Queen Mary University of London,

Chandres Tejura
Email: c.tejura@qmul.ac.uk
Office hours: Thursday 12-3pm

Lecture / Seminar 3: Activity-based costing (ABC) system

Drury Chapter 11

It was 1988, and Cooper and Kaplan unveiled ABC….

Activity-based costing (ABC) is a costing method that is used to allocate costs to products,
services or customers based on the consumption of resources caused by activities. An
activity is work performed in an organisation in the process of manufacturing a product or
providing a service. ABC recognises that in the long run most manufacturing costs are not
fixed and that it is activities that cause costs and that products create the demands for
activities.

The implementation of an ABC system involves the following steps:

1. Identifying the activities that take place in the course of production, e.g., product
design, machine setup, materials handling and sales order processing.

2. Identifying appropriate cost drivers – which are factors that influence the cost of an
activity. The cost driver in the sales processing department, for example, would be
the number of orders that are received since, as the company receives additional
orders, it will have to carry out additional sales processing.

3. Creating activity cost pools to accumulate the costs associated with each activity.
A cost pool is analogous to a cost centre under absorption costing system.

4. Allocating the total cost of each activity cost pool to cost objects in proportion to
their consumption of an activity. A cost object may be a product, service, customer
or organisational unit to which costs are accumulated for some management
purpose.

The aim of any product costing system is to ensure that a fair share of costs is charged to
each product or service. ABC attempts to do this by requiring departmental managers to
concentrate on the activities which cause the costs to arise and hence to control these
activities. In a typical manufacturing process, the following four levels of activities can be
identified:

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. Unit-level activity – performed for each unit of production, e.g., the amount of direct
materials or the hours of labour used in the manufacture of a product and the
inspection of a product for quality control purposes.

. Batch-level activity – performed for each batch of products as opposed to each unit
of production, e.g., setting up machines, scheduling of production and handing
materials for batch production.

. Product-sustaining activity – performed to support the production of a specific

product, e.g., product design and development and providing after-sales service
such as warranty.

. Facility-sustaining activity – performed to support the manufacturing of products in

general, e.g., plant maintenance and provision of security and safety facilities.

Illustrative example of ABC

Flipmode Ltd has a single production process. The following costs were estimated for
the month
just ended:

Material receipt and inspection cost £15,600

Power cost £19,500
Material handling cost £13,650

Three products (A, B and C) are produced by workers who perform a number of
operations on material blanks using hand-held electrically-powered tools. The wage
rate is £6.00 per hour.
The following budgeted information has been obtained for the month.

Product A B C

Production quantity (units) 2,000 1,500 800

Batches of material 10 5 16

Data per unit

Direct material (square metres) 4 6 3
Direct material cost (£) 5 3 6
Direct labour (minutes) 24 40 60
Number of drill operations 6 3 2

Presently, overhead costs for material receipt and inspection, process power and
material handling are absorbed into the units on the basis of direct labour hours.
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However, an ABC investigation has revealed that the cost drivers for the overhead costs
are as follows:

Material receipt and inspection : number of batches

Process power : number of drill operations
Material handling : quantity of materials handled (square metres)

Required: Prepare a summary showing the budgeted cost per unit for each product:

(a) Using the existing method for absorption of overheads (traditional approach);

(b) Using an approach that recognises the cost drivers revealed in the ABC
investigation.

Solution

(a) Using Traditional Approach

The existing approach absorbs overheads on a direct labour hour basis.

Total number of hours budgeted = ( ¿ 24 minutes) + (1,500 ¿

minutes)
+ (800 ¿ 60 minutes) = hours

£ 48 ,750
Therefore, the overhead absorption rate =
( ) = £ per labour
hour.

(b) Using ABC approach

W1 – Material receipt and inspection : Cost Driver = Number of batches.

Total batches = = batches.

Therefore, the cost to receive and inspect each batch =

( £15 ,600 ) = £503.22
per batch

Unit overhead cost allocation = Number of batches x Cost per batch

Number of units

Product A B C
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 Number of batches 10 5 16
Number of units 2,000 1,500 800

10 × £ 503 .22 × £ 503 .22 × £ 503 .22

( 2 , 000 ) ( ) ( )
£2.52 £ £

W2 – Power cost – Cost driver = Number of drill operations.

Total drill operations = (2,000 ¿ 6) + (1,500 ¿ 3) + (800 ¿ 2) =

drill operations

Therefore, the cost of a drill operation =

(18£ , 100 ) = £ per drill
operation

Unit overhead cost allocation = Number of dills ¿ Cost per drill operation

Product A B C
Number of drills 6 3 2
(£ × 6) (£ × 3) (£ × 2)
£ £ £

W3 – Material handling – Cost driver = Quantity of materials handled in square

metres.

Total material handled = (2,000 ¿ 4) + ( ¿ 6) + ( ¿ 3) =

square metres

£ 13,650
Therefore, the cost of square metre handled =
( ) = £ per
square metre

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Unit overhead cost allocation = Number of square metres ¿ Cost per
square metre

Product A B C
Number of square metre 4 6 3
(£ × 4) (£ × 6)
(£ × 3)
£ £ £

Comparison of Unit cost of product under the two costing methods

Budgeted cost per unit (Traditional costing) A B C

£ £ £
Materials 20.00 18.00 18.00
Labour (£6 per hour)
Overheads (£18.75 per hour)
Total cost per unit £ £ £

Budgeted cost per unit (ABC) A B C

£ £ £
Materials 20.00 18.00 18.00
Labour (£6 per hour)
Overheads:
Material receipt and inspection (W1)
Process power (W2)
Material handling (W3)

Total cost per unit £ £ £

Under the traditional method of costing, Product A is allocated a low amount of overheads
as each unit needs only 24 minutes to complete while Product C is allocated more than
twice the amount of overheads allocated to the former product because of its completion
time. The traditional method fails to recognise that the overheads incurred are not affected
by labour time.

In contrast, ABC recognises the factors (the levels of activities consumed) that drive the
overhead costs and allocates overheads to each product on the basis of how each product
uses each activity. Thus, for example, Product A is allocated a higher amount of power

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costs as it requires 6 drill operations whereas the other products require fewer drill
operations.

Advantages and disadvantages of an ABC costing system

The major benefits of ABC can be summarised as follows:

. More accurate and informative product costs are provided, which can result in more
accurate product profitability measurements and better-informed strategic decisions
about pricing, product line and customer market.

. More accurate measurements of activity-driven costs are provided, which can

assist management in improving product and process value through making better
product design decisions and cost control.

. Management is provided easier access to relevant costs for making business

decisions, thus enabling it to adopt a more competitive position.

Some of the limitations of ABC include the following:

. Even if activity data are available, some costs may still require to be allocated to
departments or products using some arbitrary measure since it may be difficult and
impractical to identify the specific activity that caused the cost to be incurred.

. Some costs, such as marketing, advertising, research and development costs, are
not usually included in the ABC cost analysis even though these costs are
important in determining the overall costs of a product or service.

. An ABC system is usually very costly to develop and implement and the whole
process can be very time consuming.

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