Activity Based Costing
Introduction
In the previous chapter we worked on a job costing example under traditional absorption costing.
Having worked on that example, it would be easier for us to understand the concepts of Activity
Based Costing (ABC) which is considered as a more refined method
Activity Based Costing calculates the cost of individual activities & assigns costs to cost objects such
as products and services on the basis of the activities undertaken to produce each product or
service.
A comparison of Traditional costing and Activity Based Costing
• Both systems use the two-stage allocation process.
In the first stage traditional systems tend to allocate costs to production and service departments
and reallocates service department costs to the production departments where as ABC systems
allocate overhead costs to major activities(instead of departments).These activity based cost centres
are usually known as cost pools.
Activities consist of aggregation of many different tasks. Typical support activities include schedule
production, set-up machines, purchase materials, and inspect items. Production process activities
include manufacturing products and assembling products. Overall ABC will generally have larger
number of cost centers.
• In the second stage traditional systems relies on a small number of allocation bases (typically direct
labour or machine hours) .Instead of using the terms allocation bases or overhead allocation rates,
ABC systems uses the terms cost driver or cost per cost driver. Also as mentioned above, ABC uses
many second stage cost drivers such as number of production runs for production scheduling and
number of purchase orders for purchasing activity instead of the traditional labour or machine hours
Why is ABC superior?
By using a greater number of activity cost centres and different types of cost drivers that cause
activity resource consumption and assigning activity costs to cost objects, ABC is able to measure the
resource consumption more accurately. Traditional cost systems report less accurate costs because
they use cost drivers where no cause-effect relationship exist to assign support costs to cost objects
During early stages overhead costs were relatively small and distortions arising from inappropriate
allocations were not very significant. However today with the variety of products produced by
companies, overheads have become a significant expense. Also information processing on cost
information is not as costly as it was in the past. As a result ABC has emerged as a superior method
of allocating overheads.
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Traditional Costing
Activity Based Costing
There are four steps involved in Activity Based Costing
1. Identifying the major activities that take place in an organization
2. Assigning costs to cost pools/cost centres for each activity
3. Determining the cost driver for each major activity
Costs Possible
Cost driver
Orders handling
Number of orders
Set up costs
Number of set ups/production runs
Inspection
Number of inspection
4. Calculate the activity based cost driver rates:
Activity cost driver rate= Total cost of Activity
Activity Driver
5. Assigning the cost activities to products according to the product’s demand for activities
Example
The following information relates to the budget for the year ahead.
Production overhead cost budget
Rs.
Machinery costs
285,000
Set-up costs
235,000
Purchasing costs
300,000
Total production overheads
820,000
The following table shows the total budgeted activities of the company (it manufactures many
different types of products) and the details relating to the manufacture of two product lines: S and T.
Data
Machine hours
Number of production runs
Purchase orders
Production quantities of S & T
Total
95,000
235
5,000
Product S
2 per unit
20
100
5,000 units
Product T
1 per unit
5
100
20,000units
Calculate, using activity based costing, the production overhead costs that would be attributed to
one unit of Product S and one unit of Product T.
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Tutorial
Question No. 01
ACCA PM – F5 Pilot Paper
Triple Limited makes three types of gold watch – the Diva (D), the Classic (C) and the
Poser (P). A traditional product costing system is used at present; although an activity
based costing (ABC) system is being considered. Details of the three products for a
typical period are:
Product
D
C
P
Hours per unit
Labour hours
Machine hours
½
1½
1½
1
1
3
Materials Cost
per unit ($)
20
12
25
ProductionUnits
750
1,250
7,000
Direct labour costs $6 per hour and production overheads are absorbed on a machine
hour basis. The overhead absorption rate is based on machine hours.
Required:
(a) Calculate the cost per unit for each product using traditional methods, absorbing
overheads on the basis of machine hours.
Total production overheads are $654,500 and further analysis shows that the
total production overheads can be divided as follows:
Costs relating to set-ups
Costs relating to machinery
Costs relating to materials handling
Costs relating to inspection
Total production overhead
35%
20%
15%
30%
100%
The following total activity volumes are associated with each product line for the
period as a whole:
Product
D
C
P
Number of Set Number of movements
ups
of materials
75
12
115
21
480
87
Number
inspections
150
180
670
(b) Calculate the cost per unit for each product using ABC principles.
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of
Question 02
Comma Ltd manufactures two types of Sprizzer - Standard and Deluxe. Each product requires the
incorporation of a difficult-to-handle special part (one of them for a Standard and four for a Deluxe). Both of
these products are made in batches (large batches for Standards and small ones for Deluxes). Each new batch
requires that the production facilities are 'set up'.
Details of the two products are:
Annual production and sales - units
Sales price per unit
Manufacturing batch size - units
Direct Labor time per unit - hours
Direct labor rate per hour
Direct material cost per unit
Number of special parts per unit
Number of set-ups per batch
Number of separate material issues from stores per batch
Number of sales invoices issues dper year
Standard
12,000
65
1,000
2.0
8
22
1
1
1
50
Deluxe
12,000
87
50
2.5
8
32
4
3
1
240
In recent months, Comma Ltd has been trying to persuade customers who buy the Standard to purchase the
Deluxe instead. An analysis of overhead costs for Comma Ltd has provided the following information:
Overahead cost analysis
Set-up cost
Special part handling cost
Customer invoicing cost
Material handling cost
Other overheads
$
73,200
60,000
29,000
63,000
108,000
Cost driver
Number of set-ups
Number of special parts
Number of invoices
Number of batches
Labor hours
Calculate the profit per unit and the return on sales for Standard and Deluxe, first using the traditional directlabor-hour-based absorption of overheads, and then using activity-based costing method.
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