Cambridge AS & A Level9706

Activity based costing (ABC) (A Level)

Accounting 9706 Chapter Notes

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Activity based costing (ABC) (A Level)
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In this chapter

  1. 1Introduction to Activity-Based Costing (ABC)
  2. 2The ABC Calculation Method
  3. 3ABC for Strategic Decision-Making
  4. 4Evaluating ABC: A Balanced View

1. Introduction to Activity-Based Costing (ABC)

Traditional costing methods, like absorption costing, often use a single, broad-brush rate (like direct labour hours) to spread overheads across all products. This can be inaccurate, especially in a modern business with diverse products and complex processes. Activity-Based Costing (ABC) is a more modern and precise method. It works on a simple principle: activities consume resources, and products consume activities. ABC identifies the major activities within a business, groups the costs of those activities into 'cost pools', and then shares out those costs to products based on how much each product uses the activity. The measure of use is called a 'cost driver'. This results in a much fairer and more realistic product cost.

Key term

Cost Driver: An activity or event that causes a cost to be incurred; it is the factor that links an activity's cost to a product.

Examiner insight

Examiners reward students who can clearly explain *why* ABC provides a more accurate cost allocation than traditional methods, focusing on the link between activities and costs.

Common pitfall

Confusing a cost pool (the total cost of an activity, e.g., $50,000 for inspections) with a cost driver (the measure of the activity, e.g., the number of inspections).

Fun fact

Hospitals use ABC to determine the true cost of patient care. A routine check-up has a very different cost profile from major heart surgery, and ABC helps the hospital understand and manage these costs effectively.

Worked example 13 marks

A furniture manufacturer has identified three key activities that incur overheads: materials handling, machine processing, and quality assurance. The total costs for these activities are $50,000, $120,000, and $30,000 respectively. For each activity, suggest a suitable cost driver.

  1. 1

    Activity 1: Materials Handling. This cost is driven by the movement of materials. A suitable cost driver would be the 'number of material requisitions' or 'number of deliveries received'.

  2. 2

    Activity 2: Machine Processing. This cost is driven by the use of machinery. A suitable cost driver would be 'machine hours'.

  3. 3

    Activity 3: Quality Assurance. This cost is driven by the need to check products. A suitable cost driver would be the 'number of inspections' or 'number of quality tests performed'.

Recap

  • ABC is an alternative to traditional absorption costing for allocating overheads.
  • It provides a more accurate calculation of product costs.
  • A 'cost pool' is a collection of overhead costs related to a single activity.
  • A 'cost driver' is the activity that causes the cost in the cost pool to be incurred.
  • ABC links costs to products based on the product's consumption of activities.

Quick check

  1. What is the difference between a cost pool and a cost driver?2 marks
  2. Suggest a cost driver for the 'order processing' cost pool.1 mark

2. The ABC Calculation Method

Calculating product costs using ABC is a logical, step-by-step process that ensures overheads are allocated accurately. The goal is to calculate a specific overhead charge for each activity and then apply it to the products that use that activity.

The Steps:

  1. Identify Activities and Cost Pools: Group factory overheads into the activities that cause them (e.g., machine set-ups, quality inspections).
  2. Identify Cost Drivers: For each cost pool, determine the most appropriate cost driver (e.g., number of set-ups, number of inspections).
  3. Calculate the Cost Driver Rate: For each activity, divide the total cost in the cost pool by the total volume of the cost driver. This gives you a cost per activity unit.
  4. Allocate Overheads to Products: Multiply the cost driver rate by the number of driver units consumed by each product. Sum these amounts to find the total overhead for each product.
  5. Calculate Unit Cost: Add the total allocated overheads to the product's direct costs (materials and labour) and divide by the number of units produced.

Cost Driver Rate = Total Cost in Cost Pool / Total Volume of Cost Driver

Overhead Allocated to Product = Cost Driver Rate × Number of Drivers Consumed by Product

Total Cost per Unit = (Total Direct Costs + Total Allocated Overheads) / Total Units

Key term

Cost Driver Rate: The rate used to charge overheads from a cost pool to a product, calculated by dividing the total cost in the pool by the total volume of the cost driver.

Common pitfall

Using the total number of production units as the denominator when calculating the cost driver rate, instead of the total volume of the cost driver itself (e.g., total setups, total inspection hours).

Worked example 16 marks

Style Co makes two types of jeans: Skinny and Baggy. Budgeted production is 10,000 Skinny and 8,000 Baggy. The accountant has identified the following activities, costs, and drivers:

ActivityCost Pool ($)Cost DriverSkinnyBaggyTotal Drivers
Machine set-up66,000Number of set-ups5070120
Machine maintenance100,000Machine hours8001,2002,000
Quality control50,000Number of checks1,0001,5002,500

Calculate the total overhead to be allocated to one unit of Skinny jeans.

  1. 1

    Step 1: Calculate Cost Driver Rates

  2. 2

    Machine set-up rate = $66,000 / 120 set-ups = $550 per set-up

  3. 3

    Machine maintenance rate = $100,000 / 2,000 hours = $50 per machine hour

  4. 4

    Quality control rate = $50,000 / 2,500 checks = $20 per check

  5. 5

    Step 2: Allocate Overheads to the Skinny Jeans Product Line

  6. 6

    Machine set-up cost = $550 per set-up × 50 set-ups = $27,500

  7. 7

    Machine maintenance cost = $50 per hour × 800 hours = $40,000

  8. 8

    Quality control cost = $20 per check × 1,000 checks = $20,000

  9. 9

    Total overhead for Skinny = $27,500 + $40,000 + $20,000 = $87,500

  10. 10

    Step 3: Calculate Overhead Cost Per Unit

  11. 11

    Overhead per unit of Skinny = Total overhead for Skinny / Units of Skinny

  12. 12

    Overhead per unit of Skinny = $87,500 / 10,000 units = $8.75

Recap

  • First, calculate the rate for each cost driver by dividing the cost pool by the total driver volume.
  • Next, allocate overheads to each product by multiplying the driver rate by the product's usage of that driver.
  • Sum the allocated overheads for each product to find its total overhead cost.
  • To find the unit overhead cost, divide the total allocated overhead by the number of units produced.
  • Always double-check you are using the total driver volume, not the number of units, to find the driver rate.

Quick check

  1. A cost pool for purchasing is $20,000. The cost driver is 'number of purchase orders', and there are 500 orders in total. What is the cost driver rate?2 marks

3. ABC for Strategic Decision-Making

The primary benefit of ABC's accuracy is that it empowers managers to make better-informed strategic decisions. Traditional costing can distort profitability, leading to poor choices. ABC provides a clearer picture, particularly in areas like pricing, product mix, and cost control. For example, a product that appears profitable under absorption costing might be revealed as loss-making under ABC. This happens because ABC correctly assigns a high share of overheads (like machine setups or engineering support) to complex, low-volume products which traditional methods often miss. This effect is known as cross-subsidisation, where simple, high-volume products are over-costed and appear less profitable, effectively subsidising the under-costed complex products.

Profit per Unit = Selling Price per Unit - Total ABC Cost per Unit

Key term

Cross-subsidisation: An effect of inaccurate cost allocation where one product's reported costs are artificially low, making it seem more profitable, while another's are artificially high.

Examiner insight

Top marks are awarded for answers that use the results of ABC calculations to make a clear, justified recommendation. Don't just state the numbers; explain what they mean for the business and what action should be taken.

Worked example 16 marks

Letters Limited makes Product A and Product B. Using absorption costing, both products appear to have a profit of $50 per unit. After performing ABC analysis, the cost of Product A is found to be $180 and the cost of Product B is $65. The selling prices are $200 for A and $100 for B. Advise management on its product strategy.

  1. 1

    Step 1: Calculate Profit per Unit using ABC

  2. 2

    Profit for Product A = Selling Price - ABC Cost = $200 - $180 = $20 per unit.

  3. 3

    Profit for Product B = Selling Price - ABC Cost = $100 - $65 = $35 per unit.

  4. 4

    Step 2: Compare ABC results with Absorption Costing results

  5. 5

    Under absorption costing, both products seemed equally profitable ($50 profit).

  6. 6

    ABC reveals that Product A is significantly less profitable ($20) than previously thought, and Product B is more profitable ($35) than Product A, though less than the original $50 estimate.

  7. 7

    Step 3: Provide Advice to Management

  8. 8

    The company was likely over-pricing Product B and under-pricing the more complex Product A.

  9. 9

    Management should investigate why Product A consumes so many overhead resources. They could seek to raise its price, reduce its activity consumption (e.g., by simplifying its design), or consider discontinuing it if it cannot be made more profitable.

  10. 10

    Product B is more profitable than A. The company could focus marketing efforts on Product B.

Recap

  • ABC provides more accurate product costs, leading to better decisions.
  • It helps in setting realistic selling prices that cover all costs.
  • ABC can identify unprofitable products that may have appeared profitable under other methods.
  • It helps to eliminate cross-subsidisation between products.
  • Managers can use ABC data to target activities for cost reduction and efficiency improvements.

Quick check

  1. Explain how ABC can help a company improve its pricing strategy.2 marks
  2. What is product cross-subsidisation?2 marks

4. Evaluating ABC: A Balanced View

While ABC offers significant advantages in accuracy, it is not always the best choice for every business. Management must weigh the benefits against the drawbacks. The decision to implement ABC is a strategic one that depends on the company's products, processes, and competitive environment.

Key term

Cost-Benefit Analysis: The process of comparing the projected costs and benefits of a project or decision to determine if it is worthwhile.

Examiner insight

Evaluation questions require a balanced argument. A good answer will discuss both the advantages and disadvantages of ABC in the context of the specific business in the question, before arriving at a justified conclusion.

Common pitfall

Stating that ABC is always 'better' than absorption costing. The correct evaluation is that it is 'more accurate' but also more complex and costly, so its suitability depends on the specific business context.

Worked example 14 marks

A small bakery makes two products: bread and cakes. Production is simple and overheads are very low, mostly consisting of rent and the baker's salary. Would you recommend the bakery use Activity-Based Costing? Justify your answer.

  1. 1

    Recommendation: It is unlikely to be worthwhile for the bakery to use ABC.

  2. 2

    Justification (Disadvantages outweigh Advantages):

  3. 3
    1. Low Overheads: Since overheads are a small part of the total cost, even a more accurate allocation will not significantly change the final product cost. The main costs are direct (flour, sugar, etc.).
  4. 4
    1. Simplicity: The production process is not complex, and the two products likely consume overheads in similar proportions. Traditional costing is probably 'good enough'.
  5. 5
    1. Cost and Complexity of ABC: Implementing ABC would be time-consuming and costly for a small business owner, requiring them to identify activities, drivers, and perform complex calculations. The benefits of slightly more accurate information would not justify this effort.
  6. 6

    Conclusion: In this case, the costs and complexity of implementing ABC would almost certainly outweigh the very limited benefits.

Recap

  • Advantage: ABC provides a fairer and more realistic allocation of overheads.
  • Advantage: It gives managers a better understanding of what drives costs, leading to better cost control.
  • Advantage: It is excellent for complex manufacturing environments with diverse products.
  • Disadvantage: ABC is time-consuming and expensive to implement and maintain.
  • Disadvantage: It can be difficult to identify appropriate cost drivers for all activities.
  • Disadvantage: The benefits may not be worth the cost for simple businesses or those with low overheads.

Quick check

  1. State two reasons why a business may choose to use ABC.2 marks
  2. State two reasons why a business may decide against using ABC.2 marks

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Define the terms 'cost pool' and 'cost driver' in the context of Activity-Based Costing.4 marks
  2. A company's factory maintenance cost pool is $150,000. The cost driver is machine hours. Total machine hours for the period are 7,500. Calculate the cost driver rate for factory maintenance.2 marks
  3. Explain why ABC is considered to provide a 'fairer' allocation of overheads compared to traditional absorption costing.4 marks
  4. List two advantages and two disadvantages of implementing an Activity-Based Costing system.4 marks
  5. Tech Ltd produces two products, a Basic model and a Pro model. The purchasing department has overheads of $80,000. The cost driver is the number of component orders. The Basic model requires 150 orders and the Pro model requires 650 orders. How much of the purchasing overhead should be allocated to the Pro model?4 marks
  6. A company finds that after switching to ABC, the cost of its high-volume, simple product has decreased, while the cost of its low-volume, complex product has increased. Explain the term that describes this effect and why it occurs.5 marks
  7. Pristine Plc makes two cleaning products: 'Sparkle' and 'Gleam'. Budgeted overheads, activities and other data are as follows: | | Total | Sparkle | Gleam | |---|---|---|---| | Production Units | | 20,000 | 5,000 | | Set-up Costs | $100,000 | 40 set-ups | 160 set-ups | | Inspection Costs | $75,000 | 600 inspections | 900 inspections | | Direct Costs per unit | | $10 | $12 | Calculate the full cost per unit for one bottle of 'Gleam' using Activity-Based Costing.8 marks
  8. Using the data from the previous question for Pristine Plc, calculate the full cost per unit for 'Sparkle'. Comment on the relative profitability of the two products if Sparkle sells for $15 and Gleam sells for $30.6 marks
  9. The manager of a large, multi-product manufacturing firm is considering switching from absorption costing (using machine hours) to ABC. Advise the manager on this decision, considering both financial and non-financial factors.8 marks
  10. A special order for 1,000 units of a product is received. The price offered is $45 per unit. Using ABC, the full cost of the product is calculated as $48 per unit ($20 direct costs, $28 allocated overheads). The activities required for the special order are minimal and would only incur $5,000 of the overheads. Advise whether the order should be accepted. Justify your decision with calculations.6 marks

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