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Activity based costing

Example 1 Total budgeted fixed overheads for a firm are $712,000. These have traditionally been absorbed on a machine hour basis. The firm makes two products, A and B. A B Direct material cost $20 $60 Direct labour cost $50 $40 Machine time 3 hrs 4 hrs Annual output 6,000 40,000 Required: (a) Calculate the total cost for each product on the assumption that the firm continues to absorb overheads on a machine hours basis. The firm is considering changing to an Activity Based Costing system and has identified the following information: Machine Annual Total No of No of Hours/unit output machine hrs set ups purchase orders Product A 3 6,000 18,000 16 52 Product B 4 40,000 160,000 30 100 46,000 178,000 46 152 Cost pools: Cost driver: $ Machine related 178,000 Machine hours Set-up related 230,000 Set-ups Purchasing related 304,000 Purchase orders Total overheads 712,000 Required: (b) Calculate the cost per unit using the ABC system. To calculate product cost using absorption costing Overhead is absorbed on a machine hour basis. Therefore we need to calculate total budgeted overheads and total machine hours to find the overhead absorption rate. Total budgeted fixed overheads are already given and it is $712,000.

Development of ABC
In the past we had a more labour intensive production system. Direct cost formed a major part of total production cost There was less need to concentrate on fixed costs as they were not material. Fixed cost was absorbed using mostly on labour or machine hours to total unit cost. In modern manufacturing environment we are more geared towards capital intensive production system and fixed cost forms a major part of total cost. It is no longer appropriate to use labour or machine hours to absorb fixed overheads as there is less relation between them. For example it does not make sense to absorb purchase related overheads using machine hours as there is no relation between them. ABC is an answer to the above problems. ABC is most appropriate in a manufacturing environment. ABC is an advanced version of absorption costing In ABC we break down the fixed overheads in more detail We then identify the activities that gives rise to the overheads Find the cost drivers. A Cost Driver is any activity that causes a cost to be incurred Then absorb the overhead In ABC we just extend the range of absorption bases thus leading to better cost control 1

ABC is appropriate where There is a requirement to apportion costs i.e in a multi product business. Where there are significant overheads to be apportion 1. Where there is a sophisticated information retrieval system that allows management to track product costs 1. Multi product ABC is appropriate where multi products are produced Where a single product is produced there are no cost to apportion between products. in a single product, all the costs of the business are identifiable with the products. however it is still useful in a single product business as it helps to identify fix and variable costs. In a multi product business ABC helps to accurately value stock and manage stock 2. Significant overheads need to be apportioned ABC is a cost apportionment method and it is beneficial where there is a high proportion of overheads costs to be apportioned to products. If a business has only direct costs, then ABC is not useful ABC is based on the premise that activities lead to costs and the cost should be apportioned on the basis of the activities that the different products consume. In doing so, management is better able to understand the behaviour of the overheads. The use of an activity by a product can be examined and costed. For example how much the purchasing department is costing in terms of product X, Y or Z. 3. Retrieval system - Availability of information The basic requirement for the efficient functioning of ABC is the availability of information. ABC rely heavily on activity information With many products and variants of products, the monitoring of costs itself becomes a large and complex process. Such that an overhead may have several cost drivers. This may be highly supported by computer support services How ABC helps in performance Management One of the principle of performance management is that management performance should be assessed only on costs that are under their control and hence traceable. ABC is based on more accurate information than absorption costing, therefore controllable and uncontrollable costs are easily identified. It therefore improves performance appraisal. ABC absorbs costs into products in a wider variety of ways than traditional absorption methods. in extending the range of absorption bases ABC is able to more closely track costs to the causes of the costs which then links to management decisions. Better information on product profitability It helps management to accurately calculate product cost and identify which products are most profitable This can lead to better decisions on product promotion and pricing. Advantages Better allotment of overhead leading to more accurate product cost. A better understanding of what causes costs leading to better cost control Better pricing decision 2

Performance appraisal of management becomes easier and more meaningful Areas of weaknesses and efficiencies are easily identified Better planning and budgeting Activity based budgeting can be used Overhead costs are assigned on a cause-and-effect basis rather than on an ad hoc or subjective basis. Cost behavior is better understood due to the analysis of activities. Cost control becomes easier leading to improved cost control. Cost control is facilitated through the identification and management of cost-generating activities. For example, in order to reduce set-up costs, production planning could be used to eliminate short production runs and hence reduce the number of set-ups. Poor decisions due to inadequate cost information are less likely to occur. Limitations ABC may be based on historic information but could not be used for future strategic decisions Selection of cost drivers may not be easy. There may be more than one cost driver for a particular cost Time and cost for setting up ABC system. It is expensive to Identify the main activities that generate costs. Cost of training staff to use the new costing system. It may not be easy to measure cost Variance analysis becomes complicated Many judgemental decisions required in the construction of an ABC system. Some costs may not be traceable to activities Based on cost and benefits maintaining an ABC system may exceed the benefits gained. It may be most appropriate where indirect costs are a significant proportion of total cost, or where a wide product range is maintained. Not appropriate where a company produces a single product Key Features of ABC ABC says that activities create costs, while products consume activities. ABC attaches overheads to product cost in a more meaningful way than traditional absorption costing. Overhead costs are collected in cost pools. Activity-based costing uses more cost pools than traditional absorption costing. In ABC, the link between cost pools and product cost is called a cost driver. A cost driver represents the extent to which a particular activity has been used by a particular product in its production. Activity-based costing is uses more cost drivers than traditional absorption costing The key steps in introducing an activity-based costing system Identify the main activities that generate costs Assign costs to cost pools Select appropriate cost drivers for assigning cost pool costs to products Calculate activity-based charge rates to assign the cost of activities to products

Question Lineacre
Cost Pool Production set-ups Product testing Component supply and storage Cost 105,000 300,000 25,000 Cost Driver Number of Set-ups Tests Component orders Drivers 300 1,500 500 3

Customer orders and delivery

112,500

Customer orders

1,000

General fixed overheads such as lighting and heating, which cannot be linked to any specific activity, are expected to be 900,000 and these overheads are absorbed on a direct labour hour basis. Total direct labour hours for next year are expected to be 300,000 hours. Linacre Co expects orders for Product ZT3 next year to be 100 orders of 60 units per order and 60 orders of 50 units per order. The company holds no stocks of Product ZT3 and will need to produce the order requirement in production runs of 900 units. One order for components is placed prior to each production run. Four tests are made during each production run to ensure that quality standards are maintained. The following additional cost and profit information relates to product ZT3: Component cost : 100 per unit Direct labour : 10 minutes per unit at 780 per hour Profit mark up : 40% of total unit cost Required: (a) Calculate the activity-based recovery rates for each cost pool. (4 marks) (b) Calculate the total unit cost and selling price of Product ZT3. (9 marks) (c) Discuss the reasons why activity-based costing may be preferred to traditional absorption costing in the modern manufacturing environment. (12 marks) (25 marks)

Question - SPRING PLC At a recent board meeting of spring plc, there was a heated discussion on the need to improve financial performance. The Production Director argued that financial performance could be improved if the company replaced its existing absorption costing approach with an activity-based costing system. He argued that this would lead to better cost control and increased profit margins. The Managing Director agreed that better cost control could lead to increased profitability, but informed the meeting that he believed that performance needed to be monitored in both financial and non-financial terms. He pointed out that sales could be lost due to poor product quality or a lack of after-sales service just as easily as by asking too high a price for Spring plcs products. He suggested that while the board should consider introducing activity-based costing, it should also consider ways in which the company could monitor and assess performance on a wide basis. Required: (a) Describe the key features of activity-based costing and discuss the advantages and disadvantages of adopting an activity-based approach to cost accumulation. (b) Explain the need for the measurement of organisational and managerial performance, giving examples of the range of financial and non-financial performance measures that might be used. Question 4 EGERTON MANUFACTURING LTD Egerton Manufacturing Ltd produces a range of products at seven separate sites. Each site produces a maximum of four products. The directors have decided to introduce Activity Based Costing (ABC) and have asked each site manager to obtain and analyse the relevant data for their site. Product costs are currently calculated using absorption costing, with overheads being absorbed on a machine hour basis. As part of the process of introducing ABC, the directors wish to assess the profitability of individual products, with the possibility that the product range may be reduced. You are the Manager of the Brumley site and you have obtained the following data 4

Product Selling price per unit Direct material per unit Direct labour per unit Overheads per unit Total cost per unit Budgeted production volume Machine hours per unit Production runs in period Number of sales orders Number of deliveries of material

$ 300 55 41 11720 21320

$ 530 67 54 293 414 400 units 15 40 5 2

C $ 435 98 57 11720 27220 200 units 06 25 15 16

600 units 06 32 19 8

The budgeted overheads of the site for the period are: Machine running costs Set up costs Material handling costs Machine hours are limited to 1,140 hours per period. Required: (a) Calculate the cost of each product using ABC. (b) Draft a memo to the Managing Director which: (i) be (ii) Using the ABC information, indicates which product(s) should no longer Manufactured and justifies your recommendation; (4 marks) $78,560 $82,900 $49,500

Discusses the other factors which should be considered before a final decision is made. (4 marks)