MANAGERIAL ACCOUNTING AND FINANCE 3A
WEEK 2: COST ESTIMATION AND ACTIVITY-BASED COSTING
PREPARED SOLUTIONS:
Activity-Based Costing
Textbook Question IM11.4 33 mins
Textbook Question IM11.5 30 mins
MAFM3A Test 1 2017 (abridged) 15 mins
MAFM300 Test 1 2010 60 mins
Cost Estimation
MAFM3A Exam 2017 (abridged) 13 mins
MAFM300 Test 1 2014 (abridged) 18 mins
MAFM300 Test 1 2013 (abridged) 15 mins
TEXTBOOK QUESTION IM11.4
(a) Production cost per unit (conventional method)
Product X Product Y
Product Z
(R) (R) (R)
Direct labour at R14 per hour 7 21 14
Direct materials 20 12 25
Production overhead at R28/MH 42 (1½ hr) 28 (1 hr) 84 (3 hrs)
–– –– –––
69 61 123
–– –– –––
(b) The total production overhead is derived from the overheads allocated to the product in part (a):
(R)
Product X 31 500 (750 x R42)
Product Y 35 000 (1250 x R28)
Product Z 588 000 (7000 x R84)
–––––––
654 500
–––––––
Overhead costs traced to cost pools:
(R)
Set-up cost 229 075 (35%)
Machining 130 900 (20%)
Materials handling 98 175 (15%)
Inspection 196 350 (30%)
–––––––
654 500
–––––––
Cost driver rates:
(R)
Cost per set-up 341.903 (R229 075/670)
Cost per machine hour 5.60 (R130 900/23 375a)
Cost per material movement 818.125 (R98 175/120)
Cost per inspection 196.35 (R196 350/1 000)
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Note
a Machine hours = (750 x 1.5) + (1250 x 1) + (7000 x 3) = 23 375
Overhead cost assigned to each product:
Product X Product Y Product Z
(R) (R) (R)
Set-up costs at R341.903 25 643 (75) 39 319 (115) 164 113 (480)
Machining at R5.60/MH 6 300 (1125) 7 000 (1250) 117 600 (21 000)
Materials handling at R818.125/move 9 817 (12) 17 181 (21) 71 177 (87)
Inspection at R196.35 per inspection 29 453 (150) 35 343 (180) 131 554 (670)
––––––– ––––––– –––––––
71 213 98 843 484 444
––––––– ––––––– –––––––
Number of units 750 1250 7000
Overhead cost per unit R95 R79 R69
Production cost per unit (ABC principles)
Product X Product Y Product Z
(R) (R) (R)
Direct labour 7 21 14
Materials 20 12 25
Production overhead 95 79 69
––– ––– –––
122 112 108
––– ––– –––
Change (compared with traditional method) +77% +84% -12%
(c) The traditional method allocates overheads in proportion to machine hours to products (4.8% to X,
5.3% to Y and 89.9% to Z). However, when overheads are assigned on the basis of number of set-ups,
movements of materials and inspections the proportion of overheads assigned to product Z are 72%
(480/670) for set-up costs, 72% (87/120) for materials handling costs and 67% (670/1000) for
inspection costs. In contrast, the traditional method allocates approximately 90% of all costs to product
Z. Therefore, the unit cost for product is higher with the traditional method. The opposite situation
applies with products X and Y and as a result, unit costs are lower with the traditional method.
TEXTBOOK QUESTION IM11.5
i) Traditional volume-based system
The first stage of the two-stage overhead allocation procedure requires that the service department
overheads are reallocated to the production departments (Machinery and Fittings). Typical allocation
bases are:
Materials handling – Direct material cost
Material procurement – Direct material cost
Set-up – Direct labour hours
Maintenance – Machine cost or maintenance hours
Quality control – Direct labour hours
It is assumed that the R10 500 service department costs will be apportioned as follows:
(R’000)
Machinery 6 500
Fittings 4 000
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(Note that students will require details of the above allocation since the details are not given in the
question.)
The computation of the departmental overhead rates is as follows:
Machinery Fitting
department department
(R) (R)
Original overhead allocation 2 500 000 2 000 000
Service department reallocations 6 500 000 4 000 000
Total production overhead cost (R) 9 000 000 6 000 000
Total direct labour hours 1 100 000 350 000
Overhead rate R8.182 per DLH R17.143 per
DLH
Product costs
Product A Product B
(R) (R)
Machinery department:
500 000 DLH x R8.182 4 091 000
600 000 DLH x R8.182 4 909 200
Fitting department:
150 000 DLH x R17.143 2 571 500
200 000 DLH x R17.143 3 428 600
Total production overhead cost (R) 6 662 500 8 337 800
Production volume 300 000 300 000
Unit product overhead cost (R) 22.21 27.79
(ii) Activity-based costing system
Computation of cost driver rates:
Overhead Annual Annual cost driver volume Cost driver rate
cost
(R’000)
Material handling 1 500 2 540 material movements R590.55 per
material movement
Material procurement 2 000 6 500 orders R307.69 per order
Set-up 1 500 624 set-ups R2403.85 per set-up
Maintenance 2 500 30 000 maintenance hours R83.33 per
maintenance per hour
Quality control 3 000 4 120 inspections R728.16 per inspection
Machinery 2 500 1 100 000 direct labour hours R2.27 per DLH
Fitting 2 000 350 000 direct labour hours R5.71 per DLH
Overheads assigned to part numbers
Material Material Quality Total
handling procurement Set-up Maintenance control Machinery Fitting (R’000)
Part 1:
Cost driver consumption 180 200 12 7000 360 150 000 50 000
Cost driver rate (R) 590.55 307.69 2 403.85 83.33 728.16 2.27 5.71
Total cost (R000) 106.30 61.54 28.85 583.31 262.14 340.50 285.50 1 668
Part 2:
Cost driver consumption 160 300 12 5000 360 350 000 100 000
Cost driver rate (R) 590.55 307.69 2 403.85 83.33 728.16 2.27 5.71
Total cost (R’000) 94.49 92.31 28.85 416.65 262.14 794.50 571.00 2 260
Part 3:
Cost driver consumption 1000 2000 300 10 000 2400 200 000 60 000
Cost driver rate (R) 590.55 307.69 2 403.85 83.33 728.16 2.27 5.71
Total cost (R’000) 590.55 615.38 721.16 833.30 1 747.58 454.00 342.60 5 305
3
Part 4:
Cost driver consumption 1200 4000 300 8000 1000 400 000 140 000
Cost driver rate (R) 590.55 307.69 2 403.85 83.33 728.16 2.27 5.71
Total cost (000) 708.66 1 203.76 721.16 666.64 728.16 908.00 799.40 5 763
Product costs
Product A Product B
(R) (R)
Part 1 1 668 000
Part 2 2 260 000
Part 3 5 305 000
Part 4 5 763 000
Production overhead cost (R) 3 928 000 11 068 000
Production volume 300 000 units 300 000
units
Unit cost (R) 13.09 36.89
MAFM3A TEST 1 2017 (ABRIDGED)
(7) ABC superior to traditional costing systems
Traditional costing systems were designed many years ago when the predominant costs were variable
material and labour costs. Labour-intensive manufacturing meant that there were few fixed
manufacturing overheads related to machine costs. Most companies also tended to manufacture either
single products only, or a very narrow range of products. Distortions arising from inappropriate
overhead allocations were not significant.
The emergence of multi-product manufacturing methods using fixed machinery costs meant that the
variable element was very small, with a high proportion of fixed costs. Simple single activity absorption
rates have become totally inappropriate. ABC is superior to the traditional method as it recognises that
there are several activities that cause the costs to be incurred and therefore uses multi-activity recovery
rates.
Many resources are consumed for reasons other than volume of production. Non-volume-related
activities consist of support activities such as materials handling, materials procurement, set-ups,
production scheduling and inspection activities. Traditional volume-based costing systems therefore
tend to over-cost high-volume products and under-cost low-volume products. To remedy this
discrepancy, ABC allocates costs according to activities that cause costs to be incurred. Costs are
assigned to products based on an individual product’s consumption or demand for each activity. ABC
systems simply recognise that businesses must understand the factors that drive each major activity, the
cost of activities and how activities relate to products.
MAFM300 TEST 1 2010
1. Traditional method
Fixed overhead absorption rate - budgeted manufacturing overheads
direct labour hours
Set ups Purchase R12 000 x 50% R 6 000
orders Deliveries R12 000 x 30% 3 600
Total overheads R12 000 x 20% 2 400
R12 000
FOAR R12 000
200 + 220 + 80DLH
= R24 per DLH
4
Giant Specialised Trek
Selling price Raw 14 000 16 000 18 000
materials 1 400 1 600 1 900
Labour DLH x R50 Overheads 5 000 6 875 10 000
DLH x R24 2 400 3 300 4 800
Profit 5 200 4 225 1 300
DLH 100 137.5 200
2. Activity Based Costing method
Cost Driver R No of movements Driver per movement R
Set-ups 6 000 000 100 60 000
Purchase orders 3 600 000 800 4 500
Deliveries 2 400 000 250 9 600
Giant Specialized Trek
Set-ups R60 000 x 35; 40; 25 2 100 000 2 400 000 1 500 000
Purchase orders R4 500 x 400; 300; 100 1 800 000 1 350 000 450 000
Deliveries R9 600 x 100; 80; 70 960 000 768 000 672 000
4 860 000 4 518 000 2 622 000
Number of units 2 000 1 600 400
Rate per unit R2 430 R2 823.75 R6 555
Giant Specialized Trek
Selling price 14 000 16 000 18 000
Raw materials 1 400 1 600 1 900
Labour 5 000 6 875 10 000
Overheads 2 430 2 823.75 6 555
Profit/(loss) 5 170 4 701.25 (455)
3. Comparison traditional vs ABC profit
Giant Specialzed Trek
Traditional R5 200 R4 225 R1 300
ABC R5 170 R4 701.25 (R455)
R -R30 +R476.25 -R1 755
%age change -0.58% +11.27% -135%
Trek, the low volume product, reports a loss under ABC methods, a decrease of 135% from traditional
costing to ABC. The change in profit for product Giant is minimal, 0.58% and the change for product,
Specialized, a high volume product, is an increase of 11.27%.
These changes are expected with a change to ABC as high volume products become more
profitable and low volume products, (Trek) relatively less profitable.
4. Direct labour hours (traditional) vs ABC
• Direct labour costs are identical for both costing methods.
• Direct labour is a relatively minor cost but the existing method that allocates overhead costs on the
basis of direct labour overstates their importance.
• The existing method is based on the assumption that there is a cause-and-effect relationship
between overheads and labour hours. This assumption appears to be unlikely based on the
information given in the question. If this assumption is incorrect then misleading results will
be reported.
• ABC attempts to allocate overheads based on using several different cost drivers rather than
the single base used with the existing method.
5
• ABC seeks to assign overheads based on cause-and-effect cost driver. The accuracy of the
reported ABC product costs depends on the extent to which the cause-and- effect assumption is
correct.
5. Report to the Directors
TO: Board of Directors
FROM: Management Accountant
DATE: 5 April 2010
IMPLICATIONS OF ACTIVITY-BASED COSTING
The comment by the Finance Director is incorrect since Trek is profitable with the existing system
but unprofitable with the ABC system. The reason for the difference in product profits is that Trek
has the lowest volume but it makes the greatest relative demand on the three activities identified by
the ABC system. Because Trek uses lower proportion of direct labour hours than the other products
the existing system allocates a lower share of overheads to Trek.
The marketing director argues that incremental costs are required for the pricing decision. It is
important to distinguish between short-term and long-term incremental costs. ABC seeks to report
long-term incremental costs. ABC recognises that longer-term incremental costs can be reduced by
making decisions that ensure that activities should be undertaken only where incremental revenues
exceed long-term incremental costs. It is important that facility-sustaining costs are omitted from
the costs reported by the ABC system since they are neither short-term nor long-term incremental
costs.
The managing director is correct that the cost per activity should not remain constant over the
longer term. Attempts should be made to reduce the costs of activities and improve their efficiency.
Thus ABC reported costs should be reviewed and revised at periodic intervals. Also some costs (i.e.
facility sustaining costs) do not change with activity and are not variable with any activity measure.
Such costs should be excluded from the reported costs or reported separately as facility sustaining
costs.
The chairman is correct that the profitability analysis based on maintaining the same product mix
will yield the same total profits. However, different profit/losses are reported by products and
making future decisions on the basis of ABC information compared with the existing system should
result in a different product mix and therefore have an impact on total future profits. For example,
assuming that the costs reported by the ABC system are all based on cause-and-effect relationships
then a decision may be made to discontinue production of Trek. This is not apparent with the
existing system. However, it is important that decisions should not be based solely on financial
factors and non-financial factors should also be taken into account.
MAFM3A EXAM 2017 (ABRIDGED)
3. Analysis of costs into their fixed and variable elements is used by the management accountant in
the following areas:
Planning: an analysis of costs into fixed and variable costs is necessary to predict costs for a range
of output levels in order to determine the target activity level at which the budget should be set.
Control: flexible budgets are needed for cost control purposes. When flexing the budget, the
variable costs in total will change and the fixed costs will remain constant within the relevant range.
Decision-making: analysis or fixed and variable costs is necessary in order to determine the
incremental costs for various short-term decisions. For example, the incremental costs of making
a component would be assessed where a company has spare capacity and wishes to evaluate a make
or buy decision.
6
MAFM300 TEST 1 2014 (ABRIDGED)
a) Total anticipated kilowatt hours for next year is 660 megawatt hours
Ʃx = 2540 Ʃy = 530 000
Ʃx = 1 387 600
2
Ʃxy = 283 000 000
N = 5 observations
Ʃy = Na + bƩx
Ʃxy = aƩx + bƩx2
530 000 = 5a + 2 540b
283 000 000 = 2 540a + 1 387 600b
269 240 000 = 2 540a + 1 290 320b
13 760 000 = 97 280b
b = R141 (VC)
530 000 = 5a + (2 540 x R141)
a = R34 372 (FC)
Budgeted cost – (660 hrs x R141) + R34 372 = R 127 432
ALTERNATE SOLUTION
Total anticipated kilowatt hours for next year is 660 megawatt hours
Ʃx = 2 540 Ʃy = 530 000
Ʃx2 = 1 387 600 Ʃxy = 283 000 000
N = 5 observations ƩxƩy = 1 346 200 000
(Ʃx)2 = 6 451 600
M = nƩxy - ƩxƩy
nƩx² - (Ʃx)²
= (5*283 000 000) – 1 346 200 000
5*1 387 600 – 6 451 600
= 141
C = Ʃy - mƩx
n
= 530 000 – 141*2 540
5
= 34 372
Budgeted cost – (660 hrs x R141) + R34 372 = R127 432
ALTERNATE SOLUTION
Using a Financial Calculator
Total anticipated kilowatt hours for next year is 660 megawatt hours
X Y
1 490 100 000
2 250 70 000
3 650 130 000
4 600 110 000
5 550 120 000
7
Y = 141X+34 372
Budgeted Cost = (141*660) – 34 372 = 127 432
b) Data adjustments are sometimes required to reflect a forecast period eg. Inflation.
There should be a sufficient number of observations to achieve a degree of reliability, usually at
least thirty.
Regressions estimates are only valid in a certain range.
Allocated fixed costs should be eliminated from departmental costs as these are common and
unavoidable and do not change with volumes in the short term.
Multiple regression analysis may be necessary if no one driver gives an adequate reliability.
Incorrect matching of costs and activities may lead to distortions (e.g. electricity incurred in one
year but only paid in next year).
Possibility of choosing the wrong driver, regression is based on the information obtained from the
scatter diagram regarding the cost driver. Should the cost driver be incorrect, then the cost estimated
using regression analysis will not make sense.
Missing data. Misplaced source documents or failure to record a transaction accurately can result
in missing data. The regression analysis is based on the information provided; it cannot detect the
missing or inaccurate information.
MAFM300 TEST 1 2013 (ABRIDGED)
1. Budgeted selling and administration costs
R178 546 – R121 582 = R0.67 per unit (VC)
250 000 – 165 000
FC = R121 582 – (165 000 x R0.67)
R11 032
For 2013 sales – (R0.67 x 204 375 units) + R11 032
R147 963
Some costs do not fall clearly into being either variable or fixed. They are the costs that are a mix
of variable and fixed – sometimes called semi-variable or mixed costs. The following techniques
could be used to separate the fixed and variable components of semi-variable or mixed costs:
– the high-low method
– linear regression
Many costs are a mix of variable and fixed elements, for example power costs (gas or electricity).
The tariffs for power costs often consist of a fixed charge irrespective of the amount of power
consumed and a variable charge per unit of consumption.
