ABC COSTING LECTURE Notes

This is a relative new approach to costing. It was pioneered by Professors Kaplan and Cooper of
Harvard University .
Traditionally all overheads are absorbed on production volume activities such as labour or
machine hours.. Therefore high volume products get charged with most of the overheads and
short run production gets lower overheads. But short run production may require more overheads
due to cost associated with frequent set ups, retooling, production planning etc.
ABC seeks to overcome the above problem by relating support overheads to product cost based
on specific factors known as cost drivers instead of production volume. Cost Drivers are
activities that drive cost. Example :COST ACTIVITY
Inspection
Production Planning
Set Up Cost

COST DRIVER
No. of Production Run
No. of Production Run
No. of Production Run

Despatch Dept
Invoice Dept.

No. of Despatches
No. of Despatches

Purchasing Dept.

No. of of Purchase Orders

Technical Dept
No. of Engineering Changes
Production Planning
No. of Engineering Changes
.
The principle of ABC Costing is that some overhead overhead cost does not vary with
production volume. Using ABC costing a product consist of its diredt cost plus a share of
overheads related to the number of cost driver units the production causes.
STEPS IN DEVELOPING AN ABC SYSTEM
(1) Identify the main activities in an organization e.g.
Material Handling
Purchasing
Despatch
Assembly
(2) Identify the factors which determine the costs of an activity. These are called cost drivers.
(3) Collect the cost of each activity known as Cost Pools or Cost Centres.
(4) Charge support overheads to products based on their usage of activity
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EXAMPLE 1
Cost Pool

Purchasing Cost
Number of Purchase Order

$200,000
1,000 Orders

Cost Driver Rate

200,000/1000
= $2,000

Cost driver

For every order placed an overhead of $2,000 will be charged to the product or the job,
EXAMPLE 2
Cost Pool

Budgeted
Overhead

Material
Procurement
Material
Handling
Set Up
Maintenance
Quality
Control
Machinery

Cost Driver

Budgeted
Volume

1,100

No. of Orders

4,500

1,100,000 =
4,500

$244 per order

1.850

No. of
Movements

2,750

1,850,000 =
2,750

900

No. of Set-ups

525

$673 per
movement
$1,714 per set-up

2,650

Maint. hours

21,000

$000

2,300
3,600

No. of
inspections
No. of
Machine hrs

8,500
125,000

Cost Driver
Rate

900,000 =
525
2,650,000 =
21,000
2,300,000 =
8,500
$3,600,000 =
125,000

$126 per hour

$271 per
inspection
$28.8 per hr

A Batch of 4,200 Part # X528 had a direct cost (material and labour) of $363,500 and usage of
activities as follows:84
49
22
610
90
1,060

Material orders
Material movements
Set-ups
Maintenance hours
Inspections
Machone hours

What was the cost of the batch using ABC?

Solution
Cost of Batch of 4,200 Part No. x5288
Direct Cost

$363,500

Overheads
84 Material orders @ $244
49 Material movements @$673
22 Set-ups@$1,714
610 Maintenance hours@$126
90 Inspections@$271
1,060 Machine hours@$28.80
Batch Cost

$20,496
32,977
37,708
76,860
24,390
30,528

222,959
$586,459

EXAMPLE 3
The following details have been recorded for 4 batches made in a period:
Batch
Output in units
Cost per batch
Direct Material
Direct Labour
Labour hours
per batch

A
250
$
1650
9200

B
60
$
750
1520

C
200
$
2100
6880

D
120
$
900
2400

1150

190

860

300

The total production overhead for the period has been analysed as follows:$
14,600
6,800
8,250
5,850
6,200
8,300
50,000

Machine related costs

Materials handling & dispatch
Stores
Inspection quality control
Set-up
Engineering support

Cost drivers have been identified for the cost pools as follows:Cost pool
Machine costs
Materials handling & dispatch
Stores
Inspection quality control
Set-up
Engineering support

Cost driver
Machine hours
Materials movements
Requisitions raised
No. of inspections
No. of set-ups
Engineering hours
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The following cost driver volumes were recorded in the batches:Batch

Machine hrs per batch
Materials movements
Requisitions raised
No. of inspections
No. of set-ups
Engineering hours

A
520
180
40
18
12
65

B
255
70
21
8
7
38

C
610
205
43
13
16
52

D
325
40
26
8
8
35

Total
1710
495
130
47
43
190

Required
(a) The batch and unit costs using traditional costing based on a labour hours overhead
absorption rate
(b) The batch and unit costs using ABC
(c) Compare the costs in (a) and (b)
(d) Comment on the likely position if the firm uses cost-plus pricing
SOLUTION
(a) The batch and unit costs using traditional costing based on a labour hours overhead
absorption rate
Labour hour OAR

$50,000
1,150 + 190 + 860 + 300

Batch
Output in units
Cost per batch
Direct Material
Direct Labour
= Prime Cost
+ Overhead (Labour hrs x OAR)
Total Batch Cost
Unit Cost

A
250
$
1650
9200
10850
23000
33850
135.40

B
60
$
750
1520
2270
3800
6070
101.17

= $20 per hour

C
200
$
2100
6880
8980
17200
26180
130.9

D
120
$
900
2400
3300
6000
9300
77.50

(b) The batch and unit costs using ABC

Calculation of Cost Driver Rates
Cost Driver

Cost Pool/Total no. of Cost

Driver Volume
$14,600/1,710
$6,800/495
$8,250/130
$5,850/47
$6,200/43
$8,300/190

Machine hrs
Materials movements
Requisitions raised
No. of inspections
No. of set-ups
Engineering hours

Cost Driver Rate

$8.54 per hour
$13.74 per movement
$63.46 per requisition
$124.47 per inspection
$144.19 per set-up
$43.68 per hour

Batch Unit Costs using ABC

Batch
A
B
C
D
Quantity
250
60
200
120
$
$
$
$
Prime Cost
10850
2270
8980
3300
(520 4441
(255 2178
(610)
(325)
5209
2775
Machine hrs @$8.54
Mat. Move @ $13.74
Reqns raised @$63.46
No of insp. @. $124.47
No.of set-ups @$144.19
Engineer. hrs @ 43.68
Total Overheads
Total batch Cost
Unit Cost

)
(180
)
(40)
(18)
(12)
(65)

2473
2538
2240
1730
2839
16261
27111
108.44

)
(70)
(21)
(8)
(7)
(38)

962

(205)

2817

(40)

550

1333
996
1009
1660
8138
10408
173.47

(43)
(13)
(16)
(52)

2729
1618
2307
2271
16951
25931
129.65

(26)
(8)
(8)
(35)

1650
996
1153
1529
8653
11953
99.61

(c) Compare the costs in (a) and (b)

Batch A
Trad.
ABC
$
$
135.40
108.44

Batch B
Trad.
ABC
$
$
101.17
173.47

Batch C
Trad.
ABC
$
$
130.9.
129.65

Batch D
Trad.
ABC
$
$
77.50
99.61

It will be seen that in this example there are significant differences between the costs using the
two systems. Batch C's costs are broadly the same but the costs of Batch B and D are much
higher using ABC, whereas Batch A is lower.
Study of the usage of support overheads by the batches shows that Batches B and D have a higher
relative usage of resources so incur greater overhead costs using ABC. Because the traditional
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method absorbs overheads on labour hours these differences in usage are effectively ignored. It
is this feature which, it is claimed, makes product costs more realistic when ABC is used.
(d) Comment on the likely position if the firm uses cost-plus pricing
Cost-plus pricing is a pricing method where a margin (say 40%) is added to costs to produce the
selling price. Cost-plus pricing is widely used in many jobbing and batch production firms.
If the firm in the example uses cost-plus pricing then the quoted selling prices will differ
considerably depending on whether the traditional or ABC method was used to calculate costs. If
it is accepted that the ABC costs are the more realistic then serious errors in pricing may occur if
the traditional costs were used as the basis. This would mean that, based on traditional costs,
Batch A would be over-priced and Batches B and D under-priced.
In effect, if pricing decisions were based on the less realistic costs then Batch A products would
be subsidising Batch B and Batch D products and, in the long run, the firm would tend to receive
more orders for the under-priced B and D products. This would be likely to lead to declining
profits as these products place relatively higher demands on resources which should be reflected
in higher prices.
NOTE
Prime costs are gathered from labour and material bookings on the shop floor and, in the case of
expenses, from invoice or cash book analysis. Overheads can be charged to jobs either by
the traditional methods using labour or machine hour absorption rates or by various cost
driver rates using ABC. At present, overhead attribution by labour or machine hour rates is
more common but this may change in the future if the use of ABC becomes more widespread.
Activity Based Costing (ABC)
Costing systems can vary in terms of which costs are assigned to cost objects and their levels of
sophistication. Typically cost systems are classified as follows:
Direct costing systems
Traditional absorption costing systems
Activity based costing systems
Direct costing systems only assign direct cost to cost objects. Hence they report contribution to
indirect cost. Both absorption costing and ABC systems assign indirect cost to cost objects
ABC systems versus Absorption Costing systems
Both the ABC system and the Overhead absorption system use a two stage allocation process. In
the first stage of the absorption costing system allocates overheads to production and service
departments and then reallocates service department costs to the production departments. An
ABC system assigns overheads to each major activity (rather than departments). With ABC
systems, many activity based cost centres (alternatively known as cost pools) are established,
whereas with absorption costing systems overheads tend to be pooled by departments, although
they are normally described as cost centres.
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Activities consist of the aggregation of many different tasks and are described by verbs
associated with objects. Typical support activities include : schedule production, set up machines,
move materials, purchase materials, inspect items, process supplier records, expedite and
customer orders. Production process activities include machine products and assembly products.
Within the production process, activity cost centres are often identical to cost centres used by
absorption costing systems, such as when the purchasing department and activity are both treated
as cost centres. Overall .however ABC systems will normally have a greater number of cost
centres.
The second stage of the two stage allocation process allocates costs from cost centres to products
or other chosen cost objects. Absorption costing systems assign overheads to products using a
small number of second stage cost drivers, which vary directly with the volume produced.
Instead of using the term 'cost driver' the term overhead absorption rates is used. Direct labour
hours and machine hours are the volume bases normally used by absorption costing systems.
In contrast ABC systems use many second stage cost drivers, including non volume based cost
drivers such as the number of production runs for production scheduling and the number of
purchase orders for the purchasing activity. A further distinguishing feature is that absorption
costing systems allocate service (support) costs to production centres. Their cost are merged with
the production department cost and thus included in the production department overhead rates. In
contrast, ABC systems tend to establish separate cost driver rates for service or support centres
,and assign the cost of support activities directly to cost objects without any reallocation to
production departments.
Therefore the major distinguishing features of ABC systems are that they rely on a greater
number of cost centres and second stage drivers.By using a greater number of cost centres and
cost drivers that cause activity resource consumption , and assigning activity costs to cost objects
on the basis of cost driver usage ,ABC systems can more accurately measure the resources
consumed by cost objects. Absorption costing systems report less accurate costs because they use
cost drivers where no cause - and-effect relationship exist to assign support(service) costs to cost
objects.

(A)TRADITIONAL COSTING SYSTEMS

Overhead cost accounts
(for each category of expenses , eg depreciation)
First stage allocations

Cost centre
1
(Normally Depts.)

Cost centre
2
(Normally Depts.)

Cost centre
3
(Normally Depts.)

Second stage allocation (direct labour hours or machine hours)

Cost objects (products, Jobs and services)
ACTIVITY BASED COSTING SYSTEMS
Overhead cost accounts
(for each category of expenses , eg depreciation)
First stage allocations

Activity Cost
Centre 1

Activity Cost
Centre
2

Second stage allocation (activity cost drivers)

Cost objects (products, Jobs and services)

Designing the ABC systems

Four steps are involved in designing an ABC system:
Identify the major activities that take place in the organization;
8

Activity Cost
Centre
3

Assigning costs to cost pools or cost centres for each activity

Determining the cost driver for each major activity
Assigning the cost of activities to products according to the products demand for
activities

1. Identifying Activities
Activities are composed of the aggregation of units of work or tasks and are described by verbs
associated with the tasks. For example purchasing of materials might be identified as separate
activity. This activity consist of the aggregation of many different tasks, such as receiving a
purchase request, identifying suppliers, preparing purchase orders, mailing purchase orders and
performing follow ups.
Activities are identified by carrying out an activity analysis. A useful starting point is to examine
a physical plan of the work place (to identify how all work space is being used) and the payroll
listings (to ensure all relevant personnel have been taken into account) This examination
normally has to be supplemented by a series of interviews with the staff involved ,or have staff
complete a time sheet for a specific period explaining how their time is spent.
2.Assigning cost to Activity Cost Centres
After the activities have been identified the cost of resources consumed over a specified period
must be assigned to each activity. The aim is to determine how much the organization is
spending on each of its activities. Many of the resources will be directly attributable to specific
activity centre (such as labour) may be indirect and jointly shared by several activities. These
costs should be assigned to activities on the basis on the basis of cause- and -effect cost drivers,
or interviews with staff who can provide reasonable estimates of the resources consumed by
different activities. Cause- and -effect cost drivers used at this stage to allocated shared resources
to individual activities are called resource cost drivers.
3. Assigning Appropriate Cost Drivers for assigning the cost of activities to Cost Objects
In order to assign the cost attached to each activity cost center to products a cost driver must be
selected for each activity centre, Cost drivers used at this stage are called activity cost drivers.
Several factors must be borne in mind when selecting a suitable cost driver. First, it should
provide a good explanation of costs in each activity cost pool. Second, a cost driver should be
easily measurable, the data should be relatively easy to obtain and be identifiable with products.
Activity cost drivers consist of three types:

transaction drivers
duration drivers
intensity drivers

Transaction drivers, such as the number of purchase orders processed, number of customer
orders processed , number of inspections performed and the number of set ups undertaken, all
count the number of time an activity is performed. Transaction drivers are the least expensive
type of cost driver but they are also likely to be the least accurate because they assume that the
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same quantity of resources is required every time an activity is performed. However if the
variation in the amount of resources required by individual cost objects is not great transaction
cost drivers will provide a reasonable accurate measurement of activity resources consumed. If
this condition does not apply then duration cost drivers should be used.
Duration drivers represent the amount of time required to perform an activity. Examples of
duration drivers include set up hours and inspection hours. For example if one product requires a
short set up time and another requires a long set up time then using set up time as the cost driver
will more accurately measure activity resource consumption than the transaction
driver(numberof set up) which assumes that an equal amount of activity resources are consumed
by both products. Using the number of set ups will result in the product that requires a long set
up time being undercosted whereas the product that requires a short set up time will be
overcosted This problem can be overcome by using set up hours as the cost driver, but this will
increase the measurement costs.
Intensity drivers directly charged for the resources used each time an activity is performed.
Whereas duration drivers establish an average hourly rate for performing an activity, intensity
drivers involve direct charging based on the actual activity resources committed to a product. For
example, if activities require unskilled and skilled personnel a duration driver would establish an
average hourly rate to be assigned to products whereas an intensity driver would record the
actual or estimated for each type of personnel and assign the specific resources to the products.
4. Assigning the Cost of Activities to Products
The final stage involves applying the cost driver rates to products. Therefore the cost driver must
be measurable in a way that enables it to be identified with individual products. Thus if set up
hours are selected as a cost driver .there must be a mechanism for measuring the set up hours
consumed by each product. Alternatively, if the number of set ups is selected as the cost driver
measurements by products are not required since all the products that require a set up are charged
with a constant set up cost. The ease and cost of obtaining data on cost driver consumption by
products is therefore a factor that must be considered during the third stage when a cost driver is
being selected.
Lecture Question 1
Sager, a chocolate manufacturer, produces three products:
The good bar, a bar of solid milk chocolate.
The bad bar, a fondant filled milk chocolate egg.
The ugly Bar, a biscuit and nougat based chocolate bar.
Information relating to each of the products is as follows:
Good
0.10
0.15
500,000
0.001
0.01

Direct labour hours cost per unit ($)

Direct Material cost per unit
($)
Actual production/sales (units)
Direct labour hours per unit
Direct machine hours per unit
10

Bad
0.15
0.20
150,000
0.01
0.04

Ugly
0.20
0.25
250,000
0.005
0.02

Sales Price per unit

Annual production overheads: $100,000

0.50

0.45

0.55

Required:
Using traditional absorption costing, calculate the full production cost per unit and the
profit per unit of each product. Comment on the implications of the figures calculated.

Lecture Question 2
Sager, a chocolate manufacturer, produces three products:
The good bar, a bar of solid milk chocolate.
The bad Egg, a fondant filled milk chocolate egg.
The ugly Bar, a biscuit and nougat based chocolate bar.
Information relating to each of the products is as follows:
Good
Bad
Direct labour hours cost per unit ($)
0.10
0.15
Direct Material cost per unit
($)
0.15
0.20
Actual production/sales (units)
500,000
150,000
Direct labour hours per unit
0.001
0.01
Direct machine hours per unit
0.01
0.04
Production set ups
2
2
Component costs
5
5
Number of customer orders
20
5
Sales Price per unit
0.50
0.45
Annual production overheads: $100,000
The overheads are sub-divided into:

Machining cost
Number of production set
ups

10,000.00

Component costs

20,000.00

Packing costs

40,000.00

30,000.00

100,000.00
Required:

11

Ugly
0.20
0.25
250,000
0.005
0.02
26
20
25
0.55

a. Using traditional absorption costing, calculate the full production cost per unit and the
profit per unit of each product. Comment on the implications of the figures calculated.
b. Calculate overheads using ABC

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