!"#$ &'() Lesson 3: Activity Based Costing ABC problems are kind of mechanical and an d tedious, but tha t really is the nature of these t hese topics. We W e want to drill the concept of costs into you so that it will come out naturally. Enjoy! Warm-Up 1) What are the fun damental differen ces between a traditional trad itional and an ABC system? sys tem? 2) Describe the circumstances when traditional costing systems are likely to report distorted costs. 3) Explain how low volume products can be undercosted and high volume products overcosted when traditional costing systems are used. used. 4) Having attended a CIMA course on activity-based costing (ABC) you decide to experiment by applying the principles of ABC to the four products currently made and sold by your company. Details of the four products and relevant information are given below for one period:
Product
Output in units Costs per unit: Direct material Direct labour Machine hours (per unit)
A
B
C
D
12 0 (£) 40 28 4
100 (£) 50 21 3
80 (£) 30 14 2
120 (£) 60 21 3
The four products are similar and are usually produced in production runs of 20 units and sold in batches of 10 un its. The produc tion overhead overhea d is currently abso rbed by using a mach ine hour rate, and the total of the production overhead for the period has been analyzed as follows: (£)
Machine department costs (rent, business rate ra tes, s, dep epre reci ciat atio ion n an and d su supe perv rviisi sion on)) Set-up costs Stores receiving Inspection/Quality control Materials handling and dispatch
10430 10430 5 250 3 600 2 10 100 4 62 620
You have ascertained asce rtained that the ‘cost drivers’ to b e used are as liste d below for the ov erhead costs shown
Cost
Cost driver
Set up costs Stores receiving Inspection/Quality control Mate Ma teri rial als s ha hand ndli ling ng an and d de desp spat atch ch
Number of production runs Requisitions raised Number of production runs Orde Or ders rs ex exec ecut uted ed
The number of requisitions raised on the stores was 20 for each product and the number of orders executed was 42, each order being for a batch of 10 of a product.
!"#$ &'()
You are required to: a) to calculate the total costs for each product if all overhead costs are absorbed on a machine hour basis (b) to calculate the total costs for each product, using activity-based costing; (c) to calculate and list the unit product costs from your figures in (a) and (b) above, to show the differences and to comment briefly on any conclusions which may be drawn which could have pricing and profit implications. 5) W is a manufacturing company that produces three products: X, Y and Z. Each uses the same resources, but in different quantities as shown in the table of budgeted data for 2010 below:
Product
Budgeted production Direct labour hours per unit Machine hours per unit Batch size Machine setups per batch Purchase orders per batch Material movements per batch
X
V
Z
1500 2 3 50 2 4 10
2500 4 2 100 3 4 5
4000 3 3 500 1 6 4
W’s budgeted production overhead costs for 2010 are $400 000 and current practice is to absorb these costs into product costs using an absorption rate based on direct labour hours. As a result the production overhead cost attributed to each product unit is: Product X $32
Product Y $64
Product Z $48
The management of S are considering changing to an activity based method of attributing overhead costs to products and as a result have identified the following cost drivers and related cost pools: Cost pool
Machine maintenance Machine setups Purchasing Material handling
$
100 000 70 000 90 000 60 0 00
Cost driver
machine hours machine setups purchase orders material movements
The remaining $80 000 of overhead costs are caused by a number of different factors and activities that are mainly labour related and are to be attributed to products on the basis of labour hours. Required: (a) Calculate the production overhead cost attributed to each product unit using an activity-based approach. (b) Explain how W has applied Pareto Analysis when determining its cost drivers and how it may continue to use Pareto Analysis to control its production costs
!"#$ &'() 6) XY provides accountancy services and has three different categories of client: limited companies, self employed individuals, and employed individuals requiring taxation advice. XY currently charges its clients a fee by adding a 20% mark-up to total costs. Currently the costs are attributed to each client based on the hours spent on preparing accounts and providing advice. XY is considering changing to an activity based costing system. The annual costs and the causes of these costs have been analyzed as follows:
$
Accounts preparation and advice Requesting missing information Issuing fee payment reminders Holding client meetings Travelling to clients
580 000 30 000 15 000 60 000 40 000
The following details relate to three of XY’s clients and to XY as a whole: en
Hours spent on preparing accounts and providing advice Requests for missing information Payment reminders sent Client meetings held Miles travelled to meet clients
A
B
C
XY
1 0 00 4 2 4 150
250 10 8 1 600
340 6 10 2 0
18 0 00 250 400 250 10 000
Required: Prepare calculations to show the effect on fees charged to each of these three clients of changing to the new costing system. 7) Abkaber plc assembles three types of motorcycle at the same factory: the 50cc Sunshine; the 250cc Roadster and the 1000cc Fireball. It sells the motorcycles throughout the world. In response to market pressures Abkaber plc has invested heavily in new manufacturing technology in recent years and, as a result, has significantly reduced the size of its workforce. Historically, the company has allocated all overhead costs using total direct labour hours, but is now considering introducing activity-based costing (ABC). Abkaber plc’s accountant has produced the following analysis.
Sunshine Roadster Fireball
Annual Output (units)
Annual Direct Labour Hours
Selling Price (£ per unit)
Raw material cost (£ per unit)
2000 1600 400
200 000 220 000 80 000
4000 6000 8000
400 600 900
!"#$ &'()
The three cost drivers that generate overheads are: Deliveries to retailers
–
Set-ups
–
Purchase orders
–
the number of deliveries of motorcycles to retail showrooms the number of times the assembly line process is re-set to accommodate a production run of a different type of motorcycle the number of purchase orders.
The annual cost driver volumes relating to each activity and for each type of motorcycle are as follows:
Sunshine Roadster Fireball
Number of deliveries to retailers
Number of set-ups
Number of purchase orders
100 80 70
35 40 25
400 300 100
The annual overhead costs relating to these activities are as follows: £
Deliveries to retailers Set-up costs Purchase orders
2 400 000 6 000 000 3 600 000
All direct labour is paid at £5 per hour. The company holds no stocks. At a board meeting there was some concern over the introduction of activity-based costing. The finance director argued: ‘I very much doubt whether selling the Fireball is viable but I am not convinced that activity-based costing would tell us any more than the use of labour hours in assessing the viability of each product.’ The marketing director argued: ‘I am in the process of negotiating a major new contract with a motorcycle rental company for the Sunshine model. For such a big order they will not pay our normal prices but we need to at least cover our incremental costs. I am not convinced that activity-based costing would achieve this as it merely averages costs for our entire production.’ The managing director argued: ‘I believe that activity-based costing would be an improvement but it still has its problems. For instance, if we carry out an activity many times surely we get better at it, and costs fall rather than remain constant. Similarly, some costs are fixed and do not vary either with labour hours or any other cost driver.’ The chairman argued: ‘I cannot see the problem. The overall profit for the company is the same no matter which method of allocating overheads we use. It seems to make no difference to me.’ Required: (a) Calculate the total profit on each of Abkaber plc’s three types of product using each of the following methods to attribute overheads: (i) the existing method based upon labour hours; and (ii) activity-based costing (b) Write a report to the directors of Abkaber plc, as its management accountant. The report should:
!"#$ &'() (i) evaluate the labour hours and the activity-based costing methods in the circumstances of Abkaber plc; and (ii) examine the implications of activity-based costin g for Abkaber plc, and in so doing evaluate the issues raised by each of the directors. Refer to your calculations in requirement (a) above where appropriate. 8) A healthcare company specialises in hip, knee and shoulder replacement operations, known as surgical procedures. As well as providing these surgical procedures the company offers pre operation and post operation in-patient care, in a fully equipped hospital, for those patients who will be undergoing the surgical procedures. Surgeons are paid a fixed fee for each surgical procedure they perform and an additional amount for any follow-up consultations. Post procedure follow-up consultations are only undertaken if there are any complications in relation to the surgical procedure. There is no additional fee charged to patients for any follow up consultations. All other staff are paid annual salaries. The company’s existing costing system uses a single overhead rate, based on revenue, to charge the costs of support activities to the procedures. Concern has been raised about the inaccuracy of procedure costs and the company’s accountant has initiated a project to implement an activity based costing (ABC) system. The project team has collected the following data on each of the procedures. Procedure information
Fee charged to patients per procedure Number of procedures per annum Average time per procedure Number of procedures per theatre session In-patient days per procedure Surgeon’s fee per procedure % of procedures with complications Surgeon’s fee per follow up consultation Cost of medical supplies per procedure
Hip
Knee
Shoulder
$8000
$10 000
$6000
600 2.0 hours
800 1.2 hours
400 1.5 hours
2 3 $1200
1 2 $1800
4 1 $1500
8%
5%
10%
$300
$300
$300
$400
$200
$300
The project team has obtained the following information about the support activities.
Activity
Cost driver
Theatre preparation for each session Operating theatre usage Nursing and ancillary services Administration Other overheads
Number of theatre preparations Procedure time In-patient days Sales revenue Number of procedures
Overheads $000
864 1449 5428 1216 923
!"#$ &'() Required: (a) Calculate the profit per procedure for each of the three procedures, using the current basis for charging the costs of support activities to procedures. (b) Calculate the profit per procedure for each of the three procedures using activity-based costing (c) Discuss the ways in which the information obtained by the project team may be of benefit to the management of the company 9) Trimake Limited makes three main products, using broadly the same production methods and equipment for each. A conventional product costing system is used at present, although an activity-based costing (ABC) system is being considered. Details of the three products for a typical period are: Hours per unit
Product X Product Y Product Z
Labour hours
Machine unit
½
1½ 1 3
1½ 1
Materials per unit £
Volumes Units
20 12 25
750 1250 7000
Direct labour costs £14 per hour and production overheads are absorbed on a machine hour basis. The rate for the period is £28 per machine hour. a) You are required to calculate the cost per unit for each product using conventional methods. Further analysis shows that the total of production overheads can be divided as follows: (%)
Costs relating to set-ups Costs relating to machinery Costs relating to materials handling Costs relating to inspection Total production overhead
35 20 15 30 100%
The following activity volumes are associated with the product line for the period as a whole. Total activities for the period:
Product X Product Y Product Z
Number of set-ups
Number of movements of materials
Number of inspections
75 115 480 670
12 21 87 120
150 180 670 1000
b) calculate the cost per unit for each product using ABC principles; (c) to comment on the reasons for any differences in the costs in your answers to (a) and (b).
!"#$ &'() 10) A company sells and services photocopying machines. Its sales department sells the machines and consumables, including ink and paper, and its service department provides an after sales service to its customers. The after sales service includes planned maintenance of the machine and repairs in the event of a machine breakdown. Service department customers are charged an amount per copy that differs depending on the size of the machine. The company’s existing costing system uses a single overhead rate, based on total sales revenue from copy charges, to charge the cost of the Service Department’s support activities to each size of machine. The Service Manager has suggested that the copy charge should more accurately reflect the costs involved. The company’s accountant has decided to implement an activity-based costing system and has obtained the following information about the support activities of the service department: ver ea s per annum $000
Activity
Cost driver
Customer account handling Planned maintenance scheduling Unplanned maintenance scheduling Spare part procurement
Number of customers
Other overheads Total overheads
126
Number of planned maintenance visits Number of unplanned maintenance visits Number of purchase orders Number of machines
480 147 243 600 1596
The following data have also been collected for each machine size: Small Medium Large photocopiers photocopiers photocopiers
Charge per copy Average number of copies per year per machine Number of machines Planned maintenance visits per machine per year Unplanned maintenance visits per machine per year Total number of purchase orders per year Cost of parts per maintenance visit Labour cost per maintenance visit
$0.03
$0.04
$0.05
60 000 300
120 000 800
180 000 500
4
6
12
1
1
2
500
1200
1000
$100
$300
$400
$60
$80
$100
Each customer has a service contract for two machines on average: A) Calculate the annual profit per machine for each of the three sizes of machine, using the current basis for charging the costs of support activities to machines. B) Calculate the annual profit per machine for each of the three sizes of machine using activity based costing.
!"#$ &'() Answer Key: 1)
The main difference between a traditional based costing and an ABC system is that an ABC tends to have more detailed cost drivers, and allocates costs based on specific activities as opposed to just a singular overhead rate.
2) Traditional costing is likely to report distorted costs when there is a significant amount of different products and overhead comprises a large amount of costs. It is especially distorted when direct labor or direct machine hours are used but some products are more complicated than the other products. 3) Some costs are incurred on a batch level as opposed to a unit level basis, and high volume products tend to have a larger batch size. For example, a high volume product would have a batch size of 100 and a low volume product would have a batch size of 10. If you allocate them on a unit basis instead of a batch basis, you will overcost the high volume for things such as machine setups, orders, or inspections. 4) a) Step 1: Obtain total overhead costs: Total overhead costs = 10,430 + 5,250 +3,600 +2,100 + 4,620 = 26,000 Step 2: Total Machine Hours 120 x 4 + 100 x 3 + 80 x 2 + 120 x 3 = 480 + 300 + 160 + 360 = 1,300 Step 3: Get overhead rate = 26,000 / 1,300 = $20 / hour Step 4 : Allocate!
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!"#$ &'() b) Step 1: Obtain overhead cost per activity center and list activity drivers Step 2: calculate for total activity Step 3: Solve for rate per activity driver Step 4: Allocate
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The costing for product C is significant different. Why? The number of requisitions raised is the same regardless of volume. Because C is a low volume product, this cost is allocated to less units.
5) Every problem beyond this point is a bit repetitive, but practice makes perfect. ! I actually recommend converting everything to a per product basis (total indirect cost per product) instead of on a per batch / per unit basis. As I discussed, this can hlep serve as your double-checking mechanism for errors. Remember to convert everything and be aware if it is stated in per units or per batch. So get the number of batches first.
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Main difference between this and traditional costing is product X and Z. Because Product Z’s batch size is so much bigger, it has a tendency to incur less costs since it uses less batches (8) as opposed to X (30). Pareto will be explained in POM105. 6) Similar ABC problem but applied to a service company, which is kinda cool. In order to show the effect of a change in system (20% of total costs), we need to compute both traditional and ABC. Certainly, the “total cost” will change based on the system, and so will the selling price. First, compute traditional-based costing. If we need to use only one cost driver (hours preparing account services), then we need to allocate the TOTAL costs to this single driver.
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!"#$ &'() 7) Key thing: Don’t forget the DLH Cost. It’s hidden within the paragraphs at $5 per hour, and the table is stated in TOTAL DLH annually for all units produced, while selling price and raw materials is per unit. It is asking for total profit so you need to solve for total costs. Starting with the traditional costing:
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b) The finance director is right that the more complicated fireball is selling at a loss, and ABC does show it to him (contrary to his hesitation regarding ABC). This shows the flexibility of ABC system for complex products. It does not average the costs of the entire production, contrary to the marketing director’s stance. Some OH can still be variable and this is where ABC becomes important.
!"#$ &'() 8) This is ABC applied to a healthcare system. We are running out of examples to use at this point haha! What is unusual about this problem is that REVENUE is the cost driver ($ sales).
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ABC is useful for finding out which part of the procedure is inefficient (costs too much), after which operations can be revamped. For a hospital, it’s not feasible to simply drop a procedure offering because it does not make any money. 9) a)
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3,375 x 28 = $654,500 Overhead
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The key difference is because product Z was slightly overcharged. Multiplied by the large amount of units, the difference is enhanced. The overcharging was because product Z uses a disproportionate amount of machine hours, even though some costs are not machine driven.
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