CHAPTER 6

ACTIVITY BASED COSTING

Learning objectives
i. Difference between direct and indirect costs
ii. Absorption costing
iii. Comparison of traditional absorption costing and activity-based costing
iv. Description of Activity Based costing system
v. Process of implementing ABC
vi. Computation of product cost under:
• Traditional absorption costing
• Activity based costing
vii. Merits and demerits of activity-based costing

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1) Direct cost vs indirect costs
Direct costs are specific to product costs but indirect costs are common expenses of business
and needs to be allocated among the products manufactured by the entity.

2) Absorption Costing
Absorption Costing is a system to distribute common overheads cost among various products of
business. Absorption costing has two main types:
i. Traditional absorption costing
a) Single rate system
b) Departmental rate system
ii. Activity based costing

3) Traditional Absorption costing vs Activity Based Costing

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4) Description of ABC System
ABC is an improved version of traditional absorption costing in which each type of
overhead cost is distributed using different bases.
5) Process of ABC System
ABC system can be implemented through the following steps:
a. Identify the organisation’s major activities.
b. Collect the total costs associated with each activity.
c. Identify the cost drivers and estimate their quantity
d. Calculate activity-based absorption rate or cost driver rate
Activity based rate (Cost Driver rate) = Total cost of activity
Total quantity of driver
e. Absorb the overheads cost to products on the basis of cost driver
Factory overheads cost = Activity based rate x product wise driver quantity
5.1) Cost pool and cost driver
• A cost pool is simply the total expenditure charged to each activity.
• A cost driver is a factor that determines the cost of the activity. It is something that
will cause the costs for an activity to increase as more of the activity is performed.
5.2) Examples of Cost driver
Sr. No. Activity Cost pool Possible Cost Driver
1. Material procurement/ No. of purchase orders
Purchase ordering cost
2. Customer order Time to process order (or)
processing/Order handling No. of customer orders handled
3. Packing Packing hours (or)
No. of customer orders

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 4. Material handling and Number of requisitions (or)
management No. of production run
5. Machine set up/ No of batches/
Production setup No. of production runs/
No. of production setups
6. Production scheduling No. of production runs
7. Quality control and inspection Inspection hours for inspected units
(or)
No. of inspections/ No. of Tests
8. Repair and maintenance Maintenance hours/
Machine hours operated
9. Delivery and dispatch No. of deliveries made (or)
No. of orders delivered
10. Engineering cost Engineering hours/
Machine hours
11. Machine running Machine Hours
cost/Machining cost
12. Warehousing cost Number of material requisitions/
Direct material usage
13. Production control Machine hours

6) Product cost under traditional absorption costing system & ABC system
Product cost has three elements:
i. Direct material cost
ii. Direct labour cost
iii. Factory overheads cost
Under traditional absorption costing, allocation of overheads cost will be made to various
products by using either:
i. Single overheads absorption rate, or
ii. Departmental overheads absorption rate
Under activity-based costing, allocation of overheads cost will be made to various products
by using cost driver rate.

6.1) Product cost per unit under single rate system

Product Product Product
A B C
Direct material cost per unit x x x
Add: Direct labour cost per unit x x x
Add: Factory overheads cost per unit by using single
overheads rate (W1) x x x
= Product cost per unit x x x

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 (W1) - Single overheads absorption rate = Total budgeted overheads cost
Total activity level
6.2) Product cost per unit under departmental rate system
Product Product Product
A B C
Direct material cost per unit x x x
Add: Direct labour cost per unit x x x
Add: Factory overheads cost per unit (W2)
Department 1 FOH cost x x x
Department 2 FOH cost x x x
= Product cost per unit x x x

(W2) - Departmental absorption rate

Step (i) - Preparation of budgeted overheads distribution sheet
Step (ii) - Computation of departmental overheads absorption rate by using appropriate
base.

6.3) Product cost per unit under activity- based rate system
Product Product Product
A B C
Direct material cost per unit x x x
Add: Direct labour cost per unit x x x
Add: Factory overheads cost per unit (W3) x x x

= Product cost per unit x x x

(W3) – Overhead cost under ABC

Step (i) - Allocate overheads cost among various activities to create cost pool
Step (ii) - Computation of activity-based absorption rate and absorb overheads to
products
Activities Cost Driver Overhead cost
(Cost pool) rate Product A Product Product C
B
Procurement (N1) (N2) (N2) (N2)
Set up (N1) (N2) (N2) (N2)
Inspection (N1) (N2) (N2) (N2)

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N1) Activity based rate (Cost Driver rate) = Total cost of activity
Total quantity of driver
N2) Factory overheads cost of each product = Activity based rate x product wise

Example 1
A company manufactures two products, C and D, for which the following information is
available:
Product C Product D Total
Budgeted production (units) 1,000 4,000 5,000
Labour hours per unit/in total 8 10 48,000
Number of production runs required 13 15 28
Number of inspections during production 5 3 8

Total production set up costs Rs. 140,000

Total inspection costs Rs. 80,000
Other overhead costs Rs. 96,000
Other overhead costs are absorbed on a labour hour basis.
Required: Using activity-based costing, what is the overhead cost per unit of each product

Solution
Overheads cost per unit of each product
Cost pools Cost Driver Overhead cost
Rate Product C Product D
(Rs.) (Rs.)
Set up cost Rs. 140,000/ 28 production run
= Rs. 5,000 per run 65,000 75,000
Inspection cost Rs. 80,000 / 8 inspections
= Rs. 10,000 per inspection 50,000 30,000
Other overheads Rs. 96,000 / 48,000 labour hours
= Rs. 2 per hour 16,000 80,000
= Factory overheads cost of each product 131,000 185,000
÷ Production units ÷ 1,000 ÷ 4,000
= Factory overheads cost per unit of each product Rs. 131 Rs. 46.25
Example 2
A company manufactures two products, A and B. Monthly data relating to production and
sales are as follows.
Product A Product B
Direct material cost per unit $30 $ 40
Direct labour cost per unit @ $ 40 per hour $40 $ 80
Production and Sales 200 units 1,900 units

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Production overheads are $ 400,000 each month and are currently absorbed on a direct labour
hour basis. The management of company wants to switch to activity-based costing system.
The management accountant has gathered the following monthly information:

Activity Cost Pool Total Cost driver Total Product Product

Cost Quantity A B
($)
Set up 40,000 Number of setups 8 2 6
Machine Running 160,000 Machine hours 4,000 200 3,800
Ordering 40,000 Number of orders 8 2 6
Quality control 40,000 Number of 10 2 8
Inspections
Material 120,000 Number of 2,000 1,000 1,000
management requisitions
Total 400,000

Required: Calculate the cost per unit for product A and product B, by using:
a) Traditional absorption costing
b) Activity based costing
Solution
a) Cost per unit under traditional absorption costing
Product A Product B
$ $
Direct Material cost per unit 30 40
Direct Labour cost per unit 40 80
70 120
Factory overheads cost per unit (W1)
(Rs. 100 per hour x labour hours per unit) 100 200
= Product cost per unit 170 320

(W1) – Single FOH absorption rate

FOH rate = $ 400,000 ÷ 4,000 labour hours = Rs. 100 per labour hour

b) Calculation of Cost per unit – Activity based costing (ABC)

Product A Product B
$ $
Direct Material cost per unit 30 40
Direct Labour cost per unit 40 80
70 120
Production overheads cost per unit (W2)
Set up Cost per unit 50 15.79
Machine Running cost per unit 40 80
Ordering cost per unit 50 15.79
Quality Control cost per unit 40 16.84

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 Material management cost per unit 300 31.58
= Product cost per unit 550 280

(W2) Production overheads cost per unit

Activity Cost Activity based OAR
pool
Setting up $40,000/8 setups
= $ 5000 per set up
Machining $160,000/4000 Machine hours
= $ 40 per machine hour
Order $40,000/8 orders
Handling = $ 5000 per order
Quality $40,000/10 Inspections
control = $ 4000 per inspection
Material $120,000/2000 requisition
management = $ 60 per requisition
Overheads absorbed per unit
Product A Product B
$ $
= ($ 5000 x 2 set up) = $ (5000 x 6 set up)
200 units 1900 units
= $ 50 per unit = $ 15.79 per unit
= ($ 40 x 200 mach. Hour) =($ 40 x 3800 mach. Hour)
200 units 1900 units
= $ 40 per unit = $ 80 per unit
= ($ 5000 x 2 order) = ($ 5000 x 6 orders)
200 units 1900 units
= $ 50 per unit = $ 15.79 per unit
= ($ 4000 x 2 inspection) = ($ 4000 x 8 inspections)
200 units 1900 units
= $ 40 per unit = $ 16.84 per unit
=($ 60 x 1000 requistions) = ($ 60 x 1000 requisitions)
200 units 1900 units
= $ 300 per unit = $ 31.58 per unit

7) Merits and demerits of Activity Based Costing system

Merits
1) The complexity of manufacturing has increased due to use of advance technologies and
multiple products range, along with shorter product life cycles. Activity based costing
recognizes this complexity with multiple cost drivers.
2) Activity based costing technique helped entities to absorb indirect costs into products on
the basis of activities in order to calculate realistic product cost. So, in competitive
environment, entities must be able to assess its product profitability in more realistic
manner.
3) Activity based costing can be applied to all overhead costs, and not restricted to production
overheads.
4) Activity based costing can be used easily in service costing as in product costing.
Demerits
1) Activity based costing will be of limited benefit if
• overhead costs are primarily volume related or
• overhead costs is not significant proportion of total costs.
2) Cost apportionment may still be required at the cost pooling stage for shared general items
of costs like rent, depreciation of building. Apportionment can be an arbitrary way of
sharing costs.
3) The cost of implementing and maintaining an activity-based costing system might exceed
the benefits of improved accuracy in product or service costs.
4) The choice of both activities and cost drivers might be inappropriate.
5) This model is difficult to understand and even can create problems in implementation
due to fair understanding activities and their related costs.

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 EXAM STANDARD PRACTICE QUESTIONS

Question 1 ACCA Pilot paper F5

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 Question 2 ACCA F5 – December 2010

Question 3 ICAP Study Text – Q 2

Rizwan Industries has six standard products from stainless steel and brass. The company’s most
popular product is RI-11 and following annual budgeted data is given for product RI-11.
Activity Cost driver Cost driver Cost pool (Rs.)
volume /year
Purchasing cost Purchase orders 15,000 750,000
Setting cost Batches produced 28,000 1,120,000
Material handling cost Material requisition 80,000 960,000
Inspection cost Inspections 28,000 700,000
Machining cost Machine hours 500,000 1,500,000
Rizwan manufacturing industries data relating to RI-11 for the month of July, 2021 is given below:
Description
Purchase orders 25
Output (in units) 15,000
Production batch size (in units) 100
Material requisition per batch 6
Inspections per batch 1
Machine hours per unit 0.1
Required:Calculate the unit overhead cost of product RI-11 using activity-based costing.

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 Question 4 ICAP Study Text – Example 2
Rajput Enterprises manufactures two products, J and K, using the same equipment and similar
processes. An extract of the production data for these products for the month of June is shown
below:
Product J Product K
Quantity produced in units 5,000 7,000
Direct labour hours per unit 1 2
Machine hours per unit 3 1
Set-ups in the period 10 40
Orders handled in period 15 60
Oveheads cost for the month of June are given below:
Rs.
Machine related costs 220,000
Production run set-ups cost 20,000
Order handling cost 45,000
Total 285,000
Required: Calculate overheads cost per unit for each product by using activity-based costing

Question 5 ICAP Study Text – Example 3

Star Limited produces three products, Sky, Moon and Sun and relevant data for the month of
March 2021 is given in the following table:
Sky Moon Sun
Actual units produced and sold 500,000 150,000 250,000
Machine hours per unit 0.01 0.05 0.04
No. of production setups 3 1 26
No. of components 8 12 20
No. of customer orders 21 4 25
The overhead cost incurred by Star Limited during the month of March 2021 is given below:
Rs.
Machining costs 36,000
Component cost 100,000
Set-up cost 180,000
Packing cost 150,000
Total 466,000
Required: Calculate overheads cost per unit for each product by using activity-based costing

Question 6 ICAP Study Text – Example 1

Mustajab Limited manufacturers four products, A, B, C and D. Output and cost data for the period
just ended are as follows:
Products Output No. of Material cost Direct labour Machine
(units) production per unit (Rs.) hours per hours per
runs unit unit
A 10 2 200 10 10
B 10 2 800 30 30
C 100 5 200 10 10
D 100 5 800 30 30

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Overhead costs are given as under:
Rs.
Short run variable cost 30,800
Set up costs 109,200
Expediting and scheduling costs 91,000
Material handling cost 77,000
Total 308,000
Labour cost per hour is equal to Rs. 5.
Required: Calculate unit cost for each product using Activity based costing.

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 SOLUTIONS
Q 1 - Solution

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Q 2 - Solution

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Q 3 - Solution
Overheads cost per unit for Product RI-11 using activity-based costing
Activity Cost Activity based Overheads absorbed per unit
pool OAR Product RI - 11
(Rs.)
Purchasing cost Rs. 750,000/15,000 Rs. 50 x 25 orders
= Rs. 50 per purchase order = Rs. 1,250
Setting cost Rs. 1,120,000/28,000 Rs. 40 x 150 batches
= Rs. 40 per batch = Rs. 6,000
Material Rs. 960,000/80,000 Rs. 12 x 6 material requisition per batch x 150
handling cost = 12 per material requisition batches
= Rs. 10,800
Inspection cost Rs. 700,000/28,000 Rs. 25 x 1 inspection per batch x 150 batches
= Rs. 25 per inspection = Rs. 3,750
Machining cost Rs. 1500,000/500,000 Rs. 3 x 0.1 machine hour per unit x 15,000 units
= Rs. 3 per machine hour = Rs. 4,500
Total overheads cost = Rs. 26,300
Overheads cost per unit for product RI-11= Rs. 26,300 ÷ 15,000 units = Rs. 1.75 per unit
(W1) Number of batches produced = 15,000 units ÷ 100 units = 150 batches

Question 4 - Solution
Overheads cost per unit by using activity-based costing
Activity Cost Activity based OAR Overheads absorbed per unit
pool Product J Product K
(Rs.) (Rs.)
Machine related Rs. 220,000/22,000 Rs. 10 x 15,000 MH Rs. 10 x 7,000 MH
costs = Rs. 10 per machine hour = Rs. 150,000 =Rs. 70,000
Production run Rs. 20,000/50 Rs. 400 x 10 setups Rs. 400 x 40 setups
set-ups cost = Rs. 400 per setup = Rs. 4,000 = Rs. 16,000

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 Order handling Rs. 45,000/75 Rs. 600 x 15 orders Rs. 600 x 60 orders
cost = Rs. 600 per order = Rs. 9,000 = Rs. 36,000
Total overheads cost 163,000 122,000
÷ Production units 5,000 7,000
Overheads cost per unit (Rs.) 32.60 17.43
Question 5 - Solution
Overheads cost per unit by using activity-based costing
Activity Cost Activity based OAR Overheads absorbed per unit
pool Sky Moon Sun
(Rs.) (Rs.) (Rs.)
Machining Rs. 36,000/22,500 Rs. 1.60 x 5,000 MH Rs. 1.60 x 7,500 MH Rs. 1.60 x 10,000 MH
costs = Rs. 1.60 per = Rs. 8,000 =Rs. 12,000 = Rs. 16,000
machine hour
Component Rs. 100,000/40 Rs. 2,500 x 8 Rs. 2,500 x 12 Rs. 2,500 x 20
cost = Rs. 2,500 per components components components
component = Rs. 20,000 = Rs. 30,000 = Rs. 50,000
Set-up cost Rs. 180,000/30 Rs. 6,000 x 3 setups Rs. 6,000 x 1 setup Rs. 6,000 x 26 setups
= Rs. 6,000 per setup = Rs. 18,000 = Rs. 6,000 = Rs. 120,000
Packing cost Rs. 150,000/50 Rs. 3,000 x 21 orders Rs. 3,000 x 4 orders Rs. 3,000 x 25 orders
= Rs. 3,000 per order = Rs. 63,000 = Rs. 12,000 = Rs. 75,000
Total overheads cost 115,000 90,000 261,000
÷ Production units 500,000 150,000 250,000
Overheads cost per unit (Rs.) 0.23 0.60 1.044

Question 6 - Solution
Cost per unit of each product by using activity-based costing
A B C D
(Rs.) (Rs.) (Rs.) (Rs.)
Direct material cost per unit 200 800 200 800
Add: Direct labour cost per unit 50 150 50 150
Add: Overheads cost per unit 4,030 4,170 1,060 1,200
= Cost per unit 4,280 5,120 1,310 2,150
(W1) Overheads cost per unit by using activity-based costing
Activity Cost Activity based OAR Overheads absorbed per unit
pool A B C D
(Rs.) (Rs.) (Rs.) (Rs.)
Short run variable Rs. 30,800/4,400 700 2,100 7,000 21,000
cost = Rs. 7 per machine hour
Set up costs Rs. 1009,200/14 15,600 15,600 39,000 39,000
= Rs. 7,800 per production run
Expediting and Rs. 91,000/14 13,000 13,000 32,500 32,500
scheduling costs = Rs. 6,500 per production run
Material handling Rs. 77,000/14 11,000 11,000 27,500 27,500
cost = Rs. 5,500 per production run
Total overheads cost 40,300 41,700 106,000 120,000
÷ Production units 10 10 100 100
Overheads cost per unit (Rs.) 4,030 4,170 1,060 1,200

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