In discussing cost systems, a term called activity-based costing comes into play. Activity-based costing is a method of allocating overhead that focuses on activities. Its underlying principle is that the activities that are performed in a process is what causes costs to be incurred. With activity-based costing, we determine what activities are being performed, determine the cost of those activities, and then allocate the cost of those activities to cost objects or products based on the cost objects use of those activities. So for example, if a product is responsible for 40% of a particular activity, ordering material from suppliers, for example, then that product will be allocated 40% of the cost of ordering material from suppliers. The idea here is that activities, and here we've got ordering material was our activity, uses resources. In this example, purchasing department personnel, and those resources have costs, purchasing department salaries and other costs in that department. And the products that cause those activities ordering the material should be allocated the cost of using those resources. Let's apply our four steps for allocating overhead to activity-based costing. And remember, step one is to identify groups or pools of overhead costs. With the plant wide allocation approach, that was easy, there was one pool and it consisted of all the indirect manufacturing cost. So how do we do that with activity-based costing? Well, we start by identifying the key activities that take place in the production process. Activities include things like maintaining equipment, setting up equipment to make a batch of a product, taking orders from customers, ordering material from suppliers, shipping finished products, and I could go on and on and on. But then, what we do is we put the cost of each activity group into a cost pool. Now, recall that step two in the allocation process is to choose an allocation base for each cost pool. With activity-based costing, we want to choose an allocation base that has a causal relationship with the cost in the cost pool. We use the term cost driver to refer to the allocation base and an activity-based costing system because it's something that drives those costs to be incurred. For example, if purchasing costs are in a cost pool, then we might choose the number of orders placed with the supplier as an allocation base. If we place more orders over time, we would expect purchasing department costs to be higher, or if we place less orders over time we would expect the purchasing department costs to be lower. Remember, in designing cost allocation systems, we have to make those two choices, pool and base. And it's the process of making those choices that makes activity-based costing different from the traditional allocation systems. We get to the third and fourth steps. They're no different than we've seen before. We just calculate an allocation rate for each cost pool and we use that allocation rate to assign overhead costs to our cost objects. Let's go back to the T-shirt maker. Suppose that after studying the activities required to make the T-shirts, we observe that many activities are taking place in that work space but most of them are driven primarily by one of two things, either by running the equipment to make the T-shirts or by performing work-related orders from customers. Now activities driven by running the equipment would include things like operating the equipment itself, using the electricity, maintaining the equipment, and things like that. So we group the cost related to all those things into one cost pool. Now let's just say that they total to $13,000, and we use machine hours because it seemed like the cost driver here as an allocation base to allocate that cost pool. And activity is driven by taking orders. Taking orders from customers include things like purchasing material from suppliers once the order from the customer has been received, receiving the material when it arrives, packing and shipping the order when it's finished, setting up the equipment to make a new order of T-shirts. So we group the costs related to all of those things into one cost pool. And let's say they total to the remaining $13,000, and we use the number of orders because it seems like the cost driver here as an allocation base to allocate that cost pool. So what we've done is divide the $26,000 in manufacturing overhead cost into two cost pools, here they happen to be $13,000 each, and we allocate one pool based on machine hours and the other pool based on customer orders. Next, of course, we calculate an allocation rate for each pool. For the first pool, we divide the $13,000 pool of the overhead cost by the 3,000 machine hours to obtain a rate of $4.33 per machine hour. And then for the second pool, we divide that $13,000 pool of overhead cost by the 130 orders to obtain a rate of $100 per order. And then we use those rates to allocate each pool to the T-shirts. Let's allocate the first $13,000 pool of overhead, the one that's based on machine hours. Since basic T-shirts require 2,310 machine hours, they're allocated $10,000 from the first pool. This is how we get that. $4.33 per machine hour, the allocation rate, and they require 2,310 machine hours, and there's 10,000 basic T-shirts so that's one dollar per shirt. This numerator was $10,000. So we get $1 per shirt. And since deluxe T-shirts require 690 machine hours, they're going to be allocated $4.33 per machine hour times 690 machine hours and there's 2,000 of those, so that's $1.50 per shirt. Okay? Now, let's allocate the second cost pool based on orders. Since the basic T-shirts require 50 orders, they're going to be allocated $5,000 from the second pool, the order related cost. $100 per order times 50 orders, and again, there's 10,000 basic T-shirts, so we're at 50 cents per shirt. And since deluxe T-shirts require 80 orders, we're going to allocate $100 per order times the 80 orders, there's 2,000 of those T-shirts, so that's $4 per shirt. So with this system, the total manufacturing cost of a basic T-shirt is $7.50 and the total manufacturing cost of the deluxe T-shirt is $13.50. Now it's important to note that this compares to $8 under the traditional system, that prior traditional system, where we allocated all $26,000 overhead based on direct labor. Notice that when we went from the traditional to the activity-based costing system, the cost of the basic T-shirt went down under the activity-based costing system while the cost of the deluxe T-shirt went up. Why the change? Well, just think about it this way. The basic T-shirt is responsible for 77% of direct labor costs. So those basic T-shirts were assigned 77% of the overhead costs under the previous system where we used direct labor as the allocation base. How did I get the 77%? Is that what you're wondering? So what I did is I recognized that the direct labor in total is $2 per shirt for the basic T-shirts, there's 10,000 basic T-shirts, the direct labor per shirt is $3 for a deluxe T-shirt, and there's 2,000 deluxe T-shirts, the basic T-shirt direct labor divided by this total direct labor is 77%. Okay. They're also responsible for 77% of the machine hours. And remember, machine hours is used as the allocation base under the activity-based costing system. All right. How did I get that? Let's take a look. Basic T-shirts use 2,310 machine hours. The total machine hours used are the basic plus the $6.90 for deluxe. So 77% of the machine hours are being used by the basic T-shirts. But, here's the catch. They're responsible for only 38% of the orders, 50 orders divided by 130 orders. And remember, this was also used as an allocation base in the activity-based costing system. So under the ABC system, they're allocated 77% of half the overhead costs that are driven by machine hours and they're allocated 38% of the other half of the overhead costs that are driven by customer orders. So customer orders was used to allocate half of the overhead under the ABC system. So, naturally, the allocation of overhead to the basic T-shirts would go down and the allocation to deluxe T-shirts would go up when we consider that it's the deluxe T-shirt that's causing most of that portion of the overhead to be incurred.