CMA311S – NOTES 2010. UNIT 2: ACTIVITY-BASED COSTING
1.
Introduction
Activity-based costing (ABC) is a recent development in Management Accounting which gives an
alternative method of accounting for manufacturing overheads. Its development is in response to perceived
limitations of the Traditional absorption costing system you learnt in Cost & Management Accounting 2A.
This unit explains the techniques and rationale behind Activity-based costing. In addition, a comparison with
the traditional costing method is made.
2.
Traditional product costing system
2.1
Introduction
In Cost & Management Accounting 2A you learned that the manufacturing (production) cost of a product is
computed as follows:
Direct material
+ Direct labour
+ Manufacturing overheads
Direct material is the raw material that needs to be converted in order to produce a final product that can be
used by consumers. For example, wood is a raw material used in the manufacturing of wooden furniture,
sheet metal is a raw material used in the manufacturing of refrigerators, and paper is a raw material used in
the production of newspapers, magazines, etc. The raw material changes its form and is physically
consumed (incorporated) in the manufacturing process.
Direct labour is the cost of wages for personnel who work directly on the manufactured products.
Examples are the wages paid to cabinet-makers, welders and machine operators.
Manufacturing overheads are all manufacturing costs other than direct material and direct labour cost.
Manufacturing overheads include three types of cost:
•
Indirect material. This is the material required for the production process but which does not
become an integral part of the finished product; or material consumed in production but insignificant
in cost. An example is the cost of cloths and cleaning materials used in a factory. They do not
become part of the product. Materials such as glue or paint do become part of the final product, but
they may be so inexpensive that it is not worth tracing their costs to specific products as direct
materials
•
Indirect labour. This is the cost of personnel who do not work directly on the product, but whose
services are necessary for the manufacturing process. Factory supervisors, storekeepers, cleaners,
security guards, etc. are all indirect labourers.
•
Other manufacturing costs. All other factory costs that are neither material nor labour costs are
classified as manufacturing overheads. These costs include depreciation of plant and equipment,
property taxes, insurance, electricity, etc.
You also learned that it is normally quite simple to calculate the direct material and direct labour cost per
unit. However, manufacturing overheads is a pool of indirect production costs and cannot easily be traced to
individual units. Manufacturing overheads are therefore assigned to individual units. This process is called
overheads application (absorption, recovery). Overheads are applied (absorbed, recovered) on the basis of
estimates made at the beginning of the accounting period. The accounting department chooses some
measure of productive activity to use as the basis for overhead absorption. In traditional product-costing
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systems, this measure is usually some volume-based cost driver (or activity base), such as direct labour
hours, direct labour cost, machine hours, etc. An estimate is made of:
1.
2.
the amount of manufacturing overheads that will be incurred during a specified period of time and
the amount of the cost driver (or activity base) that will be used or incurred during the same time
period.
A predetermined overhead rate is then computed as follows:
Budgeted manufacturing overhead cost
Overhead absorption rate (OAR) = Budgeted amount of cost driver (or activity base)
2.2
Basis of absorption
The objective of the overhead absorption process is to include in the total cost of a product an appropriate
share of the firm’s total overheads. An appropriate share is generally taken to mean an amount that reflects
the effort and/or time taken to produce one unit. If identical products are produced by identical processes for
the whole of a period, the total overheads are simply shared equally amongst the products. These bases are
illustrated by the following example relating to a firm:
Example 1
The following is the budget of a manufacturing enterprise that produces only one type of product:
Total
Budgeted production
1 000 units
Budgeted direct material cost
N$15 000
Budgeted direct labour cost
N$20 000
Budgeted manufacturing overheads N$12 000
Budgeted direct labour hours
4 000 hours
Budgeted machine hours
3 000 hours
Required:
Calculate the predetermined overhead absorption rate to be used for the recovery of overheads according to
each of the following six bases:
1.1
1.2
1.3
1.4
1.5
1.6
production units
direct labour hours
machine hours
direct material cost
direct labour cost
prime cost
Solution to Example 1
1.1
Product unit basis:
Budgeted manufacturing overheads
Predetermined overhead rate = Budgeted number of units to be produced
N$12 000
= 1 000
= N$12 overheads per unit produced
29
1.2
Labour hour basis:
Predetermined overhead rate =
=
Budgeted manufacturing overheads
Budgeted labour hours
N$12 000
4 000
= N$3 overheads per labour hour
1.3
Machine hour basis:
Predetermined overhead rate =
Budgeted manufacturing overheads
Budgeted machine hours
N$12 000
= 3 000
= N$4 overheads per machine hour
1.4
Direct material cost basis:
Predetermined overhead rate =
Budgeted manufacturing overheads 100%
Budgeted direct material cost
X 1
N$12 000 100%
= N$15 000 X 1
= 80% of direct material cost
1.5
Direct labour cost basis:
Budgeted manufacturing overheads 100%
Predetermined overhead rate =
Budgeted direct labour cost
X 1
N$12 000 100%
= N$20 000 X 1
= 60% of direct labour cost
1.6
Prime cost basis:
Predetermined overhead rate =
Budgeted manufacturing overheads 100%
Budgeted prime costs
X 1
N$12 000 100%
= N$35 000 X 1
= 34% of prime costs
30
Activity 1
Mouers Ltd supplied the following budgeted information for 2010:
Manufacturing overheads
Direct labour hours
Direct wages
Direct material used
Machine hours
Units produced
N$60 000
8 000 hours
N$16 000
N$30 000
12 000 hours
450 units
Required:
Use the above data to calculate six (6) different manufacturing overhead absorption rates.
2.3
Using the calculated overhead absorption rate (oar)
Each firm must decide which rate will be the most appropriate to be used. It often happens that different
departments (cost centres) use different overhead rates. For example, the machining department would use
machine hours as the most appropriate rate whereas a department where labour is done manually would use
direct labour hours or direct labour cost as the most appropriate rate for the absorption of its overheads.
In example1 and activity 1 above we assumed that all the units produced were identical. However, in
practical situations products are often dissimilar. Thus, although they use the same facilities, they may
require different production processes or occupy the facilities for varying lengths of time. In such situations
overhead absorption becomes of greater importance because the overheads absorbed into the product or job
should, as far as possible reflect the load that the product or job places upon the production facilities.
Example 2
Refer to example 1 above. Assume that it has been decided that direct labour hours is the most appropriate
rate to use in order to absorb the manufacturing overheads in this enterprise. A cost unit X has been
produced and the following details were recorded:
Direct material used
Direct wages
Direct labour hours
Machine hours
Cost unit X
N$100
N$130
45 hours
13 hours
Required:
Calculate the total cost of cost unit X.
Solution to Example 2
Total cost of cost unit X
Direct material
Direct wages
Manufacturing overheads:
45 labour hours at N$3 per direct labour hour
N$
100
130
135
365
31
Example 3
Azar Ltd supplied the following budgeted figures for 2010:
Manufacturing costs:
N$
Direct material
Direct labour
Indirect labour
Electricity
Rates and taxes
Machine maintenance and repairs
Indirect material
Factory heat and light
Depreciation on factory machinery
Insurance on factory buildings
Direct labour hours
Machine hours
Production units
200 000
600 000
100 000
140 000
22 800
115 200
6 000
34 000
130 000
172 000
N$1 520 000
200 000
90 000
100 000
Required:
3.1
Calculate three different overhead absorption rates based on each of the following:
3.1.1 Direct labour hours
3.1.2 Machine hours
3.1.3 Direct labour cost
3.2
During June 2010, Job Card no 146 showed the following particulars:
Direct material used
Direct labour
Machine hours
N$4 000
N$2 000 (800 hours)
380
Calculate the total cost of Job No 146, using each of the overhead absorption rates calculated in 3.1
above.
Solution to Example 3
3.1.1
Direct labour hour basis:
Budgeted manufacturing overheads
Predetermined overhead rate = Budgeted direct labour hours
N$720 000
= 200 000
= N$3,60 per direct labour hour
3.1.2
Machine hour basis:
Budgeted manufacturing overheads
Predetermined overhead rate =
Budgeted machine hours
32
=
N$720 000
90 000
= N$8 per machine hour
3.1.3
Direct labour cost basis:
Predetermined overhead rate =
Budgeted manufacturing overheads 100%
Budgeted direct labour cost
X 1
N$720 000 100%
= N$600 000 X 1
= 120% of direct labour cost
3.2
Calculation of total cost of Job No 146:
Cost item
Direct material
Direct labour
Manufacturing overheads:
800 labour hours x N$3,60
380 machine hours x N$8
N$2 000 labour cost x 120%
Total cost of Job No 146
Labour hour
basis
N$
4 000
2 000
Machine hour
basis
N$
4 000
2 000
Labour cost
basis
N$
4 000
2 000
2 880
3 040
8 880
9 040
2 400
8 400
Activity 2
The production manager of Poly Manufacturing Company Ltd has compiled the following budgeted figures
for Cost Centre no 17 for 2010:
Labour hours
Direct wages
Direct material
Machine hours
Production units
Manufacturing overheads
1 400 hours
N$3 600
N$7 500
2 850 hours
535 units
N$12 900
Required:
2.1
Calculate six (6) different manufacturing overhead absorption rates for Cost Centre no 17 to be used
during 2010.
2.2
During April 2010 the following details were recorded in the production of unit no 137:
Direct material used
Direct wages
Direct labour hours
Machine hours
N$16,50
N$17,50
5½ hours
8½ hours
Calculate the total cost of unit no 137, using each of the following overhead absorption rates
calculated in 2.1 above:
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1.2.1 direct labour hours
1.2.2 machine hours
1.2.3 direct material cost
1.2.4 direct labour cost
1.2.5 prime cost
2.4
Summary
In this unit so far we have assumed that there is a linear relationship between the amount of manufacturing
overheads and the production volume, i.e., we have assumed that the manufacturing overheads vary in direct
proportion to production volume. For example, we assumed that if the number of units, labour hours,
machine hours, etc. vary, the manufacturing overheads will vary in the same proportion. The approach to
product costing outlined in the paragraphs above is what may be termed the traditional approach. It is widely
used and must be thoroughly understood by students.
However, we must appreciate that traditional product costing systems were designed decades ago, when
most companies manufactured only a narrow range of products and direct labour and materials were the
dominant factory costs. Overhead costs were relatively small, and if overheads were inappropriately
allocated, the distortions arising as a result would be insignificant. Today companies produce a wide range
of products; direct labour represents only a small fraction of total costs, and overhead costs are of
considerable importance. As will be indicated in the rest of this chapter, the traditional approach to the
allocation of manufacturing overheads has been based on a wrong assumption and for this reason the unit
costs of products have been incorrectly calculated.
Activity-based costing (ABC) is a more recent approach to product costing. ABC is an attempt to reflect
more accurately the cost of products by acknowledging the fact that costs are determined by specific
activities rather than production volume.
3.
The emergence of activity-based costing systems
It is important to note that many overhead costs consist of, and are caused by activities such as material
handling, material procurement, the performing of machine set-ups, production planning and scheduling,
product inspection, dispatching, etc. It is therefore incorrect to apportion all overhead costs according to one
overhead rate only. Consider the following example (Example 4) where we assume that total overheads
consist of two types of cost, each type driven by a specific activity, also called a cost driver.
Example 4
Walton Manufacturers Ltd started business on 1 January 2010. Ever since the company has been using a
single overhead rate based on machine hours. Patricia Mapedi, a newly appointed director, has noticed that
Walton incurs relatively high overheads that relate to buying, receiving, storing and issuing of materials. She
believes that the company could benefit if these overheads are absorbed on the basis of direct material cost.
She has consequently recommended that two overhead rates be used, one based on material cost and the
other on machine time.
The total budgeted production overheads for 2010 have been analysed as follows:
Material-related overheads
Machine-related overheads
Total overheads
N$ 48 000
N$130 000
N$178 000
Other budgeted data for 2010 are as follows:
Cost of direct material
N$160 000
Machine hours
20 000 hours
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Required:
4.1
4.2
Compute the predetermined (budgeted) overhead absorption rate per machine hour, assuming Walton
uses only machine hours to recover all overheads.
Compute the predetermined (budgeted) overhead absorption rates if overheads are recovered on the
two bases suggested by Patricia.
Solution to Example 4
4.1
All overheads recovered using one basis only (Traditional costing):
Overhead absorption rate = Budgeted overheads ÷ Budgeted machine hours
= N$178 000 ÷ 20 000 hours
= N$8,90 per machine hour
4.2
Using a separate overhead rate for each activity in the company (activity-based costing):
The activity-based approach suggests that overhead costs are caused (driven) by activities. Materialrelated overheads originate because of the direct material costs (if there were no materials, there
would be no material-related overheads like costs incurred for ordering, procurement, storage, etc).
Similarly the machine-related overheads are caused (driven) by the machine hours (if there were no
machine hours, there would be no machine-related overheads like maintenance, repairs, depreciation,
etc). Each type of overheads forms an overhead cost pool and each cost pool is caused (driven) by a
cost driver. Separate overhead absorption rates are then computed for each cost driver by using the
following formula:
Budgeted overheads in cost pool (activity costs)
Cost driver rate =
Budgeted cost driver volume
If we apply the above formula to the figures given in the question the overhead absorption rates will
be as follows:
Cost driver rate (for material-related overheads):
Budgeted material-related overheads x 100%
=
Budgeted direct material cost
N$48 000 x 100%
= N$160 000
= 30% of direct material cost
Cost driver rate (for machine-related overheads):
=
Budgeted machine-related overheads
Budgeted machine hours
N$130 000
= 20 000
= N$6,50 per machine hour
Summary:
Cost Pool
Material-related overheads
Machine-related overheads
Cost driver
Direct material costs
Machine hours
35
Cost driver rate
30% of Direct material cost
N$6,50 per machine hour
4.
Activity-based cost systems
You should note that the only significant difference between the traditional method of assigning overheads to
products and the ABC system is that according to the traditional method overheads are assumed to be
volume related, .i.e, it varies in proportion to the volume of production whereas ABC assumes that overheads
are activity-related, i.e., overheads are generated (created or caused) by activities (driven by activities or cost
drivers).
Activity 3
Schubert Ltd supplied the following budgeted information for 2010:
Units produced
Labour hours per unit
Machine hours per unit
Machine set-ups
Orders handled
8 000
2
3
60
72
Manufacturing overheads
Relating to production set-ups
Relating to orders handling
Relating to machine activity
Total budgeted overheads
N$
180 000
36 000
48 000
264 000
Required:
Calculate the overheads to be absorbed per unit of product based on:
3.1
3.2
Conventional absorption costing using a labour hour absorption rate
An ABC approach using suitable cost drivers.
Activity 4
Kharises Ltd manufactures a variety of products. The budgeted costs and estimated operating information
are as follows:
Accounting information
Machine set-up costs
Inspection costs
Material handling costs
Material procurement costs
Production costs
Total overheads
N$
125 000
93 750
187 500
218 750
312 500
937 500
Operating information
Production hours (machine hours)
Material usage (kg)
Number of machine set-ups
Number of purchase orders
Number of inspections
25 000
125 000
500
6 250
750
36
Required:
4.1
4.2
5.
Calculate a single overhead absorption rate for the entire plant using machine hours as allocation
basis.
Calculate the cost centre rates which the company will use during the next financial year according to
the ABC system.
A comparison of ABC and traditional product costs
Example 5
Roberto Ltd manufactures two products: Product A which is a high-volume product and Product B which is a
low-volume product. The company uses direct labour hours as basis to determine its overhead absorption
rate. The following budgeted figures have been compiled for 2010:
Production units
Direct labour hours
Direct material
Direct wages
Production overheads
Product A
Product B
80 000
40 000
N$
160 000
200 000
5 000
2 500
N$
10 000
12 500
N$467 500
Required:
Compute the unit cost of each product by apportioning the overheads on the basis of direct labour hours.
Solution to Example 5
Calculation of overhead absorption rate:
Budgeted production overheads
Overhead absorption rate = Budgeted direct labour hours
N$467 500
= (40 000 + 2 500)
= N$11 per direct labour hour
Calculation of unit cost of each product:
Cost item
Direct material
Direct labour
Manufacturing overheads (labour hours x N$11)
Total cost
Number of production units
Cost per unit (Total cost ÷ Number of units)
Product A
N$
160 000
200 000
440 000
800 000
80 000 units
N$10
37
Product B
N$
10 000
12 500
27 500
50 000
5 000 units
N$10
Example 6
Refer to Example 5 above. You have explained to the management of Roberto Ltd that with their current
system of overhead absorption the high-volume product is over-costed and the low-volume product is undercosted. You have suggested that they should rather make use of an activity-based costing system. An
analysis of their overheads revealed that the amount of N$467 500 for overheads was made up as follows:
Activity
Machine set-ups
Inspection
Material handling
Material procurement
N$
137 500
85 000
90 000
155 000
The following information was gathered through an analysis of the company’s operating procedures:
Product A
Product B
Number of machine set-ups
10
10
Number of inspections
20
30
Material usage (kg)
10 000
5 000
Number of purchase orders
40
10
Required:
Compute the unit cost of each product by first calculating cost driver rates for the different activities.
Solution to Example 6
Calculation of cost driver rates:
Cost Pool
Machine set-up costs
Inspection costs
Materials handling costs
Material procurement costs
Cost driver
No. of set-ups
No. of inspections
Material usage (kg)
No. of orders
Cost driver rate
N$6 875 per set-up (N$137 500 ÷ 20)
N$1 700 per inspection (N$85 000 ÷ 50)
N$6 per kg (N$90 000 ÷ 15 000)
N$3 100 per order (N$155 000 ÷ 50)
Calculation of unit cost of each product:
Cost item
Direct material
Direct labour
Manufacturing overheads
Machine set-up costs
Inspection costs
Materials handling costs
Material procurement costs
Total cost
Number of production units
Cost per unit
Product A
N$
160 000
200 000
68 750
34 000
60 000
124 000
N$646 750
80 000
N$8,08
Product B
N$
10 000
12 500
68 750
51 000
30 000
31 000
N$203 250
5 000
N$40,65
38
Activity 5
The following budgeted data has been supplied by Corlia Ltd regarding two products to be manufactured
during 2010:
Output in units
Direct labour hours
Direct material
Direct labour
Product A
250
1 050
N$
16 500
92 000
Product B
60
200
N$
7 500
15 200
The total production overheads for the year have been analysed as follows:
Machine related costs
Materials handling & dispatch
Stores
Inspection/Quality control
Set-up costs
Engineering support
N$
14 600
6 800
8 250
5 850
6 200
8 300
50 000
Cost drivers have been identified for the cost pools and their volumes have been budgeted as follows:
Cost driver volumes
Cost Pool
Cost Driver
Product A Product B
Machine related costs
Machine hours
500
230
Materials handling & Dispatch Materials movements
180
70
Stores
Requisitions raised
40
20
Inspection/Quality control
Number of inspections
18
7
Set-up costs
Number of set-ups
12
8
Engineering support
Engineering hours
60
20
Required:
5.1
5.2
Calculate the unit cost of each product by using the traditional costing method where the overhead
rate is based on direct labour hours.
Calculate the unit cost of each product by using an activity-based costing system where overheads are
absorbed according to activities.
Example 7
Poller Ltd manufactures two products, namely A and B. The company operates an absorption costing system
according to which all production overheads are gathered in a single cost centre and allocated to products
using direct labour cost as allocation basis. An ABC system has been introduced recently.
Budgeted information for the following financial year is as follows:
39
Direct material cost per unit
Direct labour cost
Production overheads:
Machine set-up costs
Design costs
Other overheads
Total overheads
Number of units manufactured
Number of machine set-ups
Number of design hours
Product A
N$
90
100 000
Product B
N$
10
900 000
Total
N$
1 000 000
100 000
300 000
1 100 000
1 500 000
1 000
50
2 000
9 000
50
8 000
10 000
100
10 000
Other overheads are allocated to individual products based on direct labour costs.
Required:
7.1
7.2
7.3
Calculate the unit cost of each product using the absorption costing system.
Calculate the unit cost of each product using the ABC system.
Comment on the results of 7.1 and 7.2.
Solution to Example 7
7.1
Calculation of unit costs using the absorption costing system
Product A
Product B
N$
N$
Direct material
90
10
Direct labour
100¹
100²
Manufacturing overheads
150³
150
Cost per unit
340
260
¹ N$100 000 labour cost divided by 1 000 units
² N$900 000 labour cost divided by 9 000 units
³ N$1 500 000 manufacturing overheads divided by 10 000 units
7.2
Calculation of unit costs using the ABC system:
Step 1: Calculation of cost driver rates (activity rates)
Cost driver rate (for machine set-ups):
Budgeted machine set-up costs
= Budgeted number of machine set-ups
=
N$100 000
100
= N$1 000 per machine set-up
Cost driver rate (for design-related overheads):
=
Budgeted design-related overheads x 100%
Budgeted number of design hours
40
N$300 000
= 10 000
= N$30 per design hour
Cost driver rate (for other overheads):
Budgeted manufacturing overheads x 100%
=
Budgeted direct labour costs
N$1 100 000 x 100%
=
N$1 000 000
= 110% of direct labour costs
Step 2: Calculation of activity costs per unit
Machine set-up costs:
Total set-up costs for product A
Per unit of product A = Number of units of product A
=
(50 set-ups x N$1 000 per set-up)
1 000 units
= N$50 per unit
Total set-up costs for product B
Per unit of product B = Number of units of product B
(50 set-ups x N$1 000 per set-up)
=
9 000 units
= N$5,56 per unit
Design costs:
Total design costs for product A
Per unit of product A = Number of units of product A
=
(2 000 design hours x N$30 per design hour)
1 000 units
= N$60 per unit
Total design costs for product B
Per unit of product B = Number of units of product B
(8 000 design hours x N$30 per design hour)
=
9 000 units
= N$26,67 per unit
41
Other overhead costs:
Per unit =
Total other overhead costs
Number of units
N$1 100 000
= 10 000 units
= N$110 per unit
Step 3: Calculation of total cost per unit
Cost item
Direct material
Direct labour
Manufacturing overheads:
Overheads related to machine set-ups
Overheads related to design hours
Other overheads (based on labour hours)
Total cost per unit
7.3
Product A
N$
90,00
100,00
Product B
N$
10,00
100,00
50,00
60,00
110,00
410,00
5,56
26,67
110,00
252,23
Comment on the results of 7.1 and 7.2
In 7.1 the total overheads are shared equally among all the units. The following facts were totally
ignored: Product A is a large (expensive) product (it uses N$90 material) and it is produced in low
quantities (1 000 units). It is also a very complex product in the sense that it takes many hours to
design 2 hours per unit) and the machines have to be set-up regularly 1 set-up for every 50 units). On
the other hand Product B is a small (cheap) product (it uses only N$10 material) and it is produced in
large quantities (9 000 units). It is very simple to design (only 0,89 hours per unit) and the machines
do not have to be set-up regularly (only one set-up for every 140 units). The result is that product A
is under-costed and product B is over-costed.
In 7.2 the fact that the two products use different activities (machine set-ups and design hours) in
different quantities is taken into account. Surely it takes more hours to design a complex product
than to design a simple product. According to the ABC system overheads are apportioned according
to the ratios in which activities are used and consequently the costs are shared among the different
products in a more logical manner.
Activity 6
Gobabis Ltd manufactures three products, namely A, B and C. The company operates an absorption costing
system accumulating all overheads in a single cost centre and allocates overheads to products using direct
labour hours as allocation basis. The enterprise currently considers the implementation of an ABC system.
The budgeted information for the following financial year is as follows:
42
Direct material cost per unit
Direct labour cost
Production overheads:
Machine set-up costs
Other overheads
Total overheads
No of units manufactured
Direct labour hours
No of machine set-ups
Product A
N$
3,20
480 000
Product B
N$
32,00
56 000
Product C
N$
160,00
8 000
Total
N$
544 000
640 000
360 000
1 000 000
48 000
72 000
240
1 600
7 200
160
80
800
80
49 680
80 000
480
Other overheads are allocated to individual products based on direct labour hours.
Required:
6.1
6.2
6.3
Calculate both the total manufacturing costs and the unit costs using the absorption costing system.
Calculate both the total manufacturing costs and the unit costs using the ABC system.
Comment on the results of 6.1 and 6.2.
Activity 7
7.1
Mega Ltd manufactures three products X, Y and Z. The total budgeted overheads for the next year
amount to N$168 000. Overheads are traditionally recovered on the basis of machine hours. Details
of products manufactured and machine hours are as follows:
Product
X
Y
Z
Annual output (units)
500
2 000
4 000
6 500
Machine hours
6 000
12 000
24 000
42 000
Required:
Compute the overhead cost per unit of each product by apportioning the overheads on the basis of
direct labour hours.
7.2
As newly appointed management accountant of Mega Ltd you would like to analyse the overheads
per unit of product on an ABC basis and have extracted the following information:
Activity
Set-up costs
Inspection & Quality control
Maintenance
Packing
Receiving
Machine related costs
Total overheads
Overheads (N$)
39 000
24 000
42 000
22 000
20 000
21 000
168 000
43
The following information was gathered through an analysis of the company’s operating procedures:
Cost driver
Number of set-ups
Number of inspections
Maintenance hours
Number of external orders
Number of raw material orders
Product X
2
9
100
120
20
Product Y
7
9
200
80
40
Product Z
1
12
300
20
40
Required:
Compute the overhead cost per unit of each product using the activity-based costing method.
6.
An illustration of ABC and traditional product costing systems
With the traditional product costing system manufacturing overheads are first apportioned to production
departments (cost centres) as well as service departments (cost centres). This is called primary
apportionment. Then the costs of the service departments are re-apportioned to the production departments
(secondary apportionment). Finally the costs of the production departments are absorbed by the products.
For this purpose volume-related bases are used (normally direct labour hours or machine hours).
With an ABC system many activity-based cost pools (cost centres) are established. Separate cost pools
are established for service activities such as materials handling and maintenance. The costs of these
activities are assigned directly to products through cost driver rates. Thus reapportionment of service
department costs is avoided.
7.
Volume-based and non-volume-based cost drivers
With an ABC system many different cost pools may be established, depending on the number of activities in
an enterprise. If volume-related bases are used, high-volume products will be allocated an excessively high
proportion of costs whenever overhead costs are driven by forces that are not proportional to the volume of
output (such as the number of machine set-ups). The result is that high-volume products are over-costed and
low-volume products under-costed. In such a case the high-volume products will subsidise the low-volume
products whenever volume-based allocation methods are used. Because of this, there is a danger that firms
may make incorrect product-mix decisions by expanding the range of low-volume products at the expense of
the high-volume products. The result will be a growth in overhead costs and a decline in long-run
profitability.
8.
Designing ABC systems
When designing an ABC system the following stages are involved:
•
Identifying activities
An activity analysis should be carried out in order to identify activities. An activity consists of different
tasks. For example, purchasing of materials may be identified as an activity consisting of tasks such as
receiving of purchase requests, identifying suppliers, preparing purchase orders, mailing purchase orders and
performing follow-ups. The nature of the enterprise and the type of product being manufactured will
determine the number of activity cost centres. In practice large companies can have between twenty and
thirty activity cost centres.
44
•
Assigning costs to activity cost centres
Costs are generated (created) in each activity cost centre. For example, if maintenance has been identified as
an activity cost centre, all costs related to maintenance will be assigned to that activity. This may include
costs such as wages, depreciation on tools, lubricating materials, cleaning materials, etc.
Selecting appropriate cost drivers
In order to assign the costs attached to each activity cost centre to products, a cost driver must be selected for
each activity centre. A cost driver is that factor (element) that causes (drives) the costs. For example, the
number of machine set-ups will be a cost driver for the activity cost centre: machine set-ups because the
number of machine set-ups will determine the amount of the costs (the more the number of set-ups, the more
the costs will be). A cost driver should be easily measurable; the data should be relatively easy to obtain and
be identifiable with products.
•
Assigning the cost of the activities to products
The final stage involves applying the cost driver rates to the different products by multiplying the cost centre
rate by the cost driver volume. It is therefore obvious that the cost driver must be measurable in a way that
enables it to be identified with individual products.
9.
Activity hierarchies
A useful way to think about activities and how to combine them is to organize them into four general levels:
these are unit-level activities, batch-related activities, product-sustaining activities, and facility-sustaining
activities.
9.1
Unit-level activities
Unit-level activities are performed each time a unit of the product or service is produced. Costs in this
category vary in proportion to the number of units produced, for example direct material costs.
9.2
Batch-level activities
Batch-level activities are performed each time a batch of goods is produced. The cost of these activities
varies with the number of batches made but is fixed for all units within the batch. For example, for each
batch the machine must be set up. The set-up costs vary in proportion to the number of set-ups, but once the
machine has been set up, the cost is independent of the number of units produced.
9.3
Product-sustaining activities
Product-sustaining activities are performed to support the different products manufactured, for example the
development of a new production process or product testing procedures. The cost of these activities is
independent of the number of units or batches produced.
9.4
Facility-sustaining activities
Customer-level activities relate to specific customers and include activities such as sales calls, catalogue
mailing and general technical support that are not tied to any specific product.
Activity 8
Nekoto Ltd manufactures products “Nek” and “Oto”. Presently the company is operating a traditional
absorption costing system based on production volume (number of production units) to allocate overheads to
products. The budgeted costing information for 2010 is as follows:
45
Activities
Machine set-ups
Material procurement
Quality control
Material insertion
Cost drivers
Number of set-ups
Number of orders
Number of inspections
Number of parts
Production volumes
Costs
N$ 55 000
N$ 64 000
N$ 52 500
N$
800
N$172 300
Cost drivers
Number of set-ups
Number of orders
Number of inspections
Number of parts
Product “Nek”
500
6 000
9 000
128
10 000
Product “Oto”
50
400
1 500
32
10 000
Total
550
6 400
10 500
160
20 000
Required:
8.1
8.2
8.3
Calculate the manufacturing overhead costs per unit of each product using the existing absorption
costing system.
Calculate the overhead costs per unit of each product using the ABC system.
Comment on the results in 9.1 and 9.2.
10.
FEEDBACK ON ACTIVITIES
Feedback on Activity 1
1.1
Product unit basis:
Budgeted manufacturing overheads
Predetermined overhead rate = Budgeted number of units to be produced
=
N$60 000
450
= N$133 overheads per unit produced
1.2
Labour hour basis:
Predetermined overhead rate =
=
Budgeted manufacturing overheads
Budgeted labour hours
N$60 000
8 000
= N$7,50 overheads per labour hour
1.3
Machine hour basis:
Budgeted manufacturing overheads
Predetermined overhead rate =
Budgeted machine hours
N$60 000
= 12 000
= N$5 overheads per machine hour
46
1.4
Direct material cost basis:
Budgeted manufacturing overheads 100%
Predetermined overhead rate =
Budgeted direct material cost
X 1
N$60 000 100%
= N$30 000 X 1
= 200% of direct material cost
1.5
Direct labour cost basis:
Budgeted manufacturing overheads 100%
Predetermined overhead rate =
Budgeted direct labour cost
X 1
N$60 000 100%
= N$16 000 X 1
= 375% of direct labour cost
1.6
Prime cost basis:
Predetermined overhead rate =
Budgeted manufacturing overheads
100%
Budgeted prime costs
X 1
N$60 000 100%
= N$46 000 X 1
= 130% of prime cost
Feedback on Activity 2
2.1.1
Product unit basis:
Budgeted manufacturing overheads
Predetermined overhead rate = Budgeted number of units to be produced
N$12 900
= 535
= N$24,11 per unit
2.1.2
Labour hour basis:
Predetermined overhead rate =
Budgeted manufacturing overheads
Budgeted labour hours
N$12 900
= 1 400
= N$9,21 per labour hour
47
2.1.3
Machine hour basis:
Predetermined overhead rate =
Budgeted manufacturing overheads
Budgeted machine hours
N$12 900
= 2 850
= N$4,53 per machine hour
2.1.4
Direct material cost basis:
Predetermined overhead rate =
Budgeted manufacturing overheads 100%
Budgeted direct material cost
X 1
N$12 900 100%
= N$ 7 500 X 1
= 172% of direct material cost
2.1.5
Direct labour cost basis:
Predetermined overhead rate =
Budgeted manufacturing overheads 100%
Budgeted direct labour cost
X 1
N$12 900 100%
= N$ 3 600 X 1
= 358% of direct labour cost
2.1.6
Prime cost basis:
Predetermined overhead rate =
Budgeted manufacturing overheads 100%
Budgeted prime costs
X 1
N$12 900 100%
= N$11 100 X 1
= 116% of prime costs
2.2
Calculation of total cost of Unit No 137:
Cost item
Direct material
Direct labour
Manufacturing overheads:
Labour hours: N$9,21 x 5½ hours
Machine hours: N$4,53 x 8½ hours
Material cost: N$16,50 x 172%
Labour cost: N$17,50 x 358%
Prime cost: N$34 x 116%
Total cost of Unit No 137
Basis for absorption of overheads
Labour Machine Material Labour
hours
hours
cost
cost
N$
N$
N$
N$
16,50
16,50
16,50
16,50
17,50
17,50
17,50
17,50
Prime
cost
N$
16,50
17,50
50,65
38,50
28,38
62,65
84,65
48
72,50
62,38
96,65
39,44
73,44
Feedback on Activity 3
3.1
Manufacturing overhead rate based on direct labour hours
Budgeted manufacturing overheads
Overhead absorption rate = Budgeted direct labour hours
N$264000
= (8 000 x 2)
= N$16,50 per direct labour hour
3.2
Manufacturing overhead rates based on activities (cost drivers):
Cost driver rate based on production set-ups:
Budgeted production set-up related overheads
= Budgeted number of production set-ups
N$180 000
=
60
= N$3 000 per production set-up
Cost driver rate based on orders handled:
=
Budgeted orders handling related overheads
Budgeted number of orders handled
N$36 000
=
72
= N$500 per order handled
Cost driver rate based on machine hours:
=
Budgeted machine activity related overheads
Budgeted number of machine hours
N$48 000
= (8 000 x 3)
= N$2 per machine hour
Feedback on Activity 5
5.1
Budgeted manufacturing overheads
Overhead absorption rate = Budgeted direct labour hours
N$50 000
= (1 050 + 200)
= N$40 per direct labour hour
49
Cost item
Product A
N$
16 500
92 000
Direct material
Direct labour
Manufacturing overheads
(direct labour hours x N$40)
Total cost
42 000
150 500
8 000
30 700
250
N$602
60
N$511,67
Number of units
Cost per unit
5.2
Product B
N$
7 500
15 200
Activity-based costing:
Cost Pool
Cost driver
Cost driver rate
Machine costs
Machine hours
Materials handling
Materials movements
Stores
Requisitions raised
Inspection
No. of inspections
Set-up costs
No. of set-ups
Engineering support
Engineering hours
N$20 per machine hour
(N$14 600 ÷ 730)
N$27,20 per movement
(N$6 800 ÷ 250)
N$137,50 per requisition
(N$8 250 ÷ 60)
N$234 per inspection
(N$5 850 ÷ 25)
N$310 per set-up
(N$6 200 ÷ 20)
N$103,75 per engineering hour
(N$8 300 ÷ 80)
Cost item
Direct material cost
Direct labour cost
Manufacturing overheads:
Materials handling
Stores
Inspection
Set-up costs
Engineering support
Total cost
Number of units
Cost per unit
Product A
N$
16 500
92 000
10 000
4 896
5 500
4 212
3 720
6 225
143 053
250
N$572,21
Product B
N$
7 500
15 200
4 600
1 904
2 750
1 638
2 480
2 075
38 147
60
N$635,78
Feedback on Activity 7
7.1
Overhead absorption rate =
Budgeted manufacturing overheads
Budgeted machine hours
N$168 000
= 42 000
= N$4 per machine hour
50
Apportionment of overheads
Total
Per unit
Product X
N$24 000
(6 000 hours x N$4)
N$48 000
(12 000 hours x N$4)
N$96 000
(24 000 hours x N$4)
N$48
(N$24 000 ÷ 500)
N$24
(N$48 000 ÷ 2 000)
N$24
(N$96 000 ÷ 4 000)
Product Y
Product Z
7.2
Cost Pool
Set-up costs
Inspection & Quality control
Maintenance
Packing
Receiving
Machine-related costs
Overheads
Set-up costs
Inspection & Quality control
Maintenance
Packing
Receiving
Machine-related costs
Total overhead costs
Number of units
Cost per unit
11.
Cost driver
No. of set-ups
Cost driver rate
N$3 900 per set-up
(N$39 000 ÷ 10)
No. of inspections
N$800 per inspection
(N$24 000 ÷ 30)
Maintenance hours
N$70 per hour
(N$42 000 ÷ 600)
No. of external orders
N$100 per order
(N$22 000 ÷ 220)
No. of raw material orders N$200 per order
(N$20 000 ÷ 100)
Machine hours
N$0,50 per hour
(N$21 000 ÷ 42 000)
Product X
N$
7 800
7 200
7 000
12 000
4 000
3 000
41 000
500
N$82,00
Product Y
N$
27 300
7 200
14 000
8 000
8 000
6 000
70 500
2 000
N$35,25
Product Z
N$
3 900
9 600
21 000
2 000
8 000
12 000
56 500
4 000
N$14,125
Summary
Activity based Costing (ABC) is a recent development in product/service costing. It challenges the
traditional approach of collecting all overhead costs in one cost centre which are then allocated to products
using a volume base such as units of output, labours hours etc. With ABC, activities are identified and
overheads collected according to those activities in centres called cost pools. A cost driver rate (base) is then
identified for each cost pool and used to allocate overhead costs. The intention is to increase the accuracy of
the allocation of resources consumed by products/services. The next unit will explore the techniques for
managing inventory in an organisation.
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