Ngee Ann Polytechnic

Accounting for Decision Making

WEEK 1 (2022): COST ACCOUNTING TECHNIQUES PART 1

Introduction – Cost Item, Cost Object, Cost Behaviour, Functional Income Statement

Absorption Costing Systems – Job Order and Process Costing

Absorption cost systems ensure that ALL manufacturing costs (i.e. DM, DL and FOH) are directly traced or
allocated to the various products made. Absorption cost systems are widely used in financial reporting
for calculating the book value of inventory and cost of goods manufactured (In week 2, we will touch on
the variations of absorption methods - full cost method vs variable cost method).

There are basically two types of absorption systems: Job Order system and Process Cost system. Job
order costing is used in departments that produce output in distinct jobs or batches. Job order costing is
also widely used in assembly processes. A job might consist of a single unit, such as the construction of
an office building, or a batch of units, such as 200 windshield wiper motors for automobiles.

In a service organisation, a job might be handling a client’s lawsuit or processing a loan application at a
bank. The cost of each job is tracked separately, and job order cost systems accumulate costs by jobs.

Alternatively, some assembly processes and continuous flow production processes use Process costing.
Production in these settings e.g. soft drink producers and oil refining is continuous and distinct batches
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do not exist. Costs are assigned to the production processes and ultimately to the products flowing
through the various processes.

With either system, all manufacturing costs are assigned to the products produced.

A. Job Order Costing

To illustrate job order costing in a manufacturing setting, consider a plant that produces multiple
products. Each product is produced in a batch requiring different raw material inputs and different
classes of direct labour. Moreover, the products utilise various combinations of common resources such
as machines, supervisors, engineers, and factory space.

Every job manufactured passes through a common machining process. The time spent in this machining
centre is recorded for each job and used to allocate overhead costs to the job. Each job has a job order
cost sheet that records the costs attached to the products produced in the batch and the number of
machine hours spent processing the job.

Cost Flows through the T-Accounts

Job order cost sheets allow the assignment of all factory costs to the jobs flowing through the factory. As
jobs enter the factory and remain in process, direct labour costs and direct materials costs are posted to
job sheets, normally via a computer system.

Modern factories can have hundreds or even thousands of jobs in various stages of completion in the
factory at any one time. The accounting system tracks the costs charged to each job by posting them to
ledger accounts via the usual mechanics of double-entry bookkeeping.

The image shows the flow of costs among the various T-accounts. When a job is finished and transferred
to finished goods inventory, the total job cost from the job order cost sheet is transferred out of the work
in-process T-account and into the finished goods T-account.
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The overhead T-account contains all indirect labour (supervisors as well as factory workers who are not
working on jobs because they are either in training programmes, setting up or maintaining machines, or
idle), indirect materials (supplies not directly assignable to particular jobs), and other factory costs. Other
factory costs include insurance, property taxes, depreciation, production accounting costs, purchasing,
security, general factory management and utilities.

These costs represent the common resources used by all jobs. In a typical plant, direct labour is about
30% of total factory costs, direct materials another 30%, and factory overheads 40%. However, these
percentages can vary widely. Direct labour can be aslow as 1% of total manufacturing costs and
overheads as high as 80%. The FOH T-account is a control account. It is used to temporarily accumulate
and then
distribute the indirect costs to the jobs. At the end of the accounting period, any remaining balance in
this account must be charged to a balance sheet or income statement account.

Allocating Overheads to Jobs

The most interesting aspect of costing is its treatment of factory overheads because it involves
management’s judgement and offers managers discretion in product costing and income determination.
If all resource utilisation and factory costs could be traced directly to the products consuming those
resources, then cost accounting would be nothing more than arithmetic. The innovation of job order
costing is the accumulation of all indirect costs in an FOH account and the subsequent distribution of
these costs to individual jobs through the use of an overhead rate.

Allocation of factory overheads is an important topic (applies to both Job Order and Process Costing
Systems) and will be covered from page 4.

B. Process Costing: The Extent of Averaging

An oil refinery is a continuous flow production process with no jobs. Crude oil is fed in and various
petroleum products, from gasoline to asphalt, are produced in (roughly) continuous streams. If the
production process does not have jobs, how are costs accumulated? In such continuous flow production
processes, all costs are averaged via an allocation process, not unlike overhead allocations in a job order
cost system.

Process costing is an extreme case of averaging. It is job order costing with one job. Since the production
process is a continuous flow operation, discrete jobs do not exist. In process costing, costs are assigned
to identical products that undergo a series of manufacturing processes in a continuous flow. These
processes are usually organised as separate cost centres.

Costs are assigned to products flowing through each process (weighted average basis). Total
manufacturing costs must be allocated among units still in work-in-process, as well as units transferred
out of the plant to finished goods inventory or cost of goods sold.

Process costing is inherently simpler and less costly to maintain than job order costing because one does
not have to account forseparate jobs. On the other hand, the information provided isfar more
aggregated and often less useful for decision making. In particular, costs for individual jobs are not
available and hence cannot be used to evaluate cost trends across different jobs of similar products.

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1. Volume-Based or Traditional allocation

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Most firms use prospective, not actual, overhead rates.

Suppose overhead is charged to jobs based on the total actual machine hours used in the plant for the
entire year. Then, the total cost of each job (including overhead) is unavailable until the end of the year.
The overhead costs for the first job cannot be determined until all the jobs are finished.

For example, suppose the first job completed in the year uses 1,000 machine hours and overhead is
assigned based on actual machine hours. Overhead on the first job could be 1% of actual overhead if
actual total hours for the year end up being 100,000 hours or 2% if the final number of machine hours is
50,000 hours.

Using a prospective overhead rate allows timelier reporting of total costs, including indirect costs.

In this example, factory volume is measured in labour hours, not units of production. That is, volume is
being measured with an input measure, not an output measure. This practice is common in most plants.
Inputs are used to measure volume because most plants produce heterogeneous products. If a factory
manufactures small pumps and large pumps, the number of pumps manufactured can give a misleading
measure of plant output. Plant volume can actually fall while the total number of pumps increases if
there is a shift from large to small pumps. Therefore, an input measure rather than an output measure
captures volume in plants manufacturing heterogeneous products.

The input measure selected (direct labour hours, machine hours, direct material dollars, direct labour
dollars) is usually the one that has the greatest association or cause-and-effect relation with overhead.

That is, the allocation base is the factor input most correlated with overhead. Overheads comprise both
fixed and variable factory overheads.

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Practice Question 1:
High Desert Potteryworks makes a variety of pottery products that it sells to retailers. The company uses
a job-order costing system in which departmental predetermined overhead rates are used to apply
factory overheads to jobs. The predetermined overhead rate in the Molding Department is based on
machine hours, and the rate in the Painting Department is based on direct labour-hours. At the beginning
of the
year, the company provided the following estimates:

Department
Molding Painting
Direct labour-hours 12,000 60,000
Machine-hours 70,000 8,000
Fixed manufacturing overhead cost $497,000 $615,000
Variable manufacturing overhead per machine-hour $1.50 -
Variable manufacturing overhead per direct labour-hour - $2.00

Job 205 was started on August 1 and completed on August 10. The company's cost records show the
following information concerning the job:

Department
Molding Painting
Direct labour-hours 30 84
Machine-hours 110 20
Direct materials $ 770 $ 1,332
Direct labour cost $ 525 $ 1,470

Required:
1. Compute the predetermined overhead rates used in the Molding Department and the Painting
Department.
2. Compute the total overhead cost applied to Job 205.
3-a. What would be the total manufacturing cost recorded for Job 205?
3-b. If the job contained 50 units, what would be the unit product cost?

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Volume-based costing can be a good strategic choice for some firms. It is generally appropriate when
common costs are relatively small or when activities supporting the production of the product or service
are relatively homogeneous across different product lines. For example, a firm that manufactures a
limited range of paper products or a firm that produces a narrow range of agricultural products. Similarly,
a professional service firm e.g. law firm, accounting firm may not need ABC because labour costs for the
professional staff are the largest cost of the firm, and labour is also easily traced to clients (the cost
object).

2. Activity-Based Costing Allocation (ABC)

Learning Objective:
Explain the strategic role of activity-based costing (ABC)

Activity-based costing (ABC) is a method for improving the accuracy of cost determination. While ABC is
a relatively recent innovation in cost accounting, it has been adopted by companies in varying industries
and within government and not-for-profit organisations.

Suppose you, Joe and Don are product managers at a plant that manufactures furniture. There are three
product lines. Don is in charge of sofa manufacturing, Joe handles dining room tables and chairs, and
you are in charge of bedroom furniture.

The direct materials and labour costs are traced directly to each product line. Also, there are indirect
manufacturing costs (FOH) that are associated with activities that cannot be traced to a single product,
including materials acquisition, materials storage and handling, product inspection, manufacturing
supervision, job scheduling, equipment maintenance, and fabric cutting.
However, the usage of these activities is not proportional to the number of units produced so some
managers will be overcharged and others undercharged under the Volume-based approach.

For example, suppose Don insists on more frequent inspections of his production; then he should be
charged a higher proportion of overhead (inspection) than that based on units alone. Moreover, why
should you pay any portion of fabric cutting if your bedroom furniture does not require fabric?

One solution is to use activity-based costing to charge these indirect costs to the products, using detailed
information on the activities that make up the indirect costs - inspection, fabric cutting, and materials
handling.

Learning Objective:
Describe activity-based costing, the steps in developing an ABC system, and the benefits of an ABC
system.

To develop a costing system, we need to understand relationships among resources, activities, and
products or services.

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Resources are used to perform activities, and products or services are a result of activities. Many of the
resources used in an operation can be traced to individual products or services and identified as direct
materials or direct labour costs.

Most overhead costs relate only indirectly to final products or services. A costing system identifies costs
with activities that consume resources and assigns resource costs to cost objects - such as products,
services, or intermediate cost pools based on activities performed for the cost objects.

A cost driver is a factor that causes or relates to a change in the total cost of an activity. Because cost
drivers cause or relate to cost changes, measured or quantified amounts of cost drivers are excellent
bases for assigning resource costs to activities and for assigning the cost of activities to cost objects.

Examples of resource consumption cost drivers are the number of items in a purchase or sales order,
changes in product design, and square feet of occupied space.

Examples of activity consumption cost drivers are the number of machine hours in the manufacturing of
product X or the number of batches used to manufacture product Y.

What Is Activity-Based Costing?

Activity-based costing (ABC) is a costing approach that assigns resource costs to cost objects such as
products, services, or customers based on activities performed for the cost objects. The premise of this
costing approach is that a firm’s products or services are the result of activities, and activities require
resources, which have costs.

Costs of resources are assigned to activities based on the activities that use or consume resources
(resource consumption drivers), and costs of activities are assigned to cost objects based on activities
performed for the cost objects (activity consumption drivers). See picture on next page.

ABC recognises the causal or direct relationship between resource costs, cost drivers, activities, and cost
objects in assigning costs to activities and then to cost objects.

ABC assigns factory overheads costs to cost objects such as products or services by identifying the
resources and activities as well as their costs and amounts needed to produce output.

Using resource consumption cost drivers, a firm determines the resource costs consumed by activities,
calculates the cost of a unit of activity, and then assigns the cost of an activity to cost objects by
multiplying the cost of each activity by the amount of the activity consumed by each of the cost objects.

The Two-Stage Cost Assignment Procedure

The first stage assignsfactory overhead coststo activities by using appropriate resource consumption cost
drivers. The second stage assigns the costs of activities to cost objects using appropriate activity
consumption cost drivers that measure the demands cost objects have for the activities.

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By using cost drivers in both the first- and second-stage cost assignments, activity-based costing systems
provide more accurate measures of product or service costs for the cost of activities that are not
proportional to the volume of outputs produced.

Resources Activities Products (Cost Object)

DM, DL DM, DL direct trace

Step 2 - Cost Driver:
Step 1 - Cost Driver:
Indirect Mat - Product design ------- Allocated FOH
Resource Activity consumption e.g. no of set ups required,
Indirect labour - Machine set up consumption e.g. allocated to Cost objects
Utilities - Quality Control team Factory rent -
Materials handling
space per sq feet,
Depreciation - Product Packaging allocated to
Activities

a.k.a. Cost Pools

With the above, the unit cost of product X and Y (including DM, DL, FOH) can be obtained. Gross margin
by product can be ascertained.

Step 1: Identify Resource Costs and Activities (FOR YOUR OWN READING)
Most firms record resource costs in specific accounts in the accounting system. These accounts are often
based upon the underlying function of the resources that are included, such as purchasing, marketing,
and office supplies. The first step in the ABC process is to determine which of the resources in each of
the accounts is consumed by the identified activities.

The costs of the resources consumed for a particular activity may be only a small part of the costs in a
particular account. For example, a single factory supplies account may include the cost of resources
consumed by several different manufacturing operations.

Also, the resourcesto perform an activity may come from several accounts. For example, order
fulfillment might require resources from warehousing, shipping, and billing accounts.

An activity analysis identifies the work performed to carry out a firm’s operations. It includes gathering
data from existing documents and records, as well as collecting additional data using questionnaires,
observations, or interviews of key personnel.

Questions that ABC project team members typically ask employees or managers in gathering activity
data include the following:

• What work or activities do you do?

• How much time do you spend performing these activities?
• What resources are required to perform these activities?
• What value does the activity have for the product, service, customer, or organisation?

With the help of industrial engineers and management accountants, the team also collects activity data
by observing the work performed and making a list of all the activities involved.
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Levels of Activities
To identify resource costs for various activities, a firm classifies all activities according to the way in which
the activities consume resources.

1. A unit-level activity is performed for each individual unit of product orservice of the firm. Consider
the activity of inserting a component. This activity is required for each unit produced, so the activity
level varies in direct proportion to the quantity of the cost object produced. As a result, unit-level
activities are essentially be volume-based.

2. A batch-level activity is performed for each batch, or group, of products or services, regardless of how
many units are in a batch.

Examples of batch-level activities are setting up machines, placing purchase orders, scheduling
 production, conducting inspections by batch, handling materials by batch, and expediting production.

Cost of setting up a machine is the same regardless of whether the batch contains one 1 or 1,000 items.

3. A product-level activity supports the production of a specific type of product or service, regardless of
number of batches or number of units produced.

Examples of product-level activitiesinclude designing products, purchasing partsrequired for

products, and engaging in engineering changes to modify products.

4. A facility-level activity supports operations in general. These activities are not caused by products or
customer service needs and cannot be traced to individual units, batches, or products.

Examples of facility-level activities include providing security for the plant, performing maintenance
of general purpose machines, and incurring factory property taxes/insurance. Some firms refer to
these activities as business or infrastructure-sustaining activities.

Step 2: Assign Resource Costs to Activities

Activities drive the consumption of resources, so the next step is to use resource consumption drivers to
assign resource costs to activities. A firm should choose resource consumption cost drivers based on
cause-and-effect relationships.

Typical resource consumption cost drivers include the number of

• Labour hours for labour-intensive activities
• Employees for payroll-related activities
• Setups for batch-related activities
• Moves for materials-handling activities
• Machine hours for machine repair and maintenance
• Square feet for general maintenance and cleaning activities

Ideally, the cost of resources is directly traced or assigned to activities, which requires measuring the
actual usage of resources by an activity.

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For example, power used to operate a machine can be traced directly to that machine’s operation by
reading the meter attached to the machine. When direct tracing is not available, department managers
and supervisors need to estimate the amount or percentage of time (or effort) employees spend on each
identified activity.

Step 3: Assign Activity Costs to Cost Objects

The final step is to assign costs of activities to items of interest, generically called cost objects, based on
the appropriate activity consumption cost drivers. The cost objects are the outputs resulting from the
firm’s activities and, typically, are products or services; however, customers, projects, and even business
units can be cost objects.

For example, the cost objects of an insurance company may be individual insurance policies sold to
 customers, claims processed, and types of policies offered, insurance agents, or divisions of the
company.

Among the major benefits of activity-based costing that many firms have experienced from the improved
information are:

1. Better profitability measures. ABC provides more accurate and informative product costs, leading to
more accurate product and customer profitability measurements.

2. Better decision making. ABC provides more accurate measurements of activity-driving costs, helping
managers to improve product and process value by making better product design decisions and
better customer support decisions and fostering value-enhancement projects.

3. Process improvement. The ABC system provides the information necessary to identify areas where
process improvement is needed. Improved product costs lead to better estimates of costs for
budgeting and planning.

4. Identification of the cost of unused capacity. Because many firms have seasonal and cyclical
fluctuations in sales and production, there are times when plant capacity is supplied but not used.
This can mean that costs are incurred for activities at the batch, product, and facility levels but are not
used. ABC systems provide better information to identify the cost of unused capacity and maintain a
separate accounting for this cost.

Each of these benefits can contribute significantly to a company’s competitiveness by helping the
company make better decisions and implement its strategy.

Learning Objective: Determine product costs under both the volume-based method and the
activity-based method and contrast the two.

Haymarket BioTech Inc. (HBT) produces and sells two secure communications systems, AW(Anywhere)
and SZ (SecureZone). AW uses satellite technology and allows customers to communicate anywhere on
the earth. SZ uses similar technology but only allows communication between two parties that are within
10 miles of each other. HBT’s customers are governmental and corporate customers for which these
products are critical; the customers rely on HBT’s ability to quickly adapt its products to threats from

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devices that would compromise the security of the products. SZ has been successful for nearly 10 years
and has undergone a number of improvements in this time; sales are expected to continue to grow at 8–
10% per year. AW, a more recent product, has also been successful, but demand has not been as strong
and sales growth is expected to be 3–5% per year.

Because of the higher profitability of the AW system, HBT is considering an extensive advertising
campaign to boost sales of AW and is making plans for reallocating manufacturing facilities from SZ to
AW to make this possible.

HBT has the following operating data for the two products:
 AW SZ
Production volume 5,000 20,000
Selling price $400 $200
Unit direct materials and labour $200 $80
Direct labour hours 25,000 75,000
Direct labour hours per unit 5.00 3.75

Volume-based costing:
The volume-based costing system assigns FOH based on direct labour hours (DLH). The firm has total
budgeted FOH of $2,000,000. Because the firm budgeted 100,000 direct labour hours for the year, the
FOH rate is $20 per direct labour hour:

Total FOH $2,000,000

Total DLH 25,000 + 75,000 = 100,000
FOH rate per DLH $ 20.00
The firm uses 25,000 direct labour hours to manufacture 5,000 units of AW, so the FOH assigned to AW is
$500,000 in total and $100 per unit:
Total FOH assigned to AW $20 × 25,000 = $500,000
Number of units of AW 5,000
FOH per unit of AW $ 100.00

The FOH for SZ is $1,500,000:

Total FOH assigned to SZ $20 × 75,000 = $1,500,000
Number of units of SZ 20,000
FOH per unit of SZ $ 75.00

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Below shows a product profitability analysis using the firm’s volume-based costing system.

AW SZ
Unit selling price $400 $200
Unit manufacturing cost:
Direct materials and labour $200 $80
Factory overhead 100 75
Cost per unit 300 155
 Gross margin $100 $ 45
Gross margin % 25% 22.5%

Activity-based costing:
To be able to assign activity costs to cost objects, HBT identified the following activities, budgeted costs,
and activity consumption cost drivers in steps 1 and 2 of the ABC method.
Activity Budgeted Cost Activity Consumption Cost Driver
Engineering $ 125,000 Engineering hours
Setups $300,000 Number of setups
Machine operation $1,500,000 Machine hours
Packing orders $75,000 Number of packing orders
Total $2,000,000
HBT also gathered the following operating data pertaining to each of its products:
AW SZ Total
Engineering hours 500 750 1,250
Number of setups 200 100 300
Machine hours 50,000 100,000 150,000
Number of packing orders 5,000 10,000 15,000
Using the preceding data, the cost driver rate for each activity consumption cost driver is calculated as
follows:
(2) Budgeted Activity Activity
(1) Budgeted Cost Consumption Consumption Rate
Activity (3) (4) = (2) ÷ (3)
Engineering $ 125,000 1,250 hours $100 Setups $300,000 300
setups $1,000 Machine operations $1,500,000 150,000 machine
hours $10 Packing orders $75,000 15,000 orders $5

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Factory overhead costs are assigned to both products by these calculations:

AW (5,000 units)

Activity (3) (4) = (2) × (3) (5)

(1) Consumption Activity Total Overhead per
Activity Rate Consumption Overhead Unit
(2)
Engineering $ 100 500 hours $ 50,000
 Setups $1,000 200 setups $200,000 (intensive setup!) Machine operations $10 50,000 hours
$500,000 Packing orders $5 5,000 orders $25,000 Overhead cost per unit $775,000 $155 SZ
(20,000 units)
(2) (3) (4) = (2) × (3) (5)
(1) Activity Activity Total Overhead per
Activity Consumption Consumption Overhead Unit
Rate
Engineering $ 100 750 hours $ 75,000
Setups $1,000 100 setups $100,000 (less intensive setup) Machine operations $10 100,000
hours $1,000,000
Packing orders $5 10,000 orders $50,000
Overhead cost per unit $1,225,000 $61.25

The comparison shows that the volume-based product costing system significantly undercosts AW and
overcosts SZ when considering the actual overhead consumption of the two products. This
overcosting/undercosting is sometimes called cross subsidisation. Often, the cross-subsidisation is in the
direction of undercosting the low-volume products (as for AW) and overcosting the high-volume
products (as for SZ) using the volume-based approach.

The reason is that the non volume-based ABC costs are averaged over a larger number of units for high
volume products, thus bringing the costs of these products down.
AW SZ
Unit selling price $400.00 $200.00 Unit manufacturing cost
Direct materials and labour $200.00 $80.00 Factory overhead
Engineering $ 10.00 $ 3.75
Setups $40 $5.00
Machine running $100 $50.00
Packing $5 155 $2.50 61.25 Cost per unit 355 141.25 Gross margin $ 45 $ 58.75 Gross margin
% 11.25% 29.38%

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PRODUCT PROFITABILITY ANALYSIS UNDER THE ABC
COSTING SYSTEM
AW SZ
Unit overhead cost
Volume-based $100.00 $75.00
Activity-based 155.00 61.25
Difference ($ 55.00) $13.75
Gross margin
Volume-based $100.00 $45.00
Activity-based 45 58.75
 Difference ($ 55) $13.75
Gross margin Percentages
Volume-based 25% 22.5%
Activity-based 11.25% 29.38%

Summary for HBT

Distorted or inaccurate product costing can lead to inappropriate inventory valuations, unrealistic
pricing, ineffective resource allocations, misplaced strategic focus, misidentified critical success factors,
and lost competitive advantage.

1. Obtain information and conduct analyses of the alternatives. The information available to HBT under
the volume-based costing system shows a unit margin of $100 for AW and $45 for SZ, while the ABC
based costing system shows unit margins for AW and SZ of $45 and $58.75, respectively. As the ABC
system provides more comprehensive and accurate cost information, HBT should rely on the latter
figures, which show that on a unit basis the SZ product is more profitable.

2. Based on strategy and analysis, choose and implement the desired alternative. Considering the ABC
cost information and the higher margins for SZ relative to AW, the plans to promote AW and reallocate
manufacturing facilities from SZ to AW are not consistent with HBT’s long-term growth and
profitability. The firm’s best advantage for future growth and profitability would be to put resources
behind SZ rather than AW.

3. Provide an ongoing evaluation of the effectiveness of implementation. HBT should continue to

review the ABC costs and profit margins of existing and new products, together with long-term
projections of sales and customer expectations for these products, to choose the products with the
best advantage for long-term growth and profitability.

Learning Objective:
Explain activity-based management (ABM).

What Is Activity-Based Management? (FOR YOUR OWN READING)

Activity-based management (ABM) manages resources and activities to improve the value of products or
services to customers and increase the firm’s competitiveness and profitability. ABM draws on ABC as its

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major source of information and focuses on the efficiency and effectiveness of key business processes
and activities.

Using ABM, management can identify ways to improve operations, reduce costs, or increase value to
customers, all of which can enhance the firm’s competitiveness. ABM applications can be classified into
two categories: operational ABM and strategic ABM.

• Operational ABM enhances operational efficiency and asset utilisation and lowers costs; its focuses are
on doing things right and performing activities more efficiently. Operational ABM applications use
 management techniques such as activity analysis, business process improvement, total quality
management, and performance measurement. For example, in the HBT example, why must AW need
200 set ups, whereas SZ only 100 set ups? Can AW look into having less set ups to reduce the set up
cost per unit of AW?

• Strategic ABM focuses on choosing appropriate activities for the operation, eliminating nonessential
activities, and selecting the most profitable customers.

Strategic ABM applications use management techniques such as process design, customer profitability
analysis, and value-chain analysis, all of which can alter the demand for activities and increase
profitability through improved activity efficiency.

The Cost of Complexity and the Role of ABC: Lego, Nike & GM (FOR YOUR OWN READING) For Nike,
General Motors, and the LEGO Group, the strong influence of the design staff created a proliferation of
products that created additional complexity and costs without improving profits.

Nike, a leader in the sports apparel industry, discovered in 2006 that it had 30 different styles of the basic
T-shirt. The company knew, however, that 95% of the company’s apparel sales came from 40% of its
apparel products. Over several months, a design team was assigned to bring this to one design that
would be available in a variety of colours and fabrics. This was part of a company-wide effort to reduce
complexity. The goal was to reduce costs and improve overall profitability.

GM found that car models that sold less than 2,000 units were unprofitable. Even if the vehicle shared
most parts with other vehicles, there were incremental costs of engineering, sales, brochures, owner
manuals, and the like. Thus, GM, as well as Ford and Chrysler, is simplifying its model lineups.

For LEGO Group, the concern arose when sales were increasing but profits were falling. This is a common
sign of a company that could use ABC costing to identify those products that might have sales growth but
are unprofitable. LEGO found there was a proliferation of products. The solution for LEGO was to place
more emphasis on costs and to reduce the number of products and colour variety; this was
accomplished in part by requiring closer coordination between operations and design teams.

The cost of complexity as illustrated in the preceding examples is a key reason that ABC costing can play
a strategic role for these firms - it provides a way to accurately determine the cost of product variety and
other operating complexities so the firm can identify the most profitable products and operations.
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Learning Objective:
Identify key factors for successful ABC implementation.

A successful ABC implementation requires close cooperation among management accountants,

engineers, and manufacturing and operating managers. They need to act as a team in identifying
activities, cost drivers, and requisite information, both financial and nonfinancial.

Implementation Process Why This Leads to Success

 Allows them to become familiar with ABC.
Involve management and employees in creating the system because they feel included and share
an ABC system in ownership of the new system.

Shows how and why the process works.

Use ABC on a job that will succeed Keep the Successfully completing one job enables
individuals to see the benefits of ABC more
clearly.
initial ABC design simple Avoids overwhelming users and holds costs
down; also reduces implementation time.

They could then be more willing to implement

Time-driven ABC – a variation of the normal ABC allocation (FOR YOUR OWN READING) The ABC traces
and reassigns resources expenses to the activities that consume them and then further reassigns them
proportionately to the final cost objects based on quantity of each activity’s cost driver.

TDABC recognises that the common element in the utilisation of activities is the unit of time. Since
substantial amount of activities are a highly repetitive process, the cost of assignment cab be based on
the averate time required for each activity.

TDABC assigns resources costs directly to cost objects using the cost per time unit in supplying the
resource, rather than first assigning costs to activities and then from activities to cost objects e.g. Product
X, Product Y

Illustration using a credit card processing company:

• One supporting activity is the validation of mailing addresses. Cost of activity per year = $90,000,
comprising 2 workers who are paid $45,000 each
• 10,000 validations done per year
• 17 mins taken to do a validation
• Working hours per worker 30 hours per week, 50 weeks per year

Under the usual ABC, we would calculate the activity rate to be $9 per validation. We will then use this
to allocate to products based on the number of validations used - the 2 step method of ABC.

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Under TDABC, we would convert the denominator to minutes (time based), we want to determine first
the standard time for each validation.

Time available for the 2 workers = 30 hr week x 50 weeks x 60 mins x 2 pax = 180,000 mins
The TDABC rate is thus $90,000 ÷ 180,000 mins = $0.50 per minute

Cost of one validation = 17 mins x $0.50 = $8.50

The beauty of TDABC is that it can immediately calculate and measure the idle capacity.
Total activity cost = 10,000 validations x 17 mins x $0.50 $85,000
Total payroll for the 2 workers ($45,000 x 2 pax) $90,000 (we pay them more) Idle capacity cost
$5,000

OR looking at it in terms of minutes:

Total activity minutes used by the 2 workers = 10,000 x 17 mins 170,000 mins
Total capacity for the year 180,000 mins Idle capacity minutes 10,000 mins

$5,000 or 10,000 mins of unused capacity is potentially available to be used for other work.

TDABC can be expanded for further complexities, in what is called a time equation. To add on to the
above base scenario, assume it takes an additional 22 min to validate an international address

Time to validate address = 17 mins + 22 mins = 39 mins. With this, the way to calculate cost per minute is
done in the same manner as the above.

In summary, TDABC is capacity sensitive as it computes a standard activity cost using standard rates,
meaning the activity driver rates remain constant ($8.50 per validation). In contrast, ABC might not
include capacity, computes the activity each period, and therefore the final cost object’s unit cost may
fluctuate each period.

To use TDABC, significant investment is needed to measure activity times and continuously maintain
them. This is a disadvantage of TDABC. Furthermore, TDABC also hinges on the accuracy of time
estimates. Lastly, if the activity contains a majority of costs that are not time-driven e.g. indirect materials
used in the activity, these should theoretically be removed from the costs before we apply the TDABC
model.

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Practice Question 2: Full Question (25 marks) From Dec 2018 CA Qualification Mock Exam Papers
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Practice Question 3:
McCullough Hospital uses a job-order costing system to assign costs to its patients. Its direct materials
include a variety of items such as pharmaceutical drugs, heart valves, artificial hips, and pacemakers. Its
direct labour costs (e.g., surgeons, anesthesiologists, radiologists, and nurses) associated with specific
surgical procedures and tests are traced to individual patients. All other costs, such as depreciation of
medical equipment, insurance, utilities, incidental medical supplies, and the labour costs associated with
around-the clock monitoring of patients are treated as overhead costs.

Historically, McCullough has used one predetermined overhead rate based on the number of
patient-days (each night that a patient spends in the hospital counts as one patient-day) to allocate
overhead costs to patients. Recently a member of the hospital’s accounting staff has suggested using
two predetermined overhead rates (allocated based on the number of patient-days) to improve the
accuracy of the costs allocated to patients. The first overhead rate would include all overhead costs
within the Intensive Care Unit (ICU) and the second overhead rate would include all Other overhead
costs. Information pertaining to the hospital’s estimated number of patient-days, its estimated overhead
costs, and two of its patients— Patient A and Patient B—is provided below:

ICU Other Total

Estimated number of patient-days 2,000 18,000 20,000 Estimated fixed overhead cost $
3,200,000 $ 14,000,000 $ 17,200,000 Estimated variable overhead cost per patient-day $ 236 $
96

Patient A Patient B
Direct materials $ 4,500 $ 6,200
Direct labour $ 25,000 $ 36,000
Total number of patient-days (including ICU) 14 21
Number of patient-days spent in ICU 0 7

Required:
1. Assuming McCullough uses only one predetermined overhead rate, calculate:
a. The predetermined overhead rate.
b. The total cost, including direct mat, direct labour and applied overhead, assigned to Patients A and B.

2. Assuming McCullough calculates two overhead rates as recommended by the staff accountant,
calculate:
a. The ICU and Other overhead rates.
b. The total cost, including direct mat, direct labour and applied overhead, assigned to Patients A and B.

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Practice Question 4: Partial extracts (30 marks) From June 2018 CA Qualification Exam Papers BSB
Education Institute (BSB) is a new private education institution dedicated to broadening the
opportunities for Polytechnic and Junior College students to achieve alternative qualifications (for
example, fashion design) or overseas degrees in Singapore. The Director of Education (DoE) is also keen
on offering classes to help students pass business professional qualifications including those in Data
Analytics, Accounting, Banking and Finance, Human Resource Management (HRM), and Marketing. The
DoE aspires to help the younger generation achieve their personal and professional best and to nurture
future talents. BSB also offers business training to help improve productivity and performance of
organisations and their employees.

BSB has two business divisions: 1) Professional and Executive Development (PED); and 2) Diploma and
Degree Programmes (Academic). The PED division offers short courses which range from a few hours to
three months whereas the Academic division offers diploma and degree programmes (undergraduate
and postgraduate degrees) ranging from six months to three years in duration.
BSB has recruited office administrative and management staff who are working at the leased premises
where the fitted-out classrooms are located. Fixed assets have been purchased and annual fixed costs
totalling $5.3 million have been committed.
BSB is considering implementing activity-based costing to allocate the following fixed costs to the three
programmes – Diploma (D), Undergraduate (UG), and Postgraduate (PG) in its Academic division: •
Depreciation of furniture and fittings;
• Depreciation of computer equipment and software;
• Rental of premises;
• Other operating expenses; and
• Administrative labour costs (including student support e.g. career and internship).

BSB’s accountant unfortunately fell sick and requires two weeks medical leave. You are required to help
BSB with the following tasks while the accountant is away.

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Practice Question 5:

Drilling Company uses activity-based costing and provides this information:

Manufacturing Activity Cost Driver Driver Rate

Materials handling Number of parts $ 0.60
Machinery Number of machine hours 51.00
Assembly Number of parts 2.85
Inspection Number of finished units 30.00

Drilling has just completed 80 units of a component for a customer. Each unit required 100 parts and 3
machine hours. The prime cost is $1,300 per finished unit. All other manufacturing costs are classified as
manufacturing overhead.

Required:
1. Compute the total manufacturing costs and the unit costs of the 80 units just completed using ABC
costing.
Practice Question 6:
ADA Pharmaceutical Company produces three drugs—Diomycin, Homycin, and Addolin—belonging to
the analgesic (pain-killer) family of medication. Since its inception four years ago, ADA has used a direct
labour hour–based system to assign manufacturing overhead costs to products.

Eme Weissman, the president of ADA Pharmaceutical, has just read about activity-based costing in a
trade journal. With some curiosity and interest, she asked her financial controller, Takedo Simon, to
examine differences in product costs between the firm’s current costing and activity-based costing
systems.

ADA has the following budget information for the year:

Diomycin Homycin Addolin

Cost of direct materials $ 205,000 $ 265,000 $ 258,000 Cost of direct labour 250,000
234,000 263,000 Number of direct labour hours 7,200 6,800 2,000 Number of
capsules 1,000,000 500,000 300,000

ADA has identified the following activities and cost drivers and has assigned them a total overhead cost
of $200,000.
Budgeted Overhead Cost
Budgeted Cost Driver Volume
Activity Cost Driver
Machine setup Setup hours $ 16,000 1,600 Plant management Number of Workers
36,000 1,200 Supervision of direct labour Direct labour hours 46,000 16,000 Quality
inspection Inspection hours 50,400 1,050
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Order expediting Customers served 51,600 645 Total overhead $ 200,000

Takedo selected the cost drivers with the following justifications:

SETUP HOURS: The cost driver of setup hours is used because the same product takes about the same
amount of setup time regardless of size of batch. For different products, however, the setup time varies.

NUMBER OF WORKERS: Plant management includes plant maintenance and corresponding managerial
duties that make production possible. This activity depends on the number of workers. The more workers
involved, the higher the cost.

DIRECT LABOUR HOURS: Supervisors spend their time supervising production. The amount of time they
spend on each product is proportional to the direct labour hours worked.

INSPECTION HOURS: Inspection involves testing a number of units in a batch. The time varies for
different products but is the same for all similar products.
NUMBER OF CUSTOMERS SERVED: The need to expedite production increases as the number of
customers served by the company increases. Thus, the number of customers served by ADA is a good
measure of expediting production orders.

Takedo gathered the following information about the cost driver volume for each product:

Diomycin Homycin Addolin

Setup hours 200 600 800
Number of workers 200 400 600
Direct labour hours 7,200 6,800 2,000
Inspection hours 150 200 700
Customers served 45 100 500

Required:
1. Use the firm’s current costing system to calculate the total and unit cost of each product.
2. Use the activity-based cost system to calculate the total and unit cost of each product.

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