ABC

Question 1:

Alfa Company makes four products which involve ordering materials, setting up machinery and
handling production runs. The indirect costs of these activities are as follows.

$
Ordering 20,000
Set-up 40,000
Handling 54,000
Total 114,000
Other information relating to the products is as follows:
Products Number of units Number of orders Set-ups Handling hours
X1 2,000 10 200 60
Y2 800 40 300 60
Z3 3,200 50 600 120
W4 4,000 100 500 120

Required:
1. Prepare a schedule of each activity costs per unit and calculate the indirect cost to
be allocated to each of the four products.
2. Define Activity based management (ABM). Explain how ABM might be
implemented in an organization and give examples?
Solution:

1-

Products Number of units Number of orders Set-ups Handling hours

X1 2,000 10 200 60
Y2 800 40 300 60
Z3 3,200 50 600 120
W4 4,000 100 500 120
Total 10,000 200 1,600 360
 The cost of each activity will be as follows:
Ordering: $20,000 ÷ 200 = $100 per purchase order
Set-up: $40,000 ÷ 1,600 = $25 per set-up
Handling: $54,000 ÷ 360 = $150 per handling hour
X1 ($) Y2 ($) Z3 ($) W4 ($) Total ($)
Ordering 1,000 4,000 5,000 10,000 20,000
Set-up 5,000 7,500 15,000 12,500 40,000
Handling 9,000 9,000 18,000 18,000 54,000
Total 15,000 20,500 38,000 40,500 114,000
Number of 2,000 800 3,200 4,000
units
Cost per unit 7.5 25.625 11.875 10.125

The activity components costs per unit are as follows:

X1 ($) Y2 ($) Z3 ($) W4 ($)
Ordering 0.5 5 1.5625 2.5
Set-up 2.5 9.375 4.6875 3.125
Handling 4.5 11.25 5.625 4.5
Total 7.5 25.625 11.875 10.125

2-

Activity based management (ABM) describes the management and control of organizational
performance using activity based costing information. The aim is to control causes of costs
directly. Managing cost drivers will manage costs in the long term. ABM extends ABC by
analyzing the management of activities, instead of simply analyzing the costs of activities.

ABM represents the set of actions that management can take to increase profitability, using
activity based costing information. The actions can include:

- Making operational improvements to high cost processes,

- Modifying product mix or prices,
- Restructuring customer relationships.

Question 2:

Sigma Manufacturing Inc ., recently introduced a new product, which managers refer to
as X12, to complement their other products, X13 and X14. The traditional method of
 allocating the indirect cost according to the units produced was used by the accountant.
Due to the recent addition of an expanded computer system, Sigma would like to
investigate the possibility of implementing ABC. Before making a final decision,
management has come to you for advice. The following information was provided to you
regarding manufacturing overhead:

Table (1)
Type of manufacturing Manufacturing overhead Allocation bases
overhead costs
Set-up $40,000 Number of set-ups
Ordering materials $45,000 Number of material orders
Handling materials $9,000 Number of times material was
handled
Inspection $21,000 Number of inspection hours
$115,000

Table (2)
Activity Products
X12 X13 X14
Total number of set- 5 20 55
ups
Total number of 1 2 7
material orders
Total number of 1 2 17
times material was
handled
Total number of 3 2 10
inspection hours
Number of units 6,000 3,000 1,000
produced
Required:

1. Calculate the indirect cost of each activity of the four types of the manufacturing
overheads.
2. Prepare a schedule showing the total manufacturing overhead cost allocated for each of the
products under ABC.
3. Calculate the total manufacturing overhead cost allocated for each product under the
traditional costing method.
4. Show the cost distortion between the two methods in a table.

Solution:
 Set-up related costs:
- Cost per set-up = $40,000 ÷ 80 set-ups = $500 per set-up
 Material ordering related costs:
- Cost per order = $45,000 ÷ 10 orders = $4,500 per order
 Material handling related costs:
- Cost per material handling = $9,000 ÷ 20 = $450 per time
 Inspection:
 - Cost per part = $21,000 ÷ 15 = $1,400 per hour
Table (1)
Product Set-up
Cost driver Allocation rate Cost
X12 5 $500 $2,500
X13 20 $500 $10,000
X14 55 $500 $27,500
Total $40,000

Table (2)
Product Material ordering
Cost driver Allocation rate Cost
X12 1 $4,500 $4,500
X13 2 $4,500 $9,000
X14 7 $4,500 $31,500
Total $45,000

Table (3)
Product Material handling
Cost driver Allocation rate Cost
X12 1 $450 $450
X13 2 $450 $900
X14 17 $450 $7,650
Total $9,000

Table (4)
Product Inspection
Cost driver Allocation rate Cost
X12 3 $1,400 $4,200
X13 2 $1,400 $2,800
X14 10 $1,400 $14,000
Total $21,000

The Mfg. overhead allocated for each product under the ABC:

Table (5)
Product Manufacturing overhead costs
Set-up Ordering Handling Inspection Product Mfg
overhead
X12 $2,500 $4,500 $450 $4,200 $11,650
X13 $10,000 $9,000 $900 $2,800 $22,700
X14 $27,500 $31,500 $7,650 $14,000 $80,650
Total $40,000 $45,000 $9,000 $21,000 $115,00

Traditional method:
- X12: ($115,000/10,000) x 6,000 = $69, 000
- X13: ($115,000/10,000) x 3,000 = $34,500
- X14: ($115,000/10,000) x 1,000 = $11,500
The cost distortion between the two methods:

X12 X13 X14

ABC $ 11,650 $ 22,700 $ 80,650
Traditional $69, 000 $34,500 $11,500
Cost Distortion ($57,350) ($11,800) $69,150

Question 3:

Parker Company produces mathematical and financial calculators and operates at capacity.
Data related to the two products are presented here:

Mathematical Financial
Annual production in units 50,000 100,000
Direct materials costs $ 150,000 $ 300,000
Direct manufacturing labor $ 50,000 $100,000
costs
Direct manufacturing labor 2500 5000
hours
Machine-hours 25,000 50,000
Number of production runs 50 50
Inspection hours 1000 500
Total manufacturing overheads are as follows:

Total
Machining costs $ 375,000
Setup costs 120,000
Inspection costs 105,000

Required

1-Choose a cost driver for each overhead cost pool and calculate the manufacturing overhead
cost per unit for each product.

2-Compute the manufacturing cost per unit for each product.

3-How does the activity –based costing system help Parker’s managers to better manage their
business.

Solution

1. Rates per unit cost driver:

Activity Cost Rate

driver
 Machining Machine hours $375,000 ÷(25,000 + 50,000)= $5
per machine run
Set-up Production runs $120,000 ÷ (50 + 50)= $1,200 per
production run
Inspection Inspection hours $105,000 ÷ (1,000 + 500)= $70
per inspection hour
Overhead cost per unit:

Financial Mathematical
$ $
Machining 125,000 250,000
Set-up 60,000 60,000
Inspection 70,000 35,000
Total manufacturing overhead costs 255,000 345,000
Divide by number of units 50,000 100.000
Manufacturing overhead cost per unit 5.10 3.45

2. Manufacturing cost per unit:

Mathematical Financial
Direct materials
$150,000 ÷ 50,000 $3
$300,000 ÷ 100,000 $3
Direct manufacturing labor
$50,000 ÷ 50,000 $1
$100,000 ÷ 100,000 $1
Manufacturing overhead $5.10 $3.45
$9.10 $7.45

3. Disaggregated information can improve decisions by allowing managers to see the details
that help them understand how different aspects of cost influence total cost per unit.
Managers can also understand the drivers of different cost categories and use this information
for pricing and product-mix decisions, cost reduction and process-improvement decisions,
design decisions, and to plan and manage activities. However, too much detail can overload
managers who don’t understand the data or what it means. Also, managers looking at per-
unit data may be misled when considering costs that aren’t unit-level costs.

Question 4:

A company makes four furniture products which involves ordering materials, setting up
machinery and production. The indirect costs of these activities are as follows.

$
Ordering 30,000
Set-ups 42,000
Other factory overheads 400,000
Total cost 472,000
Other information relating to the products is as follows.

Number of units Buying transactions Set-up activities Machine hours

Beds 240 40 660 1,260
Tables 400 20 2,800 3,200
Desks 600 8 3,000 4,200
Chairs 5,400 12 540 11,340
Total 80 7,000 20,000

Calculate the cost to be allocated to each of the four products and prepare a schedule of
activity component costs per unit of each product.

Solution:

The cost of each activity will be as follows.

Buying ($30,000 ÷ 80) $375

Set-ups ($42,000 ÷ 7,000) $6
Other factory overheads ($400,000 ÷ 20,000) $20

Allocating the activity costs among the products.

Beds Tables Desks Chairs Total

$ $ $ $ $
Buying 15,000 7,500 3,000 4,500 30,000
Set-up 3,960 16,800 18,000 3,240 42,000
Other factory overheads 25,200 64,000 84,000 226,800 400,000
Total 44,160 88,300 105,000 234,540 472,000
Number of units produced 240 400 600 5,400
Cost per unit 184 220.75 175 43.43

The activity components costs per unit are as follows.

Beds Tables Desks Chairs

$ $ $ $
Buying 62.5 18.75 5 0.83
Set-up 16.5 42 30 0.6
Other factory overheads 105 160 140 42
Total 184 220.75 175 43.43