Professional Documents
Culture Documents
Learning Objectives
After studying this chapter, you should be able to
) Discuss the limitations of using only unit-based drivers
to assign costs.
) Provide a detailed description of activity-based product
costing
) Explain how homogeneous cost pools can be used to
reduce the number of activity rates.
) Describe activity-based system concepts including an
ABC relational database and ABC software.
INTRODUCTORY THEORY
Introduction
Activity based costing system is a cost accounting system that uses both unit and non-unit based cost drivers to
assign costs to cost objects by first tracing costs to activities and then tracing costs from activities to products.
Definitions of Important Terms
Cost Object: Cost object is any item such as products, departments, projects, activities, and so on, for which costs
are measured and assigned.
Cost Driver: Cost driver is a factor that causes a change in resource usage, activity usage, costs and revenues.
Resource Cost Driver: It is a factor that measures the demand placed on resources by activities and is used to
assign the cost of resources to activities.
Activity Cost Driver: It measures the demands that cost objects place on activities. It is used to assign activity
cost to cost objects.
Stages in Activity Based Costing
1. Identify, define, and classify activities and key attributes.
2. Assign the cost of resources to activities.
3. Assign the cost of secondary activities to primary activities.
4. Identify cost objects and specify the amount of each activity consumed by specific cost objects.
5. Calculate primary activity rate.
6. Assign activity costs to cost objects.
Classifying Activities
To help identify activity driver and enhance the management of activities, activities are often classified into one of
the following four general activity categories:
(i) Unit level activities
(ii) Batch level activities
(iii) Product level activities
(iv) Facility level activities
Purpose of ABC
ABC is used particularly in organisations where:
(i) Production overheads are high in relation to direct costs.
(ii) There is a great diversity in the product range.
(iii) Product use very different amounts of overhead resources.
(iv) Overheads are significantly non unit level overheads.
ABM Model
Systems
Planning
Identify, Define,
and Classify Activities
PVA ABC
Increase
Search for Improvement Profitability Assign Costs to
Opportunities Cost Objects
Activities
Value added activities Non value added activities
↓ ↓
• Activities necessary to remain in the business • There are unnecessary activities
• Not valued by internal or external customers • Fails to produce a change in state
• Contributes to customer value • Helps to meet organisational needs
Points to Remember
Product A Rs B Rs C Rs Total Rs
Material (identified)
Labour (identified) XX XX XX XX
Overhead XX XX XX XX
XX XX XX XX
Set up Cost XX XX XX XX
COST POOL
Overheads Amount Activity No. of Cost
Rs. activity activity
Machine Rent XX No. of times Usage XX XX purchase
XX usage
Setup Cost XX No. of Setup/Setup hour XX XX set up
Stores XX No. of Required XX XX slip
XX Slip/Material Cost/Qty.
Inspection Cost XX No. of Set up XX
XX Production Rent
Packing Charges XX No. of livery XX
Others XX Method of absorption XX
Cost Driver
Cost Pool means a statement in which all the overheads to be analysed into two parts:
■ Activity oriented over heads.
■ Non activity oriented overheads
so that all the overheads called be identified with the product can the basis of their respective activities.
Cost Driver means the allocation base with the application of which the overheads can be identified with
the product.
Direct Material: 1: Directing traced with production
2: Final quantity increase.
3: Integral and major part.
Indirect material: Used to produced finished Good with raw material.
Points to Remember
Question 1: XYZ Plc manufactures four products, namely A, B, C and D, using the same plant and processes. The
following information relates to a production period.
Product Volume Material cost per Direct labour per Machine time per Labour cost
unit unit unit per unit
A 500 $5 ½ hour ¼ hour $3
B 5,000 $5 ½ hour ¼ hour $3
C 6,00 $16 2 hour 1 hour $12
D 7,000 $17 2½ hours 1½ hours $9
Total production overhead recorded by the cost accounting system is analysed under the following headlines
Factory overhead applicable to machine oriented activity is $ 37,749. Set-up costs are $4250. The cost of ordering
materials is $1920 Handling materials- $7560. Administration for spares parts - $8400.
These overhead costs are absorbed by products on a machine hour rate of $4.80 per hour, giving an overhead
cost per product of:
A = $1.20, B = $1.20, C = $ 4.80, D = $7.20
However investigation into the production overhead activities for the period reveals the following totals:
Product Number of set-ups Number of material Number of times Number of spare parts
orders Materials was handled
A 1 1 2 2
B 6 4 10 5
C 2 1 3 1
D 8 4 12 4
Required:
1. To compute an overhead coproduct using activity-based costing, tracing overheads to production units by
means of cost drivers.
2. To comment briefly on the differences disclosed between overheads traced by the present system and those
traced by activity based costing.
Solution:
Statement of Cost Pool (ABC)
Overhead Amount (`) Basis No of Activity Cost per Activity
Set-up cost 4,250 No of set-up 17 [1 + 6 + 6 +2 + 8] 250
Ordering cost 1,920 No of order 10 [1 + 4 + 1 + 4 +] 192
Handling cost 7,560 No of times 27 [2 + 10 + 3 + 12] 57.77
Administration for spare ports 8,400 No of spare ports 12 [2 +5 + 1 + 4] 700
Factory overhead 37,749 Machine hours 12475 [125 + 1250 + 60 + 10500] 3.0259
Question 2: A company produces three products A, B and C for which the standard costs and quantities per unit are
as follows:
Particulars Products
A B C
Quantity produced 10,000 20,000 30,000
Direct material/p.u.(`) 50 40 30
Direct Labour/p.u. (`) 30 40 50
Labour hours/p.u. 3 4 5
Machine hours 4 4 7
No. of purchase requisitions 1,200 1,800 2,000
No. of set ups 240 260 300
Required:
(i) Prepare Product Cost Statement under traditional absorption costing and Activity Based costing Method.
(ii) Compare the results under two methods.
Solution:
Statement of Cost Pool (Absorption)
Department Cost (`) Basis No. of Activity Cost per Activity
I 1,100,000 Labour hours 1,83,333 6
II 15,00,000 Machine hours 5,00,000 3
Question 3: The following information provides details of costs, volume and cost drivers for a particular period in
respect of ABC Ltd; for product X, Y and Z:
Overhead costs:
Set-up 30,000
Machines 7,60,000
Receiving 4,35,000
Packing 2,50,000
Engineering 3,73,000
` 18,48,000
The Company operates a just-in-time inventory policy and received each component once per production run.
In the past the company has allocated overheads to products on the basis of direct labour hours. However the
majority of overheads are related to machine hours rather than direct labour hours. The company has recently
redesigned its cost system by recovering overheads using two volume related bases: Machine hours and a material
handling overhead rate for recovering overheads of the receiving department. Both the current and the previous cost
system reported low profit margins for product X, which is the company’s highest-selling product. The management
accountant has recently attended a conference on activity-based costing and the overhead costs for the last period
have been analyzed by the major activities in order to compute activity-based costs.
Required:
(a) Compute the product costs using a traditional volume-related costing system based on the assumption that:
(1) All overheads are recovered on the basis of direct labour hours ( i.e. the company past product costing
system.).
(2) The overheads of the receiving department are recovered by a materials handling overhead rate and
the remaining overheads are recovered using a machine hour rate (i.e. the company current costing
system).
(b) Compute product costs using an activity based costing system.
Solution:
1 (a) Statement of cost pool [Absorption]
Overhead cost = ` 184,8000
Direct labour hours = 88,000 hrs (40000 + 40,000 + 8000]
Overhead cost per labour hours = 21 per hours
Statement of Cost (Absorption)
Particulars Product
X (`) Y (`) Z (`) Total (`)
Material 7,50,000 4,00,000 88,000 12,38,000
Labour 2,40,000 2,40,000 48,000 5,28,000
Overhead 8,40,000 8,40,000 1,68,000 18,48,000
(21 × 40,000) (21 × 40,000) (21 × 800)
Total 18,30,000 1,48,0000 3,04,000 36,14,000
Question 4: G Ltd. produces four products. A conventional product costing system is used at present. Now, use an
activity based costing (ABC) system is being considered. Details of the four products and relevant information are
given below for one period:
Product A B C D
Output in units 240 200 160 240
Costs per unit ` ` ` `
Direct material 80 100 60 120
Direct labour 56 42 28 42
Machine hours (per unit) 8 6 4 6
The four products are similar and are usually produced in production runs of 20 units and sold in batches of 10
units. The production overhead is currently absorbed by using a machine hour rate, and the total of the production
overhead for the period has been analysed as follows:
Particulars Amount (`)
Machine department costs (Rent dep. and supervision) 20,860
Set-up costs 10,500
Stores receiving 7,200
Inspection/quality control 4,200
Output handling and dispatch 9,240
52,000
The cost drivers to be used for the overhead costs are as listed below:
Cost Cost Driver
Set up costs Stores receiving Inspection/Quality control Output Number of production runs Requisitions raised Number of
handling and dispatch production runs Orders executed
The number of requisitions raised on the stores was 20 for each product and the number of orders executed was
84, each order being for a batch of 10 of a product.
Required:
(a) to calculate the total costs for each product if all overhead costs are absorbed on a machine hour basis;
(b) to calculate the total costs for each product, using activity-based costing system;
(c) to calculate and list the unit product costs from your figures in (a) and (b) above, to show the differences and to
comment briefly on any conclusions which may be drawn which could have pricing and profit implications.
Solution:
Statement of Cost Pool
Overhead Amount Basis No. of Activity Cost per Activity
Machine 20,860 Machine hours 5,200 (1,920 + 1,200 + 640 + 1,440) 4.01
Setup cost 10,500 No. of set-up 42 (12 + 10 + 8 + 12) 250
Store 7,200 No. of requisition 80 (20 + 20 + 20 + 20) 90
Inspection 4,200 No. of purchase order 42 (12 + 10 + 8 + 12) 100
Output handling and dispatch 9,240 No. of order 84 (24 + 20 + 16 + 24) 110
Statement of Reconciliation
A B C D Total
ABC (`) 48,979 40,712 23,006 53,303 1,66,000
Absorption (`) 51,840 40,400 20,480 53,280 1,66,000
Difference (2,861) 312 2,526 23 nil
The difference of distribution of the overhead occurred due to the following reasons:
(i) The ratio of difference activity between the products are different from the ratio of single recovery rate
basis.
(ii) The product which consumes high volume of activity as compared to machine working hours will absorb
high volume of overhead. (The total value of overhead remains same).
Question 5: Repak Ltd is a warehousing and distribution stores the products and then re-packs them for distribution
as required. There are three customers for whom the service is provided: John Ltd., George Ltd and Paul Ltd. The
products from all three customers are similar in nature but of varying degrees of fragility. Basic budget information
has been gathered for the year to 30 June and is shown in the following table:
Products handled (cubic meter)
Note 1: Packaging materials are used in re-packing each cubic meter of product for John Ltd, George Ltd and Paul
Ltd in the ratio 1:2:3 respectively. This ratio is linked to the relative fragility of the goods for each customer.
Note 2: Additional information has been obtained in order to enable unit costs to be prepared for each of the three
customers using an activity-based costing approach. The additional information for the year to 30 June has been
estimated as follows:
1. Labour and overhead costs have been identified as attributable to each of three work centers receipt and
inspection, storage and packing as follows:
Cost Allocation Proportions
Receipts and Storage Packing
inspection
% % %
Labour-basic 15 10 75
Overtime 50 15 35
Occupancy 20 60 20
Administration and management 40 10 50
(iii) Studies have revealed that the fragility of different goods affects the receipts and inspection time needed for
the products for each customer. Storage required is related to the average size of the basic incoming product
units from each customer. The re-packing of goods for each customers have been evaluated as follows (All
Data are provided for each cubic meter for each customer).
Required:
A: Calculate the budgeted average cost per cubic mater of packaged products for each customer for each of the
following two circumstances:
1. Where only the basic budget information is to be used.
2. Where the additional information enables an activity-based costing Approach to be applied.
(ICWA Final 1988)
Solution:
Statement of Cost Pool (Basis budget)
Cost Amount (`) Basis No. of Activity Cost per Activity
Packing material 19,50,000 Composite Ratio 1,950 (30:90:75 W.N.) 10,000
Statement of Cost
John Ltd. George Ltd. Raul Ltd.
Quantity 30,000 45,000 25,000
Packing material (30:90:75) ` 3,00,000 ` 9,00,000 ` 7,50,000
Other cost ` 2,82,000 ` 4,23,000 ` 2,35,000
(9.4 × 30,000) (9.4 × 45,000) (9.4 × 25,000)
Total Cost ` 5,82,000 ` 13,23,000 ` 98,5,000
2. Department of Overhead
Inspection Storage Packing
Labour 52,500 35,000 3,63,500
Overtime 15,000 4,500 10,500
Occupancy 1,00,000 3,00,000 1,00,000
Administration & management 24,000 6,000 30,000
Total 1,91,500 3,45,500 4,03,000
Working Notes:
John George Paul
Ratio of packing material used 1 2 3
Qty. 30,000 45,000 25,000
Relative composite material ratio 30,000 90,000 75,000
Ratio: 30: 90: 75
Question 6: A company manufactures several products of varying levels of designs and models. It uses a single
overhead recovery rate based on direct labour hours. The overheads incurred by the company in the first half of the
year are as under:
Particulars `
Machine operation expenses 10,12,500
Machine maintenance expenses 1,87,500
Salaries of technical staff 6,37,500
Wages and Salaries of stores staff 2,62,500
During this period, the company-introduced activity based costing system and the following significant activities
were identified:
• Receiving materials and components
• Set up of machines for production runs
• Quality inspection. It is also determined that:
• The machine operation and machine maintenance expenses should be apportioned between stores and
production activity in 20:80 ratio.
• The technical staff salaries should be apportioned between machine maintenance, set up and quality
inspection in 30:40:30 ratio. The consumption of activities during the period under review are as under:
• Direct labour hours worked 40,000
• Direct wage rate ` 6 per hour
• Production set-ups 2,040
• Material and component consignments received from suppliers 1,960
• Number of quality inspections carried out 1,280
The data relating to two products manufactured by the company during the period are as under:
Products
Particulars
P Q
Direct material costs ` 6,000 ` 4,000
Direct labour hours 960 100
Direct material consignment received 48 52
Production runs 36 24
Number of quality inspection done 30 10
Quantity produced (units) 15,000 5,000
A potential customser has approached the company for the supply of 24,000 units of a component K to be
delivered in lots of 3,000 units per quarter. The job will involve as initial design cost of ` 60,000 and the manufacture
will involve the following per quarter:
Direct material costs ` 12,000
Direct labour hours 300
Production runs 6
Inspection 24
Number of consignment of direct materials to be received 20
Required:
1. Calculate the cost of product P and Q based on the existing system of single overhead recovery rate.
2. Determine the cost of products P and Q using activity based costing system.
3. Compute the sales value per quarter of component K using activity based costing system.
(C.A. Final May 2003)
SolutionL
Statement of Cost Pool
Overhead Amount ` Basis No. of Activities Cost per Activity
Stores 2,78,250 + 2,62,500 No. of receipt 1,960 (48 + 52 + …) 275.89
Setup 2,55,000 + 11,13,000 Inspection 1,280 (30 + 10 +…) 149.41
Avoidable overhead
60,000 7500
Desige ⎛⎜ x3000 ⎞⎟
⎝ 24 ⎠
Overhead:
Store (275.89 × 20)
Prod. (670.5 × 6)
Quality inspection (149.41 × 24) 13,128
Total cost 34,428
Profit (25%) 8,607
Sale value 43,035
Selling Price P.U. 14.345
Working Notes
Machine material Set-up Quantity Inspection
30% 40% 30%
Salary of technical staff (637500) 19,14,250 2,55,000 1,91,250
` `
Factory Overhead Service department cost
Set up 1,370 Purchasing 4,440
Supervision 2,400 Warehouse & dispatch 3,100
Machines 19,800 Power 3,300
23,570 10,840
Selling expenses 7,920
Following the usual practice of allocating all the factory overheads and service departments costs using a blanket
rate of 400% of unit direct labour cost and the selling expenses as 8% of unit selling price, the unit profit is worked
out as:
Product
Particulars
A B C D
Profit per unit (`) 0.30 9.60 3.60 7.20
The Cost Accountant of the company considering that using a blanket rate for common cost allocation will
always be misleading. As all the operations are predominantly machine operation, arriving at a machine hour rate
for each department for allocating the common costs to the products, he finds that each product requires one half an
hour of machine time. During the period the machines are used for 1,650 hours–900 in X and 750 in Y. Going into
details the Cost Accountant makes a fresh calculation and arrives at the unit profitability of the products under:
Product
Particulars
A B C D
Profit per unit (`) 2.20 7.50 4.78 4.38
His calculation is based on the following details: Allocation of Common Costs (`)
Factory Overheads Total X Y
Set up 1,370 470 900
Supervision 2,400 1,200 1,200
Machines 19,800 10,800 9,000
The Management Accountant who has joined the company recently is not at all satisfied with the Cost Accountant’s
calculation. He feels that an important decision to drop a product cannot be taken based on those figures. He is of
the view that a more refined technique is required and when details are available, why not do an activity based
costing:
With this end in view, he collects the following details:
Activity Cost-pools Amount (`)
Set up 1,370
Supervision 2,400
Machines 19,800
Order processing 440
Material handling 4,000
Finished goods storage 1,600
Dispatch 1,500
Power 3,300
Selling expenses 7,920
Cost Drivers
Particulars A B C D
Production batch size (units) 100 50 100 25
Set up time (hrs.) 1.5 2 1 4
Supervisor’s time per period (hrs.) 75 40 75 50
Machine timer per unit (hrs.) 0.5 0.5 0.5 0.5
Orders processed per period 10 20 20 60
Raw materials inputs per unit 2 5 2 4
Average holding of finished goods (unit) 0 100 100 200
No. of deliveries per period 10 40 50 200
Sales staff time per period (hrs.) 30 160 200 400
With the help of these figures, he makes that allocation activity based and produces a profit statement for submis-
sion to management.
Required: Prepare the product profitability statement based on – (a) the blanket rate, (b) the machine hour rate as
the Cost Accountant has done, (c) activity based costing as suggested by the Management Accountant.
(ICWA Final Dec. 1994)
Solution:
1. Statement of Profit (Absorption)
A (`) B (`) C (`) D (`) Total (`)
Material 10,000 6,400 9,000 7,500 32,900
Direct labour 3,000 1,600 3,000 1,000 8,600
Factory overhead (34410) 12,003 6,402 12,003 4,002 34,410
Selling expenses 2,200 1,920 2,400 1,400 7,920
Total cost 27,203 16,322 26,403 13,902 83,830
Selling price 27,500 24,000 30,000 17,500 99,000
Profit 297 7678 3597 3,598 15,170
Note: Under recovery and over recovery exist only when actual base is different from budgeted base.
2. Statement of Profit (Machine Hour Base)
A (`) B (`) C (`) D (`)
Material 10,000 6,400 9,000 7,500
Labour 3,000 1,600 3,000 1,000
Overhead 10,095 (500 × 20.19) 8,076 (400 × 20.19) 10,820 (500 × 21.648) 5,410 (250 × 21.648)
Question 8: The Excel Ltd. make and sell two products,V4 and V2. Both products are manufactures through two
consecutive process-making and packing raw materials is input at the commencement of the making process. The
following estimated information is available for the period ending 31 March.
Making Packing
Conversion cost ($000) ($000)
Variable 350 280
Fixed 210 140
40% of fixed costs are product specific, the remainder are company fixed costs. Fixed Costs will remain un-
changed throughout a wide activity range.
Product information V4 V2
Production time per unit
Making (minutes) 5.25 5.25
Packing (minutes) 6 4
Production sales (units) 5,000 3,000
Selling price per unit($) 150 180
Direct material per unit (S) 30 30
(iii) Conversion costs are absorbed by products using estimated time based rates.
Required:
(a) Using the above information, Calculate unit costs for each product, analysed as relevant.
(b) Comment on a management suggestion that the production and sale of one of the product should not proceed
in the period ending 31 March.
(c) Additional information is gathered for the period ending 31 March has follows:
(i) The proportion of product specific conversion costs (variable and fixed) are analysed as follows:
Making Process: moulding (60%); trimming (40%)
Packing Process; conversion (70%), Packing material (30%)
(ii) The making process consist of two consecutive activities, mounding and trimming.The moulding
variable and product fixed cost conversion costs are incurred in proportion to the temperate required in
the moulds. The trimming conversion variable and product fixed costs are incurred in proportion to the
consistency of the material. The variable and Product fixed packing process conversion cost are incurred
in proportion to the time required for each product. Packing materials (which are part of the variable
packing cost) requirements depends on the complexity of packing specified for each product.
(iii) An investigation into the effect of the cost drivers on costs has indicated that the proportions in which
the total product specific conversion costs are related to V4 and V2 are as follows:
V4 V2
Temperature (moulding) 2 1
Material consistency (trimming) 2 5
Time (packing) 3 2
Packing (complexity) 1 3
(iv) Company fixed costs is apportioned to product at an overall average rate per product unit based on the
estimated figures.
Required: Calculate amended unit costs for each product where activity based costing is used and company fixed
costs are apportioned as detailed above.
Solution:
Statement of Cost Pool
Conversion $ Basis No. of Activity Cost per Activity
Making: Variable 3,50,000 Time minute 42,000 [(5.25 × 5000) + 5.25 × 3000)] 8.33
Avoid: Fixed cost 84,000 Time 42,000 2
Unavoidable overhead 1,26,000 Time 42,000 3
Packing:
Variable 28,000 Time 42,000 6.66
Fixed unavoidable 84,000 Time 42,000 2
Fixed avoidable 56,000 Time 42,000 1.33
Decision: It is not advisable to discontinue the product V4 because unavoidable fixed cost 78,750 + 60,000, i.e.
1,38,750 remains constant. Hence, we can say that such fixed cost can be termed as fixed cost.