Activity Based Costing

LEARNING OBJECTIVES After studying this chapter, you should be able to understand:
y

Meaning of Activity Based Costing Terms used in Activity Based Costing Examples of Cost Drivers for various Business Activities Practical Steps in Activity Based Costing Approach Traditional Approach Distinction between Traditional Approach and Activity Based Costing

y
y y y y

Approach

MEANING OF ACTIVITY BASED COSTING  Activity Based Costing (ABC) is a technique of charging overheads to cost objects (i.e., products, services, jobs, customers etc.) under which overheads are first calculated separately for each activity and then are charged to various cost objects on the basis of activities consumed by these cost Objects.  According to Cooper and Kalpan, "ABC systems calculate the costs of individual activities and assign costs to cost objects such as products and services on the basis of activities undertaken to produce each product or service."  CIMA, London, defines activity based costing as "Cost attribution to cost units on the basis of benefits received from indirect activities, i.e., ordering, setting up, assuring quality etc."  Note: Activity based costing is not an alternative to job costing or process costing.

1. TERMS USED IN ACTIVITY BASED COSTING (a) Activity -- An activity may be defined as a particular task or unit of work with a specific purpose. For example, placing of a purchase order, setting up of a machine, after sales service, etc. (b). Cost object It is an item for which cost measurement is required. For example, a product, a service, a job or a customer etc. (c) Cost driver -it is a factor that influences the cost of an activity. Cost drive is of two typesresource cost driver and activity cost driver.
(i)

Resource cost driver - It is a measure of the quantity of resource consumed by an activity. For example, number of purchase orders placed will influence the cost of purchasing the materials. Similarly, the number of times machines are set up will influence the cost of setting up of machines. Resource cost driver is used to assign the cost of a resource to an activity or cost pool.

(ii)

Activity cost driver - It is a measure of the frequency and intensity of demand placed on the activities b y cost objects. It is used to assign activity costs to cost objects consuming the activity.

EXAMPLES OF COST DRIVERS FOR VARIOUS BUSINESS ACTIVITIES Business Activities Cost drivers 1 Purchase of materials Number of orders placed. Number of receipts of materials. Number of inspections. Number of machine set-ups. Number of machine hours. Number of products serviced. Number of service calls. Number of hours spent on servicing.

2 3

Setting up of machines Customer service

PRACTICAL STEPS IN ACTIVITY BASED COSTING APPROACH

Step 1

Identify significant activities An activity is considered to be significant when the total cost involved in the activity is significant enough to justify giving an activity a separate treatment. Example Ordering of materials, Receiving and

inspection of deliveries. Production set-up, Shelf stocking, Customer support, Step 2 Calculate the total cost of each activity Example - Total "cost of ordering,. Total cost of receiving deliveries. Total cost of Production set-up, total cost of shelf stocking, Total cost of customer support Step 3 Determine the appropriate activity cost drivers Cost driver is 'a factor that influences the cost of an activity. Example No. of orders, No of deliveries, No of production setups, No of hours of shelf-stocking per store delivery, No. of items sold. Step 4 Calculate the Activity Cost Driver Rate as follows: Activity cost driver rate = Total cost of an activity Cost driver Example Total cost of ordering Rs. 1,00,000, No. of orders 1000 Cost per purchases order = Rs 1,00,000 =Rs. 100 per purchase order 1000 Step 5 Charge activity cost to end products. jobs and processes as follows Activity cost .charged to end product = Activity consumed x Activity cost-driver rate Example - No. of purchase orders for Product A and Product B are 10 and 20. Activity cost driver rate is Rs. 100 per purchase order Ordering cost charged to Product A = 10 x Rs.100 = Rs.1,000 Ordering cost charged to product B = 20 x Rs.100 = Rs.2,000

TRADITIONAL APPROACH

Under traditional approach, overheads are first allocated and apportioned to various production departments and service departments, then overheads of service departments are re-apportioned to production departments and then overheads of production departments are charged to the end ducts on some suitable basis (like machine' hours, labor hours, direct wages etc.) It is based on the assumption that end products consume resources in proportion to the volume of production. Practical Example: Product 'X'
A. Annual B.

Product 'Y' 20,000 10,000

Output (Units)

10,000 20,000

Total Machine Hours Total annual overheads Rs. 3,00,000

Overhead Absorption Rate =

Total Overheads = Rs 3,00,000 = Rs. 10 per hour Total machine hours 30,000 Rs. 2,00,000 Rs. 1,00,000 Rs. 20 Rs.5

C. Overhead Cost @ Rs. 10 per machine hour D. Overhead Cost per unit (C/A)

DISTINCTION

BETWEEN

TRADITIONAL

APPROACH

AND

ACTIVITY BASED COSTING APPROACH

Traditional Approach differs from Activity Based Costing Approach in the following respects: Basis of distinction Traditional approach Activity Based Costing (ABC) approach Assumption It is based on the assumption It is based on the assumption that that end products consume end products consume resources in resources in proportion to the proportion to the volume of

volume of production Procedure Overheads are first allocated and apportioned to various production service departments departments, and then

activities. Activity Based Costing is a

technique of charging overheads to cost objects (i.e., products, services, jobs, customers etc.) under which overheads It is an accurate system of costing

overheads of service de-

Accuracy It is not as accurate as ABC.

because the distribution o overheads is based on cause an effect

relationship Objective It is subjective approach It is an objective approach because it uses activities as bases foils

because it uses arbitrary bases for apportionment of

overheads. Control

distribution of overheads.

It does not facilitate the control It facilitates the control over those which cause fixed over those activities which activities cause fixed overheads overheads the It facilitates the identification of

Identification unnecessary activities

of It

does

not

facilitate

identification of unnecessary unnecessary activities. activities.

Illustration 1 PCT Ltd. produces three products X, Y and Z or which the standard cost and quantities p unit are as follows: Product Output (units) Direct material cost unit Direct labor wages per unit (@ Rs. 20) Machine hours per unit No. of purchase requisitions No. of machine set-ups Production overheads: Department P - Rs. 7,00,000 Q - Rs. 11,00,000 x 10,000. Rs. 30 R. 20 3 1000 150 Y 20,000 Rs. 20 Rs. 40 2 200 100 z 30,000' Rs. 10 Rs. 60 1 300 50

Department P is labor intensive and Q is machine intensive. Total labor hours in Dept. P = 1,40,000; Total machine hours in Dept. Q = 1,00,000. Production over as by activity: Receiving and inspection Production scheduling/set up Rs. 6,00,000 Rs. 12,00,000

Required: Prepare Statement of cost per unit under traditional absorption costing and activity based costing approaches. Also compare the result of the. Two methods and give your comments.

Traditional Method Step 1 > Overhead absorption rate : Overheads of the department Hours Department P = Rs. 7,00,000 1,40,000 labor hours Department Q = Rs. 11,00,000 =Rs. 11 per machine hour. = Rs. 5 per labor hour.

1,00,000 machine hours Step 2 > Statement of Cost under Traditional Method Particulars X Rs. Direct Materials Direct Wages Overheads - Dept. P X - 1 hr @ Rs. 5 Y - 2 hrs. @ Rs. 5 Z - 3 hrs @ Rs. 5 - Dept.Q X - 3 hrs Rs. 11 Y - 2 hrs Rs. 11 Z - 1 hrs Rs. 11 Total Cost per unit 88 92 33 22 11 96 5 10 15 30 20 Cost per unit

Y Rs. 20 40

Z Rs. 10 60

ABC Method Step 1 > Cost driver rates = Overhead cost of the activity Cost drivers

Receiving and inspection = Rs.6,00,000 1500 batches

=Rs. 400 per batch

Scheduling and set-up = Rs. 12,00,000 =Rs. 4,000 per set-up. 300 batches

Step 2 > Calculation of Activity Cost chargeable to products Part icul ar

A.

Receiving

Set-up

Receiving

Set-up

Receiving

Set-up

Activity cost driver rate

B.

400

4000

400

4000

400

4000

Activity

1000 4,00,000

150 6,00,000

200

100 4,00,000

300

50

consumed
C.

Activity cost assigned (A x B)

80,000

1,20,000

2,00,000

D.

No. of units

10,100 40

10,000 60

20,000 4

20,000 20

30,000 4

30,000 6.67

E.

Per unit (C/D)

Step 3 > Statement of Cost under ABC Method Particulars X Rs. Direct materials cost per unit Direct wages per unit Overhead per unit - Receiving 30 20 40 Cost per unit Y Rs. 20 40 4 Z Rs. 10 60 4

- Set-up Total cost per unit Comparison

60 150

20 84

6.67 80.67

Under traditional method, product Z appears quite costly as compared to activity based costing, because product Z consumers relatively more direct labor hours. On the other hand, product X shows higher cost under activity based costing than traditional method. As the ABC approach is considered more logical, it may be presumed that results shown by ABC are more accurate. If selling prices are fixed on the basis of cost, product Z would be priced higher under traditional costing and product X would be priced lower. This will result in loss of sales of product Z and loss per unit on product X, leading to a loss to the company.

Illustration 2 ABCD Co. Ltd. produces and sells four products A, B, C and D. These products are similar and usually in production runs of 10 units and sold in a batch of 5 units. The production details of these products are as follows: Product Production (Units) Cost per unit: Direct material (Rs.) Direct labor (Rs.) Machine hour (per unit) 30 25 5 40 30 4 35 30 3 45 40 4 A 100 110 120 150

The production overheads during the period are as follows:

Factory works expenses Stores receiving costs Machine set-up costs Cost relating to quality control Material handling and dispatch The cost drivers of these overheads are detailed below: Cost Factory works expenses Stores receiving costs Machine set-up costs Cost relating to quality control Material handling and dispatch

Rs. 19,000 Rs. 19,800 Rs. 12,000 Rs. 4,800 Rs. 9,000 Cost drivers Machine hours Requisitions raised

No. of production runs No. of production runs No. of orders executed

The number of requisitions raised on the stores was 25 for each product and number of orders executed was 96, each order was in a batch of 5 units. Required:
i.

Total cost of each products assuming the absorption of overheads on machine hour basis

ii.

Total cost of each product assuming the absorption of overheads by using activity base costing; and

iii.

Show the differences between (i) and (ii) and comment.

Solution I) Absorption of Overheads on Machine Hour basis Step 1 - Overhead Rate = Total overhead cost Total machine hrs = Rs. 64,600 = Rs. 34 per unit 1,900

Step 2 - Statement showing total cost of each product assuming absorption of overheads on Machine Hour Rate Basis Particulars A. Output (units) B. Direct material (Rs.) C. Direct labor (Rs.) D. Machine hrs E. Overheads @ Rs. 34 per machine hr [D x Rs. 34] F. Total cost per unit (Rs.) [B+C+E] G. Total Cost (Rs.) (A x F) A 100 30 25 5 170 225 22,500 B 110 40 30 4 136 206 22,660 C 120 35 30 3 102 167 20,040 D 150 45 40 4 136 221 33,150 Total 480 150 125 544 819 98,350

(ii) Absorption of Overheads using Activity Base Costing Step 1 > Calculation of Cost Driver Rate Factory works expenses = Total expenses Total No. of machine = Rs. 19,000 Hrs 1900 = Rs. 10

Stores receiving cost = Stores receiving cost = Rs. 19,800 = Rs.198 No. of Stores requisition 100 48 = Rs 4,800 = Rs. 100 48 Machine setup casts = Machine set-up cost = Rs 12,000 = Rs. 250 No. of production runs Costs relating to quality control = Cost to QC

No. of production runs Expense relating of material = Material handling & dispatch cost No. of order executed = Rs. 9,000 = Rs. 93.75 96

Step 2 > Calculation of total overheads of each product assuming Activity Based Costing

Particulars Output (Units) No. of machine hours No. of production runs No. of stores requisition No. of sales orders Total factory work exp.@ Rs. 10

A 100 500 10 25 20 5,000

B 110 440 11 25 22 4,400 4,950 2,750 1,100 2,062.5

C 120 360 12 25 24 3,600 4,950 3,000 1,200 2,250

D 150 600 15 25 30 6,000 4,950 3,750 1,500 2,812.5

Total 480 1,900 48 100 96 19,000 19,800 12,000 4,800 9,000

Total stores receiving cost @ Rs. 198 4,950 Total machine set up costs Total cost relating to quality control 2,500 1,000

Total material handling & dispatch 1,875 cost

Step 3 > Statement showing total cost of each product assuming absorption of overhead by using Activity Based Costing Particula rs A Total Rs. Direct Material Direct Labour Factory work exp Stores receivin g cost 4,950 49.50 4,950 45.00 4,950 41.25 4,950 33.00 5,000 50.00 4,400 40.00 3,600 30.00 6,000 40.00 2,500 25.00 3,300 30.00 3,600 30.00 6,000 40.00 3,000 B Per unit Total Rs. 30.00 Rs. 4,400 C Per unit Total Rs. 40.00 Rs. 4,200 D Per unit Rs. 35.00 Total Rs. 6,750 Per unit Rs. 45.00

Machine set-up cost Cost related to quality control Material handling & dispatch cost Total

2,500

25.00

2,750

25.00

3,000

25.00

3,750

25.00

1,000

10.00

1,100

10.00

1,200

10.00

1,500

10.00

1875

18.75

2,062.5

18.75

2,250

18.75

2,812.5

18.75

20,825

208.25

22,962. 5

208.75

22,800

190.00

31,762. 50

211.75

Statement showing differences (in Rs.) Particulars Total cost under MHR Total cost under ABC A 22,500 20,825 B 22,660 22,962.50 C 20,040 22,800 D 33,150 31,762.50

Why difference: Because A consumes comparatively more of machine hours. Comment -The use of activity based costing gives different product costs than what were arrived at by utilizing traditional costing. It can be argued that product costs using ABC are more precise as overheads have been identified with specific activities. Illustration 3

An engine manufacturing company has two production departments:

(i) (ii)

Snowmobile engine and Boat engine and two service departments:

(i) (ii)

maintenance and factory office.

Budgeted cost data and relevant cost are as follows: Departmental costs: Snowmobile engine Boat engine Factory office Maintenance Cost drivers: Factory office department: Snow mobile engine department Boat engine department Maintenance department Maintenance department: Snow mobile engine department Boat engine department Factory office department No. of employees 2,160 employees 540 employees 300 employees 3,000 employees No. of work orders 1,140 orders 380 orders 80 orders 1600 orders Wired:
(i)

Rs. 12,00,000 34,00,000 6,00,000 4,80,000

Compute the cost driver allocation percentage and then use these percentages to allocate the service department costs by using direct method.

(ii)

Compute the cost driver allocation percentage and then use these

percentages to allocate the service department costs by using non reciprocal method/step method . Step 1 Calculation of Cost Driver allocation percentages Factory office dept. Snow mobile engine Boat engine Total Maintenance dept. Snow mobile engine Boat engine Charging of Number of employees 2160 540 2700 Number of work orders 1140 380 1520 75% 25% 100% Percent used 80% 20% 100%

Step 2 Charging of Service department costs Particulars Factory office dept. 6,00,000 Maintenance dept. Rs. 4,80,000 Snowmobile engine Rs. 12,00,000 34,00,000 Boat engine Rs.

Departmental Cost Allocated Costs (Rs.): Factory Office Dept. Maintenance Dept. Total

(6,00,000)

(4,80,000) 0

4,80,000 3,60,000 20,40,000

1,20,000 1,20,000 36,40,000

Step 3 Calculation of allocation percentages Factory office dept. Snowmobile engine Number of employees 2,160 Per cent used 72%

Boat engine Maintenance dept

540 300 3,000

18% 10% 100% Per cent used 75% 25% 100%

Maintenance dept Snowmobile engine Boat engine

Work order 1,140 380 1,520

Step 4 Charging service department costs Particulars Factory office dept. Departmental costs (a) Factory office (b) Maintenance dept. Total cost Rs. 6,00,000 (6,00,000) 0 Maintenance dept. Rs. 4,80,000 60,000 (5,40,000) 0 Snowmobile engine Rs. 12,00,000 4,32,000 4,05,000 20,37,000 34,00,000 1,08,000 17,35, 000 36,43,000 Boat engine Rs

Solved problems Problem 1 A company manufacturing two products, furnishes the following data for a year Products Annual output (units) A B 5,000 60,000 20,000 1,20,000 160 384 20 44 Total machine Total number of Total number of set-ups hours purchases order

The annual overhead are as under : Volume related activity costs

Rs. 5,50,000

Set-up related costs Purchase related costs You are required to calculate the cost per unit of each product A and B bases on : i. ii. Traditional method of charging overheads. Activity based costing method.

8,20,000 6,18,000

Solution: 1. traditional methods Step 1 calculation oh machine hour rate Total overheads = Rs. 5,50,000 + Rs. 8,20,000 + Rs. 6,18,000 = Rs. 19,88,000 Total machine hours = Rs. 20,000 + Rs. 1,20,000 = Rs. 1,40,000 Machine hour rate = Total overheads Total machine hours = Rs. 19,88,000 = Rs. 14.20 1,40,000 hours

Step 2 Statement showing the Cost per unit Particular A. B. C. D. Output (units) Machine hours Over head cost @ Rs. 14.20 per machine hour overhead cost per unit (C A) Rs. 56.80 28.40 A 5,000 20,000 2,84,000 Products B 60,000 1,20,000 17,04,000

2. ABC method

Step 1 calculation of cost driver rates Total overhead cost for 1. Machine hour rate=volume related activities = Rs.5,50,000 = Rs. 3.93(appox) Total machine hours 1,40,000 hours

2. Cost of one setup = Total costs related to setup Total number of setups = Rs.8,20,000 = Rs.12,812.50 64 setups

3. Cost of one purchase order = Total costs related to purchase Total number of purchases order = Rs. 6,18,000 = Rs. 1,136.03 544 orders

Step 2 Statement showing the cost per unit Particulars Machine hours No. of Purchase Orders No. of Set-ups Cost related to volume related activities @ Rs. 3.93 Cost related to purchase orders @ Rs. 1,136.03 Cost related to set-ups @ Rs.12,812.50 Total cost (D + E + F) Annual output (units) Cost per unit (FIG) A 20,000 160 20 Rs. 78,600 Rs. 1,81,765 Rs. 2,56,250 Rs. 5,16,615 5,000 Rs. 103.323 Products B 1,20,000 384 44 Rs. 4,71,600 Rs. 4,36,235.52 Rs. 5,63,750 Rs. 14,71,586 60,000 Rs. 24.526

Problem 2 Alpha Limited has decided to analyze the profitability of its five new customers. It buys bottled w at Rs. 90 per case and sells to retail customers at a list price of Rs. 108 per case. The data pertai ning to five customers are: Particulars A Rs. Cases sold List selling price Actual selling price Number of purchase orders Number of customer visits Number of deliveries Kilometers travelled per deliver) Number of expedited deliveries 4,680 Rs. 108 Rs. 108 15 2 10 20 0 B Rs. 19,688 Rs. 108 Rs. 106.20 25 3 30 6 0 Customers C Rs. 1,36,800 Rs. 108 Rs. 99 30 6 60 5 0 D Rs. 71,550 Rs. 108 Rs. 104.40 25 2 40 10 0 E Rs. 8,775 Rs. 108 Rs. 97.20 30. 3 20 30 1

Its five activities and their drivers are: Activity Order taking Customer visits Deliveries Product handling Expected deliveries Cost driver rate Rs. 750 per purchase order Rs. 600 per customer visit Rs. 5.75 per delivery km travelled Rs. 3.75 per case sold Rs. 2,250 per expedited delivery

Required: Compute the customer level operating income of ea ch of five retail customers now being examined (A, B, C, D and E). Comment on the results. (C.A. P.E. 2)

Solution
Step 1 Calculation of Customer Level Activity Costs

Particulars A Rs.
1.

Customers B Rs. 18,750 1,800 1,035 C Rs. 22,500 D Rs. 18,750 1,200 2,300 E Rs. 22,500

Order taking costs (No. of purchase orders x Rs. 750)

11,250 1,200 1,150

2.

Customer visits costs (No. of customer visits x Rs. 600)

3,600

1,800 3,450:

3.

Delivery vehicles travel costs (Kms travelled by delivery vehicles x Rs. 5.75 per km) Products handing costs (Cases sold x Rs. 3.75) Cost of expedited deliveries (No. of expedited deliveries x Rs. 2,250) Total cost of customer level operating activities:

1,725

17,550

73,830

5,13,000

2,68,313

32,906

2,250

31,150

95,415

5,40,825

2,90,563

62,906

Step 2 Calculation of customer level operating income Customer Particular Cases sold Actual selling price Sales at actual price (AB) A 4,680 Rs. 108 5,05,440 B 19,688 Rs. 106.20 20,90,866 C 1,36,800 Rs. 99 1,35,43,200 D 71,550 Rs. 104.40 74,69,820 E 8,775 Rs. 97.20 8,52,930

Less: Cost of goods sold (A x C) Gross Margin [D E] Less: Customer level activity costs (as per
PROBLEM3

4,21,200 84,240

17,71,920 3,18,946 95,415

1,23,12,200 12,31,200 5,40,825

64,39,500

7,89,750

10,30,320 2,90,563

63,180 62,906

31,150

step 1) Customer Level 53,090 2,23,531 6,90,375 7,39,757 274 Operating Income [F G]

Problem 3 S.K. Store wants information about the profitability of individual product lines: Soft drinks, Fresh produce and Packaged food. S.K. Store provides the following data for the year 20X5-20X6 for each product line: Particulars Revenues Cost of goods sold Cost of bottle returned Number of purchase orders placed Number of deliveries received Hours of self-stocking time Items sold Soft drinks Rs. 7,93,500 Rs. 6,00,000 Rs. 12,000 360 300 540 1,26,000 Fresh produce Rs. 21,00,600 Rs. 15,00,000 Rs. 0 840 2,190 5,400 11,04,000 Packaged food Rs. 12,09,900 Rs. 9,00,000 Rs. 0 360 660 2,700 3,06,000

S.K. Store also provides the following information for the year 20X5 -20X6 Activity Bottle returns Description Returning of empty bottles Total cost (Rs.) Cost-allocation base 12,000 Direct tracing to soft drink line Ordering Delivery Placing order for purchase Physical delivery and receipt of goods Shelf stocking Stocking of goods on store shelves and on-going restocking Customer support Assistance provided to customers including checkout 3,07,200 15,36,200 items sold 1,72,800 8,640 hours of shelf stocking time 1,56,000 2,52,000 1,560 purchases orders 3,150 deliveries

Required:
(i)

If S.K. Store currently allocates support costs (all costs other than cost of goods sold) product lines on the basis of cost of goods sold of each product line. Calculate the operating income and operating income as a % of revenues for each product line.

(ii)

If S.K. Store allocates support costs (all costs other than cost of goods sold) to product line using an activity-based costing system, calculate the operating income and operating incom e as a % of revenues for each product line.

(iii)

Comment on your answers in requirements (i) and (ii).

(C.A. P.A. I)

Solution (i) Traditional Approach Step 1 Bottles returns Ordering Delivery Shelf-stocking Customer support Total support cost Step 2 Total cost of goods sold = Rs. 6,00,000 + Rs. 15,00,000 + Rs. 9,00,000 = Rs. 30,00,000 Step 3 Total support cost as a % of cost of goods sold = Rs. 9,00,000 x 100 = 30% Rs. 30,00,000 Step 4 --> Statement of Operating Income and Operating Income as a % of Revenues Particulars A. Revenues (A) B. Total cost (a) Cost of goods sold (COGS) (b) Support cost (30% of COGS) 7,80,000 C. Operating (A B) income 13,500 19,50,000 1,50,600 11,70,000 39,900 39,00,000 2,04,000 1,80,000 4,50,000 2,70,000 9,00,000 Soft Drinks 7,93,500 6,00,000 Fresh Produce 21,00,600 15,00,000 Packaged Foods 12,09,900 9,00,000 Total Rs. 41,04,000 30,00,000 Calculation of total support cost (overhead) Rs. 12,000 1,56,000 2,52,000 1,72,800 3,07,200 9,00,000

D. Operating income as a % of revenue (C 100) A (ii) ABC Approach

1.70%

7.17%

3.30%

4.97%

Step 1 Calculation of Cost Driver Rates Activity Total cost (Rs.) Cost drivers Cost driver rate (Rs.)

1.

Ordering

1,56,000

1,560 purchase orders

100 per purchase order

2.

Delivery Shelf-stocking Customer

2,52,000 1,72,800 3,07,200

3,150 deliveries 8,640 hours 15,36,000 items sold

80 per delivery 20 per stocking hours 0.20 per item sold

3.

4.

support

Step 2 Statements of Operating Income and Operating Income as a % of Revenues Particulars A. Revenues B. Total Cost
(i) (ii) (iii)

Soft Drinks 7,93,500 6,00,000

Fresh Produce 21,00,600 15,00,000

Packaged Foods 12,09,900 9,00,000

Total Rs. 41,04,000 30,00,000 12,000 1,56,000 2,52,000

Cost of goods sold Bottle return costs Ordering cost (360: 840: 360) Delivery cost (300 : 2,190 : 660) 12,000 36,000 24,000 0 84,000 1,75,200 0 36,000 52,800

(iv)

(v)

Shelf stocking cost (540: 5,400: 2,700)

10,800 25,200

1,08,000 2,20,800

54,000

1,72,800 3,07,200

(vi)

Customer support cost

61,200

(1,26,000: 11,04,000: 3,06,000) 7,08,000 C. Operating income 85,500 10.78% (A B) D. Operating income as a % of revenues 20,88,000 12,600 0.60% 11,04,000 1,05,900 8.75% 39,00,000 2,04,000 4.97%

Comments: Statements prepared under traditional approach and activity based costing show different results in the form of operating income as a % of revenue. It is generally felt that allocation of support costs under activity based costing is more reliable and accurate than under traditional method. -The allocation of delivery cost on the basis of number of deliveries and self stocking cost on the basis of per stocking hour, has caused substantial increase of the those costs for Fresh Produce product line. With the decrease in the share of revised support costs under ABC system, the operating income of Soft Drinks and Packaged Foods has increased.

Problem 4 RST Limited specializes in the distribution of pharmaceutical products. It buys from the pharmaceutical companies and results to each of the three different markets:
(i)

General Supermarket Chains Drugstore Chains Chemist Shops

(ii)

(iii)

The following data for the month of April, 20X6 in respect of RST Limited has

Activity Area Customer purchase order processing Line-item ordering Store delivery

Cosactivityer

Purchase orders by customers Line-items per purchase order Store deliver ies

been reported: Drugstore Chains Rs. 28,875 Rs. 27,500 Rs. 5,445 Rs. 4,950 Chemist Shops

Cartons dispatched to stores Shelf-stocking at

Cartons dispatched tfourtore per delivery Hours of shelf-stocking

General Supermarket Chains Average revenue per delivery Average cost of goods sold per delivery Number of deliveries Rs. 84,975 Rs. 82,500

330

825

2,750

In the past, RST Limited has used gross margin percent to evaluate the relative profitability of tits distribution channels. The company plans to use activity-based costing for analyzing the profitability of its distribution Channels. The Activity analysis of RST Limited is as under:

Activity Area Customer purchase order processing Line-item ordering Store delivery Cartons dispatched to stores Shelf-stocking at customer store

Cost driver Purchase orders by customers Line-items per purchase order Store deliveries Cartons dispatched to store per delivery Hours of shelf-stocking

The April, 20X6 operating costs (other than cost of goods sold) of RST Limited are Rs. 8,27,970. These operating costs are assigned to five activity areas. The cost in each area and the quantity of cost allocation basis used in that area for April, 20X6 are as follows:

Activity area

Total costs in April, Total 20X6

units

of

cost

allocation base used in April, 20X6

Customer

purchase

order

processing

Rs. 2,20,000 Rs. 1,75,560 Rs. 1,95,250 Rs. 2,09,000 Rs. 28,160

5,500 orders 58,520 line items 3,905 store deliveries 2,09,000 cartons 1,760 hour

Line-item ordering Store delivery Cartons dispatched to store Shelfstocking at customer store

Other data for April, 20X6 include the following: General Supermarket Chains Total number of orders Average number of line items per order Total number of store deliveries Average number of cartons shipped per store delivery Average number of hours of shelf stocking per store delivery Required:
(i)

Drugstore Chains

Chemist Shops

385 14 330 300 3

990 12 825 80 0.6

4,125 10 2,750 16 0.1

Compute for April, 20X6 gross-margin percentage for each of its three distribution channels and compute RST Limited's operating income.

(ii)

Compute the. April, 20X6 rates per unit of the cost-allocation base for each of the five activity areas.

(iii)

Compute the operating income of each distribution channel in April, 20X6 using the activity, based costing information. Comment on the results. What new insights are available with the activity based cost information?

(i) Statement of Operating Income and Gross Margin Percentage for April 20X6 General Particulars Supermarket Chains Rs. A. Revenues 2,80,41,750 (330 x Rs. 84,975) B. Less : Cost of goods sold 2,72,25,000 (330 82,500) C. Gross margin D. Less : Other operating costs E. Operating income F. Gross margin % of revenue G. Operating income % of revenue 2.91% 4.76% 9.09% 8,16,750 x 2,38,21,875 (825 x Rs. 28,875) 2,26,87,500 Rs. (825 x 27,500) 11,34,375 1,49,73,750 (2,750 x Rs. 5,445) 1,36,12,500 6,35,25,000 6,68,37,375 Drugstore Chains Rs. Chemist Shops Rs. Total Rs.

Rs. (2,750 x Rs. 4,950) 13,61,250 33,12,375 8,27,970 24,84,405 4.96% 3.72%

ABC Approach (ii) Computation of Rate per Unit of the Cost-Allocation Base for April 20X6 A. Customer purchase order processing (Rs. 2,20,000 5,500 orders) B. Line item ordering (Rs. 1,75,560 58,520 line items) C. Store delivery (Rs. ,95,250 + 3,905 store deliveries) D. Cartons dispatched (Rs. 2,09,000 4- 2,09,000 dispatches) E. Shelf-stocking at customer store (Rs. 28,160 1,760 hours) Rs. 3 per line item order Rs. 50 per delivery Rs. 1 per dispatch Rs. 16 per hour Rs. 40 per order

(iii) Computation of Operating Income of each Distributon Channel General Particulars Super Market Chains Rs. A. Gross margin as per part (i) B. Operating cost: 15,400 (Rs. 40 x 385 orders) Line item ordering. 16,170 (Rs. 3 x 14 x 385 orders) 39,600 (Rs. 40 x 990 orders) 35640 (Rs. 3 x 12 x 990 orders) 1,65,000 (Rs. 40 x 4,125 orders) 1,23,750 (Rs. 3 x 10 x 4,125 orders) 8,16,750 11,34,375 13,61,250 Drugstore Chains Rs. Chemist Shops Rs.

Customer

purchase

order processing

Particulars

General super market chains Rs.

Drugstore chains Rs.

Chemist shops Rs.

Store delivery

16,500 (Rs. 50 330 41,250 (Rs. 50 825 1,37,500 (Rs. 50 deliveries) deliveries) 2,750 deliveries)

Cartons dispatched

99,000 (Rs. 1 300 66,000 (Rs. 1 80 44,000 (Rs. 1 16 cartons deliveries) 330 cartons deliveries) 825 cartons deliveries) 2,750

Shelf-stocking

15,840 (Rs. 16 330 7,920 (Rs. 16 825 4,400 (Rs. 16 2,750 deliveries 3 hrs) deliveries 0.6 hrs) 1,90,410 9,43,965 deliveries 0.1 hrs) 4,74,650 8,86,600

Operating cost

1,62,910

Operating income (A- 6,53,840 B) (Operating income/Revenue) 100 2.33%

3.96%

5.92%

Comments: The ABC shows that chemist shops use a larger amount of company resources per rupee of revenue than general supermarket chains and drugstore chains. Operating costs as a percentage of revenues for the three channels is shown below:
1.
2. 3.

General supermarket chains (Rs. 1,62,910 2,80,41,750) x 100 Drug store chains (Rs. 1,90, 410 Rs.2,38,21,875) x 100 Chemist shops (Rs. 4,74,650 Rs. 1,49,73,750) x 100 (v) Challenges Faced in Assigning Total Operating Cost In assigning total operating cost of Rs. 8,27,970 to different activity areas, one may face the followin g challenges: (i) For each activity an appropriate cost driver is to be selected.

0.58% 0.80% 3.17%

(ii) For each cost driver, a reliable data base is to be developed. (iii) There may be certain costs that may be common several activities. How to distribute these costs over activities may pose questions. (iv) For computing cost driver rates, appropriate time period is to be selected.