cmabdtheblogger: Strategic Cost Management - Activity-Based Costing System

STRATEGIC COST MANAGEMENT

Activity-Based Costing System

Part A: Discussion of importat definitions, basic theories and concepts about Activity-Based Costing System along with various relevant computation formats.

Part B: Three Illustrations along with solutions.

Part A

Activity-based costing (ABC) system is a system that first accumulates overhead costs for each of the activities of the area being costed (an area can be a plant, department, value chain function, or the entire organisation), and then assigns the overhead costs of the activity to the products, services or other cost objects that require that activity.

In a two-stage ABC system there are two stages of allocation to get from the original resource cost to the final product or service cost. The first stage allocates resource costs to the activity-cost pools (Cost pool is a group of individual activity costs that is allocated to cost objectives using a single cost driver). The second stage allocates activity costs to the products or services. In two-stage ABC system, the first stage cost drivers are usually percentages.

Cost object (also known as cost objective) means anything for which a separate measurement of costs is desired. Examples include departments, products, services, divisions and territories.

Cost driver means any output measure that causes costs i.e. that causes the use of costly resources. Examples include labour hours, machine hours, number of employees supervised, number of service calls, kilowatt hours (KWH), etc. In simple words, cost drivers are the bases used for allocating the overhead costs of each of the activities to cost objectives.

In multi-stage ABC system, which is another variant of the ABC system, there are more than two stages of allocations and there are cost drivers other than percentages.

ABC system can turn many indirect costs (Indirect costs can be defined as the costs which cannot be identified specifically and exclusively with a given cost objective in an economically feasible way) into direct costs (Direct costs can be defined as the costs which can be identified specifically and exclusively with a given cost objective in an economically feasible way). ABC system can also turn unallocated costs (Unallocated costs can be defined as the costs for which no relationship can be identified to a cost objective) from non-productive functions of the value chain into indirect costs. Appropriate selection of activities and cost drivers allow managers to trace many manufacturing indirect costs to cost objectives just as specifically as they have traced direct material costs. Because ABC systems classify more costs as direct than do traditional systems and because cost drivers have a stronger casual relationship between activities and resources, managers have a greater confidence in the accuracy of the costs of products and services reported by ABC systems.

ABC systems are more complex and costly than traditional systems, so not all companies use them. But more and more organisations in both manufacturing and non-manufacturing industries are adopting ABC systems for a number of benefits they give which ultimately outweigh their costs.

Ascertainment of cost and profit under ABC systems

STEP: 1 – Computation of product wise number of cost driver units for different cost drivers

	Cost drivers (only examples)	Total units	Products
	Cost drivers (only examples)	Total units	A	B	C
1	Square feet
2	Cubic feet
3	Machine hours
4	Direct labour hours
5	Setup hours
6	No. of shipments
7	No. of employees supervised
8	No. of service calls
9	Kilowatt hours (KWH)
10	No. of machine breakdowns

STEP: 2 – Computation of activity cost per Cost Driver Unit (CDU)

	Activities (only examples)	Total activity cost (Rs)	Cost drivers (only examples)	Total no. of CDU	Activity cost per CDU (Rs)
1	Designing		Square feet
2	Distribution		Cubic feet
3	Mfg		M/c hours
4	Admn		D/L hours
5	Setup of m/c		Setup hours
6	Shipment		NO. of shipments
7	Supervising		NO. of employees supervised
8	After-sales service		NO. of service calls
9	Power consumption		KWH
10	Breakdown maintenance		NO. of m/c breakdowns

CDU = Cost Driver Unit

STEP: 3 – Preparation of statement showing total cost and profit

Particulars	Total (Rs)	Product A (Rs)	Product B (Rs)	Product C (Rs)
*DIRECT COSTS:*
Direct material
Direct labour
Other direct expenses
TOTAL (A)
*INDIRECT COSTS* *(ACTIVITY-BASED):*
Designing
Distribution
Manufacturing
Administration
Setup of machine
Shipment
Supervising
After-sales service
Power consumption
Breakdown maintenance
TOTAL (B)
TOTAL COST (A + B)
SALES
PROFIT

Part B

Illustration: 1

The budgeted overheads and cost driver volumes of XYZ Limited are as follows:

Cost Pool (Activity)	Budgeted Overheads	Cost Drivers	Budgeted Volume
Material Procurement	5,80,000	No. of orders	1,100
Material Handling	2,50,000	No. of movements	680
Set-up	4,15,000	No. of set ups	520
Maintenance	9,70,000	Maintenance hours	8,400
Quality Control	1,76,000	No. of inspections	900
Manufacturing	7,20,000	No. of machine hours	24,000

The company has produced a batch of 2,600 components of AX-15. Its material cost was Rs 1, 30,000 and labour cost Rs 2, 45,000.

The usage activities of the said batch are as follows.

Material orders – 26, maintenance hours – 690, material movements – 18, inspection – 28, set ups – 25, machine hours – 1,800.

Required:

1. Calculate cost driver rates that are used for tracing appropriate amount of overheads to the said batch, and

2. Ascertain the cost of batch of components using Activity Based Costing.

Solution: 1

Illustration: 2

A company produces four products, viz. P, Q, R and S. The data relating to production activity are as under:

Product	Qnty of Prodn (uts)	Mat cost p.u. (Rs)	Lab hrs p.u.	M/c hrs p.u.	Lab cost p.u. (Rs)
P	1,000	10	1	0.5	6
Q	10,000	10	1	0.5	6
R	1,200	32	4	2	24
S	14,000	34	3	3	18

Production overheads are as under:

	Rs
(i) Overheads applicable to manufacturing activity	1,49,700
(ii) Overheads relating to ordering materials	7,680
(iii) Set up costs	17,400
(iv) Administration overheads for spare parts	34,380
(v) Material handling costs	30,294

The following further information has been compiled:

Product	No of set ups	No of mat orders	No of times mat handled	No of spare parts
P	3	3	6	6
Q	18	12	30	15
R	5	3	9	3
S	24	12	36	12

Required:

(i) Select a suitable cost driver for each item of overhead expense and calculate the cost per unit of cost driver.

(ii) Using the concept of activity based costing, compute the factory cost per unit of each product.

Solution: 2

Illustration: 3

Trimake Limited makes three main products, using broadly the same production methods and equipment for each. A conventional product costing system is used at present, although an Activity Based Costing (ABC) system is being considered. Details of the three products, for typical period are:

Product	Lab hrs p.u.	M/c hrs p.u.	Mat cost p.u. (Rs)	Volume (units)
X	0.5	1.5	20	750
Y	1.5	1	12	1,250
Z	1	3	25	7,000

Direct labour costs Rs 6 per hour and production overheads are absorbed on a machine hour basis. The rate for the period is Rs 28 per machine hour.

You are required:

(a) To calculate the cost per unit for each product using conventional methods.

Further analysis shows that the total of production overheads can be divided as follows:

	%
Costs relating to set-ups	35
Costs relating to machinery	20
Costs relating to materials handling	15
Costs relating to inspection	30
Total production overhead	100