Chapter 2a • Activity based costing

(ABC)
• Absorption costing versus
Activity based ABC
costing • Merits and criticisms of
ABC

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 Chapter summary diagram
Activity based
costing

Calculation of Comparison with Implications of

cost/unit absorption ABC
costing

Cost pools Benefits

Cost drivers Criticisms
Implications

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 Tackling the exam

• Questions will require you to identify an

appropriate driver to use when calculating
costs per unit using ABC.
• Calculation of OARs and then cost per unit
using ABC will be required.
• In 10-mark questions, a discussion element
explaining the differences in the resulting cost
per units under absorption and ABC could be
required.

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 Activity based costing (ABC) (1)

Features of a modern manufacturing

environment
• An increase in support services, which are
unaffected by changes in production volume,
varying instead with the range and complexity
of products
• An increase in overheads as a proportion of
total costs due to more reliance on technology

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 Activity based costing (ABC) (2)

Inadequacies of absorption costing

• Implies all overheads are related to production
volume
• Developed when production was only a narrow
range of products and overheads were a small
fraction of total costs
• Tends to allocate too great a proportion of
overheads to larger products
• Could lead to over production (in order to show
increased profit)

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 Activity based costing (ABC) (3)

Volume
related
overheads

Complexity
Complexity Diversity
Diversity

Service support functions

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 Activity based costing (ABC) (4)

Outline of an ABC system

• Identify major activities
• Identify cost drivers – factors which determine
the size of an activity/cause the costs of an
activity
• Collect costs associated with each activity into
cost pools
• Charge costs to products on the basis of the
number of an activity's cost driver they
generate

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 Activity based costing (ABC) (5)

Steps in ABC
1. Group overheads into activities
• Cost pools
2. Identify significant factors driving the costs
• Cost drivers
3. Calculate a cost per unit of cost driver
4. Absorb activity costs based on usage of
drivers

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 Activity based costing (ABC) (6)

Production No. of production

OAR
set up costs set ups

Machine oil and No. of machine

OAR
machine repairs hours

No. of labour
Supervisor's salary OAR
hours

Activities
Activities Cost
Cost drivers
drivers

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 Activity based costing (ABC) (7)

Cost drivers
• Volume related (eg labour hrs) for costs that
vary with production volume in the short term
(eg power costs)
• Transactions in support departments for other
costs (eg number of production runs for the
cost of setting up production runs)

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 Activity based costing (ABC) (8)

Example
• Cost of goods inwards department = $10,000
• Cost driver for goods inwards activity = number
of deliveries
• During 20X0 there were 1,000 deliveries, 200 of
which related to product X
• 4,000 units of product X were produced

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 Activity based costing (ABC) (9)

Example continued
• Cost per unit of cost driver = $10,000 ÷ 1,000 =
$10
• Cost of activity attributable to product X = $10
× 200 = $2,000
• Cost of activity per unit of X = $2,000 ÷ 4,000 =
$0.50

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 Absorption costing versus ABC (1)

• Absorption costing uses one universal OAR

based on machine/labour hours
• Implication that overheads are volume related

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 Absorption costing versus ABC (2)

• Production
set up costs
Production
• Machine oil
department OAR
= machine
hrs
• Supervisor A

salary

• Machine

repairs
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 Absorption costing versus ABC (3)

• Costs are more closely linked to the causes of

overhead. This makes activity based costing
more appropriate in today's environment where
…
─ Overheads are high compared with prime
costs
─ Product ranges are diverse
─ Resources are not merely driven by volume

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 Merits and criticisms of ABC (1)

Merits of ABC
• Simple once information obtained
• Focuses attention on what causes costs to
increase (cost drivers)
• Absorption rates more closely linked to causes
of overheads because many cost drivers are
used

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 Merits and criticisms of ABC (2)

Better analysis of costs leads to better:

• Cost control
• Production decisions
• Pricing decisions
• Profitability analysis

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 Merits and criticisms of ABC (3)

Criticisms of ABC
• More complex and so should only be introduced
if provides additional information
• Can one cost driver explain the behaviour of all
items in a cost pool?
• Cost drivers might be difficult to identify

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 Merits and criticisms of ABC (4)

Criticisms of ABC
• Time consuming
• Costly
• Some arbitrary apportionment may still exist
• Limited benefit if products have similar cost
structures

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 Merits and criticisms of ABC (5)
Consider:

When
When to
to use
use
ABC
ABC

Benefits
Benefits of
of Criticisms
Criticisms of
of
ABC
ABC ABC
ABC

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 Question: Absorption costing vs ABC (1)
Dodo Co manufactures three products, A, B and C. Data for the period
is as follows.

Total production overheads for Dodo Co amount to $190,000.

A B C

Output (units) 20,000 25,000 2,000

Sales price $ 20 20 20

Direct material cost $ 5 10 10

Labour hours/unit 2 1 1

Wages paid at $5/hr

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 Question: Absorption costing vs ABC (1)
(cont'd)
Required
Calculate the profit per unit obtained on each
product if production overheads are absorbed on
the basis of labour hours (traditional absorption
costing).

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 Answer: Absorption costing vs ABC (1)

Traditional
Traditional absorption
absorption costing
costing

A B C
$ $ $
Product cost:
Direct materials 5 10 10
Direct labour 10 5 5
Prime cost 15 15 15
Overheads Need
Need aa
Product cost working
working

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 Answer: Absorption costing vs ABC (1)
(cont'd)

OAR
OAR working
working

A B C Total
Lab hrs per unit 2 1 1
Production 20,000 25,000 2,000
Total lab hrs 40,000 25,000 2,000 67,000

OAR = $190,000 ÷ 67,000 = $2.836/hr

Overhead 5.67 2.84 2.84

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 Answer: Absorption costing vs ABC (1)
(cont'd)
Traditional
Traditional absorption
absorption costing
costing

A B C
$ $ $
Prime cost 15 15 15
Overheads 5.67 2.84 2.84
Product cost 20.67 17.84 17.84

Sales price 20.00 20.00 20.00

Profit (0.67) 2.16 2.16

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 Question: Absorption costing vs ABC (2)

The following
• data is now also available:

Machining $
Quality control and set‑up 90,000
costs
Receiving 30,000
Packing 15,000
190,000

A B C
Output (units) 20,000 25,000 2,000
Cost driver data
Labour hours/unit 2 1 1
Machine hours/unit 2 2 2
No. of production runs 10 13 2
No. of component receipts 10 10 2
No. of customer orders 20 20 20

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 Question: Absorption costing vs ABC (2)
(cont'd)
Required
Using ABC, show the cost and gross profit per
unit for each product during the period and
contrast this with the profit calculated using
absorption costing.

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 Answer: Absorption costing vs ABC (2)

Activity
Activity based
based costing
costing

A B C

Product cost ($):

Direct materials 5 10 10
Direct labour 10 5 5
Prime cost 15 15 15
Overheads
Product cost Need
Need aa
working
working

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 Answer: Absorption costing vs ABC (2)
(cont'd)
ep 1: Group overheads into activities 
Step 2: Identify cost drivers

$
Cost driver
Machining 55,000
Machine hours
QC & Setup 90,000
Production runs
Receiving 30,000
Component receipts
Packing
15,000 Customer orders

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 Answer: Absorption costing vs ABC (2)
(cont'd)
3: Calculate a cost per unit of cost driver

OAR
OAR working
working –– machining
machining costs
costs

A B C Total
Mach hrs per unit 2 2 2
Production 20,000 25,000 2,000
Total mach hrs 40,000 50,000 4,000 94,000

OAR = $55,000 ÷ 94,000 = $0.585/hr

Mach costs
total $23,404 $29,255 $2,341
$0.585  40,000
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 Answer: Absorption costing vs ABC (2)
(cont'd)

AA BB CC
Machining
Machining $23,404
$23,404 $29,255
$29,255 $2,341
$2,341
QC
QC and
and set-up
set-up
Receiving
Receiving
Packing
Packing

Total
÷ Units 20,000 25,000 2,000
OAR / unit

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 Answer: Absorption costing vs ABC (2)
(cont'd)

OAR
OAR working
working –– QC
QC and
and set
set up
up costs
costs

A B C Total
Production runs 10 13 2
25

OAR = $90,000 ÷ 25 = $3,600 / run

QC costs $36,000 $46,800 $7,200

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 Answer: Absorption costing vs ABC (2)
(cont'd)

AA BB CC
Machining
Machining $23,404
$23,404 $29,255
$29,255 $2,341
$2,341
QC
QC and
and set-up
set-up $36,000
$36,000 $46,800
$46,800 $7,200
$7,200
Receiving
Receiving
Packing
Packing

Total
÷ Units 20,000 25,000 2,000
OAR / unit

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 Answer: Absorption costing vs ABC (2)
(cont'd)

OAR
OARworking
working––receiving
receivingcosts
costs
A B C Total
Component receipts 10 10 2
22

OAR = $30,000 ÷ 22 = $1,363.64/receipt

Receiving costs $13,636 $13,636 $2,728

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 Answer: Absorption costing vs ABC (2)
(cont'd)

AA BB CC
Machining
Machining $23,404
$23,404 $29,255
$29,255 $2,341
$2,341
QC
QC &
& set-up
set-up $36,000
$36,000 $46,800
$46,800 $7,200
$7,200
Receiving
Receiving $13,636
$13,636 $13,636
$13,636 $2,728
$2,728
Packing
Packing

Total
÷ Units 20,000 25,000
2,000
OAR / unit

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 Answer: Absorption costing vs ABC (2)
(cont'd)

OAR
OAR working
working –– packing
packing costs
costs

Equal number of orders across all products, so...

… just divide $15,000 by 3.

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 Answer: Absorption costing vs ABC (2)
(cont'd)

AA BB CC
Machining
Machining $23,404
$23,404 $29,255
$29,255 $2,341
$2,341
QC
QC &
& set-up
set-up $36,000
$36,000 $46,800
$46,800 $7,200
$7,200
Receiving
Receiving $13,636
$13,636 $13,636
$13,636 $2,728
$2,728
Packing
Packing $5,000
$5,000 $5,000
$5,000 $5,000
$5,000

Total $78,040 $94,691 $17,269

Units 20,000 25,000 2,000
OAR/unit $3.90 $3.79 $8.63

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 Answer: Absorption costing vs ABC (2)
(cont'd)
Step 4: Absorb activity costs based on usage of drivers

A B C
Profit/unit ($):
Prime cost 15 15 15
Overheads 3.90 3.79 8.63
Product cost 18.90 18.79 23.63
Sales price 20.00 20.00 20.00
Profit 1.10 1.21 (3.63)

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 Formula summary

Costpool($)
OAR =
Costdriver

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 Chapter summary (1)

1. Activity based costing (ABC)

 Activity based costing groups overheads into
activities. These are referred to as cost pools.
 The item that causes the costs to be incurred is the
cost driver.
 Overheads are absorbed into products using the cost
drivers.

2. Absorption costing versus ABC

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

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 Chapter summary (2)

3. Merits and criticisms of ABC

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

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