Activity based costing (ABC) ….

Feb 2020
Introduction
ABC is a modern alternative to absorption costing which attempts to overcome the
problems of costing in a modern manufacturing environment.

Traditional absorption costing

Traditional absorption costing uses a single basis for absorbing all overheads into cost
units for a particular production department cost centre.
A business will choose the basis that best reflects the way in which overheads are being
incurred, eg in an automated business much of the overhead cost will be related to
maintenance and repair of the machinery. It is likely that this will vary to some extent with
machine hours worked so we would have used a machine hour absorption rate.

Activity based costing

Production overheads are by no means all volume-related and hence a single basis for
absorption, eg labour hours, would not adequately reflect the complexity of producing
certain products/cost units as opposed to others.
ABC is an extension of absorption costing specifically considering what causes each
type of overhead category to occur, ie what the cost drivers are. Each type of overhead
is absorbed using a different basis depending on the cost driver.

Steps in ABC
(1) Group overheads into activities, according to how they are driven. These are known
as cost pools.
(2) Identify the cost drivers for each activity, ie what causes the activity cost to be
incurred.
(3) Calculate a cost per unit of cost driver.
(4) Absorb activity costs into production based on usage of cost drivers.

Cost driver analysis

Today's complex business environment means that costs are incurred because cost
drivers occur at different levels.

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There are four key categories for activities and their related costs.
Categories Type of cost Cost driver
Unit Direct Units produced
Batch Set ups Batch produced
Inspection
Product R&D Product produced
Marketing
Facility sustaining Depreciation None
Rent
The difference between unit costs under absorption costing and ABC depends upon the
proportion of overhead in each category.
If most overheads are unit level or facility sustaining the costs will be similar.
If overheads are batch or product sustaining costs, the resulting unit costs will be very
different.

Absorption costing vs Activity based costing

Overhead absorption rates using ABC should be more closely linked to the causes of
overhead costs.
The modern business environment has much wider product ranges than seen before,
complex production process and decreasing product lifecycles. ABC recognises these
factors by using multiple cost drivers when absorbing overheads.

Implications of ABC
When ABC should be used
(a) When production overheads are high relative to prime costs (eg service sector)
(b) When there is a whole diversity of product range
(c) When there are considerable differences in the use of resources by products
(d) Where consumption of resources is not driven by volume

Benefits of ABC
The use of ABC provides opportunities for
(a) Cost control and reduction by the efficient management of cost drivers
(b) Better costing information used to assist pricing decisions
(c) Reanalysis of production and output/product mix decisions
(d) Profitability analysis (by customer, product line etc)
(e) A more realistic estimate of costs and profits which can be used in performance
appraisal

Criticisms of ABC
(a) It is time consuming and expensive
(b) Will be of limited benefit if overhead costs are primarily volume related
(c) Reduced benefit if the company is producing only one product or a range of products
with similar costs
(d) Complex situations may have multiple cost drivers
(e) Some arbitrary apportionment may still exist

Before considering a switch to ABC it is important to consider whether the benefits

outweigh the costs and to ensure that the appropriate cost drivers can be identified
as such a switch will have implications on:
• Pricing • Performance management
• Sales strategy • Decision making
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Q.1 F plc supplies pharmaceutical drugs . Although the company makes a satisfactory return,
the directors are concerned that some orders are profitable and others are not. The
management has decided to investigate a new budgeting system using activity based costing
principles to ensure that all orders they accept are making a profit.
Each customer order is charged as follows. Customers are charged the list price of the drugs
ordered plus a charge for selling and distribution costs (overheads). A profit margin is also
added, but that does not form part of this analysis.
Currently F plc uses a simple absorption rate to absorb overheads. The rate is calculated
based on the budgeted annual selling and distribution costs and the budgeted annual total list
price of the drugs ordered.
An analysis of customers has revealed that many customers place frequent small orders with
each order requesting a variety of drugs. The management of F plc has examined more
carefully the nature of its selling and distribution costs, and the following data have been
prepared for the budget for next year:
Total list price of drugs supplied Rs 8m
Number of customer orders 8,000
Selling and Distribution Costs Rs 000 Cost driver
Invoice processing 280 See Note 2
Packing 220 Size of package – see Note 3
Delivery 180 Number of deliveries – see Note 4
Other overheads 200 Number of orders
Total overheads 880
Notes:
1. Each order will be shipped in one package and will result in one delivery to the customer
and one invoice (an order never results in more than one delivery).
2. Each invoice has a different line for each drug ordered. There are 28,000 invoice lines
each year. It is estimated that 25% of invoice processing costs are related to the
number of invoices, and 75% are related to the number of invoice lines.
3. Packing costs are Rs 32 for a large package, and Rs 25 for a small package.
4. The delivery vehicles are always filled to capacity for each journey. The delivery
vehicles can carry either 6 large packages or 12 small packages (or appropriate
combinations of large and small packages). It is estimated that there will be 1,000
delivery journeys each year, and the total delivery mileage that is specific to particular
customers is estimated at 350,000 miles each year. Rs 40,000 of delivery costs are
related to loading the delivery vehicles, and the remainder of these costs are related to
specific delivery distance to customers.

The management has asked for two typical orders to be costed using next year’s budget data,
using the current method, and the proposed activity-based costing approach. Details of two
typical orders are shown below:
Order A Order B
Lines on invoice 2 8
Package size small large
Specific delivery distance 8 miles 40 miles
List price of drugs supplied Rs 1,200 Rs 900

Required:
Calculate the charge for selling and distribution overheads for Order A and Order B
using:
(i) the current system; and
(ii) the activity-based costing approach. (10 marks)
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Q.2 K makes many products, one of which is Product Z. K is considering adopting an activity-based
costing approach for setting its budget, in place of the current practice of absorbing overheads
using direct labour hours. The main budget categories and cost driver details for the whole
company for October are set out below, excluding direct material costs:
Budget category Rs Cost driver details
Direct labour 128,000 8000 direct labour hours
Set-up costs 22,000 88 set-ups each month
Quality testing costs* 34,000 40 tests each month
Other overhead costs 32,000 absorbed by direct labour hours
* A quality test is performed after every 75 units produced

The following data for Product Z is provided:

Direct materials budgeted cost of Rs 21·50 per unit
Direct labour budgeted at 0·3 hours per unit
Batch size 30 units
Set-ups 2 set-ups per batch
Budgeted volume for October 150 units
Required:
a) Calculate the budgeted unit cost of product Z for October assuming that a direct
labour based absorption method was used for all overheads. (2 marks)
b) Calculate the budgeted unit cost of product Z for October using an activity-based costing
approach. (3 marks)

Q.3 DRP Limited has recently introduced an Activity Based Costing system. It manufactures
three products, details of which are set out below:
Product D Product R Product P
Budgeted annual production 100,000 100,000 50,000
Batch size (units) 100 50 25
Machine set-ups per batch 3 4 6
Purchase orders per batch 2 1 1
Processing time per unit (minutes) 2 3 3
Three cost pools have been identified. Their budgeted costs for the year ending
31 December 2014 are as follows:
Machine set-up costs Rs 150,000
Purchasing of materials Rs 70,000
Processing Rs 80,000
Required:
a) Calculate the annual budgeted number of:
(a) batches
(b) machine set-ups
(c) purchase orders
(d) processing minutes (2 marks)
b) Calculate the budgeted overhead unit cost for Product R for inclusion in the
budget for 2014. (4 marks)

Q.4 RJ produces and sells two high performance motor cars: Car X and Car Y. The company
operates a standard absorption costing system. The company’s budgeted operating statement
for the year ending 30 June 2008 and supporting information is given below:
Operating statement year ending 30 June 2008

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 Car X Car Y Total
- Rs'000 ' Rs'000 ' Rs'000 '
Sales 52,500 105,000 157,500
Production cost of sales 40,000 82,250 122,250
Gross profit 12,500 22,750 35,250
Administration costs
Variable 6,300 12,600 18,900
Fixed 7,000 9,000 16,000
Profit/(loss) (800) 1,150 350

The production cost of sales for each car was calculated using the following values:
Car X Car Y
Units Rs'000 ' Units Rs'000 '
Opening inventory 200 8,000 250 11,750
Production 1,100 44,000 1,600 75,200
Closing inventory 300 12,000 100 4,700
Cost of sales 1,000 40,000 1,750 82,250
Production costs

The production costs are made up of direct materials, direct labour, and fixed production
overhead. The fixed production overhead is general production overhead (it is not product
specific). The total budgeted fixed production overhead is Rs 35,000,000 and is absorbed
using a machine hour rate. It takes 200 machine hours to produce one Car X and 300
machine hours to produce one Car Y.
Administration costs

The fixed administration costs include the costs of specific marketing campaigns:
Rs 2,000,000 for Car X and Rs 4,000,000 for Car Y.

Required:
(a) Produce the budgeted operating statement in a marginal costing format. (7 marks)
(b) Reconcile the total budgeted absorption costing profit with the total budgeted
marginal costing profit as shown in the statement you produced in part (a). (5 marks)

The company is considering changing to an activity based costing system. The company has
analysed the budgeted fixed production overheads and found that the costs for various activities
are as follows:
Rs'000 '
Machining costs 7,000
Set up costs 12,000
Quality inspections 7,020
Stores receiving 3,480
Stores issues 5,500
35,000

The analysis also revealed the following information: Car X Car Y

Budgeted production (number of cars) 1,100 1,600
Cars per production run 10 40
Inspections per production run 20 80
Number of component deliveries during the year 492 900
Number of issues from stores 4,000 7,000

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 Required:
(c) Calculate the budgeted production cost of one Car X and one Car Y using the
activity based costing information provided above. (10 marks)

Q.5 CJD Ltd manufactures plastic components for the car industry. The following budgeted
information is available for three of their key plastic components:
W X Y
Selling price Rs per unit 20 183 175
Direct material 50 40 35
Direct labour 30 35 30
Units produced and sold 10,000 15,000 18,000

The total number of activities for each of the three products for the period is as follows:
Number of purchase requisitions 1,200 1,800 2,000
Number of set ups 240 260 300
Overhead costs have been analysed as follows:
Receiving/inspecting quality assurance £1,400,000
Production scheduling/machine set up £1,200,000
Calculate the budgeted profit per unit for each of the three products using activity based
budgeting. (4 marks)

Q.6 Privmed is a privately owned profit seeking hospital that specialises in operations to
replace hip and knee joints. Privmed traditionally determines its prices by adding a 10%
mark-up to the budgeted full cost of an operation. The fixed overheads are absorbed on
the basis of operating hours using a predetermined rate.
Privmed Operating and Financial Data for 2001
Hip Knee Total
Total operating capacity (hours) 10,800
Average duration of operation 3·0 hours 3·6 hours
Number of operations taken * 1,270
Total Costs £15,036,780
Fixed overheads £12,000,000

The variable costs per operation are as budgeted.

Privmed Budgeted Data for 2001
Annual operating hours 8,000
Variable cost per operation £ 1450 *
* not given

Required:
(a) Calculate the number of hip operations undertaken during the year and the variable
cost of performing a knee operation. (4 marks)

(b) Calculate the prices that Privmed would have charged in 2001 for:
(i) A hip operation; (ii) A knee operation. (4 marks)

(c) An activity based costing study recently discovered that the fixed overheads are
determined by non operating time related activities. The study revealed the following data:

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 Activity Cost Driver Hip Knee Fixed 0verheads
Consultations with Number of 3,000 2,000 £8,980,000
potential patients consultations
X-rays Number of X-rays 6,200 6,200 £1,800,000
Post-operative care Days of care 7,860 23,580 £1,220,000

Required:
Re-calculate the prices that would have been charged in 2001 for each knee and hip
operation by using an activity based costing approach. (5 marks)

Q.7 Playlearn manufactures plastic toys for children which also have a strong educational value.
These toys are mainly supplied to a variety of independent shops selling toys, children's
clothings and accessories. In the past year, Playlearn has been successful in negotiating
a large contract with an international chain store to supply product B. The company is currently
in the process of preparing the production budget for the year ending 31-3-2011.

The managing director is concerned that some models in the present range may be
unprofitable and that as sales expand some production may have to be placed with other
companies. Selling prices are dictated by the market and in the face of strong competition
there is a little opportunity to raise prices, although the market is growing.

The factory is highly automated. All the toys use a common injection moulding process,
although differences occurs in the amount of material required. Also, depending on the
complexity of the mould, the amount of time needed for hand finishing varies between
models. The hand finishing process uses relatively unskilled labour, mostly part time
staff who are paid on a piece work basis.

The management accountant has prepared the following cost data for the year
ended 31-3-2010.

Model A B C D
Sales (units) 40,000 120,000 60,000 20,000
Material Cost £ 1.10 0.80 2.30 3.95
Direct Labour 0.40 0.20 1.60 2.20
Variable overhead 0.27 0.27 0.27 0.27
Fixed overhead @ 320%
of labour cost 1.28 0.64 5.12 7.04
Total cost 3.05 1.91 9.29 13.46
Profit 0.95 0.29 (0.29) 2.54
Selling price 4.00 2.20 9.00 16.00

The following estimates are available for next year.

Sales (units) 45,000 130,000 55,000 20,000

Production is equal to sales, there are no stocks

Price adjustments
Material Cost minus 2%
Direct Labour plus 5%
Variable overhead no change
Total fixed overhead £609,840
Selling price no change
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 Required:
a) Prepare a table showing the budgeted full cost, revenue and profit for each product
line and in total for the year ending 31-3-2011. Marks: 10
b) Redraft the budget on a marginal costing basis Marks: 3
(Note a summary statement only is required)

As a result of attending a seminar on activity based costing, the managing director has
asked for further information. The management accountant has produced the following
analysis of the fixed overheads.
Note £
Factory rent and power 1 148,000
Indirect labour 2 145,000
Stores and testing of materials received 3 70,000
Marketing 4 58,000
Despatch - packaging and transport 5 93,000
Administration 6 95,840
609,840
The following notes have also been prepared as a result of management accountant's
investigations.
1 Factory rent and power is related to the number of machines used in production. Each
machine is capable of producing 10,000 units of model B or 5,000 units of A, C and D
2 Indirect labour is mainly associated with setting up the machine for each production batch
as a result of change in color and variation in model demand throughout the year. The
average production batch is 500 units for model D, 1,000 units for model A and C. Model
C is produced continuously throughout the year, although five setups in total are
programmed each year to allow for maintenance work.
3 The cost of storage and material testing is related to the cost of raw material consumed.
4 Model B is produced exclusively for a large chain store. The contract is negotiated on
an annual basis. As such only 10% of marketing costs are thought to relate to model B.
The remainder of marketing costs occur evenly across the other products.
5 Model B is delivered to the central warehouse of the chain store in 12 consignments
each year. Each of these consignment cost £750 to deliver. The remainder of the despatch
cost are related to the total number of units delivered for model A, C and D.
6 As a result of time logs completed by office staff, the administration costs have been
assigned tot eh four models as follows: model A £26,021 model B £17,169 model C
£33,482 and model D £19,168
Required:
c) Redraft the budget using activity based costing Marks: 10
d) State what your advice would now be to the management Marks: 2

Q.8 Mega Incorporations is at the leading edge of paint-spraying technology. It has three
May customers ‘A’, ‘B’ and ‘C’ who produce ‘B-1’, ‘B-3’ and ‘B-5’ products respectively.
2014 These products are finished by Mega Incorporation after final completion. Product B-1
requires 6 coats of paint, product B-3 requires 4 coats and product B-5 requires 3 coats
of paint. All products are of different shapes and sizes therefore, different quantities of
paint are needed. Paint is delivered in batches of various sizes, depending upon the
finishing required.
Product Litres per Unit
B-1 7
B-3 5
B-4 4
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 Production details for each product are budgeted as follows for the coming month:
B-1 B-3 B-4
Units sprayed 500 400 300
Batches of paint required 10 8 6
Machine attendant time (mins) 45 60 50
Cost of paint per unit Rs. 550 500 450
Machine attendants are paid Rs. 86 per hour.
Estimated overheads in the coming month are given below:
Rupees
Paint stirring and quality control 50,000
Electricity 150,000
Filling of spraying machines 90,000

Cost drivers used for each activity are as follows:

Activity Cost Driver
Paint stirring and quality control Batches of paint
Electricity Coats of paint
Filling of spraying machines Litres of paint
Required:
Calculate the unit cost using activity based costing approach. 08

Q.9 A company plans to experiment activity based costing (ABC) by applying its principles to
Sept its four products. Details and relevant information are given below for a particular month:
2013 Products W X Y Z
Output in units 120 100 80 120
Cost per unit: Rupees
Raw material 40 50 30 60
Direct labour 28 21 14 21
Machine hours per unit 4 2 2 3
All the products are similar and usually manufactured in production runs of 20 units and
sold in batches of 10 units. Manufacturing overhead is currently absorbed by using a
machine hour rate of Rs. 20 per hour. Total overhead for the month and cost drivers to be
used are as follows:
Manufacturing overhead Cost driver
Amount (Rs.) to be used
Machine department cost 10,430
Set-up costs 5,250 Number of production runs
Stores receiving 3,600 Requisitions raised
Inspection/ quality control 2,100 Number of production runs
Materials handling and despatch 4,620 Orders executed
Number of requisition raised on the stores was 20 for each product and number of orders
executed was 42. Each order has a batch of 10 units.
Required:
Calculate the following:
(i) Total cost for each product, if all overhead costs are absorbed on machine hour basis. 02
(ii) Manufacturing overhead cost per unit. 04
(iii) Total cost for each product, using ABC approach. 06

Q.10 XY provides accountancy services and has three different categories of client: limited companies,
self employed individuals, and employed individuals requiring taxation advice. XY currently
charges its clients a fee by adding a 20% mark-up to total costs. Currently the costs are attributed
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 to each client based on the hours spent on preparing accounts and providing advice.
XY is considering changing to an activity based costing system. The annual costs and the causes
of these costs have been analysed as follows:
Accounts preparation and advice 580,000
Requesting missing information 30,000
Issuing fee payment reminders 15,000
Holding client meetings 60,000
Travelling to clients 40,000
The following details relate to three of XY’s clients and to XY as a whole:
Client A B C XY
Hours spent on preparing
accounts and providing advice 1,000 250 340 18,000
Requests for missing information 4 10 6 250
Payment reminders sent 2 8 10 400
Client meetings held 4 1 2 250
Miles travelled to meet clients 150 600 - 10,000
Required:
Prepare calculations to show the effect on fees charged to each of these three clients of
changing to the new costing system.

Q.11 Feroz & Company manufactures three products, `A', `B' and `C'. Each product uses
many years, the company has been using full absorption costing and absorbing overheads
May-18
on the basis of machine hours. Now, an activity based costing (ABC) system is being
considered by the company. The details of the three products are as follows:
Hours [per Unit] Materials Cost Production
Products Labour Machine [Rs. per Unit] [Units]
A 1.0 2.0 2,200 1,500
B 2.0 1.5 1,320 2,500
C 1.5 2.5 2,750 14,000
The total production overheads are reported as Rs. 71,995,000 and further analysis
shows that the total production overheads can be divided as follows:
Percentage
Set-up costs 30%
Machinery related costs 24%
Material handling costs 21%
Inspection related costs 25%
Total production overhead 100%
The following total activity volumes are associated with each product lines for the period
as a whole: Number of
Number of Movements Number of
Products Set-ups of Material Inspections
A 80 15 160
B 120 25 190
C 500 90 680
700 130 1,030
Direct labour costs is Rs. 600 per hour and the overhead absorption rate for the period
is Rs. 1,070 per machine hour.
Required:
Calculate per unit cost for each product using activity based costing (ABC) principles.
All workings should be rounded off to the nearest digit. 13

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Q.12 Sapphire Textile Mills Limited (STML) manufactures four products 'A', 'B', `C' and 'D'.
Feb-17 The direct labour cost per hour is Rs. 750. Other output and cost data for the period
just ended are as follows:
No of Direct
Production Material Labour Machine
Output Runs in the Cost Hours per Hours per
Products Units Period per Unit Unit Unit
A 15 3.0 3,000 1.5 1.5
B 15 3.0 12,000 4.5 2.0
C 150 7.5 3,000 1.5 3.0
D 150 7.5 12,000 4.5 3.5
Overhead Costs: Rs. `000'
Short-run machine related variable costs 462
Setup cost 1,638
Expediting and scheduling costs 1,365
Material handling costs 1,155
4,620
Required:
Prepare unit costs for each product using:
(a) Traditional Costing Method using labour hour for absorption rate 06
(b) Activity Based Costing Method 09

Q.13 MM (Pvt.) Limited manufactures industrial clothes for mechanical and electrical
workshop-based industries. The company has adopted activity based costing (ABC)
Aug-19
method to allocate its overhead costs in order to provide more realistic data for each
division. The following data is available for the use in its ABC system:
Distribution of Resource Consumption Across
Total Activity Costs Pools
Cost Cutting Stitching Support Other
[Rupees] Division Division Division Division Total
Salaries and wages 5,000,000 30% 35% 25% 10% 100%
Miscellaneous costs 1,000,000 25% 15% 20% 40% 100%
6,000,000

Activity costs drivers are as follows:

Activity Costs Pools Activity Measure Total Activity
Cutting Division Number of direct labour hours 15,000 direct labour hours
Stitching Division Number of orders 500 orders
Support Division Number of customers 100 customers
Other Divisions Not allocable to products or customers
During the year, the company completed an order of special industrial clothes for NZ
Enterprises. The direct material cost was Rs. 1,800 per unit and one unit required 0.5
direct labour hours at a wage rate of Rs. 250 per direct labour hour. The selling price was
Rs. 2,500 per unit and ordered quantity was 150 units.
Required:
Being a Management Accountant, you are required to calculate the following:
(a) Allocation of overhead costs to activity costs pools 03
(b) Activity rates for activity costs pools 03
(c) Overhead costs for ordered quantity of NZ Enterprises (Do not include
Support Division cost) 03
(d) Product margin and customer margin for NZ Enterprises 08
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