Traditional Overhead Allocation in Activity-Based Costing

By Stephen L. Nelson

To really understand the contribution that activity-based costing (ABC) makes, you need to understand how overhead allocation traditionally works. To give you an example, take a look at the following table.

A Simple Income Statement
Sales revenue $13,000
Less: Cost of goods sold 3,000
Gross margin $10,000
Operating expenses
Rent 1,000
Wages 4,000
Supplies 1,000
Total operating expenses 6,000
Operating profit $4,000

This simple income statement shows the profit for an imaginary hot dog stand business that you operate on the opening day of baseball season in your city.

Suppose that in this imaginary business, you sell two products: a regular hot dog for $2.50 and a super-duper chili dog for $4.00. Suppose also that you sell 2,000 of both of these products. Therefore, the $13,000 of revenue shown actually represents $5,000 in sales of regular hot dogs and $8,000 in sales of chili dogs.

Further suppose that you can break down the cost of goods sold as follows:

  • Buns: Each bun cost you $0.15. This means that you spent $300 on buns for regular dogs and $300 on buns for the chili dogs.

  • Dogs: Each hot dog cost you $0.40. This means that you spent $800 on hot dogs for the regular hot dog product line and another $800 on hot dogs for the chili dog product line.

  • Chili: Each serving of chili for the chili dogs cost you $0.40. (A serving is three heaping tablespoons of chili, as you enjoy telling customers.) This means that you spent another $800 on chili for the chili dog product line.

Given this information, you can create an income statement that shows revenues, cost of goods sold, and gross margin by product line, as shown in here.

Traditional 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
$0.15 buns 300 300 600
$0.40 hot dogs 800 800 1,600
$0.40 of chili for each chili dog ___ 800 800
Total cost of goods sold 1,100 1,900 3,000
Gross margin 3,900 6,100 10,000
Operating expenses
Rent $500 $500 $1,000
Wages 2,000 2,000 4,000
Supplies 500 500 1,000
Total operating expenses 3,000 3,000 6,000
Net profit 900 3,100 4,000

Furthermore, note that the preceding table does something very traditional: It allocates operating expenses by using a simple rule. Here, the operating expenses are split right down the middle, allocating $3,000 of operating expenses to the regular hot dog product line and $3,000 of operating expenses to the chili dog product line.

Stop for a minute and look at the information shown. When you consider and make decisions based on this information, it becomes much easier to understand traditional overhead allocations.

If you examine the income statement shown, several pieces of data suggest that there’s money in them there chili dogs. For example, look at the sales revenue. The income statement shows that chili dogs generate $8,000 of sales revenue, whereas regular hot dogs generate only $5,000 of sales revenue.

Now look at the gross margin. The income statement shows that chili dogs generate $6,100 of gross margin, whereas regular hot dogs generate only $3,900 of gross margin. Finally, look at the net profit. Based on a simple split of overhead or operating expenses, the net profit from the regular hot dog line equals a measly $900, whereas the net profit from the chili dog product line equals a whopping $3,100.

After reviewing the information shown, what is your conclusion? It seems pretty clear that you should sell more chili dogs and fewer hot dogs. In fact, you may want to give up on selling regular hot dogs and concentrate on chili dogs.

You may also decide that your chili dogs are priced too high; perhaps you could shave the cost a bit on these. You may further decide that the regular hot dogs are priced too low; perhaps the price of these should be bumped up a bit.

Indeed, you can make all sorts of decisions from the collective set of data shown. You may not realize that the overhead allocation plays an important part in all this. Unfortunately, the overhead allocation shown and any of the conclusions suggested in the preceding paragraphs are wrong. This error, however, doesn’t show up until you use activity-based costing, and that’s why ABC is cool.