10 Activity-based costing
Contents:
1. Learning Outcomes
2. Definitions
3. Activity Based Costing (ABC)
Candidates should be able to:
The application of activity-based costing (ABC)
What is meant by cost drivers
The ways to use ABC to
Identify the appropriate cost driver
Apportion and allocate overheads
Calculate the total cost and selling price of a unit
The uses and limitations of ABC.
Definitions
It is the direct cause of the cost incurred by the
Cost Driver
business activities.
The amount of money spent on the ”activity”
Cost pool
rather than splitting the overhead costs equally.
10.1 Activity-Based Costing (ABC)
10.1.1 The application of activity-based costing and its need
We should recall that total cost contains direct costs and indirect or overhead costs. Direct costs are
those costs that can be directly traced to a unit being produced while overheads refer to those indirect
costs that can't be directly traced.
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In the past direct costs such as direct labour formed a significant chunk of the total cost, therefore
using absorption costing made sense as the basis of apportionment used would be the direct labour
hours.
However, in recent times the component make-up of the total cost is dominated mostly by overheads.
The direct costs are only a small portion of the total cost now, Therefore, this change in total cost
structure has made it necessary to use absorption-based costing.
Activity-based costing is an attempt to overcome the shortcomings of absorption costing. It uses a
more realistic approach to absorb factory overheads rather than using labour hours or machine hours.
Each activity that generates cost is analyzed and then the cost incurred is absorbed on the basis of
the number of times the particular activity was performed.
The number of absorption rates depends upon the number of overheads being incurred.
The cost of running each department is analyzed. Then each separate activity or cost driver is totalled
into cost pools.
Finally, the cost of each activity can then be calculated:
Cost of Activity
Number of times that activity is performed
10.1.2 What is a cost driver?
A cost driver is an activity that will cause an overhead to be generated. These overheads arise as a
result of several different activities such as:
Setting-up machinery for a new batch of products
Maintenance of machinery
Inspection and checking
Packaging of products
Ordering of supplies and materials
These cost drivers are driven by the activity of the business i.e., they aren’t caused by the labour or
cost of the material. Hence, this cost will need to be included in the cost of each unit of output. These
costs are not related to the production of the units, or the labour cost incurred. They are indirect
overhead costs and need to be allocated on an activity consumption basis. Thus, the use of ABC is
deemed to be more realistic.
10.1.3 How to use activity-based costing
The stages of an activity-based costing system are:
1. Record and classify all costs.
2. Identify the activities that produce overhead costs
3. Identify cost drivers
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4. Apportion the overheads to the cost drivers
5. Calculate the cost driver rate.
6. Absorb direct and indirect costs into the product.
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Skill Check 1
Danlop incurred the following costs:
Machinery set-up 7290
Ordering Costs 7000
Quality Control 2170
Selling Expenses 6800
Product selling price is based on cost plus 30%
Additional Information
Product A Product B Product C
Direct Materials $10 000 $3 000 $9 000
Direct Labor $12 000 $15 000 $4 000
Number of machine
30 16 8
set-ups
Number of purchase
4 000 1000 2000
orders
Number of quality
20 20 30
inspections
Number of sales 4 000 3 500 1000
Number of products
5 000 3 000 900
produced
Required:
Calculate:
1. The activity-cost driver rate
2. Overheads per product
3. Total cost per product
4. Selling price for each product
Solution
Machine set- Selling
Activity Ordering Quality control
1. ups expenses
7290 7000 2170 6800
Cost ($) 58
7000
70
8500
Cost driver
Cost driver rate $135 $1 $31 $0.8
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Machine set- Selling
Ordering Quality control
2. ups expenses
30*$135 4000*$1 20*$31 4000*$0.8
A
=$4050 =$4000 =$620 =$3200
16*$135 1000*$1 20*$31 3500*$0.8
B
=$2160 =$1000 =$620 =$2800
8*$135 2000*$1= 30*$31 1000*$0.8
C
=$1080 $2000 =$930 =$800
Total Overheads:
A) $11870 (4050+4000+620+3200)
B) $6580 (2160+1000+620+2800)
C) $4810 (1080+2000+930+800)
3.
Product A Product B Product C
$ $ $
Allocated direct
costs
materials 10000 3000 9000
Labor 12000 15000 4000
Apportioned
11870 6580 4810
overheads
Total Cost 33870 24580 17810
4.
The selling price can be determined by using the total costs from (c) or by using the unit
costs.
Using total costs $33870 * 1.3 (mark-up)= $44031 for 5000 units of A
The selling price of product A = $8.806
Total costs $24580 *1.3= $31954 for 3000 units of B
The selling price of product B= $10.65
Total Costs $17810 * 1.3= $23153 for 900 units of C
The selling price of product C = $25.72
Using unit costs for each product:
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Product A Product B Product C
$ $ $
Direct materials 2 1 10
Direct labour 2.4 5 4.44
Prime Cost 4.44 6 14.44
Overheads 2.374 2.193 5.34
Total cost per unit 6.814 8.193 19.78
Mark-up 2.044 2.457 5.934
Selling price 8.858 10.65 25.714
10.1.4 The total cost and selling price of a unit
Activity-based costing can be used to help a business set prices for its products. This would be
calculated either as a percentage of markup based on the cost calculated as per ABC.
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Skill Check 2
Kellops Ltd manufactures two products Brant and Drimp. The following budgeted figures are
available.
Brant Drimp
Sales (Units) 7000 3000
Direct labour hours per unit 3 2
Direct labour costs per unit $10 $8
Direct materials used per unit 5kg 6kg
Direct materials cost per kg $14 $12
The company’s director use activity-based costing to apportion the production overheads. They
have identified the four major activities involved in the production i.e., maintenance of machinery,
set-up of machinery, ordering costs and inspection. The costs of each activity have been
established and the overheads apportioned between the activities as follows:
Production
Brant Drimp
Overheads ($)
Machine
26000 60 hours 40 hours
maintenance costs
Machine set-up 36900 30 times 15 times
Ordering costs 31200 8 orders 16 orders
Inspection Costs 45000 20 hours 10 hours
139 100
Required:
1. Calculate the production overheads apportioned to each product using activity-based costing.
2. Calculate the cost per unit and selling price of each product based on a 20% markup on the
unit cost of production.
Solution
Machine
Inspection
Activity Machine set-up Ordering
costs
Maintenance
Cost $26000 $36900 $31200 $45000
Cost driver 100 hours 45 times 24 orders 30 hours
Cost driver rate $260 $820 $1300 $1500
Total overheads would be allocated as follows:
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Machine
Inspection
Machine set-up Ordering Total
costs
Maintenance
$260 * 60 $820 * 30 $1300 * 8 $1500*20
Brant $80600
=$15600 =$24600 =$10400 =$30000
$260 * 40 $820 * 15 $1300 * 16 $1500 * 10
Drimp $58500
=$10400 =$12300 =$20800 =$15000
Brant Drimp
$ $
Direct labour
210 000 48 000
cost
Direct materials
490 000 216 000
cost
Apportioned
80 600 58 500
overheads
Total cost 780 600 322 500
Cost per unit
(total
111.51 107.5
cost/number of
units)
Selling price
133.812 129
(20% mark-up)
10.1.5 The uses and limitations of activity-based costing
Uses of activity-based costing
Activity-based costing has the following benefits:
It helps one understand where and how overheads arise.
It provides more realistic costing information.
It helps set benchmarks for future planning.
It helps in estimating the cost and setting selling prices to provide quotes to customers.
It helps in the identification of unprofitable or overpriced products.
Limitations of activity-based costing
Some of the limitations of an activity-based cost system are:
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Some overhead costs cannot be assigned to a cost pool, for instance, the CEO’s salary.
It is very costly to implement ABC.
This process of ABC can be very time-consuming.
Workers might require training or specialist accountants may need to be hired.
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