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ACTIVITY BASED COSTING

ABC - is defined as cost attribution to cost units on the basis of benefit received from
indirect activities Li.e overheads that cannot be allocated to a particular product of process ].

Cost drivers - are activities undertaken in each

department, they are activities that are part of the process of making
a product.

Cost pools - are accounts that collect the costs

incurred by each activity.

-Abc can be alternative to absorption costing or marginal costing.

-Absorption costing is a method of charging overheads to a product/s and this is done

by calculating OAR and then charging that rate to products on the basis of direct labour
hours or machine hours.
-Absorption costing can lead to inaccurate results because overheads are not spread fairly
among products.
-ABC aims to give more realistic results than absorption costing because it apportions each
overhead in a fairer way by carefully considering how it is used.

-Absorption costing uses a single overhead absorption rate for every product.

-ABC uses a number of different absorption rates for different overheads.

-ABC tries to identify which specific overeads should be charged to a product, by looking at
the activities that are needed to make a product and charging the product with overheads
based on how much activity is used.
-ABC carefully considers the individual overhead costs incurred by each product.

-These individual costs are grouped together in a cost pool.

Stages in using ABC system

The stages of an activity based costing system are:
1.Record and classify all costs
2.Identify the activities producing the overhead cost.

3.Identify cost drivers

4.Apportion appropriate overheads to the cost drivers.

5. Calculate the cost driver rates.

6. Absorp both indirect and direct costs into the product or service.
If a business uses a forklift truck to unload deliveries from suppliers, then the cost of
running the truck is one of the factory overheads. Suppose the individual costs of running
the forklift trucks are as follows :

$
Drivers' wages 60 000
Maintenance costs 20 000
Power and fuel 12 000
Depreciation 8 000
Total forklift truck costs 100 000

The total forklift truck costs of $100 000 represent a cost pool.

-This basis for apportioning the cost pool must be identified.

-This basis should reflect has much of the cost pool a particular product uses.

-In ABC this is a cost driver.

Example
Bilop incurred the following costs:

Machinery set up 7 452

Ordering costs 6 000

Quality control 1 972
Selling expenses 7 225

Product selling price is based on cost plus 30%.

Additional Information

Product A Product B Product C

Direct Materials $10 000 $3 000 $9 000

Direct Labour $12 000 $15 000 $4 000
No of machine set-ups 30 16 8
No of purchase orders 3000 1000 2000
No of quality inspections 20 18 30
No of sales 4000 3500 1000
No of pdts produced. 5000 3000 900
Required
Calculate

(a)The activity cost driver rate

(b) Overheads per product

(c) Total cost per product

(d) Selling price for each product

Answer

a) Activity Machine set - ups Ordering Quality control Sellingexpenses

Cost($) 7 452 6 000 1972 7225

Cost driver 54 6 000 68 8500

Cost driver rate $138 $1 $29 $0.85

b) Machine set - ups Quality Control

A 30 × $138 = $4 140 20× $29 = $580

B 16× $138 = $2 208 18 ×$29 = $522

C 8 × $138 = $1 104 30×$29 = $870

Ordering Selling expenses

A 3000 × $1 = $3 000 4000 × $0.85 = $3 400

B 1000 × $1 = $1 000 3500× $0.85 = $2 975

C 2000 × $1 = $2 000 1000× $0.85 = $850

c). Product A Product B Product C

$ $ $

Allocated Direct Costs

Materials 10 000 3 000 9 000

Labour 12 000 15 000 4 000

Apportioned overheads 11 120 6 705 4824

Total Cost 33 120 24 705 17 824

d) The selling price can be determined by using the total costs from (c) or by using the unit
costs.

Using Total Cost $33 120×1.3 (mark -up)

= $43 056 for 5000 units of A

Selling price per unit of product A = $43 056 ÷ 5000

= $8.61

Product A Product B Product C

$ $ $

Direct materials 2.00 1.00 10 00

Direct labour 2.40 5.00 4.44

Prime Cost 4.40 6.00 14.44

Overheads 2. 22 2.24 5.36

Total Cost 6.62 8.24 19.80

Mark - up 1.99 2.47 5.94

Selling Price per unit 8.61 10.71 25.74

Advantages of ABC System

A system of ABC allows managers to :
-provide more accurate costing identify where and understand how overheads arise

-set bench marks for planning and control purposes

-improve performance by replicating good practice identified in one department across
other departments.
-help in preparation of estimates and quotes for other work.
-identify individual products or services that are unprofitable or overpriced (set prices for
products).

Limitations of ABC System

- it is very time consuming to try to work out which specific overhead costs a product incurs
and why.

-it is very difficult to say with certainty which overhead costs are cost drivers for a
particular product.
-it requires a greater degree of analysis of overheads than absorption costing. Thereare may
not be suitable for small businesses where managers lack time and expertise.