LaiACCT3500/Fall 20 (answers to tutorial 3)

ADA University School of Business

ACCT3500, Managerial Accounting, Fall 2020
Suggested answers to tutorial 3 – Activity based costing

1. Criticisms of traditional costing and arguments in support of ABC:

 Traditional cost systems use volume-related cost drivers / absorption bases (such
as direct labour hour or machine hour) where no cause and effect relationships
exist.
 In using volume related bases, the traditional product cost system assumes that
products consume all resources in proportion to their production volumes. Thus
more overhead costs are assigned to high volume than low volume products,
resulting in understating profits on high volume products and overstating profits
on low volume specialty products.
 Misleading product costs could lead to wrong strategic product decisions.
 The traditional cost system therefore distorts product costs. Many resources of
indirect and support departments are not used in proportion to physical volume.
The system accurately measures direct labour and direct material costs, energy
costs, and all volume-related costs; but it does not measure accurately the costs
of non-volume related activities such as material procurement, production set-up
and production scheduling activities.
 ABC system assigns overhead costs on a cause-and-effect basis; costs are
assigned to products using many cost drivers (cost driver rates) which are non-
volume-based such as the number of purchase orders for purchasing activity
and the number of production runs for set-up costs.
 ABC assigns the cost of support activities directly to cost objects without any
reapportionment to production centres in contrast to traditional systems which
normally apportion service / support costs to production centres first before
reabsorption to cost objects.

2.
 transaction cost driver - counts the number of times an activity is performed; least
expensive type of cost driver but also least accurate because they assume that the same
quantity of resources is required every time an activity is performed (example number
of set-ups undertaken).
 duration cost driver - represents the amount of time required to perform an activity;
thus more accurate than transaction cost driver but more costly to apply (example set-
up hours).
 Duration cost drivers should be used instead of transaction cost drivers when products
consume different amounts of activity resources, for example one product requires a
short set-up time while another product requires a long time, then using set-up hours
will more accurately measure resource consumption by the products.

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 LaiACCT3500/Fall 20 (answers to tutorial 3)

3. Designing ABC system involves the following steps:

● Step 1 - Identify the major indirect activities in the organization. ● Examples of
indirect activities are purchasing, receiving materials, materials handling, packing and
dispatching. ● Activities are identified by carrying out an activity analysis (includes
interviews with departmental managers, supervisors, employees).
● Step 2 - Assigning costs to cost pools / cost centres for each activity.
● Step 3 - Identify for each activity its “cost driver”, that is, the factor or event that
causes or determines the costs of each activity. ● Examples are no. of purchase orders
for purchasing; the no. of production runs for set-up; the no. of machine hours for
power costs. ● Calculate the cost driver rate for each activity by dividing the costs of
the activity centres by the respective total number or quantity of cost drivers.
● Step 4 – By applying the cost driver rates to products, assign costs of activities to
products based on the product’s demand for each activity. ● In this aspect, knowledge
of the quantity or number of each activity cost driver consumed by every individual
product is required.

4. (a) Calculation of unit product costs using traditional costing method:

 Calculation of predetermined overhead absorption rate:
Total machine hours = 480 + 300 + 160 + 360 = 1,300 hours
Total production overhead = 10,430 + 5,250 + 3,600 + 2,100 + 4,620 = $26,000.
Machine hour overhead absorption rate = $26,000 / 1,300 = $20 per machine
hour.
A ($) B ($) C ($) D ($)
Direct materials 40 50 30 60

Direct labour 28 21 14 21
Production overhead 80 60 40
60 Total cost 148 131 84
141

4. (b) Calculation of unit product costs using ABC:

 Calculation of cost-driver rates:
Activity $ Cost driver Total no. of Cost
cost drivers
driver
rate($)
Machine department 10,430 machine hours 1,300 8.02

Set-up 5,250 production runs 21 250

Stores receiving 3,600 requisitions raised 80 45
Inspection / quality control 2,100 production runs 21 100

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Finished products handling 4,620 orders executed 42 110
and dispatch

LaiACCT3500/Fall 20 (answers to tutorial 3)

Activity costs per unit of output:

Machine department: A = 8.02 x 4 = $32.08.
B = 8.02 x 3 = $24.06.
C = 8.02 x 2 = $16.04.
D = 8.02 x 3 = $24.06.
Set-up cost: A = (250 x 6) / 120 = $12.50.
B = (250 x 5) / 100 = $12.50.
C = (250 x 4) / 80 = $12.50.
D = (250 x 6) / 120 = $12.50.
Stores receiving cost: A = (45 x 20) / 120 = $7.50.

B = (45 x 20) / 100 = $9.00.

C = (45 x 20) / 80 = $11.25.
D = (45 x 20) / 120 = $7.50.
Inspection / quality control cost: A = (100 x 6) / 120 = $5.00.
B = (100 x 5) / 100 = $5.00.
C = (100 x 4) / 80 = $5.00.
D = (100 x 6) / 120 = $5.00.
Finished products handling and dispatch: A = (110 x 12) / 120 = $11.00
B = (110 x 10) / 100 = $11.00.
C = (110 x 8) / 80 = $11.00.
D = (110 x 12) / 120 = $11.00.
 Calculation of unit product cost using ABC method:
A ($) B ($) C ($) D ($)
Direct materials 40.00 50.00 30.00 60.00
Direct labour 28.00 21.00 14.00 21.00
Machine department 32.08 24.06 16.04 24.06
Set-up 12.50 12.50 12.50 12.50
Stores receiving 7.50 9.00 11.25 7.50
Inspection/quality control 5.00 5.00 5.00 5.00
Finished products handling
and dispatch 11.00 11.00 11.00 11.00
Total cost 136.08 132.56 99.79 141.06

4.(c) ● Product A is over-cost and C is under-cost under traditional costing system.

● A is over-priced and C is under-priced
● A appears to be unprofitable while C appears to be profitable.
● May make wrong decision to stop producing A.

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5. (a) Calculation of unit product costs using traditional costing method:
 Calculation of predetermined overhead absorption rate:
Total direct labour hours = 40,000 + 40,000 + 8,000 = 88,000
Total production overhead = $1,848,000
Overhead allocation rate = $1,848,000 / 88,000 = $21.00 per direct labour hour.
LaiACCT3500/Fall 20 (answers to tutorial 3)

X ($) Y ($) Z ($)

Direct materials 25.00 20.00 11.00
Direct labour 8.00 12.00 6.00
Fixed production overhead 28.00 42.00 21.00
Total cost 61.00 74.00 38.00

5.(b) Calculation of unit product costs using ABC:

 Calculation of cost-driver rates:
Activity $ Cost driver Total no. of Cost
cost drivers
driver
rate($)
Set-up 30,000 production runs 30 1,000.00
Machines 760,000 machine hours 76,000 10.00
Receiving 435,000 receipts 270 1,611.00
Packing 250,000 deliveries 32 7,812.50
Engineering 373,000 production orders 50 7,460.00

Activity costs per unit of output:

Set-up cost: product X = (1,000 x 3) / 30,000 = $0.10.
product Y = (1,000 x 7) / 20,000 = $0.35.
product Z = (1,000 x 20) / 8,000 = $2.50.
Machine cost: X = $13.33.
Y = $10.00.
Z = $20.00
Receiving cost: product X = (1,611 x 15) / 30,000 = $0.81.
product Y = (1,611 x 35) / 20,000 = $2.82.
product Z = (1,611 x 220 / 8,000 = $44.30.
Packing: product X = (7,812.5 x 9) / 30,000 = $2.34.
product Y = (7,812.5 x 3) / 20,000 = $1.17.
product Z = (7,812.5 x 20) / 8,000 = $19.53.
Engineering: product X = (7,460 x 15) / 30,000 = $3.73.
product Y = (7,460 x 10) / 20,000 = $3.73.
product Z = (7,460 x 25) / 8,000 = $23.31.

 Calculation of unit product cost using ABC method:

X ($) Y ($) Z ($)_
Direct materials 25.00 20.00 11.00
Direct labour 8.00 12.00 6.00

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 Set-up 0.10 0.35 2.50
Machines 13.33 10.00 20.00
Receiving 0.81 2.82 44.30
Packing 2.34 1.17 19.53
Engineering 3.73 3.73 23.31
Total cost 53.31 50.07 126.64
LaiACCT3500/Fall 20 (answers to tutorial 3)

5.(c) Comparison of product cost information:

● ABC system assigns overhead costs on a cause-and-effect basis whereas
traditional cost systems use cost drivers / absorption bases where no cause and
effect relationships exist. For example, (with reference to the company in the
question), in the traditional system, costs are assigned to products using a
volume-related base (direct labour hour) while in the ABC system, costs are
assigned to products using many cost drivers (cost driver rates), which are non-
volume-based such as the number of receipts for receiving activity and the
number of production runs for set-up costs.
● Using direct labour hour as the “cost driver”, the traditional system assigns
11/3 and twice the amount of fixed overheads to products X ($28.00) and Y
($42.00) respectively as compared to product Z ($21.00). An examination of the
data indicates that product Z consumes more cost drivers and therefore more
indirect activity resources than products X and Y; and product Z therefore
should be assigned a higher production overhead cost than products X and Y.
Appropriately, ABC assigns $20.31 and $18.07 and $109.64 of overhead costs to
products X, Y and Z respectively.

6.
(a) Traditional absorption costing:
No. of course days
Accountancy 50 x 2 = 100
Taxation 30 x 5 = 150
250

Overhead rate = £130,750 / 250 = £523 per course day

Overhead cost per Accountancy course = 2 days x £523 = £1,046 per course
Overhead cost per Taxation course = 5 days x £523 = £2,615 per course

Check (50 x £1,046) + (30 x £2,615) + £130,750

(b) ABC
Centre hire:
No. of cost drivers (course days) = 100 + 150 = 250 course days
Cost driver rate = £50,000 / 250 = £200 per course day

Enquiries administration:

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No. of cost drivers (enquiries) = 10,000 + 1,500 = 11,500 enquires
Cost driver rate = £34,500 / 11,500 = £3 per enquiry

Brochures:
No of cost drivers (brochures) = 12,500 + 6,000 = 18,500 brochures
Cost driver rate = £46,250 / 18,500 = £2.50 per brochure
LaiACCT3500/Fall 20 (answers to tutorial 3)

Activity Costs per course

Centre hire: Accountancy: 2 days x £200 per day = £400
Taxation: 5 days x £200 per day = £1,000

Enquiries: Accountancy: 200 x £3 per enquiry = £600

Taxation: 50 x £3 per enquiry = £150

Brochures: Accountancy: 250 x £2.50 per brochure = £625

Taxation: 200 x £2.50 per brochure = £500

Accountancy course total overhead costs = (£400 + £600 + £625) = £1,625

Taxation course total overhead costs = (£1,000 + £150 + £500) = £1,650

*N.B. cost per course day

Accountancy £812.50
Taxation £330

(c) - More accurate costing and therefore pricing of products mix; for example,
accountancy course should be allocated more overhead costs and the taxation course
should be allocated less overhead costs.
- Focuses management’s attention on the causes of costs – by reducing the causes (the
number of cost drivers) you can reduce the costs.

7.
(a) Sell Goods £46,000/ 2,000 units = £23 per unit
Process purchases = £9000/600 orders = £15 per order
Advertising = £60,000/200 = £300 per ad
Record Keeping = £13,000/250 product = £52 per product
Accepting returns = £2,000/80 = £25 per return
Use of Building = £64,000/14,000sm = £4.57 per square meter

Activity Comfybed (£) Fourtable (£)

Sell Goods (£23 per unit) 460 230
Process 45 30
Advertising 600 900
Record Keeping 52 52
Returns 75 50

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Use of Building 457 366
1,689 1,628
Purchase Cost 1,740 480
Total Cost 3,429 2,108
Unit Cost £171.45 £210.80

LaiACCT3500/Fall 20 (answers to tutorial 3)

(b) Total overheads/No of units = £194,000/2000 = £97 per unit

Cost Comfybed Fourtable
Purchase cost 87 48
Overheads 97 97
Total cost £184 £145

(c) ABC profit per unit

Comfybed Fourtable
Selling Price 320 199
Activity Based Cost 171.45 210.80
Profit (Loss) £148.55 (£11.80)

Traditional profit per unit

Comfybed Fourtable
Selling Price 320 199
Traditional method cost 184 145
Profit (Loss) £136 £54

Comments
Using Traditional Costing both products show profits but ABC shows that the Fourtable product
is, in fact, generating losses. The company needs to look at its pricing policy for this product
and/or look at the activities that cause the costs that are absorbed by this product. Depending on
the cost structure there might even be an argument to suspend the sales of Fourtables.