Management Accounting and Finance III

Activity Based Costing

© School of Accountancy, University of the Witwatersrand

 Management Accounting and Finance III
© School of Accountancy, University of the Witwatersrand

ACTIVITY-BASED COSTING

DRURY TEXTBOOK CHAPTERS

Chapter 11
Chapter 22

LEARNING OBJECTIVES FOR THE TOPIC

Textbook Learning objectives

Activity-based Understand the concept of traditional costing and be able to allocate costs using this approach.
costing Calculate and analyse the under and over recovery of overheads, and advise regarding the correct
Chapter 11 accounting treatment thereof/ Calculate and perform year-end adjustments where allocated indirect costs
differ from actual indirect costs.
Describe the characteristics of an ABC system.
Design an ABC system.
Explain the use of appropriate allocation bases, allocation rates, cost pools and allocated costs.
Distinguish between cause-and-effect and arbitrary cost allocations.
Identify activities, cost pools, appropriate cost drivers and be able to allocate costs using ABC.
Explain the difference in product costs calculated under the traditional costing system and an ABC system.
Justify why budgeted overhead rates should be used in preference to actual overhead rates.
Discuss the short-comings of traditional costing and identify how ABC addresses these short-comings.
Evaluate the limitations of implementing ABC costing systems.
Discuss the use of ABC in service organisations.
Describe and apply the four-part activity hierarchy.
Understand how ABC systems could be used for activity-based-management and apply to a given scenario.
Explain how ABC systems could be used for activity-based-management.

Activity-based Describe how Activity based management (ABM) can be used to reduce costs and improve customer value.
management
Chapter 22
Pages 598-601

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 Management Accounting and Finance III
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ABC NOTES

THE NEED FOR A COST ACCUMULATION SYSTEM

Read page 256.

Why do we need a cost accumulation system?

Refer to Figure 3.1 on page 46.

• Direct costs are traced to cost objects.
• What allocation base is used to allocate the indirect costs? (Traditional arbitrary or ABC Cause and
Effect)
• Traditional vs ABC (refer to page 257)

Products may seem unprofitable but the company is well suited to make them:

• Complex products appear to be very profitable.

• Simple products appear to be losing money.

TRADITIONAL ABC

Allocate costs to departments Allocate costs to activities

(more cost centres / cost pools)
Arbitrary allocation bases Cause-and-effect cost drivers
E.g. Machine hours, labour hours or production Allocates costs in proportion to their utilisation of
volume. resources within the firm.
Volume based cost drivers Includes non-volume based cost drivers*
(Leads to product under and over costing)
Was appropriate when: ABC could be most beneficial if:
Direct costs were the dominant costs (Indirect The majority of the indirect overheads are non-
costs were relatively small), information costs volume related and there are many diverse
were high, there was a lack of intense global products; and where the company operates in a
competitive environment (accurate product costs
competition and a limited range of products was
are necessary to maintain market share).
produced.
Additional considerations before implementing ABC:
What is the current competition?
Does the firm use a cost-plus pricing policy?
Indirect costs as % of total costs?
Training of staff?
Software requirements?
Cost management and ABM

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 Management Accounting and Finance III
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ABC
Work through pages 263-265. Refer to page 56 for another full ABC example.

Four steps in designing an ABC system

1.

2.

3.

4.

From an
exam technique point of view, do a table for step 1, 2 and 3 (work on a double page). Concerning
step 3- what is the most appropriate cost driver to use?

ACTIVITY-BASED COSTING PROFITABILITY ANALYSIS

Refer to pages 265-271.

Use ABC hierarchical activity classification for profitability analysis per cost object
(product/customer/locations). Allocate ALL indirect costs (including non-manufacturing costs) until you
need to rely on a random allocation.

COST HIERARCHY TO IDENTIFY COST ALLOCATION BASES

OUTPUT UNIT-level costs (volume- Each time a is produced

based)
BATCH level costs Every time a is produced
PRODUCT SUSTAINING costs On activities undertaken to a product
line or service line
FACILITY SUSTAINING costs To support the company’s general manufacturing
process

What is the LOWEST level to which a cost can be assigned without relying on arbitrary allocations?
• Used for attention directing —claimed provides more accurate information.
• Aim is to assign all organisational expenses to a particular hierarchical level where cause-and-
effect cost assignments can be established.
• The approach helps to identify the impact of resource consumption of adding or dropping items at
each level of the hierarchy.

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 Management Accounting and Finance III
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Short-comings of traditional costing How does ABC address these

Significant amounts of indirect costs are allocated using only Many homogenous indirect cost pools
one or two cost pools. based on activities.

Allocation base may not be a good cost driver. All or most costs Allocation base is more likely to be a
are treated as output unit-level costs. cost driver. Often basis is non-financial
like number of set-ups.
Overly broad averages may result in over or under costing* Allocation base is more likely to be a
leading to erroneous decisions: cost driver. Using activities as opposed
Incorrect pricing/ Loss in market share/ Producing a product to products can improve management
that is in fact making a loss/ Products that a company is well- control over costs throughout the value
suited to make and sell show small profits while products for chain.
which a company is less suited show large profits →complex
products appear to be very profitable and simple products
appear to be losing money.

*Traditional costing tends to over-cost high volume products,

and under-cost low volume products (product cost cross-
subsidisation).

LIMITATIONS OF ABC SYSTEMS

• Very detailed ABC systems are costly to operate and difficult to understand (do the benefits
outweigh the costs?)
• ABC systems require management to estimate costs of activity pools and to identify and measure
cost drivers for these pools.
• Activity-cost rates also need to be updated regularly.

ACTIVITY-BASED MANAGEMENT

Refer to pages 598-601.

Activity-based management focuses on managing activities to reduce costs and improve customer value.

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ACTIVITY-BASED COSTING – Lecture Example

BlancMont Pens Ltd

You are a costing specialist and have been approached to assist the director of one of your clients,
BlancMont Pens Limited (BMP). BMP is a company that manufactures unique, quality corporate writing
instruments. They manufacture three products: fountain pens, pencils and pen cases, all of which are
primarily made from expensive precious metals such as silver. BMP was established eight years ago and is
the preferred supplier of these writing instruments to audit partners at major audit firms in Gauteng. The
audit firms place orders with BMP a year in advance (for their audit partners and for client gifts); no extra
writing instruments in excess of the orders are produced. BMP has a 31 December year-end and is
completing the budgetary process for the 2010 year. BMP has received orders for 1 750 pens, 3 250 pencils
and 520 pen cases for 2010.

The three products require virtually the same production process and make use of the same equipment.
Production is relatively labour intensive, as workers engrave each product. The following information is
applicable per product for the 2010 year:

Per pen Per pencil Per pen case

Direct materials R280 R220 R320
Labour hours 5 3.5 2
Machine hours 1.5 3 1

Direct labour is paid R20 per hour and production overheads are absorbed on a machine hour basis. The
production overhead rate for the 2010 period is R28 per machine hour.

Even though BMP currently uses a traditional costing system, the director would like you to assess the
impact on their product costs when using an activity-based-costing system as he attended a short course
in management accounting recently and was very impressed with the various cost-allocation methods
discussed during the course. He has established that 38% of the production overheads relate to set-up
costs, 42% are machining costs and 20% relate to the inspection of equipment.
The director has also provided you with the following budgeted activity volumes associated with the
product line for the period as a whole:
Number of set-ups Number of inspections
Pens 175 520
Pencils 135 270
Pen cases 360 210
Total 670 1000

You are required to:

1. Calculate the cost per unit for each product using traditional absorption costing.

2. Calculate the cost per unit for each product using activity-based-costing principles, assuming the
company operates an absorption costing system

3. Given your answers in (1) and (2) above, write a memorandum to the financial director:

i) Commenting on and explaining the differences in the unit costs

ii) Make a recommendation as to which cost allocation method BMP should use and give reasons
for your answer.
 Management Accounting and Finance III: ACCN 3007 and ACCN 3012 Management Accounting and Finance III: ACCN 3007 and ACCN 3012
June exam 2016 June exam 2016

Question 1 36 Marks guided into the individual moulds of the bottle-making equipment, as part of a process known as forming (see

CJC (Pty) Ltd (hereafter CJC) is a privately owned South African company that has been manufacturing and Step 3 that follows).

selling glass bottles since 1998. The company is situated in Johannesburg and specialises in the

manufacturing of 750 ml clear glass bottles. The company initially only made this one type of bottle, the STEP 3: Forming

product is called Alpha. CJC has a 30 June year-end. Each gob is placed into a mould specific to the bottle CJC is producing (initially only 750ml bottles) and blown

to its correct shape and size using compressed air.

The glass bottle production involves four steps:

STEP 1: The introduction of raw materials to form glass powder STEP 4: Inspection

Glass is manufactured from mainly natural materials; the raw material inputs into the production process being Throughout the entire production process, the quality of the bottles is monitored through sensors by

Silica sand, Soda ash and Limestone. CJC also adds recycled glass to the raw material mix, which is called sophisticated equipment. Upon completion of the production process, the bottles undergo physical inspection

“cullet”. The inclusion of cullet in production means that less of the other raw materials (Silica sand, Soda ash at a separate warehouse as well, the cost of which is driven by the time taken to inspect the bottles. Delivery of

and Limestone) are used. Furthermore, cullet melts at a lower temperature, enabling CJC to reduce carbon these bottles from the factory to the warehouse takes place daily by truck and 10 000 Alpha bottles can be

emissions and save energy. delivered at a time. During the final inspection stage, a trained specialist physically checks every 4th bottle that

is delivered to the inspection warehouse. They are able to inspect 100 bottles per hour. Rejected bottles are

All the raw materials are stored in large silos, from where they are measured and delivered to the batch mixers, sent to the recycling operation to be turned into cullet (the recycled glass used in the production) and re-enter

which will then mix the material in batches of glass powder according to pre-programmed recipes (refer to the production process. A normal loss of 10% of input into the process is expected and this inspection happens

Step 2 below). at the end of the process.

STEP 2: Raw material mixing, melting and cutting Introduction of a new product

Once the raw material mixture has been completed, the batches of mixed material are transferred via CJC’s rents its production facilities and their rental agreement lapsed during June 2016. The facility used to
1
conveyer belt to the furnaces and melted at 1565°C to form glass. Streams of glass are then cut into gobs of date was no longer available to CJC and thus management entered into a new rental agreement, renting a

a predetermined weight – exactly as much as is needed to make a single 750 ml bottle. These gobs are then different factory fitted with the right equipment for glass bottle production. The new rental agreement was

signed for the rent to commence 1 July 2016, stipulating a monthly rental of R240 000. The contract is for two

years, with heavy penalties in case of cancelling the agreement.

1 Small pieces of glass – exact weight for 1 bottle

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 Management Accounting and Finance III: ACCN 3007 and ACCN 3012 Management Accounting and Finance III: ACCN 3007 and ACCN 3012
June exam 2016 June exam 2016

The new facility has increased capacity and as a result (after doing market research relating to glass bottle for Beta

demand) management introduced a new product during July 2016 on a trial basis – a 1 litre bottle called Beta. Machine time needed (per bottle) 1 minute 3 minutes Half of the machine time per

The two products are produced in the same production facility, with a production scheduling team managing unit relates to Step 2, the

the production process for the two products. other to Step 3.

Direct raw materials (per bottle) R 2,50 R 3,20 This cost takes into account

Management of the company is currently analysing their budgets for the 2017 financial year. Upon inspection the cost of the normal loss.

of the upcoming year’s performance they will decide whether to continue producing the new product
Direct labour (per bottle) R 2,80 R 3,90
permanently. As the Beta bottle is a different size to CJC’s usual production, it is necessary to inspect every

single Beta bottle during the inspection phase. Only 50 Beta bottles are inspected per hour. Furthermore, as
*If the budgeted production quantity is produced at the budgeted machine time per unit, the full machine
the trucks that are delivering the bottles to the inspection warehouse are not designed to transport 1 litre
capacity will be utilised.
bottles, only 2 500 Beta bottles can be delivered at a time. Once production of the Beta bottle is introduced

permanently, only 25% of production will be inspected. A normal loss of 10% of input into the process is
Recommendations by the newly appointed management accountant:
expected and this inspection happens at the end of the process. The production lines of CJC’s two products
CJC recently appointed a new management accountant. The management accountant recommended CJC
are marketed under one brand, CJC Bottles.
should consider implementing an Activity-Based-Costing (ABC) system to allocate its indirect costs. He

estimated that 30% of the “Other indirect manufacturing costs” related to mixing, melting & cutting and 24%
The company operates a traditional absorption costing system, with indirect costs allocated to units based on
related to forming the bottles. The remaining 46% related to inspection of the bottles. 60% of these inspection
machine hours (minutes) used.
costs related to the delivery of completed units to the inspection warehouse.

Budgeted production information for the year ended 30 June 2017 is given below:
CJC pays the accountant a monthly salary of R40 000.
2017 FINANCIAL YEAR Alpha Beta Notes

Fixed indirect rental cost R 2 880 000

Other indirect manufacturing costs R10 500 000

Budgeted production and sales quantity* 4 140 000 900 000 Selling price of R9.50 for

Alpha and R12.00 per unit

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 Management Accounting and Finance III: ACCN 3007 and ACCN 3012
June exam 2016

Question 1 – Please answer required (a - e) in the BLUE Book

Required
Marks
(Round your answers to two decimals, where applicable)
a) Calculate the budgeted gross profit per unit of both Alpha & Beta during the 2017
financial year, using an ABC system to allocate the indirect costs as per the 20
management accountant’s recommendation.

b) Justify which indirect cost allocation method would you recommend CJC use, with
specific reference to the scenario. 6

c) Given the information in the scenario and your calculations in (a), briefly discuss
qualitative factors that CJC should consider when deciding whether to continue
4
producing the Beta bottles permanently.

d) Assuming that the company continues with the Beta product line, explain whether
any brand-sustaining expenses related to CJC Bottles should be attributed to the
Alpha bottles and the Beta bottles within the brand.
3
*Your answer should make reference to ABC hierarchical analysis.

e) Briefly explain what Activity-based management (ABM) is and how CJC would use
3
this strategic management tool.
TOTAL 36

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 Management Accounting and Finance III: ACCN 3007 and ACCN 3012 Management Accounting and Finance III: ACCN 3007 and ACCN 3012
June Exam 2014 June Exam 2014

Question 3 (40 Marks) STEP 1

The Planning phase involves the design and layout of the products to be made: Cardo’s designers
Cardo (Pty) Ltd, (“Cardo”), is a small manufacturing company that specialises in the production and
collaborate with the clients to determine their needs and propose designs. Once a design is
sales of plastic cards (the use of these cards is explained below). The company has a
approved, the production of the cards commences. The design for AB-Bank’s Credit Cards is already
31 December 2014 year-end. The company has annual contracts with three customers at present,
in place from previous years (the bank has not changed its branding during the past two years). The
resulting in three different product lines:
mall however changed their design in May 2014 for the Mall Voucher production going forward from
 Durable, full-colour Business Cards are made for a small stationary company called “IPrint”
then. Each Business Cards’ design is determined by the stationary company (IPrint)’s clients. Both
 Credit Cards are manufactured for AB-Bank Cardo and IPrint use a “cost-plus” mark-up policy to determine the selling prices for their products,
 Electronic Mall Vouchers (for gift card purposes) are produced and sold to a retail mall in and define “cost” as full cost per unit (being both manufacturing and non-manufacturing costs).
Rosebank, Johannesburg
Due to the risk of card fraud (fake credit cards and electronic mall vouchers), the location of Cardo STEP 2
has not been made public, and the manufacturing facility has been fitted with high-tech security The Mixing step entails ink being mixed to colour specifications according to
features. The security measures are intended to deter criminals from entering the premises and the approved design (each card uses 10ml of ink). Labourers then manually
accessing sensitive information, as well as to ensure that the production facility is filmed with CCTV enter instructions and load the designs onto the printing machines. The ink
cameras to ensure that there is no theft from the factory. that is used in the mixing step is made from secret ingredients by an approved
supplier, who is contractually bound through a confidentiality agreement in an
Cardo operates a standard costing system. The company has a contract with AB-Bank for 80 000 effort to reduce the likelihood of the ink being copied. A relationship exists between the indirect mixing
Credit Cards to be produced and supplied each month of the year. Cardo is further contractually costs and the litres of ink mixed, and thus this cost should be allocated based on the number of litres
bound to produce 120 000 Mall Vouchers monthly, and the expected standard monthly production per product-line, as any other cost driver would not be economically feasible. The mixing machines
and sales of IPrint for January to June 2014 is 50 000 Business Cards (it is the standard practice for were due for a service in April 2014, but management decided to cut costs by not servicing any
IPrint to place 100 orders per month, with each order consisting of standard 500 business cards). The machines during 2014.
contracts with AB-Bank and the mall are entered into annually. Cardo has a policy of keeping no
additional stock as it poses a security risk due to the nature of some of their products, thus the STEP 3 and 4
company produces units to match demand. Cardo covers the cost of courier companies who collect Printing machines are filled with laminated sheets (which form the basis of all three product lines),
the personalised cards on behalf of the banks on a daily basis, mall vouchers are delivered on a onto which the design is printed with the mixed ink. The final step in the common production process
weekly basis and IPrint’s stock is couriered on a monthly basis. involves steel presses compressing the cards at 150 degrees Celsius, covered with a clear
protective sheet. Each time a printing and compression cycle is run on the machine, the printing and
The three types of products are made through a (mainly automated) process which involves compressing costs are driven up. Credit Cards and Mall Vouchers are produced in sheets of 1 000
“Planning”, “Mixing”, “Printing” and “Compressing”: cards, and Business Cards are produced separately for each IPrint customer order.

Planning Mixing Printing Compressing

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 Management Accounting and Finance III: ACCN 3007 and ACCN 3012 Management Accounting and Finance III: ACCN 3007 and ACCN 3012
June Exam 2014 June Exam 2014

FURTHER PROCESSING The projected standard profit per card for May 2014 was as follows:
The Business Cards are counted, packaged and stored*. The Credit Cards and Mall Vouchers Credit Cards Mall Vouchers Business Cards
however require one more step. Security measures such as UV-imprints, R
Contribution before indirect cost allocation 2.50 3.00 1.00
holograms, coded chip-and-pin tags and magnetic strips are added to the Traditional indirect cost allocation -1.07 -1.07 -1.07
latter two products before they are counted, packaged and stored. Cardo Standard profit per card 1.43 1.93 -0.07

receives daily lists from the banks with their customers’ details; which are Top management has been concerned about the profitability of the Business Cards and has
then imprinted on the blank cards, along with the customers’ personal considered the implementation of an activity-based-costing (ABC) system as from May 2014 onwards
information which is added to the magnetic strip. Two-thirds of the security to aid in evaluating the profitability of their customer base.
costs (which includes the cost of the personalisation of the cards) relate to Credit Cards, the rest is as
a result of Mall Voucher production. ACTUAL RESULTS FOR MAY 2014
*You may assume that the packaging and storage costs are negligible. More raw material losses occurred than expected as a result of certain production inefficiencies being
identified. Labourers were required to work overtime to move boxes of raw materials from the stock
TRADITIONAL ABSORPTION STANDARD COSTING SYSTEM room where they were delivered to the production plant. Differences in actual production and sales,
Cardo currently operates a traditional absorption standard costing system and allocates indirect costs and standard production and sales, resulted in standard-costing-variances. An extract from the
based on the number of cards produced. variance analysis report has been provided below.

The standard monthly indirect costs during 2014 are estimated to be R266 400. This amount is made Extract from variance analysis report- May 2014
up of:
 R20 200 indirect fixed manufacturing costs as a result of the planning process;
Credit Cards Mall Vouchers Business Cards
 R40 000 relating to indirect fixed mixing costs; SALES MARGIN PRICE VARIANCE Adverse Favourable Favourable
 R6 200 to indirect printing and compressing costs (together), SALES MARGIN VOLUME VARIANCE - - Adverse
 R80 000 to security costs and
 R120 000 to delivery costs.
INK
RAW MATERIAL PRICE VARIANCE Favourable
Standard selling prices were based on the prevailing market prices for similar product offerings. The
RAW MATERIAL USAGE VARIANCE Adverse
standards have not been updated to reflect the actual selling prices (which are determined in terms of
the company’s cost-plus policy).
LABOUR
DIRECT LABOUR RATE VARIANCE Adverse
DIRECT LABOUR EFFICIENCY VARIANCE Adverse

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 Management Accounting and Finance III: ACCN 3007 and ACCN 3012 Management Accounting and Finance III: ACCN 3007 and ACCN 3012
June exam 2014 June exam 2014

Question 3 [40 Marks]

a) Calculate and comment on the proposed budgeted profitability of Cardo's main

customer base* for May 2014, using Activity-Based-Costing (ABC) to allocate indirect
costs. (20 Marks)
*Assess the profitability of each of the following contracts: AB-Bank, Rosebank retail mall and IPrint.
*You may assume that there were 5 weeks/ 25 production days in May 2014.
*Restrict your discussions to relevant points relating to the scenario.

b) With reference to your calculations in (a), sales variances and other information in the
scenario, discuss the impact that the use of a traditional costing system had on the
sales during May 2014. (13 Marks)

c) Briefly discuss potential causes for the raw material usage and direct labour efficiency
variances, and suggest strategic management tools in the context of the scenario that
could have prevented these variances from occurring. (7 marks)

*Provide your answer in the following table format:

Variance Reason Strategic management tools
Raw material usage variance

Direct labour efficiency variance

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