AAS/JP/PMS/DPA30073 CM1 2.

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CHAPTER 2.0

THE COST CLASSIFICATION (ACTIVITY BASED COSTING)

Course Outline
2.4 Activity Based Costing (ABC)
2.4.1 Describe ABC
2.4.2 Identify appropriate cost drivers under ABC
2.4.3 Calculate costs per driver and per unit using ABC
2.4.4 Compare ABC and traditional methods of overhead absorption based on production
units, labour hours or machine hours
2.4.5 Explain the advantages, limitations and benefits of implementing ABC system

Introduction

1. ABC is a costing method whereby overhead costs are assigned to activities, instead of
assigning them to products and services.
2. This will enable such costs to be traced back to the activities that drive the costs.
3. ABC is based on the concept that products consume activities.
4. Activities may also be known as processes, tasks or functions undertaken for a certain period
of time and for production purposes.
5. These activities consume resources to produce goods or provide services.
6. These resources are subject to processes or activities performed by the labour force and
machines of the business.
7. The activities consume resources such as materials, time, services and information.

Designing Activity Based Costing

Steps for designing ABC:

Identify activities and cost classification

1

Trace costs to the pools

2

Relate activities to the cost drivers and then to

3 the rate

Total up the costs and show new costs under the

4 new classification
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The Basics of the ABC System

The basics of the ABC system are as follows:

Recognizing a few classifications of major activities and pooling their costs

Cost pools are the groups of overhead costs of various categories in which the costs
can be associaed with the activities.
For example, inspection costs, machining costs and setting up costs.

Establishing the cost drivers

Cost driver or activity driver is the unit of an activity that causes the change of an
activity cost. A cost driver is any activity that causes a cost to be incurred.
A cost driver rate is the rate of overheads expressed in terms of units of activities that
will be charged to the products and services.

Cost driver rate is a predetermined rate for each cost pool

Cost Driver Rate = Cost Pool

Basis of activity driver

Application of costs to products and services. Once the cost driver rate is
calculated, it is multiplied by the consumption rate of the cost driver.

The total derived will then be divided by the volume of products or services,
in order to get the overhead rate per unit for the particular cost driver.

Example 1:

The budgeted manufacturing overhead costs of B-Best factory for the year 2018 are as follows:

Overheads cost RM Cost drivers Total usage of Usage of drivers

pools drivers for Product M
Purchasing 570,000 No. of orders 300 150
Setting up 95,000 No. of set-ups 950 400
machine
Quality control 230,000 No. of checks 2,000 1,200
Total 895,000
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In the last five years, the business used the basis of direct labour hours to charge overheads. In the
year 2018, the budgeted direct labour hours is 100,000 and the budgeted production of Product M is
10,000 units.

Required:

a) Calculate the appropriate absorption rates using traditional and ABC methods.
b) What is the product cost per unit if the direct materials cost is RM50 per unit and direct
labour is 2 hours per unit at RM15 per hour, under traditional and ABC methods?

Comparison Between Traditional and ABC Product Costing

Traditional (absorption) Costing ABC

Overhead items are listed and assigned to
various production and service departments.
Overheads rate on common basis of absorption
is calculated to arrive at one amount of
overheads charge.
Cost behavior is not shown since the overheads
are only linked to the cost centres.
There are just two levels of activity, namely
facility level and unit level.
Overhead items are listed and assigned to
activities termed as cost pools.
Activities or cost drivers are used to determine
the cost of the cost objects.
The use of cost behavior is more realistic
because the overheads are linked with the cost
drivers.
Various levels of cost hierarchy are identified
namely unit level, batch level, product level and
facility.

Advantage of ABC

1. Pricing and decision-making are improved as product costs are calculated more accurately,
resulting in improved pricing and decision-making in general.
2. As the cost pools are identified, management will have better control over the items charged
and might be able to reduce costs.
3. ABC provides better incentive to link activities with cost behavior.
4. Management will have a better understanding of costs that are not only driven by volume.
5. Budgets are better prepared as management has a clearer view on various activities in
detail.
6. Activities that do not add value are identified, which assists in cost control.

Limitation of ABC

1. The division of overhead items is subjective and difficult since only a few categories of the
cost pools are generally created by the decision-makers.
2. There is a tendency that the segregation and assignment of overheads to the various cost
pools to be inaccurate as portions of an overhead item may not be allocated objectively.
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For example, the total rental of the factory may not be fairly allocated on the cost driver
basis to various processes or activities, as measuring the usage of the rental might be
subjective.
3. It might be costly for companies which have adopted the traditional costing system to invest
and change their routine to an ABC system.

Benefit of ABC

1. Highlights those products, services, divisions, as well as activities that are not performing
and are leading to losses.
2. Facilities using more of the inputs for products and divisions that are producing higher
profits.
3. Exercises controls over the costs.
4. Facilitates fairer pricing of products and services, on a per unit basis.

EXERCISE

QUESTION 1

Edgeworth Box Corporation manufactures a variety of special packaging boxes used in the
pharmaceutical industry. The company’s Dallas plant is semiautomated, but the special nature of the
boxes requires some manual labour. The controller has chosen the following activity cost pools, cost
drivers, and pool rates for the Dallas plant’s product-costing system.

Activity Cost Pool Overhead Cost Cost Driver Budgeted Level Pool Rate
RM for Cost Driver
RM
Purchasing, 200,000 Raw material 1,000,000 20% of material
storage, and costs cost
material handling
Engineering and 100,000 Hours in design 5,000hr. RM20 per hour
product design department
Machine setup 70,000 Production runs 1,000 runs RM70 per run
costs
Machine 300,000 Machine hours 100,000 hr. RM3 per hour
depreciation and
maintenance
Factory 200,000 Machine hours 100,000 hr. RM2 per hour
depreciation,
taxes, insurance,
and utilities
Other 150,000 Machine hours 100,000 hr. RM1.50 per hour
manufacturing
overhead costs
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Two recent production orders had the following requirements.

20,000 Units of 10,000 Units of

Box C52 Box W29
Direct labour hours 42 hr. 21 hr.
Raw-material cost RM40,000 RM35,000
Hours in design department 10 25
Production runs 2 4
Machine hours 24 20

Required:
1. Compute the total overhead that should be assigned to each of the two production orders,
C52 and W29.
2. Compute the overhead cost per box in each order.
3. Suppose the Dallas plant were to use a single predetermined overhead rate based on direct
labour hours. The direct labour budget calls for 4,000 hours.
a) Compute the predetermined overhead rate per direct labour hour.
b) Compute the total overhead cost that would be assigned to the order for box C52 and
the order for box W29.
c) Compute the overhead cost per box in each order.
4. Why do the two product-costing systems yield such widely differing overhead costs per box?

QUESTION 2

The Gorgeous Co produces three products, A, B and C, all made from the same material. Until now, it
has used traditional absorption costing to allocate overheads to its products. The company is now
considering an activity based costing system in the hope that it will improve profitability. Information
for the three products for the last year is as follows:

A B C
Production and sales volumes (units) 15,000 12,000 18,000
Selling price per unit RM7.50 RM12 RM13
Raw material usage (kg) per unit 2 3 4
Direct labour hours per unit 0.1 0.15 0.2
Machine hours per unit 0.5 0.7 0.9
Number of production runs per annum 16 12 8
Number of purchase orders per annum 24 28 42
Number of deliveries to retailers per annum 48 30 62

The price for raw materials remained constant throughout the year at RM1.20 per kg. Similarly, the
direct labour cost for the whole workforce was RM14.80 per hour. The annual overhead costs were
as follows:
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RM

Machine set up costs 26,550

Machine running costs 66,400
Procurement costs 48,000
Delivery costs 54,320

Required:
a) Calculate the full cost per unit for product A, B and C under traditional absorption costing,
using direct labour hours as the basis for apportionment.
b) Calculate the full cost per unit of each product using activity based costing.

QUESTION 3

Triple Limited makes three types of gold watch – the Diva (D), the Classic (C) and the Poser (P). A
traditional product costing system is used at present; although an activity based costing (ABC)
system is being considered. Details of the three products for a typical period are:

Hours per unit Materials Production

Labour Hours Machine Hours Cost per unit (RM) Units
Product D ½ 1½ 20 750
Product C 1½ 1 12 1,250
Product P 1 3 25 7,000

Total production overheads are RM654,500 and further analysis shows that the total production
overheads can be divided as follows:

%
Costs relating to set-ups 35
Cost relating to machinery 20
Costs relating to materials handling 15
Costs relating to inspection 30
Total production overhead 100
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The following total activity volumes are associated with each product line for the period as a whole:

Number of Number of movements Number of

Set ups of materials inspections
Product D 75 12 150
Product C 115 21 180
Product P 480 87 670
670 120 1,000

Direct labour costs RM6 per hour and production overheads are absorbed on a machine hour basis.
The overhead absorption rate for the period is RM28 per machine hour.

Required:
a) Calculate the cost per unit for each product using traditional methods, absorbing overheads
on the basis of machine hours.
b) Calculate the cost per unit for each product using ABC principles (work to two decimal
places).