ACTIVITY BASED COSTING (ABC)

The traditional approach to costing a product (cost unit) is to add together materials,
labour and overheads, with overheads being absorbed on a volume-related basis e.g.
Direct Labour Hours (dlh) or Machine Hours or Production Output. This results in one
overhead absorption rate known as a blanket rate. For example, overheads might be
absorbed at the rate of 15 per direct labour hour where total overheads come to 30,000
and 2,000 dlh are expected to be worked. This is a very simple way of calculating an
absorption rate. This method does not distinguish between the running costs of particular
activities or departments when absorbing costs into cost units
ABC has been developed from the ideas of a Harvard professor, Robert Kaplan. In the
1980s, Kaplan recognised that traditional costing methods had developed when most
manufacturing was labour-intensive and overheads made up just a small portion of total
costs. Traditional absorption costing was accurate enough in such circumstances. Today,
production processes are highly automated. The heavy investment in capital equipment
that results from this means that, for example, the fixed overhead cost of depreciation is
now an important part of total costs and the variable cost of labour is a much smaller
proportion. As overheads are so significant, it is now increasingly important to more
accurately apportion overhead costs to cost units.
ABC recognises that in the long run most manufacturing costs are not fixed and analyses
costs as short-term variable costs (volume related and change proportionately with
output) and long-term variable costs (akin to fixed costs under traditional costing
systems). ABC also recognises that it is activities that cause costs. Products create the
demand for those activities.
The steps in setting up an ABC system are
1.

Identify the activities that occur in a firm e.g. sales processing, assembly,
finishing etc.

2.

Identify the factors that influence the cost of an activity. These are known as
Cost Drivers. The cost driver in the sales processing department would be the
number of orders that are received.

3.

Create a cost centre for each activity. (Cost Pool)

4.

Allocate the total cost of the activity to products in proportion to each product's
demand for that service.

The aim of any product costing system is to ensure that a fair share of costs is charged to
each product. ABC not only does this, but also requires department managers to
concentrate on the activities which cause the costs to arise and hence to control these
activities.

ACTIVITY BASED COSTING (ABC)

ABC recognizes that in the long run most manufacturing costs are not fixed and analyses
costs as short-term variable costs (which are volume related and change proportionately
with output) and long-term variable costs (akin to fixed costs under traditional costing
systems). ABC also recognises that it is activities that cause costs and that it is the
products which create the demands for those activities.
Example: A company has a cost centre for sales processing which is expected to
handle200 orders for Widdlies, 300 orders for Xeniths and 500 orders for Zolts. The
total budgeted cost of the Sales Processing operation is 200,000. The traditional basis
would allocate the costs of processing orders between each product on the basis of the
value of each products sales. ABC rejects this method. Instead, under ABC, the cost is
allocated in the ratio 2:3:5. This reflects the recognition that it is the activity of
processing the sales that causes the 200,000 cost rather than the value of the sales itself.
The aim of any product costing system is to ensure that a fair share of costs is charged to
each product. ABC not only does this, but also requires department managers to
concentrate on the activities which cause the costs to arise and hence to control these
activities. In the above example the sales manager, having realised that it the processing
of a sales order that drives a cost, might insist on a minimum order size. (The work
required to process a sales order for 20 Widdlies is exactly the same as the work required
for 2 Widdlies.)
Basically ABC assumes

All costs can be treated as variable in the long run.

Cost Pools represent costs for a particular activity.
Costs come into being as a result of a cause which can be readily identified.
By instituting an ABC system more information about costs and cost reduction, new
product design and the elimination of uneconomic products may be obtained.

An ABC system does cost a lot of money to establish and maintain. For this reason, it
is necessary to keep cost pools to a minimum so that the system does not become too
complex and costly. While the ABC system became increasingly popular in the early
and mid 1990s, its popularity had begun to lessen by the turn of the century (see
article below).

Activity-Based Costing (ABC)

In recent years, ABC has lost ground in the metric wars. But it may be set for a resurgence.
David M. Katz, CFO.com
December 31, 2002

(Note: Metric in this article refers to way of measurement)

In the late 1980s, it was hard to imagine that the din over activity-based costing would
ever die down. Just a few years earlier, Harvard Professor Robert Kaplan, along with
others, had published their first papers on the new metric, touching off a rush of
excitement in corporate conference rooms.
Kaplan's idea was downright revolutionary. In its broadest terms, ABC involves
identifying cost drivers and assigning them to specific activities rather than
attributing overhead, for instance, to the entire organization. Kaplan and fellow ABCbackers asserted that many corporations didn't have a clue as to the true profitability
of their products, or the best mix of products. Why? Because, managers at these
companies didn't really know what resources (activities) went into producing their
goods.
A lightning bolt. But by the mid-1990s, ABC started losing ground to flashier metrics,
things like economic value added (EVA) and the balanced scorecard (another Kaplan
creation). Even Kaplan admitted ABC had lost its luster. "ABC has stagnated over the
last five to seven years," he said in 1998.
Activity-based costing did get a bit of a bump-up during the new economy. At the
time, many corporate managers found themselves knee-deep in expensive customer
relationship management (CRM) initiatives such as overnight delivery and 360-degree
customer service. The problem: These managers were having a real tough time telling
if those expensive projects were actually doing anything. To be sure, the rollouts
tended to increase customer satisfaction, and with it, customer loyalty. But often
those boosts were accompanied by "declining profits, especially when the increased
services are not accompanied by increases in prices or order volumes," wrote Kaplan
and his Harvard colleague V.G. Narayanan, in a May 2001 white paper.
ABC offered executives therapy for those uncontrollable customer-delighting urges.
By using a costing system based on precise activities, companies could customize
their prices to account for service sweeteners, Kaplan and Narayanan argued.
What's more, ABC fit neatly into the marketing plans of software vendors and
consultants looking to make the costing method part of grander, enterprise-wide
installations. But such ambitions quickly lost traction as the economy foundered.
When the Age of the Customer morphed into the Age of the Accounting Scandal,
complex internal data gathering and reporting suddenly seemed less appealing. These
days, it's hard to convince an accountant to keep two sets of books for an entire
organization, says Michael Paris, president of Paris Consulting, a company that
advises manufacturers on their operations. "I think the idea of overlaying a second set
of costing systems has gone away."

This is not to say that ABC has completely vanished. Lots of consultancies still offer
activity-based costing and activity based management services. In addition, scores of
application vendors -- particularly makers of ERP systems -- now offer ABC tools and
modules as part of their software offerings.
Moreover, the American Government seems to like ABC -- the U.S. Marine Corps. is
an advocate of ABC. In the private sector, ABC is still found in business-intelligence
software applications and in assorted one-off projects that tend to fall well short of 24hour, total systems.
In fact, some observers contend that ABC will come back in vogue -- if the recession
continues. During an economic downturn, they note, companies tend to focus their
resources on existing customers, rather than seeking out new ones. ABC is excellent at
helping separate profitable customers from money-losers. In addition, ABC can help
companies figure out ways to raise profits without raising prices -- crucial in a period
of low-inflation.

CFO Publishing Corporation 2004. All rights reserved.

ACTIVITY BASED COSTING

Question 1
Kalash Ltd has a single production process in which three different products
are produced. For the month just ended the following costs were estimated:
Factory overheads related to labour activity
Material receipt and inspection
Power
Material Handling

11,280
31,200
39,000
27,300

The three products (A, B and C) are produced by workers who perform a
number of operations on sheet metal using hand-held electrically powered
tools. The wage rate of the workers is 6.00 per hour.
The following information has been obtained for the month.
Product
A
B
Production quantity (units)
2,000 1,500
Batches of Material (per
product)
10
5
Data per UNIT of product
Direct Material (square
metres)
Direct Material cost ( per sq
m)
Direct Labour (hours)
Number of drill operations
(per unit)

C
800
16

5
0.4

3
0.6

6
1

At the moment, overhead costs for material receipt and inspection, process
power and material handling are absorbed by the units on the basis of direct
labour hours. An activity based costing investigation has revealed that the
cost drivers for the overhead costs are as follows:
Material Receipt and
Inspection
: Number of Batches
Number of Drill
Process Power
: Operations
Material Handling
: Quantity of Materials
Handled (square metres)
Required:
Prepare a summary showing the budged total cost per UNIT for each
product:a) Using the existing method for absorption of overheads
b) Using an approach which recognises the cost drivers revealed in the
ABC investigation.
c) Kalash uses a cost-plus 50% method of pricing. Critically assess the
potential pit-falls of using such a method of pricing. You should explain
your answer referring to the results in parts (a) and (b).

Question 2
Kaplan plc manufactures four varieties of telephones: namely Apiece (A),
Beacon (B), Carrier (C), Distributor (D), using the same plant and processes.
The following information relates to the production period;

Product
A
B
C
D

Volume
5000
560
7500
600

Material
cost per
unit

5
5
18
15

Direct
Labour per
unit
Hours
0.5
0.5
1.5
2

Machine
time per
unit
Hours
0.25
0.25
1.5
1

Labour
cost per
unit

3
3
8
14

Total production overhead recorded by the cost accounting system is analysed

under the following headings:
Factory overhead applicable to machine oriented activity is 44634
Set-up costs are 4084
The cost of ordering materials is 3635
Handling materials 9463
Administration for spare parts 11000
The overheads are absorbed by products on a machine hour basis. The rate is
5.50 per hour giving an overhead per product of:
A=1.37

B=1.37

C=8.25

D=5.50

However investigation into the production overhead activities for the period
reveals the following totals:
Produc
t
A
B
C
D

Number of
set-ups
3
2
6
2

Number of
material orders
4
1
4
2

Number of times
material was
handled
10
2
11
1

Number
of parts
5
12
6
13

You are required to:

a]
b]
c]

Compute an overhead cost per product using activity based costing tracing
the overheads to production units by means of cost drivers
Derive the machine hour overhead absorption rate of 5.50 by calculation.
Comment briefly on the differences disclosed between overheads traced
by the present system and those traced by activity based costing.

Q3 (August 2004)
Campus plc provides meals and catering at three university campuses from a
central warehouse. Their budget for next year shows the following

Sales
Cost of Sales
Gross Profit
Local Expenses
Variable
Fixed
Operating Profit

Able
University
000
5,000
2,800
2,200

Babble
University
000
4,000
2,300
1,700

Cable
University
000
3,000
1,900
1,100

660
700
840

730
600
370

310
500
290

Central costs to be allocated to the three universities are as follows:

000
Head Office
Salaries
Advertising
General Overheads

200
80
120

Warehouse Costs
Depreciation
Storage
Operating
Delivery

100
80
120
300
1,000

The management of Campus plc all agree that the Able University contract is
highly profitable, but there is disagreement about which of the other two
universities are worth bothering with. The Sales Director is in favour of
keeping both. The Operations Director is in favour of withdrawing from the
other two contracts.
At present central costs are charged to each university in proportion to the
amount of sales.
Required:
a] Calculate the profitability of each university contract on the basis of the
existing system for allocating overheads.
(4 marks)
b] Based on the following information use Activity Based Costing to
calculate the profitability of each university contract.
The Finance Director has arranged for more detailed analysis of the
costs that most influence each of the following, and an MBA student has
produced the following analysis for her, based on activity during the past

twelve months.
Number of despatches
Total delivery distance
miles
Proportion of warehouse
space occupied

Able
550
70,000 miles

Babble
450
50,000 miles

Cable
520
90,000

40%

30%

30%

The student recommended that central costs should be allocated to each

of the different university contracts on the basis of more appropriate cost
drivers, as follows:
Head Office
Salaries: 10% of their time is spent on warehouse operations; the
remainder should be divided equally between the three universities.
Advertising: the only justifiable basis was to continue with charging it in
relation to the volume of sales at each university
General Overheads: in proportion to the time spent by head office staff
Warehouse
Depreciation, Storage, and Head Office staff costs: in proportion to the
space occupied
Operations, Head Office costs: in proportion to the number of
despatches

c]

Delivery: in proportion to the number of miles travelled.

marks)
Assess the results of your calculations.
marks)

(16
(5
(Total: 25 marks)

Question 4 June 2006

Valvex plc produces a range of products at various sites around the world.
Each site produces three types of products. The site in India produces valves
the Regular, the Super and the Exclusive. Product costs are currently
calculated using absorption costing, with overheads absorbed on a machine
hour basis.
The directors are now proposing to introduce Activity Based Costing (ABC)
and have asked the local managers at each site to obtain and analyse the
relevant data for their site. The directors also want to assess the profitability of
individual products, with the possibility that the product range is reduced.
The manager at the Indian site has asked for your advice in preparing the
revised costs of the valve and has provided you with the following information.
(Note: the domestic currency of India is called the Rupee)
VALVE
Selling price per valve
Direct Material per valve
Direct Labour per valve
Overheads per valve
Total Cost per valve
Budgeted Production Volume
Machine hours per
unit
Production runs in a month
Number of sales orders
Number of deliveries of
material

Regular
Rupee
600.00

Deluxe Exclusive
Rupee
Rupee
870.00
1060.00

110.00
82.00
234.40
426.40

196.00
114.00
234.40
544.40

134.00
108.00
586.00
828.00

600 units

200 units

400 units

0.6
32
19

0.6
25
15

1.5
40
5

16

The budgeted overheads for the Indian site for the period are:
Machine running costs
Set up costs
Material handling costs
Sales Processing

Rupee 157,120
Rupee 135,800
Rupee 99,000
Rupee 30,000

Machine hours are limited to 1,080 hours per month

Required
(a) Calculate the total cost of manufacturing each valve using ABC.
(12 marks)

(b) Using the results of your computations in part (a), and any other
information in the question, write a report to the manager of the Indian site
indicating which valve(s) should no longer be manufactured and justify your
recommendation. In your advice discuss other factors which should be
considered before a final decision is made and critically discuss the proposed
method of costing.
(13marks)
(Total: 25 marks)
Question 5 (May 2007)
The Winterwarm division of Bercurrent Clothes Ltd makes two coats the
high quality Foxfur (FF) coat and the lower quality Polyfur (PF) coat.
The Chief Executive has noticed that the company has increased its market
share for the Foxfur coat but has lost market share for the lower quality
Polyfur. She has discovered that competitors prices are higher for the FF but
lower for PF. She does not understand the reasons for these price differences
as all companies in the industry use similar production techniques and are
equally efficient.
You have now been asked to analyse the product costing method used by the
company to see if the product prices should be changed.
Your investigations reveal the following:
1. The high quality FF coats are made in batches of 1,000 coats while the
low quality PF are made in batches of 3,000 coats.
2. There are only two production departments: Cutting and Assembly
3. The company currently absorbs overheads based on direct labour
hours.
4. The total budgeted manufacturing overheads were 1,200,000
5. The budget direct labour hours were 27,800 and the budgeted machine
hours were 27,400.
6. Total set-up hours were budgeted at 280.
7. Normal production is 40,000 FF coats and 180,000 PF coats
You also ascertain the following information about the production of batches of
FF and PF:
Each Batch of Foxfur (1,000 coats)
Item
Direct Labour
Hours
Machine Hours
Setup hours
Direct Costs

Cutting Dept
80

Assembly Dept
120

Total
200

160
3
87,500

120
1
12,000

280
4
99,500

10

Each Batch of Polyfur (3,000 coats)

Item
Direct Labour
Hours
Machine Hours
Setup hours
Direct Costs

Cutting Dept
150

Assembly Dept
180

Total
330

150
1
90,000

120
1
12,000

270
2
102,000

Further investigations reveal that the overheads can be broken down into the
following categories, cost pools and drivers:
000
Cost Driver
Maintenance
160
Number of
batches
Production line setups
400
Number of setup
hours
Cutting Supervision
280
Labour hours
Cutting Depreciation
160
Machine hours
Assembly Supervision
160
Labour hours
Assembly Depreciation
40
Machine hours
Total
1,200
Required
a) Using a blanket rate based on direct labour hours, determine the cost of
one Foxfur coat and one Polyfur coat
(6 marks)
b) Determine the costs of each type of coat using activity based costing.
(14 marks)
c) Explain why unit costs are higher for FF coats when activity based costing
is used.
(2 marks)
d) The company uses a cost plus 100% method of pricing. Outline the main
advantages and dangers of using such a method of pricing.
(3 marks)
(Total: 25 marks)

11