ACTIVITY BASED COSTING

The traditional costing system use actual departments or cost centres for accumulating and redistributing / allocating costs. The ABC system ,instead of using cost centres, uses activities for accumulating costs. The focus shifts from what the money was being spent on (e.g. labor, equipment, supplies etc) to how much of the resource expenses are required or used to perform the activities such as material procurement, set up ,processing of order, maintenance, inspection and quality control, material handling & dispatch etc . The ABC system is a system based on activities linking on resources to the products / services produced / delivered to customers.

A Cost Driver is a variable ,such as the level of activity of volume, that casually affects costs over a given time span. There is a direct cost and effect relationship between a change in the level of activity or volume and a change in the level of total cost. For e.g. if the setup workers are paid an hourly wage, the number of setup hours is the cost driver of setup cost.

Cost Pool Material Procurement

Cost Drivers Types of material Number of orders Number of deliveries Quantity of material received

Customer Order Processing

Number of customers Number of orders

Production Control

Number of set-up Number of production hours Number of production batches

Maintenance

Number of set-up Number of production hours Number of machine break downs

Inspection and Quality Control Batch sizes Number of inspections

Illustration 1: Kapoors Ltd manufactures two products X and Y .Product X is produced in two runs of 500 units and product Y in five runs of 200 units. Assuming each product consumes equal direct material and direct labor contents. The manufacturing overheads amounts to Rs 14,000, which comprises of line set-up cost of Rs 7,000; product inspection cost of Rs 3,500 and Rs 3,500 for material movement to the product line. Total costs incurred for producing 1000 units of product X and 1000 units of product Y will be as under:

Direct material Direct labor Manufacturing overhead Total Cost

Rs 10,000 2,000 14,000 26,000

Calculate the product wise cost using traditional costing method as well as activity based costing method.

Product-wise Total Cost under Traditional Costing Method

Particulars

Product X Total Cost (Rs)

[1000 units]

Product Y [1000 units] Total Cost (Rs) Per Unit Cost (Rs)

Per Unit Cost (Rs)

Direct Material Direct Labor Manufacturing Overheads(700% of direct labor) Total Cost

5,000 1,000 7,000

5.00 1.00 7.00

5,000 1,000 7,000

5.00 1.00 7.00

13,000

13.00

13,000

13.00

Product-wise Total Cost under Activity Based Costing

Particulars

Product X [1000 units]

Product Y [1000 units]

Total Cost Per Unit Total Per Unit (Rs) Cost(Rs) Cost (Rs) Cost (Rs) Direct Material Direct Labor Manufacturing Overheads: Line Set-up Cost [X: 2 set-up ; Y: 5 set-up] @ Rs 1,000/- per line set-up Product Inspection Cost [X: 2 inspections ; Y: 5 inspections] @ Rs 500/- per inspection Material Movement [X: 2 movements ; Y: 5 movements] @ Rs 500/-per movement Total Cost 2,000 2.00 5,000 5.00 5,000 1,000 5.00 1.00 5,000 1,000 5.00 1.00

1,000

1.00

2,500

2.50

1,000

1.00

2,500

2.50

10,000

10.00

16,000

16.00

Illustration 2: Bombay Steel Ltd manufactures four products A, B, C and D using the same plant and process. The following information relates to a production period: Volume Product A B C D 500 5,000 600 7,000 Material Cost per unit(Rs) 5 5 16 17 Direct Labour per unit hr hr 2 hrs 1 hrs Machine Time per unit hr hr 1 hr 1 hrs Labor Cost per unit 3 3 12 9

Total production overhead recovered by the cost accounting system is analyzed under the following headings:

Factory Overhead applicable to machine-oriented activity Set-up Cost Cost of Ordering Materials Cost of Handling Materials Administration for Spare-parts

Rs 37,424 4,355 1,920 7,580 8,600

These overhead costs are absorbed by products on a machine hour rate of Rs 4.80 per hr giving an overhead cost per product of A=Rs 1.20; B= Rs 1.20;C= Rs 4.80 and D= Rs 7.20. However, investigation into the production overhead activities for the period reveals the following totals: Number of Set-ups 1 6 2 8 No. of Material Orders 1 4 1 4 No. of times Material was Handled 2 10 3 12 No. of spare Parts 2 5 1 4

Product A B C D

You are required to: a)compute an overhead cost per product using ABC, tracing overheads to production units by means of cost drivers. b) Comment briefly on the differences disclosed between overheads traced by the present system and those traced by ABC.

W/N 1: Calculation of cost per unit of cost driver: Product A B C D Total Number of Set-ups 1 6 2 8 17 No. of Material Orders 1 4 1 4 10 No. of times Material was Handled 2 10 3 12 27 No. of Spare- parts 2 5 1 4 12

Total Machine Hours =(500 x ) + (5,000 x ) + (600 x 1) + (7,000 x 1 ) =125+1,250+600+10,500 =12,475 hrs

Machine Overhead Charges: = Machine Overhead Charges / Total Machine Hours = Rs 37,424 / 12,475 hrs = Rs. 3 per hr Set-up Cost: = Set-up Cost/ Total Set-ups = Rs. 4,355/ 17 set ups = Rs. 256.18 per set up Cost of Ordering Materials: = Cost of Ordering Materials / Total No. of Material Orders =Rs. 1,920 / 10 orders = Rs. 192 per order Cost of Handling Materials: =Cost of Handling Materials / No. of times Material was Handled =Rs. 7,580 / 27 times = Rs. 280.74 per time Administration for Spare-parts: =Cost for Administration for Spare-parts / Total Number of Spare-parts =Rs. 8,600/12 Spare-parts =Rs. 716.67 per Spare-part

Products [ Rs. per unit cost] A Factory Overhead applicable to machine-oriented activity Set-up Cost 0.75
[ x Rs 3]

B 0.75
[ x Rs 3]

C 3.00
[1 x Rs 3]

D 4.50
[1 x Rs 3]

0.51
(1 x 256.18) / 500

0.31
(6 x 256.18) / 5000

0.85
(2 x 256.18) /600

0.29
(8 x 256.18) /7,000

Cost of Ordering Materials Cost of Handling Materials Administration for Spare-parts Total Overhead Cost

0.38
(1 x 192) / 500

0.15
(4 x 192) / 5000

0.32
(1 x 192) / 600

0.11
(4 x 192)/7,000

1.12
(2x 280.74) /500

0.56
(10 x 280.74) /5000

1.40
(3 x 280.74) /600

0.48
(12 x 280.74)/7,000

2.87
(2x 716.67) /500

0.72
(5 x 716.67) /5000

1.19
(1 x 716.67) /600

0.41
(4 x 716.67)/7,000

5.63

2.49

6.76

5.79

Comparison of Per Unit Overhead Cost

Products [ Rs. per unit overhead cost] A Old System ABC System Difference 1.20 5.63 4.43 B 1.20 2.49 1.29 C 4.80 6.76 1.96 D 7.20 5.79 (1.41)

Illustration 3: Newgon Ltd currently manufactures and sells four different products the related information is given below:

Product Output [units] Cost per unit: Direct Material Direct Labor Machine Hour per unit

A 120 Rs 40 28 4

B 100 Rs 50 21 3

C 80 Rs 30 14 2

D 120 Rs 60 21 3

The four products are similar and are usually produced in production runs of 20 units and sold in batches of 10 units. The production overhead is currently absorbed by using a machine hour rate and the total of the production overhead for the period has been analyzed as follows:

Machine department cost [rent, business, rates, depreciation and supervision] Set-up cost Stores receiving Inspection / Quality Control Materials Handling and Dispatch

Rs 10,430 5,250 3,600 2,100 4,620

You have ascertained that the cost drivers to be used are as listed below for the overhead costs shown:

Set-up cost Stores receiving Inspection / quality control Materials handling and dispatch

Number of production runs Requisitions raised Number of production runs Orders executed

The number of requisitions raised on the stores was 20 for each product and the number of orders executed was 42, each order being for a batch of 10 of a product. Require: a)calculate the total cost for each product if all overhead costs are absorbed on a machine hour basis. b)calculate the total costs for each product, using activity based costing.

a) Statement Showing Total Cost of different products assuming absorption of overhead on a machine hour basis

Product Direct Material Direct Labor Overhead Cost of Production per unit Output in units Total Cost

A 40 28 80 148

B 50 21 60 131

C 30 14 40 84

D 60 21 60 141

120 17,760

100 13,100

80 6,720

120 16,920

Rate per machine hour: = Total Overheads / Total Machine Hours = [10,430+5,250+3,600+2,100+4,620/ [480+300+160+360] = 26,000 / 1,300 hrs = Rs 20 per machine hour

W/N 1: Calculation of Total Production Runs: Total Production Runs (A+B+C+D): =(120/20) + (100/20) + (80/20) + (120/20) = 6 + 5+ 4+ 6 = 21 production runs W/N 2: Calculation of total number of Requisition = 20 for each product i.e. 80 in total W/N 3: Calculation of Machine Hour Rate: Machine department cost of Rs 10,430 will continue to be absorbed on the machine hour basis as before. The relevant absorption rate will be= Rs.10,430/1,300= Rs 8.02 per machine hour. W/N 4: Calculation of Cost per Activity:
Cost Rs Cost Drivers Numbers Cost per activity of Driver Rs

Set-up cost Stores receiving Inspection / quality control Materials handling and dispatch

5,250 Number of production runs 3,600 Requisitions raised 2,100 Number of production runs 4,620 Orders executed

21 80 21 42

250 45 100 110

Product Direct Material

A [120 units] 4,800

[120 units @Rs 40/per unit]

B[100 units] 5,000

[100 units @Rs 50/per unit]

C[80 units] 2,400

[80 units @Rs 30/per unit]

D[120 units] 7,200

[120 units @Rs 60/per unit]

Direct Labor

3,360
[120 units @Rs 28/per unit]

2,100
[100 units @Rs 21/per unit]

1,120
[80 units @Rs 14/per unit]

2,520
[120 units @Rs 21/per unit]

Set-up Cost [number of

runs* cost per production run ]

1,500
[6 runs@ Rs 250/per production run]

1,250
[5 runs@ Rs 250/per production run

1,000
[4 runs@ Rs 250/- per production run

1,500
[6 runs@ Rs 250/per production run

Stores Receiving
[number of requirements* cost per requirement]

900
[20 @ Rs 45/- per requirement]

900
[20 @ Rs 45/- per requirement]

900
[20 @ Rs 45/per requirement]

900
[20 @ Rs 45/- per requirement]

Inspection/Quality Control
[number of production runs*cost of inspection per production run]

600
[6 runs@ Rs 100/per production run]

500
[5 runs@ Rs 100/per production run]

400
[4 runs@ Rs 100/- per production run]

600
[6 runs@ Rs 100/per production run]

Material Handling/Dispatch
[number of orders* cost per order]

1,320
[12 orders @ Rs 110/- per order]

1,100
[10 orders @ Rs 110/- per order]

880
[8 orders @ Rs 110/- per order]

1,320
[12 orders @ Rs 110/- per order]

Machine Deptt Cost

[number of hrs* cost per hr]

3,850
[480 hrs@ Rs 8.02 per machine hour]

2,406
[300 hrs@ Rs 8.02 per machine hour]

1,283
[160 hrs@ Rs 8.02 per machine hour]

2,887
[360 hrs@ Rs 8.02 per machine hour]

Total Cost Output in units Cost per Unit

16,330 120 136.09

13,256 100 132.57

7,983 80 99.80

16,927 120 141.07

c)

Comparative Analysis

Product Cost per Unit Traditional Method Cost per Unit ABC Method Difference

A 148.00

B 131.00

C 84.00

D 141.00

136.09 (11.91)

132.57 1.57

99.80 15.80

141.07 0.07