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If a company manufactures a product, the cost of the product will include direct costs
such as material and labour. However, other costs would be incurred that are not
directly attributable to the product, but are incurred in the process of manufacturing
and selling a large number of units. These costs are classified as indirect costs or
overheads, and include the following.

Ô Supervision costs
Ô Heat and lighting
Ô Factory rent and rates
Ô Machine depreciation
Ô Maintenance costs

These costs may, in some cases, exceed the direct productions costs, therefore it
would be unwise to ignore them because to do so would give unrealistic costs and
selling prices for the units produced. In order to make a p rofit on sales, companies
must ensure they charge enough to cover all costs involved in the production and
selling process plus their required profit.

The problem facing management accountants is - how should the indirect or
overhead costs be allocated to the products?




Traditionally, the view has been that a fair share of overheads should be added to
each product. A method called absorption costing was used to spread the cost of
the overheads fairly between the products.

This method requires the calculation of an overhead absorption rate, this could be
calculated using many methods, the main ones being:

Ô No of labour hours
Ô No of machine hours

Absorption costing involves calculating the budgeted overheads and dividing them
by the basis of absorption (such as total labour hours), this would give a cost of
overhead per direct labour hour or an overhead absorption rate. This would then be
used in deciding how much of the overheads to allocate to each unit.

 
0  

A product uses 3 hours of direct labour and 5kg of material. The company expects it
indirect costs to be £200,000 per annum and the budgeted labour hours to be 50,000
hours. The cost of materials is £2.00 per kg and the labour force are paid at £6.00
per hour

The cost of each unit could be calculated as follows:

£
Materials: 5kg@ £2.00 per kg 10.00
Labour: 3 hours @ £6.00 per hour 18.00
Prime cost 28.00

The prime cost is the direct costs involved in making the product ± but what about
the overhead costs?

They are absorbed by calculating an overhead absorption rate.

The overhead absorption rate is calculated by taking the overhead cost and dividing
it by the activity level on which they will be absorbed.

In this example the overhead cost id £200,0 00 and the activity level is 50,000 hours.

The overhead absorption rate is calculated as follows:

£200,000 ÷ 50,000 = £4

The overheads are now allocated at £4 per direct labour hour. This is the overhead
absorption rate.

Carrying on with our example.

£
Materials: 5kg@ £2.00 per kg 10.00
Labour: 3 hours @ £6.00 per hour 18.00
Prime cost 28.00
Overheads 3 hours @ £4 per direct labour hour 12.00
Total cost 40.00

The company can now add on its required profit per unit to set a selling price.
 
   

Traditional product costing methods were developed many years ago when most
companies made a much narrower range of products. The main factory costs at the
time were material and labour whilst the overhead c osts were relatively small. In
view of this, and the fact that information processing costs were high, the allocation
of overheads was relatively unimportant and more sophisticated methods were
unlikely to be cost effective.

In the present day most companies produce a wider range of products, direct labour
costs have greatly reduced in relation to total costs, overheads have greatly
increased and information processing costs have fallen.

Most traditional overhead allocation was based on some measure of d irect labour
and this, is argued is no longer valid.

With increased globalisation of markets it has become essential to have more

accurate product cost information. It was with this in mind that Activity Based
Costing was developed.


 
  

Traditional systems were introduced to measure accurately resources that vary in
proportion to the quantity produced of individual products. These include material,
labour and machine related costs such as energy. There are however many
resources which are unrelated to volume. These are mainly support/administration
activities: - material handling, purchasing. Setting up costs, production scheduling.

Traditional costing systems assume that all resources are consumed in proportion to
volume and as such can lead to distorted product costs. These are most
pronounced in organisations that produce a diverse range of products.

 
  
  

For activity based systems it is necessary to have a better understanding of

overhead costs behaviour ± what causes overhead costs and how they relate to
products. With traditional systems the assumption is made that many overheads are
fixed. Activity Based Costing systems make no such assumption and recognises
that , in the long term, most man ufacturing costs are not fixed and examines what
causes overheads to change over time.
The assumption that with ABC is that activities that create costs and the products,
and the customer demand for products, create the activities. In ABC the costs are
allocated to products based on consumption or the product¶s demand for activities.
ABC recognises the need to understand the factor that drives each activity, the costs
of these activities and how they relate to products.

This is done in four stages:

  

 
  
    
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Examples

„ Machine related activities ± machine costs centres

„ Direct labour related activities ± assembly
„ Support activities ±Ordering, receiving, materials handling, part
administration, product scheduling, packing and despatch

  

 
  
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In ABC this is usually referred to as the cost driver ± the event or force that
significantly determines the costs of the activity.

Examples

If production scheduling costs are generated by the number of production runs of

each product then the number of set ups is the cost driver for product scheduling.

Other examples of cost drivers: -

„ Number of order received in the receiving department.

„ Number of production runs undertaken for scheduling and set -up costs.
„ Number of purchase orders for the cost of operating the purchasing
department.
„ Number of despatch orders for cost of operating the despatch department.
Where costs vary directly with output in the short term ABC uses volume related
costs drivers such as machine hour or labour hours. Machine power costs can be
traced to products using machine hours since machine hours determine or drive the
power consumption.

Production increase % = Power consumption increase % =Machine hour increase %.

A fundamental of the ABC system is that cost behaviour is dictated by cost drivers
and that tracing of overheads to products requires changes in the level of each
overhead.


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Set-up costs could be a cost centre/pool for all set up related costs.

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Trace the costs of activities to the products according to the demand for these
activities. The cost driver is the measure of the demand an d the product¶s demand
for any activity is measured by the number of transactions it generates for the costs
driver.

Examples

„ How many set-ups

„ How many purchase orders
0  

A company makes two products, A & B. Both are produced on the same
equipment using the same processes. Product a is a high volume while
product B is low volume.

Details of the product inputs, outputs and the cost of activities is as follows:

Product A B

Machine hours per unit 2 2

Direct labour hours per unit 4 4
Annual output - units 10000 1000
Total machine hours 20000 2000
Total direct labour hours 40000 4000
Number of purchase orders 160 80
Number of set-ups 60 40

Cost of Activities £

Volume related 110,000

Purchase related 120,000
Set-up related 210,000

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Calculate the cost per unit using:

1 Traditional absorption costing

2 Activity based costing
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Total overhead costs £440,000

Direct labour hours 44000
Overhead absorption rate = (440,000/44000)= £10 per direct labour hour.

Product A per unit units total charge

4 hrs x £10 per unit £40 10,000 £400,000

Product B
4 hrs x £10 per unit £40 1,000 £40,000

Total £440,000

 
    

         
       
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 £110,000 £120,000 £210,000



Labour No of purchase No of

Hours orders set-ups



" 44000hrs 240 100




£2.50 £500 £2,100

per per per
labour hour purchase order set-up

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Volume related £100,000 £10,000 £110,000
Purchase related £80,000 £40,000 £120,000
Set-up related £126,000 £84,000 £210,000
Total overhead cost £306,000 £134,000 £440,000

No of units 10,000 1,000



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ACCAREV Ltd manufactures four products, A, B, C,and D Output and cost data for
period just ended are as follows:

Number of Direct
production Material labour Machine
Output runs in the Cost hours hours
Units period per unit per unit per unit

A 20 3 £25 2 2
B 25 2 £82 4 4
C 120 6 £25 1 1
D 150 5 £90 2 2

Direct Labour cost per hour is £6

Overhead costs are as follows:

£
Variable Overhead costs 6,720
Set up costs 17,280
Scheduling costs 15,040
Materials handling costs 11,360

Calculate the cost of one unit of each using:

(a) A traditional absorption method

(b) Activity based costing.