Activity-Based Costing

As discussed previously, total cost is the sum of the direct materials, direct labor, and production overhead costs. The assignment of direct materials and direct labor costs to individual activities is generally straightforward. The assignment of overhead often is not. Overhead costs frequently contain allocations that only approximate the demand the activity has made o; the overhead resources. The inaccuracy of the overhead calculation can create erroneous production cost information and lead to suboptimal management of the operation. This problem is particularly acute when determining the production cost of individual products in multiproduct firms. Pricing, process management, and product mix decisions are especially susceptible to errors in product costing. The problem of properly determining production cost is complicated by the fact that few if any alternative methods exist to identify the inaccuracies in overhead allocation. To avoid errors, some firms simply ignore overhead costs in their product cost calculations, particularly those resulting from marketing and distribution of the final product.