A tool for refining a costing system is Activity Based Costing. ABC is that costing in which costs are first traced to activities and then the products. This system calculates the cost of individual activities and assign costs to products and services on the basis of the activities needed to produce each product or service.
Identifying major activities (eg in the purchasing dept)
Identifying the supplier
Preparing purchase order
Mailing the purchase order
Follow up etcâ€¦..
Perform an in-depth analysis of the operating processes, each process may consist of one or more activities required by outputs.
Assign resources costs to activities: (eg employees, travel expenses,)
Types of costs are:
General and Administrative:(phone, electricity)
Costs that cannot be associated with any particular product or service produced. There costs would remain the same regardless of activity produced.
Identify all of the outputs. Outputs can be products ,services or customers.
Assign activity costs to out put:
Assign activity costs to outputs using activity drivers . Activity drivers assign activity costs to outputs based on consumption or demand for activities. Given below are few examples of activities and the relevant cost drivers.
Activities Cost drivers Machine set-up Number of production runs
Purchasing materials Numbered of orders placed
Ware housing Items in stock
Packing Number of packing orders
Quality testing Hours of test time
Stores delivery Number of stores delivery
The grouping of activities is preferably done using different levels at which activities are performed. Broadly activities are classified in to four. They are:
Unit level activities :These are the activities which are performed each time a unit is produced.
Batch level activities: These are the activities which are performed each time a batch of goods or products are produced.
Product level activities: These are the activities which are performed to support the production of each different type of production.
Facility level activities: These are those which are needed to certain a factories general manufacturing process.
Characteristics of ABC
Managers manage activities and not products. The changes in activities leads to changes in costs. Therefore if the activities are managed well,costs will fall and resulting product will be more competitive.
ABC highlights the problem areas that deserves the managements attentions and more detailed analysis.
ABC system is used in setting priorities for action.
Makes "Indirect" expenses "Direct".
ABC is not conformed to generally accepted accounting principles in same area.
Using ABC for short run decisions may sometimes prove costly in the long run.
An over emphasis on cost reduction with out regard to the constraints does not create an environment for learning about the problems and management.
Steps involved in installation of ABC
Inventorization and screening of activities.
Identification of cost and cost drivers.
Activity Based Costing
The following information provides details of the costs, volume and transaction cost drivers for a period in respect of XYZ Ltd:
Sales and production (units)
Raw materials usage (units)
Direct materials cost (â‚¬)
Direct labour hours
Direct labour cost (â‚¬)
Number of production runs
Number of deliveries
Number of receipts
Number of production orders
You are required to
(a) calculate the total costs for each product, using activity based costing;
(b) calculate overhead costs per product and determine as a percentage of total costs.
As we said above, to apply the ABC method, we need to identify cost drivers for two stages:
1 cost drivers tracing the costs of inputs into cost pools; and
2 cost drivers tracing the cost pools into product costs
Step 1 cost drivers tracing the costs of inputs into cost pools; and
The calculations for each of the rates to be used are:
For the set up costs, we first devise a rate to tell us the cost per set up: total set up overheads divided by the number of set ups: in this case, this is
65 production runs
The machine hour overhead rate
652,500 machine hours
All of the other rates are calculated similarly. Hence they will be presented now without further comment.
130 production orders
Step 2 cost drivers tracing the cost pools into product costs
The cost per unit statement follows, and then we will work through the calculations.
Set up costs
We already know direct material and labour costs. We now need to calculate overhead costs per unit.
Machine overheads are found by multiplying the machine hour rate by the number of machine hours per product per unit:
machine hour rate £1.5326 x
The set up costs rate we have already is the rate per machine set up, the cost per unit is calculated by multiplying the rate per set up by the number of set up per product and then dividing the results by the total number of units per product:
Set up cost per set up â‚¬1,153.85 x
No of set ups
these values are then divided by the number of units per product to give us the cost per unit:
The receiving, packing and engineering costs are all calculated in the same way as the set up costs. There is no need to repeat these calculations, but check that they are understood.
Summary 1: Total costs per unit using each of the three methods
Summary 2: Overheads per unit using each of the three methods
Summary 3: Overheads as a percentage of total costs