A wrong cost means a wrong price. And a wrong price means either a silent loss or customers lost to an inflated price — and both start with how overhead was allocated.
1 The elements of product cost
Direct materials
The materials that go into the product
Direct labour
The wages of those who make it
Manufacturing overhead
Rent · depreciation · supervision · electricity
Materials + direct labour = prime cost · labour + overhead = conversion cost
2 The traditional absorption rate
The problem lies in the third element: how do we spread it? The traditional method uses a single rate:
The formula
- Absorption rate = estimated manufacturing overhead ÷ estimated allocation base
- The base may be: direct labour hours · machine hours · direct wages
- A product’s share = absorption rate × its consumption of the base
Estimated manufacturing overhead for the year: SAR 1,200,000 · estimated machine hours: 30,000.
Absorption rate = 1,200,000 ÷ 30,000 = SAR 40 per machine hour.
| Item | Product A | Product B |
|---|---|---|
| Direct materials per unit | 120 | 90 |
| Direct labour per unit | 60 | 45 |
| Machine hours per unit | 2 | 1 |
| Overhead absorbed (40 × hours) | 80 | 40 |
| Cost per unit | 260 | 175 |
3 When does a single rate deceive you?
When products differ in the activities they consume rather than in machine hours alone. A product made in many small batches consumes far more set-ups, inspections and purchase orders than one made in a single large batch — and a single rate cannot see that difference.
The practical effect
The result is a hidden cross-subsidy: the simple high-volume product carries costs that are not its own and looks less profitable than it is, while the complex low-volume product looks profitable while draining resources.
4 Activity-based costing
This method solves the problem in two steps: costs are pooled into activities, then charged to products according to each product’s consumption of each activity’s cost driver.
| Activity | Cost driver | Cost | Driver quantity | Rate |
|---|---|---|---|---|
| Machine set-up | Number of set-ups | 300,000 | 600 | 500 |
| Quality inspection | Number of inspections | 200,000 | 2,000 | 100 |
| Material handling | Number of move orders | 250,000 | 1,250 | 200 |
| Machine running | Machine hours | 450,000 | 30,000 | 15 |
A batch of Product B of 500 units consumed: 4 set-ups · 50 inspections · 20 move orders · 500 machine hours.
| Activity | Calculation | Cost |
|---|---|---|
| Set-up | 4 × 500 | 2,000 |
| Inspection | 50 × 100 | 5,000 |
| Handling | 20 × 200 | 4,000 |
| Running | 500 × 15 | 7,500 |
| Total for the batch | — | 18,500 |
| Per unit | 18,500 ÷ 500 | 37 |
Under the traditional method the unit carried SAR 40 (one hour × 40). The gap here is small, but it widens as batches get smaller and set-ups multiply — and it can turn the ranking of product profitability upside down.
When is it worth the effort?
When indirect costs are a large proportion and products vary in complexity and batch size. For a business with one simple product it will add nothing worth its cost.
Lesson summary
- Product cost = direct materials + direct labour + manufacturing overhead.
- The traditional rate = estimated overhead ÷ estimated allocation base.
- A single rate distorts cost when products differ in the activities they consume.
- Activity-based costing charges by genuine drivers and corrects that distortion.
- Choosing the method is a cost-benefit decision, not a case of “newer is better”.
5 Test yourself
Three quick questions
Choose the answer you think is correct — the result appears immediately.
1. Estimated overhead is 800,000 and estimated machine hours 20,000. What is the absorption rate?
800,000 ÷ 20,000 = SAR 40 for every machine hour.
2. When is a single rate misleading?
Diversity of activities is what breaks the assumption that every product consumes resources in the same proportion.
3. What is the appropriate cost driver for the “machine set-up” activity?
The cost arises with every set-up regardless of batch size, so the driver is the number of set-ups.