CHAPTER THREE

ACTIVITY BASED COSTING

Problems of Traditional Methods

Both the traditional absorption and marginal costing systems (used prior to activity-based
costing) have fundamental weaknesses and can therefore be inaccurate as a means of costing. In
the case of marginal costing, the main problem is that overheads are virtually ignored. This is
because overheads are a "sunk" cost, i.e. they must be paid for regardless of the level of activity.
Ignoring overheads tends to inflate profits artificially. The profit is, in effect, the contribution.
The major danger, therefore, is that overheads are not allocated to products and may not be
recovered when setting a selling price. As a result, the company may drift into loss and
eventually go out of business.
Absorption costing, on the other hand, allocates or apportions all overheads to products.
In order to do this, companies must allocate and apportion service overheads to the main
production departments. Direct labour and/or machine hour rates are then calculated. Costs are
therefore allocated to various departments and the process assumes that overheads relate directly
to the level of production. The problem with this approach is that the allocation of costs is carried
out on an arbitrary basis and may not reflect accurately on those activities which are truly
responsible for the costs. Sometimes, a particular product or activity may show a loss simply
because the ways in which costs are allocated have changed.
Absorption costing is also time-consuming. It requires a lot of time and energy to decide and
implement a basis of overhead allocation and apportionment. However, this allocation process
may obscure the main causes for these costs.

ABC theory has arisen as a result of dissatisfaction with traditional costing methods. It attempts
to apportion costs in relation to activities. Specifically, the problems it intends to counteract are
as follows:
a. As businesses grow over a period of time, the complexity of the business increases also. Thus,
costs vary due to this complexity and not necessarily with volume. A business which produces,
for example, a hundred items will probably require more sophisticated support functions than a
business which produces only one or two. When costs are allocated on volume, the products with
the highest output will be allocated the highest level of apportioned cost. In reality, however, the
items with the smaller volumes may take a disproportionate amount of time and material to set
up, but will only be allocated a very small proportion of support cost.
b. Many costing systems are based on financial costing systems and are therefore inappropriate
for decision-making purposes. In particular, only production overheads may be absorbed into
product cost for the purposes of stock valuation, whilst ignoring selling and administration
overheads.

Stages in Activity-Based Costing

The stages in activity-based costing are as follows:
a. Identify those activities that cause overheads to be incurred.
b. Adjust the accounting system so that costs are collected by activity rather than by cost
centre.
c. Identify those factors which cause each activity's costs to change (the cost drivers – see
below).
d. Establish the volume of each cost driver.
e. Calculate the cost driver rates by dividing the activity's cost by the volume of its cost
driver.
 f. Establish the volume of each cost driver required by each product.
g. Calculate overheads attributable to each product by multiplying step (e) by step (f).

Cost Drivers
Emphasising the approach of ABC to identifying activities and their associated costs is the
concept of "cost drivers" which can be defined as activities which cause costs rather than the
costs themselves. A distinction can also be made between those processes which add value and
those which do not. The importance of this is that processes which do not add value are potential
areas for cost reduction without affecting the product itself.
Short-term variable costs may be allocated using volume-related cost drivers such as direct
labour hours, machine hours, or direct material cost. Items such as electricity would be driven by
machine hours and apportioned according to the variability of the driver. In a similar way, some
items may vary with the value of materials consumed or with direct labour hours.

In terms of support functions, it is the transactions undertaken by the personnel of the support
department which are the relevant cost drivers. A few examples will help to make this a little
clearer.
 The number of goods inwards orders drives the goods inwards department.

 The number of production runs undertaken drives several items such as inspection, set-up
and production scheduling costs.

 The number of despatch orders would drive the costs of the goods outwards department.

Once the cost drivers are identified, each one is designated as a cost centre to which are allocated
all associated costs. In the goods outwards example, the costs identified with the cost centre are
divided by the number of goods outwards to determine the charge-out rate.
If, for example, costs were identified as K5,000 and 1,000 items were despatched, the charge-out
rate would be K5 per item.
Advantages of ABC
The benefits put forward for the ABC approach include the following:
a. The identification of costs with the activities which cause them becomes much clearer,
the resultant "cause and effect" enhancing managerial control.
 b. Cost drivers can be used not only as a cost measure but also as a performance measure.
c. The identification of costs from cost-driver analysis is helpful for budgeting within
support departments.
d. The availability of cost-driver rates can be used as an input into the design of new
products and modification to existing ones.
e. In overcoming some of the historic problems associated with cost allocation, the
provision of costing information is viewed with much more confidence by the relevant
managers.
f. In comparison with traditional methods, costs will be allocated in different proportions,
so highlighting unprofitable products that should either be improved or removed from the
range.
Disadvantages of ABC
a. The impact of ABC on profitability and cost reduction is as yet unclear also.
b. The information produced is on a historic basis so care must be exercised when using it
as a basis for future strategy.
c. Initial problems are often encountered because of the change of emphasis on the cause of
costs.
d. The identification of cost drivers is not always obvious. If the wrong ones are identified
the whole system will be incorrect.
e. The reporting of activity-based costs often cuts across traditional boundaries of control
when attempting to define responsibility. Care must be taken to ensure that the costs
allocated to a cost centre or driver are controllable by the manager concerned.

Example
Abkaber plc assembles three types of motorcycle at the same factory: the 50cc Sunshine; the
250cc Roadster and the 1000cc Fireball. It sells the motorcycles throughout the world. In
response to market pressures Abkaber plc has invested heavily in new manufacturing technology
in recent years and, as a result, has significantly reduced the size of its workforce. Historically,
the company has allocated all overhead costs using total direct labour hours, but is now
considering introducing Activity Based Costing (ABC). Abkaber plc’s accountant has produced
the following analysis.
Annual Annual Direct Raw
Output Labour Selling material
(units) Hours Price Cost
(MK per unit) (MK per unit)
Sunshine 2,000 200,000 4,000 400
Roadster 1,600 220,000 6,000 600
Fireball 400 80,000 8,000 900
The annual overhead costs are as follows:
Deliveries to retailers 2,400,000
Set-up costs 6,000,000
Purchase orders 3,600,000
The three cost drivers that generate overheads are:
Deliveries to retailers – the number of deliveries of motorcycles to retail showrooms
Set-ups – the number of times the assembly line process is re-set to accommodate
a production run of a different type of motorcycle
Purchase orders – the number of purchase orders.
The annual cost driver volumes relating to each activity and for each type of motorcycle are as
follows:
Number of Number of Number of
Deliveries set-ups purchase to retailers orders
Sunshine 100 35 400
Roadster 80 40 300
Fireball 70 25 100
Required:
Calculate the total profit on each of Abkaber plc.’s three types of product using Activity Based
Costing.
Solution
Deliveries to retailers K2,400,000/250 = K9,600
Set-ups K6,000,000/100 = K60,000
Deliveries inwards K3,600,000/800 = K4,500
Sunshine Roadster Fireball
K K K
Direct labour (K5/hour) 1,000,000 1,100,000 400,000
Materials (at K400/600/900) 800,000 960,000 360,000
Overheads:
Deliveries at K9,600 960,000 768,000 672,000
Set-ups at K60,000 2,100,000 2,400,000 1,500,000
Purchase orders at K4,500 1,800,000 1,350,000 450,000
Total cost 6,660,000 6,578,000 3,382,000

Sales (K4,000/6,000/8,000) 8,000,000 9,600,000 3,200,000

Total Profit/(loss) 1,340,000 3,022,000 (182,000)
Total Profit K4,180,000
Budgeted overheads rates
Our discussion in this chapter has assumed that actual overheads for an accounting period have
been allocated to the products. However, this is not the case in real practice and the calculation
of overhead rates based on the actual overheads incurred during an accounting period causes a
number of problems.
First, the product cost calculations have to be delayed until the end of the accounting period,
since the overhead rate calculations cannot be obtained before this date.
Secondly, one may argue that the timing problem can be resolved by calculating actual
overheads at intervals, say on a monthly basis, but the objection to this proposal is that the a
large amount of overhead expenditure is fixed in the short term whereas activity will vary from
month to month, giving large fluctuations in the overhead rates. This means that some products
will be more expensive than others when using fluctuating overhead rates.
Taking these into consideration, it is preferable to establish a budgeted overhead rate based on
the estimated overhead expenditure and activity. Consequently the procedure for calculating cost
centre overhead rates for traditional and ABC systems should be on standard activity levels and
not actual activity levels.
Under- and over-recovery of overheads
The effect of calculating overhead rates based on budgeted annual overhead expenditure is that it
will be most unlikely that the overhead allocated to products manufactured during the period will
be the same as the actual overhead incurred.
Under-recovery
This occurs if actual overheads are greater than absorbed overheads.
For example, budgeted overheads of K1 000 000 and budgeted activity of 500 000 hours giving
an estimated fixed overhead rate of K2 per hour. Then it happens that the actual overheads
incurred are K100 000 same as with budgeted and actual activity 450 000 hours.
The overheads charged to production will be K900 000 based on 450 000 hours at K2 per hour,
giving an under-recovery of overheads of K100 000. This is treated as an expense and as a period
cost.
Over-recovery
This occurs if actual overheads are less than absorbed overheads.
For example, budgeted overheads of K1 000 000 and budgeted activity of 500 000 hours. The
actual activity level is 500 000 hours but the actual overheads are K980 000. There is an over-
recovery of K20 000 which has to be treated as income because the actual is lower than the
budgeted.
Note that under- or over-recovery of overheads is not allocated to products.
Non-Manufacturing Overheads
Non-manufacturing overheads are regarded as period costs and are disposed of the same way as
the under- or over-recovery of manufacturing overheads. In short, they are not allocated to
products rather written off as period costs in the statement of comprehensive income.
However, for decision-making non-manufacturing overheads should be assigned to products in
order to formulate selling prices based on the absorption of total cost.
Example
The estimated overheads in the production department is K80 000 and the estimated activity is
40 000 direct labour hours. The overhead recovery rate using direct labour hours is, therefore, K2
per direct labour hour (K80 000/40 000 hours).
Actual overheads in the period are K84 000 and 45 000 direct labour hours are worked.
Solution
K
Overhead incurred (actual) 84 000
Overhead absorbed (45 000 × K2) 90 000
Over absorption of overhead 6 000
Practice question
The following data have been recorded for batches made in a period:
Batch A B C D
Output in units 250 60 200 120
Cost per batch K K K K
Direct material 1650 750 2100 900
Direct labour 9200 1520 6880 2400
Labour hours per batch 1150 190 860 300
The total production overhead for the period has been analysed as follows:
Machine related costs K 14, 600
Materials handling & dispatch K 6, 800
Stores K 8, 250
Inspection/quality control K 5, 850
Set-up K 6, 200
Engineering support K 8, 300
Total K 50, 000
The following cost centres have the following cost drivers:
Cost centre Cost driver
Machine related costs machine hours
Materials handling & dispatch material movements
Stores no. of requisitions
Inspection/quality control no. of inspections
Set-ups no. of set-ups
Engineering support engineering hours
The following cost driver volumes were recorded for the batches:
Batch A B C D Total
Machine hours per batch 520 255 610 325 1710
Material movements 180 70 205 40 495
Requisitions 40 21 43 26 130
Inspections 18 8 13 8 47
Set-ups 12 7 16 8 43
Engineering hours 65 38 52 35 190
Required:
a. Calculate batch unit cost using traditional costing based on labour hour overhead
absorption rate.
b. Calculate batch unit cost using ABC.