Managerial Accounting and Finance 3A
Chapter 11:
Activity Based Costing
Learning Objectives
1. Explain the need for a cost accumulation system.
2. Explain the concepts underlying an ABC system
and describe differences between ABC and
traditional costing systems.
3. Illustrate how traditional systems provide
potentially misleading information.
4. Design an ABC system.
5. Describe the ABC cost and profitability hierarchy
6. Consider when an ABC system should be used.
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Need for cost accumulation
The Repairman
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Key Concept of ABC
Key ideas underlying ABC
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Potentially misleading information
Example 1
Kalin Ltd has one overhead cost centre.
Currently operates a traditional costing system using direct labour hours.
Product HV is made in high volumes whereas product LV is made in low volumes.
Product HV consumes 30% of the direct labour hours and product LV consumes
only 5%.
Product HV can be made in large production batches but product LV requires it to
be made in small batches.
A detailed investigation indicates that the number of batches processed causes the
demand for overhead resources.
You ascertain that product HV accounts for 20% of the batches processed while
product LV accounts for 15% of the batches
Overheads assigned to the cost centre amount to R1 million.
The direct costs and sales revenues assigned to the products are as follows:
Product HV Product LV
R R
Direct costs 310 000 40 000
Sales revenues 600 000 150 000
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Example 1 solution
Traditional System
Product HV Product LV
R R
Sales revenue
Direct costs
Overheads allocated
Profit/(loss)
ABC system
Product HV Product LV
R R
Sales revenue
Direct costs
Overheads allocated
Profit/(loss)
Comparing ABC to traditional
Activity-based costing Traditional costing
Uses a two stage allocation process. Uses a two stage allocation process.
In the first stage, overheads are assigned In the first stage, overheads are allocated
to each major activity cost centre. to production and service departments (or
cost centres).
ABC systems establish separate cost driver Service department costs are then
rates for support activities and assign reallocated to production departments.
these costs directly to cost objects.
In the second stage, cost drivers are used In the second stage, overhead allocation
to assign activity cost centre costs to cost rates (based on labour hours or machine
objects. hours) are used to allocate production
department costs to cost objects.
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Designing an ABC system
Example 2
ACTIVITY LEVEL EXAMPLE
Packing of the product by
workers (direct labour)
Design of the new flavoured
products by experts
Setting up of equipment
Use of machines to mix and
bottle the drinks
Sending out of monthly bills to
regular customers
Moving of materials from point
of delivery to where materials
are to be used in production
lines
Inspection of all completed
units for defects or faults.
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Example 3
ACTIVITY DRIVER
Machine settings are changed Machine hours
between batches of different
products
Products are made on a lathe (i.e. a Number of purchase orders
machine)
New products are designed Number of bills
A bill is sent to a customer who is Number of batches produced
late in making payments
Purchase orders are issued for Hours of design time
materials to be used in production
ABC Profitability Analysis
What is a hierarchy?
What is the goal of ABC profitability analysis?
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ABC Profitability Analysis
Product contribution • Contribution after deducting unit-level costs
(per unit)
Product contribution • Contribution after deducting batch-level costs
(per batch)
Product contribution • Contribution after deducting product-sustaining costs
(per product type)
Product brand • Contribution after deducting product-brand costs
contribution
Product line profit • Profits after deducting product-line costs
• Profits after deducting business unit/facility sustaining
Business unit profit costs
Resource Consumption Models
Cost of resources supplied = cost of resources
used + Cost of unused capacity
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When to use ABC
Key limitations of ABC
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Time-driven ABC
Under Time-Driven ABC, managers directly
estimate the resource demands required by
each cost object.
Self-Study
1. Periodic review of an ABC database (p. 274)
2. ABC cost management application (p. 274)
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