ABC approach to product-line profitability often produces surprising results.

ABC Income Statement by Product Line
$2.50 Hot Dogs $4.00 Chilidogs Total
Sales revenue
(2,000 sold in each product line) 5,000 8,000 13,000
Cost of goods sold
$.15 buns 300 300 600
$.40 hot dogs 800 800 1,600
$.40 of chili for each chilidog 0 800 800
Total cost of goods sold 1,100 1,900 3,000
Gross margin 3,900 6,100 10,000
Operating expenses
Rent 0 1,000 1,000
Wages 1,143 2,857 4,000
Supplies 200 800 1,000
Total operating expenses 1,343 4,657 6,000
Net profit 2,557 1,443 4,000
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