CPA SPM Prior Learning

Accounting for Overheads - Activity Based Costing (ABC)

Activity based costing is an alternative to absorption costing. It involves the identification of the
factors which cause the costs of an organisation’s major activities. These are known as cost
drivers. Support overheads are then charged to products based on their usage of these
activities.

The absorption costing approach was developed in a time when most organisations produced
only a narrow range of products and when overhead costs were only a small fraction of total
costs. Direct labour and direct materials would have been the largest proportion of total costs.

Nowadays, however, the situation is different. With the advent of advanced manufacturing
technology, overheads are likely to be far more important, for reasons including:

• Direct labour may account for as little as 5% of a product’s cost

• The accessibility of information technology now allows for more sophisticated overhead
methods than in the past.
• In today’s business environment it is difficult to justify the use of direct labour or direct
materials as the basis for allocating overheads. It is against this background that Activity
Based Costing (ABC) has emerged.

Many resources are used in non-volume related support activities, which have increased due to
advanced manufacturing technology, such as setting-up, production scheduling, inspection and
data processing. These support activities assist the efficient manufacture of a wide range of
products and are not, in general, affected by changes in production volume. They tend to vary in
the long term according to the range and complexity of the products manufactured rather than
the volume of output. The wider the range and the more complex the products, the more
support services will be required.

Consider for example, factory X which produces 10,000 units of one product the Alpha and
factory Y which produces 1,000 units each of 10 slightly different versions of the Alpha.

Support activity costs in factory Y are likely to be a lot higher than support activity costs in
factory X but the factories produce an identical number of units.

Take setting up for example. Factory X will only need to set up once, while factory Y will have to
set up the production run at least ten times for ten different products. Factory Y will therefore
incur more set-up costs.

The major ideas behind activity based costing include:

• Activities cause costs. Activities include ordering, materials handling, machining,
assembly, production scheduling and despatching.
• Producing products creates demand for the activities
• Costs are assigned to a product on the basis of the products consumption of activities
Activity based costing involves the identification of the factors which cause the costs of an
organisation’s major activities. Support overheads are then charged to products on the basis of
their usage of the factor causing the overheads.

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Calculating product costs using ABC

An ABC system operates as follows:
Step 1: Identify an organisation’s major activities

Step 2: Identify the cost drivers. (A cost driver is a factor which causes the cost of an activity.)
Example:
Activity Cost Driver:
Ordering No of Orders
Materials Handling No of Production Runs
Production Scheduling No of Production Runs
Despatching No of Despatches

Step 3: Collect the costs of each activity into cost pools.

Step 4: Charge support overheads to products on the basis of their usage of the activity.

Suppose, for example, that the cost pool for the activity of ordering is €100,000 and that there
were 10,000 orders (no of orders being the cost driver). Each product would therefore be
charged with €10 for each order it required.

Example:
Cooper Ltd manufactures four products, W, X, Y and Z. Output and cost data for the period just
ended are as follows:

Output No of Material Direct Machine

Units production Cost per Labour hours
runs unit hours per unit
per unit

W 10 2 20 1 1
X 10 2 80 3 3
Y 100 5 20 1 1
Z 100 5 80 3 3
14

Direct labour cost is €5 per hour. Overhead costs are as follows:

Short-run variable costs 3,080

Set-up costs 10,920
Production and scheduling costs 9,100
Materials Handling costs 7,700
30,800

Required:
Calculate product costs using the following approaches:
• Absorption Costing
• ABC

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Solution:
Absorption Costing OAR = €30,800 / 440 hours = €70 per labour hour

W X Y Z Total
Direct Materials
200 800 2,000 8,000 11,000
Direct Labour
50 150 500 1,500 2,200
Overheads
700 2,100 7,000 21,000 30,800

950 3,050 9,500 30,500 44,000

Units produced
10 10 100 100
Cost per unit
95 305 95 305

Activity Based Costing

Cost / Cost-driver = Cost per activity
Sort-run variable costs 3,080 / 440 machine hours = €7 per machine hr.
Set-up costs 10,920 / 14 prod. runs = €780 per run
Production and scheduling costs 9,100 / 14 prod. runs = €650 per run
Materials Handling costs 7,700 / 14 prod. runs = €550 per run

W X Y Z Total
Direct Materials 200 800 2,000 8,000 11,000
Direct Labour 50 150 500 1,500 2,200
Short-run Variable O/H's 70 210 700 2,100 3,080
Set-up Costs 1,560 1,560 3,900 3,900 10,920
Prod & Sched Costs 1,300 1,300 3,250 3,250 9,100
Materials Handling Costs 1,100 1,100 2,750 2,750 7,700
4,280 5,120 13,100 21,500 44,000
Units Produced 10 10 100 100
Cost per unit 428 512 131 215

If we compare the two sets of figures they suggest the traditional volume-based absorption
costing system is flawed.
Product Absorption ABC unit Difference
costing unit cost cost
W 95 428 333
X 305 512 207
Y 95 131 36
Z 305 215 -90

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Absorption costing under allocates overhead costs to low-volume products (here W and X with
ten units of output) and over allocates to higher-volume products (here Z in particular).
Absorption costing also under allocates overhead costs to less complex products (here W and Y
with just one hour of work needed) and over allocates overheads to more complex products
(here X and particularly Z).

ABC versus traditional absorption costing

Traditional absorption costing allocates overheads to production departments (cost centres)
whereas ABC systems assign overheads to each major activity (cost pools). In absorption costing
this can lead to many reapportionments of service department costs to ensure that all overheads
are allocated to production departments. ABC establishes separate cost pools for support
activities such as despatching and materials handling and as the costs of these activities are
assigned to products through cost drivers, reapportionment of service department costs is
avoided.

The principle idea of ABC is to focus attention on what causes costs to increase, the cost drivers.
Just as there are no rules for what to use as the basis for absorbing costs in traditional absorption
costing, there are also difficulties in choosing cost drivers.
Focusing attention on what actually causes overheads and tracing overheads to products on the
basis of the usage of cost drivers ensures that a greater proportion of overheads are product
related, whereas traditional costing systems allow overheads to be related to products in rather
more arbitrary ways. It is this feature of ABC which produces, it is claimed, greater accuracy.

Advantages of ABC:
• ABC focuses on the nature of cost behaviour and attempts to provide meaningful
product costs.
• ABC recognises that many overhead costs arise out of the diversity and complexity of
operations and does not assume that overhead costs are related to volume of activity
only and just use a meaningless direct labour hour recovery rate or machine hour
recovery rate.
• The complexity of manufacturing has increased, with wider product ranges, shorter
product lifecycles, a greater importance being attached to quality and more complex
production processes. ABC recognises this complexity with its multiple cost drivers.
• In a more competitive environment, companies must be able to assess product
profitability realistically. ABC facilitates good understanding of what drives overhead
costs.
• In a modern manufacturing environment, overhead functions include a lot of non-factory-
floor activities such as product design, quality control, production planning, sales order
planning and customer service. ABC is concerned with all overhead costs, including the
costs of these functions, and so it takes management accounting beyond its “traditional”
factory floor boundaries.

Criticisms of ABC
• Some measure of arbitrary cost apportionment may still be required at the cost pooling
stage for items like rent, rates and building depreciation. If an ABC system has many cost
pools the amount of apportionment needed may be even greater.
• The ability of a single cost driver to explain fully the cost behaviour of all items in its
associated pool is questionable.
• To have a usable cost driver, a cost must be caused by an activity that is measurable in
quantitative terms and which can be related to production output. But not all costs can
be treated in this way. For example, what drives the cost of the annual external audit?

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• ABC is sometimes introduced because it is fashionable, not because it will be used by

management to provide meaningful product costs or extra information. If management
is not going to use ABC information, a traditional absorption costing system may be
simpler to operate.
• There can be difficulties in gathering all of the data required for an ABC system.
• It can be costly and time-consuming to implement and operate
• There can be resistance to change by staff and lack of top management support.
August 2011 Q4:

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Solution:

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