BBA – Managerial Accounting

Activity Base Costing (ABC Costing)

Activity based costing (ABC)

Activity based costing (ABC) involves the identification of the factors which cause the
costs of an organisation’s major activities. Support overheads are charged to products
on the basis of their usage of the factor causing the overheads.
The major ideas behind activity based costing are as follows.
(a) Activity cause costs. Activities include ordering, material handling, machining,
assembling, production scheduling and dispatching.
(b) Producing products creates demand for the activities.
(c) Costs are assigned to a product on the basis of the product’s consumption of the
activities.

Outline of an ABC system

An ABC system operates as follows.

Step 1 Identify an organisation’s major activities.

Step2 Identify the factors which determine the size of the costs of an
activity/cause the costs of an activity. These are known as cost drivers.

A cost driver is a factor which causes a change in the cost of an activity.

Look at the following examples.

Costs Possible cost driver
Ordering costs Number of orders
Material handling cost Number of production runs
Production scheduling costs Number of production runs
Despatching costs Number of despatches

Step 3 Collect the costs associated with each cost driver into what are known as
cost pools.

Step 4 Charge costs to products on the basis of their usage of activity. A

product’s usage of an activity is measured by the number of the activity’s
cost driver it generates.

Page 1 of 12
 BBA – Managerial Accounting

Question # 12.1
A company manufactures two products, L and M, using the same equipment and similar
processes. An extract of the production data for these products in one period is shown
below.
L M
Quantity produced (units) 5,000 7,000
Direct labour hours per unit 1 2
Machine hour per unit 3 1
Set-ups in the period 10 40
Orders handled in the period 15 60

Overhead costs Rs.

Relating to machine activity (based on machine hour) 220,000
Relating to production run set-ups (based on setup) 20,000
Relating to handling of orders (based on order handled) 45,000
285,000

Required:
Calculate the production overheads to be absorbed by one unit of each of the products
using the following costing method.
(a) A traditional approach using a direct labour hour rate to absorbed overheads.
(b) An activity based costing approach, using suitable cost drivers to trace overheads
to products.

Page 2 of 12
 BBA – Managerial Accounting
Question # 12.2
Southcott Ltd is a firm of financial consultants which offers short revision courses on
taxation and auditing for professional examinations. The firm has budgeted annual
overheads totaling Rs.152,625. Unit recently the firm has applied overheads on a
volume basis, based on the number of course days offered. The firm has no variable
costs and the only direct costs are the consultants’ own time which they divide equally
between their two courses. The firm is considering the possibility of adopting an activity
based costing (ABC) system and has identified the overhead costs as shown below.

Details of overheads Rs.

Centre hire 62,500
Enquiries administration 27,125
Brochures 63,000
Total 152,625

The following information relates to the past year and is expected to remain the same
for the coming year.
Course No. of Courses Duration of No. of No. of
sold courses enquiries per brochures
course printed per
course
Auditing 50 2 days 175 300
Taxation 30 3 days 70 200

All courses run with the maximum number of students (30), as it is deemed that beyond
this number the learning experience is severely diminished, and the same centre is hired
for all courses at a standard daily rate. The firm has the human resources to rum only
one course at any one time.

Required:
(a) Calculate the overhead cost per course for both auditing and taxation using
traditional volume based absorption costing.
(b) Recalculate the overhead costs per course using activity based costing and
explain your choice of cost driver in your answer.

Page 3 of 12
 BBA – Managerial Accounting
Question # 12.3
Abkaber assembles three types of motorcycle at the same factory: the 50cc sunshine;
the 250cc Roadster and the 1000cc fireball. It sells the motorcycles through the world.
In response to market pressures Abkaber has invested heavily in new manufacturing
technology in recent years and, as a result, has significantly reduced the size of its
workforce.
Historically, the company has allocated all overhead costs using total direct labour
hours, but it now considering introducing Activity Based Costing (ABC). Abkaber’s
accountant has produced the following analysis.

Motorcycle Annual output Annual direct Selling price Raw material

(units) labour hours (Rs. Per unit) cost (Rs. Per
unit)
Sunshine 2,000 200,000 4,000 400
Roadster 1,600 220,000 6,000 600
Fireball 400 80,000 8,000 900

The three cost drivers that generate overheads are:

Deliveries to retailers ---the number of deliveries of motorcycles to retail showrooms
Set-ups ---the number of times the assembly line process is re-set to
accommodate a production run of a direct type of motorcycle.
Purchase order ---the number of purchase orders.

The annual cost driver volumes relating to each activity and for each type of motorcycle
areas follows:
Motorcycle Number of Number of set-ups Number of
deliveries to purchase orders
retailers
Sunshine 100 35 400
Roadster 80 40 300
Fireball 70 25 100

The annual overhead costs relating to these activities are as follows:

Deliveries to retailers Rs.2,400,000
Set-up costs 6,000,000
Purchase orders 3,600,000

All direct labour is paid at Rs.5 per hour. The company holds no inventories.
Required:
Calculate the total profit on each of Abkaber’s three types of product using each of the
following methods to attribute overheads.
(i) the existing method based upon labour hours; and
(ii) activity based costing.

Page 4 of 12
 BBA – Managerial Accounting
Question # 12.4
The budgeted information relates to Brunti for the forthcoming period.
Products
XYI YZT ABW
Sales and production (units) 50,000 40,000 30,000
$ $ $
Selling price per unit 45 95 73
Prime cost per unit 32 84 65
Hours Hours Hours
Machine department (machine hours per unit) 2 5 4
Assembly department (labour hours per unit) 7 3 2

Overhead allocated and apportioned to production departments were as follows:

Machine department $504,000
Assembly department $437,000

You ascertain that the above overheads could be re-analysed into cost pools as follows
Cost pool $000 Cost driver Quantity for the
period
Machining services 357 Machine hours 420,000
Assembly services 318 Direct labour hours 530,000
Set up costs 26 Set ups 520
Order processing 156 Customer orders 32,000
Purchasing 84 Suppliers’ orders 11,200
941

You have also been provided with the following estimates for the budget period.
Product
XYI YZT ABW
Number of setup 120 200 200
Customer order 8,000 8,000 16,000
Suppliers’ order 3,000 4,000 4,200

Required:
Prepare and present budgeted profit statement using:
(a) Conventional absorption costing; and
(b) Activity base costing

Page 5 of 12
 BBA – Managerial Accounting
Question # 12.5
Jola Publishing Co publishes two forms of book.
The company publishes a children’s book (CB), which is sold in large quantities to
government controlled schools. The book is produced in only four large production runs
but goes through frequent government inspections and quality assurance checks.

The directors are keen to introduce AC for the coming year and have provided the
following cost and selling price data:
1. The paper used costs $2 per kg for a CB but the TJ paper costs only $1 per kg.
The CB uses 400g of paper for each book, four times as much as TJ uses.
2. Printing ink costs $30 per litre. The CB uses one third of the printing ink of the
large TJ. The TJ uses 150 ml of printing ink per book.
3. The CB needs six minutes of machine time to produce each book, whereas the TJ
needs 10 minutes per book. The machine cost $12 per hour to run.
4. The sales prices are to be $9.30 for the CB and $14.00 for the TJ.

There are three main overheads the data for these are:
Overhead Annual cost Activity driver
Property cost 2,160,000 Machine hours
Quality control 668,000 Number of inspections
Production setup costs 52,000 Number of setup
2,880,000
The CB will be inspected on 180 occasions next year, whereas the TJ will be inspected
just 20 times.
Jola publishing will produce its annual output of 1,000,000 CBS in four production runs
and approximately 10,000 TJs per month in each of 12 production runs.
Required:
(a) Calculate the cost per unit and the margin for CB and the TJ using machine hours
to absorb the overheads.
(b) Calculate the cost per unit and the margin for the CB and the TJ using activity
base costing principles to absorb the overheads.

Page 6 of 12
 BBA – Managerial Accounting
Question # 12.6
Linacre Co operates an activity base costing system and has forecast the following the
following information for next year.
Cost pool Cost$ Cost Driver Number of drivers
Production setup 105,000 setups 300
Product testing 300,000 Test 1,500
Component supply and storage25,000 Component order 500
Customer orders and delivery112,500 Customer orders 1,000

General fixed overheads such as lighting and heating, which cannot be linked to any
specific activity, are expected to be $900,000 and these overheads are absorbed on a
direct labour hour’s basis. Total direct labour hours for next year are expected to be
300,000 hours.

Linacre Co expects orders for Product ZT3 next year to be 100 orders of 60 units per
order and 60 orders of 50 units per order. The company holds no inventory of product
ZT3 and will need to produce the order requirement in production runs of 900 units.
One order for components is placed prior to each production run. Four tests are made
during each production run to ensure that quantity standards are maintained. The
following additional cost and profit information relates to product ZT3:
Component cost: $1.00 per unit
Direct labour 10 minutes per unit at $7.80 per hour
Profit markup 40% of total unit cost
Required:
(a) Calculate the activity base recovery rate for each cost pool.
(b) Calculate the total unit cost and selling price of product ZT3.

Page 7 of 12
 BBA – Managerial Accounting
Question 12.1
(a) Traditional costing approach
Direct labour hours
Product L = 5,000 units x 1 hour 5,000
Product M = 7,000 units x 2 hours 14,000
19,000
Overhead absorption rate = $285,000
19,000
= $15 per hour
Product L 1 hour x $15 = $15 per unit
Product M 2 hours x $15 = $30 per unit

(b) ABC approach

Machine hours
Product L = 5,000 units x 3 hours 15,000
Product M = 7,000 units x 1 hour 7,000
22,000
Using ABC the overhead costs are absorbed according to the cost drivers.
Machine hour driven costs $220,000/22,000 machine hour = $10 per machine hour
Set-up driven costs $20,000/50 set-ups = $400 per set-up
Order driven costs $45,000/75 order =$600 pr order

Overhead costs are therefore as follows.

Product L ($) Product M ($)
Machine driven costs (15,000 hours x $10) 150,000 (7,000 hours x $10) 70,000
Set-up costs (10 x $400) 4,000 (40 x $400) 16,000
Order handling cost (15 x $600) 9,000 (60 x $600) 36,000
163,000 122,000
Units produced 5,000 7,000
Overhead cost per unit $32.60 $17.43

Solution # 12.2
(a) Traditional volume base absorption costing
Auditing Taxation Total
Number of courses sold 50 30
Duration of course (day) 2 3
Number of course day 100 90 190

Overhead cost per course day = $152,625/190 = $803.29

Overhead cost per course

Auditing $803.29 x 2 days = $1,606.58
Taxation $803.29 x 3 days = $2,409.87

Page 8 of 12
 BBA – Managerial Accounting
(b) Overhead costs per course using activity based costing
Auditing per course ($) Taxation per course ($) Total
Centre hire (W1) 657.90 986.85
Enquiries administration (W2) 437.50 175.00
Brochure (W3) 900.00 600.00
Overhead cost per course 1,995.40 1,761.8
Working notes:
1. Centre hires cost per course day.
= $62,500/190 = $328.95
2. Enquiries administration cost per enquiry.
= $27,125/ (50 x 175) + (30 x 70) = $2.50
3. Brochure cost per brochure printed:
= $63,000/ (50 x 300) + (30 x 200) = $3 per brochure

Solution # 12.3
(a) Existing method
Sunshine ($) Roadster ($) Fireball ($)
Direct labour 1,000,000 1,100,000 400,000
Material 800,000 960,000 360,000
Overhead 4,800,000 5,280,000 1,920,000
Total cost 6,600,000 7,340,000 2,680,000
Output unit 2,000 1,600 400
$ $ $
Selling price 4,000 6,000 8,000
Cost per unit 3,300 4,578.5 6,700
700 1,412.5 1,300
Total profit (unit output x profit/unit) 1,400,000 2,260,000 520,000
Total profit = $4,180,000

(b) Activity base costing

Sunshine ($) Roadster ($) Fireball ($)
Direct labour 1,000,000 1,100,000 400,000
Material 800,000 960,000 360,000
Deliveries 960,000 768,000 672,000
Setup costs 2,100,000 2,400,000 1,500,000
Purchase order 1,800,000 1,350,000 450,000
6,600,000 6,578,000 3,382,000
Output units 2,000 1,600 400
$ $ $
Selling price 4,000 6,000 8,000
Cost per unit 3,330 4,111.25 8,455
670 1,888.75 (455)
Total profit/ (loss) 1,340,000 3,022,000 (182,000)
Total profit= $4,580,000

Page 9 of 12
 BBA – Managerial Accounting
Solution # 12.4
(a) Absorption Costing
XYI YZT ABW Total
Volume 50,000 40,000 30,000
$000 $000 $000 $000
Sales 2,250 3,800 2,190
Prime cost (1,600) (3,360) (1,950)
Overhead
Machine at $1.20/hr (W1) (120) (240) (144)
Assembly at $0.825/hr (W2) (289) (99) (49)
241 101 47 389
(b) Activity base costing
XYI YZT ABW Total
Volume 50,000 40,000 30,000
$000 $000 $000 $000
Sales 2,250 3,800 2,190
Prime cost (1,600) (3,360) (1,950)
Overhead (W3)
Machine at $0.85/hr (85) (170) (102)
Assembly at $0.60/hr (210) (72) (36)
Set-ups at $50/setup (6) (10) (10)
Ordering at $4.875/order (39) (39) (78)
Purchasing at $7.50/order (23) (30) (31)
Profit 287 119 (7)

Working note:
1. Machine
Total machine hours = (2 x 50,000) + (5 x 40,000) + (4 x 30,000) = 420,000
= $504,000/420,000 = $1.20 per machine hour
2. Assembly
Total assembly hours = (7 x50,000) + (3 x 40,000) + (2 x 30,000) = 530,000
= $437,000/530,000 = $0.825 per assembly hour
3. Overhead (ABC)
Cost pool Machining Assembly Setup Ordering
$000 357 318 26 156
Driver quantity 420,000 530,000 520 32,000
Rate $0.85/hr $0.6/hr $50/setup $4.875/order

Solution # 12.5
(a) Cost per unit calculation using machine hours for overhead absorption
$CB $TJ
Paper (400g at $2/kg) 0·80 (100g at $1/kg) 0·10
Printing (50ml at $30/ltr) 1·50 (150ml at $30/ltr) 4·50
Machine cost (6 mins at $12/hr) 1·20 (10 mins at $12/hr) 2·00
Overheads (6 mins at $24/hr) (W1) 2·40 (10 mins at $24/hr) 4·00
–––– ––––––
Total cost 5·90 10·60

Page 10 of 12
 BBA – Managerial Accounting
Sales price 9·30 14·00
–––– ––––––
Margin 3·40 3·40
–––– ––––––

(W1) Workings for overheads:

Total overhead $2,880,000
Total machine hours
(1,000,000 x 6 mins) + (120,000 x 10 mins) = 7,200,000 mins
Which is 120,000 hours
Cost per hour =$2,880,000
––––––––– = $24/hr
120,000 hrs
(b) Cost per unit calculations under ABC
CB TJ
$ $
Paper (400g at $2/kg) 0·80 (100g at $1/kg) 0·10
Printing (50ml at $30/ltr) 1·50 (150ml at $30/ltr) 4·50
Machine cost (6 mins at $12/hr) 1·20 (10 mins at $12/hr) 2·00
Overheads (W2) 2·41 (W2) 3·88
–––– ––––––
Total cost 5·91 10·48
Sales price 9·30 14·00
–––– ––––––
Margin 3·39 3·52
–––– ––––––

(W2) Working for ABC overheads alternative:

Total CB TJ No of drivers Cost/driver CB TJ
$ $ $
Property costs 2,160,000 1,800,000 360,000 120,000 18/hr 1·80 3·00
Quality control 668,000 601,200 66,800 200 3340 0·6012 0·56
Production set up 52,000 13,000 39,000 16 3250 0·013 0·325
Total 2,880,000 2,414,200 465,800 Cost per unit 2·41 3·88
Production level 1,000,000 120,000
Cost per unit 2·41 3·88

Solution # 12.6
(a) Activity base costing
Activity based recovery rates are found by dividing the expected cost in each cost pool by the
number of cost driver transactions expected during the coming year.
Cool Pool Cost ($) Number of Drivers ABC recovery rate ($)
Production setup 105,000 300 set-ups 350 per set-up
Production testing 300,000 1,500 tests 200 per test
Component supply/storage 25,000 500 component orders 50 per order
Customer orders/delivery 112,500 1,000 customer order 112.50 per order

Page 11 of 12
 BBA – Managerial Accounting

(b) Production of product ZT3 = (100 x 60) + (60 x 50) = 9,000 units per year
Number of production runs = number of setups = 9,000/900 = 10 setup
Number of production test = 10 x 4 = 40 tests
Number of component orders = number of production runs = 10 orders
Number of customer orders = 100 + 60 = 160 orders
General overhead absorption rate = 900,000/300,000 = $3 per direct labour hour
Annual direct labour hours for production ZT3 = 9,000 x 10/60 = 1,500 hours

Activity ABC recovery rate ($) Number of drivers Annual cost ($)
Setting up 350 per setup 10 setup 3,500
Production testing 200 per test 40 tests 8,000
Component supply 50 per order 10 orders 500
Customer supply 112.50 per order 160 orders 18,000
30,000
General overheads = 1,500 x $3 per hour 4,500
Total annual overhead cost 34,500

Total unit cost $

Components 1.00
Direct labour = 7.80 x 10/60 1.30
Overheads = 34,500/9,000 3.83
6.13
Profit mark up 2.45
Selling price 8.58

Page 12 of 12