Activity-based costing
Content
01 Identify appropriate cost drivers under ABC
02 Calculate costs per driver and per unit using ABC
03 Steps in ABC
04 Advantages and disadvantages of ABC
Traditional absorption costing:
Machine oil
Supervisor salary Production OAR
department = machine
Machine repairs A hrs
Production set up
costs
Traditional absorption costing suits for:
• One or a few simple and similar products
• Overhead costs were only a very small proportion
Modern manufacturing environment:
Production overheads become a larger proportion of total
costs
The production has become more complex and more
supporting activities are involved
Companies must be able to assess product profitability
realistically in order to gain competitive advantages
Activity-based costing:
Machine oil No. of machine hours OAR
Supervisor salary No. of labour hours OAR
Machine repairs No. of machine hours OAR
Production set up No. of production set
OAR
costs ups
Cost pool Activities Cost drivers
Other cost drivers
Ordering processing costs - no. of customer orders
Packing costs - no. of packing orders/customer orders
Example- ABC
The following data is available:
Machine cost $7000
Set-up cost $9000
Packing cost $2000
Total production overhead $18000
Example- ABC
Product A Product B Product C
Actual output(units) 2000 1000 1500
Cost driver data
Labor hour per unit 0.25 0.12 0.3
Machine hour per unit 0.1 0.2 0.2
No.of production set-up 2 2 5
No.of production orders 3 4 3
Direct labor cost per unit($) 0.1 0.3 0.3
Direct material cost per unit($) 0.5 0.8 0.6
Required
Calculate each product's full cost under ABC.
Step 1. Group overheads into activities, according to how they are
driven. These are called cost pools.
Machine cost $7000
Set-up cost $9000
Packing cost $2000
Total production overhead $18000
Step 2. Identify cost drivers for each activity. ie, what causes
these activity costs to be incurred.
Machine cost Machine hour
Set-up cost Production set-up/production run
Packing cost Customer order
Step 3. Calculate an O.A.R for each activity
Machine cost per machine hour = Machine cost
total machine hour
= 7,000 =
(0.1×2000)+ (0.2×1000)+ (0.2×1500)
= $10 per machine hour
Set-up cost per production set-up
= 9,000 = $1000 per set-up
2 + 2+ 5
Packing cost per customer order
= 2,000 = $200 per customer order
3+ 4+ 3
Step 4. Absorb the activity costs into the product.
Product A Product B Product C
Machine cost 2000×0.1×$10=$2000 $2000 $3000
=$10per machine hour
Set-up cost $1000×2=$2000 $2000 $5000
=$1000 per set-up
Packing cost $200×3=$600 $800 $600
=$200
Total overheads $4600 $4800 $8600
No of products 2000 1000 1500
Total production overheads per unit $2.3 $4.8 $5.73
Step 5: Calculate the full product cost per unit
Product A Product B Product C
Direct labor cost per unit($) 0.5 0.8 0.6
Direct material cost per unit($) 0.1 0.3 0.3
Total production overheads 2.3 4.8 5.73
Full production cost 2.9 5.9 6.63
Advantages
• It provides a more accurate cost per unit. Hence, it can be
used in performance appraisal.
• Management can control overhead costs by managing cost
drivers.
• It provides profitability analysis to customers and product
line, etc
• It provides better understanding of what drives overhead
costs.
Disadvantages
• Time consuming and expensive
• ABC will be of limited benefit if the overheads are volume
related or if the company only produce single or similar
products.
• Complex situations may have multiple cost drivers
• It is difficult to allocate all overhead costs to specific activities
• Some arbitrary apportionment may still exist
The following statements have been made in relation to activity-based costing:
(1) A cost driver is a factor which causes a change in the cost of an activity
(2) Traditional absorption costing tends to under-estimate overhead costs for high volume products
Which of the above statements is/are true?
A 1 only
B 2 only
C Neither 1 nor 2
D Both 1 and 2
Question
A company makes two products using the same type of materials
and skilled workers. The following information is available:
Product A Product B
Budgeted volume (units) 1,000 2,000
Material per unit ($) 10 20
Labour per unit ($) 5 20
Fixed costs relating to material handling amount to $100,000. The
cost driver for these costs is the volume of material purchased.
General fixed costs, absorbed on the basis of labour hours, amount
to $180,000.
Question
Using activity-based costing, what is the total fixed overhead
amount to be absorbed into each unit of product B (to the nearest
whole $)?
A. $113
B. $120
C. $40
D. $105
