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School of Business and Computer Science Limited

ACCA PM – Performance Management

Overheads (Indirect cost)

Methods of Charging Overheads

(1) Absorption Costing (2) Activity Based Costing

- Traditional Method - Absorbs overheads by calculating

- Absorbs overheads by calculation OAR cost driver rates
- OAR = Budgeted Overheads - Individual cost driver rates are
Budgeted Activity calculated for each cost pool
- Absorbs overheads into the cost of a - cost driver rate = cost pool
Product / service cost driver
- Cost driver rates are absorbed
Into the total cost drivers used to
make a product.
- It is a modern approach to
charging overheads into the cost
of a product or service

Lecture 2 – Activity Based Costing

Introduction:
Activity Based Costing (ABC) is a modern alternative to absorption costing which
attempts to overcome the problems of costing in a modern manufacturing environment.

Activity based costing was developed for businesses that manufacture a wide number
of products and those businesses that occur a large portion of overheads. Activity
Based Costing is a method of allocating overheads to specific cost units.

Activity Based Costing (ABC) involves the identification of the factors which cause the
costs of an organization’s major activities. Support overheads are charged to products
on the basis of their usage of the factor causing the overheads.
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The Major Ideas behind Activity Based Costing are as follows:

(1) Activities cause costs. Activities include ordering, materials handling, machining,
assembly, production scheduling and dispatching.

(2) Producing products creates demand for the activities.

(3) Costs are assigned to a product on the basis of the product’s consumption of the
activities.

An ABC System Operates as Follows:

Step 1 Identify an organisation's major activities that support the manufacture of the
organization’s products or the provision of its services.

Step 2 Use Cost allocation and apportionment methods to charge overhead costs to
each of these activities. The costs that accumulate for each activity cost centre
is called a Cost Pool.

Step 3 Identify the factors which determine the size of the costs of an activity/cause
the costs of an activity. These are known as cost drivers.

A Cost driver is a factor which causes a change in the cost of an activity. It has the
most influence on the cost of an activity.

Examples: Cost Drivers

Cost Pool Possible Cost Driver

(1) Ordering Costs: handling customer orders Number of Orders
(2) Materials Handling Costs Number of Production runs
(3) Machine Set-up Costs Number of Machine set-ups
(4) Machine Operating Costs Number of Machine Hours
(5) Production Scheduling Costs Number of Production runs
(6) Despatching Costs Number of orders despatched

Step 4 For each cost pool/activity cost centre, calculate an absorption rate per unit of
cost driver

Step 5 Charge Overhead costs to products for each activity, on the basis of their
usage of the activity (the number of cost drivers they use). Overheads are
charged by absorbing them into product costs at a rate per unit of cost driver.
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Question (1)
Suppose that Cooplan manufactures four products, W, X, Y and Z. Output and cost data
for the period just ended are as follows.
Number of
production
runs Material cost Direct labour Machine
Output units in the period per unit hours per unit hours 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
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Direct labour cost per hour $5

Overhead costs $
Short run variable costs 3,080
Set-up costs 10,920
Expediting and scheduling costs 9,100
Materials handling costs 7,700
30,800
Required: Prepare unit costs for each product using conventional costing and ABC.

Question (2)
A company manufactures two products, L and M, using the same equipment and similar
processes. An extract of the production data for these products in one period is shown
below.
L M
Quantity produced (units) 5,000 7,000
Direct labour hours per unit 1 2
Machine hours per unit 3 1
Set-ups in the period 10 40
Orders handled in the period 15 60

Overhead costs $
Relating to machine activity 220,000
Relating to production run set-ups 20,000
Relating to handling of orders 45,000
285,000
Required
Calculate the production overheads to be absorbed by one unit of each of the products
using the following costing methods.
(a) A traditional costing approach using a direct labour hour rate to absorb overheads
(b) An activity based costing approach, using suitable cost drivers to trace overheads to
products
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When ABC should be used

(a) When production overheads are high relative to prime costs (eg service sector)
(b) When there is a whole diversity of product range
(c) When there are considerable differences in the use of resources by products
(d) Where consumption of resources is not driven by volume

Benefits of ABC
The use of ABC provides opportunities for:

(a) Cost control and reduction by the efficient management of cost drivers
(b) Better costing information used to assist pricing decisions
(c) Re-analysis of production and output/product mix decisions
(d) Profitability analysis (by customer, product line etc)
(e) A more realistic estimate of costs and profits which can be used in performance
Appraisal

Criticisms of ABC
(a) It is time consuming and expensive
(b) Will be of limited benefit if overhead costs are primarily volume related
(c) Reduced benefit if the company is producing only one product or a range of
products with similar costs
(d) Complex situations may have multiple cost drivers
(e) Some arbitrary apportionment may still exist

Switching to ABC has implications for pricing, sales strategy, performance

management and decision making.

ABC and Decision Making

Many of ABC's supporters claim that it can assist with decision making in a number of
ways.
 Provides accurate and reliable cost information
 Establishes a long-run product cost
 Provides data which can be used to evaluate different ways of delivering
business.

It is therefore particularly suited to the following types of decision.

 Pricing
 Promoting or discontinuing products or parts of the business
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 Redesigning products and developing new products or new ways to do business

Note, however, that an ABC cost is not a true cost; it is simply an average cost
because some costs such as depreciation are still arbitrarily allocated to products. An
ABC cost is therefore not a relevant cost for all decisions.

The traditional cost behaviour patterns of fixed cost and variable cost are felt by
advocates of ABC to be unsuitable for longer-term decisions, when resources are not
fixed and changes in the volume or mix of business can be expected to have an impact
on the cost of all resources used, not just short-term variable costs.

Main Points to Remember: Activity Based Costing (ABC)

(1) Activity based costing groups overheads into activities. These are referred to as
cost pools.

(2) The item that causes the costs to be incurred is the cost driver.

(3) Overheads are absorbed into products using the cost drivers.

(4) Overhead absorption rates under ABC should be more closely linked to the causes
of overhead costs.

(5) ABC results in a more meaningful product cost when overheads are high and
there is a wide diversity of product range.

(6) A Cost Driver is any factor which causes a change in the cost of an activity

(7) Traditional Absorption Costing under-allocates overhead costs to low-volume

products and over-allocates overheads to higher-volume products

(8) Traditional Absorption Costing under-allocates overhead costs to smaller sized

products and over-allocates overheads to larger sized products

(9) ABC can be used as an information source for budget planning based on activity
rather than incremental budgeting.

(10) Implementation of ABC is likely to be cost effective when variable costs are a low
proportion of total production costs and overhead costs

(11) For long‐term variable overhead costs, the cost driver will be the volume of
activity.

(12) A cost pool is an activity which consumes resources and for which overhead costs
are identified and allocated.
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(13) The overhead absorption rate (OAR) is calculated in the same way as the
absorption costing OAR, and a separate OAR will be calculated for each activity.
(14) ABC can be used in service industries as well as manufacturing industries

(15) ABC apportions all production overheads i.e. both fixed and variable overheads

(16) ABC can be applied to all overhead costs, not just production overheads.

(17) ABC provides a more accurate cost per unit, and as a result pricing should be
improved.

(18) ABC is a fairer approach to charging overheads than traditional absorption

costing

(19) ABC will be of limited benefit if overhead costs are primarily volume related, or if
the overheads represent a small proportion of the overall cost.

(20) In a system of ABC, there is under- or over-absorption of overheads.

(21) In a system of ABC, a larger proportion of overheads are attributed to low

volume products than in a traditional absorption costing system.

(22) The cost of implementing ABC are high for businesses with a limited product range,
the benefits may not be sufficient to justify these costs.

(23) ABC recognizes the drivers that cause overhead costs to vary

(24) Judgment will be required in selecting drivers for a particular activity, as there may
be several potential drivers, but only one can be selected for use in ABC

(25) ABC can make use of volume as a means of measuring costs.

(26) Introducing ABC does not always reduce costs in the short term; some costs are
fixed in the short term and can only be reduced in the long term

(27) ABC provides greater insight into the causes of costs. This will allow managers to
exercise greater control of costs by focusing attention on managing the causes of cost.