COST AND MANAGEMENT ACCOUNTING (CMA)

UG027

SEMESTER 4

LECTURE 6

ACTIVITY BASED COSTING

Undergraduate Department
Learning objectives

❖ At the end of the session, you should be able to:

➢ Understand the shortcomings of traditional costing systems in

product costing

➢ Appreciate the benefits of an activity-based costing system in

product costing

➢ Contrast the traditional and activity based costing approaches of

dealing with overhead costs

➢ Appreciate the value of ABC generated information for decision-

making purposes
Traditional costing methods

➢ Allocate and accumulate overhead costs to production departments

➢ Assign the accumulated overhead costs from production

departments to individual products

➢ Use a volume-based cost driver

An example

▪ Dinner of 4 persons
▪ Waleed $38, Fatima $32, Ahmed $25, Joan $27
▪ Total = $122
▪ Split the bill in 4 and everyone pays = $30.50 (W1)
W1= (38+32+25+27) = 122 ÷ 4 = $30.5

▪ Waleed & Fatima consume more, pay less

▪ Ahmed & Joan consume less, pay more
Limitations of traditional costing systems

❖ Traditional systems are…

➢ Adequate when overheads are low

➢ Adequate when product variety is limited.
➢ Appropriate only if a large proportion of overheads are volume-
related.

❖ However, they suffer from the following limitations

➢ Ignore non-volume related support activities, as material handling,

material procurement, set-ups, inspection activities.
➢ Inappropriate today because organisations produce a wide range
of products
➢ Assume that products consume all resources in proportion to their
production volumes
Activity-Based Cost Systems

❖ ABC refines traditional costing systems by..

➢ Calculating the costs of individual activities

➢ Assigning costs to cost objects (i.e., products or services) on the
basis of the activities undertaken to produce each product or
service.

❖ So, ABC is system based on activities linking organizational spending on

resources (overheads) to the products and services produced and delivered to
customers.

➢ Objective is to measure and then price out all the resources used
for activities that support the production and delivery of products.
Example: Lens manufacturing
(Absorption Costing Method- traditional costing)

▪ Normal lenses (NL) and Complex lenses (CL)

▪ Indirect costs (setup activities) £409,200
▪ Manufacturing labor hours 50,000

NL: 36,000 labor hours; CL: 14,000 labor hours

Setup costs per labor hour(OAR) = Budgeted Overhead ÷ Budgeted Activity
(409,200 ÷ 50,000)= £8.184
▪ Allocation:

▪ NL: 36,000 x £8.184 = $294,624

▪ CL: 14,000 x £8.184 = $114,576
Example- Lens Company (Activity Based Costing-
ABC)

NL CL
Quantity produced 80,000 20,000
Total setup-hours 640 2,000

Total setup costs are £409,200.

Total Set up hours = 640 + 2000= 2640
Setup cost per setup-hour = £409,200 ÷ 2,640 hours = £155
Example –Cont. ABC

Allocation using direct labor-hours:

NL: £8.184 × 36,000 = $294,624
CL: £8.184 × 14,000 = $114,576
Total $409,200

Allocation using setup-hours:

NL: £155 × 640 = $ 99,200
CL: £155 × 2,000 = $310,000
Total $409,200
Steps in developing ABC systems
Step1-Organisational activities
Identify the organisation’s major activities and Its cost.
Step2 -Cost driver
Identify the cost driver for each major activity.
Step3-Cost centre (or Cost pool)
Establish a cost centre (or cost pool) for each major activity.
Step4- Cost per Activities
Calculate Cost per Activity
Step5- Allocate Cost of Activities
Allocate the cost of the activities to products according to their demand for
activities
Examples of cost drivers
❖ Activity ❖ Cost driver
➢ Set up machines
➢ Handle production runs
➢ Invoicing
➢ Order processing
➢ Quality control
➢ Buying materials
➢ Set up hours
➢ Number of production
runs
➢ Number of invoices
➢ Number of orders
➢ Number of inspections
➢ Number of purchase
orders
Traditional v. ABC System

❖ Traditional costing ❖ Activity based costing:

➢ Uses actual departments or cost ➢ Uses activities, for accumulating
centers for accumulating and costs and redistributing costs
redistributing costs

➢ Asks what activities are being

➢ Asks how much of an allocation performed by the resources of the
basis (usually based on volume) is support department
used by the production department

➢ Support department expenses are

allocated to a production ➢ Resource expenses are assigned
department based on the ratio of to activities based on how much
the allocation basis used by the of the resource is required or
production department used to perform the activities
So ABC Benefits are…
❖ Better profitability measures

❖ Better information for controlling capacity cost

❖ Detail and visibility of overheads

❖ More accurate and powerful insights

❖ Better decision and control

However, ABC Problems are…

❖ The main limitations of ABC are the measurements necessary to implement the system.

❖ ABC systems require management to estimate costs of activity pools and to identify and measure
cost drivers for these pools.

❖ Activity-cost rates also need to be updated regularly.

❖ Very detailed ABC systems are costly to operate and difficult to understand.
 Practice Question -6 ABC Costing
Bradford plc manufactures product A and B. The following information is available from the company:
Product A Product B
Units produced 5,000 20,000
Selling price 400 200
Direct materials and labour per unit 200 80
Direct labour hours 25,000 75,000
Direct labour hours per unit 5 3.75

The company has a total budgeted overhead of £2 million. The following details are also available about overheads:
Budgeted cost Cost Driver A B
Engineering £ 125,000 Engineering hours 5,000 7,500
Set-ups 300,000 Number of set-ups 200 100
Machine running 1,500,000 Machine hours 50,000 100,000
Packing 75,000 Number of packing orders 5,000 10,000
Total 2,000,000

You are required to allocate overheads using :

1. Absorption Costing Method(Traditional)
2. ABC costing Method
 Solution: 1. Absorption costing system

1. Calculate the overhead rate per direct labour hour (predetermined absorption rate)

OAR = total Budgeted overhead/total direct labour hours

= £2,000,000/100,000 = £20 per hour.

2. Calculate overhead cost per unit:

Product A = 5 hours x 20 = £100

Product b = 3.75 hours x 20 = £75

 Solution: Activity Based Costing
Steps 1, 2,3and 4

1 2 3 = 1÷2
Activity Cost £ Cost Driver Total Number of Cost Cost Driver
Drivers Rate £

Engineering 125,000 Engineering hours 12,500 10

Set-ups 300,000 Number of set up hrs 300 1000
M. running 1,500,000 Machine hours 150,000 10
Packing 75,000 Packing orders 15,000 5
2,000,000
Step-5
PRODUCT - A PRODUCT - B

Engineering
Product A=5000 x10=50,000 50,000 75000
Product B=7500x10= 75,000
Set Up:
Product A=200 x1000=200,000 200,000 100,000
Product B= 100x1000= 100,000
Machine Running :
Product A=50,000x10=500,000 500,000 1000,000
Product B= 100,000x10= 1000,000
Packeging :
Product A=5,000x5=25,000 25,000 50,000
Product B= 10,000x5= 50,000
Total 775000 1225,000
÷ Number of units ÷ 5000 ÷ 20000

Cost per unit 155 61.25

Evaluate the difference

Product A Product B
Absorption costing 100 75
ABC costing 155 61.25
Diffference 55 under costed 13.75 overcosted

Cost in absorption costing is 100 which the if company decides

price based on this they will deprive of desired profit. On the
other hand product B is over costed , the selling price based on
this will be higher which will drive away the customers.
Both the methods have their own limitations companies should
evaluate them before deciding which method to use.
References

1. Burn,Martin,Lizz,Oliveira,2013,Management Accounting ,McGraw Hill.

2. ACCA ,2017,BPP,Management Accounting.
Undergraduate Department
Undergraduate Department