What Is Peanut Butter Costing? - dummies

By Kenneth Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman, Maire Loughran, Vijay S. Sampath, John A. Tracy, Tage C. Tracy, Jill Gilbert Welytok

Despite the benefits of activity-based costing (ABC), many business managers use cost smoothing, or peanut butter costing, instead, which spreads costs over a broad range of cost objects.

When you spread peanut butter, you smooth it over the entire slice of bread. You don’t pay much attention to how much cost is assigned to any particular part of the bread. Likewise, cost smoothing spreads the cost without paying too much attention to how much cost is assigned to any particular cost object. The trouble is, costs aren’t assigned as accurately as they should be.

With activity-based costing (ABC) you incur costs when production and sales happen. When you take an order over the phone, manufacture a product, or place a box on a delivery truck, the activities generate costs. The activity becomes the focus to assign costs. Because you’re connecting cost to the activity that creates the cost, your cost per product is more accurate, and so is your pricing.

Cost allocation is the process of allocating indirect costs to products and services. The cost allocation base is the level of activity you use to assign costs. Maybe you use 1,000 machine hours or 200 labor hours. Also, keep in mind that direct costs are traced to products and services, not allocated.

To understand the benefits of ABC, you need to see the slippery slope of peanut butter costing.

Here’s the setup: Say you’re a food distributor. You have five restaurant clients that order meat, fish, and poultry every day. You take orders, package them, and deliver the food to these businesses every day. Your restaurant clients have high expectations; they expect high-quality, fresh food to be delivered quickly so they can prepare their meals.

Your order manager handles the details of order processing. Her salary, benefits, and other costs total $5,000 per month, an indirect cost. The cost must be charged to the restaurant clients. You can’t trace the cost of the order manager to your service. Instead, you need to allocate it.

A single indirect cost allocation uses one cost pool. The food distribution setup uses one pool of costs — order manager costs. With ABC, you end up dividing the costs of order management into more cost pools, and you’re better off for it.

Everybody pretty much starts by creating a predetermined or budgeted overhead rate. When you plan at the beginning of the year, using a single indirect cost pool, you come up with an overhead rate for the order manager’s cost, such as the following:

Annual budgeted indirect cost rate = Cost / orders = $60,000 / 1,250 = $48 per order

The order manager’s cost of $5,000 per month amounts to $60,000 per year. The five restaurants order nearly every business day of the year. You figure that total orders will be 1,250 — 250 orders per year from five customers. (Isn’t it great that in samples all customers order exactly the same number of times?)

The single indirect cost allocation spreads the cost (order manager) uniformly over the cost object (orders). That’s $48 dollars per order. This is an example of peanut butter costing, where all services receive the same or similar amounts of cost.