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Costing is used in business accounting strategies as a way of determining the cost of
manufacturing a product in relation to the revenue generated by that product. Costing systems
determine the overhead of production and then allocate those overhead costs to a business’
products.

Methods for allocating indirect costs:

There are two common methods for allocating indirect costs to products. Both of these methods
assess overhead costs and then attach these costs to products based on certain cost drivers.

(i) Activity-based costing: ABC costing systems allocate manufacturing overhead by
assigning indirect costs to activity cost pools, then dividing each cost pool by a cost driver to
obtain the rates used for allocation . ABC is optimal when accuracy is very important and
when indirect costs comprise a large proportion of total costs compared to direct costs. By
allocating indirect costs to products based on usage a company can more accurately see
where the resources and energy is going in their company. By figuring out where the costs
and energy is going, efforts can be focused upon those products that are eating up the most
time and energy. This will eventually lead to a drop in cost, in theory, as efforts will be made
to reduce the costs on the bulk of the products. Activity based costing is all about efficiency.
Efficiency is paramount to success and growth within a company and that is why activity
based costing is an effective way to allocate indirect costs within a company to products.

(ii) Absorption costing or traditional costing: Absorption costing or traditional costing
assigns costs to products based on an average overhead rate. This method pools all indirect
costs in production and applies those costs equally across the board using one appropriate
cost driver, such as machine hours or labour hours.

Which costing method should be used?

ABC can be used when one or more of the following conditions are present:

• Product lines differ in volume and manufacturing complexity.
• Product lines are numerous and diverse, and they require different degrees of support
services.
• Overhead costs constitute a significant portion of total costs.
• The manufacturing process or number of products has changed significantly, for example,
from labour intensive to capital intensive automation.
• Production or marketing managers are ignoring data provided by the existing system and is
instead using other costing data when pricing or making other product decisions.

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Activity-based costing should be used when accuracy is crucial, because it is the most precise.
Although it is costly to implement, it should be used for:

 Times when overhead is high, because small changes in each product cost can make a
large difference overall. This method makes it easy to visualize and understand all
indirect costs and activities.
 Internal use, because decision-makers will be able to see all relevant spending and can
document all indirect costs accurately. This method is good for finding areas of wasteful
spending.

Absorption or Traditional costing should be considered when time is limited or when accuracy
won’t be affected much by production activities. Traditional costing is most effective for:

 Times when overhead is low compared to the direct costs, because this is when it will
be the most accurate. This works well when there are a large number of similar items (or
a single item) being produced.
 External use, because it will be easier for outsiders to determine the value of products.

ABC costing Steps:

There are four steps in the activity based costing process.

 Identify and classify all of the activities in the value chain related to the production of the
product.

 Estimate a total cost for each of the activities identified.

 Compute a cost-driver rate for each activity based on a cost allocation base that has a
causal link to the cost of the activity.

 Apply activity costs to products using the appropriate cost-driver rate.

Terms used in ABC costing:

 Activity: It represents a specific type of work or task performed. An activity can be a
single action or a combination of several interrelated actions. For example, purchasing
material is an activity but it includes several sub tasks within purchasing department. On
the other hand property tax is a single but independent activity.

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 Resource: Resources are items of monetary nature required or used in performing
activities. For example rent paid for factory, in which production process is carried on, is
a resource needed to perform production operations.

 Cost drivers: A cost driver is any factor or activity that has a direct cause and effect
relationship with the resources consumed. The costs of an activity are caused by factors
known as cost drivers. Thereby management should be able to control the amount of
costs by controlling the amount of cost drivers, for example, the cost of ordering is driven
by the amount of orders placed. If the monthly cost of ordering is $12 000 and there are
1000 orders placed in a month, then the cost per order is $12. Products are then
assigned the costs of an activity on the basis of the number of cost drivers the products
generate. For example, if product A requires 5 orders to be placed then the cost of
ordering for product A is $60 (5 x $12).

 Cost pool: A cost pool is a grouping of individual costs, typically by department or
service center. Cost allocations are then made from a cost pool. For example, the cost of
the maintenance department is accumulated in a cost pool and then allocated to those
departments using its services.

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Example 1:

OJW Company manufactures two types of widgets - Widget A and Widget B. The company has
to evaluate its process expenses to determine its activity cost pools. The following information is
given:

Expenses:

Payroll taxes

Fringe benefits

Electricity

Factory rent

Equipment maintenance

Factory maintenance

The first step to creating activity cost pools is to determine what drives each individual cost; that
is, what factor influences how much is spent in that expense category. For example, the amount
spent on electricity depends on how many hours a machine is running. Therefore, the cost
driver for electricity would be machine hours. The drivers for each of the above expenses are
listed below:

Cost pools Cost drivers
Payroll taxes Direct Labor Hours
Fringe benefits Direct Labor Hours
Electricity Direct Machine Hours
Factory rent Square Feet
Equipment maintenance Direct Machine Hours
Factory maintenance Square Feet

Once the cost drivers are determined, the expenses influenced by the same cost drivers are
grouped into activity cost pools.

Direct Labor Hours:

 Payroll taxes
 Fringe benefits

Direct Machine Hours:

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 Electricity
 Equipment maintenance

Number of Square Feet:

 Factory rent
 Factory maintenance

OJW Company will need three activity cost pools for the following cost drivers: direct labor
hours, machine hours, and number of square feet.

Example 2:

Two years later, OJW Company has added a third widget to its production - Widget C. The
manufacturing process is now more complex and the company has asked you to reevaluate its
process expenses to determine its activity cost pools. The following information is given:

Expenses:

Forklift operator labour

Purchasing labour

Inspector labour

Payroll taxes

Fringe benefits

Electricity

Factory rent

Purchasing supplies

Inspecting supplies

Equipment depreciation

Equipment maintenance

Factory maintenance

As in the first example, the first step to creating activity cost pools is to determine what drives each individual cost.
The drivers for each of the above expenses are listed below:

Cost pools Cost drivers

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Forklift operator labour Direct Machine Hours
Purchasing labour Number of Purchase Orders
Inspector labour Number of Inspections
Payroll taxes Direct Labor Hours
Fringe benefits Direct Labor Hours
Electricity Direct Machine Hours
Factory rent Square Feet
Purchasing supplies Number of purchase orders
Inspecting supplies Number of Inspections
Equipment depreciation Cost of machine
Equipment maintenance Direct Machine Hours
Factory maintenance Square Feet

Benefits and limitations of using ABC system:

ABC system has the following benefits and limitations:

Benefits:
 ABC provides a more accurate cost per unit. As a result, pricing, sales
strategy, performance management and decision making should be improved.
 It provides much better insight into what drives overhead costs.

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

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

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

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

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

Limitations:

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 ABC will be of limited benefit if the overhead costs are primarily volume related or if the
overhead is a small proportion of the overall cost.
 It is impossible to allocate all overhead costs to specific activities.

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

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

 The benefits obtained from ABC might not justify the costs.

 Other systems may need to be changed - for example, how variances are calculated.

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WORKSHEET

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3. Ferris Corporation makes a single product - a fire resistant commercial filing cabinet - that it
sells to office furniture distributors. The company has a simple ABC system that it uses for
internal decision making. The company has two overhead departments whose costs are listed
below:

Manufacturing overhead $5,00,000

Selling and administrative overhead $3,00,000

Total overhead costs $8,00,000

The company's activity based costing system has the following activity cost pools and activity measures:

Activity Cost Pool Activity Measures

Assembling units Number of units

Processing orders Number of orders

Supporting customers Number of customers

Other Not applicable

Costs assigned to the "other" activity cost pool have no activity measure; they consist of the costs of
unused capacity and organization-sustaining costs - neither of which are assigned to products, orders or
customers. Ferris Corporation distributes the costs of manufacturing overhead and of selling and
administrative overhead to the activity cost pools based on employee interviews, the results of which
are reported below:

Distribution of Resource Consumption Across Activity Cost Pools
Assembling Processing Supporting
Other Total
Units Orders Customers

Manufacturing overhead 50% 35% 5% 10% 100%

Selling and administrative
10% 45% 25% 20% 100%
overhead

100
Total activity 1,000 units 250 orders -- --
customers

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Required:

(a) Perform the first stage allocation of overhead costs to the activity cost pools.

(b) Compute activity rates for the activity cost pools.

(c) OfficeMart is one of the Ferris Corporation's customers. Last year OfficeMart ordered filing
cabinets four different times. OfficeMart ordered a total of 80 cabinets during the year.
Construct a table showing the overhead costs of these 80 units and four orders.

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