Activity Based Costing (ABC)


In absorption costing, overheads are absorbed solely on volume-based cost drivers such as units of output, machine hours and direct labour hours. The overhead rate is usually expressed as cost per direct labour hour (labour intensive) or cost per machine hour (capital intensive). It is usually assumed that variable costs vary in direct proportion to the changes in the output level whereas fixed costs remain constant in total. However, fixed costs only remain constant over a certain range of time period or output level as in of ‘step costs’. In the same manner, variable costs per unit may often increase at higher output levels.

This usually results in over or under-costing of products. In over-costing a product is allocated high cost per unit while it is actually consuming low level of resources. On the other hand, in under-costing low cost per unit is allocated to a product which is using a high level of resources.

Activity based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. Resources are assigned to activities and activities to cost objects, based on consumption estimates. Activity is any event, action, transaction, or work sequence that incurs cost when producing a product. Cost pool is the overhead cost attributed to a distinct type of activity. Cost driver is any activity that has a direct relationship with the resources consumed.

ABC allocates overhead to multiple activity cost pools, and assigns the activity cost pools to products or services by means of cost drivers. Overheads are absorbed using both volume-based and non-volume based cost drivers, such as number in the production set-up, number of material requisitions and number of purchase orders.

When the cost for each cost driver has been accumulated in a cost pool, then a cost driver rate can be determined. The cost driver rate can be used to apportion overheads to products in accordance with the use of each activity for each of the products.

The following are few examples of cost drivers with particular reference to their related activity levels.


Activity Level

 

Activity Cost Pool

Cost Driver

 

Unit level activities

Costs are allocated over number of units produced

Machine related

cutting, trimming, drilling, pressing, milling, burning, machine parts, maintenance

Number of machine hours

Labour related

assembling, sanding

painting, sewing

Direct labour hours (cost)


Batch level activities

Costs are allocated over total number of units within the batch.

Machine (production) setups

Number of setups, production runs

Purchasing goods

Number of purchase orders

Inspection or quality control

Number of inspections

Product handling

Number of product move/ handling time


Product level activities

Costs are allocated over total number of units within the same product line

Production control

Number of production process

Product design

Number of product designs

Research and development

Number of new codes

Engineering

No of engineering time


Facility level activities

Costs are allocated over total number of units using the same facility


Plant Management salaries

Number of employees

Plant depreciation

Area in square feet

Rent

Area in square feet

Light & Heat

Area in square feet


Customer level activity

Costs are allocated over total number of units sold to the

specific customer

Packing

Number of packing hours

Delivery cost

Number of deliveries/miles

Customer visit

Number of customer visit

Correspondence

Number of letters



Advantages of Activity-Based Costing (ABC):

  1. Product cost determination under activity-based costing is more accurate and reliable because it focuses on the cause and effect linkage of costs and activities in the context of producing goods.
  2. Determining selling price for multi-products under activity-based costing is fair and correct because overheads are allocated on the basis of relevant cost drivers.
  3. Control of overheads consisting of fixed and variable becomes possible by controlling and monitoring activities. Relationship between cost and activities are clearly identified in activity-based costing and thus provides opportunities to control overhead costs.
  4. Sufficient information can be obtained to make decisions about the profitability of different product lines.
  5. Fair allocation of overheads occupies a considerable portion in the total cost components.
  6. This system is particularly helpful in identifying business activities which are wasteful or non value adding services.

Disadvantages or Limitations Of Activity-Based Costing (ABC)

  1. Difficult to identify the overall activities that influence costs.
  2. Not easy to select the most suitable cost driver.
  3. Difficult to evaluate cost on the basis of activities.
  4. Not suitable for small manufacturing concerns.
  5. The implementation and running of ABC requires significant amount of time and costs.
  6. Some costs do not have appropriate or relevant activity consumption cost driver.


Example 1

 The following information is available:

Total Overheads

$ 100 000

Costs relating to set ups

70 % of overheads

Costs relating to inspections

30% of overheads

No of set ups

100 setups

No of inspections

50 inspections

               

a) Calculate the cost per driver (Cost Driver Rate)

To produce product A

No of set ups

20 setups

No of inspections

3 inspections

                    

b) Calculate the total overheads applicable to Product A.

   

STEP 1 – COST POOL

STEP 2 – COST DRIVER RATE

Activity

Workings

Cost Pool

No of Drivers

Workings

Cost Driver Rate

Setups

70% * $ 100 000

70 000

100

70 000 / 100

$ 700

Inspections

30% * $ 100 000

30 000

50

30 000 / 50

$ 600

Total Overheads

100 000

 


STEP 3 - Product A

Activity

No of activities

Cost Driver Rate

Total cost

Setups

20 setups

$ 700

$ 14 000

Inspections

3 inspections

$ 600

   $ 1 800

Total overheads per unit of Product A

$ 15 800


Example 2

A company has the following information applicable to its products

Product

A

B

No of units produced

2 500

5 000

Direct materials per unit

$ 30

$ 50

Direct labour per unit

$ 20

$ 16


                                               

Total Overheads

$ 100 000

% Allocated


Setups cost

35 %

Inspections

45 %

Materials handling

20 %

                                                                                                                                                               



A

B

Total

No of setups

300

50

350

No of inspections

500

250

750

Movement of goods

300

700

1000

                                                                               

Calculate the cost per unit of A and B under Activity Based Costing?


   

STEP 1 – COST POOL

STEP 2 – COST DRIVER RATE

Activity

Workings

Cost Pool

No of Drivers

Workings

Cost Driver Rate

Setups

35% * $ 100 000

35 000

350

35000 / 350

$ 100

Inspections

45% * $ 100 000

45 000

750

45 000 / 750

$ 60

Material Handling

20%* $ 100 000

20 000

1000

20 000 / 1000

$ 20

Total Overheads

100 000

 









STEP 3

Product A

Product B


$


$

Direct Materials per unit

30

Direct Materials per unit

50

Direct labour per unit

20

Direct labour per unit

16

Overheads:


Overheads:


Setup

300*100=30000


Setup

50*100=5000


Inspection

500*60=30000


Inspection

250*60=15000


Handling

300*20=6000


Handling

700*20=14000


Total

66000


Total

34000


No of units

2500


No of units

5000


Overhd per unit

66000/2500

26.40

Overhd per unit

34000/5000

6.80

Cost per unit


76.40

Cost per unit


72.80


Example 3

Explorer Limited produces two products, Y and Z. The budgeted data for the two products for the year ending 31 December 2017 is as follows:



Y

Z

Raw materials used (kilo)

2

3

Direct labour hours

0.75

1

Unit selling price

$19

$25

Annual production and sale

2500

4000


The cost of raw materials is $ 2.50 per kilo and the labour force are paid $ 8 per hour. Annual overheads are as follows:



$

Machine maintenance overheads

8 500

Purchasing overheads

17 000

Selling and distribution overheads

18 750


Additional information



Y

Z

Number of production runs

20

16

Number of purchase orders

55

65

Number of sales deliveries

85

160


Calculate the cost per unit for each product using ABC.


STEP 1 – COST POOL

STEP 2 – COST DRIVER RATE

Activity

Cost Pool

No of Drivers

Workings

Cost Driver Rate

Production Runs

8 500

36

8 500 / 36

$ 236.11

Purchase Orders

17 000

120

17 000 / 120

$ 141.67

Sales Deliveries

18 750

245

18 750 / 245

$ 76 .53


Product Y

Product Z


$


$

Direct Materials per unit

5.00

Direct Materials per unit

7.50

Direct labour per unit

6.00

Direct labour per unit

8.00

Overheads:


Overheads:


Runs

20*236.11=4722


Runs

16*236.11=3778


Orders

55*141.67=7792


Orders

65*141.67=9208


Deliveries

85*76.53=6505


Deliveries

160*76.53=12245


Total

19019


Total

25231


No of units

2500


No of units

4000


Ovhd per unit

19019/2500

7.61

Ovhd per unit

25231/4000

6.31

Cost per unit


18.61

Cost per unit


21.81