ACTIVITY-BASED
COSTING
LECTURE NOTES & EXAMPLES
Prepared by Sara du Toit CA (SA)
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ACTIVITY-BASED COSTING (ABC)
The difference between the various costing methods (i.e. variable costing, absorption costing
and activity-based costing) is in the treatment of the fixed overheads.
Variable costing
Traditional
Costing Methods
volume-based measures
Absorption costing
Activity-based costing
VARIABLE COSTING
Using variable costing fixed manufacturing costs are treated as period costs and expensed in
the period that they are incurred.
ABSORPTION COSTING: TRADITIONAL VOLUME-BASED
MEASURES
Using traditional absorption costing fixed manufacturing costs are allocated to products using
a single overhead rate for the organisation as a whole (blanket overhead rate).
Overheads are allocated to products on an arbitrary basis. This means that no cause-and-
effect relationship exists to assign costs to products.
Fixed manufacturing costs are allocated to products using volume-based measures (using
machine hours or labour hours or number of units manufactured):
• Volume-based cost drivers are appropriate when activities are performed each time a
unit is produced e.g. machine hours is an appropriate cost driver for depreciation
based on machine usage because as more units are produced machine time will
increase resulting in the machine to depreciate.
• In contrast, non-volume-related activities are not performed each time a unit is
produced e.g. setting up of a machine only happens when the machine is changed
from one product to another. Using machine hours as a cost driver for machine set up
costs would not be appropriate. Instead, the cost should be allocated based on the
number of machine setups.
• In modern manufacturing systems overheads include a lot of non-volume related
support activities, such as: product design, quality control, production planning,
ordering, production set-ups, despatching and customer services. Therefore allocating
overheads using volume-based cost drivers is inappropriate.
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EXAMPLE 1:
Jasmine (Pty) Ltd has the following information concerning its two product lines:
Product A Product B
Machine hours per unit 4 6
Total number of machine setups per annum 5 2
Production units per annum 2 000 3 000
Budgeted machine setup cost for the year: R200 000
REQUIRED
Calculate the machine setup cost per unit for Product A and Product B if Jasmine (Pty) Ltd:
(a) Uses a traditional cost allocation system based on machine hours.
(b) Uses activity-based costing (ABC).
SUGGESTED SOLUTION
(a) Traditional costing based on machine hours
Total machine hours for the year:
Product A = 4 hours per unit x 2 000 units = 8 000 machine hours
Product B = 6 hours per unit x 3 000 units = 18 000 machine hours
Total machine hours = 8 000 + 18 000 = 26 000
Machine setup cost per machine hour = R200 000 / 26 000 = R7.69 per machine hour
Cost allocation:
Product A = R7.69 per hour x 8 000 hours = R61 538
Product B = R7.69 per hour x 18 000 hours = R138 462
Does the allocation of setup costs above seem fair?
???
Cost per unit:
Product A = R61 538 / 2 000 units = R30.80 per unit
Product B = R138 462 / 3 000 units = R46.15 per unit
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(b) Activity-based costing
Total machine setups for the year:
Product A = 5 setups
Product B = 2 setups
Total machine set ups = 5 + 2 = 7 set ups
Machine setup cost per setup = R200 000 / 7 = R28 571.43 per setup
Cost allocation:
Product A = R28 571.43 per setup x 5 setups = R142 857
Product B = R28 571.43 per setup x 2 setups = R57 143
Cost per unit:
Product A = R142 857 / 2 000 units = R71.43 per unit
Product B = R57 143 / 3 000 units = R19.05 per unit
SUMMARY:
Product A Product B
Traditional costing R30.80 per unit R46.15 per unit
Activity-based costing R71.43 per unit R19.05 per unit
Discussion:
• Traditional costing allocates more setup costs per unit to Product B. This is because
the traditional method uses machine hours as a base and Product B requires more
machine hours per unit than Product A.
• Traditional costing is less accurate in the costing of products because cost drivers are
used where no cause-and-effect relationship exists to assign costs to products.
• Activity-based costing allocates more setup costs per unit to Product A. This is because
the ABC method uses activities (number of set ups) as an allocation base and Product
A requires more setups.
• Activity-based costing ensures that the product which caused the cost is allocated
more of the cost.
When ABC is used instead of traditional costing:
??? • Does the total overhead change?
• Does prime cost change?
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ABSORPTION COSTING: ACTIVITY-BASED COSTING
Traditional volume-based measures were appropriate decades ago when most companies
manufactured a narrow range of products and direct material and labour were the dominant
factory costs. Overhead costs were relatively small and distortions arising from inappropriate
overhead allocations were not significant.
Nowadays, companies produce a wide range of products and direct costs often represent only
a small fraction of total costs. Overhead costs are of considerable importance and simplistic
overhead allocations cannot be justified. Today’s intense global competition has made
decision errors due to poor cost information more costly.
Using activity-based costing fixed manufacturing costs are allocated to products using many
allocation bases/cost drivers (factors which cause a change in the cost of an activity). These
cost drivers are both volume and non-volume based.
ABC recognises that many indirect costs vary in proportion to changes other than production
volume. Cost drivers are identified and costs are assigned to products on the basis of cost
driver usage. The cause-and-effect relationship results in a fairer allocation of overhead costs
to products and provides a superior way of costing products.
Cost versus benefit considerations:
An organisation should implement and operate an ABC system when the cost of expected
errors (from using an overly simplified system) exceeds the additional costs of implementing
and operating the system.
A sophisticated ABC system is optimal for an organisation with the following characteristics:
• Intensive competition
• Non-volume-related overheads that are a high proportion of total overhead costs
• A diverse range of products with high product diversity
What is product diversity?
• Product diversity applies where different products consume organisational resources
in different proportions.
• If all products consume organisational resources in similar proportions product
diversity will be low and products will consume non-volume-related activities in the
same proportion as volume-related activities. In this case product cost distortion will
not occur.
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EXAMPLE 2:
Jasmine (Pty) Ltd has the following information concerning its two product lines:
Product A Product B
Machine hours per unit 4 4
Total number of machine setups per annum 2 3
Production units per annum 2 000 3 000
Budgeted machine setup cost for the year: R200 000
REQUIRED
Calculate the machine setup cost per unit for Product A and Product B if Jasmine (Pty) Ltd:
(a) Uses a traditional cost allocation system based on machine hours.
(b) Uses activity-based costing (ABC).
SUGGESTED SOLUTION
(a) Traditional costing based on machine hours
Total machine hours for the year:
Product A = 4 hours per unit x 2 000 units = 8 000 machine hours
Product B = 4 hours per unit x 3 000 units = 12 000 machine hours
Total machine hours = 8 000 + 12 000 = 20 000
Machine setup cost per machine hour = R200 000 / 20 000 = R10 per machine hour
Cost allocation:
Product A = R10 per hour x 8 000 hours = R80 000
Product B = R10 per hour x 12 000 hours = R120 000
Cost per unit:
Product A = R80 000 / 2 000 units = R40 per unit
Product B = R120 000 / 3 000 units = R40 per unit
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(b) Activity-based costing
Total machine setups for the year:
Product A = 2 setups
Product B = 3 setups
Total machine set ups = 2 + 3 = 5 setups
Machine setup cost per setup = R200 000 / 5 = R40 000 per setup
Cost allocation:
Product A = R40 000 per setup x 2 setups = R80 000
Product B = R40 000 per setup x 3 setups = R120 000
Cost per unit:
Product A = R80 000 / 2 000 units = R40 per unit
Product B = R120 000 / 3 000 units = R40 per unit
Why does the method of allocation make no difference?
???
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WRAP UP EXAMPLE:
Wellington (Pty) Ltd manufactures two kinds of shoes, namely running shoes and hiking
boots, using an automated manufacturing process.
Wellington budgets to manufacture and sell 75 000 pairs of running shoes and 55 000 pairs
of hiking boots. Running shoes are manufactured in batches of 1 000 pairs and hiking boots
in batches of 500 pairs.
Wellington currently allocates all manufacturing overheads to products according to machine
hours. It takes 4 machine hours to manufacture a batch of running shoes and 6 machine hours
to manufacture a batch of hiking boots. The budgeted fixed manufacturing overhead for the
year is R17 400 000.
The management accountant of Wellington (Pty) Ltd is investigating alternative ways of
allocating the fixed manufacturing overheads to products. She has analysed the budgeted
fixed manufacturing overheads and found the following:
Activity Percentage Cost driver
of cost
Material purchase and storage 10% Number of orders placed: 75 orders for
running shoes and 50 orders for hiking
boots per year.
Setting up of machines 25% Set-up hours: Set-ups are done for every
batch and each set-up takes 24 minutes
for running shoes and 15 minutes for
hiking boots.
Production 55% Machine hours
Maintenance 10% Inspection hours: An inspection is done
(routine inspection of machines) after every 10 hours of machine time
and takes 12 minutes for running shoes
and 36 minutes for hiking boots.
REQUIRED:
Calculate the budgeted fixed overhead cost per pair of running shoes and hiking boots if
Wellington (Pty) Ltd:
(c) Uses a traditional cost allocation system based on machine hours.
(d) Uses activity-based costing (ABC).
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SUGGESTED SOLUTION:
Calculations:
C1: Number of batches:
Running shoes: 75 000 / 1 000 = 75 batches
Hiking boots: 55 000 / 500 = 110 batches
= 185 batches
C2: Total machine hours:
Running shoes: 75 x 4 = 300 machine hours
Hiking boots: 110 x 6 = 660 machine hours
= 960 machine hours
C3: Number of orders:
Running shoes: 75 orders
Hiking boots: 50 orders
125 orders
C4: Set-up hours:
Running shoes: 75 x 24/60 = 30 set-up hours
Hiking boots: 110 x 15/60 = 27.5 set-up hours
= 57.5 set-up hours
C5: Inspection hours:
Running shoes: 300/10 = 30 inspections x 12/60 = 6 inspection hours
Hiking boots: 660/10 = 66 inspections x 36/60 = 39.6 inspection hours
= 45.6 inspection hours
(a) Traditional costing (based on machine hours):
STEP 1: CALCULATE THE OVERHEAD ALLOCATION RATE
Allocation rate = Budgeted overhead / normal capacity
= R17 400 000 / 960 hours (C2)
= R18 125 per machine hour
STEP 2: ALLOCATE THE COST
Running Shoes Hiking Boots Total
Total allocated overhead R18 125 x 300 R18 125 x 660 R17 400 000
(machine hours) = R5 437 500 = R11 962 500
Overhead cost per unit R5 437 500/ 75 000 R11 962 500 / 55 000
= R72.50 per unit = R217.50 per unit
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(b) Activity-based costing:
STEP 1: CALCULATE THE ACTIVITY RATE
Activity Annual Cost Cost Annual cost Activity Rate
driver driver volume
Material purchase R1 740 000 Number of 125 orders R13 920
and storage (10%) orders (C3) per order
Setting up of R4 350 000 Set-up 57.5 set-up R75 652.17 per
machines (25%) hours hours (C4) set-up hour
Production R9 570 000 Machine 960 machine R9 968.75 per
(55%) hours hours (C2) machine hour
Maintenance R1 740 000 Inspection 45.6 R38 157.89 per
(10%) hours inspection inspection hour
hours (C5)
R17 400 000
STEP 2: ALLOCATE THE COST
Running Shoes Hiking Boots
Material purchase and R13 920 x 75 R13 920 x 50
storage = R1 044 000 = R696 000
Setting up of machines R75 652.17 x 30 R75 652.17 x 27.5
= R2 269 565 = R2 080 435
Production R9 968.75 x 300 R9 968.75 x 660
= R2 990 625 = R6 579 375
Maintenance R38 157.89 x 6 R38 157.89 x 39.6
= R228 947 = R1 511 053
Total R6 533 137 R10 866 863
Fixed overhead cost per pair R6 533 137 / 75 000 R10 866 863 / 55 000
= R87.11 per pair = R197.58 per pair
The total allocated overhead will not always tie back!
NB!! Where only selected products of the company are evaluated and not all the
products then the overhead will not tie back.
NOTE: It is possible to take a shortcut and combine steps 1 and 2. Let’s look
at the calculation for “Material purchase and storage” as an example:
• Running shoes = R1 740 000 / 125 x 75 = R1 044 000.
• Hiking boots = R1 740 000 / 125 x 50 = R696 000.
BE CAREFUL: Sometimes there are marks in the solution for calculating the activity rate first
and if you don’t perform the calculation in two separate steps you will forfeit these marks.
If you have time I recommend always splitting the calculation into 2 steps. However, if you
are short of time then rather take a chance with the shortcut.
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SUMMARY:
Running Shoes Hiking Boots
Traditional costing R72.50 per unit R217.50 per unit
Activity-based costing R87.11 per unit R197.58 per unit
Discussion:
• Traditional costing allocates more overhead costs per unit to the Hiking Boots. This is
because the traditional method uses machine hours as a base and the Hiking Boots
require more machine hours per unit than the Running Shoes.
• Using traditional costing the Hiking Boots are over-costed and the Running Shoes are
under-costed. This is because cost drivers are used where no cause-and-effect
relationship exists to assign costs to products. Traditional costing is therefore less
accurate in the costing of products.
• Activity-based costing ensures that the product which caused the cost is allocated
more of the cost.
Sometimes it is not possible to calculate the activity rate!!
For example:
NB!! You are told that the total maintenance cost is: R1 740 000.
But you are not given the number of inspection hours OR it is not possible
to calculate the number of inspection hours. Instead you are told that the
cost should be split as follows:
• Running Shoes: 60%
• Hiking Boots: 40%
It is then not possible to calculate the activity rate and instead you need to
go directly into the allocation of the overhead cost to products:
• Running Shoes: R1 740 000 x 60% = R1 044 000
• Hiking Boot: R1 740 000 x 40% = R696 000
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