The Activity-Based Costing Product Line Income Statement - dummies

The Activity-Based Costing Product Line Income Statement

By Stephen L. Nelson

To create an activity-based costing (ABC) product line income statement, you attempt to trace the overhead cost directly to products or services. 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 chili dogs. It needs to be allocated to chili dogs.

You can treat the supplies expense in a very similar way. Suppose that the $1,000 of supplies is really just napkins. Also suppose that based on your observations, a regular hot dog customer grabs two napkins for his hot dog, whereas a chili dog customer grabs eight napkins for his chili dog (you know, to clean up the mess on the front of his shirt when the chili spills).

In this case, you can use this information to better allocate the $1,000 of supplies expense. Consider that this information means that regular hot dog customers use roughly 4,000 napkins. (Calculated by multiplying the 2,000 hot dogs you’ve sold by the 2 napkins used for each regular hot dog customer.) And chili dog customers use 16,000 napkins. (Calculated by multiplying the 2,000 chili dogs that you’ve sold by the 8 napkins used by each chili dog customer.)

Using this napkin use information, you can calculate which percentage of the supplies expense is used by regular hot dog customers and which percentage is used by chili dog customers. If regular hot dog customers use 4,000 of a total 20,000 napkins, 20 percent of the napkins are going to regular hot dog customers (20 percent of the $1,000 of supplies expense equals $200). Therefore, the correct allocation of supplies expense to the regular hot dog line is $200.

You can allocate a portion of the supplies expense for chili dogs by using similar math. If 16,000 of the 20,000 napkins go to chili dog customers, that’s 80 percent of the napkins (80 percent of the $1,000 of supplies expense equals $800). Therefore, logically, $800 out of $1,000 of supplies expense should be allocated, or traced, to the chili dog product line.

All this makes sense, right? 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:

  1. Grab a hot dog bun.

  2. Slide a hot-off-the-grill frankfurter into the bun.

By comparison, the process of serving a chili dog requires five steps:

  1. Grab a hot dog bun.

  2. Slide a hot-off-the-grill frankfurter into the bun.

  3. Ladle a heaping tablespoon of chili into the bun.

  4. Ladle another heaping tablespoon of chili into the bun.

  5. Ladle a third heaping tablespoon of chili into the bun (yes, you read that correctly).

In this example, the wages expense actually gets used in an activity called serving or serving customers. Note that the process of serving a regular hot dog customer requires two steps, but the process of serving a chili dog customer actually requires five steps.

These steps are known as cost drivers. That sounds like something you may not understand right away, but in fact, the notion of cost drivers is simple common sense. 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.

You may have already guessed how to do this: By looking at the total number of steps required to serve regular hot dogs and the total number of steps required to serve chili dogs, you can trace the wages expense to the regular hot dog and chili dog product lines.

For example, if you sell 2,000 regular hot dogs, and each hot dog requires 2 steps, regular hot dogs require 4,000 steps in total. If you sell 2,000 chili dogs, and each chili dog requires 5 steps, the chili dog product line requires 10,000 steps.

You can use these two values — the number of steps for the regular hot dog line and the number of steps for the chili dog line — to allocate the wages expense. For example, 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 chili dog product line. Here’s how that calculation may work:

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

This calculation returns the value $2,857.00.

Now take a look at the following table, which summarizes all this ABC analysis. The most noteworthy item — and the first item to observe about ABC analysis — is that an ABC approach to product line profitability often produces surprising results.

ABC Income Statement by Product Line
$2.50 Hot Dogs $4.00 Chili Dogs 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 chili dog 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

When you look at the net profit number, regular hot dogs make twice as much profit as chili dogs — even though they sell for less money and even though they produce much less gross margin. Only a fair and accurate tracing of overhead expenses shows this fact. Wow. Pass the mustard.