Activity Based Costing

Question 1

Activity Based Costing (ABC)

Why do managers need accurate cost information?
What are the limitations of traditional absorption costing methods? (2)
Why are traditional costing methods becoming less effective? (2)
What is Activity Based Costing (ABC)?
How does ABC allocate costs? (2)

Answer 1

Why do managers need accurate cost information?

• To make informed decisions that drive efficiency and profitability.

What are the limitations of traditional absorption costing methods?

• They often result in inaccurate cost allocation.
• Overhead costs are assigned using arbitrary cost drivers, like direct labour hours.

Why are traditional costing methods becoming less effective?

• Modern industries have increasing overheads.
• Poor cost allocation can lead to incorrect decision-making.

What is Activity Based Costing (ABC)?

• An alternative costing approach first developed by technology-driven manufacturing companies.

How does ABC allocate costs?

• It accumulates costs based on organisational activities.
• Costs are then assigned to the products or services responsible for those activities.

Question 2

Activity Based Costing (ABC)

ABC has the following steps: (7 steps)

Answer 2

ABC has the following steps:

1. Identify the different activities performed by the organisation
2. Assign costs to activities
3. Direct costs such as materials are directly allocated
4. Indirect cost require the calculating of the total cost of each activity over the financial period (cost pool)
5. Identify a cost driver (causation factor)
6. Calculate a cost driver rate
7. Assign part of the cost of each activity to different products based on the extent to which each product has caused the activity to occur (apply the cost driver rate)

Question 3

Activity Based Costing (ABC) - Activities in ABC

What is an activity centre?
What is not feasible and what is the solution to this?

Answer 3

Activities in ABC

• An activity centre for the purposes of ABC is any part of the production process which the management wants a separate reporting of the cost of the activity involved
• It is not feasible to treat every single activity as a separate activity centre so companies will combine related activities into one centre to reduce the amount of detailed recording

Question 4

Activity Based Costing (ABC) - Identification of activities

What are activities composed of?
How should they be chosen (2)?

Identification of activities guided by a number of factors: (3)

What are cost drivers?

Answer 4

• Activities are composed of the aggregation of units of work or tasks.
• The activities chosen should be at a reasonable level of aggregation based on costs versus benefits.
• Not too detailed, not too generalised.

Identification of activities guided by a number of factors:

• Significance in terms of cost incurred
• Importance to output processes
• Ability to identify single related cost driver

Cost drivers:

• factors that most closely influence the cost of an activity. Factors that cause costs to occur.

Question 5

Examples of activities and relevant cost drivers (6)

Answer 5

Question 6

The major distinguishing features of ABC systems are that within the two stage allocation process they rely on:

Therefore there are _____ general levels of activities recognised in ABC (and what are they - with description)

Answer 6

1. a greater number of cost centres
2. a greater number and variety of second-stage cost drivers.

Therefore there are four general levels of activities recognised in ABC

1. Unit level activities

• i.e. every time a unit is produced e.g. machine hours, processing time, labour related activities

2. Batch level activities

• i.e. every time a batch is produced e.g. setting up machines, purchase ordering, quality inspection

3. Product level activities

• i.e. needed for that particular product, e.g. product testing, product design, inventory management

4. Facility level activities

• i.e. relating to the overall production, e.g. plant occupancy, personal administration and training, grounds maintenance.

Question 7

Examples of cost drivers are: (16)

Answer 7

Examples of cost drivers are:

1. Machine set ups
2. Purchase orders
3. Quality inspections
4. Production orders
5. Engineering change orders
6. Miles driven,
7. Power consumed
8. Shipments
9. Material receipts
10. Stock movements
11. Maintenance requests
12. Scrap/rework orders
13. Computer hours logged
14. Beds occupied
15. Flight hours logged
16. Machine time

Question 8

Example

1. Identify the activity –
2. What is the activity cost pool?
3. What is the cost driver –
4. Calculate the cost driver rate –
5. Calculate the costs assigned to both products –

Answer 8

1. Identify the activity – setting up machinery
2. What is the activity cost pool? - £20,000
3. What is the cost driver – the number of set-ups
4. Calculate the cost driver rate - £100 per machine set up
5. Calculate the costs assigned to both products – fountain pen £ 12,000 and ball pen £8,000

Question 9

Alpha makes many products, one of which is Product B. Alpha is considering adopting an ABC approach for setting its budget, in place of the current practice of absorbing overheads using direct labour hours. The main budget categories and cost driver details for the whole company for October are set out below, excluding direct material costs

a) Calculate the budgeted unit cost of product B for October assuming that a direct labour-based absorption method was used for all overheads

Answer 9

Question 10

Alpha makes many products, one of which is Product B. Alpha is considering adopting an ABC approach for setting its budget, in place of the current practice of absorbing overheads using direct labour hours. The main budget categories and cost driver details for the whole company for October are set out below, excluding direct material costs

b) Calculate the budgeted unit cost of product B for October using an ABC approach

Answer 10

Costs absorbed by a product using an ABC approach could be higher than those absorbed if a traditional labour-based absorption system were use because:

• Small batch size
• High levels of non manufacturing activity

Question 11

Benefits of ABC (7)

Limitations of ABC (6)

Answer 11

Benefits of ABC

• Increases accuracy of product costing, therefore setting of selling prices. Traditional costing may result in cost subsidisation.
• Useful for cost comparison purposes
• Results in better product mix decisions
• Can be applied to other costs such as marketing costs to ascertain profitability of a particular customer
• Helps to focus more on cost consumption and what causes costs to be incurred. Can result in better cost management
• Non value adding activities become more visible and can be reduced or eliminated e.g use of electricity in non production areas
• It better supports other management techniques such as the balanced scorecard, activity based budgeting, continuous improvement and performance management

Limitations of ABC

• Implementing ABC is challenging as requires organisational wide buy-in
• Less useful in organisations with high levels of direct materials and labour and minimal overheads
• Analysing processes and ascertaining activities as the basis for ABC is time consuming and arbitrary too
• It is more costly to implement and run ABC compared with the simpler traditional methods. Record keeping and separate calculations can be complex if there are many products.
• ABC still uses arbitrary methods of cost allocation in selecting drivers and combining activities e.g general/non specific overheads at facility level. In some companies these form a substantial part of the overhead costs.