Why ABC? (QS.

ABC system takes precedence over the traditional cost accounting system)
QS. ABC recognizes that activities create cost and product creates the demand for these activities.
Modern production techniques are such that many complex products with different specifications, designs will
come off the same production line. Aside from costs associated with simple absorption drivers such as labor
hours there will be many more costs associated with modern production lines such as setup costs, inspection
costs and materials handling costs. ABC costing recognizes these drivers of a complex manufacturing
environment.
Purpose of Activity-Based Costing and Activity Based Management
 Activity-Based Costing (ABC) improves the tracing of costs to individual products and customers
 Activity Based Management uses activity analysis and activity-based costing to help managers improve
the value of products and services, and to increase the organization’s competitiveness.
ABC is used to allocate just Overheads. ABC links costs to the drivers or causes of those costs.
Activity-based costing differs from traditional costing systems in a number of following ways:
 Traditional product costing assigns only manufacturing cost to products. ABC product costing assigns
both manufacturing and non-manufacturing cost to product.
 In activity-based costing, some manufacturing costs—including the costs of idle capacity—may be
excluded from product costs.
 Traditional costing allocates all manufacturing overhead costs using a volume-related allocation base
such as direct labor hours and/or machine hours. ABC costing also uses non-volume related allocation
bases. An activity-based costing system typically includes a number of activity cost pools, each of
which has its unique measure of activity.
 Traditional costing disregards selling and administrative expenses because they are assumed to be
period expenses. ABC costing directly traces shipping costs to products and includes nonmanufacturing
overhead costs caused by products in the activity cost pools that are assigned to products.
Traditional Absorption Costing and ABC
The difference between traditional absorption costing and ABC is shown by the following diagrams:

1
Although ABC is a form of absorption costing, the effect of ABC could be to allocate overheads in a completely
different way between products. Product costs and product profitability will therefore be very different with
ABC compared with traditional absorption costing.

Steps for Implementing Activity-Based Costing:

(1). Define activities, activity cost pools, and activity measures.
(2). Assign overhead costs to activity cost pools.
(3). Calculate activity rates.
(4). Assign overhead costs to cost objects using the activity rates
and activity measures.
(5). Prepare management reports.

2
Advantages of ABC over absorption costing.
1). Better Allocation of service costs.
(2). Links costs to drivers so we can understand and control them better.
(3). More accurate cost per unit can be calculated.
Problems with ABC costing are: (1). Time consuming and costly.
(2). Too much information needed.
(3).New systems required.
(4). Too complex to understand.
(5).Not suitable for service industries or simple production facilities.

3
QS 1: Company ABC has the following information for a month applicable to its products:
Total Overheads = $100,000
Total machine Hours = 50,000
Overheads are absorbed on a machine hour basis.
Product A B
Units of Production 2,500 5,000
Material Cost p/unit $30 $50
Labor Cost per unit $20 $16
Machine Hrs P/unit 10 5
An analysis of overhead costs suggests that there are three main activities that cause overhead expenditure.
% Overheads
Set up Costs 35%
Inspections 45%
Materials Handling 20%
A B Total
Set ups 300 50 350
Inspections 500 250 750
Goods Movements 300 700 1000
What is the Cost per unit of A and B(1) Under Traditional Absorption Costing.(2) Under ABC.
SOLUTION

ABC Cost Per Unit

Comparison

Qs 2:Blue makes and sells two products, X and Y. Data for production and sales each month are as
follows:
Product X Product Y
Sales demand 4,000 units 8,000 units
Direct material cost/unit $20 $10
Direct labour hours/unit 0.1 hour 0.2 hours
Direct labour cost/unit $2 $4

Production overheads are $500,000 each month. These are absorbed on a direct labour hour basis.

An analysis of overhead costs suggests that there are four main activities that cause overhead expenditure.
Activity Total cost Cost driver Total Product Product
number X Y
$
Batch setup 100,000 No. of set-ups 20 10 10
Order handling 200,000 No. of orders 40 24 16
Machining 120,000 Machine hours 15,000 6,000 9,000
Quality control 80,000 No. of checks 32 18 14
500,000
Required:
Calculate the full production costs for Product X and Product Y, using:
(a) traditional absorption costing
(b) activity based costing.
Solution:
Traditional absorption costing
The overhead absorption rate = $500,000/ (4,000 × 0.1 + 8,000 × 0.2) = $250

Product X Product Y Total

$ $
Direct materials 20 10
Direct labour 2 4
Overhead (at $250 per hour) 25 50
Cost per unit 47 64

No. of units 4,000 8,000

Total cost $188,000 $512,000 $700.000

Activity based costing

Activity Total cost Cost driver Product Product
X Y
$ $ $ $
Batch setup 100,000 Cost/setup 5,000 50,000 50,000
Order handling 200,000 Cost/order 5,000 120,000 80,000
Machining 120,000 Cost/machine hour 8 48,000 72,000
Quality control 80,000 Cost/check 2,500 45,000 35,000
500,000 263,000 237,000

Product X Product Y Total

$ $ $
Direct materials 80,000 80,000
Direct labour 8,000 32,000
Overhead 263,000 237,000
Total cost 351,000 349,000 700,000

No. of units 4,000 8,000

Cost per unit $87.75 $43.625

Using ABC in this situation, the cost per unit of Product X is much higher than with
traditional absorption costing and for Product Y the unit cost is much less.
The difference is caused by the fact that Product X use only 20% of total direct
labour hours worked, but much larger proportions of set-up resources, order
handling resources, machining time and quality control resources. As a result, the
overheads charged to each product are substantially different.
This is an important feature of activity-based costing. The overheads charged to
products, and so the overhead cost per unit of product, can be significantly
different from the overhead cost per unit that would be obtained from traditional
absorption costing.
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16

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Spring 2018-SOLUTION: (a)Total Overhead = (15,000+50,000+30,000+20,000) =$1,15,000
Existing overhead absorption rate =$1,15,000/(1000unitX0.6hour)+(500X0.8)+(300X2)
=$1,15,000/1600 hours
=$71.875 per hour
Unit Cost Calculation (Using Existing Method of Absorption of Overhead)
Product Product Product C
A ($) B ($) ($)
Direct Material: 20 18 18
A= 4 sq .meter per unit X $5 per meter
B=6 meter per unit X $3 per meter
C=3 meter per unit X $6 per meter
Direct Labor: 3.6 4.8 12
A=0.6 hour per unit X $6 per hour
B=0.8 hour per unit X $6 per hour
C=2 hour per unit X $6 per hour
Manufacturing Overhead: 43.125 57.5 143.75
A=0.6 hour per unit X $71.875 per hour
B=0.8 hour per unit X $71.875 per hour
C=2 hour per unit X $71.875 per hour
Cost Per Unit $66.725 $80.3 $173.75
(b) ABC Costing : (Cost per Driver)
Factory overhead related to labor activity
=$15,000/(1000unitX0.6hour per unit)+(500X0.8)+(300X2)
=$15,000/1600 hours
=$9.375 per hour

Material receipt and inspection

=$50,000/(10batch per product+5+16)
=$50,000/31 batch (i.e. 31 batches for total 1800 units)
=$1612.9 per batch (i.e. for total1800 units)

Process Power
=$30,000/(1000unitX2 drill per unit)+(500X8drill per unit)+(300X5drill)
=$30,000/7500 power drill
=$4 per power drill

Material Handling
=$20,000/(1000unitX4 square meter per unit)+(500X6)+(300X3)
=$20,000/7900 square meter
=$2.531 per square meter
10
Unit Cost Calculation (ABC Costing)
Particulars Product Product Product
A ($) B ($) C ($)
Direct Material: A= 4 sq. meter per unit X $5 per meter 20 18 18
B=6 sq. meter per unit X $3 per meter
C=3 sq. meter per unit X $6 per meter
Direct Labor: A=0.6 hour per unit X $6 per hour 3.6 4.8 12
B=0.8 hour per unit X $6 per hour
C=2 hour per unit X $6 per hour
Manufacturing Overhead:
Factory Overhead: A=0.6 hour per unit X $9.375 per hour 5.625 7.5 18.75
B=0.8 hour per unit X 9.375 per hour
C=2 hour per unit X $9.375 per hour
Material Receipt: A=(10batch/1000units) X $1612.9 per batch 16.13 16.13 86.02
B=(5batch/500units) X $1612.9 per batch
C=(16batch/300units) X $1612.9 per batch
Power: A=2 drill per unit X $4 per drill 8 32 20
B=8 drill per unit X $4 per drill
C=5 drill per unit X $4 per drill
Material Handling: 10.124 15.186 7.593
A=4 square meter P/U X $2.531 per sq.
meter B=6 square meter P/U X $2.531 per sq.
meter C=3 square meter P/U X $2.531 per sq.
meter
Cost Per Unit $63.479 $93.616 $162.36
(c)
Comparison of Costing Method A ($) B ($) C ($)
Existing (overhead absorption based on labor hour) $66.725 $80.3 $173.75
ABC $63.479 $93.616 $162.363
% Increase / Decrease *** -4.9% 16.6% -6.6%
1/n
***NOTE: Growth rate= (Ending Value/Beginning Value) -1
Comment: If Kalash uses a cost plus 50% method of pricing, it may lead to incorrect pricing using the existing
method of absorbing overheads in production costs. This pricing would not be based on realistic cost data
since all the manufacturing overheads are absorbed into production cost by labor hour only whereas it is
evident that overheads are caused by different activity measure. Hence, price set by full cost or cost plus 50%
method would be unrealistic.
On the other hand, ABC costing will have the following implication for Kalash limited:
i) Pricing can be based on more realistic cost data. The cost plus pricing under ABC has increased by 16.6%
for product B whereas reduced by 4.9% and 6.6% for product A and C respectively. The price of the products
will be based on this more realistic cost data and therefore pricing will be improved.
ii) Decision making will be improved - the more realistic product costs means that Kalash ltd. can focus on the
products which give the highest margin and may decide to stop selling products which give a low or negative
margin. Information on sales prices would be required in order to calculate these margins.
iii) Performance management can be improved – Kalash Ltd. will focus on the most profitable products and, as
a result, performance should be improved. In addition, control should be improved since the more realistic
costs will form the basis of the budget.
 Autumn 2017-SOLUTION:
(a)Total Overhead = (60,000+5000+6000+10,000+11,000) =$92,000
Existing overhead absorption rate
=$92,000/(3500unitX0.25hour)+(1500X0.25)+(7000X1.5)+(1000X1)
=$92,000/12750 machine hours
=$7.216 per machine hour
Unit Cost Calculation (Using Existing Method of Absorption of Overhead)
A ($) B ($) C ($) D ($)
Direct Material 5 5 18 18
Direct Labor 3 3 8 14
Manufacturing Overhead: 1.804 1.804 10.824 7.216
A=0.25 hour per unit X $7.216 per machine hour
B=0.25 hour per unit X $7.216 per machine hour
C=1.5 hour per unit X $7.216 per machine hour
D=1 hour per unit X $7.216 per machine hour
Cost Per Unit $9.804 $9.804 $36.824 $36.216

(b) ABC Costing : (Cost per Driver)

Factory overhead related to machine oriented activity
=$60,000 /(3500unitX0.25hour)+(1500X0.25)+(7000X1.5)+(1000X1)
=$60,000/12,750 machine hours
=$4.71 per machine hour

Set-up cost
=$5,000/(3 setup per product+2+6+2)
=$5,000/13 setups (i.e. 13 set-ups for total 13,000 units)
=$384.62 per setup

Ordering Cost
=$6,000/(4 order per product+1+4+2)
=$6,000/11 orders (i.e. 11 orders for total 13,000 units)
=$545.45 per order

Material Handling Cost

=$10,000/(10 times material handled+2+11+1)
=$10,000/24 times material handled (i.e. 24 times material handled for total 13,000 units)
=$416.67 per material handled.

Administration for Spare parts Cost

=$11,000/(5 parts per product+12+6+13)
=$11,000/36 spare parts (i.e. 36 spare parts for total 13,000 units)
=$305.56 per spare parts
Unit Cost Calculation (ABC Costing)
Particulars A ($) B ($) C ($) D ($)
Direct Material 5 5 18 18
Direct Labor 3 3 8 14
Manufacturing Overhead:
Factory Overhead: 1.18 1.18 7.07 4.71
A=0.25 hour per unit X $4.71 per machine hour
B=0.25 hour per unit X $4.71 per machine hour
C=1.5 hour per unit X $4.71 per machine hour
D=1 hour per unit X $4.71 per machine hour
Set-up Cost: 0.33 0.51 0.33 0.77
A=(3 setup/3500unit) X $384.62 per set-up
B=(2 setup/1500unit) X $384.62 per set-up
C=(6 setup/7000unit) X $384.62 per set-up
D=(2 setup/1000unit) X $384.62 per set-up
Ordering Cost: 0.62 0.36 0.31 1.09
A=(4 orders/3500unit) X $545.45 per order
B=(1 order /1500unit) X $545.45 per order
C=(4 orders/7000unit) X $545.45 per order
D=(2 orders/1000unit) X $545.45 per order
Material Handling Cost: 1.19 0.56 0.65 0.417
A=(10 times/3500unit) X $416.67 per material handle
B=(2 times/1500unit) X $416.67 per material handle
C=(11 times/7000unit) X $416.67 per material handle
D=(1 time/1000unit) X $416.67 per material handle
Cost of Administration of Spare Parts: 0.44 2.44 0.26 3.97
A=(5 spare parts/3500unit) X $305.56 per spare parts
B=(12 spare parts /1500unit) X $305.56 per spare parts
C=(6 spare parts /7000unit) X $305.56 per spare parts
D=(13 spare parts /1000unit) X $305.56 per spare parts
Cost Per Unit $11.76 $13.05 $34.62 $42.96
(c)
Comparison of Costing Method A ($) B ($) C ($) D ($)
Existing (overhead absorption based on labor hour) $9.804 $9.804 $36.824 $36.216
ABC $11.76 $13.05 $34.62 $42.96
% Increase / Decrease *** 20% 33% -6% 19%
1/n
***NOTE: Growth rate= (Ending Value/Beginning Value) -1
Comment: If Kaplan Plc. uses a cost plus 50% method of pricing, it may lead to incorrect pricing using the
existing method of absorbing overheads in production costs. This pricing would not be based on realistic cost
data since all the manufacturing overheads are absorbed into production cost by labor hour only whereas it is
evident that overheads are caused by different activity measure. Hence, price set by full cost or cost plus 50%
method would be unrealistic.
On the other hand, ABC costing will have the following implication for Kaplan Plc:
i) Pricing can be based on more realistic cost data. The cost plus pricing under ABC has reduced by 6% for
product C whereas increased by 20%, 33% and 19% for product A, B and D respectively. The price of the
products will be based on this more realistic cost data and therefore pricing will be improved.
ii) Decision making will be improved - the more realistic product costs means that Kaplan Plc. can focus on the
products which give the highest margin and may decide to stop selling products which give a low or negative
margin. Information on sales prices would be required in order to calculate these margins.
iii) Performance management can be improved – Kaplan Plc. will focus on the most profitable products and, as
a result, performance should be improved. In addition, control should be improved since the more realistic
costs will form the basis of the budget.