Activity Based Costing

Prepared By : Noor Alam (MC16-103), 3rd Semester

Submitted To : Prof. Dr. Hafiz Zafar Ahmad

Hailey College of Commerce, University of The Punjab

 Activity Based Costing 2017

Example 1 :
Total budgeted fixed overheads for a firm are £712,000 these have traditionally been absorbed
on a machine hour basis. The firm makes two products, A and B.

A B

Direct material cost £20 £60

Direct labour cost £50 £40

Machine time 3 hrs 4 hrs

Annual output 6,000 40,000

Required:

a) Calculate the total cost for each product on the assumption that the firm continues to
absorb overheads on a machine hours basis.

The firm is considering changing to an Activity Based Costing System and has identified
the following information:

Machine hrs/ Annual Total No of No of

unit Output machine hrs set ups purchase orders
Product A: 3 6,000 18,000 16 52

Product B: 4 40,000 160,000 30 100

46,000 178,000 46 152

Cost pools: £ Cost driver:

Machine related 178,000 Machine hours
Set-up related 230,000 Set-ups
Purchasing Related 304,000 Purchase orders
Total overheads 712,000

Required:

a) Calculate the cost per unit using traditional overhead absorption.

b) Calculates the cost per unit the ABC system.

Submitted To: Prof. Dr. Hafiz Zafar Ahmad 2

 Activity Based Costing 2017

Example 2 :
Hensau Ltd has a single production process for which the following costs have been
estimated for the period ending 31 December 20X1.
£
Material receipt and inspection cost 15,600
Power Cost 19,500
Material handling cost 13,650

Three products X,Y and Z are produced by workers who perform a number of
operations on material blanks using hand-held electrically powered drills. The
workers have a wage rate of £4 per hour.
The following budgeted information has been obtained for the period ending 31
December 20X1.

Product X Product Y Product Z

Production quantity (units) 2,000 1,500 18,000
Batches of material 10 5 16
Data per product unit:
Direct material (square meters) 4 6 3
Direct material (£) 5 3 6
Number of power drill operations 6 3 2

Overhead costs for material receipt and inspection, process power and material handling are
presently each absorbed by product units using rates per direct labour hour.

An activity-based costing investigation has revealed that the cost drivers for the overhead
costs area as follow:

Material receipt and inspection: number of batches of material

Process power: number of power drill operations
Material handling: quantity of material (square meters) handled

Required:
Prepare a summary, which shows the budgeted product cost per unit for each of products X, Y
and Z for the period ending 31 December 20X1 detailing the unit costs for each cost element.

a) Using the existing method for the absorption of overhead costs; and
b) Using an approach, which recognizes the cost drivers revealed in the activity-based
costing investigation?

Submitted To: Prof. Dr. Hafiz Zafar Ahmad 3

 Activity Based Costing 2017

Question 2 :
A company has two production departments (A and B) in its factory. Overheads in
each department are currently absorbed into product cost based on machine hours
worked.

The production overhead absorption rate in Department A is £5.60 per machine hour.
In Department B the absorption rate is to be established from the following date
relating to the department for a period.

£
Allocated production overheads 24,260
Apportionment of factory level production overheads 37,539
Apportionment of service department production overheads 32,911
£94,710
Machine hours worked 11,550

The company is considering the introduction of a revised overhead apportionment system

using activity-based costing. The overheads incurred in the factory in the period have been
identified and measured, as follows:

Activity Overhead Cost driver Cost drive volume

£ (Dept A and B)

Machine set up 22,224 Batches 100

Machine operation 69,255 Machine hours 25,650
Inspection and testing 42,816 Units produced 446,000
Servicing 39,375 Labour hours 18,750
£173,670

The following information is available for the period to product X, one of the product
manufactured in the factory:

8 batches
2,540 machine hour (Department A 1,400; Department B 1,140)
58,068 units produced
2,303 labour hours

Required:

a) Using the existing absorption method:

i. Establish the product overhead absorption rate in Department.
ii. Calculate production overhead cost per unit of Product X.

b) Using an activity-based approach:

i. Establish the product overhead absorption rate for each activity;
ii. Calculate production overhead cost per unit of Product X.

Submitted To: Prof. Dr. Hafiz Zafar Ahmad 4

 Activity Based Costing 2017

Question 3 :
Birtles pic is a manufacture of small domestic electrical appliances. It market is very
competitive in terms of both price and product innovation. As a result, product life cycles
are short.

Birtles pic’s managers are concerned about the reliability of its product costing system. It
currently uses an absorption costing system and absorbs overheads based on budgeted direct
labour hours. On this basis the estimated cost of its latest product, a talking electric kettle, is
as follows:

£ per unit
Direct material 4.50
Direct labour (£12 per hours) 0.50
Production overheads (£120 per hour) 5.00
Production 10.00

The firm’s management accountant has suggested that more accurate product costs would
be obtained if an activity based costing (ABC) approach were used. He has collected the
following information as a Budgeted factory overhead per annum.

Cost pools Cost per annum Cost Driver

£000
Stores administration 5,000 Number of different components
Production line set up 3,000 Number of set ups
Dispatch 1,000 Number of dispatches
Other overheads 3,000 Direct labour hours
Total production overhead 12,000
Estimated activity per annum

Cost Driver Total Activity per annum

Number of different components 2,000 items

Number of set ups 10,000 set ups
Number of dispatches 20,000 dispatches
Direct labour hours 100,000 hours

Each talking kettle uses 10 different components and kettle manufacture will involve six-
production line set-up per annum. Five hundred dispatches will be required per annum.
Budgeted production is 10,000 Kettle per annum.

Required:

Estimate the cost of talking kettle using an ABC approach and the cost drivers
suggested by the management accountant.

Submitted To: Prof. Dr. Hafiz Zafar Ahmad 5

 Activity Based Costing 2017

Question 4 :
Naceur, a textile manufacturer, makes three products A, B, C. Budgeted cost, and production
information for the coming period is as follows:

Product A B C
Per thousand meters

Costs
Direct materials £120.00 £100.00 £60.00
Direct labour £42.00 £42.00 £28.00

Machine hours 6.00 hrs 6.00 hrs 4.00 hrs

Labour hours 0.1 hrs 0.1 hrs 0.02 hrs

Output in thousand meters 120 100 80

The three products are manufactured using the same production technology. They are
usually produced in production runs of 10,000 meters and sold to wholesalers in batches of
5,000 meters.

The company uses a cost plus pricing system and a gross margin of 20% on sales to
calculate prices.

Budgeted production overhead is absorbed using a machine hour rate and the budgeted
overhead for the coming period has been analyzed as follows:

£
Rates, rent, supervision ,power and depreciation 26,000
Set up costs 15,000
Goods inwards 9,600
Finishing goods inspection 5,250
Dispatch 9,750
Total £65,600
Budgeted machine hours for the period are 1,640 hours.

Required:

a) Part one
(1) Calculate the budgeted total cost per thousand meters for each product, showing
clearly prime cost, overhead cost and total cost; (5 marks)
(2) Using your total cost estimates from (a) (1) and a GROSS MARGIN of 205 on
sales calculate the budgeted price per thousand meters of each of the three
products. ( 3 marks)
b) Part two

Submitted To: Prof. Dr. Hafiz Zafar Ahmad 6

 Activity Based Costing 2017

The sales manager of Naceur has complained that its main competitor is undercutting its
prices for products A by B by several pounds. Naceur’s price for product C on the other
hand is lower than that of the competitor. She believes three price differences are caused
by their competitors using an activity based costing (ABC) system to cost products, and a
cost plus pricing system with a mark-up 20% on total activity based cost to calculate prices.

In an attempt to make Naceur’s costing, more accurately reflect the usage of resources by
products you have ascertained that the cost drivers for the overhead activities are as
follows:

Cost Pool Cost driver Budgeted driver Activity (Year)

Rates, rent supervision,

power and Depreciation Machine hours 1,640
Set-up costs Number of production runs 30
Goods inwards costs Number of requisitions 120
Finishing goods inspection costs Number of production runs 30
Dispatch cost Number of sales orders 60
The number of requisitions raised by goods inwards was 40 for each product and the number
of sales orders was 60 (one order per batch sold).

Required:

(1) Calculate the budgeted cost driver rate for each overhead activity ;(5 marks)
(2) Calculate the budgeted total cost per thousand meters for each product using an
activity-based costing approach ;(10 marks)
(3) Using your total cost estimates from b (2) and a MARK-Up of 20% on total cost,
calculate the price per thousand meters of each of the three products. Comment briefly
on the causes of any charges in prices. (7 marks)

Submitted To: Prof. Dr. Hafiz Zafar Ahmad 7

 Solutions

Prepared By : Noor Alam (MC16-103), 3rd Semester

Submitted To : Prof. Dr. Hafiz Zafar Ahmad

Hailey College of Commerce, University of The Punjab

 Activity Based Costing 2017

Example 1. (Solution):
Calculation of Overheads Absorption Rate Based on Machine Hours:
= Total overhead Cost ÷ Total Direct Labour Hours
= 712,000 ÷ 178,000 (W-1)
= £ 4 per hour

(W-1):
= Production Quantity x Per Product Machine Hours
A: 6,000 x 6 = 18,000
B: 40,000 x 10 = 160,000
Total = £ 178,000

Calculation of Overheads Charged To Each Product Under Existing

Traditional Absorption Costing:
Calculation & Amount(£)
Sr.# Overheads Applied
A B
(6,000x20) (40,000x60)
i Direct Material
=120,000 =2,400,000
(6,000x50) (40,000x40)
ii Direct Labour
=300,000 =1,600,000
(18,000x4) (160,000x4)
iii FOH Absorbed
=72,000 =640,000
Total Overhead 492,000 4,640,000
Unit Produced 6,000 40,000
Per Unit Overhead 82 116

Calculation of Product Overheads Absorption Rate for Each Activity:

i. Machine Related Cost:
=£ 178,000 ÷ 178,000
=£ 1 per machine hour

ii. Set Up Cost:

=£ 230,000 ÷ 46
=£ 5,000 per set up

iii. Purchasing Related Cost:

=£ 304,000 ÷ 152
=£ 2,000 per order

Submitted To: Prof. Dr. Hafiz Zafar Ahmad 9

 Activity Based Costing 2017

Calculation of Overheads Charged To Each Product Under Activity Based

Costing:
Calculation & Amount(£)
Sr.# Overheads Applied
A B
i Direct Material 120,000 2,400,000
ii Direct Labour 300,000 1,600,000
iii FOH Absorbed:
(18,000x1) (160,000x1)
Machine Related Cost
=18,000 =160,000
(16x5,000) (30x5,000)
Set Up Cost
=80,000 =150,000
(52x2,000) (100x2,000)
Purchasing Related Cost
=104,000 =200,000
Total Overhead 622,000 4,510,000
Unit Produced ÷ 6,000 ÷ 40,000
Per Unit Overhead 103.67 112.75

Example 2. (Solution):
(a) Using the existing absorption methods:

Calculation of Product Overheads Absorption Rate Based on Direct

Labour Hours:
= Total Overhead Cost ÷ Total Direct Labour Hours
= 48,750 ÷ 27,000 (W-1)
= £ 1.805 per hour
(W-1):
= Production Quantity x Per Product Labour Hours
X= 2,000 x 5 = 10,000
Y= 1,500 x 6 = 9,000
Z= 800 x 10 = 8,000
Total = £ 27,000

Submitted To: Prof. Dr. Hafiz Zafar Ahmad 10

 Activity Based Costing 2017

Calculation of Overheads Charged To Each Product Under Existing

Traditional Absorption Costing:

Calculation & Amount(£)

Sr.# Overheads Applied
X Y Z
(2,000x5) (1,500x3) (800x6)
i Direct Material
=10,000 =4,500 =4,800
(10,000x4) (9,000x4) (8,000x4)
ii Direct Labour
=40,000 =36,000 =32,000
(10,000x1.805) (9,000 x1.805) (8,000 x1.805)
iii FOH Absorbed
=18,050 =16,245 =14,440
Total Overhead 68,050 45,300 51,240
Unit Produced ÷2,000 ÷1,500 ÷800
Per Unit Overhead 34.025 30.2 64.05

(b) Using the activity-based approach:

Calculation of Product Overheads Absorption Rate for Each Activity:

i. Material receipt and Inception
=£ 15,600 ÷ 31
=£ 503.225 per batch

ii. Power Cost

=£ 19,500 ÷ 18,100 (W-2)
=£ 1.071 per operation

(W-2):
= Production Quantity x Per Product Labour Hours
X= 2,000 x 6 = 12,000
Y= 1,500 x 3 = 4,500
Z= 800 x 2 = 1,600
Total = £ 18,100

iii. Material Handling

=£ 13,650 ÷ 19,400 (W-3)
=£ 0.704 per square meter

Submitted To: Prof. Dr. Hafiz Zafar Ahmad 11

 Activity Based Costing 2017

(W-3):
= Production Quantity x Per Product Labour Hours
X= 2,000 x 4 = 8,000
Y= 1,500 x 6 = 9,000
Z= 800 x 3 = 2,400
Total = £ 19,400

Calculation of Overheads Charged To Each Product Under Activity Based

Costing:
Calculation = (Total Number of A Particular Activity Applied On Each
Product) x (Absorption Rate for That Particular Activity)
Calculation & Amount(£)
Sr.# Overheads Applied
X Y Z
(2,000x5) (1,500x3) (800x6)
i Direct Material
= 10,000 = 4,500 = 4,800
(10,000x4) (9,000x4) (8,000x4)
ii Direct Labour
= 40,000 =36,000 =32,000
iii FOH Absorbed:
Material receipt and (10x503.225) (5x503.225) (16x503.225)
Inception = 5,032.25 = 2,516.125 = 8,051.6

Power Cost (12,000x1.077) (4,500x1.077) (1,600x1.077)

= 12,924 = 4,846.5 = 1,723.2
Material Handling (8,000x0.704) (9,000x0.704) (2,400x0.704)
= 5,632 = 6,336 = 1,689.6
Total Overhead 73,588 54,199 48,264
Unit Produced ÷2,000 ÷1,500 ÷800
Per Unit Overhead 36.794 36.133 60.33

Question 2. (Solution):
(a) Using the existing absorption methods:
I. Calculation of Product Overheads Absorption Rate in
Department:
Department A: 5.60 per MH (Given)

Department b: 8.20 per MH (Calculated) (W-1)

Submitted To: Prof. Dr. Hafiz Zafar Ahmad 12

 Activity Based Costing 2017

(W-1):
= Total Overheads Cost ÷ Machine Hours Worked
= 94,710 ÷ 11,550
= 8.20 per MH

II. Calculation of Overheads Charged To Per Unit of Product X

Under Existing Traditional Absorption Costing:
Department A:

= 1,400 MH x 5.6 (Given)

= £ 7,840

Department B:

= 1,140 MH x 8.2 (Calculated)

= £ 9,348

Calculation of Per Unit Cost:

= (Department A + Department B) ÷ Total Unit Produce

= (7,840+9,348) ÷ 58,068
= £ 0.295 per unit

(b) Using the activity-based approach:

I. Calculation of Product Overheads Absorption Rate for Each

Activity:
i. Machine Set-up Cost
=£ 22,224 ÷ 100
=£ 222.24 per Batch

ii. Machine Operations

=£ 69,225 ÷ 25,650
=£ 2.7 per machine hour

iii. Inspection and Testing

=£ 42,816 ÷ 446,000
=£ 0.096 per Unit

Submitted To: Prof. Dr. Hafiz Zafar Ahmad 13

 Activity Based Costing 2017

iv. Servicing
=£ 39,375 ÷ 18,750
=£ 2.1 per labour hour

II. Calculation of Overheads Charged To Per Unit of Product X

Under Activity Based Costing:
Calculation = (Total Number of A Particular Activity Applied On Product X) x
(Absorption Rate for That Particular Activity)

Sr. # Activities Calculation Amount(£)

i Machine Set-up Cost 8 x 222.24 per Batch 1,777.92
ii Machine Operations Cost 2,540 x 2.7 per MH 6,858.00
iii Inspection and Testing Cost 58,068 x 0.096 per Unit 5,574.53
iv Servicing Cost 2,303 x 2.1 per LH 4,836.30
Total Overhead Charged 19,044.748
Per Unit Overhead 19,044.748 ÷ 58,068 0.328

Question 3. (Solution):
Calculation of Product Overheads Absorption Rate for Each Activity:
i. Store Administration:
=£ 5,000,000 ÷ 2,000
=£ 2,500 per component

ii. Production Line Set Ups:

= 3,000,000 ÷ 10,000
= £ 300 per set up

iii. Dispatch:
=£ 1,000,000 ÷ 20,000
=£ 50 per dispatch

iv. Other Overheads:

=£ 3,000,000 ÷ 100,000
=£ 30 per hour

Submitted To: Prof. Dr. Hafiz Zafar Ahmad 14

 Activity Based Costing 2017

Calculation of Overheads Charged To Product “ Taking Kettle ” Under

Activity Based Costing:
Taking Kettle
Overheads Applied
Calculation Amount(£)
Store Administration (10 x 2,500) 25,000
Production Line Set Ups (6 x 300) 1,800
Dispatch (500 x 50) 25,000
Other Overheads (10,000 x 0.042) x30 12600
Total Overhead 64,400
Unit Produced ÷ 10,000
Per Unit Overhead 6.44

Calculation of Cost of “Taking Kettle”:

Overhead Applied (£)

i Direct Material 4.50
ii Direct Labour 0.50
iii Production Overhead 6.44
Total Cost Per Kettle 11.44

Question 4. (Solution):
Using the existing absorption methods:

Calculation of Overheads Absorption Rate Based on Machine Hours:

= Total Overhead Cost ÷ Total Machine Hours

= 65,600 ÷ 1,640 (W-1)
= £ 40 Per Machine Hour

Calculation of Overheads Charged To Each Product & Sale Price on 20% Gross
Margin Under Existing Traditional Absorption Costing:

Calculation & Amount(£ 000)

Sr.# Overheads Applied
X Y Z
(120x120) (100x100) (80x60)
i Direct Material
=14,400 =10,000 =4,800
(120x42) (100x42) (80x28)
ii Direct Labour
=5,040 =4,200 =2,240
Prime Cost 19,440 14,200 7,040

Submitted To: Prof. Dr. Hafiz Zafar Ahmad 15

 Activity Based Costing 2017

(120x6x40) (100x6x40) (80x4x40)

iii FOH Absorbed
=28,800 =24,000 =12,800
Total Overhead 48,240 38,200 19840
Unit Produced ÷120 ÷100 ÷80
Per Unit Overhead 402 382 248
Sale Price (20% Margin) 502.5 477.5 310

Grossing Up Sale Price

A (402 x 100) ÷ 80 502.5
B (382 x 100) ÷ 80 477.5
C (248 x 100) ÷ 80 310

(b) Using the activity-based approach:

Calculation of Product Overheads Absorption Rate for Each Activity:

i. Rates, Rent Supervision, Power and Depreciation:
=£ 26,000 ÷ 1,640
=£ 15.85 per machine hour

ii. Set Up Cost:

= 15,000 ÷ 30
= £ 500 per run

iii. Finishing Goods Inspection:

=£ 9,600 ÷ 120
=£ 80 per requisition

iv. Inspection Cost:

=£ 5,250 ÷ 30
=£ 175 per run

v. Dispatch Cost:
=£ 9,750 ÷ 60
=£ 162.5 per order

Submitted To: Prof. Dr. Hafiz Zafar Ahmad 16

 Activity Based Costing 2017

Calculation of Overheads Charged To Each Product & Sale Price on 20%

Gross Mark Up Under Activity Based Costing:
Calculation & Amount(£ 000)
Sr.# Overheads Applied
X Y Z
(120x120) (100x100) (80x60)
i Direct Material
=14,400 =10,000 =4,800
(120x42) (100x42) (80x28)
ii Direct Labour
=5,040 =4,200 =2,240
iii FOH Absorbed:
Rates, Rent Supervision, (120x6x15.85) (100x6x15.85) (80x4x15.85)
Power and Depreciation =11,412 =9,510 =5,072
(12x500) (10x500) (8x500)
Set Up Cost
=6,000 =5,000 =4,000
Finishing Goods (40x80) (40x80) (40x80)
Inspection =3,200 =3,200 =3,200
(12x175) (10x175) (8x175)
Inspection Cost
=2,100 =1,750 =1,400
(24x162.5) (20x162.5) (16x162.5)
Dispatch Cost
=3,900 =3,250 =2,600
Total Overhead 46,052 36,910 23,312
Unit Produced ÷120 ÷100 ÷80
Per Unit Overhead 383.76 369.1 291.4
Sale Price (20% Mark Up) 460.51 442.92 349.68

Grossing Up Sale Price

A (383.76 x 120) ÷ 100 460.51
B (369.1 x 120) ÷ 100 442.92
C (291.4 x 120) ÷ 100 349.68

Submitted To: Prof. Dr. Hafiz Zafar Ahmad 17