P1A - Cost Accounting for Decision and Control

Tutorial 3 - Activity-based Costing (ABC)

Modern producers have changed the way that they produce so that they have:

• much more machinery and computerised manufacturing systems

• less use of 'direct' labour

• smaller batch sizes (this increases support activities such as placing material orders,
machine setups, etc.)

This has had the following impact on production costs:

• more indirect overheads (for example, insurance and depreciation of the machines
and computers)

• less direct labour costs

This means that the traditional methods of costing (marginal and absorption) produce standard
cost cards that are less useful due to inaccurate product costs:

• the largest cost of production is indirect overheads but these are categorised together
in one figure that lacks detail and is not useful to management

• because management does not know what the components are of the largest
production cost (indirect overheads) they cannot implement proper cost control

• the costs are often allocated between products on the basis of direct labour hours –
despite the fact that direct labour is becoming a smaller proportion of product costs
and does not fairly reflect the relationship between the products and the indirect
overheads

• because costs are inappropriately or inaccurately shared between products it means

that the total production cost can be wrong which can lead to poor pricing and
production decisions.

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Why is Marginal Costing and Absorption Costing not suitable for the modern
environment?

Marginal Costing – Does not calculate and insert a fixed production cost per unit into the total
cost per unit. Since fixed overheads are high in the modern environment, the total cost per
unit would therefore be inaccurate and misleading.

Absorption costing – Includes fixed overheads when calculating unit cost, but arbitrarily
assumes that every overhead is driven by a single absorption base (generally labour hours).
Traditionally, this assumption was valid since most overheads were production driven and
hence using labour hours as the absorption base was suitable. But in the modern environment,
support overheads account for a major part of overheads and hence different drivers need to
be calculated for different overheads in order to calculate a reliable cost per unit.

Activity Based Costing (ABC)

Due to the flaws of marginal and absorption costing mentioned above, Robin Cooper and
Robert Kaplan introduced a costing technique suitable for the modern business environment
named ABC.

The main difference in ABC in comparison to absorption costing is that it breaks down
overheads to activities, identifies a separate cost driver for each activity and absorbs
overheads based on driver rates (similar to OAR) calculated separately for each activity.

The steps followed in ABC are explained below using an example:

Step 1: Identify activities to which costs should be gathered

1. Placing material orders

2. Machine setup
3. Quality control
4. Stores issuing

Step 2: Gather costs to activities. The total cost for an activity is referred to as the cost
pool.

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 Activity Cost Pool

Placing material orders $500,000

Machine setup $300,000

Quality control $400,000

Stores issuing $150,000

Total $1,350,000

Step 3: Identify the reason for spending on that activity. In other words, identify the
factor that drives the cost for the activity. This is called the cost driver.

Placing material orders – Number of purchase orders

Machine setup – Number of setups
Quality control –Number of quality checks
Stores issuing – Number of issues

There are 3 types of cost drivers:

● Transaction drivers – The cost of the activity is affected by the number of times a
particular action is undertaken. E.g. Number of setups, number of power drill
operations, etc.

● Duration drivers – The cost of the activity is affected by the length of time that it takes
to perform the action. E.g. Quality inspection time may vary for different products, etc.

● Intensity drivers – The cost of the activity varies with the level of effort. For e.g. a
purchase order from an overseas supplier would involve more processing work
compared to a local supplier. Therefore, the weightage for an overseas order would
be higher (for example, 3 times the effort of a local order and hence 10 foreign orders
are equal to 30 local orders).

Step 4: Identify the cost driver in quantitative terms. This is called the driver value.

Product A Product B Product C Total

Purchase orders 3,000 5,000 12,000 20,000

Setups 1,200 700 1,100 3,000

Quality checks 170 120 210 500

Store issues 2,500 800 1,500 4,800

Production (units) 12,000 30,000 8,000 50,000

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Step 5: Calculate the driver rate for each activity by dividing the cost pool from the
driver value. This is the OAR for each activity.

Placing material orders = 500,000 / 20,000 = $25 per purchase order

Machine setup = 300,000 / 3,000 = $100 per setup

Quality control = 400,000 / 500 = $800 per quality check

Stores issuing = 150,000 / 4,800 = $31.25 per store issue

Step 6: Absorb overheads to each product. (see Question 1 below)

Question 1
(a) Calculate the total overheads (to the nearest whole number) and the overhead per unit
(to 2 decimal places) of A, B & C using ABC

(b) Calculate the total overheads (to the nearest whole number) and the overhead per unit
(to 2 decimal places) of A, B & C to using absorption costing.
Assume that overheads are absorbed based on labour hours (A – 4 hours per unit, B – 2.5
hours per unit, C – 7 hours per unit)

Activity classification in ABC

(a) Unit level – Consumption of resources is very strongly correlated with the number of
units produced. E.g. Direct material

(b) Batch level – Consumption of resources is very strongly correlated with number of
batches produced. E.g. Machine setups, quality checks, etc.

(c) Product level – Consumption of resources relate to the existence of particular products.
E.g. Product advertising, product administration, etc.

(d) Facility sustaining – Cost cannot be related in an way to the production of any particular
product line. E.g. Building maintenance, security, etc.

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When is ABC suitable???

1. If the organization is having a considerable proportion of OHs in comparison to direct

costs.

2. If OHs are consumed by one or two reasons, absorption costing should be considered,
but if there are a number of reasons driving OHs, ABC makes better sense.

3. If the organization is having a number of different products produced in different

volumes, consuming resources differently, ABC is more suitable.

Advantages of ABC

1. Since overheads are absorbed using different (and relevant) cost drivers for each
activity, the cost per unit is more accurate compared to absorption costing.

2. Since cost drivers are separately identified, the management will know exactly why
costs are incurred. This will enable them to implement cost control mechanisms more
effectively.

3. The pricing decision will be more effective since a reliable and accurate cost per unit
is calculated. This will minimize the chances of over-pricing (customers may switch to
competitors if overpriced) and under-pricing (losses will be experienced if
underpriced).

4. Due to more accurate costs, the profit per product group would be accurate. This will
enable the management to take better decisions in terms of the products that should
be continued and discontinued.

5. ABC can also be used in service sector businesses (such as accountancy and law
firms, etc.).

6. ABC will assist the management to distinguish between value adding and non-value
adding activities.

Disadvantages of ABC

1. ABC will be of limited benefit if the overhead costs are primarily volume related or if
the overhead is a small proportion of the overall cost.

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 2. It is impossible to allocate all overhead costs to specific activities.

3. The choice of both activities and cost drivers might be inappropriate.

4. The benefits obtained from ABC might not justify its costs. Implementing ABC would
result in the following:
 Identifying activities
 Collecting driver values for each product
 Processing the information to cost reports
These will involve a significant effort and cost (especially collecting driver values as it
is a continuous process)

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Theory Focused Questions (TFQs)
TFQ 1
A manufacturing business makes a product in two models, model M1 and model M2. details
of the two products are as follows.

Model M1 Model M2

Annual sales 8,000 units 8,000 units

Number of sales orders 60 250

Sales price per unit $54 $73

Direct material cost per unit $11 $21

Direct labour hours per unit 2.0 hours 2.5 hours

Direct labour rate per hour $8 $8

Special parts per unit 2 8

Production batch size 2,000 units 100 units

Setups per batch 1 3

Activity $ Cost driver

Setup cost 97,600 Number of setups

Material handling costs 42,000 Number of batches

Special part handling costs 50,000 Number of special parts

Invoicing 31,000 Number of sales orders

Other overheads 108,000 Direct labour hours

A customer has indicated an interest in placing a large order for either model M1 or M2, and
the sales manager wished to try to sell the higher priced model M2. Calculate the profit per
unit for each model, using ABC.

TFQ 2
A healthcare company specializes in hip, knee and shoulder replacement operations, known
as surgical procedures. As well as providing these surgical procedures the company offers
pre operation and post operation in-patient care, in a fully equipped hospital, for those patients
who will be undergoing the surgical procedures.

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Surgeons are paid a fixed fee for each surgical procedure they perform and an additional
amount for any follow-up consultations. Post procedure follow-up consultations are only
undertaken if there are any complications in relation to the surgical procedure. There is no
additional fee charged to patients for any follow up consultations. All other staff are paid
annual salaries.

The company’s existing costing system uses a single overhead rate, based on revenue, to
charge the costs of support activities to the procedures. Concern has been raised about the
inaccuracy of procedure costs and the company’s accountant has initiated a project to
implement an activity-based costing (ABC) system.

The project team has collected the following data on each of the procedures.

The project team has obtained the following information about the support activities.

(a) Calculate the profit per procedure for each of the three procedures, using the current
basis for charging the costs of support activities to procedures.
(b) Calculate the profit per procedure for each of the three procedures using activity-
based costing.
(c) Explain the advantages to the healthcare company of switching to activity-based
costing

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TFQ 3
KY makes several products including Product W. KY is considering adopting an activity- based
approach for setting its budget. The company’s production activities, budgeted activity costs
and cost drivers for next year are given below:

Activity $ Cost driver Driver value

Set-up 200,000 Setups 800

Quality control inspection 120,000 Quality tests 400

Stores receiving 252,000 Purchase requisitions 1,800

Machines are reset after each batch. Quality tests are carried out after every second
batch.
Budgeted data for Product W for next year are

Direct material $2.50 per unit

Direct labour 0.03 hours per unit @ $18 per hour

Batch size 150 units

Number of purchase requisitions 80

Budgeted production 15,000 units

Calculate, using activity-based costing, the budgeted total production cost per unit for
Product W.

Exam Focused Questions (EFQs)

EFQ 1
An organisation has a single production process with expected material receipt and inspection
costs of $35,000 for the next period. The following budgeted information has been obtained
for the period:

Product A Product B Product C

Production quantity (units) 2,000 1,500 800

Batches of material 20 10 5

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The organisation uses an activity based costing system.
The amount of material and inspection costs attributed to Product B in the period will be:
A $6.67
B $6.98
C $10.89
D $19.97

EFQ 2
PB manufactures and sells three products, E, G and F. Budgeted costs for machine running
time for the next year are $4,560,000. The following information is given on budgeted plans
for each product:

Product E Product G Product F

Production quantity (units) 5,000 4,000 6,000

Machine hours per unit 2 4 2

Labour hours per unit 1 2 4

Machine setups 10 6 8

To the nearest $, the machine running cost per unit for Product F using activity based costing
will be $_____

EFQ 3
A bank regularly samples business customer accounts and reviews these for risks to the bank.
These review costs totalled $1,050,280 in the last period. The following budgeted information
has been obtained for the period:

Sole traders Partnerships Companies

Number of customers 250,000 10,000 90,000

Number of reviews 100,000 3,000 18,000

The bank uses an activity based costing system. To the nearest $, the total amount of review
costs attributed to sole trader customers is $_____

EFQ 4
A company manufactures three products with total production overheads of $2,600,000. The
company uses an ABC system and has identified associated cost drivers:

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 Activity cost pool Cost driver Cost associated with
activity cost pool

Receiving / inspecting quality Purchase requisitions $1,400,000

assurance

Production scheduling/machine Number of batches $1,200,000

setups

Details on the three products are as follows:

P R S

Production (units) 10,000 20,000 30,000

Number of purchase requisitions 1,200 1,800 2,000

Number of set ups 240 260 300

The receiving/inspecting quality assurance cost per unit attributed to product P is:
A $25.20
B $33.60
C $36.00
D $280.00

EFQ 5
A company manufactures three products with total production overheads of $2,600,000. The
company uses an ABC system and has identified associated cost drivers:

Activity cost pool Cost driver Cost associated with

activity cost pool

Receiving / inspecting quality Purchase requisitions $1,400,000

assurance

Production scheduling/machine Number of batches $1,200,000

setups

Details on the three products are as follows:

P R S

Production (units) 10,000 20,000 30,000

Number of purchase requisitions 1,200 1,800 2,000

Number of set ups 240 260 300

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The charge out rate for production scheduling/machine setups used to attribute the cost to
product S is $_____

EFQ 6
An organisation has a single production process with expected material handling costs of
$13,650 for the next period. The following budgeted information has been obtained for the
period:

Product X Product Y Product Z

Production units 2,000 1,500 800

Batches of material 10 5 16

Data per production unit:

Direct material (sq. metres) 4 6 3

Direct material ($) 5 3 6

The organisation uses an activity based costing system and the cost driver for material
handling is the quantity of material (sq. metres) handled. The amount of material handling
costs attributed to Product X in the period will be:
A $2.81
B $2.83
C $14.05
D $14.15

EFQ 7
A small accountancy firm provides three services as follows:

Statutory audit Tax services Other services

Budgeted services 5,000 10,000 40,000

Budgeted labour hours per service 18 2 4

Average number of reviews per service 3 0.5 2

Other services include services such as pension planning, business consultancy and business
valuations. The budgeted activity cost for reviews was $55,000. To the nearest cent, if an ABC
system is used by the accountancy firm, how much review cost is attached to each statutory
audit service?

A $0.55
B $1.65

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C $3.00
D $3.67

EFQ 8
Machine set up costs are likely to be classed as which type of activity in the hierarchy of costs?
A Unit level activity
B Batch level activity
C Product level activity
D Facility level activity

EFQ 9
RS has recently introduced an activity based costing system. RS manufactures two products,
details of which are given below:

Product R Product S

Budgeted annual production (units) 80,000 60,000

Batch size (units) 100 50

Machine setups per batch 3 3

Processing time per unit (minutes) 3 5

The budgeted annual costs for two activities are as follows:

Machine set-up $180,000
Processing $108,000
The budgeted processing cost per unit of Product R is:
A $0.20
B $0.51
C $0.60
D $0.45

EFQ 10
RS has recently introduced an activity based costing system. RS manufactures two products,
details of which are given below:

Product R Product S

Budgeted annual production (units) 80,000 60,000

Batch size (units) 100 50

Machine setups per batch 3 3

Processing time per unit (minutes) 3 5

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The budgeted annual costs for two activities are as follows:
Machine set-up $180,000
Processing $108,000
The budgeted machine set-up cost per unit of Product S is:
A $150
B $1.80
C $1.50
D $30

EFQ 11
The following statements have been made in relation to activity-based costing:
(1) A cost driver is a factor which causes a change in the cost of an activity
(2) Traditional absorption costing tends to under-estimate overhead costs for high volume
products

Which of the above statements is/are true?

A 1 only
B 2 only
C Neither 1 nor 2
D Both 1 and 2

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