TRADITIONAL COSTING SYSTEM

In a traditional costing system, we calculate one plant-wide allocation rate. A three-step process is
typically used:

Step 1: Determine the basis for allocating overhead (or indirect costs). In this case, it is the direct labour
hours.

Step 2: Calculated a predetermined overhead rate using estimates. Typically calculated at the end of
the year to be used during the following year.

The formula we use for this is:

𝑬𝒔𝒕𝒊𝒎𝒂𝒕𝒆𝒅 𝑶𝒗𝒆𝒓𝒉𝒆𝒂𝒅
𝑷𝒓𝒆𝒅𝒆𝒕𝒆𝒓𝒎𝒊𝒏𝒆 𝑶𝒗𝒆𝒓𝒉𝒆𝒂𝒅 𝑹𝒂𝒕𝒆 (𝑷𝑶𝑯𝑹) =
𝑬𝒔𝒕𝒊𝒎𝒂𝒕𝒆𝒅 𝑩𝒂𝒔𝒆 (𝒄𝒐𝒔𝒕 𝒅𝒓𝒊𝒗𝒆𝒓)

Step 3: Apply overhead throughout the period using the actual amount of our base and the
predetermined overhead rate (POHR) calculated in step 2. The calculation is as follows:

𝑨𝒑𝒑𝒍𝒊𝒆𝒅 𝑶𝒗𝒆𝒓𝒉𝒆𝒂𝒅 = 𝑨𝒄𝒕𝒖𝒂𝒍 𝒂𝒎𝒐𝒖𝒏𝒕 𝒐𝒇 𝒃𝒂𝒔𝒆 × 𝑷𝑶𝑯𝑹

EXAMPLE 1:

XYZ Limited makes two products, A and B. Product A is a high-volume line, while Product B is a low-
volume, specialized product. 10 000 units of products A and 15 000 units of product B were
manufactured during January.

XYZ Limited allocated manufacturing overhead costs to the two products for the month of
January. Department X had estimated overhead of R2 000 000 and used 20 000 machine hours. XYZ
Limited has decided to allocate overhead on the basis of machine hours. At the end of January, XYZ
Limited had used 1,500 machine hours for product A and 500 machine hours for product B.

SOLUTION

Step 1: The basis for allocating overhead is machine hours.

Step 2: Calculated a predetermined overhead allocation rate using estimates.

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑀𝑎𝑛𝑢𝑓𝑎𝑐𝑡𝑢𝑟𝑖𝑛𝑔 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑

𝑃𝑟𝑒𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑒 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑅𝑎𝑡𝑒 (𝑃𝑂𝐴𝑅) =
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝐵𝑎𝑠𝑒 (𝑐𝑜𝑠𝑡 𝑑𝑟𝑖𝑣𝑒𝑟)

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑀𝑎𝑛𝑢𝑓𝑎𝑐𝑡𝑢𝑟𝑖𝑛𝑔 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑

=
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑀𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟𝑠
𝑅2 000 000
=
20 000
 = 𝑅100 𝑝𝑒𝑟 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟

Step 3: Apply overhead throughout the period using the actual amount of our base and the
predetermined allocation overhead rate (POAR) calculated in step 2. The calculation is as follows:

𝐴𝑝𝑝𝑙𝑖𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 = 𝐴𝑐𝑡𝑢𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑏𝑎𝑠𝑒 × 𝑃𝑂𝐴𝑅

Product A Product B
Machine hours per unit 1 500 500
Overheads costs per unit R150 000 (=1 500 x R100) R50 000 (=500 x R100)
Units produced 10 000 15 000
Overhead cost per unit R15 (=R150 000/10 000) R3.33 (=R50 000/15 000)

ACTIVITY-BASED COSTING SYSTEM

Activity-based costing requires accountants to use the following 4 steps:

1. Identify the activities that consume resources and assign costs to those activities. For example,
painting. Step 1 is often the most interesting and challenging part of the exercise.
This step requires people to understand all of the activities required to make the product. Imagine
the activities involved in making a simple product like a pizza—ordering, receiving and inspecting
materials, making the dough, putting on the ingredients, baking, and so forth.
In ABC costing, the more complex the business, the higher the overheads (i.e., indirect costs).

2. Identify the cost drivers associated with each activity. A cost driver is an activity or transaction
that causes costs to be incurred. For the painting activity, the cost drivers could be the number of
buildings constructed. Please note, each activity could have multiple cost drivers.

The table below shows several examples of the cost drivers that companies use. Most cost drivers
are related to either the volume of production or to the complexity of the production or marketing
process.

Identified cost Cost driver

Automobile costs Miles driven
Electricity to run machines Machine-hours
Overhead in a bank Customers served
Airplane maintenance costs Flight hours
Selling costs Number of customers

In deciding which cost drivers to use, managers consider these three factors:
 3. Compute a cost rate per cost driver unit. The cost driver rate could be the cost of painting a
building, for example.

Calculate the activity rates. The calculation uses the same formula for predetermined overhead
rate (POHR) that we used for traditional costing. In general, predetermined rates for allocating
overheads (indirect costs) to products are computed as follows:

𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒚 𝑶𝒗𝒆𝒓𝒉𝒆𝒂𝒅
𝑷𝒓𝒆𝒅𝒆𝒕𝒆𝒓𝒎𝒊𝒏𝒆 𝑶𝒗𝒆𝒓𝒉𝒆𝒂𝒅 𝑹𝒂𝒕𝒆 (𝑷𝑶𝑯𝑹) =
𝑬𝒔𝒕𝒊𝒎𝒂𝒕𝒆𝒅 𝒄𝒐𝒔𝒕 𝒅𝒓𝒊𝒗𝒆𝒓

4. Assign costs to products by multiplying the cost driver rate times the volume of cost driver
units consumed by the product for the period under observation.
For example, the cost per purchase order times the number of orders required for Product A for
the month of December would measure the cost of the purchasing activity for Product A for
December. In Step 4, we first define the notion of an activity centre. An activity centre is a unit of
the entity that performs some activity. E.g., the costs of setting up machines would be assigned to
the activity centre that sets up machines. Each activity has associated costs per product. When
the cost driver is the number of inspections, for example, the company must keep track of the cost
of inspections.
Workers and machines perform activities on each product as it is produced. Accountants allocate
costs to products by multiplying each activity’s indirect cost rate by the volume of activity used in
making the product. The formula we will use for each activity is:

𝑨𝒑𝒑𝒍𝒊𝒆𝒅 𝑶𝒗𝒆𝒓𝒉𝒆𝒂𝒅 = 𝑨𝒄𝒕𝒖𝒂𝒍 𝒂𝒎𝒐𝒖𝒏𝒕 𝒐𝒇 𝒂𝒄𝒕𝒊𝒗𝒊𝒕𝒚 𝒄𝒐𝒔𝒕 𝒅𝒓𝒊𝒗𝒆𝒓 × 𝒂𝒄𝒕𝒊𝒗𝒊𝒕𝒚 𝑷𝑶𝑯𝑹

EXAMPLE 1:

XYZ Limited makes two products, A and B. Product A is a high-volume line, while Product B is a low-
volume, specialized product. 10 000 units of products A and 15 000 units of product B were
manufactured during January.

XYZ Limited allocated manufacturing overhead costs to the two products for the month of
January. Department A had estimated overhead of R2 000 000 and used 20 000 machine hours. XYZ
Limited has decided to allocate overhead on the basis of machine hours. At the end of January, XYZ
Limited had used 1,500 machine hours for product A and 500 machine hours for product B.

Currently the production overheads are absorbed by using machine hour rate and the activity overheads
for the year are as follows:

Cost R
Purchasing materials (100 000 pieces of material were purchased) 200 000
Setting up machines when a new product was started (400 setups) 800 000
Inspecting products (4 000 hours of inspection were used) 400 000
 Operating machines (20 000 machine hours) 600 000

These estimates were made last year and will be used during all of the current year. In practice,
companies most frequently set rates for the entire year, although some set rates for shorter periods,
such as a quarter.

XYZ Limited identified the following four activities that were important cost drivers and a cost driver used
to allocate overhead.

Cost Cost drivers

Purchasing materials Pieces of material
Setting up machines when a new product was started Machine set up
Inspecting products Inspection hours
Operating machines Machine hours

For January, the XYZ limited has the following information about the actual number of cost driver units
for each of the two products:
Cost Product A Product B Total
Purchasing materials 60 000 pieces 40 000 pieces 100 000 pieces
Machine setup 100 setups 300 setups 400 setups
Inspecting products 200 hours 200 hours 400 hours

SOLUTION
1. Identify the activities that consume resources and assign costs to those activities: 4 activities
have been identified.

2. Identify the cost drivers associated with each activity. The cost drivers of the 4 activities have
been identified.

Cost Cost drivers

Purchasing materials Pieces of material
Setting up machines when product A or B is started Machine set up
Inspecting products Inspection hours
Operating machines Machine hours

3. Compute a cost rate per cost driver unit. The cost driver rate could be the cost of painting a
building, for example.
Calculate the activity rates are calculated as follows:

𝑨𝒄𝒕𝒊𝒗𝒊𝒕𝒚 𝑶𝒗𝒆𝒓𝒉𝒆𝒂𝒅
𝑷𝒓𝒆𝒅𝒆𝒕𝒆𝒓𝒎𝒊𝒏𝒆 𝑶𝒗𝒆𝒓𝒉𝒆𝒂𝒅 𝑹𝒂𝒕𝒆 (𝑷𝑶𝑯𝑹) =
𝑬𝒔𝒕𝒊𝒎𝒂𝒕𝒆𝒅 𝒄𝒐𝒔𝒕 𝒅𝒓𝒊𝒗𝒆𝒓 𝒗𝒐𝒍𝒖𝒎𝒆
 Activity Cost, R Cost drivers volume Activity Rate
Purchasing materials 200 000 100 000 pieces of material 𝑅200 000
= 𝑅2 𝑝𝑒𝑟 𝑝𝑖𝑒𝑐𝑒
100 000
Machine setup 800 000 400 machine set up 𝑅800 000
= 𝑅2000 𝑝𝑒𝑟 𝑠𝑒𝑡𝑢𝑝
400
Inspecting products 400 000 4 000 inspection hours 𝑅400 000
= 𝑅100 𝑝𝑒𝑟 𝑖𝑛𝑠𝑝. ℎ𝑜𝑢𝑟
4 000
Operating machines 600 000 20 000 machine hours 𝑅600 000
= 𝑅30 𝑝𝑒𝑟 𝑚𝑎𝑐ℎ. ℎ𝑜𝑢𝑟
20 000

4. Assign costs to products by multiplying the cost driver rate times the volume of cost driver
units consumed by the product for the period under observation.

𝑨𝒑𝒑𝒍𝒊𝒆𝒅 𝑶𝒗𝒆𝒓𝒉𝒆𝒂𝒅 = 𝑨𝒄𝒕𝒖𝒂𝒍 𝒂𝒎𝒐𝒖𝒏𝒕 𝒐𝒇 𝒂𝒄𝒕𝒊𝒗𝒊𝒕𝒚 𝒄𝒐𝒔𝒕 𝒅𝒓𝒊𝒗𝒆𝒓 × 𝒂𝒄𝒕𝒊𝒗𝒊𝒕𝒚 𝑷𝑶𝑯𝑹

Activity Product A Product B

Calculation R Calculation R
Purchasing materials (R2 x 60 000) 120 000 (R2 x 40 000) 80 000
Machine setup (R2000 x100) 200 000 (R2000 x300) 600 000
Inspecting products (R100 x 200) 20 000 (R100 x 200) 20 000
Operating machines (R30 x 1 500) 45 000 (R30 x 500) 15 000
Total 97 000 103 000

On per unit basis:

Activity Product A Product B
Calculation R Calculation R
Purchasing materials (R2 x 60 000) 120 000 (R2 x 40 000) 80 000
Machine setup (R2000 x100) 200 000 (R2000 x300) 600 000
Inspecting products (R100 x 200) 20 000 (R100 x 200) 20 000
Operating machines (R30 x 1 500) 45 000 (R30 x 500) 15 000
Total 385 000 715 000
Units produced 10 000 15 000
Overhead cost per unit 38.50 47.67

EXAMPLE 2 (20 MARKS)

REQUIRED
Use the information provided to answer the following questions:
3.1 Calculate the total manufacturing costs and the unit costs if all overheads costs are absorbed on a
machine hour basis/per hour on the machine. (6)
3.2 Calculate the unit overheads costs using the ABC system. (14)

INFORMATION
Visa Limited manufactures two products and the company is keen on applying the principles of ABC
costing. Relevant information pertaining to the two products for a given period appears below:
Product A Product B
Output in units 240 180
Machine hours per unit 7 5
R R
Direct materials cost per unit 100 80
Direct labour cost per unit 49 35

The 2 products are similar and are usually produced in production runs of 20 units & sold in batches of
10.
Currently the production overheads are absorbed by using a machine hour rate and the total of the
production overheads for the period are as follows:

R
Machine department costs (rent, rates, depreciation and supervision) 10 320
Set-up costs 5 040
Stores receiving 3 720
Inspection/Quality control 2 100
Materials handling and dispatch 4 620

The cost drivers to be used for the overhead costs are as follows:

Cost Cost driver

Set up costs Number of production runs
Stores receiving Requisitions raised
Inspection/Quality control Number of production runs
Materials handling and dispatch Orders executed

The number of requisitions raised on the stores was 40 for each product and the number of orders
executed was 42, each order being for a batch of 10 of a product.
SOLUTION
3.1 Calculate the total manufacturing costs and the unit costs if all overheads costs are absorbed on a
machine hour basis/per hour on the machine. (6)

Step 1: Calculate Total machine hours required to produce all products:

Product A Product B Total
Output in units 240 180
Machine hours per unit 7 5
Machine hours required to produce all units 1680 (=240x7) 900(=180x5) 2 580

Step 2: Calculate Total overheads:

R
Machine department costs (rent, rates, depreciation and supervision) 10 320
Set-up costs 5 040
Stores receiving 3 720
Inspection/Quality control 2 100
Materials handling and dispatch 4 620
Total overheads 25 800

Step 3: Calculate overheads cost per machine hour:

𝑇𝑜𝑡𝑎𝑙 𝑜𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠
𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑𝑠 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟 =
𝑇𝑜𝑡𝑎𝑙 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 ℎ𝑜𝑢𝑟𝑠
𝑅25 800
=
2 580
= 𝑅10
Product A Product B
Machine hours per unit 7 5
Overheads costs per unit R70 (=R10x7hours) R50(=R10x5hours)

Step 4: Calculate Total Manufacturing Costs:

Product A Product B
R R
Direct materials cost per unit 100 80
Direct labour cost per unit 49 35
Overheads costs per unit (Step 3 above) 70 50
Manufacturing cost per unit (MCPU) R219 R165
 Number of units produced(NUP) 240 180
Total Manufacturing Costs (=MCPU x NUP) R52 560 R29 700

3.2 Calculate the unit overheads costs using the ABC system. (14)

Step 5: Calculation of Activity Rates

Activities Activity Cost driver volumes Activity Rate
Costs (R)
Machine department costs 10 320 2 580 mac. hrs (step1 above) R4 per machine hr.
Set-up costs 5 040 21 production runs R240 per prod. run
Stores receiving 3 720 80 requisitions (40 each) R46.50 per requisition
Inspection/Quality control 2 100 21 production runs R100 per prod. run
Materials handling & dispatch 4 620 42 orders R110 per order
25 800

Product A Product B Total

Output in units 240 180 420
Number of units per production run 20 20 20
Production runs 12 (=240/20) 9(=180/20) 21 (=420/20)

Step 6: Calculation of Unit cost

Product A Product B
R R
Machine department costs R4 x1 680 (step 1) 6 720 R4 x 900 (step 1) 3 600
Set-up costs 12 x R240 (step 5) 2 880 9 x R240 (step5) 2 160
Stores receiving 40 x R46.50 1 860 40 x R46.40 1 860
Inspection/Quality control 12 x R100 1 200 9 x R100 900
Materials hand. & dispatch 24 x R110 2 640 18 x R110 1 980
Total 15 300 10 500
Number of products 240 180
Overheads cost per unit 63.75 58.33

• Orders executed = 42 in the ratio 12:9 = 24: 18

Product A Product B
R R
Direct materials cost per unit 100 80
Direct labour cost per unit 49 35
Overheads costs per unit (Step 3 above) 63.75 58.33
Manufacturing cost per unit (MCPU) R212.75 R173.33
Number of units produced(NUP) 240 180
Total Manufacturing Costs (=MCPU x NUP) R51 060 R31 199

EXAMPLE 3
Octopus Ltd. utilises a single manufacturing process of which the following overhead cost estimates are
available for the period ending 31 December 2020:
R
Raw materials reception and handling cost 9 360
Electricity 11 700
Material handling cost 8 190
Total 29 250

Three products X, Y, and Z, are manufactured by the workers of Octopus Ltd. The raw material arrives
in bundles and is then processed further using electrical drills, which are operated by hand. The workers
are paid a wage of R100 per hour. The following estimates are applicable for the period ending 31
December 2020:
Product X Product Y Product Z
Units manufactured 1100 825 440
Raw material received (total bundles) 10.00 6.00 16.00
Data per manufactured unit:
Direct material (m2) 5.00 8.00 4.00
Direct material (R) 6.50 3.90 7.80
Direct labour (minutes of drilling) 24.00 40.00 60.00
Number of electric drilling jobs 7.00 5.00 3.00

Overheads are currently allocated to products by means of a rate based on LABOURS.

An activity-based investigation identified the following cost drivers:
Activity cost pool Cost drivers
Raw materials reception and handling Number of material bundles
Electricity Number of drilling jobs
Material handling m2 handled

Round of calculated values to 2 decimal places.

2.1 Prepare a summary for the budgeted product cost per unit for each product (X,Y (8 marks)
and C) for the period ending 31 December 2022, where the unit cost for each of
the cost elements is set out.
 2.2 Prepare a summary for the budgeted product cost per unit for each product (X,Y (12 marks)
and C) for the period ending 31 December 2022, where the unit cost for each of
the cost elements is set out by using the identified cost drivers and on the basis of
ABC principles.

ABC is for internal purposes

For decisions, ABC is better because it is more accurate. Whether to keep or drop a product line
SOLUTION
2.1 Prepare a summary for the budgeted product cost per unit for each product (X,Y (8 marks)
and C) for the period ending 31 December 2022, where the unit cost for each of
the cost elements is set out.

Step 1: The basis for allocating overhead is labour hours.

Step 2: Calculated a predetermined overhead rate using estimates.

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑
𝑃𝑟𝑒𝑑𝑒𝑡𝑒𝑟𝑚𝑖𝑛𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑅𝑎𝑡𝑒 (𝑃𝑂𝐻𝑅) =
𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝐵𝑎𝑠𝑒 (𝑐𝑜𝑠𝑡 𝑑𝑟𝑖𝑣𝑒𝑟)

𝑅29 250
=
1 430
= 𝑅20.45 𝑝𝑒𝑟 𝑙𝑎𝑏𝑜𝑢𝑟 ℎ𝑜𝑢𝑟

Product X Product Y Product Z Total

Units manufactured 1100 825 440
Direct labour hours per unit 24/60 hour 40/60 hour 60/60 hour
Labour hours required to manufacture all 440 550 440 1 430
units

Step 3: Apply overhead throughout the period using the actual amount of our base and the
predetermined overhead rate (POHR) calculated in step 2. The calculation is as follows:

𝐴𝑝𝑝𝑙𝑖𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 = 𝐴𝑐𝑡𝑢𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑏𝑎𝑠𝑒 × 𝑃𝑂𝐻𝑅

Product X Product Y Product Z
Labour hours per unit 0.4 (=24/60) 0.67 (40/60) 1 (60/60)
Overheads costs per unit R8.18(=0.4 x R20.45) R13.70(=0.67 x R20.45) R20.45 (=1 x R20.45)
 Product X, R Product Y, R Product Z, R
Direct material cost per unit 5.00 8.00 4.00
Direct labour cost per unit 40 (=100 x 24/60 hr) 66.67(=100 x 40/60 hr) 100 (=100 x 1hr)
Overhead cost per unit R8.18 R13.70 R20.45
Budgeted product cost per unit 53.18 88.37 124.45

2.2 Prepare a summary for the budgeted product cost per unit for each product (X,Y (12 marks)
and C) for the period ending 31 December 2022, where the unit cost for each of
the cost elements is set out by using the identified cost drivers and on the basis of
ABC principles.

Product X Product Y Product Z Total

Units manufactured 1100 825 440
Raw material received (total bundles) 10.00 6.00 16.00 32
Data per manufactured unit:
Direct material (m2) 5.00 x 1100 8.00 x 825 4.00 x 440 13 860 m2
Direct material (R) 6.50 x 1100 3.90 x 825 7.80 x 440 R13 799.50
Direct labour (minutes of drilling) 24/60 x1100 40/60 x 825 1 x 440 1430 hours
Number of electric drilling jobs 7.00 x 1100 5.00 x 825 3.00 x 440 13145 jobs

Activity Activity cost, R Cost driver volumes Activity rate, R

Raw materials reception & handling 9 360 35 bundles 267.43
Electricity 11 700 13 145 drilling jobs of 0.89
Material handling 8 190 13 860 m2 of materials hand 0.59

Calculation of unit costs:

Product X, R Product Y, R Product Z
Raw materials reception 2674.30 (=10 x 267.43) 1604.58 (=6 x 267.43) 4278.88 (=16 x 267.43)
& handling
Electricity 6853 (=0.89 x 1100 x7) 3671.25 (=0.89 x 825 x5) 1174.80 (=0.89 x 440 x3)
Material handling 3245 (=0.59x5 x 1100) 3894 (=0.59x8x 825) 1038.40(=0.59x4 x 440)
Total overheads 12 772.20 9 169.83 6 492.08
Number of units 1100 825 440
Overhead cost per unit 11.61 11.11 14.75

Product X, R Product Y, R Product Z, R

Direct material cost per unit 5.00 8.00 4.00
Direct labour cost per unit 40 (=100 x 24/60 hr) 66.67(=100 x 40/60 hr) 100 (=100 x 1hr)
Overhead cost per unit 11.61 11.11 14.75
Budgeted product cost per unit 56.61 85.78 118.75

Total manufacturing cost = DM +DLC + Overheads