Advanced costing methods

Chapter learning objectives

Upon completion of this chapter you will be able to:
 explain what is meant by the term cost driver and identify appropriate cost
drivers under activity based costing (ABC)
 calculate costs per driver and per unit using (ABC) ,compare ABC and traditional
methods of overhead absorption based on production units, labour hours or
machine hours

Reasons for the development of ABC

 Absorption costing is based on the principle that production overheads are driven
by the level of production. This is because the activity level in the OAR
calculation can be units, labour hours or machine hours. These all increase as
the level of production increases. This was true in the past, because businesses
only produced one simple product or a few simple and similar products. The
following points should be remembered:

 Overheads used to be small in relation to other costs in traditional

manufacturing
 In addition, production overheads, such as machine depreciation, will have been
a small proportion of overall costs. This is because production was more labour
intensive and, as a result, direct costs would have been much higher than
indirect costs. A rough estimate of the production overhead per unit was
therefore fine.
Overheads are now a larger proportion of total costs in modern Manufacturing
 Accordingly , manufacturing has become more machine intensive and, as a
result, the proportion of production overheads, compared to direct costs, has
increased. Therefore, it is important that an accurate estimate is made of the
production overhead per unit.
 The nature of manufacturing has changed significantly. Many companies must
now operate in a highly competitive environment and, as a result, the diversity
and complexity of products has increased.

Comparing ABC with traditional methods

Traditional systems measure accurately volume related resources that are consumed in
proportion to the number of units produced of the individual products. Such resources
include direct materials, direct labour, energy, and machine related costs.

However, many organisational resources exist for activities that are unrelated to physical
volume. Non volume related activities consist of support activities such as materials
handling, material procurement, setups, production scheduling and first item inspection
activities.

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 Traditional product cost systems, which assume that products consume all activities in
proportion to their production volumes, thus report distorted product costs.

Despite the virtue that both traditional absorption costing and activity based Costing
systems adopt a two stage allocation process, the differences can be listed as follows:

Traditional costing:
(1) For overhead allocation, ABC establishes separate cost pools for support activities
such as material handling. As the costs of these activities are assigned directly to
products through cost driver rates, accordingly the reapportionment of service
department costs is avoided.

Traditional costing:

Stage Stage PRODUCT

Service Production Departments 2
1 LINES
Departments

Absorbing costs using a

Assigning costs using measure of volume
measures of service usage

ABC in action

1
Service
Departments
& 1 Activity cost Product lines
2
pool
Factory
overheads

Assigning costs of Absorbing costs using

individual activities costs drivers

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Overhead absorption into products is where the main difference lies between ABC and
traditional costing. Traditional absorption costing uses two absorption bases, (labour hours
or machine hours) to charge overhead to products, whereas ABC uses many cost drivers as
absorption bases (e.g. the number of orders, or the number of despatches.)

The use of cost drivers is the main idea behind ABC as they highlight what causes costs to
increase for example, the number of orders to suppliers each product incurs.

Overheads that do not vary with volume/output , but with some other activity, should be
traced to products using ABC cost drivers. Traditional absorption costing, on the other
hand, allows overheads to be related to products in more arbitrary ways – therefore
producing less accurate product costs.

Illustration
Pen Factories
Consider two hypothetical plants turning out a simple product: Ballpoint pens. The factories
are the same size and have the same capital equipment.

Every year, plant I makes 1 million units of only one product: blue pens. Plant II, a fullline
producer, also produces blue pens, but only 100,000 a year. Plant II also produces a variety
of similar products: 80,000 black pens, 30,000 red pens, 5,000 green pens, 500 lavender
pens, and so on. In a typical year, plant II produces up to 1,000 product variations, with
volumes ranging between 100 and 100,000 units. Its aggregate annual output equals the 1
million pens of plant I.

The first plant has a simple production environment and requires limited manufacturing
support facilities. With its higher diversity and complexity of operations, the second plant
requires a much larger support structure. For example 1,000 different products must be
Scheduled through the plant, and this requires more people for:
 scheduling the machines
 performing the setups
 inspecting items
 purchasing, receiving and handling materials
 handling a large number of individual requests.

Expenditure on support overheads will therefore be much higher in the second plant, even
though the number of units produced and sold by both plants is identical. Furthermore,
since the number of units produced is identical, both plants will have approximately the
same number of direct labour hours, machine hours and material purchases.

The much higher expenditure on support overheads in the second plant cannot therefore
be explained in terms of direct labour, machine hours operated or the amount of materials
purchased.

Traditional costing systems, however, use volume bases to allocate support overheads to
products. In fact, if each pen requires approximately the same number of machine hours,

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direct labour hours or material cost, the reported cost per pen will be identical in plant II.
Thus blue and lavender pens will have identical product costs, even though the lavender
pens are ordered, manufactured, packaged and despatched in much lower volumes.

The small volume products place a much higher relative demand on the support
departments than low share of volume might suggest. Intuitively, it must cost more to
produce the low volume lavender pen than the high volume blue pen. Traditional volume
based costing systems therefore tend to over cost high volume products and under cost low
volume products. To remedy this discrepancy ABC expands the second stage assignment
bases for assigning overheads to products.

Calculating the full production cost per unit using ABC

There are five basic steps:
Step 1: Group production overheads into activities, according to how they
are driven.
A cost pool is an activity which consumes resources and for which overhead costs are
identified and allocated. For each cost pool, there should be a cost driver. The terms
‘activity’ and
‘cost pool’ are often used interchangeably.
Step 2: Identify cost drivers for each activity, i.e. what causes these activity
costs to be incurred.
A cost driver is a factor that influences (or drives) the level of cost.
Step 3: Calculate an OAR for each activity.
The OAR is calculated in the same way as the absorption costing OAR. However, a separate
OAR will be calculated for each activity, by taking the activity cost and dividing by the total
cost driver volume.
Step 4: Absorb the activity costs into the product.
The activity costs should be absorbed back into the individual products.
Step 5: Calculate the full production cost and/ or the profit or loss.
Some questions ask for the production cost per unit and/ or the profit or loss
per unit.
Other questions ask for the total production cost and/ or the total profit or loss

Illustration 1: Tisa Co
Tisa Co operates an activity-based costing system and has forecast the following information for
next year.

Cost Pool Cost Cost Driver Number of Drivers

Production set-ups $105,000 Set-ups 300
Product testing $300,000 Tests 1,500
Component supply and storage $25,000 Component orders 500
Customer orders and delivery $112,500 Customer orders 1,000

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General fixed overheads such as lighting and heating, which cannot be linked to any specific
activity, are expected to be $900,000 and these overheads are absorbed on a direct labour hour
basis. Total direct labour hours for next year are expected to be 300,000 hours.

Tisa Co expects orders for Product MM next year to be 100 orders of 60 units per order and 60
orders of 50 units per order. The company holds no inventories of Product MM and will need to
produce the order requirement in production runs of 900 units. One order for components is
placed prior to each production run. Four tests are made during each production run to ensure
that quality standards are maintained.

The following additional cost and profit information relates to product MM: Component cost:
$1.00 per unit
Direct labour : 10 minutes per unit at $7.80 per hour , Profit mark up: 40% of total unit cost

Required:
1 Calculate the activity-based recovery rates for production set ups and product testing.

2 Calculate the activity-based recovery rates for component supply and storage, and customer
orders and delivery.

3 Calculate the general overhead per unit and the direct labour cost per unit of Product MM.

Advantages and disadvantages of ABC

ABC has a number of advantages:
 It provides much better insight into what drives overhead costs.
 ABC can be used just as easily in service costing as in product costing
 It provides a more accurate cost per unit. As a result, pricing, sales strategy,
performance management and decision making should be improved.
 ABC recognizes that overhead costs are not all related to production and sales
volume.
 In many businesses, overhead costs are a significant proportion of total costs, and
management needs to understand the drivers of overhead costs in order to manage
the business properly. Overhead costs can be controlled by managing cost drivers.
 It can be applied to derive realistic costs in a complex business environment.
 ABC can be applied to all overhead costs, not just production overheads.

Some potential criticism of ABC

 The benefits obtained from ABC might not justify the costs. In some situations, ABC
does not provide very different information from traditional absorption costing.
 It is impossible to allocate all overhead costs to specific activities.
 The choice of both activities and cost drivers might be inappropriate.
 ABC will be of limited benefit if the overhead costs are primarily volume related or if
the overhead is a small proportion of the overall cost.
 ABC can be more complex to explain to the stakeholders of the costing exercise.

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Illustration 2 Aspire limited company
Aspire ltd makes and sells two products, the Put and the Call. The direct costs of production
are $12/u of Put and $24/u of Call. Information relating to annual production and sales is
as follows:
Put Call
Annual production and sales 24,000 units 24,000
units
Direct labour hours per unit 1.0 1.5
Number of orders 10 140
Number of batches 12 240
Number of setups per batch 1 3
Special parts per unit 1 4

Information relating to production overhead costs is as follows: Other overhead costs do

not have an identifiable cost driver, and in an ABC system, these overheads would be
recovered on a direct labour hours basis.
Cost driver Annual cost
$
Setup costs Number of setups 73,200
Special parts handling Number of special parts 60,000
Other materials handling Number of batches 63,000
Order handling Number of orders 19,800
Other overheads – 216,000
432,000
Required
(a) Calculate the production cost per unit of Put and of call if the company uses traditional
absorption costing and the overheads are recovered on a direct labour hours basis.
(b) Calculate the production cost per unit of Put and of call if the company uses ABC.
(c) Comment on the reasons for the differences in the production cost per unit between the
two methods.
(d) What are the implications for management of using an ABC system instead of an
absorption costing system?

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