WK4 SEMINAR ABC & OVERHEAD ABSORPTION METHODS Q

Workshop problems

Example 1

This is a simple introduction to ABC compared to a traditional absorption cost system. The
difference in the costing outcomes is massive and you wouldn’t normally expect this.
However, in business even a small change in cost can have a massive effect on your profit.

There are12 employees in a department, and there are 2000 budgeted monthly direct labour
hours (DLH), and there is £5000 of budgeted overhead cost. (there are also some indirect
labour hours if you wondered why 12 people only worked 2000 hours in a month).

Two products are to be the focus of the costing exercise:

 product A; 100 units @ 1.25 DLH each (= 1 hour and 15 minutes)
 product B; 2500 units @ 0.75 DLH each ( = 45minutes)
Other products use remaining time.

Calculate the overhead cost per unit using a traditional DLH system

An activity-based costing system calculates the costs of activities (cost pool) related to the
number of times of occurrence of the activity (cost driver)

Assign costs to cost pools related to the three departmental activities (see example below)
first stage cost driver = number of employees

a receiving parts - requires 6 employees

second stage allocation basis is number of shipments of purchased parts (250 per month)

b receiving raw material - requires 3 employees

second stage allocation basis is number of shipments of raw materials (100 per month)

c distributing material - requires 3 employees

second stage allocation basis is number of production runs (50 per month)

Stage 2 Remove costs from activity cost pools and assign to products using second stage
cost drivers:

For product A, the 100 produced require 200 purchased part shipments, 80 raw material
shipments and 40 production runs.

For product B, the 2500 produced require 50 purchased part shipments, 20 raw material
shipments and 10 production runs.

Calculate the ABC cost and comment on the results

Example 2 - a case study

Ice Creams!!

Ericson had been the low-cost producer of chocolate and vanilla ice cream, with profit
margins exceeding 20% of sales. Several years ago Ericson expanded their business by
extending their product line into products with premium selling prices.

Five years ago strawberry ice cream was introduced. The basic production technology was
the same but the ices could be sold at a price that was 3% higher than for vanilla and
chocolate. Last year supernut ice cream was added and these could be sold at a 10% higher
price.
The Financial Controller of Ericson was disappointed with the most recent quarter’s financial
results and wondered whether the company should continue to keep introducing new
specialty premium flavours.

As a small company that had historically produced only a narrow range of products, Ericson
used a simple costing system. All the plant’s indirect expenses were aggregated at the plant
level and allocated to products based on each product’s direct labour cost. Currently the cost
system’s overhead absorption rate was 300% of direct labour cost (£180000/£60000)

The results are below.

Total Profitability by Product

  Vanilla Chocolate Strawberry Supernut Total

Units 50,000 40,000 9,000 1,000 100,000

Price £ 4.50 £ 4.50 £ 4.65 £ 4.95  

Sales £225,000 £180,000 £41,850 £4,950 £451,800

Material 75,000 60,000 14,040 1,650 150,690

Labour 30,000 24,000 5,400 600 60,000

Overhead 90,000 72,000 16,200 1,800 180,000

Total Mfg. 195,000 156,000 35,640 4,050 390,690

Expenses

Gross Margin £ 30,000 £ 24,000 £ 6,210 £ 900 £ 61,110

G.M. % 13.3% 13.3% 14.8% 18.2% 13.5%

Before the new specialty products were introduced, the overhead rate was only 200% of
direct labour cost. This is a blanket rate system.

Ericson’s management accountants designed the system years ago when:

 Production operations were mostly manual
 Total indirect costs were less than direct labour costs
 Ericsons’s two products had similar production volumes and batch sizes

Changes in the Production Environment

 Direct labour costs have decreased and indirect expenses have increased as a result
of automation
 As specialty low-volume products were added, Ericson needed:
More scheduling
More setups
More quality control personnel
A computer to track orders and product specifications

The old blanket rate system would produce cost distortions. A complex factory has a much
larger production support staff because it requires more people to:
 schedule machine and production runs
 perform setups
 inspect produced items after setup
  move materials
 ship orders
 expedite (chase) orders
 create new products
 improve existing products
 negotiate with vendors
 schedule materials receipts
 order, receive, and inspect incoming materials
 update and maintain the much larger computer-based information system

The factory has the same physical output; it has roughly the same cost of materials. The
company’s factory has about the same rent, security costs, and heating bills as before, but it
has much higher indirect and support costs because of its more varied product mix and
complex production tasks. Cost of complexity!

Important point!
On a per unit basis, high-volume standard flavours require about the same amount of
direct labour costs (the allocation basis) as the low volume flavours. The traditional
costing system would report essentially identical product costs for all products,
standard and specialty, irrespective of their relative production volumes.

Clearly, however, considerably more indirect and support resources are required on a
per-unit basis for the low-volume specialty products than for the high-volume,
standard products.

ABC at Ericson:

The controller started an analysis of indirect expenses, beginning with indirect labour
The controller interviewed department heads in charge of indirect labour and found that the
people in these departments performed three main activities

Indirect Labour Activities

50% of indirect labour was involved in what the controller called “handle production runs”
40% of indirect labour actually performed the physical changeover from one flavour to
another, an activity that she labelled “perform setups”
10% of the time was spent on activities the controller called “support products”

First Steps in Design of An ABC System

Develop the activity dictionary: the list of major activities performed by both the factory’s
human and physical resources
Obtain sufficient information to assign resource expenses to each activity in the activity
dictionary

Computer System Expenses

20% of computer expenses should be assigned to “support products,” an activity already

defined in her activity dictionary, because it was used to keep records on the four products
80% of the computer resource was involved in the production run activity and seemed to
relate well to the “handle production runs” activities

Other Overhead Expenses

There were three remaining categories of overhead expense:
• Machine depreciation
• Machine maintenance
• Energy to operate the machines

These expenses were incurred to supply machine capacity to produce the ice cream:
The controller labelled this production activity “run machines”
ACTIVITY ACTIVITY COST DRIVER
HANDLE PRODUCTION RUNS PRODUCTION RUNS
SET UP MACHINES SETUP HOURS
SUPPORT PRODUCTS NUMBER OF PRODUCTS
RUN MACHINES MACHINE HOURS
PROVIDE FRINGE BENEFITS LABOUR DOLLARS

Activity Cost Drivers

Activity Cost Supernut

Driver Vanilla Chocolate Strawberry Total**

DL hr/unit 0.02 0.02 0.02 0.02 2,000

Mach. hr/unit 0.1 0.1 0.1 0.1 10,000

Prod. runs 70 65 50 15 200

Setup time/run 4 2.4 5.6 5.6 --

Total setup hr 280 156 280 84 800

# of products 1 1 1 1 4

**Total = per unit X

quantity 50,000 40,000 9,000 1,000  

Activity Cost Driver Rates (ACDR)

  Activity Activity Cost Driver Driver

Expense Quantity ACDR

Handle Production £66,000 Number of 200 £330 per run

Runs production runs

Set up machines £33,600 Number of setup 800 £42 per setup

hours hr

Support Products £14,400 Number of products 4 £3,600 per

product

Run Machines £42,000 Number of machine 10,000 £4.20 per

hours machine hr

  £156,000      

Activity Expenses Assigned

  Supernut
Vanilla Chocolate Strawberry Total
Handle
Production £23,100 £21,450 £16,500 £4,950 £66,000
Runs

Set up 11,760 6,552 11,760 3,528 33,600

machines

Support 3,600 3,600 3,600 3,600 14,400

Products

Run Machines 21,000 16,800 3,780 420 42,000

Total Costs
Assigned £ 59,460 £ 48,402 £ 35,640 £ 12,498 £ 156,000

ABC profitability report:

• The results from the activity-based costing system were quite different from the
results based on the traditional cost system
• The two specialty products, which the previous cost system had reported as the most
profitable, were in fact the most unprofitable, and losing lots of money
• The company had added large quantities of overhead resources to enable these
products to be designed and produced, but their incremental revenue did not cover
those costs

Total ABC Profitability by Product

  Supernut
Vanilla Chocolate Strawberry Total

Sales £225,000 £180,000 £41,850 £4,950 £451,800

Material 75,000 60,000 14,040 1,650 150,690
Labour 30,000 24,000 5,400 600 60,000
40% fringe on 12,000 9,600 2,160 240 24,000
DL

Support 59,460 48,402 35,640 12,498 156,000

Total Mfg. 176,460 142,002 57,240 14,988 390,690
Expenses

Gross Margin £ 48,540 £ 37,998 £(15,390) £(10,038) £ 61,110

G.M. % 21.6% 21.1% -36.8% -202.8% 13.5%

Using ABC to Improve Profitability

The ABC information provides managers with numerous insights about how to increase the
company’s profitability:
• Increase either their sales volume or prices for the specialty products
• Impose minimum order sizes to eliminate short, unprofitable production runs
• Increase demand for the highly profitable standard products
The goal of these ABM actions is to enable the company to produce the same volume and
mix of products with fewer resources

Example 3 (old exam question)

Jefferson Airplanes produces module aeroplanes. It has recently identified "activity centres"
to which overhead costs are assigned. The cost pools for these centres and their selected
cost drivers for the year are as follows:

Activity Centres Cost Pool (£) Cost Driver

Utilities 278,000 60,000 machine hours

Scheduling and set up 260,000 780 set ups
Materials handling 640,000 1,600,000 kgs of material

The company's products and other operating statistics are:

Products
AA BB CC
Direct Cost (£) 80,000 80,000 90,000
Machine Hours 30,000 10,000 20,000
Number of set ups 130 380 270
Kgs of Material 500,000 300,000 800,000
No of Units to be made 40,000 20,000 60,000
Direct Labour Hours 40,000 20,000 60,000

Required

a Determine the unit product cost using the appropriate cost drivers for each of the
products.

b Prior to installing ABC, Jefferson had been pricing its products on the basis of
conventional costing using direct labour hours to allocate total overhead. The
firm operates in a competitive market, and prices were set on only a 20% mark-up
on cost.

i Calculate unit costs based on conventional costing.

ii Determine selling prices based on unit costs for conventional cost AND for
ABC costs.

c Discuss the problems related to setting prices based on conventional costing

and how ABC improves the information.