Section 9: Cost Accounting — Overheads, ABC, and Standard Costing
3 lessons in this module. Work through each lesson top to bottom; download the templates and worksheets inside each lesson.
Manufacturing and Non-Manufacturing Overheads matters because it’s a core skill every US bookkeeper and accountant relies on to keep the books accurate and decision-ready. This lesson covers the mechanics, a clear worked example, and the common mistakes that trip up beginners.
Apply the concepts of manufacturing and non-manufacturing overheads to a real US-market scenario, using the downloadable template attached.
Manufacturing and Non-Manufacturing Overheads
Overhead costs are indirect costs — costs that cannot be directly traced to a specific product or service, but must still be accounted for as part of the total cost of production or operations. Correctly allocating overheads is essential for accurate product costing, pricing decisions, and profitability analysis.
Manufacturing Overhead (Factory Overhead)
All manufacturing costs except direct materials and direct labor:
- Factory rent and utilities
- Depreciation on production equipment
- Factory supervisor salaries
- Factory insurance
- Machine maintenance and repairs
- Indirect materials (lubricants, small tools)
Overhead Absorption: Applying Overhead to Products
Since overheads cannot be directly traced to products, they are allocated using a predetermined overhead rate (POHR):
POHR = Budgeted Overhead ÷ Budgeted Activity Base
Common activity bases: direct labor hours, machine hours, direct labor cost.
Budgeted factory overhead: $1,200,000. Budgeted direct labor hours: 40,000.
POHR = $1,200,000 ÷ 40,000 = $30 per direct labor hour
If a product uses 2 DLH, it absorbs $60 of manufacturing overhead.
Over/Under-Absorbed Overhead
If actual overhead differs from absorbed overhead, the difference is “over-absorbed” or “under-absorbed” and is adjusted at year-end (charged to cost of goods sold or spread across work-in-progress, finished goods, and COGS).
Non-Manufacturing Overhead
Costs incurred outside the factory floor — selling expenses, administrative expenses, and distribution costs. Under absorption costing (required for external reporting), only manufacturing costs are inventoried; non-manufacturing costs are period costs, expensed immediately in the income statement.
| Cost Type | Examples | Treatment |
|---|---|---|
| Manufacturing overhead | Factory rent, depreciation | Product cost — inventoried |
| Selling expenses | Sales salaries, advertising | Period cost — expensed immediately |
| Admin expenses | CEO salary, office rent | Period cost — expensed immediately |
Lesson Summary
- Manufacturing overheads are allocated to products via a predetermined overhead rate.
- POHR = Budgeted Overhead ÷ Budgeted Activity Base (DLH, machine hours, etc.).
- Non-manufacturing costs are period costs and never inventoried under absorption costing.
Product Costs vs. Period Costs: The Manufacturing Distinction
| Category | Definition | When Expensed | Examples |
|---|---|---|---|
| Product Costs (inventoriable) | Costs that ‘attach’ to the product and go onto the balance sheet as inventory | When inventory is sold (COGS) | Direct materials, direct labor, manufacturing overhead |
| Period Costs | Costs expensed immediately as incurred — not tied to production | In the period incurred | Sales commissions, CEO salary, advertising, office rent |
Overhead Allocation: The Full Process
| Step | Action | Example |
|---|---|---|
| 1. Identify overhead costs | List all indirect manufacturing costs for the period | Factory rent $120K, supervisor wages $80K, utilities $40K = $240K total |
| 2. Choose allocation base | Select a driver that correlates with overhead consumption | Machine hours, direct labor hours, or direct labor cost |
| 3. Calculate predetermined rate | POHR = Budgeted Overhead ÷ Budgeted Activity Level | $240,000 ÷ 20,000 machine hours = $12/machine hour |
| 4. Apply to jobs/products | Multiply POHR × actual activity for each job | Job #201 used 150 hrs → $12 × 150 = $1,800 overhead applied |
| 5. Reconcile at year-end | Compare applied overhead to actual overhead | Applied $236,000 vs actual $240,000 → $4,000 underapplied |
Product Cost Build-Up: Job #201 Example
| Cost Element | Amount |
|---|---|
| Direct Materials | $8,500 |
| Direct Labor (200 hrs × $18) | $3,600 |
| Manufacturing Overhead Applied (150 mach hrs × $12) | $1,800 |
| Total Product Cost (Job #201) | $13,900 |
Waiting until year-end to know actual overhead before pricing products would make it impossible to set selling prices. Predetermined rates let businesses price jobs in real-time using estimates, then reconcile at year-end. This is standard practice across manufacturing, construction, and professional services.
Manufacturing Overhead Practice Worksheet — Download, print, and complete to reinforce this lesson.
Multi-sheet workbook · pre-built formulas · plug in your own numbers · yours to keep.
Disclaimer. This lesson is educational. The worked example uses representative numbers and does not constitute personalized financial, tax, legal, or investment advice. Trading and investing involve risk including loss of principal. US tax rates change annually — verify against the current IRS publications and your specific state’s tax code. See our Financial Disclaimer for the full statement.
Smarter Overhead Allocation matters because it’s a core skill every US bookkeeper and accountant relies on to keep the books accurate and decision-ready. This lesson covers the mechanics, a clear worked example, and the common mistakes that trip up beginners.
Apply the concepts of smarter overhead allocation to a real US-market scenario, using the downloadable template attached.
Activity-Based Costing: More Accurate Product Cost Allocation
Traditional overhead allocation uses a single, volume-based rate (like direct labor hours) to assign all overhead costs to products. This works well when products are similar and overhead is predominantly driven by volume. But in modern businesses, where products vary greatly in complexity, a single rate produces distorted costs — overcosting simple products and undercosting complex ones.
Activity-Based Costing (ABC) solves this by identifying the specific activities that drive overhead costs and assigning costs based on each product’s actual consumption of those activities.
ABC vs. Traditional Costing: Core Difference
Traditional: One overhead pool → one allocation rate → apply to all products uniformly.
ABC: Multiple cost pools (one per activity) → cost driver rate per activity → apply based on each product’s actual activity use.
The ABC Process
- Identify activities — Machine set-ups, purchase ordering, quality inspection, customer support, engineering changes.
- Assign overhead costs to activity cost pools — Group costs by the activity that causes them.
- Determine cost drivers — The measurable factor that drives each activity’s cost (number of set-ups, number of purchase orders, inspection hours).
- Calculate activity rates = Cost Pool ÷ Total Cost Driver Units.
- Assign costs to products — Multiply activity rate × each product’s use of the cost driver.
Worked Example
Two products: Product A (high-volume, simple) and Product B (low-volume, complex).
Activity: Machine Set-Ups
Cost pool: $200,000. Total set-ups: 100.
Rate: $2,000 per set-up.
Product A uses 10 set-ups → $20,000 overhead.
Product B uses 90 set-ups → $180,000 overhead.Under traditional costing (by volume), Product A (80% of units) absorbs $160,000 — a severe overstatement. ABC reveals Product B’s true cost.
Benefits of ABC
- More accurate product profitability analysis
- Better pricing decisions — charge complex products their true cost
- Identifies which activities add value and which are wasteful
- Supports process improvement initiatives
Limitations
- Expensive and time-consuming to implement
- Requires significant data collection and maintenance
- Can be overkill for simple product ranges
Lesson Summary
- ABC assigns overhead via multiple activity-based cost pools — far more accurate than a single volume-based rate.
- Process: identify activities → assign costs → find cost drivers → calculate rates → apply to products.
- Best suited for organizations with diverse products and significant overhead costs.
Why Traditional Costing Distorts Product Costs
Traditional overhead allocation uses a single plantwide rate (e.g., machine hours) applied to all products equally. The problem: not all products consume overhead in proportion to machine hours. A complex low-volume product might use far more machine setups, quality inspections, and engineering time than a high-volume simple product — but if you only charge by machine hours, the simple product subsidises the complex one.
ABC fixes this by identifying the specific activities that cause costs and assigning costs based on actual activity consumption.
Full ABC Analysis: FusionTech Inc.
FusionTech makes two products: Standard Widget (5,000 units) and Custom Widget (500 units).
| Activity | Cost Pool | Cost Driver | Total Cost | Total Driver Units | Rate |
|---|---|---|---|---|---|
| Machine operations | $300,000 | Machine hours | $300,000 | 15,000 | $20/mach hr |
| Product setup | $120,000 | # of setups | $120,000 | 400 | $300/setup |
| Quality inspection | $80,000 | # of inspections | $80,000 | 1,000 | $80/inspection |
| Engineering changes | $60,000 | # of change orders | $60,000 | 200 | $300/change order |
| Standard Widget | Custom Widget | |
|---|---|---|
| Machine hours | 12,000 | 3,000 |
| Setups | 100 | 300 |
| Inspections | 400 | 600 |
| Change orders | 30 | 170 |
| ABC Overhead | (12,000×$20)+(100×$300)+(400×$80)+(30×$300) = $311,000 | (3,000×$20)+(300×$300)+(600×$80)+(170×$300) = $249,000 |
| Units Produced | 5,000 | 500 |
| ABC Cost/Unit | $62.20/unit | $498/unit |
Under traditional costing (allocated by machine hours), Standard Widget would absorb 80% of total overhead, giving it an artificially high cost. ABC reveals the Custom Widget is the true overhead driver — critical for pricing and profitability decisions.
ABC is more accurate but more expensive to implement. It’s most valuable when: (1) products are diverse in complexity, (2) overhead is a large % of total cost, (3) competition is intense and mispricing products is costly. Many companies use ABC for strategic analysis while keeping simpler systems for day-to-day accounting.
Activity-Based Costing Practice Worksheet — Download, print, and complete to reinforce this lesson.
Multi-sheet workbook · pre-built formulas · plug in your own numbers · yours to keep.
Disclaimer. This lesson is educational. The worked example uses representative numbers and does not constitute personalized financial, tax, legal, or investment advice. Trading and investing involve risk including loss of principal. US tax rates change annually — verify against the current IRS publications and your specific state’s tax code. See our Financial Disclaimer for the full statement.
Standard Costing and Variance Analysis matters because it’s a core skill every US bookkeeper and accountant relies on to keep the books accurate and decision-ready. This lesson covers the mechanics, a clear worked example, and the common mistakes that trip up beginners.
Apply the concepts of standard costing and variance analysis to a real US-market scenario, using the downloadable template attached.
Standard Costing and Variance Analysis: Managing Performance
Standard costing sets predetermined (standard) costs for materials, labor, and overhead before production begins. Actual costs are then compared against these standards. Any difference is called a variance, and investigating variances reveals why actual performance differed from the plan — and who or what is responsible.
Setting Standards
- Standard Material Cost = Standard Quantity per unit × Standard Price per unit
- Standard Labor Cost = Standard Hours per unit × Standard Rate per hour
- Standard Overhead Cost = Standard Hours per unit × POHR
Types of Variances
Material Variances
- Material Price Variance = (Standard Price − Actual Price) × Actual Quantity Purchased. Did we pay more or less than planned per unit of material?
- Material Usage Variance = (Standard Quantity − Actual Quantity Used) × Standard Price. Did we use more or less material than planned?
- Total Material Variance = Price Variance + Usage Variance
Labor Variances
- Labor Rate Variance = (Standard Rate − Actual Rate) × Actual Hours Worked. Did we pay more or less per hour than planned?
- Labor Efficiency Variance = (Standard Hours − Actual Hours) × Standard Rate. Did workers take more or fewer hours than planned?
Worked Example
Standard: 2 kg material @ $50/kg = $100 per unit.
Actual: 100 units produced using 220 kg @ $48/kg.Price Variance = ($50 − $48) × 220 kg = $440 Favourable (paid less than standard — good)
Usage Variance = (200 std kg − 220 actual kg) × $50 = $1,000 Adverse (used more than standard — investigate)
Total Material Variance = $440F − $1,000A = $560 Adverse
Interpreting Variances
A favorable variance (F) means actual cost was below standard — generally good, but investigate if it signals quality compromise (cheaper but inferior material may cause higher usage variance). An adverse variance (A) means actual cost exceeded standard — generally bad, but may be acceptable if caused by deliberate decisions (e.g., using premium materials to reduce defect rates).
Standard Costing in Practice
Standard costing is most valuable in manufacturing environments with repetitive processes. It simplifies bookkeeping (products can be costed consistently), supports budgeting, and provides clear accountability. However, in rapidly changing markets or with flexible/customised production, standards can become quickly outdated.
Lesson Summary
- Standard costing sets pre-determined costs; variance analysis compares actual vs. standard.
- Material variances: price variance ($/unit) + usage variance (quantity used).
- Labor variances: rate variance ($/hour) + efficiency variance (hours worked).
- Favourable = below standard cost; Adverse = above standard cost.
Standard Costing: The Budgeting Tool for Manufacturing
Standard costs are predetermined benchmarks for what each unit should cost under normal, efficient operating conditions. They serve as targets that management compares to actual results. Deviations — called variances — reveal where and why performance differed.
The Complete Variance Family
| Variance | Formula | Favorable When | Unfavorable When |
|---|---|---|---|
| Material Price Variance | (Std Price − Act Price) × Act Qty Purchased | Paid less per unit than standard | Paid more per unit than standard |
| Material Usage Variance | (Std Qty − Act Qty) × Std Price | Used less material than standard | Used more material than standard |
| Labor Rate Variance | (Std Rate − Act Rate) × Act Hours | Paid lower wage than standard | Paid higher wage than standard |
| Labor Efficiency Variance | (Std Hours − Act Hours) × Std Rate | Worked fewer hours than standard | Worked more hours than standard |
| Overhead Spending Variance | Budget OH − Actual OH | Spent less than budget | Spent more than budget |
| Overhead Volume Variance | Applied OH − Budget OH | Produced more than planned | Produced less than planned |
Comprehensive Variance Analysis: ProBolt Manufacturing
Standard cost per unit: 3 lbs aluminum @ $5/lb + 0.5 labor hrs @ $20/hr = $15 material + $10 labor = $25/unit
Actual production: 1,000 units | Actual material: 3,100 lbs @ $4.90/lb | Actual labor: 490 hrs @ $21/hr
| Variance | Calculation | Result | Interpretation |
|---|---|---|---|
| Material Price | ($5.00−$4.90) × 3,100 lbs | $310 Favorable | Negotiated better material price |
| Material Usage | (3,000−3,100) × $5.00 | ($500) Unfavorable | Used 100 lbs more than standard — possible waste |
| Labor Rate | ($20−$21) × 490 hrs | ($490) Unfavorable | Used more expensive (senior?) workers |
| Labor Efficiency | (500−490) × $20 | $200 Favorable | Worked 10 fewer hours than standard — efficient! |
| Net Variance | ($480) Unfavorable | Actual cost $25,480 vs standard $25,000 |
Standard costing enables ‘management by exception’ — managers focus attention only on variances that exceed acceptable thresholds (e.g., >5%). Favorable variances can be just as important to investigate as unfavorable ones: a favorable material price variance might mean lower-quality materials are being bought, which could cause production problems downstream.
Standard Costing & Variance Analysis Worksheet — Download, print, and complete to reinforce this lesson.
Multi-sheet workbook · pre-built formulas · plug in your own numbers · yours to keep.
Disclaimer. This lesson is educational. The worked example uses representative numbers and does not constitute personalized financial, tax, legal, or investment advice. Trading and investing involve risk including loss of principal. US tax rates change annually — verify against the current IRS publications and your specific state’s tax code. See our Financial Disclaimer for the full statement.
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