# LO2 &4: Activity Based Costing

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24/02/20201LO2 &4: Activity Based Costing(ABC)Dr Fidelis AkangaLearning ObjectivesBy the end of this unit Explain the difference between ABC and TraditionalCosting System Explain why Traditional Costing systems can providemisleading information for decision-making Identify and explain EACH of the four stagesinvolved in designing ABC systems; Demonstrate how ABM can be developed from ABC24/02/20202Determining Costing per unit…
• Product Cost
All direct costsOH cost perunit• Overhead cannot betraced easily and mustbe assigned withestimates• Absorption costingsystems adopt volumerelated allocation basese.g. direct labour hour,machine hour, labour costsCosting Products…• Product CostAll direct costsOH per unit24/02/20203A Two-Stage Allocation Process(Traditional Costing System)Example 1

Martin Ltd. Manufactures two products and cost of production:

Product A£130£10010
Product B£130£100100£13,500
Materials cost per unitDirect Labour cost per unitOutput (unit produced)Total overhead costs
Activity
Cost Driver
Cost£
A
B
TotalA+b
Machinery
No of machineHrs
6600
40
400
440
Set-up
No. of set up
4800
40
80
120
Handling anddispatch
No. of purchaseorders
2100
3
4
7
How much is the product cost under Traditional cost system using machine Hrs as abase for the allocation rate?24/02/20204Workings Overheads absorbed Allocation rate = Overhead costs ÷ machine Hrs =13,500 ÷ 440 = £30.68 / hour Allocated Overhead costs for each product = Rate xmachine Hrs A = 30.68 x 40 = £1,227 B = 30.68 x 400 = £12,272 Per unit Cost = Allocated Overhead costs / No of units A = 1227 / 10 = £123 B = 12272 / 100 = £123(a) Total Cost per unit based onmachine hour Product A Product B£ £ Direct Materials 130 130 Direct labour 100 100 Overheads absorbed

Product A=Product B=
Cost Pools
Suitable cost driver
Factory Electricity Bills
Total machine hours used
Machine set up costs
Number of set ups
Material handling and dispatchcosts
Designers costs
No of product designed
24/02/20207ABC System ProcessDesigning an ABC System Identify and define activities and activitypools.Assign costs to activity cost pools. Select appropriate cost driver.Calculate activity rates.Assign costs to cost objects. Prepare management reports24/02/20208Classification of activitiesUnit-level activities:1. Performed each time a unit of the product or service is produced.2. Resources are consumed in proportion to the number of unitsproduced or sold.3. Examples —Direct materials and labour, energy costs andexpenses consumed in proportion to machine processing time.• Batch-related activities:1. Performed each time a batch of goods is produced.2. Costs vary with the number of batches made.3. Examples include set-ups, purchase ordering and first-iteminspection activities.Classification of activities Product/service sustaining activities:1. Performed to enable the production of individual products orservices.2. Examples include activities related to maintaining an accuratebill of materials, preparing engineering change notices. Facility-sustaining (or business-sustaining) activities:1. Performed to support the organization as a whole.2. Examples include plant management, property costs andsalaries of general administrative staff.3. Common to all products and services –.not allocated toproducts/services

Customer-level (carried out for each customer, unrelated to aproduct)
24/02/20209Activity Based Costing (ABC)Example

Martin Ltd. Manufactures two products and cost of production:

Product A£130£10010
Product B£130£100100£13500
Materials cost per unitDirect Labour cost per unitOutput (unit produced)Total overhead costs
Activity
Cost Driver
Cost£
A
B
TotalA+b
Machinery
No of machine Hrs
6600
40
400
440
Set-up
No. of set up
4800
40
80
120
handling anddispatch
No. of purchaseorders
2100
3
4
7
How much is the product cost under ABC costing?Activity Based Costing (ABC)SolutionCompute the cost driver rate for each overhead activity =Activity Total cost÷ No of drivers
Activity
Cost£
No of drivers
cost driver rate
Machinery
6600
440
15
Set-up
4800
120
40
handling anddispatch
2100
7
300
24/02/202010Product A Allocating Activities overhead costs to products =cost driver rate x No of drivers consumed by theproduct
Activity
cost driverrate
No of driversconsumed
Cost per costdriver
Machinery
15
x
40
=
600
Set-up
40
x
40
=
1600
handling
300
x
3
=
900
Total 3100 ÷ 10units = 310 perunit
Product B
Activity
cost driverrate
No ofdriversconsumed
Cost percost driver
Machinery
15
x
400
=
6000
Set-up
40
x
80
=
3200
handling
300
x
4
=
1200