ACTIVITY BASED COSTING (Performance Management)

1. Introduction

The traditional method of dealing with overheads is to split them between variable overheads and

fixed overheads. If we are using absorption costing we then decide on a suitable basis for absorption

(e.g. labour hours) and absorb the overheads on that basis.

Activity Based Costing (ABC) attempts to absorb overheads in a more accurate (and therefore more

useful) way.

2. The steps to be followed are as follows:

·        identify the major activities that give rise to overheads (e.g. machining; dispatching of orders)

·        determine what causes the cost of each activity – the cost driver (e.g. machine hours; number

            of dispatch orders)

·        calculate the total cost for each activity – the cost pool (e.g. total machining costs; total costs of

            dispatch department)

·        calculate an absorption rate for each cost driver

·        calculate the total overhead cost for each product manufactured

·        calculate the overhead cost per unit for each product

Una manufactures three products: A, B, and C.

Data for the period just ended is as follows:

                                                                        A                      B                              C

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

Sales price ( per unit)                                         $20                 $20                          $20

Material cost (per unit)                                        $5                  $10                          $10

Labour hours (per unit)                                     2 hours          1 hour                    1 hour

(Labour is paid at the rate of $5 per hour)

Overheads for the period were as follows:

Set-up costs     90,000

Receiving          30,000

Dispatch           15,000

Machining          55,000

                        $190,000

Cost driver data:

                                                            A                      B                                  C

Machine hours per unit                       2                       2                                   2

Number of set-ups                             10                     13                                   2

Number of deliveries received          10                     10                                   2

Number of orders dispatched            20                     20                                  20

(a) Calculate the cost (and hence profit) per unit, absorbing all the overheads on the basis of labour

hours.

(b) Calculate the cost (and hence profit) per unit absorbing the overheads using an Activity Based

Costing approach.

 Suggested Solution

Total overheads                                     $190,000

Total labour hours

            A          20,000 ×  2       =             40,000

            B          25,000 ×  1       =              25,000

            C          2,000 ×    1      =                 2,000

                                                                 67,000 hours

           

                        O.A.R. =190,000        = $2.836 per hour

                                      67,000

                       

Cost cards:

                                                      A                B                     C

Materials                                      5                10                     10

Labour                                        10                 5                       5

Overheads (at $2.84 per hr)      5.68           2.84                 2.84

                                                 20.68        17.84               17.84

Selling price                                   20            20                   20

Profit / Loss                            $(0.68)       $2.16              $2.16

(b)                                           Total                    A                       B                    C

Set-up costs

(Cost per set up = )                   90,000              36,000           46,800             7,200

Receiving

(Cost per delivery = )                 30,000               13,636         13,636            2,728

Dispatch

(Cost per order = )                    15,000              5,000               5,000               5,000

Machining

(Cost per machine hour: )          55,000           23,404              29,256              2,340

                                                190,000            78,040              94,692              17,268

Number of units                                               20,000              25,000                2,000

Overheads p.u.                                                   $3.90                $3.79                $8.63

Costings:

                                                                       A                    B                     C

Materials                                                        5                    10                   10

Labour                                                          10                     5                      5

Overheads                                                  3.90                 3.79                8.63

                                                                 18.90                18.79              23.63

Selling price                                                  20                     20                   20

Profit / Loss                                              $1.10                $1.21           $(3.63)