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Topic 2 - Activity Based Costing

Activity based costing

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44 views17 pages

Topic 2 - Activity Based Costing

Activity based costing

Uploaded by

maureen
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Activity Based Costing

Objectives
Activity Based Costing- What is it?
• 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.
Reasons for the development of ABC
The advent of advanced manufacturing
technology (AMT) means overheads are likely
to be far more important than direct labour.
Many resources are used in non-volume
related support activities, such as setting-up,
production scheduling, inspection and data
processing.
Differences between ABC and
Traditional costing systems
Traditional costing systems, assume that all
products consume all resources in proportion
to their production volumes, ABC attempts to
overcome this problem by using activity
drivers
Traditional Absorption Costing
ABC system
Outline of an ABC system

An ABC system operates as follows:


1. Identify an organization’s major activities.
2. Identify the factors which determine the size
of the costs of an activity (i.e. cost drivers)
3. Collect the costs associated with each cost
driver into cost pools.
4. Charge costs to products on the basis of their
usage of the activity.
Examples of Activities and Cost
Drivers
Activity Possible cost driver

Raw materials: purchases of materials


Materials handling and storage Finished goods: volume of products
made
Customer order processing No. of customer orders

Materials purchasing No. of purchase orders

Quality control and inspection No. of inspections

Production planning No. of production runs or batches

Repairs and maintenance No. of machines, or machine hours


operated
Example
Example 1
Jacks makes and sells two products, X and Y. Data for production and sales each
month are as follows:

Product X Product Y
Sales demand 4,000 units 8,000 units
Direct material cost/unit $20 $10
Direct labour hours/unit 0.1 hour 0.2 hours
Direct labour cost/unit $2 $4

Production overheads are $500,000 each month. These are absorbed on a direct
labour hour basis.

An analysis of overhead costs suggests that there are four main activities that cause
overhead expenditure.

Activity Total cost Cost driver Total Product Product


number X Y
$
Batch setup 100,000 No. of set-ups 20 10 10
Order handling 200,000 No. of orders 40 24 16
Machining 120,000 Machine hours 15,000 6,000 9,000
Quality control 80,000 No. of checks 32 18 14
500,000

Required:

Calculate the full production costs for Product X and Product Y, using:
(a) traditional absorption costing
(b) activity based costing.
Example- Solution

a) Traditional Absorption Costing

The overhead absorption rate = $500,000/ (4,000 × 0.1 + 8,000 × 0.2) = $250

Product X Product Y Total


$ $
Direct materials 20 10
Direct labour 2 4
Overhead (at $250 per hour) 25 50
Cost per unit 47 64

No. of units 4,000 8,000

Total cost $188,000 $512,000 $700.000


Example- Solution
b) Activity based costing
Activity Total cost Cost driver Product Product
X Y
$ $ $ $
Batch setup 100,000 Cost/setup 5,000 50,000 50,000
Order handling 200,000 Cost/order 5,000 120,000 80,000
Machining 120,000 Cost/machine hour 8 48,000 72,000
Quality control 80,000 Cost/check 2,500 45,000 35,000
500,000 263,000 237,000

Product X Product Y Total


$ $ $
Direct materials 80,000 80,000
Direct labour 8,000 32,000
Overhead 263,000 237,000
Total cost 351,000 349,000 700,000

No. of units 4,000 8,000

Cost per unit $87.75 $43.625


Example- Solution
Comment on the results
• The cost per unit of Product X under ABC is much
higher than with traditional absorption costing
and for Product Y the unit cost is much less.
• The difference is caused by the fact that Product
X use only 20% of total direct labour hours
worked, but much larger proportions of set-up
resources, order handling resources, machining
time and quality control resources
When is ABC appropriate ?
1. In a manufacturing environment, where absorption
costing is required for inventory valuations.
2. Where a large proportion of production costs are
overhead costs, and direct labour costs are relatively
small.
3. Where products are complex.
4. Where products are provided to customer
specifications
5. Where order sizes differ substantially, and order
handling and dispatch activity costs are significant.
Advantages of ABC
1. IT provides useful information about the activities
that drive overhead costs.
2. It provides information that could be relevant to long-
term cost control and long-term product selection or
product pricing.
3. ABC can provide the basis for a management
information system to manage and control overhead
costs.
4. It charges a ‘fair share’ of overhead cost that
represents the activities that go into making and
selling it.
5. In the long run all overheads are variable, which
makes ABC useful for controlling activities and long
term costs.
Disadvantages of ABC
1. ABC system may be based on unreliable data and weak
assumptions.
2. Its analysis is based historical costs while management
accounting decisions are based on expectations of future cash
flows.
3. ABC may be little more than a sophisticated absorption costing
system.
4. Within ABC systems, there is still a large amount of overhead cost
apportionment.
5. Many ABC systems are based on just a small number of cost
pools and cost drivers.
6. Many activities and cost pools have more than one cost driver.
7. It might be a costly system to design and use.
8. Traditional cost accounting systems may be more appropriate for
financial reporting (IAS 2) purpose.
Activity Based budgeting ABB

Please read about activity based budgeting, it


advantages and disadvantages.

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