ABC (Activity Based Costing)
ABC involves the identification of the factors (cost drivers) which cause the costs of an organization’s major
activities support overheads are charged to products on the basis of their usage of an activity.
The major ideas behind ABC are as follows;
(i)
Activities cause costs: These include ordering materials handling, machining, assembling, production
scheduling and dispatching.
(ii) Producing products creates demand for the activities.
(iii) Costs are assigned to a product on the basis of the products consumption of the activities.
Operation/Steps of an ABC system
Step 1: Identify an organizations major activities
Step 2: Identify the factors which determine the size of the costs of an activity / cause the costs of an
activity. These are known as cost drivers.
Step 3: Collect the costs associated with each cost driver into what are known as cost pools.
Step 4: Charge costs to products on the basis of their usage of the activity. A products usage of an activity
is measured by the number of the activity’s cost driver it generates.
Meaning of a cost driver
A cost driver is a factor which causes a change in the cost of an activity. Examples of costs and their cost
drivers include;
Costs
Cost driver
-
Ordering costs
-
No. of orders
-
Material handling costs
-
No. of production runs
-
Machine set up cost
-
No. of machine set ups
-
Machine operating costs
-
No. of machine hours
-
Production scheduling costs
-
No. production runs
-
Dispatching costs
-
No. of dispatches
Reasons for development of ABC
-
Traditional costing systems which assume that all products consume all resources in proportion to their
production volumes, tend to allocate too great a proportion of overheads to high volume products and
too a small proportion of overheads to low volume products. ABC attempts to overcome this problem.
Page 1
Example one
Quality chemical manufactures 4 products; W, X, Y, Z. Output and cost data for the period just ended are
as follows;
Product O/P units
No. of production runs Material cost per
DL hrs per
Machine hrs per
in a period
unit
unit
unit
W
10
2
20
1
1
X
10
2
80
3
3
Y
100
5
20
1
1
Z
100
5
80
3
3
Direct labour cost per hour $5
Overhead costs
Short run variable costs
Set up cost
$
3,080
10,920
Expenditure and scheduling costs
9,100
Material handling costs
7,700
Required:
Prepare unit costs for each product using Conventional Costing and ABC. Assuming the cost drivers for Set
up cost, Expenditure and Scheduling cost, Material handling cost is number of production runs and that
of Short run variable cost is machine hours.
Using conventional absorption costing approach and an absorption rate for overheads based on either
direct labour hours or machine hours, the product costs would be as follows;
TRADITIONAL METHOD
Total machine hours
W = 10X1 = 10
X = 10X3 = 30
Y = 100X1 =100
Z = 100X3 =300
Total
440 Hours
Page 2
Rate per machine hours = Total Overhead cost/Total Machine hours
= 30800/440
= 70 per machine hours
W
X
Y
Z
Direct material cost
(10x20) =200
(10x80) =800
(100x20) = 2000
(100x80) = 8000
Direct labour cost
(1x10x5) =50
(10x3x5) =150 (1x100x5) =500
(100x3x5) =1500
Overhead cost
(70x10) =700
(30x70) =2100
(300x70) = 21000
Total cost
950
3050
9500
30500
Total units
10
10
100
100
305
95
305
Cost per unit
95
(100x70) =7000
ABC Method
Workings
Short run VC = 3080/440 = $7
W = 10x1x7 = 70
X = 10x3x7 = 210
Y = 100x1x7 = 700
Z = 100x3x7 = 2100
Setup costs = 10920/14 = $780
W = 2X780 = 1560
X = 2x 780 = 1560
Y = 5x780 = 3900
Z = 5x780 = 3900
Expediting and Scheduling = 9100/14 = 650
W = 2x650 = 1300
X = 2x650 = 1300
Y = 5x650 = 3250
Z = 5x650 = 3250
Page 3
Material handling = 770/14 = 550
W = 2x550 = 1100
X = 2x550 = 1100
Y = 5x550 = 2750
Z = 5x550 = 2750
Activity Based Cost Method
W
X
Y
Z
Direct material
200
800
2000
8000
Direct labour
50
150
500
1500
Short run VC
70
210
700
Set up costs
1560
1560
3900
Expediting
1300
1300
3250
3250
Material
1100
1100
2750
2750
Total cost
4280
5120
13100
21500
Total units
10
10
100
100
Cost per unit
428
512
131
215
2100
3900
Example Two
ADRIKOS Co ltd produces two types of vases, known as pink and yellow. It has traditionally cost its vases
on a volume based overhead absorption basis. It is now considering using ABC. The following budgeted
data are available.
Vase
Quantity
Direct Cost
Type
Pink
Yellow
Machine
Material
Handling Number of Set-ups
hours
(No. of moves)
100,000
UGX 350,000
25,000
350,000
100
37,500
UGX 75,000
6,250
50,000
20
The overhead costs are as follows:
i)
Machine maintenance
UGX 125,000
Page 4
ii)
Materials handling
UGX 150,000
iii)
Set up costs
UGX 225,000
UGX 500,000
The existing absorption basis is to absorb total overheads on the basis of machine hours.
Required
a) Calculate total unit costs (direct costs plus overhead) using the existing absorption basis for
overheads.
b) Recalculate unit costs using activity based costing on the three cost drivers given.
c) State the advantages of ABC over the traditional costing methods.
Page 5
Solutions
a) Traditional Costing System
Pink
Yellow
Direct Costs
£350,000
£75000
Overheads:
400,000(16*25000) 100,000(16*6250)
Total Cost
750,000
175,000
Number Units
100000
37,500
Cost Per Unit (CPU)
£7.50
£4.67
Overhead absorption rate
= Total overheads Total machines hours = £500,000 ÷ 31,250(25000+6250) h = £16 per hour
b) ABC System
Pink
Yellow
£350,000
£75000
£100,000 (4*25000)
£25,000 (4*6250)
131,250 (0.375*350,000)
18,750 (0.375*50,000)
£225,000 ÷ 120 set-ups = £1,875 per set-up
187,500 (1,875*100)
37,500 (1,875*20)
Total Production cost
£768,750
£156,250
Number of Units
100000
37,500
Cost per Unit
£7.69
£4.17
Direct Costs
Machine Maintenance
£125,000 ÷ £31,250 MH = £4 per hour
Materials Handling
£150,000 ÷ 400,000 = £0.375 per move
Set-ups
c)

The complexity of manufacturing has increased with wider product, shorter product life cycles and
more complex production processes. ABC recognizes this complexity with its multiple cost drivers.

In a more competitive environment Companies must be able to assess product profitability
realistically. ABC facilitates a good understanding of what drives overhead costs.
Page 6

In modern manufacturing systems overhead functions include a lot of non- factory floor activities
such as product design, quality control, production planning and customer services. ABC is
concerned with all overhead costs and so it takes management accounting beyond its traditional
factory floor boundaries.

Provides accurate and reliable cost information.

Establishes a long run product cost
Example Three two
Unai manufactures three products: A, B, and C.
Data for the period just ended is as follows:
A
Production (units)
B
C
20,000 25,000
2,000
Sales price (per unit)
$20
$20
$20
Material cost (per unit)
$5
Labour hours (per unit)
2 hours 1 hour
$10
$10
1 hour
(Labour is paid at the rate of $5 per hour)
Overheads for the period were as follows:
Set-up costs
90,000
Receiving
30,000
Dispatch
15,000
Machining
55,000
US$190,000
Cost driver data:
A
B
C
Machine hours per unit
2
2
2
Number of set-ups
10
13
2
Number of deliveries received
10
10
2
Number of orders despatched
20
20
20
(a) Calculate the cost per unit, absorbing all the overheads on the basis of labour hours.
Page 7
(b) Calculate the cost per unit absorbing the overheads using an Activity Based Costing approach.
Solutions
(a) Total overheads $190,000
Total labour hours
A
20,000 × 2 = 40,000
B
25,000 × 1 = 25,000
C
2,000 × 1 = 2,000
67,000 hours
O.A.R. = 190,000/67,000 = $2.836 per hour
ABSORPTION COST CARD
A
B
C
5
10
10
Labour
10
5
5
Overheads (at $2.84 per hr)
5.68
2.84
2.84
Overheads CPU
20.68
17.84
17.84
Materials
ABC METHOD
(b)
Total
A
B
C
Set-up costs
(Cost per set up =)
90,000
36,000
46,800
7,200
30,000
13,636
13,636
2,728
15,000
5,000
5,000
5,000
Receiving
(Cost per delivery =)
Despatch
(Cost per order =)
Page 8
Machining
(Cost per machine hour) 55,000
23,404
29,256
2,340
190,000
78,040
94,692
17,268
20,000
25,000
2,000
Number of units
Overheads p.u
$3.90
$3.79
$8.63
ABC COST CARD
A
B
C
5
10
10
Labour
10
5
5
Overheads
3.90
3.79
8.63
CPU
18.90
18.79
23.63
Materials
Exercise One
A company manufactures 2 products L and M using the same equipment and similar processes. An extract
of the production data for these products in one period is shown below.
Quantity produced (units)
L
M
5000
7000
Direct labour hours per unit
1
2
Machine hours per unit
3
1
Set ups in the period
10
40
Orders handled in the period
15
60
Overhead costs
Relating to machine activity
$
220,000
Relating to production run set ups
20,000
Relating top handling of orders
45,000
285,000
Required:
Page 9
Calculate the production overheads. To be absorbed by one unit of each of the products using the following
costing methods.
(a) A traditional costing approach using a direct labour hour to absorb overheads
(b) An Activity based costing approach using suitable cost drivers to trace overheads to product
ABC Vs Traditional Costing Methods
Both traditional costing and ABC systems adopt the two stage allocation process.
Allocating overheads
ABC establishes separate cost pools for support activities such as dispatching. As the costs of these
activities are assigned directly to products through cost driver rates, re-apportionment of service
department costs is avoided.
Absorption of Overheads
-
Absorption costing most commonly uses two absorption bases (labour hours or machine hours) to
charge overheads to products.
-
ABC uses many cost drivers as absorption bases (e.g. no. of orders or dispatches).
Cost drivers
The principal idea of ABC is to focus attention on what causes costs to increase i.e. the cost drivers.
(a) The costs that vary with the production volume such as power costs should be traced to products
production volume related cost drivers such as direct labour hours or direct machine hours.
Overheads which do not vary with output but with some other activity should be traced to products
using transaction based cost drivers such as no. of production runs and number of orders received.
(b) Traditional costing systems allow overheads to be related to products in rather more arbitrary ways
producing it is claimed, less accurate product costs.
Merits of ABC
(1) The complexity of manufacturing has increased with wider product, shorter product life cycles and more
complex production processes. ABC recognizes this complexity with its multiple cost drivers.
Page 10
(2) In a more competitive environment Co’s must be able to assess product profitability realistically. ABC
facilitates a good understanding of what drives overhead costs.
(3) In modern manufacturing systems overhead functions include a lot of non factory floor activities such
as product design, quality control, production planning and customer services. ABC is concerned with
all overhead costs and so it takes management accounting beyond its traditional factory floor
boundaries.
(4) Provides accurate and reliable cost information.
(5) Establishes a long run product cost
(6) Provides data which can be used to evaluate different ways of delivering business.
ABC is suited to the following types of decision;
-
Pricing
-
Promoting or discontinuing products and parts of the business.
-
Redesigning products and developing new products or new ways to do business.
Criticisms of ABC
(1) The cost of implementing and maintaining an ABC system can exceed the benefits of improved
accuracy.
(2) Some measure of cost apportionment may still be required at the cost pooling stage for items like rent
rates and building depreciation.
(3) Implementing ABC is often problematic.
(4) Unless costs are caused by an activity that in measurable in quantitative terms and which can be
related to production output, cost drivers will not be useable.
ABC is sometimes introduced because it is fashionable, not because it will be used by management to
provide meaningful product costs or extra information. If management is not going to use ABC information.
Page 11