Cost Pool

A cost pool is an activity that consumes resources and for which overhead costs are identified and
allocated. For each cost pool there should be a cost driver.

Cost Driver
A cost driver is a unit of activity that consumes resources. An alternative definition of a cost driver
is the factor influencing the level of cost.
A cost driver is a factor that influences (or drives) the level of cost.
a cost driver
A simpler approach

Suppose we are talking of a Dominos outlet. Let us check what all overhead costs are incurred
- Maintenance costs
- Depreciation on machine

Now, it makes perfect sense to absorb these costs basis the machine hours used
- Say there are 4 types of pizzas that are made.

Number of machine Maintenance

Pizza Type Calculation
hours required cost absorbed
Margherita 200 25,000 [ 200 hours * OAR of 125 per machine hour ]
Cheese burst 100 12,500 [ 100 hours * OAR of 125 per machine hour ]
Farm Fresh 100 12,500 [ 100 hours * OAR of 125 per machine hour ]
Chicken 400 50,000 [ 400 hours * OAR of 125 per machine hour ]

Total 800 100,000

But there are other overheads as well - Like rent of premises, salary of security guy etc
- In absorption costing, even this would be absorbed using machine hour basis
- And that is wrong because machine hours are not directly responsible or connected with rent

ABC overcomes this problem by not using a generic item like machine hours for absorption
Instead it uses cost pools to group the costs which are driven by an activity

- The cost of order processing might be related to the number of orders dispatched or to the
weight of items dispatched
- the cost of purchasing might be related to the number of purchase orders made
- the cost of setting up machinery for a production run might be driven by the number of set-ups

Activity Based Costing [ABC] vs Traditional Methods

Traditional systems measure accurately volume-related resources that are consumed in proportion to the number
of units produced of the individual products. Such resources include direct materials, direct labour, energy, and
machine-related costs

However, many organisational resources exist for activities that are unrelated to physical volume. Non-volume relate
consist of support activities such as materials handling, material procurement, set-ups, production scheduling
and first item inspection activities.

Traditional product-cost systems, which assume that products consume all activities in proportion to their production
thus report distorted product costs.

So, although both traditional absorption costing and activity-based costing systems adopt a two-stage allocation proc
the differences can be listed as follows:
For overhead allocation, ABC establishes separate cost pools for support activities such as material handling
As the costs of these activities are assigned directly to products through cost driver rates, reapportionment
of service department costs is avoided.

Overhead absorption into products is where the main difference lies between ABC and traditional costing.
Traditional absorption costing uses two absorption bases, (labour hours or machine hours) to charge
overhead to products, whereas ABC uses many cost drivers as absorption bases (e.g. the number of orders,
or the number of dispatches)

The use of cost drivers is the main idea behind ABC as they highlight what causes costs to increase
for example, the number of orders to suppliers each product incurs. Overheads that do not vary with
volume/output, but with some other activity, should be traced to products using ABC cost drivers.
Traditional absorption costing, on the other hand, allows overheads to be related to products
in more arbitrary ways – therefore producing less accurate product costs.
 Say total maintenance cost is 100000
We now absorb this cost in each pizza type in proportion to number of hours

OAR = 100000 / 800 = 125 per machine hour

oportion to the number

ct labour, energy, and

volume. Non-volume related activities

oduction scheduling

oportion to their production volumes

a two-stage allocation process

s material handling
reapportionment

ditional costing.

umber of orders,
Step 1
Group production overheads into activities, according to how they are driven.

Step 2
Identify cost drivers for each activity, i.e. what causes these activity costs to be incurred.

Step 3
Calculate a cost driver rate for each activity.
The cost driver rate is calculated in the same way as the absorption costing OAR.
However, a separate cost driver rate will be calculated for each activity, by
taking the activity cost and dividing by the total cost driver volume.

Step 4
Absorb the activity costs into the product.
The activity costs should be absorbed back into the individual products.

Step 5
Calculate the full production cost and/ or the profit or loss.
Question

Kushal, a chocolate manufacturer, produces three products:

The Sky Bar, a bar of solid milk chocolate.

The Moon Egg, a fondant filled milk chocolate egg.
The Sun Bar, a biscuit and nougat based chocolate bar.

Information relating to each of the products is as follows:

Particulars Sky Bar Moon Egg Sun Bar

Direct Labour cost per unit 0.07 0.14 0.12
Direct Material cost per unit 0.17 0.19 0.16
Actual Production/ Sales (units) 500,000 150,000 250,000
Direct labour hours per unit 0.001 0.01 0.01
Direct machine hours per unit 0.01 0.04 0.02
Selling price per unit 0.50 0.45 0.43

Annual production overhead = $80,000

Breakup of OH
Machining Costs 5,000
Component Costs 15,000
Set-up Cost 30,000
Packing cost 30,000

Particulars Sky Bar Moon Egg Sun Bar

Actual production/sales units 500,000 150,000 250,000
Machine hours per unit 0.01 0.04 0.02
Number of production setups 3 1 26
Number of components 4 6 20
Number of customer orders 21 4 25

Solution

Step 1 : Identify the activities - Machining, Putting together the components, Set-ups done, Packing of orders

Step 2
Identify cost drivers for each activity, i.e. what causes these activity costs to be incurred.

Cost Pool Cost Drivers

Machining Costs Machine hours per unit
Component Costs Number of components
Set-up Cost Number of production set_x0002_ups
Packing cost Number of customer orders
 Step 3
Calculate a cost driver rate for each activity.
OAR

Cost Pool Cost Drivers

Machining Costs Machine hours per unit
Component Costs Number of components
Set-up Cost Number of production setups
Packing cost Number of customer orders

Step 4
Absorb the activity costs into the product.

Sr. No Particulars Sky Bar Moon Egg Sun Bar

Units produced 500,000 150,000 250,000
Machine hours per unit 0.01 0.04 0.02
Total machine hours 5,000 6,000 5,000
A Machining cost 1,562.50 1,875 1,562.50
[ Machine hours * OAR ] [ 5000 * 0.31 ] [ 6000 * 0.31 ] [ 5000 * 0.31 ]

Number of Components 4 6 20
Per component cost 500 500 500
B Total component cost 2,000 3,000 10,000

Number of setups 3 1 26
Set up cost per set up done 1,000 1,000 1,000
C Total set up cost 3,000 1,000 26,000

Number of customer Orders 21 4 25

Order cost per order 600 600 600
D Total order costs 12,600 2,400 15,000

E Total Production OH 19,162.50 8,275 52,562.50

[A+B+C+D]

F Total Production 500,000 150,000 250,000

(given)

G Production OH per unit 0.04 0.06 0.21

[E/F]

H Direct Labour cost per unit 0.07 0.14 0.12

I Direct Material cost per unit 0.17 0.19 0.16

J Total Production cost 0.28 0.39 0.49

 [G+H+I]

K Selling price per unit 0.50 0.45 0.43

L Profit per unit 0.22 0.06 -0.06

[K-J]

Traditional absorption costing approach - Sheet 2.1, Q - 2

Particulars Sky Bar Moon Egg Sun Bar

Direct Labour cost per unit - Given 0.07 0.14 0.12
Direct Material cost per unit - Given 0.17 0.19 0.16
Apportioned OH per unit - calculated above 0.05 0.20 0.10
Full Production Cost 0.29 0.53 0.38
Selling price per unit 0.50 0.45 0.43
Profit / (loss) per unit 0.21 -0.08 0.05

Comments

- Under absorption costing technique, all OH were absorbed using machine hours
- Now that we know the break up of costs, we can scientifically apportion costs and then better estimate the
cost per unit
- Under traditional absorption costing method, cost per unit and profit are cal;culated and it might lead us to
conclude that Moon egg is not worth producing
- But, after using ABC which is a more appropriate method, we can conclude that Sun Bar might have to be discont
 Using ABC, calculate the full production cost per unit and the profit per unit for each product.
Comment on the implications of the figures calculated.

5000 6000 5000

s done, Packing of orders

OAR = Budgeted OH / Budgeted Volume

Volume is not necessarily units produced only
It can be machine hours, nmber of set-ups etc
Total cost Cost driver (Denominator) OAR (Driver rate) Meaning
5,000 16,000 0.31 0.31$ per hour of machine run
15,000 30 500 $ 500 per component
30,000 30 1,000 $ 1000 for each setup
30,000 50 600 $ 600 for each customer order
then better estimate the

d and it might lead us to

un Bar might have to be discontinued

Calculation of cost driver
500000 * 0.01 + 150000 * 0.04 + 250000 * 0.02
4 + 6 + 20
3 + 1 + 26
21 + 4 + 25
Question

Cabal makes and sells two products, Plus and Doubleplus. The direct costs of production are $12 for one unit
of Plus and $24 per unit of Doubleplus.

Information relating to annual production and sales is as follows:

Particulars Plus Doubleplus

Annual production and sales (units) 24,000 24,000
Direct labour hours per unit 1.00 1.50
Number of orders 10 140
Number of batches 12 240
Number of setups per batch 1 3
Special parts per unit 1 4

Information relating to annual production and sales is as follows:

Setup costs Number of setups 73,200

Special parts handling Number of special parts 60,000
Other materials handling Number of batches 63,000
Order handling Number of orders 19,800
Other overheads 216,000
432,000

Other overhead costs do not have an identifiable cost driver, and in an ABC system, these overheads
would be recovered on a direct labour hours basis.

Required
Calculate the production cost per unit of Plus and of Doubleplus if the company uses traditional
absorption costing and the overheads are recovered on a direct labour hours basis.

Calculate the production cost per unit of Plus and of Doubleplus if the company uses ABC.

Comment on the reasons for the differences in the production cost per unit between the two methods.

What are the implications for management of using an ABC system instead of an absorption costing system?

Solution

Absorption Costing Approach

Absorb using labour hours

Total number of labour hours 60,000

[ 24000 * 1 + 24000 * 1.5 ]

Budgeted OH cost 432,000

OH Absorption rate per labour hour 7.20 [ 432000 / 60000 ]

Sr. No Particulars Plus Doubleplus
A Direct Production cost 12.00 24.00
B Number of labour hours used per unit 1.00 1.50
C OH Absorption rate per labour hour 7.20 7.20
D OH cost per unit [ B * C ] 7.20 10.80
E Total cost per unit [ A + D ] 19.20 34.80

ABC Approach

Cost pool Cost Driver Description Total Cost

Setup costs Number of setups 73,200
Special parts handling Number of special parts 60,000
Other materials handling Number of batches 63,000
Order handling Number of orders 19,800
Other overheads 216,000

Particulars Plus Doubleplus

Number of set ups 12 720
Set up cost per set up 100 100
Total set up cost 1,200 72,000

Number of special parts 24,000 96,000

Handling cost per unit 0.50 0.50
Total special part handling cost 12,000 48,000

Number of batches 12 240

Cost of handling per batch 250 250
Total other material handling cost 3,000 60,000

Number of orders 10 140

Per order cost 132 132
Total ordering cost 1,320 18,480

Labour hours 24,000 36,000

Cost per hour 3.60 3.60
Total other OH 86,400 129,600

Total Production OH 103,920 328,080

Total units 24,000 24,000

Production OH per unit 4.33 13.67

 Direct cost 12.00 24.00

Total cost per unit 16.33 37.67

Plus Doubleplus
Using traditional absorption costing 19.20 34.80
Using ABC 16.33 37.67
Assume the selling prices are 25.00 40.00
Using absorption costing sales margins 23.2% 13.0%
ABC sales margins are 34.7% 5.8%

c) The reasons
driven by labourfor hours
the difference
and, as a in the production
result, cost per unit between the two methods
the Double Plus
i received
By taking1.5
thistimes
into the production
account we endoverhead
up with aofmuch
the Plus.
more
ii accurate
are production
4 special parts foroverhead costPlus
the Double per unit.
compared to only one
iii for the Plus.
As a accurate
This result of allocation
this complexity, the Double
is important Plusthe
because has received more than three times the overhead of the Plus.
production
iv overhead is a large proportion of the overall cost.

d) The implications of using ABC

– Pricing – pricing decisions will be improved because the price will be based on more accurate cost data.
– Decision making – this should also be improved. For example, research, production and sales effort can be directe
– Performance management – should be improved. ABC can be used as the basis of budgeting and forward planning
In addition, an improved understanding of what drives the overhead costs should result in steps being taken to reduc
– Sales strategy – this should be more soundly based. For example, target customers with products that appeared unp
oduction are $12 for one unit

em, these overheads

uses traditional

een the two methods.

n absorption costing system?

Budgeted OH / Budgeted Labour hours

[ Given in the first line ]

Cost Driver OAR

732 100.00
120,000 0.50
252 250.00
150 132.00
60,000 3.60
wo methods

es the overhead of the Plus.

n more accurate cost data.

uction and sales effort can be directed towards the most profitable products.
s of budgeting and forward planning. The more realistic overhead should result in more accurate budgets and should improve the process o
result in steps being taken to reduce the overhead costs and hence an improvement in performance.
mers with products that appeared unprofitable under absorption costing but are actually profitable, and vice versa.
 Analysis of cost driver
240 batches and 3 set ups per batch + 12 batches and 1 set up per batch
Units produced * Special parts per unit
Total batches
10 + 140
 profitable products.
c overhead should result in more accurate budgets and should improve the process of performance management.
s and hence an improvement in performance.
orption costing but are actually profitable, and vice versa.
Advantages

It provides a more accurate cost per unit. As a result, pricing, sales strategy, performance management
and decision making should be improved.

It provides much better insight into what drives overhead costs.

ABC recognises that overhead costs are not all related to production and sales volume.

It can be applied to derive realistic costs in a complex business environment.

ABC can be applied to all overhead costs, not just production overheads.

ABC can be used just as easily in service costing as in product costing

In many businesses, overhead costs are a significant proportion of total costs, and management needs to
understand the drivers of overhead costs in order to manage the business properly. Overhead costs
can be controlled by managing cost drivers.

Disadvantages

ABC will be of limited benefit if the overhead costs are primarily volume related or if the overhead
is a small proportion of the overall cost.

It is impossible to allocate all overhead costs to specific activities.

The choice of both activities and cost drivers might be inappropriate.

ABC can be more complex to explain to the stakeholders of the costing exercise.

The benefits obtained from ABC might not justify the costs. In some situations, ABC does not provide very
different information from traditional absorption costing.
ce management

gement needs to

he overhead

oes not provide very

ABC - Public Sector

When government introduces austerity measures, there is an increased pressure on the government
- Pressure to deliver more, with lesser resources at disposal

Austerity, a word that characterizes severity or sternness, is used in economics to refer to austerity measures.
These are economic policies implemented by a government to reduce public-sector debt, by significantly curtailing
government spending, particularly when a nation is in jeopardy of defaulting on its bonds.

Public Sector organizations therefore have to be more accurate in identification, allocation and absorption of OH

Why the emphasis on ABC in Public Sector ?

Public responsibility

Public accountability

Resource allocation within organisations

Helping managers to manage

to austerity measures.
t, by significantly curtailing

ion and absorption of OH