CA INTER COST & MANAGEMENT ACCOUNTING

Chapter 5 – Activity Based Costing

Methods of Absorbing Overheads to Products

Traditional System Activity Based Costing [ABC] System

Firstly, Overheads are identified on the basis of Firstly, Overheads are identified on the basis of
Cost Centers (Departments) Cost driving Activities

Then, Overheads of Cost Centers are absorbed Then, Overheads of such activities are absorbed
on products on the basis of Direct labour hour, on products on the basis of Cost driver of related
Machine hour, Volume of products etc. activity

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Details Steps in Activity Based Costing –

1. Prepare the list of all overheads

2. Identify different activities within the organization

Examples of Activities – Production schedule changes, Customer liaison, Purchasing, Production process set up,
Quality control, Material handling, Maintenance

3. Relate overheads to the activities  It shall create cost pool for such activities

4. Determine the “Activity Cost Drivers”

Examples of Cost Drivers -
Activity Cost Pools Related Cost Drivers
Ordering and Receiving Materials cost Number of purchase orders
Setting up machine’s costs Number of Production Set-Ups
Machining costs Machine hours
Assembling costs Number of parts assembled / Assembling hours
Inspecting and testing costs Number of tests
Painting costs Number of parts
Supervising Costs Direct labour hours
Store receiving cost No. of requisitions raised on the stores

5. Calculate activity cost driver rates for each activity  Total Cost of Activity ÷ Activity driver

6. Allocate overheads of each activity over products on the basis of activity cost driver

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CA INTER COST & MANAGEMENT ACCOUNTING

1. A company produces three products A, B and C for which the standard costs and quantities per unit are as follows:
Products A B C
Quantity produced 10,000 20,000 30,000
Direct material/p.u. 50 40 30
Direct labour/p.u. 30 40 50
Labour hours/p.u. 3 4 5
Machine hours/p.u. 4 4 7
No. of purchase requisitions 1200 1800 2,000
No. of set ups 240 260 300
Production overhead split by departments — Department 1 = Rs. 11,00,000
— Department 2 = Rs. 15,00,000
Department 1 is labour intensive and Department 2 is machine intensive
Total labour hours in Department 1 = 1,83,333
Total machine hours in Department 2 = 5,00,000
Production overhead split by activity — Receiving/inspecting Rs. 14,00,000
— Production scheduling/machine set up Rs. 12,00,000
Rs. 26,00,000
Number of batches received/inspected = 5,000
Number of batches for scheduling and set-up = 800
You are required to Prepare Product Cost Statement under traditional absorption costing and ABC method.

[Ans. (i) Traditional Method = A - B- C- (ii) ABC Method = A - B- C- ]

2. Woolmark Ltd. manufactures three types of products namely P, Q and R. The data relating to a period are as under:
P Q R
Machine hours per unit 10 18 14
Direct labour hours per unit 4 12 8
Direct Material per unit (Rs.) 90 80 120
Production (units) 3,000 5,000 20,000
Currently the company uses traditional costing method and absorbs all production overheads on the basis of machine
hours. The machine hour rate of overheads is Rs.6 per hour. Direct labour hour rate is Rs. 20 per hour.
The company proposes to use activity-based costing system and the activity analysis is as under:
P Q R
Batch size (units) 150 500 1,000
Number of purchase orders per batch 3 10 8
Number of inspections per batch 5 4 3
The total production overheads are analysed as under:
Machine set up costs 20%
Machine operation costs 30%
Inspection costs 40%
Material procurement related costs 10%
Required:
(i) Calculate the cost per unit of each product using traditional method of absorbing all production overheads on the
basis of machine hours.
(ii) Calculate the cost per unit of each product using activity-based costing principles

[Ans. (i) P – 230, Q – 428, R – 364 (ii) P – 427, Q – 425, R – 335.20]

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3. G - 2020 Ltd. is a manufacturer of a range of goods. The cost structure of its different products is as follows:
Particulars Product A Product B Product C
Direct materials (Rs./u) 50 40 40
Direct labour @ 10 (Rs./hour) 30 40 50
Production overheads (Rs./u) 30 40 50
Total Cost (Rs./u) 110 120 140
Quantity produced (units) 10,000 20,000 30,000
G-2020 Ltd. was absorbing overheads on the basis of direct labour hours. A newly appointed management accountant
has suggested that the company should introduce ABC system and has identified cost drivers and cost pools as
follows:
Activity Cost Pool Cost Driver Associated Cost
Stores Receiving No. of Purchase Requisitions 2,96,000
Inspection No. of Production runs 8,94,000
Dispatch Orders Executed 2,10,000
Machine Setup Number of setups 12,00,000
The following information is also supplied:
Details Product A Product B Product C
No. of Setups 360 390 450
No. of Orders Executed 180 270 300
No. of Production runs 750 1,050 1,200
No. of Purchase Requisitions 300 450 500
You are required to calculate activity-based production cost of all the three products.

[Ans. A - B- C- ]

4. Linex Limited manufactures three products P, Q and R which are similar in nature and are usually produced in
production runs of 100 units. Product P and R requires both machine hours and assembly hours, whereas product Q
requires only machine hours. The overheads incurred by the company during the first quarter are as under:
Machine Department expenses 18,48,000
Assembly Department Expenses 6,72,000
Setup Costs 90,000
Store receiving cost 1,20,000
Order processing and dispatch 1,80,000
Inspection and Quality control cost 36,000
The data related to the three products during the period are as under:
P Q R
Units produced and sold 15000 12000 18000
Machine hours worked 30000 hrs. 48000 hrs. 54000 hrs.
Assembly hour worked (Direct labour hours) 15000 hrs. -- 27000 hrs.
Customers’ orders executed (In numbers) 1250 1000 1500
Numbers of requisitions raised on the stores 40 30 50
Prepare a statement showing details of overheads costs allocated to each products type using activity-based costing.

[Ans. P – ,Q– ,R– ]

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CA INTER COST & MANAGEMENT ACCOUNTING

5. ABC Ltd. is a multiproduct company, manufacturing three products A, B and C. The budgeted costs and production
for the year ending 31st March are as follows:
A B C
Production quantity (Units) 4000 3000 1600
Resources per Unit:
 Direct Materials (Kg.) 4 6 3
 Direct Labour (Minutes) 30 45 60
The budgeted direct labour rate was Rs. 10 per hour, and the budgeted material cost was Rs. 2 per kg. Production
overheads were budgeted at Rs. 99,450 and were absorbed to products using the direct labour hour rate. ABC Ltd.
followed the Absorption Costing System.
ABC Ltd. is now considering to adopt an Activity Based Costing system. The following additional information is made
available for this purpose.
Budgeted overheads were analysed into the following:
Material handling 29,100
Storage costs 31,200
Electricity 39,150

The cost drivers identified were as follows:

Material handling Weight of material handled
Storage costs Number of batches of material
Electricity Number of Machine operations
Data on Cost Drivers was as follows:
A B C
For complete production:
Batches of material 10 5 15
Per unit of production
Number of Machine operations 6 3 2
You are requested to -
1. PREPARE a statement for management showing the unit costs and total costs of each product using the
absorption costing method.
2. PREPARE a statement for management showing the product costs of each product using the ABC approach.
3. STATE what are the reasons for the different product costs under the two approaches?

[Ans. 1. Unit cost = A - 21.50, B – 32.25, C – 33.00 and Total cost = A – 86,000, B – 96,750, C – 52,800
2. Unit cost = A – 25.09, B – 28.97, C – 30.16 and Total cost = A – 100360, B – 86910, C – 48256]

6. MST Limited has collected the following data for its two activities. It calculates activity cost rates based on cost driver
capacity.
Activity Cost Driver Capacity Cost
Power Kilowatt hours 50,000 kilowatt hours Rs. 2,00,000
Quality Inspections Number of Inspections 10,000 Inspections Rs. 3,00,000
The company makes three products M, S and T. For the year ended March 31st, the following consumption of cost
drivers was reported:
Product Kilowatt hours Quality Inspections
M 10,000 3,500
S 20,000 2,500
T 15,000 3,000
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Required:
(i) COMPUTE the costs allocated to each product from each activity.
(ii) CALCULATE the cost of unused capacity for each activity.
(iii) DISCUSS the factors the management considers in choosing a capacity level to compute the budgeted fixed
overhead cost rate.

[Ans. (i) Power = M – 40000, S – 80000, T – 60000, Quality inspection = M – 105000, S – 75000, T – 90000 (ii)
50000]

7. The following are Product Alpha’s data for next year budget:
Activity Cost Driver Cost Driver volume/year Cost Pool
Purchasing Purchase orders 1,500 Rs. 75,000
Setting Batches produced 2,800 Rs. 1,12,000
Materials handling Materials movements 8,000 Rs. 96,000
Inspection Batches produced 2,800 Rs. 70,000
Machining costs Machine hours 50,000 Rs. 1,50,000
Purchase orders 25
Output 15,000 units
Production batch size 100 units
Materials movements per batch 6
Machine hours per unit 0.1
Required:
(i) Calculate the budgeted overhead costs using activity-based costing principles.
(ii) Calculate the budgeted overhead costs using absorption costing (absorb overhead using machine hours).

[Ans.

8. Alpha Limited has decided to analyse the profitability of its five new customers. It buys bottled water at Rs. 90 per
case and sells to retail customers at a list price of Rs. 108 per case. The data pertaining to five customers are
Customers
A B C D E
Cases sold 4680 19688 136800 71550 8775
Listed Selling Price Rs. 108 Rs. 108 Rs. 108 Rs. 108 Rs. 108
Actual Selling Price Rs. 108 Rs. 106.20 Rs. 99 Rs. 104.40 Rs. 97.20
Number of Purchase orders 15 25 30 25 30
Number of Customer visits 2 3 6 2 3
Number of deliveries 10 30 60 40 20
Kilometers travelled per delivery 20 6 5 10 30
Number of expedited deliveries 0 0 0 0 1
Its five activities and their cost drivers are:
Activity Cost Driver Rate
Order taking Rs. 750 per purchase order
Customer visits Rs. 600 per customer visit
Deliveries Rs. 5.75 per delivery Km travelled
Product handling Rs. 3.75 per case sold
Expedited deliveries Rs. 2,250 per expedited delivery
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Required:
(i) COMPUTE the customer-level operating income of each of five retail customers now being examined
(ii) STATE what insights are gained by reporting both list selling price and the actual selling price for each customer

[Ans. (i) A – 53090, B – 223531, C – 690375, D – 739757, E – 274]

9. ABC Ltd. Manufactures two types of machinery equipment Y and Z and applies/absorbs overheads on the basis of
direct-labour hours. The budgeted overheads and direct-labour hours for the month of December are Rs 12,42,500
and 20,000 hours respectively. The information about Company’s products is as follows:
Equipment Y Equipment Z
Budgeted Production volume 2500 units 3125 units
Direct material cost Rs. 300 per unit Rs. 450 per unit
Direct labour cost
Y : 3 hours @ Rs. 150 per hour Rs. 450
Z : 4 hours @ Rs. 150 per hour Rs. 600
ABC Ltd.’s overheads of Rs. 12,42,500 can be identified with three major activities: Order Processing (Rs. 2,10,000),
machine processing (Rs. 8,75,000), and product inspection (Rs. 1,57,500). These activities are driven by number of
orders processed, machine hours worked, and inspection hours, respectively. The data relevant to these activities is
as follows:
Order processed Machine hours worked Inspection hours
Y 350 23000 4000
Z 250 27000 11000
Total 600 50000 15000
Required:
(i) Assuming use of direct-labour hours to absorb/apply overheads to production, COMPUTE the unit manufacturing
cost of the equipment Y and Z, if the budgeted manufacturing volume is attained.
(ii) Assuming use of activity-based costing, COMPUTE the unit manufacturing costs of the equipment Y and Z, if the
budgeted manufacturing volume is achieved.
(iii) ABC Ltd.’s selling prices are based heavily on cost. By using direct-labour hours as an application base,
CALCULATE the amount of cost distortion (under-costed or over-costed) for each equipment.

[Ans. (i) Y – 936.38 Z -1298.50 (ii) Y - 976.80, Z - 1266.16 (iii) Y (-) 40.42, Z (+)32.34]

10. “Hamara - Apna bank” offers three products, viz., Deposits, Loans and Credit Cards. The bank has selected 4
activities for a detailed budgeting exercise, following activity based costing methods.
The bank wants to know the product wise total cost per unit for the selected activities, so that prices may be fixed
[Link] following information is made available to formulate the budget:
Activity Present Cost Estimation for the budget period
ATM Services:
(a) Machine maintenance 4,00,000 (All fixed, no change)
(b) Rents 2,00,000 (Fully fixed; no change)
(c) Currency Replenishment Cost 1,00,000 (Expected to double during budget period)
7,00,000 (This activity is driven by no. of ATM transactions)
Computer Processing 5,00,000 (Half this amount is fixed and no change is expected)
(The variable portion is expected to increase to three times
the current level)

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This activity is driven by the number of computer

transactions
Issuing Statements 18,00,000 Presently, 3 lac statements are made. In the budget period,
5 lac statements are expected;
For every increase of one lac statement, one lac rupees is
the budgeted increase
(this activity is driven by the number of statements)
Computer Inquiries 2,00,000 Estimated to increase by 80% during the budget period.
(This activity is driven by telephone minutes)
The activity drivers and their budgeted quantifies are given below:
Deposits Loans Credit Cards
No. of ATM Transactions 1,50,000 - 50,000
No. of Computer Processing Transactions 15,00,000 2,00,000 3,00,000
No. of Statements to be issued 3,50,000 50,000 1,00,000
Telephone Minutes 3,60,000 1,80,000 1,80,000
The bank budgets a volume of 58,600 deposit accounts, 13,000 loan accounts, and 14,000 Credit Card Accounts.
You are required to:
(i) Prepare the budgeted cost statement activity wise.
(ii) Calculate the budgeted rate for each activity.
(iii) Find the budgeted product cost per account for each product using (i) and (ii) above

[Ans. (i) ATM Service – 8,00,000, Computer processing – 10,00,000, Issuing Statement – 20,00,000, Computer
Inquires – 3,60,000 (ii) ATM Service – Rs. 4.00, Computer processing – Rs. 0.50, Issuing Statement – Rs. 4.00,
Computer Inquires – Rs. 0.50 (iii) Deposit – 50 per unit, Loans – 30 per unit, Credit cards – 60 per unit]

11. RST Limited specializes in the distribution of pharmaceutical products. It buys from the pharmaceutical companies
and resells to each of the three different markets.
(i) General Supermarket Chains
(ii) Drugstore Chains
(iii) Chemist Shops
The following data for the month of April in respect of RST Limited has been reported
General Supermarket Drugstore Chemist
Chains Chains Shops
Average revenue per delivery 84975 28875 5445
Average cost of goods sold per delivery 82500 27500 4950
Number of deliveries 330 825 2750
In the past, RST Limited has used gross margin percentage to evaluate the relative profitability of its distribution
channels.
The company plans to use activity–based costing for analysing the profitability of its distribution channels. The Activity
analysis of RST Limited is as under:
Activity Area Cost Driver
Customer purchase order processing Purchase orders by customers
Line-item ordering Line-items per purchase order
Store delivery Store deliveries
Cartons dispatched to stores Cartons dispatched to a store per delivery
Shelf-stocking at customer store Hours of shelf-stocking

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CA INTER COST & MANAGEMENT ACCOUNTING

The April month’s operating costs (other than cost of goods sold) of RST Limited are Rs. 8,27,970. These operating
costs are assigned to five activity areas. The cost in each area and the quantity of the cost allocation basis used in
that area for the month of April are as follows:
Activity Area Total costs Total Units of Cost Allocation Base
Customer purchase order processing 220000 5500 orders
Line-item ordering 175560 58520 line items
Store delivery 195250 3905 store deliveries
Cartons dispatched to stores 209000 209000 cartons
Shelf-stocking at customer store 28160 1760 hours

Other data for the month of April include the following

General Supermarket Drugstore Chains Chemist Shops
Chains
Total number of orders 385 990 4125
Average number of line items per 14 12 10
order
Total number of store deliveries 330 825 2750
Average number of cartons shipped 300 80 16
per store delivery
Average number of hours of shelf- 3 0.6 0.1
stocking per store delivery

Required:
(i) Compute gross-margin percentage for each of its three distribution channels and compute rst limited’s operating
income.
(ii) Compute the rate per unit of the cost-allocation base for each of the five activity areas.
(iii) Compute the operating income of each distribution channel using the activity-based costing information. comment
on the results. what new insights are available with the activity-based cost information?
(iv) Describe four challenges one would face in assigning total operating costs of Rs. 8,27,970 to five activity areas

[Ans. (i) GSMC – 2.91%, DC - 4.76%, CS - 9.09% (ii) Rs. 40 per order, Rs. 3 per line item order, Rs. 50 per
delivery, Rs. 1 per dispatch, Rs. 16 Per hour (iii) GSMC - 6,53,840, DC - 9,43,965, CS - 8,86,600]

12. Family Store wants the information about the probability of the individual product lines : Soft drinks, Fresh produce
and Packaged food. Family store provides the following data for the current year for each product line:
Soft drinks Fresh produce Packaged food
Revenues Rs. 39,67,500 Rs. 1,05,03,000 Rs. 60,49,500
Cost of goods sold Rs. 30,00,000 Rs. 75,00,000 Rs. 45,00,000
Cost of bottles returned Rs. 60,000 Rs. 0 Rs. 0
Number of purchase orders placed 360 840 360
Number of deliveries received 300 2190 660
Hours of shelf stocking time 540 5400 2700
Items sold 1,26,000 11,04,000 3,06,000

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Family Store also provides the following information for current year :
S. No. Activity Description of Activity Total cost Cost allocation
basis
1. Bottle returns Returning of empty bottles to the store 60,000 Direct tracing to
product line
2. Ordering Placing of orders of purchases 7,80,000 1560 purchase Orders
3. Delivery Physical delivery and the receipts of merchandise 12,60,000 3150 deliveries
4. Self stocking Stocking of merchandise on store shelves and 8,64,000 8640 hours of Time
ongoing restocking
5. Customer Assistance provided to customers including 15,36,000 15,36,000 items sold
support bagging and checkout
Required:
(i) Family Store currently allocates store support costs (all costs other than the cost of goods sold) to the product
line on the basis of the cost of goods sold of each product line. Calculate the operating income and operating
income as the percentage of revenue of each product line.
(ii) If Family Store allocates store support costs (all costs other than the cost of goods sold) to the product lines on
the basis of ABC system, calculate the operating income and operating income as the percentage of revenue of
each product line.

[Ans. (i) Soft drinks – 67,500 (1.70%), Fresh produce – 7,53,000 (7.17%), Packaged food -1,99,500 (3.30%) (ii)
Soft drinks – 4,27,500 (10.78%), Fresh produce – 63,000 (0.60%), Packaged food - 5,29,500 (8.75%)]

13. BABYSOFT is a global brand created by Bio-organic Ltd. The company manufactures three ranges of beauty soaps
i.e. BABYSOFT- Gold, BABYSOFT- Pearl, and BABYSOFT- Diamond. The budgeted costs and production for the
month of December are as follows:
BABYSOFT- Gold BABYSOFT- Pearl BABYSOFT- Diamond
Production of 4000 3000 2000
soaps (Units)
Resources per Unit Qty Rate Qty Rate Qty Rate
Essential Oils 60 ml Rs. 200 / 100 ml 55 ml Rs. 300 / 100 ml 65 ml Rs. 300 / 100
ml
Cocoa Butter 20 g Rs. 200 / 100 g 20 g Rs. 200 / 100 g 20 g Rs. 200 / 100
g
Filtered Water 30 ml Rs. 15 / 100 ml 30 ml Rs. 15 / 100 ml 30 ml Rs. 15 / 100
ml
Chemicals 10 g Rs. 30 / 100 g 12 g Rs. 50 / 100 g 15 g Rs. 60 / 100 g
Direct Labour 30 Rs. 10 / hour 40 Rs. 10 / hour 60 Rs. 10 / hour
minutes minutes minutes
Bio-organic Ltd. followed an Absorption Costing System and absorbed its production overheads, to its products using
direct labour hour rate, which were budgeted at Rs. 1,98,000. Now, Bio-organic Ltd. is considering adopting an Activity
Based Costing system. For this, additional information regarding budgeted overheads and their cost drivers is
provided below:
Particulars Rs. Cost Drivers
Forklifting cost 58,000 Weight of material lifted
Supervising cost 60,000 Direct labour hours
Utilities 80,000 Number of Machine operations

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The number of machine operations per unit of production are 5, 5 and 6 for BABYSOFT- Gold, BABYSOFT- Pearl,
and BABYSOFT- Diamond respectively.
(Consider (i) Mass of 1 litre of Essential Oils and Filtered Water equivalent to 0.8 kg and 1 kg respectively (ii) Mass
of output produced is equivalent to the mass of input materials taken together.)
You are requested to:
(i) PREPARE a statement showing the unit costs and total costs of each product using the absorption costing
method.
(ii) PREPARE a statement showing the product costs of each product using the ABC approach.
(iii) STATE what are the reasons for the different product costs under the two approaches.

[Ans. (i) Unit Cost = Gold - 189, Pearl – 244.17, Diamond -291.50 (ii) Unit Cost = Gold – 192.48, Pearl – 243.70,
Diamond - 285.72 ]

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Case Scenarios

The sales department of A Limited is analysing the customer profitability for its Product Z. It has decided to analyse the
profitability of its five new customers activity-based costing method. It buys Product Z at Rs. 5,400 per unit and sells to
retail customers at a listed price of Rs. 6,480 per unit. The data pertaining to five customers are:
Customers
A B C D E
Cases sold 4500 6000 9500 7500 12750
Listed Selling Price Rs. 6480 Rs. 6480 Rs. 6480 Rs. 6480 Rs. 6480
Actual Selling Price Rs. 6480 Rs. 6372 Rs. 5940 Rs. 6264 Rs. 5832
Number of Purchase orders 15 25 30 25 30
Number of Customer visits 2 3 6 2 3
Number of deliveries 10 30 60 40 20
Kilometers travelled per delivery 20 6 5 10 30
Number of expedited deliveries 0 0 0 0 1
Its five activities and their cost drivers are:
Activity Cost Driver Rate
Order taking Rs. 4500 per purchase order
Customer visits Rs. 3600 per customer visit
Deliveries Rs. 7.50 per delivery Km travelled
Product handling Rs. 22.50 per case sold
Expedited deliveries Rs. 13,500 per expedited delivery
You have been assigned the following task of computing different cost information for managerial decision making:

(i) How much cost on customer visit is incurred on customer E?

(a) Rs. 7,200
(b) Rs. 10,800
(c) Rs. 21,600
(d) Rs. 3,600

(ii) What is the cost of goods sold for customer D?

(a) Rs. 2,43,00,000
(b) Rs. 3,24,00,000
(c) Rs. 5,13,00,000
(d) Rs. 4,05,00,000

(iii) How much is the cost of expediting delivery for customer A?

(a) Rs. 13,500
(b) Rs. 27,000
(c) Rs. 40,500
(d) Rs. 0

(iv) Compute the customer-level operating income of each of customers A.

(a) Rs. 55,72,350
(b) Rs. 46,82,550
(c) Rs. 47,57,400
(d) Rs. 50,57,325

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(v) Compute the customer-level operating income of each of five retail customers D and E.
(a) Rs. 46,82,550 & 50,65,720
(b) Rs. 55,72,350 & 46,85,500
(c) Rs. 47,57,400 & 55,72,350
(d) Rs. 61,88,550 & 50,57,325

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