Comparison of

Traditional and
ABC costing
WEEK 2
ERFAN OVEE NOMAAN
 Production cost per unit £

Direct materials *
Direct labour *
Direct expenses *
Traditional Prime cost *
systems
 £

Direct materials *

Direct labour *

Direct expenses *

Production Prime cost *

cost per unit Fixed production overhead *

Production cost *
 Prod’n oh/Units produced = o/h per unit
Overhead
absorption Prod’n oh/Labour hours = o/h labour hr
rates
Prod’n oh/Machine hours = o/h machine
hr
 • Assign all manufacturing overheads
Traditional to production and service cost centres.
approach
Traditional
approach

• Assign all
manufacturing
overheads to
production and
service cost
centres.
• Reallocate the
costs assigned to
service cost
centres to
production cost
centres.
Traditional
approach
• Assign all manufacturing
overheads to production and
service cost centres.
• Reallocate the costs assigned
to service cost centres to
production cost centres.
• Compute separate overhead
rates for each production cost
centre.
Traditional
approach
• Assign all manufacturing
overheads to production and
service cost centres.
• Reallocate the costs assigned to
service cost centres to production
cost centres.
• Compute separate overhead rates
for each production cost centre.
• Assign cost centre overheads to
products or other chosen cost
units.
Class question

Brookfield Limited is a manufacturer of made to measure

furniture. Sales price is determined by adding a 20% mark-
up on cost for all jobs. The company has numerous orders
for June 2010, and wants to determine overhead absorption
rates so that jobs can be priced up.

All furniture passes through the production and finishing

departments. The production department is predominantly
capital intensive, whereas the finishing department is
predominantly labour intensive.
 £ Basis of
apportionment
Factory building 5,670 Floor area
depreciation
Factory rates
Factory insurance
11,970
7,980
Floor area
Floor area
Estimated
Canteen costs 18,876 No. of employees overheads for
Supervisory salaries
Other indirect labour
29,480
18,275
No. of employees
Machinery carrying
June 2010
Machinery 21,500
value
Machinery carrying
are as
depreciation
Cleaning 17,850
value
Floor area
follows:
Electricity 30,290 Actual
Building 5,040 Floor area
maintenance
Total 166,931
 Total Production Finishing
Floor area 10,500 sq. 6,000 sq. m. 4,500 sq. m. The following
m.
Employees 22 4 18
information is
Machinery £215,000 £146,000 £69,000 relevant for the
carrying value apportionment and
Electricity £30,290 £18,790 £11,500 absorption of
Machine hours 12,000 10,000 2,000 overheads:
Labour hours 46,000 6,000 40,000
 a) Prepare a schedule apportioning the overheads
Required: b)
between the two departments for June 2010.
Calculate overhead absorption rates for June 2010 for
the production department, and the finishing
department.
c) One of the orders for June 2010 is for 20 leather
suites. Each suite will spend 20 machine hours in the
production department, and 20 labour hours in the
finishing department, incurring the following costs:
Direct materials: 500, Direct labour: 300, Direct expenses:
100
Calculate the total sales price for the order given Brookfield
Limited's policy of adding a 20% mark-up on cost to all
jobs
 Cost centre
Overhead Basis Production Finishing
Factory deprn Floor area
Factory rates Floor area
Factory ins Floor area
Canteen costs No. employees
Overhead Supervisor sals No. employees

analysis sheet Other ind lab

Machinery depn
Machinery CV
Machinery CV

Cleaning Floor area

Electricity Actual
Building maint Floor area
 Factory
depreciation Production £5,670 x 6000/10500 =
£3,240
 Factory
depreciation Production £5,670 x 6000/10500 =
£3,240

Finishing £5,670 x 4500/10500 =

£2,430
 Cost centre
Overhead Basis Production Finishing
Factory deprn Floor area 3,240 2,430
(6000:4500)
Factory rates Floor area
Factory ins Floor area
Canteen costs No. employees
Overhead Supervisor sals No. employees

analysis sheet Other ind lab Machinery CV

Machinery depn Machinery CV

Cleaning Floor area

Electricity Actual
Building maint Floor area
 Cost centre
Overhead Basis Production Finishing
Factory deprn Floor area 3,240 2,430
(6000:4500)
Factory rates Floor area 6,840 5,130
Factory ins Floor area 4,560 3,420
Canteen costs No. employees
Overhead Supervisor sals No. employees

analysis sheet Other ind lab Machinery CV

Machinery depn Machinery CV

Cleaning Floor area

Electricity Actual
Building maint Floor area
 Cost centre
Overhead Basis Production Finishing
Factory deprn Floor area 6000:4500 3,240 2,430
Factory rates Floor area 6,840 5,130
Factory ins Floor area 4,560 3,420
Canteen costs No. employees 4:18 3,432 15,444
Overhead Supervisor sals No. employees

analysis sheet Other ind lab

Machinery depn
Machinery CV 146:69
Machinery CV

Cleaning Floor area

Electricity Actual
Building maint Floor area
 Cost centre
Overhead Basis Production Finishing
Factory deprn Floor area 6000:4500 3,240 2,430
Factory rates Floor area 6,840 5,130
Factory ins Floor area 4,560 3,420
Canteen costs No. employees 4:18 3,432 15,444
Overhead Supervisor sals No. employees 5,360 24,120

analysis sheet Other ind lab

Machinery depn
Machinery CV
Machinery CV

Cleaning Floor area

Electricity Actual
Building maint Floor area
 Cost centre
Overhead Basis Production Finishing
Factory deprn Floor area 6000:4500 3,240 2,430
Factory rates Floor area 6,840 5,130
Factory ins Floor area 4,560 3,420
Canteen costs No. employees 4:18 3,432 15,444
Overhead Supervisor sals No. employees 5,360 24,120

analysis sheet Other ind lab

Machinery depn
Machinery CV 146:69
Machinery CV
12,410 5,865

Cleaning Floor area

Electricity Actual
Building maint Floor area
 Cost centre
Overhead Basis Production Finishing
Factory deprn Floor area 6000:4500 3,240 2,430
Factory rates Floor area 6,840 5,130
Factory ins Floor area 4,560 3,420
Canteen costs No. employees 4:18 3,432 15,444
Overhead Supervisor sals No. employees 5,360 24,120

analysis sheet Other ind lab

Machinery depn
Machinery CV 146:69
Machinery CV
12,410
14,600
5,865
6,900

Cleaning Floor area

Electricity Actual
Building maint Floor area
 Cost centre
Overhead Basis Production Finishing
Factory deprn Floor area 6000:4500 3,240 2,430
Factory rates Floor area 6,840 5,130
Factory ins Floor area 4,560 3,420
Canteen costs No. employees 4:18 3,432 15,444
Overhead Supervisor sals No. employees 5,360 24,120

analysis sheet Other ind lab

Machinery depn
Machinery CV 146:69
Machinery CV
12,410
14,600
5,865
6,900

Cleaning Floor area 10,200 7,650

Electricity Actual
Building maint Floor area
 Cost centre
Overhead Basis Production Finishing
Factory deprn Floor area 6000:4500 3,240 2,430
Factory rates Floor area 6,840 5,130
Factory ins Floor area 4,560 3,420
Canteen costs No. employees 4:18 3,432 15,444
Overhead Supervisor sals No. employees 5,360 24,120

analysis sheet Other ind lab

Machinery depn
Machinery CV 146:69
Machinery CV
12,410
14,600
5,865
6,900

Cleaning Floor area 10,200 7,650

Electricity Actual 18,790 11,500
Building maint Floor area 2,880 2,160
82,312 84,619
Production Production
department overhead/Machine hrs =
OAR OAR.
Finishing Finishing
department overhead/Labour hrs =
OAR OAR
 Production
overhead/Machine hrs =
OAR

Production
£82,312/10,000 mach
department hrs = £8.231 per hr
OAR

Capital intensive
department
 Finishing
overhead/Labour hrs
= OAR

Finishing
£84,619/40,000 lab
department hrs = £2.115 per hr
OAR

Labour intensive
department
 £
Direct costs (500 + 300 + 900.00
100)

Sales price Production overhead

Finishing overhead
of order
Add mark-up @ 20%
Sales price
 £
Direct costs (500 + 300 + 900.00
100)
Production overhead (20 hrs 164.62
Sales price x £8.231)

of order
Add mark-up @ 20%
Sales price
 £
Direct costs (500 + 300 + 900.00
100)
Production overhead (20 hrs 164.62
Sales price x £8.231)
Finishing overhead (20 hrs 42.30
of order x £2.115)
1106.92
Add mark-up @ 20%
Sales price
 £
Direct costs (500 + 300 + 100) 900.00

Production overhead (20 x 164.62

£8.231)
Finishing overhead (20 x 42.30
Sales price £2.115)
1106.92
of order Add mark-up @ 20% 221.38
Sales price 1328.30

Revenue of order 20 x
£1328.30 = £26,566
Critique The major criticism of this approach is
that we often use inappropriate
allocation bases for the overheads.
  Manufacturing processes and the
Problems products they produce are now more
with complex.
 This results in over-costing or under-
Traditional costing.
Costing  Complex products are not allocated
an adequate amount of overhead
Systems costs.
 Simple products get too much.
  Are more complex
Today’s
Manufacturing  Are often automated
Plants  Often make more than one product
 Use proportionately smaller amount
of direct labor making direct labor a
poor allocation base for factory
overhead.
 When the  Then multiple allocation bases should
manufacturing be used to allocate overhead expense.
process is more  In such situations, managers need to
complex: consider using activity based costing
(ABC).
ABC Definitions

 Activity based costing is an approach

for allocating overhead costs.
 An activity is an event that incurs costs.
 A cost driver is any factor or activity
that has a direct cause and effect
relationship with the resources
consumed.
ABC Steps

 Overhead cost drivers are determined.

 Activity cost pools are created.
 A activity cost pool is a pool of
individual costs that all have the same
cost driver.
 All overhead costs are then allocated to
one of the activity cost pools.
ABC Steps:

 An overhead rate is then calculated for

each cost pool using the following
formula:
 Costs in activity cost pool/base
 The base is, of course, the cost driver
 Overhead costs are then allocated to
each product according to how much of
each base the product uses.
When do we use
ABC costing?
 When one or more of the following
conditions are present:
 Product lines differ in volume and
manufacturing complexity.
 Product lines are numerous and diverse,
and they require different degrees of
support services.
 Overhead costs constitute a significant
portion of total costs.
When do we use
ABC costing?
 The manufacturing process or number
of products has changed significantly—
for example, from labor intensive to
capital intensive automation.
 Production or marketing managers are
ignoring data provided by the existing
system and are instead using “bootleg”
costing data or other alternative data
when pricing or making other product
decisions.
Additional Uses of ABC

Activity Based Management (ABM)

Extends the use of ABC from product costing to a comprehensive
management tool that focuses on reducing costs and improving
processes and decision making.