MAKERERE UNIVERSITY
COLLEGE OF BUSINESS AND MANAGEMENT SCIENCES
SCHOOL OF BUSINESS
MASTER OF BUSINESS ADMINISTRATION
(MBA) 2
2021/2022
MBS 8101: COST AND MANAGEMENT ACCOUNTING
Course Facilitator:
DR. FESTO NYENDE
GROUP 3
No. Name Reg. No.
1 Muwanguzi Joshua Clever 2021/HD06/20495U
2 Kiggundu Andrew 2021/HD06/20452U
3 Ishimwe Benjamin 2021/HD06/20432U
4 Namugenyi Angellah 2021/HD06/23776U
5 Odwol Moses 2021/HD06/20555U
6 Opolot Masood 2021/HD06/23305U
7 Nalubwama Eva 2021/HD06/20514U
8 Bugembe Dominic 2021/HD06/20418U
9 Martin Mugavu 2019/HD06/28180U
10 Kasami Paul 2021/HD06/20439U
TABLE OF CONTENTS
Activity Based Costing (ABC)........................................................................................................3
Introduction......................................................................................................................................3
Key Definitions Under Activity Based Costing..............................................................................4
Cost Units.....................................................................................................................................4
Cost Driver...................................................................................................................................5
Advantages of ABC System............................................................................................................6
Disadvantages of ABC....................................................................................................................7
Traditional Costing vs. Activity-based Costing...............................................................................8
Cost Pools....................................................................................................................................8
The emergence of ABC systems....................................................................................................10
Weakness of the Activity Based Costing.......................................................................................11
Factors not favouring ABC implementation..................................................................................11
Designing ABC systems................................................................................................................12
ABC profit analysis.......................................................................................................................14
Job Costing Under ABC costing....................................................................................................20
ABC COST MANAGEMENT APPLICATIONS.........................................................................20
Activity Based Management (ABM).........................................................................................20
Activity Based Budgeting..........................................................................................................22
As a Decision-Making Tool.......................................................................................................23
Activity Based Costing (ABC)
Introduction
It is common knowledge that managers can use management accounting as a tool to help them make
decisions, create plans, and implement controls. Dynamic changes in the business climate and fierce
global competition have corrected some of these issues.
Modern management accounting tools like Activity based Management, Activity based Costing,
Activity based Budgeting, Benchmarking, Balance Scorecard, Total Quality Management, etc. are
in demand due to the shortcomings of traditional management accounting system (MAS) in terms of
validity, completeness, consistency, relevance, and understanding.
Activity-based costing (ABC) was created and has been promoted as a way to get around the
traditional cost accounting's systematic distortions and restore managerial accounting's relevance.
The cost of activities and processes is not reported by a traditional system, which instead reports
what money is spent on and by whom (Miller 1996). The new costing methodology has been
adopted by numerous organizations in the manufacturing sector. The authors Aranoff et al. (1998)
identified two goals for activity-based costing. Preventing cost distortion is the first goal.
Traditional costing combines all indirect costs into a single cost pool, which results in cost
distortion. ABC uses a variety of cost pools (activities) and cost drivers to avoid cost distortion. By
offering a process view, the second goal is to reduce waste or non-value-adding activities.
In a traditional system, the cost of activities and processes is not reported, only what money is spent
on and by whom (Miller 1996). The new costing approach has been adopted by many businesses in
the manufacturing sector. According to Aranoff et al. (1998), activity-based costing serves two
purposes. The primary goal is to avoid cost distortion. Because traditional costing lumps all indirect
costs into a single cost pool, cost distortion results. By implementing numerous cost pools
(activities) and cost drivers, ABC prevents cost distortion. By giving a process view, the second
goal is to reduce waste or activities that don't add value.
Some traditional costing systems link overhead expenses to production and service center expenses,
distributing service center expenses to production centers prior to determining the absorption rate.
The main errors are found when calculating the rate at which overheads are absorbed, which is
typically based on machine and labor hours under the presumption that products that take longer to
produce generate more overheads.
Organizations that don't care to know the exact unit cost of their goods are therefore fine with the
traditional costing system. But because of the current rise in automation brought on by technology,
overhead costs have increased significantly relative to direct costs, necessitating accurate costing of
these costs more than ever.
Additionally, managers need to precisely cost their products in order to compete on the market due
to the intense competition that has recently existed in business.
ABC is a contemporary method for accurately absorbing costs into products.
ABC is defined by the Certified Institute of Management Accounting as cost attribution to cost units
based, for instance, on benefits received from indirect activities. placing orders, organizing, and
ensuring quality based on activity Costing can be defined as the process of gathering data on the
financial and operational performance of an organization and connecting it to the costs of its key
initiatives.
Key Definitions Under Activity Based Costing
Activities: This is the cost-related event
A cost object is anything that requires a separate cost measurement. A cost object could be a
product, service, project, customer, brand category, activity, department, or program, for example
Product Smart phone, Tablet computer, SUV Car, Book etc.
Service An airline flight from Delhi to Mumbai, Concurrent audit
assignment, Utility bill payment facility etc.
Project Metro Rail project, Road projects etc.
Activity Quality inspection of materials, Placing of orders etc.
Process Refinement of crudes in oil refineries, melting of billets or ingots
in rolling mills etc.
Department Production department, Finance & Accounts, Safety etc.
Cost Units
It is a unit of product, service or time (or combination of these) in relation to which costs may be
ascertained or expressed.
We may for instance determine the cost per ton of steel, per ton-kilometer of a transport service or
cost per machine hour. Sometime, a single order or a contract constitutes a cost unit. A batch which
consists of a group of identical items and maintains its identity through one or more stages of
production may also be considered as a cost unit. Cost units are usually the units of physical
measurement like number, weight, area, volume, length, time and value.
A few typical examples of cost units are given below:
Industry or Product Cost Unit Basis
Automobile Number
Cement Ton/ per bag etc.
Chemicals Litre, gallon, kilogram, ton etc.
Power Kilo-watt hour (kWh)
Steel Ton
Transport Passenger- kilometer
Gas Cubic feet
Some examples from the CIMA terminology are as follows:
Industry Sector Cost unit
Brewing Barrel
Brick-making 1,000 bricks
Coal mining Tonne/ton
Electricity Kilowatt-hour (kWh)
Activity Cost unit
Credit control Accounts maintained
Selling Customer call, value of sales, orders taken
Materials storage/handling Requisition unit issued/received, material
movement, value issued/received
Personnel administration Personnel record
Cost Driver
A cost driver is a factor or variable that influences the cost level. In general, it is an activity that
causes cost to be incurred. A cost driver is the level of activity or volume of production. An activity
can be an event, a task, or a unit of work, among other things.
CIMA Official terminology defines cost driver as "Factor influencing cost level." Frequently used
in the context of ABC to denote the factor that connects activity resource consumption to product
outputs, such as the number of purchase orders, which would be a cost driver for procurement cost."
Examples of cost drivers are number of machines setting ups, number of purchase orders, hours
spent on product inspection, number of tests performed etc.
Cost Centres: The responsibility centre which is held accountable for incurrence of costs which
are under its control. The performance of this responsibility centre is measured against pre-
determined standards or budgets. The cost centres are of two types:
Standard Cost Centre and Discretionary Cost Centre
Standards Cost Centres: Cost Centre where output is measurable and input required for the output
can be specified. Based on a well-established study, an estimate of standard units of input to
produce a unit of output is set. The actual cost for inputs is compared with the standard cost.
Any deviation (variance) in cost is measured and analysed into controllable and uncontrollable
cost. The manager of the cost centre is supposed to comply with the standard and held responsible
for adverse cost variances. The input-output ratio for a standard cost centre is clearly identifiable.
Discretionary Cost Centre: The cost centre whose output cannot be measured in financial terms;
thus input-output ratio cannot be defined. The cost of input is compared with allocated budget for
the activity. Example of discretionary cost centres are Research & Development department,
Advertisement department where output of these department cannot be measured with certainty and
co- related with cost incurred on inputs.
A Cost Pool is a collection of various individual cost items. It is made up of costs that have the
same cause and effect relationship.
Advantages of ABC System
The growing industrial complexity and product diversity have made the emergence of ABC system
for growing firms. As a powerful tool for decision making purpose, the major advantages of ABC
systems are discussed below:
1. ABC increased operational performance by allocating overhead costs based on the actual
consumption of the resources by each activity.
2. ABC recognizes the interdependencies of cost drivers to activities.
3. It enables the management to see where the most important costs occur as well as what provides
them.
4. Decisions about improving pricing, marketing, product designing and product mix can be made
more efficiently by implementing an ABC system.
5. ABC system is the suitable method for correct and accurate information.
6. Redeploying a resource from a non value-added to a value-added activity.
7. By identifying the weak product lines and accurate costs, ABC helps to increase organizational
efficiency and profitability.
8. Completely eliminating a non value-adding activity ABC can takeout costs.
9. Identifying and correcting an error that was not budgeted for correcting an error that was not
budgeted for correction but would have caused an expense had it not been corrected.
10. Provide Growth by removing a bottleneck that was causing a capacity constraint.
11. It helps industrial marketers in three ways; it results in cost estimates to use in pricing, guides
industrial marketers to adjust in negotiations to yield significant cost reductions and indicates areas
for change in operations to permit cost reductions that will allow the company to satisfy customer
wishes better.
Disadvantages of ABC
1. ABC system is more costly to maintain than a traditional costing system.
2. The implementation process of ABC system is very complex for managers to understand and it
produces numerous data, activity measures and requires collecting, checking process etc.
3. Because of complexity of the process the decision making process becomes lengthy.
4. Resistances from the management as managers are accustomed to using traditional costing
systems to run their operations.
5. ABC data can easily be misinterpreted as there are huge amount of irrelevant data.
6. In practice, as managers insist on allocating all costs-to-costs objects, these results overstated cost
and understated margin results mistakes in pricing.
7. If no one in the organization looks at the new ABC cost and profitability information, the project
team becomes disappointed.
8. Consultants are not familiar with companies’ operation and problems. Hence, they failed to
support management in some cases.
9. Resistance arises because people feel threatened by the suggestion that their work could be
improved.
Traditional Costing vs. Activity-based Costing
A costing system determines the cost of a cost object through completing two basic steps: cost
accumulation and cost assignment. Cost accumulation means collecting cost data in an organized
way through an accounting system. The accumulated costs are then assigned to the cost object
through tracing (for direct costs) and allocation (for indirect costs, which are also called overheads).
Traditional costing and Activity-based Costing (ABC) are identical in the way that they trace direct
costs to a cost object, but differ in the way that they allocate indirect costs to a cost object. There are
two significant differences between traditional costing and ABC:
Cost Pools
Traditional costing uses cost centres as cost pools and allocates indirect costs to a cost object
through those cost centres. Figure 1 shows the process of cost allocation under traditional costing,
using the product as the cost object.
In the above figure, indirect costs are first assigned (both traced and allocated, depending on
whether a specific indirect cost item can be directly traced to a cost centre or not) to cost centres.
Here cost centres include service departments, which provide internal services to others
departments, and production departments, which directly participate in the production process. The
costs accumulated in service departments are then reallocated to production departments using the
direct method, step-down method or reciprocal method. By this time, the indirect costs accumulated
in production departments include the departments’ own indirect costs and any indirect costs
received from service departments. These indirect costs are then allocated to products by using the
allocation rate (also called the absorption rate). Since assigning costs to cost centres and reallocating
service departments’ costs to production departments are both complicated topics and this article is
about the difference between traditional costing and ABC, the remaining part of the article will
focus solely on cost allocation from production departments to products.
Under ABC, cost centres are not used as cost pools to allocate indirect costs. Instead, activities are
used as cost pools. Indirect costs are first accumulated in activity cost pools and then allocated to
products using activity cost driver rates according to the products’ requirements for different
activities. Figure 2 shows the process.
The choice of cost pools under ABC is more reasonable because companies consume resources as a
result of conducting activities instead of having cost centres. For example, consider a company that
claims to have a production department but does not conduct any production activities. Under
traditional costing, it does not actually incur costs. However, the company will incur costs when the
production department conducts production activities, such as handling materials, setting up
machines, running those machines and doing quality control.
The emergence of ABC systems
History of ABC System or How did Activity Based Costing emerge?
Activity Based Costing (ABC System) is the latest development of Cost Accounting System. Under
ABC system, the overheads are absorbed on a more realistic basis than just equitable basis.
Many manufacturing companies are now compelled to use advanced manufacturing technology. In
this type of environment, overheads rise while direct costs fall, particularly direct labor costs. As a
result, the proportion of direct labor costs is very low and the proportion of overheads is very high.
There used to be a sellers’ market. When the majority of companies manufacture a limited number
of products. Direct materials and direct labor were the dominant factors of production in this case.
There are very few overheads. The cost of processing the costing data was extremely high.
Today, a single company produces a large number of products at the same time. Because the
production is done automatically, the overheads are very high. With increased global competition,
accurate product costing is required to avoid misleading decision-making.
In the manufacturing industry, expenses such as material handling and machine setup are incurred.
These costs are combined with volume-rated costs such as purchase and manufacturing expenses.
This is not the proper method. These expenses are calculated separately on an activity basis and
apportioned to the end products to determine the correct product cost.
The Activity Based Costing system has the potential to provide managers with more useful
information. The primary emphasis of activity-based costing is on an activity rather than a
department, section, or division. A department, section, or division has a number of activities that
are either value-added or non-value-added. With the help of activity-based costing, non-value
activities are eliminated in order to allocate indirect costs for costing purposes.
Several factors contributed to the development of ABC, these include
-Rising overhead costs due to increasingly automated production and rising market competition,
which necessitated more accurate product costs.
-Increasing product diversity to ensure scope economies and increased market share.
-Reduced information processing costs as a result of continuous improvements and increased
application of information technology.
Areas of ABC strength
When production overheads are high and significant in cost, ABC will be very useful instead of
traditional costing system.
ABC is best suited when there is a diversity in the product range or when there are multiple
products.
When an organization is facing stiff competition and there is an urgent need to compute costs
accurately and set the selling price based on the market situation, ABC is very useful. ABC can also
assist in cost reduction by identifying non-value-adding activities in the manufacturing process that
may be a suitable focus for attention or elimination.
Non-volume related activities: When non-volume related activities, such as material handling and
inspection set-up, are prevalent and a traditional system cannot be used, ABC is a superior and
better option. ABC will identify non-value-added activities in the manufacturing process that could
be prioritized for attention or eliminated.
Weakness of the Activity Based Costing
The main disadvantages of using Activity Based Costing are: It is more expensive, especially when
compared to traditional costing systems.
It is not beneficial to small businesses.
It should not be used by organizations with few products.
The selection of the most appropriate cost driver may be ineffective.
Factors not favouring ABC implementation
First of all, the decision on the implementation of an ABC system should well be considered
because the change not only needs resources in the form of man hours and capital (in buying the
necessary equipment), but also the involvement of employees. Secondly, the difficulties of
implementing ABC are lost production, congestion on the factory floor and lack of involvement. If
cost drivers are used to measure the performance of employees in developing a reward system, then
the consequence is that manager and especially the employees will focus too much on the cost
drivers. Another example is that if the number of stations in a production line is the cost driver for a
product, then there will be a need to combine more tasks at different stations and thus limit the
number of them. This would have a positive effect on the cost driver; however, it has negative effect
on the throughput time. Overall, it may lead to a considerable cost while unnoticed. In the 1990s,
new cost and management systems have been introduced acknowledging the advantages of ABC.
However, the application of ABC cannot be generalized for any manufacturing/service
environment. For example, in many cases manufacturing strategies such as reengineering and theory
of constraints are more preferred for controlling the performance
Designing ABC systems
Steps in ABC
• Identify which activities are
necessary to create a product
• Separate each activity into its
own cost pool
• Assign activity cost drivers to
each cost pool
• Divide the total overhead in
each cost pool by the total cost
drivers to get your cost
driver rate
• Compute how many hours,
parts, units, etc. that the activity
used and multiply it by the
cost driver rate to find total cost
• Calculate Cost per Unit by
dividing the Total Cost by Total
Units produced
Steps in ABC
• Identify which activities are
necessary to create a product
• Separate each activity into its
own cost pool
• Assign activity cost drivers to
each cost pool
• Divide the total overhead in
each cost pool by the total cost
drivers to get your cost
driver rate
• Compute how many hours,
parts, units, etc. that the activity
used and multiply it by the
cost driver rate to find total cost
• Calculate Cost per Unit by
dividing the Total Cost by Total
Units produced
Steps in ABC
• Identify which activities are necessary to create a product
• Separate each activity into its own cost pool
• Assign activity cost drivers to each cost pool
• Divide the total overhead in each cost pool by the total cost drivers to get your cost driver rate
• Compute how many hours, parts, units, etc. that the activity used and multiply it by the cost driver
rate to find total cost
• Calculate Cost per Unit by dividing the Total Cost by Total Units produced.
The following are the stages in ABC calculations:
1. Identify the various activities that occur within the organization: A traditional overhead system
typically employs a small number of cost centers, say up to fifteen. The number of activities in ABC
will be much higher, say 400; the exact number will depend on how the organization's activities are
subdivided by management. The organization can be divided into many very small activities.
However, if ABC is to be accepted as a practical system, larger groupings must be used, so that, say,
50 activities can be used in practice. Because of the increased number of activities over cost centers,
ABC should be more accurate than the traditional method regardless of other factors.
Activities can include
Material handling
Maintenance
Marketing
Advertisement
2. Connect the overheads to the activities that caused them, both support and primary. This results in
the formation of 'cost pools' or 'cost buckets.' This will be accomplished through the use of resource
cost drivers that reflect causality.
3. Support activities are then distributed across the primary activities on some appropriate base,
reflecting the support activity's use. The base is the cost driver that is used to determine how support
activities are used.
4. Identify the activity cost drivers that will be used to link overheads collected in cost pools to cost
objects/products. This is based on the factor that drives activity consumption. The question is, what
causes the activity to cost money? For example, in production scheduling, the driver will probably
be the number of batches ordered
5. Determine activity cost driver rates for each activity in the same way that an overhead absorption
rate would be determined in the traditional system.
¿Total cost of activity
Activity cost driver rate=
Total Cost Driver
Difference between Traditional Cost System and ABC system
Basis Traditional ABC
One or limited number Many
1. Cost pools
2. Applied Rate Volume based Activity Based
3. Applied for Labour Intensive Capital Intensive
4. Benefits Simple, Inexpensive Accurate product costing,
identification of necessary
activities etc
5. Cost assignments Primary and secondary Allocation of cost pool based
distribution of Overhead and on cost drivers then
then allocation of Overhead allocation of costs to product
as per the suitable or service based on the
drivers used by the
particular product or service
6. Focus Departments or responsibility Processes and activities
centres
Allocation Bases Under traditional costing,
The allocation bases used to allocate indirect costs are volume-based allocation bases. Examples
include direct materials costs, direct manufacturing labour hours, machine hours, output volume,
and so on. These allocation bases have a positive correlation with output volume. Therefore, they
are called volume-based allocation bases. By using volume-based allocation bases, traditional
costing simply assumes that all indirect costs are driven by output volume. However, this
assumption is not realistic because many indirect costs are not actually affected by output volume.
For example, the design cost of a product is affected by the complexity of the product. Once the
product design is finished, the design cost is fixed no matter how many units of the product are
finally produced. To recognize the diversity of operating activities, the ABC method classifies
operating activities into four hierarchies and applies relevant allocation bases to allocate activity
costs. The allocation bases chosen usually have a causal relationship with activities in different
hierarchies, and thus they are also called activity cost drivers.
ABC profit analysis
Table 1 provides a summary of cost hierarchy
Table 1: Activity Cost Hierarchy
Activities Examples of Cost Pools Examples of Cost Drivers
Unit-level activity (a) Electricity costs (a) Machine hours
Activities that are performed
(b) Product handling (b) Output unit
on each unit of a product or
service costs
Batch-level activity (a) Machine setup (a) Number of setups
Activities that are performed
costs (b) Number of production
for each batch of products,
regardless of batch size (b) Inspection costs runs
Product-sustaining activity (a) Product design (a) Number of components,
Activities that are performed which reflects product
to support each type of complexity
product, regardless of the
number of batches or number
of units produced
Facility-sustaining activity (a) Factory (a) Direct labour hours,
Activities that are performed supervision costs assuming most of the factory
to maintain business (b) Plant insurance manager’s work is related to
operations but not directly managing workers (b) Square
linked to a specific product footage of plant space
By recognizing the diversity in activities and using relevant cost drivers, ABC releases the
assumption that all indirect costs are driven by output volume. Thus, it can provide more accurate
cost information for decision-making purposes.
Illustration 1
MBA 2021 Co. is an ice cream producer. Currently it produces at capacity and sells ice cream in
two flavours: vanilla and mocha-almond. The company is using traditional costing, under which
indirect costs are allocated based on direct labour hours. The operating data for MBA 2021 Co. in
May 2022 is as follows.
Particulars Vanilla Mocha-almond
Units produced and sold 50,000 1,000
Price $30 $50
Direct labour hours per unit 0.02 0.02
Direct labour cost per hour $50 $50
Machine hours per unit 0.01 0.01
Machine setup hours per 4 6
production run
Number of production runs 50 10
Direct Material Used 300,000 10000
The company incurs manufacturing overheads totaling $1,275,000 in May 2022. An interview with
the production manager shows that the following activities are required in the production process
during the month.
Activity Hierarchy Cost Driver Costs
Run machine Unit-level activity Machine hours $510,000
Handle production run Batch-level activity Production runs $144,000
Set up machine Batch-level activity setup hours $520,000
Support products Support products Number of products $101,000
activity
$1,275,000
Required:
1. Calculate the profit for each product using traditional costing.
2. Calculate the profit for each product using ABC.
3. Comment on the results calculated above
Solutions:
Requirement 1:
Profitability of Two Products under Traditional Costing
Particulars Vanilla ($) Mocha-almond (($) Total ($)
Sales revenue 1,500,000 50,000 1,550,000
Direct materials 300,000 10,000 310,000
Direct labour 50,000 1,000 51,000
Manufacturing 1,250,000 0 25,000 1,275,000
overhead
Gross margin (100,000) 14,0000 (86,000)
Requirement 2
Activity Cost Driver Rate
Activity Cost Vanilla Mochaal- Total Activity Driver rate
Driver mond Activity Cost ($) ($)
Run Machine 500 10 510 510,000 1,000
machine hours
Handle Handle Handle Handle Handle Handle Handle
Handle production 50 10 60 144,000 2,400
production runs
run
Set up Machine 200 60 260 520,000 2,000
manches setup
hours
Support Number of 1 1 2 101,000 50,500
Products Products
Profitability of Two Products under ABC
Vanilla ($) Mocha-almond ($) Total ($)
Sales revenue 1,500,000 50,000 1,550,000 1,550,000
Direct materials 300,000 10,000 310,000
Direct labour 50,000 1,000 51,000
Manufacturing
overheads
Run machine 500,000 10,000 510,000
($1,000 × 500;
$1,000
× 10)
Handle production 120,000 24,000 144,000
run
($2,400 × 50; $2,400
×
10)
Setup machine 400,000 120,000 520,000
($2,000 × 200;$2,000
× 60)
Support product 50,500 50,500 101,000
($50,500 × 1)
Gross margin 79,500 (165,500) (86,000)
Requirement 3:
The result shows that traditional costing overcosted ‘Vanilla’ and undercosted ‘Mocha-almond’.
Although ‘Mocha-almond’ is a small-volume product, it consumes a lot of batch-related resources,
as well as having the same product-sustaining cost as ‘Vanilla’. Allocating overheads based on
product volume using traditional costing results in product-cost cross-subsidization, which means
that the high-volume product ‘Vanilla’ subsidizes the low-volume product ‘Mochaalmond’. In other
words, ‘Vanilla’ bears some of the costs that are actually consumed by ‘Mocha-almond’.
According to the ABC result, ‘Vanilla’ is profitable product. However, due to the loss caused by
‘Mocha-almond’, the company suffers a loss as a whole. The company may improve its profits by
[Link] the production batch size for ‘Mocha-almond’ by encouraging customers to place
large-size orders. Given the same production volume, batch-related costs can be reduced by
increasing the batch size.
2. Increasing sales of ‘Mocha-almond’ by offering a discount. The product-sustaining cost will
remain the same even though sales increase. Therefore, profits will increase faster than costs will
increase.
3. Improving production efficiency to reduce activity cost driver rate. For example, the company
can better train its setup workers to reduce the cost for each machine setup hour.
Illustration 2
Jose Co Limited has been spending on two types of overhead costs namely; material handling and
quality inspection. The company predicts the costs of these categories for the coming year to be as
follows:
Ugx.
Material handling 1,000,000
Quality inspection 3,000,000
Currently, the company charges overhead costs using direct labour hours and projected actual
capacity is 50.000 direct labour hours. The production manager has been asked to submit a bid and
has put together the following data concerning the proposed job.
Job (Ugx.)
Direct material costs 37,000
Direct labour costs (1,000 hours) 70,000
Number of material moves 10
Number of inspections 5
The manager has been informed that many competitors use an ABC approach to assign overhead to
jobs. Before submitting her bid for proposed job, she wants to assess the effects of this alternative
approach. She estimates that the likely number of materials moves for all jobs during the year is
1,000. Similarly, she expects 5,000 quality inspections to be performed.
i) Compute the total cost of the proposed job using direct labour hours to assign overhead
(i.e., traditional approach). Assume the bid price is full manufacturing cost plus 25%,
what would be the manager’s bid?
ii) Compute the total cost of the job using number of material moves to allocate material
handling costs and the number of inspections to allocate the quality inspection costs 6
(ABC approach). Assume bid price is full manufacturing cost plus 25%. What would be
his bid using this approach?
iii) Which approach do you think best reflects the actual cost of the job? Explain.
Solutions
(i) Traditional Based Costing
budgeted
Total
Absorption rate overhead = head
Total labour hours
4 ,000,000
Absorption rate for the overhead =
50,000
= 80/= per labour hours
Job costing Under traditional based costing
Item /cost Calculation Amount
Material 37,000
labour 70,000
Overhead 80*1000 80,000
Total cost 187,000
Job cost 1.25*187,000 233,750
(ii) Activity Based Costing
handling
Total budgeted material
Cost driver rate for material handling overhead = head
Total cost driver
1,000,000
=
1,000
= 1000 per material moves
handling
Total budget material
Cost driver rate for material handling overhead = head
Total cost driver
3,000,000
=
5,000
= 600 per number of inspections
Job Costing Under ABC costing
Item /cost Calculation Amount
Material 37,000
labour 70,000
Overheads
Material handling 1000*10 10,000
Quality Inspection 600*5 3,000
Total cost 120,000
Job cost 1.25*187,000 150,00
ABC COST MANAGEMENT APPLICATIONS
Activity Based Management (ABM).
Activity Based Management (ABM) deals with the procedures or phases of implementing
ABM,system in organization. Each organization requires information to make decisions, set
priorities, allocate resources and monitor the actions taken. Activity Based Costing (ABC) covers
the accounting perspective to provide the accurate cost information and ABM undertakes a
managerial perspective focusing on using information generated by ABC to manage activities and
improve the business. The analysis done in ABC provides both financial and non-financial
information which is the basis for ABM. It makes the cost and operational information (activity
information) useful by providing a value analysis, cost and activity driver analysis, and performance
measures to initiate and support various improvement efforts with an ultimate goal of improving the
quality of decision.
Various Activity Based Management analyses
The following are the various types of analysis involved in ABM:
I Cost Driver Analysis:
In order to manage activity costs, the factors that cause activities to be performed must be identified.
These causal factors are identified through cost driver analysis.
(ii) Activity Analysis.
VA: Value-Added Activities The value-added activities are those that are required for the process
to be completed. Customers are usually willing to pay for services (in some way). Polishing
furniture by a furniture manufacturer, for example, is a value-added activity.
Non-Value-Added (NVA) Activities: An NVA activity is work that is not valued by the external or
internal customer. NVA activities have no effect on the quality or function of a product or service,
but they can have a negative impact on costs and prices. NVA activities include moving materials
and preparing a machine for a production run.
(III) Performance Analysis:
Performance analysis entails identifying appropriate measures to report the performance of activity
centers or other organizational units that are consistent with the goals and objectives of each unit.
More particularly, the standard may be applied by the management accountants, as well as others
who want to implement ABM in their organizations, among others, for the following purposes:
Attribute analysis: Under attribute analysis costs and performance data are classified and combined
into manageable and controllable clusters. ABM system can use different attributes or data tags for a
specific cost. These data attributes help of the companies to perform different dimensions of
management problem using the same basic warehouse/ storage of data. Some common forms of
attribute analysis are value analysis, time variability analysis, cost of quality analysis etc
Strategic analysis: ABM system supports strategic analysis by providing both strategic and
operational information. Strategic analysis, using ABM, may include: strategic planning/budgeting,
consolidation of operations analysis, acquisition analysis, and analysis of revenue and growth
potential.
Benchmarking: ABM supports different type of benchmarking e.g. internal benchmarking,
industry/ competitive benchmarking, best-in-class benchmarking etc.
Operational analysis: ABM may be used to perform operational analysis, including "what-if"
analysis, project management, creation and use of activity based performance measures, capacity
management, constraints analysis, process based costing etc
Profitability/ pricing analysis: Organizations may use ABM in analyzing costs and benefits of
products/ services and processes both in the present scenario and post improvement scenario. ABM
can also be used in pre-launch analysis and improvident of product/ service profitability. ABM
facilitates other analysis including product/ service profitability analysis, distribution channel
profitability analysis, market segment profitability analysis, target and life-cycle costing etc.
Improvement of operating process: ABM may be used for improvement of operating process
identifying causes of variation, waste, inefficiency and then taking incremental or quantum change
efforts to increase the value per resources consumed by an organization. Process improvement may
include business process modeling, business process reengineering, total quality initiatives, analysis
of outsourcing, shared services opportunities etc.
Product mix: ABM may help to take decision regarding the product mix- which products to
produce/ sale and at what proportion.
Activity Based Budgeting
Activity-Based Budgeting (ABB) is a budgeting method in which activities are identified, and
costs are directly allocated to those activities.
ABB is budgeting by Activities rather than by Expenditure Types.
By budgeting according to activities, it can show where the project is providing value for money,
and where potential costs are difficult to justify.
This will lead to greater efficiency, enabling us to identify waste and lack of value, and to link the
budget to project planning/implementation. It will also enable us to monitor the progress of the
project, financially, by comparing planned against actual expenditures.
Illustration
The following, more traditional, budget tells us little about the project we are being asked to assess.
It is a budget based upon Expenditure Types. We do not know to which activities the costs are
applicable, or whether we are spending unwisely on some elements of personnel, for example, or
whether the capital costs, whatever they may be, are justifiable. We do not know what each of the
project activities will cost. This type of budget is more akin to an advance invoice than a budget for
activities to be undertaken.
Expenditure Category Total Cost
Personnel 11075
Accommodation & Subsistence 6000
Capital 2000
Monitoring and Evaluation 1600
others 9800
Total 66900
An Activity Based Budget focuses upon the process, rather than the inputs. ABB shows that
required resources are a consequence of activities to be undertaken, and so justifies the allocation of
resources. ABB identifies the sequence of activities and enables the identification of milestones for
monitoring. ABB identifies what resources need to be budgeted to perform the activities.
ABB is not an end in itself. It becomes part of the process, and part of the project structure. Filling
in Section B2 is a requirement, and should be undertaken as outlined above. It is simple, logical and
extremely productive. It will identify many strengths and weaknesses in the project structure before
implementation, and will consequently strengthen or weaken the case.
Without an ABB, a project is fundamentally weakened and strongly indicates poor planning.
As a Decision-Making Tool
• ABC, in conjunction with another Cost Management technique, can be used to improve an
organization's performance and profitability.
By correlating costs to various activities, wholesale distributors can gain a significant advantage in
the decision-making process by implementing ABC concepts. ABC can help you decide when to
introduce a new product or vendor.
• ABC can help with facility and resource expansion decisions. Cost associations are frequently
used to justify the relocation or opening of a new distribution center. Reduced freight or other
logistic costs can help to offset the cost of the new facility, staff, or equipment. The ABC model can
identify the specific cost elements being targeted, providing management with a much clearer
picture from which to act.
• ABC can help with human resource decision support. New levels of financial performance can be
determined when activity, and thus cost, can be linked to an individual. This could be useful in cases
of branch management or sales.
• Companies that want to price their products on a cost-plus markup basis find the ABC method of
costing to be very useful in determining competitive prices.
REFERENCES:
Anthony A. Atkinson, Robert S. Kaplan, Ella Mae Matsumura, and S. Mark Young (2011).
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Charles T. Horngren, Srikant M. Datar, and Madhav V. Rajan (2015). Cost Accounting: A
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of Management Accounting, Harvard Business School Press, Boston, MA.
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accountant”, Management Accounting, July/August, pp. 34‐8.
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