ACTIVITY BASED COSTING (ABC)
The traditional approach to costing a product (cost unit) is to add together materials, volume-related basis e.g. labour labour and overheads, overheads, with overheads overheads being absorbed on a volume-related Direct Labour Hours (dlh) or Machine Hours or Production Output. This results in one overhead absorption rate nown as !a blanet rate". #or e$ample, overheads might be absorbed at the rate o% &' per direct labour hour where total overheads come to &*,*** and +,*** dlh are e$pected to be wored. This is a ver simple wa o% calculating an absorption rate. This method does not distinguish between the running costs o% particular activities or departments when absorbing costs into cost c ost units -/ has been developed %rom the ideas o% a Harvard pro%essor, 0obert 1aplan. 2n the '34*5s, 1aplan recognised that traditional costing methods had developed when most manu%acturing was labour6intensive and overheads made up 7ust a small portion o% total costs. Traditional absorption costing was accurate enough in such circumstances. Toda, productio production n processes are highl highl automated. automated. The heav investment investment in capital capital e8uipment e8uipment that results %rom this means that, %or e$ample, the %i$ed overhead cost o% depreciation is now an important part o% total costs and the variable cost o% labour is a much smaller proportio proportion. n. -s overheads overheads are so signi%ican signi%icant, t, it is now increasingl increasingl important important to more accuratel apportion overhead costs to cost units. -/ recognises that in the long run most manu%acturing costs are not %i$ed and analses costs costs as short6t short6term erm variab variable le costs costs (volum (volumee related related and chang changee propor proportio tionat natel el with with outpu output) t) and long6t long6term erm variab variable le costs costs (ain (ain to %i$ed %i$ed costs costs under under tradit tradition ional al costin costing g sstems). -/ also recognises that it is ativities that cause costs. Products create the demand %or those activities. The steps in setting up an -/ sstem are '.
2denti% th the ativities that that occur occur in a %irm %irm e.g. e.g. sales sales proces processin sing, g, assemb assembl l,, %inishing etc.
+.
2den 2denti ti% % the the %acto %actors rs that that in%l in%lue uenc ncee the cos costt o% an acti activi vit t.. Thes Thesee are no nown wn as as Cost Drivers! Drivers! The cost driver in the sales processing department would be the number o% orders that are received.
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/reate a co cost ce centre %o %or ea each ac activit. t. (Cost "ool)
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-llo -llocat catee the the tota totall cost cost o% o% the the acti activi vit t to to prod produc ucts ts in in pro propo port rtio ion n to each each pro produ duct ct:s :s demand %or that service.
The aim o% an product costing sstem is to ensure that a %air share o% costs is charged to each each produc product. t. -/ not onl does does this, this, but also re8uir re8uires es depart departmen mentt manag managers ers to concentrate on the activities which cause the costs to arise and hence to control these activities.
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ACTIVITY BASED COSTING (ABC)
-/ recogni;es that in the long run most manu%acturing costs are not %i$ed and analses costs as short6term variable costs (which are volume related and change proportionatel with output) and long6term variable costs (ain to %i$ed costs under traditional costing sstems). -/ also recognises that it is ativities that cause costs and that it is the products which create the demands %or those activities.
E#am$le< - compan has a cost centre %or sales processing which is e$pected to handle+** orders %or =iddlies, ** orders %or >eniths and ** orders %or ?olts. The total budgeted cost o% the @ales Processing operation is &+**,***. The traditional basis would allocate the costs o% processing orders between each product on the basis o% the value o% each product5s sales. -/ re7ects this method. 2nstead, under -/, the cost is allocated in the ratio +<<. This re%lects the recognition that it is the activit o% processing the sales that causes the &+**,*** cost rather than the value o% the sales itsel%.
The aim o% an product costing sstem is to ensure that a %air share o% costs is charged to each product. -/ not onl does this, but also re8uires department managers to concentrate on the activities which cause the costs to arise and hence to control these activities. 2n the above e$ample the sales manager, having realised that it the processing o% a sales order that drives a cost, might insist on a minimum order si;e. (The wor re8uired to process a sales order %or +* =iddlies is e$actl the same as the wor re8uired %or + =iddlies.) Basiall% ABC assumes • • • •
-ll costs can be treated as variable in the long run. /ost Pools represent costs %or a particular activit. /osts come into being as a result o% a cause which can be readil identi%ied. instituting an -/ sstem more in%ormation about costs and cost reduction, new product design and the elimination o% uneconomic products ma be obtained.
-n -/ sstem does cost a lot o% mone to establish and maintain. #or this reason, it is necessar to eep cost pools to a minimum so that the sstem does not become too comple$ and costl. =hile the -/ sstem became increasingl popular in the earl and mid '33*5s, its popularit had begun to lessen b the turn o% the centur (see article below).
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Ativit%-Based Costin& (ABC) In reent %ears' ABC as lost &round in te metri ars! But it ma% be set *or a resur&ene! David M. 1at;, /#O.com December ', +**+
(Aote< !Metric" in this article re%ers to !wa o% measurement") 2n the late '34*s, it was hard to imagine that the din over activit6based costing would ever die down. Bust a %ew ears earlier, Harvard Pro%essor 0obert 1aplan, along with others, had published their %irst papers on the new metric, touching o%% a rush o% e$citement in corporate con%erence rooms. 1aplan:s idea was downright revolutionar. 2n its broadest terms, -/ involves identi%ing cost drivers and assigning them to speci%ic activities Crather than attributing overhead, %or instance, to the entire organi;ation. 1aplan and %ellow -/6 bacers asserted that man corporations didn:t have a clue as to the true pro%itabilit o% their products, or the best mi$ o% products. =h ecause, managers at these companies didn:t reall now what resources (activities) went into producing their goods. - lightning bolt. ut b the mid6'33*s, -/ started losing ground to %lashier metrics, things lie economic value added (EF-) and the balanced scorecard (another 1aplan creation). Even 1aplan admitted -/ had lost its luster. G-/ has stagnated over the last %ive to seven ears,G he said in '334. -ctivit6based costing did get a bit o% a bump6up during the new econom. -t the time, man corporate managers %ound themselves nee6deep in e$pensive customer relationship management (/0M) initiatives such as overnight deliver and *6degree customer service. The problem< These managers were having a real tough time telling i% those e$pensive pro7ects were actuall doing anthing. To be sure, the rollouts tended to increase customer satis%action, and with it, customer loalt. ut o%ten those boosts were accompanied b Gdeclining pro%its, especiall when the increased services are not accompanied b increases in prices or order volumes,G wrote 1aplan and his Harvard colleague F.I. Aaraanan, in a Ma +**' white paper. -/ o%%ered e$ecutives therap %or those uncontrollable customer6delighting urges. using a costing sstem based on precise activities, companies could customi;e their prices to account %or service sweeteners, 1aplan and Aaraanan argued. =hat:s more, -/ %it neatl into the mareting plans o% so%tware vendors and consultants looing to mae the costing method part o% grander, enterprise6wide installations. ut such ambitions 8uicl lost traction as the econom %oundered. =hen the -ge o% the /ustomer morphed into the -ge o% the -ccounting @candal, comple$ internal data gathering and reporting suddenl seemed less appealing. These das, it:s hard to convince an accountant to eep two sets o% boos %or an entire organi;ation, sas Michael Paris, president o% Paris /onsulting, a compan that advises manu%acturers on their operations. G2 thin the idea o% overlaing a second set o% costing sstems has gone awa.G
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This is not to sa that -/ has completel vanished. Lots o% consultancies still o%%er activit6based costing and activit based management services. 2n addition, scores o% application vendors 66 particularl maers o% E0P sstems 66 now o%%er -/ tools and modules as part o% their so%tware o%%erings. Moreover, the -merican Iovernment seems to lie -/ 66 the J.@. Marine /orps. is an advocate o% -/. 2n the private sector, -/ is still %ound in business6intelligence so%tware applications and in assorted one6o%% pro7ects that tend to %all well short o% +96 hour, total sstems. 2n %act, some observers contend that -/ will come bac in vogue 66 i% the recession continues. During an economic downturn, the note, companies tend to %ocus their resources on e$isting customers, rather than seeing out new ones. -/ is e$cellent at helping separate pro%itable customers %rom mone6losers. 2n addition, -/ can help companies %igure out was to raise pro%its without raising prices 66 crucial in a period o% low6in%lation.
K /#O Publishing / orporation +**9. -ll rights reserved.
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ACTIVITY BASED COSTING Question 1 Kalash Ltd has a single production process in which three different products are produced. For the month just ended the following costs were estimated: Factory overheads related to labour activity #aterial receipt and inspection %ower #aterial 'andling
£11,!" £$1,"" £$&,""" £(,$""
)he three products *+, and - are produced by wor/ers who perform a number of operations on sheet metal using hand0held electrically powered tools. )he wage rate of the wor/ers is £."" per hour. )he following information has been obtained for the month. Product A B %roduction 2uantity *units ,""" 1,3"" atches of #aterial *per product 1" 3 Data per UNIT of product 4irect #aterial *s2uare metres 4irect #aterial cost *£ per s2 m 4irect Labour *hours 6umber of drill operations *per unit
C !"" 1
5
$
3 ".5
$ ".
1
3
$
+t the moment, overhead costs for material receipt and inspection, process power and material handling are absorbed by the units on the basis of direct labour hours. +n activity based costing investigation has r evealed that the cost drivers for the overhead costs are as follows: #aterial 7eceipt and 8nspection : 6umber of atches 6umber of 4rill %rocess %ower : 9perations #aterial 'andling : uantity of #aterials 'andled *s2uare metres e!uired" %repare a summary showing the budged total cost per UNIT for each product:0 a# ;sing the e
ou should e
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Question % Kaplan plc manufactures four varieties of telephones: namely Apiece &A#' Beacon &B#' Carrier &C, Distri$utor &D#, using the same plant and processes. )he following information relates to the production period?
Product A B C D
Vo(u)e 3""" 3" (3"" ""
*ateria( cost per unit + 3 3 1! 13
Direct ,a$our per unit -ours ".3 ".3 1.3
*ac.ine ti)e per unit -ours ".3 ".3 1.3 1
,a$our cost per unit + $ $ ! 15
)otal production overhead recorded by the cost accounting system is analysed under the following headings: Factory overhead applicable to machine oriented activity is £55$5 @et0up costs are £5"!5 )he cost of ordering materials is £$$3 'andling materials £&5$ +dministration for spare parts £11""" )he overheads are absorbed by products on a machine hour basis. )he rate is £3.3" per hour giving an overhead per product of: +A£1.$(
A£1.$(
-A£!.3
4A£3.3"
'owever investigation into the production overhead activities for the period reveals the following totals:
Produc t A B C D
Nu)$er of set/ups $
Nu)$er of )ateria( orders 5 1 5
Nu)$er of ti)es )ateria( 0as .and(ed 1" 11 1
Nu)$er of parts 3 1 1$
You are re!uired to" a] b] c]
-ompute an overhead cost per product using activity based costing tracing the overheads to production units by means of cost drivers 4erive the machine hour overhead absorption rate of £3.3" by calculation. -omment briefly on the differences disclosed between oer.eads traced by the present system and those traced by activity based costing.
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Q2 &Au3ust %445# -ampus plc provides meals and catering at three university campuses from a central warehouse. )heir budget for ne
Sa(es Cost of Sa(es Gross Profit ,oca( E7penses Varia$(e 8i7ed Operatin3 Profit
A$(e Uniersit6 £""" 3,""" ,!"" ,""
Ba$$(e Uniersit6 £""" 5,""" ,$"" 1,(""
Ca$(e Uniersit6 £""" $,""" 1,&"" 1,1""
" ("" !5"
($" "" $("
$1" 3"" &"
-entral costs to be allocated to the three universities are as follows: +444 -ead Office @alaries +dvertising Beneral 9verheads
"" !" 1"
9are.ouse Costs 4epreciation @torage 9perating 4elivery
1"" !" 1" $"" 1,"""
)he management of -ampus plc all agree that the +ble ;niversity contract is highly profitable, but there is disagreement about which of the other two universities are worth bothering with. )he @ales 4irector is in favour of /eeping both. )he 9perations 4irector is in favour of withdrawing from the other two contracts. +t present central costs are charged to each university in proportion to the amount of sales. e!uired" a] -alculate the profitability of each university contract on the basis of the e
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twelve months.
Nu)$er of despatc.es Tota( de(ier6 distance miles Proportion of 0are.ouse space occupied
A$(e 33" (",""" miles
Ba$$(e 53" 3",""" miles
Ca$(e 3" &","""
5"=
$"=
$"=
)he student recommended that central costs should be allocated to each of the different university contracts on the basis of more appropriate cost drivers, as follows: -ead Office @alaries: 1"= of their time is spent on warehouse operations? the remainder should be divided e2ually between the three universities. +dvertising: the only justifiable basis was to continue with charging it in relation to the volume of sales at each university Beneral 9verheads: in proportion to the time spent by head office staff 9are.ouse 4epreciation, @torage, and 'ead 9ffice staff costs: in proportion to the space occupied 9perations, 'ead 9ffice costs: in proportion to the number of despatches
c]
4elivery: in proportion to the number of miles travelled. (16 marks) +ssess the results of your calculations. (5 marks) (Total: 25 marks)
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Question 5 :une %44; Calve< plc produces a range of products at various sites around the world. Dach site produces three types of products. )he site in 8ndia produces valves E the 7egular, the @uper and the D
VA,VE @elling price per valve 4irect #aterial per valve 4irect Labour per valve 9verheads per valve )otal -ost per valve udgeted %roduction Colume #achine hours per unit %roduction runs in a month 6umber of sales orders 6umber of deliveries of material
e3u(ar upee "".""
De(u7e E7c(usie upee upee !("."" 1"".""
11"."" !."" $5.5" 5.5"
1&."" 115."" $5.5" 355.5"
1$5."" 1"!."" 3!."" !!.""
"" units
"" units
5"" units
". $ 1&
". 3 13
1.3 5" 3
!
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)he budgeted overheads for the 8ndian site for the period are: #achine running costs @et up costs #aterial handling costs @ales %rocessing
7upee 13(,1" 7upee 1$3,!"" 7upee &&,""" 7upee $","""
#achine hours are limited to 1,"!" hours per month
e!uired *a -alculate the total cost of manufacturing each valve using +-. *1 mar/s
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*b ;sing the results of your computations in part *a, and any other information in the 2uestion, write a report to the manager of the 8ndian site indicating which valve*s should no longer be manufactured and justify your recommendation. 8n your advice discuss other factors which should be considered before a final decision is made and critically discuss the proposed method of costing. *1$mar/s &Tota(" %< )ar=s# Question < &*a6 %44># )he interwarm division of ercurrent -lothes Ltd ma/es two coats E the high 2uality Foou have now been as/ed to analyse the product costing method used by the company to see if the product prices should be changed. >our investigations reveal the following: 1. )he high 2uality FF coats are made in batches of 1,""" coats while the low 2uality %F are made in batches of $,""" coats. . )here are only two production departments: -utting and +ssembly $. )he company currently absorbs overheads based on direct labour hours. 5. )he total budgeted manufacturing overheads were £1,"",""" 3. )he budget direct labour hours were (,!"" and the budgeted machine hours were (,5"". . )otal set0up hours were budgeted at !". (. 6ormal production is 5",""" FF coats and 1!",""" %F coats >ou also ascertain the following information about the production of batches of FF and %F: Eac. Batc. of 8o7fur &1'444 coats# Ite) 4irect Labour 'ours #achine 'ours @etup hours 4irect -osts
Cuttin3 Dept !"
Asse)$(6 Dept 1"
Tota( ""
1" $ £!(,3""
1" 1 £1,"""
!" 5 £&&,3""
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Eac. Batc. of Po(6fur &2'444 coats# Ite) 4irect Labour 'ours #achine 'ours @etup hours 4irect -osts
Cuttin3 Dept 13"
Asse)$(6 Dept 1!"
Tota( $$"
13" 1 £&","""
1" 1 £1,"""
(" £1","""
Further investigations reveal that the overheads can be bro/en down into the following categories, cost pools and drivers: +444 Cost Drier #aintenance 1" 6umber of batches %roduction line setups 5"" 6umber of setup hours -utting @upervision !" Labour hours -utting 4epreciation 1" #achine hours +ssembly @upervision 1" Labour hours +ssembly 4epreciation 5" #achine hours Tota( 1'%44 e!uired a ;sing a blan/et rate based on direct labour hours, determine the cost of one Fo
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