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    Activity Based Costing Notes and Exercise

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    francis Magoba
    Activity-based costing (ABC) is a new development that allocates overhead costs based on the activities that give rise to those overheads. Traditional cost accounting arbitrarily allocates overheads using bases like machine hours or direct labor hours. ABC addresses this limitation by tracing costs to products based on their demand for activities. It identifies main activities like manufacturing and support activities like purchasing. Cost drivers that influence activity costs are identified, like labor hours or number of setups. Accurate cost data is collected and products' demand for each activity is established using cost drivers. Costs are then traced to products based on their demand for activities. ABC helps measure performance, improve pricing, analyze profitability, and choose distribution channels. However,

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    Activity Based Costing Notes and Exercise

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    francis Magoba
    41 views6 pages
    Activity-based costing (ABC) is a new development that allocates overhead costs based on the activities that give rise to those overheads. Traditional cost accounting arbitrarily allocates overheads using bases like machine hours or direct labor hours. ABC addresses this limitation by tracing costs to products based on their demand for activities. It identifies main activities like manufacturing and support activities like purchasing. Cost drivers that influence activity costs are identified, like labor hours or number of setups. Accurate cost data is collected and products' demand for each activity is established using cost drivers. Costs are then traced to products based on their demand for activities. ABC helps measure performance, improve pricing, analyze profitability, and choose distribution channels. However,

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    Activity-based costing (ABC) is a new development that allocates overhead costs based on the activities that give rise to those overheads. Traditional cost accounting arbitrarily allocates overheads using bases like machine hours or direct labor hours. ABC addresses this limitation by tracing costs to products based on their demand for activities. It identifies main activities like manufacturing and support activities like purchasing. Cost drivers that influence activity costs are identified, like labor hours or number of setups. Accurate cost data is collected and products' demand for each activity is established using cost drivers. Costs are then traced to products based on their demand for activities. ABC helps measure performance, improve pricing, analyze profitability, and choose distribution channels. However,

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    41 views6 pages

    Activity Based Costing Notes and Exercise

    Uploaded by

    francis Magoba
    Activity-based costing (ABC) is a new development that allocates overhead costs based on the activities that give rise to those overheads. Traditional cost accounting arbitrarily allocates overheads using bases like machine hours or direct labor hours. ABC addresses this limitation by tracing costs to products based on their demand for activities. It identifies main activities like manufacturing and support activities like purchasing. Cost drivers that influence activity costs are identified, like labor hours or number of setups. Accurate cost data is collected and products' demand for each activity is established using cost drivers. Costs are then traced to products based on their demand for activities. ABC helps measure performance, improve pricing, analyze profitability, and choose distribution channels. However,

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    of 6

    ACTIVITY BASED COSTING

    Traditional approach to cost accounting uses various bases arbitrarily chosen to allocate overheads. The
    various bases that are used are machine hour rate, labour hour rate, direct material cost percentage method etc.

    A limitation of the traditional method is that it’s only appropriate for valuing stock for financial
    reporting purposes but is inappropriate for decision making purposes

    ABC is a new development in cost accounting that attempts to allocate overhead costs based on the activities that
    give rise to those overheads. CIMA defines ABC as –a contribution to cost units on the basis of the benefits
    received from indirect activities.

    Cost Pool
    A cost pool is a term used to indicate the grouping of costs incurred on a particular activity which drives
    them. Cost drivers are the various activities which give rise to overhead cost. Examples of cost drivers include,
    number of set ups which may be used to as a cost driver for set up costs, labour hours which may be the cost
    driver for assembly services etc.

    Types of cost drivers

    There are two types of cost drivers:


    Output based cost drivers- these are cost drivers that change proportionately with a change in the output.
    Examples include, labour hours and machine hours.

    Non-output based cost drivers- these are cost drivers that have no direct relationship with each and every unit
    produced. They arise for each and every batch or production run or delivery etc. examples include number of set
    ups, number of purchase orders, number of batches etc.

    Steps in ABC system

    Identify the main activities performed in the organization such as manufacturing, assembly etc as
    well as support activities such as purchasing, packaging and dispatching.

    Identify the factor which influence the cost of each activity i.e. the cost drivers

    Collect accurate data on direct materials, direct labour and overheads.

    Establish the demand made by particular products on activities using the cost drivers as a
    measure of demand.

    Trace the cost of activities to products demand for each activity

    Advantages of ABC

    ABC helps in measuring performance by identifying the responsibility or accountability for cost
    behavior.

    It helps with price fixing by identifying the true cost of products

    It helps in analyzing customer profitability i.e. determining which customer yields more profit by
    identifying the cost and profitability of each type of customer.

    It helps in choosing the alternative distribution channels by analyzing costs and performance of each
    channels

    Disadvantages of ABC

    It is not suitable to all businesses especially those where overheads are relatively small and
    which do not produce a wide range of products

    This method cannot be used to prepare monthly or periodical profit statements

    It is cumbersome where many activities are involved

    Illustration-1
    (a) Write short notes on the following terms as used in strategic management accounting:

    (i) Life-cycle costing. (3 marks)

    (ii) Target costing. (3 marks)

    (b) Modern Company Ltd. manufactures and sells three products namely: D, E and F.

    The company’s production departments consist of processing and assembly.

    The management accountant of Modern Company Ltd. has provided you with the following budgeted
    information for the six-month period ending 31 December 2006:

    Product Production Selling Direct Direct Machine Direct


    Units price per materials labour Hours labour
    unit cost per unit cost per per unit hours per
    Sh. Sh. unit unit
    Sh.
    D 100,000 45 16 14 4 14
    E 80,000 95 50 30 10 6
    F 60,000 70 30 30 8 4

    In a bid to embrace modern business techniques, the management accountant intends to adopt the activity-based
    costing (ABC) method of cost allocation and has identified the following activities as the main cost drivers for the
    overhead costs:

    Overhead costs Cost driver


    Processing services Assembly Machine hours Direct
    services Quality control labour hours Number of
    Materials handling and dispatch Selling and inspections
    administration Machine set-ups Number of internal requisitions
    Number of customer orders
    Number of production runs.

    The following additional information is provided:


    1. The company’s projected overhead costs for the period are:

    Cost pool Sh.


    Processing services 714,000
    Assembly services 636,000
    Quality control 52,000
    Materials handling and dispatch 156,000
    Selling and administration 168,000
    Machine set-ups 156,000
    1,882,000

    2. All units produced will be sold within the six-month period.

    3. Production takes place in batches of 1,000 units.

    1. The following estimates have also been provided for the period:

    Product Number of Number of internal Number of


    inspections requisitions customer orders

    D 240 8,000 3,000


    E 400 8,000 4,000
    F 400 16,000 4,200

    Required:
    (i) Prepare budgeted income statements for the period ending 31 December 2006 based on
    activity-based costing. (12 marks)

    (ii) Highlight the shortfalls of the activity-based costing method over the conventional cost
    allocation methods. (2 marks)
    (Total: 20 marks)

    3.5 SELF TEST QUESTIONS


    QUESTION ONE
    a) In what fundamental ways does activity-based costing differ from traditional costing
    method? (5 marks)
    b) Service organization such as banks and hospitals used to be noted for their lack of
    standard costing techniques and their relatively unsophiscated budgeting and control
    systems compared to the practice in large manufacturing organizations. However, this has
    changed service organizations have reversed their use of management accounting
    techniques.

    Required:
    i) Explain which features of service organizations encourage the application of
    activity- based costing to the analysis of cost information. (7 Marks)

    ii) Explain which features of service organizations may create problems for the
    application of activity-based approaches. (7 Marks)
    iii) Explain the uses of activity-based cost information in service industries. (6 Marks)

    QUESTION TWO
    The DM Ltd produces four products, W, X, Y and Z using the same plant and
    processes.
    The following information relates to the company.

    Products W X Y Z
    Volume (units) 1,000 10,000 1,200 14,000
    Material cost/unit (Shs.) 10 10 32 34
    Direct labor/unit (Hours) 1 1 4 3
    Machine time/unit (hours) ½ ½ 2 3
    Labour cost/unit (Sh.) 6 6 24 18

    The cost accountant analyzed the production overhead recorded as under the following
    headlines:-

    Overhead cost Sh.000


    Factory overhead (Machine oriented activity) 74,848
    Set-up costs 8,710
    Material cost. (Cost of ordering material) 3,840
    Material handling costs. 15,160
    Administration cost for repair parts. 17,200

    Overhead costs are absorbed by products on a machine hour rate of sh.9.60 per hour
    giving an overhead cost per unit for products as follows:-

    Product W X Y Z
    Number of set-ups 2 12 4 16
    Number of material orders 2 16 2 16
    Number of times material handled. 4 20 6 24
    Number of spare parts used 4 10 2 8

    Required:
    a) Unit costs per product using Activity-based costing.
    b) Comment briefly on the difference between overhead traced by present system and
    those used by Activity based costing system.

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