319 Resource 1(b) Activity Based Cost Management

Cost management-final 1

1(b): Activity Based Approaches to Management & Cost Analysis

Learning objective

1. Why ABC?2. Activity cost analysis & selection of cost driver3. Product pricing on the basis of activity analysis 4. Performance measurement with standard costing

Introduction:

The emergence of ABC systems During the 1950s the limitations of traditional product costing systems began to be widely publicised. These systems were designed decades ago when most companies manufactured a narrow range of products, and direct labour and materials were the dominant factory costs. Goetz (1949) advocated ABC principles first.

Need for emergence of activity based costing :

- Traditional product costing systems were designed when most companies manufactured a narrow range of products.

- Direct materials and direct labour were the dominant cost factors of production. Then their ratio with overhead was 100:20

- Companies were in sellers’ market.

- Overheads were relatively small and distortions due to inappropriate treatment were not significant.

- Cost of processing information was high.

Today companies produce a wide range of products. Overheads are considerable importance.

- Simple methods of apportioning overheads on direct labour or machine hour basis are not justified as dir cost : overhead is 100: 800.

- Intense global competition calls for correct costing of products to avoid errors in decision making. i.e. apply the cause & effect relationship.

- Traditional systems can measure volume related costs.

- Non volume related activities like material handling, set up etc. are important and their costs cannot be apportioned on volume basis.

Meaning of ABC:

Activity Based costing is an accounting methodology that assign costs to activities rather than products or services. This enables resources & overhead costs to be more accurately assigned to products & services that consume them.

In order to correctly associate costs with products & services, ABC assign cost to activities based on their use of resources. It then assign cost to cost objects, such as products or customers, based on their use of activities. ABC can track the flow of activities in organization by creating a link between the activity (resource consumption) and the cost object. The flow is characterized through four core areas:


1. Cost object2. cost drivers3. Resource cost drivers4. Activity cost drivers

In order to understand how ABC operates it is necessary to understand the meaning of above terms.

Definitions:

A cost object: It is an item for which cost measurement is required e.g. a product or a customer.

A cost Driver: It is a measure of the quantity of resources consumed by an activity. It is used to assign the cost of a resource to an activity or cost pool.An Activity Cost Driver: It is a measure of the frequency and intensity of demand, placed on activities by cost objects. It is used to assign activity costs to cost objects.

The cost driver for business functions viz,. Research & Development and customer Service are as below:

Business functions: Cost Driver

Research & Development -- Number of research products-- Personal hours on a project-- Technical complexities of projects

Customer Service -- Number of Service calls-- Number of products serviced-- Hours spent on servicing products.

In traditional costing overheads are first related to cost centers (production & service centers) and then to cost objects i.e. products. In ABC overheads are related to activities or grouped into cost pools (depending on the terminology preferred). Then they are related to the cost objects, e.g., products. The two processes are, therefore, very similar, but the first stage is different as ABC uses activities instead of functional departments (cost centers). The problem with functional departments is that they tend to include a series of different activities, which incur a number of different costs that behave in different ways. Activities also tend to run across function; for instance, procurement of materials often includes raising a requisition note in a manufacturing department or stores. It is not raised in the purchasing department where most procurement costs are incurred. Activity costs tend to behave in a similar way to each other i.e., they have the same cost driver. Therefore, ABC gives a more realistic picture of the way in which costs behave.

As with traditional absorption costing ABC rates are calculated in advance, normally for a year ahead, and so the same rates are used for a year at a time. The advantage of this is that any seasonal variations will be spread giving an average cost. If this was not done and actual rates were used the absorption rates would vary monthly. This would mean that when output was high the overhead rate would be low and vice versa; if pricing were based on cost the prices quoted would be higher when the business was slack.

Stages in Activity Based Costing:

The different stages in activity based costing are listed below:


1. Identification of the activities that may take place in an organization: Usually the number of cost centers that a traditional overhead system uses are quite small, say up to fifteen. In ABC the number of activities will be much more, say 200; the exact number will depend on how the management sub-divides the organization’s acidities. It is possible to break the organization down into many very small activities. But if ABC is to be acceptable as practical system it is necessary to use larger groupings, so that, say, 40 activities may be used in practice. The additional number of activities over cost centers means that ABC should be more accurate than the traditional method regardless of anything else.

2. Assigning costs to cost pool for each activity: Both support and primary activities, that caused them. This creates ‘cost pools’ or ‘cost buckets’. This will be done using resource cost drivers that reflect causality.

3. Support activities are then spread across the primary activities: on some suitable base, which reflects the use of the support activity. The base is the cost driver that is the measure of how the support activities are used.

4. Determine the cost drivers for each activity: That will be used to relate the overheads collected in the cost pools to the cost objects/products. This is based on the factor that drives the consumption of the activity. The question to ask is-What causes the activity to incur costs? In production scheduling, for example, the driver will probably be the number of batches ordered.

5. Assigning the costs of activities to products according to product demand for activities: The requires to calculate cost driver rate for each activity, just as an overhead absorption rate would be calculated in the traditional system:

Activity cost driver rate = Total cost of activity ÷Activity driver

The activity driver rate can be used to cost product, as in traditional absorption costing, but it can also cost other cost objects such as customers/customers segments and distribution channels. The possibility of costing objects other than products is part of the benefit of ABC. The activity cost driver rates will be multiplied by the different amount of each activity that each product/other cost object consumes.

Cost flow in activity based costingResources: Staff wages Electricity Advertising(Resource cost drivers)

Support activities:

(Activity cost drivers) Cost objects Products/ Customer Distribution Services Segments Channels

i iii

ii

i ii iii


Activities basically fall into four different categories, known as the manufacturing cost hierarchy. These categories are generally accepted today but were first identified by Copper (1990), The categories of activities help to determine the type of activity cost driver required.

The categories of activities are:

1. Unit level activities: The costs of some activities (mainly primary activities) are strongly correlated to the number of units produced. For example, the use of indirect materials/consumables tends to increase in proportion to the number of units produced. Another example of a unit level activity is the inspection or testing of every item produced, if this was deemed necessary or, perhaps more likely, every 100th item produced.

2. Batch level activities: The cost of some activities (mainly manufacturing support activities) are driven by the number of batches of units produced. Examples of this are:

Material ordering-where an order is placed for every batch of production. Machine set-up costs- where machines need resetting between each different batch of production.

Inspection of products- where the first item in every batch is inspected rather than every 100th

item quoted above.3. Product level activities: The costs of some activities (often once only activities) are driven

by the creation of a new product line and its maintenance, for example, designing the product, producing parts specifications and keeping technical drawings of products up to date. Advertising costs fall into this category if individual products are advertised rather than the company’s name.

4. Facility level activities: Some cost cannot be related to a particular product line, instead they are related to maintaining the buildings and facilities. Examples are the maintenance of buildings, plant security, business rates, etc. Also included in this category are salaries, such as the production manager’s. Advertising campaigns the promote the organization would also be included.

The first and last categories above are the same as those in traditional absorption costs and so if an organization costs are mainly made up of these two categories ABC, will not improve the overhead analysis greatly. But if the organization’s costs fall mainly in the second and third categories an ABC analysis will provide a different and more accurate analysis.

Benefits ABC is more expensive than the traditional system. So a cost-benefit analysis is desirable. The benefits of ABC are many.

1. In ABC managers focus attention on activities rather than products because activities in various departments may be combined and costs of similar activities ascertained e.g. quality control, handling of materials, repairs to machines, etc

2. Costs are identified with activities and then allocated to products or services, based on appropriate cost drivers. So more accurate product/service costs are obtained Since overhead or indirect costs occupies a significant proportion of the total costs of the firm, the overall impact of allocation of indirect costs to products/ services more accurately is significant.

3. Managers manage activities and not products . Change in activities lead to changes in costs. Therefore, if the activities are managed well, costs will fall and resulting products will be more competitive.


4. To manage activities better and to make wiser economic decisions, managers need to identify the relationships of activities and costs in a more detailed and accurate manner.

5. ABC highlights problem areas that deserve management’s attention and more detailed analysis.

Some important activities & cost driver :

Activity Cost Driver

Machine set-up Number of set up / set up hrsNumber of production runs

Purchase materials Number of orders placedNumber of components

Warehousing Items in stock/ wt. / volume

Material handling Number of moves or partsNumber of material moves

Inspection Inspection per item

Quality testing Hours of test timeReceiving material Number of receiving orders

Packing Number of packing ordersStore delivery Number of store deliveries

Research & Development Number of research projects Personal hours on a project Technical complexities of projects.

Customer Service Number of service calls. Hours spent on servicing product

Engineering Production orderDesigning cost No. of New job or production order

Weakness of ABC

ABC is not free from certain weakness. They are mentioned below:

1. ABC fails to encourage managers to think about changing work processes to make business more competitive.

2. ABC does not conform to generally accepted accounting principles in some areas. For example, ABC encourages allocation of such non-product costs as research and development to products while committed product costs such as factory depreciation and not allocated to products.

3. Using ABC for short-run decisions may sometimes prove costly in the long run. In a competitive environment (when other companies may be willing to meet the customers’ needs); long term profits may suffer due to elimination of small orders.

4. ABC does not encourage the identification and removal of constraints creating delays and excesses.


Activity Based cost system installation and operation:

The motives for pursuing an ABC implementation, or at least of investigating its feasibility, must be established at the outset. Most commonly these will be:

1. To improve product costing where a belief exists that existing methods under cost some products and over cost others; or

2. To identify non-value-adding activities in the production process which might be a suitable focus for attention or elimination.

In practice, the former is the most quoted goal, even though the latter may be more appropriate. This is especially so for firms which are highly labour intensive and which do not have a great diversity of products in their range, and where allocation of overhead based on direct labour hours may already function efficiently.

Direct costs, like materials and direct labour, are easily assigned directly to products. Some indirect costs, particularly those selling costs which are product specific (e.g. advertising), may be directly assigned to the product too. The remaining indirect costs are those which are problematical and provide the focus for ABC, with resource costs indirectly assigned to the cost object via cost pools and activity drivers.

A number of distinct practical stages in the ABC implementation are as follows:

1. Staff training: The co-operation of the work force is critical to the successful implantation of ABC. They are closest to the process and most aware of the problems. Staff training should be, as far as possible, jargon-free, & create an awareness of the purpose of ABC. It should be non-threatening in nature, stressing that increased efficiencies resulting from a successful implementation will mean rewards not redundancies. The need for the co-operation of staff in the concerted team effort, for mutual benefit, must be emphasized throughout the training activity.

2. Process specification: Informal, but structured, interviews with key members of personal will identify the different stages of the production process, the commitment of resources to each, processing times and bottlenecks. The interviews will yield a list of transactions which may, or may not, be defined as ‘activities’ at a subsequent stage, but in any case provide a feel for the scope of the process in the entirety.

3. Activity definition: The problem must be kept manageable at this stage, despite the possibility of information overload from new data, much of which is in need of codification. The listed transactions must be rationalized in order to aggregate those in similar categories and eliminate those deemed immaterial. The resultant cost pools will likely have a number of different events, or drivers, associated with their incurrence.

4. Activity driver selection: A single driver covering all of the transactions grouped together in an ‘activity’ probably does not exist. Multiple driver models could be developed if the data were available, but cost-benefit analysis has rarely shown these to be desirable. The inter correlation of potential activity drivers will probably be so strong as to suggest that it really does not matter which one is selected. This argument might be employed to avoid the costly collection of data items otherwise not monitored, nor easily accessible.

5. Costing: A single representative activity driver can be used to assign costs from the activity pools to the cost objects. If, for example, the number of engineering set-ups has company producing four products (A, B, C, D) then the number of set-ups per product can be used to assign these costs. If product A requires 2 set-ups; B4 set-ups; C24 and D10, then the average cost per set-up of Rs. 40,000/40 set ups = Rs. 1,000, a misleading figure taken at face value, which does not imply the different demands of the set up resource made by the


different products. However, total set-up costs can be distributed to product groups in proportion to use, i.e. A: Rs. 2,000, B: Rs. 4,000, C: Rs. 24,000 and D: Rs. 10,000 and then assigned to individual units of product in proportion to the total level of output.

This procedure can then be repeated for all material activities.

Activity based cost Management (ABM):

In the previous section of this chapter we have focused on Activity Based product costing. Empirical studies of ABC implementation have frequently shown that the greater benefit derived from its adoption is in Cost Management rather in providing accurate product cost. The use of ABC as a costing tool to manage costs at activity level is known as Activity Based Cost Management (ABM) is a discipline that focuses on the efficient and effective management of activity as the route to continuously improving the value received by customers and the profit received by providing this value. ABM utilizes cost information gathered through ABC. Through various analysis, ABM manages activities rather than resources. It determine what drives the activities of the organization and how these activities can be improved to increase the profitability.

Stages in Activity Based Cost management: We have already discussed the various stages involved in activity based product costing. These stages are:

1. Identification of the activities that have taken place in the organization.

2. Assigning cost to cost pool for each activity.

3. Spreading of support activities across the primary activities.

4. Determining cost driver for each activity.5. Assigning the costs of activities to products according to product demand for activities.

The application of ABC as a costing tool to manage cost requires the firm to omit the final stage of assigning costs to products and adopt activity based costing without activity based product costing. Alternatively, organization can design an activity based system and incorporates both ABM and Activity Based Product Costing.

Activity Based Management Model: Consortium for Advanced Management international (CAM) defines ABM as “adds a dynamic, continuous improvement dimension to the more static ABC model.” Interestingly, it has been observed that Japanese accountants began exploring Activity-based techniques in the early 1990s following movement in the USA towards the ABM model.

CAM-1 defines ABM as: “A discipline that focuses on the management of activities as the route to improving the value received by the customer and the profit achieved by providing this value. This discipline includes cost driver analysis, activity analysis, and performance measurement. Activity-Based Management draws on Activity-Based Costing as it major source of information.”

Pictorially represents ABM model in a chart developed for CAM-1. in commenting on this model, one of its co-developers stated, “ABC supplies the information, and ABM uses this information in various analyses designed to yield continuous improvement”.

a) Cost Driver Analysis: The factors that cause activities to be performed need to be identified in order to manage activity costs. Cost driver analysis identifies these causal factors.

For example, a cost driver analysis study might determine that slow processing of customer invoices largely from lack of training of the customer invoice associates. This lack of training is thus a cost driver of the customer invoice processing activity. It is one of the factors causing this activity to take place (in this case, inefficiently). Managers have to address this cost driver to


correct the root cause of the slow processing problem. To accomplish this task, managers might decide that an internal training program for customers invoice associates should be designed and implemented to increase the speed of customer invoice processing.

Cost Assignment Continuous improvement View process

Process view

Activity –Based Management Model. Source: From the CAM-1 Glossary of Activity-Based Management, Edited by Norm Raffish and peter B.B. Turney, (Arligton: CAM-1, 1991)

The time saving from the improved training may lead to a reduction in the number of customer invoice associated and, thus, to lower costs for the “customer invoice processing” activity. Of course, real salary cost savings occur only if the number of jobs in the organization actually decreases (e.g. through attrition) or if displaced customer invoice associates are redeployed to VA activities, thus canceling the need to hire new employees from outside. The tangible cost savings and intangible benefits from the customer invoice processing improvements should be compared with both the tangible and intangible costs of the new training program in a cost-benefit analysis.

The hypothetical customer invoice processing example shows that the identification and analysis of cost drivers (casual factors) is a necessary first step toward improving the cost effectiveness of activities and cost management through ABM.

b) Activity Analysis: Activity analysis, defined in section (a), identifies the activities of an organization and the activity centre (or activity cost pools) that should be used in an ABC system. Activity analysis also identifies VA and NVA activities. The degree to which activities are grouped together into activity centers depends on the costs and benefits of the alternatives. The number of activity information evolve.

For example, only a few activity centers may be used in an initial ABC pilot study. As managers become more accustomed to the initial ABC system and find the output useful, they may request a more detailed and refined ABC model.

c) Performance Analysis: Performance analysis involves the identification of appropriate measures to report the performance of activity centers or other organizational units, consistent with each unit’s goals and objectives. Performance analysis aims to identify the best ways to measure the performance of factors that are important to organizations in order to stimulate continuous improvement.

Activity analysis

Cost driver analysis

Performance analysis

Resources

ActivitiesPerformance

Measures

Cost objects

Cost drivers


Extending the hypothetical customer invoice processing example, assume that timely processing of customer invoices is one of the activity centers goals. A performance analysis study identified the number of customer invoices processed per hour as the most appropriate performance measure to monitor timeliness in processing customer invoices. A subsequent benchmarking study revealed the relatively slow processing of customer invoices in the organization’s customer invoices activity center and led to the cost driver analysis study discussed previously.

Business application of ABM: ABM views the business as a set of linked activities that ultimately add value to the customer. ABM is based on the premises that activities consume costs. Therefore, by managing activities costs will be managed in long-term. Activities may be grouped in such a way as to describe the total process. For example, serving a particular customer involves a number of discrete activities, but the sum total of these activities represents the process by which the client in serviced. ABM classifies each activity within a process as value-added activities or non-value added activities.

Value–added activities (VA): The value –added activities are those activities which are necessary for the performance of the process. Such activities represents work that is valued by the external or internal customer. The customers are usually willing to pay (in some way) for the service. For example polishing a furniture by a manufacturer dealing in furniture is value added activity.

Non-value-added activities (NVA): The NVA activity represents work that is not valued by the external or internal customer. NVA activities do not improve the quality or function of a product or service, but they can adversely affect costs and prices. Non-value added activities create waste, result in delay of some sort, add costs to the products or services and for which the customer is not willing to pay. Moving materials and machine set up for a production run are examples of NVA activities. NVA activities are found in both the private and public sectors. For example, in the internal revenue service, rerouting documents and the wait or delay time in completing a case are examples of NVA activities in the “installment agreements” area.

The preparation of tax returns and other compliance work by organizations do not directly benefit the customers of their products and services, but because they are required by law. They are not considered NVA activities.

By measuring activities rather than traditional departmental costs, business can focus on cross functional processes in order to identify non-value adding activities and pinpoint the time drives of cost at each stage. The goal of the ABCM is to make customer needs to be satisfied while making fewer demands for resources. Current research suggests that customers have perceived needs in four areas, all of which must be satisfied simultaneously.

The customers require:1. Lower costs2. Higher quality3. Faster response time4. Greater innovation

To satisfy these needs ABM currently being used for a variety of business application. Such as:1. Activity Based Budgeting2. Cost Reduction3. Business process re-engineering4. Benchmarking5. Performance measurement


Now, we shall discuss each of these business application:

i) Cost reduction: ABCM helps the organization to identify costs against activities and to find opportunities to streamline or reduce the costs or eliminate the entire activity, especially if there is no value added. It is particularly useful in identifying and quantifying process waste and providing vehicle for continuous process improvement through continuous cost reduction.

ii) Activity Based Budgeting: Activity based budgeting analyze the resource input or cost for each activity. It provides a framework for estimating the amount of resources required in accordance with the budgeted level of activity. Actual results can be compared with budgeted results to highlight both in financial and non-financial terms those activities with major discrepancies from budget for potential reduction in supply of resources. It is a planning and control system which seeks to support the objectives of continuous improvement.

iii) Business process re-engineering: Business process re-engineering involves examining business processes and making substantial changes to how organization currently operates. ABCM is a powerful tool for measuring business performance, determining the cost of business output and is used as a means of identifying opportunities to improve process efficiency and effectiveness. A business process consist of linked set of activities. For example purchasing of materials might be considered as business process consist of activities such as receiving a purchase request, identifying supplies, preparing purchase orders, mailing purchase orders and performing follow up. The process might be reengineered by sending the production schedule direct to the suppliers and to enter into contractual agreement to deliver materials according to the production schedule. The end result might be permanent reduction or elimination of some activities.

iv) Benchmarking: This aspect has been discussed later in chapter 14.

v) Performance measurement: Many organizations are now focusing on activity performance as a means of facing competitors and managing costs. To monitor efficiency and effectiveness of activities performance measures are required. Activity performance measures consists of measures relating to costs, time, quality and innovation. For instance, now a days in the globalization the overall goal which is significant for a company is to produce a quality product at a price that will be competitive in world market. But the quality is not something which one can apply somewhere in the production process are assume will happen automatically. Product quality starts with the correct design. The next stages are high quality raw material inputs, quality processing and work, and proper handling and packaging etc. The various performance measures of quality are:

Area Measures1. Quality of purchased component Zero defects2. Quality of output % yield3. Customer awareness orders; number of complaints

Activity Based Budgeting (ABB)

Activity-based budgeting is a process of planning and controlling the expected activities for the organisation to derive a cost-effective budget that meets forecast workload and agreed strategic goals. An activity-based budget is a quantitative expression of the expected activities of the firm, reflecting management’s forecast of workload and financial and non-financial requirements to meet agreed strategic goals and planned changes to improve performance.


Thus, the key elements of ABB are:

type of work/activity to be performed; quantity of work/activity to be performed; and cost of work/activity to be performed.

ABB focuses on the activity/business processes. Resources required are determined on the expected activities and workload. The objective is to bring in efficiency into the system. So, in the process of budget preparation, many key questions, need to be addressed and properly answered

Difference between ABC & ABM:

The ABC refers to the technique for determining the cost of activities and the output that those activities produce. The aim of ABC is to generate improved cost data for use in managing a company’s activities.

The ABM is a much broader concept. It refers to the management philosophy that focuses on the planning, execution and measurement of activities as they key to competitive advantage.

ABC: A decision making tool:

It is a useful tool for many of the management decisions facing companies today. It can bring a picture of the operation to light that may not be obvious through other analysis tools. Specifically, ABC is useful in analyzing specific segments of an organization. This might include a market line, a group of products (even a single product), a customer, or an employee. The ABC is implemented in following decisions:

1. ABC is a complement to total quality management (TQM). It provides quantitative data that can track the financial impact of improvements implemented as part of the TQM initiative. Some have been suggested that ABC is the most important concept introduced since TQM. Amoco performance products, Transparent Container Co. and fellows manufacturing co. are a few companies that have utilized the ABC/TQM modeling concept to improve performance and profitability.

2. Wholesale distributors can gain significant advantage in the decision-making process through implementation of ABC concepts. The expansion of line offerings has brought about difficult decisions for the distributor. Using traditional financial data, overhead burden is distributed equally across the product line.

Introduction of new products or vendors might also introduce variance to the overhead. For instance, the need to support a special storage area for control or environment reasons, or the need of new handling equipment will increase overall operational costs. These costs will be spread over the product line, reducing margin or existing products and reducing the cost impact of the new items. ABC models the costs back to the activity. The burden created by the new product is correctly reflected. This allows the existing merits while leaving the new line to justify itself.

3. Other decisions that can be assisted by ABC include facility and resource expansion. Often the basis of relocation or opening of a new distribution center is based on cost associations. Reduction in freight or other logistics costs can offset the expense of the new facility, staff or equipment. When the numbers used are enterprise-based, the return might not develop as expected. The ABC model can identify the specific cost elements being targeted, providing a much clearer picture from which management can act.


4. Decision support for human resources can be augmented by ABC. Where activity, and therefore cost, can be associated to an individual, new levels of financial performance can be determined. This might be appropriate in cases of branch management or sales. Adding or deleting resource slots can be determined based on costs of activities as well. The added data provided through ABC can present a number of options, including outsourcing, productivity improvement through automation, and a determination of employee/revenue ratios.

In summary, activity-based costing is a management decision-making tool. It provides financial support data structured in a fashion fundamentally different from accounting data provided in the general ledger. By associating cost to the activity, a clear relationship can be established between sources of activity demand and the related costs. This association can benefit the distributor in determining where costs are being incurred, what is initiating the costs and where to apply efforts to curb inflationary costs. This can be of particular value in tracking new products or customers. It can also provide tracking of logistics costs, one of the fastest growing areas of expenses to the distribution operations.

Problem 1A company produces three products A, B and C for which the standard costs and quantities per unit are as follows: Products A B C Quantity produced 10,000 20,000 30,000Direct material/p.u. (Rs.) 50 40 30Direct labour/P.u. (Rs.) 30 40 50Labour hours/P.u. 3 4 5Machine hours/p.u. 4 4 7No. of purchase requisitions 1,200 1,800 2,000No. of set ups 240 260 300

Production overhead split by departments –Department 1 = 11,00,000 - Department 2 = 15,00,000

Department 1 is labour intensive and department 2 is machine intensiveTotal labour hours in Department 1 = 1,83,333Total machine hours in department 2 = 5,00,000Production overhead split by activity –receiving/inspecting Rs. 14,00,000 - Production scheduling/machine set up Rs. 12,00,000

Rs. 26,00,000

No. of batches received/inspected = 5,000No. of batches for scheduling and set up = 800

You are required to:(i) Prepare product cost statement under traditional absorption costing and Activity based

costing method.

(ii) Compare the results under two methods.

Solution Traditional absorption costingAbsorption rates:

Department 1 = ------------------------------------ = Rs. 6 per labour hourRs. 11,00,0001,83,333 labour hours


Department 2 = ------------------------------------------- = Rs. 3 per machine hour

Product cost statement Product A B C Rs. Rs. Rs. Direct material 50 40 30Direct labour 30 40 50Overhead:Department 1 18 24 30

(3 hrs.Rs. 6) (4 hrs.Rs.6) (5 hrs.Rs. 6)Department 2 12 12 21

(4 hrs. Rs.3) (4 hrs. Rs. 3) (4 hrs. Rs. 7) Total cost p.u. 110 116 131Activity based costingCost driver rates:

Receiving/inspecting = -----------------------------------------------------------------

= Rs. 280 per requisition

Production scheduling /Machine set ups = --------------------------------------------------------------

= Rs. 1,500 per set up.

Product cost statement (per unit) Products A B C Rs. Rs. Rs. Direct material (Rs.) 50 40 30Direct labour (Rs.) 30 40 50Overhead:Receiving 34* 25 19Production scheduling 36** 20 15 Total cost per unit _150 125 114

{Rs. 2801,200}10,000 units = Rs. 34* similarly Rs. 25 and Rs. 19(Rs. 1,500240)10,000 units = Rs. 36**; similarly Rs. 20 and Rs. 15.

The two absorption methods produce different results. Product C appears to be much more expensive using the traditional method than it does with ABC, while product A is the opposite. If it is assumed that ABC is more accurate, which it may or may not be, then product C would be overpriced on the traditional method and sales would presumably be poor as a consequence- assuming competitors supply more cheaply. Product A would be the opposite: sales would be high and it is possible that the company would unknowingly make a loss per unit on product A.

Problem 2The following information provides details of costs, volume & cost drivers for a particulars period in respect of ABC Ltd. for product X, Y and Z.

Product X product Y Product Z Total1. production & sales (units) 30,000 20,000 8,0002. Raw material usage (units) 5 5 113. Direct material cost (Rs.) 25 20 11 12,38,000

4. Direct labour hours 2 1 88,000

5. Machine hours 1 1 2 76,000

Rs. 15,00,0005,00,000 machine hours

Rs. 14,00,0005,000 (No. of batches received/inspected)

Rs. 12,00,000800 (No. of batches for scheduling)


6. Direct labour cost (Rs.) 8 12 67. No. of production runs 3 7 20 308. No. of deliveries 9 3 20 329. No. of receipts (27)* 15 35 220 27010. No. of production orders 15 10 25 5011. Overhead costs:

Set-up 30,000Machines 7,60,000Receiving 4,35,000Packing 2,50,000Engineering 3,73,000

Rs. 18,48,000

* The company operates a just-in-time inventory policy, and receives each component once per production run. In the past the company has allocated overheads to products on the basis of direct labour hours. However, the majority of overheads are related to machine hours rather than direct labour hours. The company has recently redesigned its cost system by recovering overheads using two volume related bases: machine hours and a materials handling overhead rate for recovering overheads of the receiving department. Both the current and the previous cost system reported low profit margins for product X, which is the company’s highest-selling product. The management accountant has recently attended a conference on activity-based costing, and the overhead costs for the last period have been analyzed by the major activities in order to compute activity based costs.

From the above information you are required to:(a) Compute the product costs using a traditional volume-related costing system based on

The assumption that:(i) All overheads are recovered on the basis of direct labour hours (i.e. the company’s past

product costing system);

(ii) The overheads of the receiving department are recovered by a materials handling overhead rate and the remaining overheads are recovered using a machine hour rate (i.e., the company current costing system).

(b) Compute product costs using an activity-based costing system.

Solution(a) Computation of the product cost using a traditional volume related costing system based

on assumption that:(i) All overheads are recovered on the basis of direct labour hours (i.e., the company product

Costing system)

Statement showing the product cost Products X Y Z Rs. Rs. Rs. Direct labour 8 12 6Direct materials 25 20 11Overheads 28 42 21

(Refer to working note)

_______ ______ ______Total 61 74 38

Working note:Overheads to be charged to products

Total overheadsTotal direct labour

hours


Direct labour overhead rate = ----------------------------------

=

= Rs. 21 per direct labour hour.

(ii) The overheads of the receiving department are recovered by material handling overhead rate & the remaining overheads are recovered by using a machine hour rate (i.e. the company current costing system)

Products X Y Z Rs. Rs. Rs. Direct labour 8 12 6Direct materials 25 20 11Material handling overhead 8.78 7.03 3.87(Ref. To working note) (Rs. 2535.14%)(Rs. 2035.14%)(Rs. 1135.14%)other overheads 24.79 18.59 37.18(Machine hour basis)

(Ref. To working note) (1 hrs.Rs. 18.59) (1hr.Rs. 18.59)(2 hrs.Rs. 18.59)

---------- ---------- ------------Total cost 66.57 57.62 58.05

Working note:Overheads to be charged to products:

Material handling overhead rate = ------------------------------------------------------

=

= 35.14% of direct material cost.

Machine hour overhead rate = ----------------------------------

=

= 18.59 per machine hours.

(b) Statement showing the product costs using an activity based costing system. Products X Y Z Rs. Rs. Rs. Direct labour 8 12 6Direct material 25 20 11Machine overheads 13.33 10 20

(Refer to working note 1) (1 hrs.Rs. 10)(1 hr.Rs. 10) (2 hr.Rs. 10)

Set-up costs 0.10 0.35 2.50

(Ref. To working note 2 (i))

Receiving 0.81 2.82 44.36

(Ref. To working note 2(ii))

Packing 2.34 1.17 19.53

Receiving department overheadsDirect material cost

Other overheadsMachine hours


(Ref. To working note 2 (iii))

Engineering 3.73 3.73 23.31

(Ref. To working note 2 (iv))

----------- ----------- ---------Total manufacturing cost 53.31 50.07 126.64

Working note:

1. Machine overhead rate per hour =

= Rs. 10

2. The cost per transaction or activity for each of the cost Centres is as follows:

(i) Set-up costCost per setup = ---------------------------------------------- = Rs. 1,000

(ii) Receiving costCost pre receiving order = ----------------------------------------------- = Rs. 1,611

(iii) Packing CostCost per packing order = ------------------------------------------------- Rs. 7,812

(iv) EngineeringCost per production order = --------------------------------------------- = Rs. 7,460

Problem 3Apollo plc manufactures and sells several products, two of which are Alpha and Beta. Estimated dataFor the two products for the forthcoming period is as follows:

(i)Product data Alpha Beta other

ProductsProduction/sales units 5,000 10,000 40,000

Rs.000 Rs.000 Rs.000Total direct material cost 80 300 2,020Total direct labour cost 40 100 660

(ii) Variable overhead cost is Rs.1,500,000 of which 40 percent is related to the acquisition, storage and use of direct materials and the remainder is related to the control and use of direct labour.

(iii) It is current practice for Apollo plc to absorb the two types of variable overhead cost to products using an overall company-wide percentage based on either direct material cost and direct labour cost as appropriate.

(iv) Apollo are considering the use of activity-based costing. The cost drivers for material and labour related overheads have been identified as follows:

Alpha Beta other Product

Direct material relatedOverheads-cost driver isWeight of materialWeight of material/unit 4 1 1.5

Setup cost (Rs. 30,000)Number of production runs (30)

Receiving cost (Rs. 4,35,000)No. of orders (270)

Packing cost (Rs. 2,50,000)Number of orders (32)

Engineering cost (Rs. 3,73,000)No. of production order (50)


Direct labour relatedOverheads-cost drivers isNumber of labour operationsLabour operations/unit 6 1 2

(v) Market investigation indicates that markets prices for Alpha and Beta of 75 and 95 per unit Respectively will achieve the estimated sales shown in (i) above.

(vi) Apollo plc require a minimum estimated contribution: sales ration of 40 percent before proceeding with the production or sale of any product.

Requirements(a) Prepare estimated unit product costs for Alpha and beta where the variable overhead is

charged to product units as follows:(i) Using the existing absorption rates as detailed above,(ii) Using an activity-based costing approach.

(b) Using the information in (a) prepare an analysis that will help Apollo determine whether both A and B should remain in production.

Your answer should include relevant calculations and discussion and be prepared in a form suitable for presentation to management.(c) Explain how Apollo could make use of target costing in conjunction with activity-based

costing with respect to Alpha and Beta.

Solution (a) (i) Unit costs using traditional absorption costing

Material related overhead cost (40% of Rs. 1.5m) = Rs.600,000

Overhead absorption rate Rs.600,000 x 100 = 25% of direct material cost Rs.2,400,000

Labour related overhead cost (60% of Rs.1.5m) = Rs.900,000

Overhead absorption rate Rs.900,000 x 100 = 112.5% of direct labour cost Rs. 800,000

Alpha BetaRs. Rs.

Direct materials 16 30Direct labour 8 10

____ ____Prime cost 24 40Material related overhead (25%) 4 7.5Labour related overheads (112.5%)9 11.25

____ ________Total variable costs 37 58.75

(iii) Unit costs based on activity-based costing

Alpha Beta OtherProduction units 5,000 10,000 40,000Weight of direct material (kg) 4 1 1.5Total weight of material (kg) 20,000 10,000 60,000


Mat. Related overhead/kg Rs. 600,000_____________ = Rs. 6.67/kg 20,000+10,000+60,000

Alpha Beta OthersProduction units 5,000 10,000 40,000Labour operations/unit 6 1 2Total operations 30,000 10,000 80,000

Lab. Related overheads/op Rs. 900,000 = Rs. 7.5 per op. Rs. 30,000+10,000+80,000

Unit costs based on ABC Alpha BetaRs. Rs.

Direct materials 16 30Direct labour 8 10

_____ ____Prime cost 24 40Material overhead 26.68 6.67Labour related overheads 45 7.5

_____ ____Total variable costs 95.68 54.17

_____ _____

(b) Alpha Beta Traditional ABC Traditional ABC Rs. Rs. Rs. Rs.Direct material 16 16 30 30Direct labour 8 8 10 10Material overhead 4 26.68 7.50 6.67Labour related overhead 9 45 11.25 7.50 ______ __________ ___________ _________Total variable cost 37 95.68 58.75 54.17Selling price 75.00 75.00 95.00 95.00 ______ ___________ ___________ _________Contribution/unit 38 (20.68) 36.25 40.83 _______ ___________ ___________ _________C/S ration 51% (28)% 38% 43%

Apollo plc require a minimum C/S ratio of 40 per cent. If product costs are determined using the traditional methods Apollo would decide to proceed with the production of Alpha (C/S ratio of 51 per cent) and reject Beta which has a C/S just below the required 40 per cent.

If ABC is used the decision will be reversed. Alpha will be rejected on the basis of a negative C/S ratio and Apollo will proceed with Beta, which has a C/S ratio of 43 per cent.

ABC Provides a more accurate cost of products unlike the traditional methods used, which is a broad-based averaging of costs. ABC attempts to reflect the true consumption of resources.

(c) The use of target costing in conjunction with ABC will enable Apollo to find ways of reducing the costs of Alpha to arrive at a target cost. Cost reduction methods such as value analysis and value engineering could be used to achieve this. Though Beta just meets the required 40 per cent C/S ratio, Apollo could decide to increase margins further by carrying out a similar exercise on Beta. Target costing should also be used to identify selling prices for specific markets.


Problem 4Trimake Ltd makes three main products, using broadly the same production methods and equipment for each. A conventional product costing system is used at present, although an activity-based costing (ABC) system is being considered. Details of the three products for a typical period are:

Hours per unit Material Volume Labour Machine per unit unitsHours hours Rs.

Product x 0.5 1.5 20 750Product Y 1.5 1 12 1,250Product Z 1 3 25 7,000

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

Requirements(a) Calculated the cost per unit for each product using conventional methods

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

%Costs relating to set-up 35Costs relating to machinery 20Costs relating to material handling 15Costs relating to inspection 30

_________Total production overhead 100

__________The following total activity volumes are associated with the product line for the period as a whole:

Number of Movements Number ofSet-ups of materials inspections

Product X 75 12 150Product Y 115 21 180Product Z 480 87 670

______ _______ _______670 120 1,000

______ _______ _______

(b) Calculate the cost per unit for each product using ABC principles.(c) Comment on the reasons for any differences in the costs in your answers to (a) and (b).

Solution (a) Conventional cost per unit

X Y ZRs. Rs. Rs.

Materials 20 12 25Labour 3 9 6


____ ____ ____Direct cost 23 21 31Production overheads (Rs.28/hour) 42 28 84

____ ____ ____Total production cost per unit 65 49 115

____ ____ ____

(b) ABC cost per unitAnalysis of total overheads and cost per unit of activity

% Total Level Cost per unitOverhead of activity of activity

Rs. Rs.Set-ups 35 229,075 670 341.90Machining 20 130,900 23,375 5.6Materials movement 15 98,175 120 818.13Inspection 30 196,350 1,000 196.35

_____ ________ 100 654,500 *

Working*Total overheads

Production Machine hours Total OAR TotalUnits per unit Machine hours overheads

X 750 1.5 1,125 Rs.28 Rs.31,500Y 1,250 1.0 1,250 Rs.28 Rs.35,000Z 7,000 3.0 21,000 Rs.28 Rs.588,000

________ _________23,375 Rs.654,500

________ ________

Total overheads by product and per unit

Overhead X Y ZActivity Cost Activity Cost Activity Cost Total

Rs. Rs. Rs.Set-ups 75 25,643 115 39,319 480 164,113 229,075Machining 1,125 6,300 1,250 7,000 21,000 117,600 130,900Mat. Movement 12 9,817 21 17,181 87 71,177 98,175Inspection 150 29,453 180 35,343 670 131,554 196,350

_______ ________ _______ _______Total overheads 71,213 98,843 484,444 654,500

_______ _______ _______ _______No. of units 750 1,250 7,000 Overhead cost per unit Rs.94.95 Rs.79.07 Rs.69.21

Total cost per unit

X Y ZRs. Rs. Rs.

Direct costs 23.00 21.00 31.00Overhead costs 94.95 79.07 69.21

________ ________ ________Total production cost 117.95 100.07 100.21Per unit


(c) Comment

Product X Y ZRs. Rs. Rs.

Overheads per unit 42.00 28.00 84.00(Conventional system)Overheads per unit 94.95 79.07 69.21(activity-based costing)

A change to activity-based costing results in the overhead costs of X and Y increasing while the overhead cost of Z decreases.

The adoption of ABC provides a fairer unit cost that better reflects the effort required in the manufacture of different products.

This can be illustrated with Z, a major product line which takes longer to produce but once production has begun is simple to administer unlike X and Y which are minor products but still require a fair amount of administrative time. See table below :

Activities per 1000 units Set-ups Material Inspections MovementX 100 16 200Y 92 17 144Z 69 12 96

This highlights: Product Z has fewer set-ups, material movements and inspections per 1,000 units that X

or Y. As a consequence product Z’s overhead cost per unit for these three activities has fallen. The machine overhead cost per unit is still two to three times greater than X and Y.

Problem 5Having attended a CIMA course on activity-based costing (ABC) you decide to experiment by applying the principles to the four products currently made and sold by your company. Details of the four products and relevant information are given below for one period:

Product A B C D

Output in units 120 100 80 120Costs per unit Rs. Rs. Rs. Rs.

Direct material 40 50 30 60 Direct labour 28 21 14 21

Machine hours (per unit) 4 3 2 3

The four products are similar and are usually produced in production runs of 20 units and sold in batches of 10 units.The production overhead is currently absorbed by using a machine hour rate, and the total of the production over head has been analysed as follows:

Rs.Machine department costs (rent,Business, rates, depreciation andSupervision) 10,430Set-up costs 5,250Stores receiving 3,600Inspection/quality control 2,100


Material handling and dispatch 4,620

You have ascertained that the ‘cost drivers’ to be used are as listed below for the overhead costs shown:

Cost Cost

Set-up costs Number of production runsStores receiving Requisitions raisedInspection/quality control Number of production runsMaterials handling and dispatch Orders executed

The number of requisitions raised on the stores was 20 for each product and the number of orders executed was 42, each order being for a batch of 10 of a product.

Requirements(a) Calculate the total costs for each product if all overhead costs are absorbed on a machine

hour basis.

(b) Calculate the total cost of each product, using activity-based costing.

(c) Calculate and list the unit product costs from your fingers in (a) and (b) above, to show the differences and comment briefly on any conclusions which may be drawn which could have pricing and profit implications.

Solution (a) Overheads absorbed on machine hour basis

Machine hour absorption rate = Total overheads___

Total machine hours =Rs.10,430+Rs.5,250+Rs.3,600+Rs.2,100+Rs.4,620___

(120 X 4)+ (100 X 3)+(80 X 2)+(120 X 3) = Rs.26,000 = Rs.20 per machine hour

1,300

Total costs based on machine hour basis

A B C DRs. Rs. Rs. Rs.

Direct material 40 50 30 60Direct labour 28 21 14 21Production overhead 80 60 40 60

____ ____ _____ _____Production cost/unit 148 131 84 141

____ ____ _____ _____Out put in units 120 100 80 120Total production cost Rs.17,760 Rs.13,100 Rs.6,720 Rs.16,920

(b) Overheads absorbed based on ABC

Overhead costs Level of activity Cost/activityRs.

Machine department costs 10,430 1,300 8.02/hourSet-up costs 5,250 21* 250.0/runStores receiving costs 3,600 80** 45.00/requisition


Inspection/quality costs 2,100 21* 100.00/runMaterial handling and dispatch 4,620 42 110.00/order

Workings *No. of production runs = output in units/20

= 120+100+80+120 20 = 420 = 21 20 ** No. of requisitions raised = No. of products X 20 = 4 x 20 = 80

A B C DRs. Rs. Rs. Rs.

Direct materials 40.00 50.00 30.00 60.00Direct labour 28.00 21.00 14.00 21.00Machine dept costs 32.09 24.07 16.05 24.07Set-up costs 12.50 12.50 12.50 12.50Stores receiving 7.50 9.00 11.25 7.50Inspection 5.00 5.00 5.00 5.00Material handling 11 .00 11 .00 11 .00 11 .00 Production cost/unit 136 .09 132 .57 99 .80 141 .07 Output in units 120 100 80 120Total production costs Rs.16,331 Rs.13257 Rs.7,984 Rs.16,928

(c) Comparison of the two unit costs calculated in (a) and (b) above,

A B C DProduct Rs. Rs. Rs. Rs.

Based on machineHour rate 148.00 131.00 84.00 141.00ABC method 136 .09 132 .57 99 .80 141 .07

Difference 11 .91 (1 .57 (15 .80) (0 .07)

Problem 6D has recently set up a small business, which manufactures three different types of chair to customer order. Each type is produced in a single batch per week and dispatched as individual items. The size of the batch is determined by the weekly customer orders. The comfort, the Relaxer and the Scandinavia. The comfort is a fully leather-upholstered chair and is the most expensive of the range. The Relaxer is the middle-of –the-range chair, and has a comfortable leather seat. The cheapest of the range, the Scandinavia, is purely a wooden chair, but D feels it has great potential and hopes it will provide at least 50 per cent of sales revenue.

D has employed F, an experienced but unqualified accountant, to act as the organization’s accountant. F has produced figures for the past month, April 20X2, which considered a normal month in terms of costs:

Profit statement for April 20X2

Rs. Rs.

Sales revenue 79,800


Material costs 17,250

Labour costs 27,600

Overheads __34,500

__79,350

Profit _____450

Comfort Relaxer Scandinavia

Unit produced & sold during April 30 120 150Rs. Rs. Rs.

Selling price per chair 395 285 225Less: Costs per chair:

Material 85 60 50 Labour

120 100 80 Overheads absorbed on labour

Hours 150 125 100 355 285 230

Profit per chair 40 -- (5)

D hopes to use these figures as the basis for budgets for the next three months. He is pleased to see that the organisation has made its first monthly profit, however small it might be. On the other hand, he is unhappy with F’s advice about the loss-making Scandinavia, which is, either to reduce its production or to increase its price. D is concerned because this advice goes against the strategy on which he based his business idea. After much discussion F says that he has heard about a newer type of costing system, known as activity-based costing (ABC), and that he will recalculated the position on this basis. In order to do this, F extracts the following information:

Comfort Relaxer Scandinavia

Wood (metres) per chair 10 9 9Leather (metres) per chair 4 2 -

Labour (hour) per chair 24 20 16

The overheads included in April’s profit statement comprised:

Rs.

Set-up costs 5,600Purchasing and checking leather hides 4,000Purchase of wood 2,400Quality inspection of leather seating 3,200Dispatch and transport 6,000Administration and personnel costs 13,300Use the ABC technique to prepare a revised product cost statement for April 20X2 such as F might produce.

Solution

The following activity-based cost drivers may be developed:

Comfort Relaxer Scand. Total

Wood 10 X 30 9 X 120 9 X 150


Metres (m) =300 =1,080 =1,350 2,730

Leather 4 X 30 2 X 120

m =120 =240 360

Labour 24 x 30 20 X 120 16 X 150

Hrs =720 =2,400 =2,400 5,520

Despatch

Units 30 120 150 300

Overhead cost analysis

Comfort Relaxer Scand. Total

Rs. Rs. Rs. Rs.

Set-up costs (batches) 1,867 1,867 1,867 5,601

Purchase of leather (m) 1,333 2,667 4,000

Purchase of wood (m) 264 949 1,187 2,400

Quantity (leather m) 1,067 2,133 3,200

Despatch (units) 600 2,400 3,000 6,000

Admin. (Labour hours) 1,734 5,783 5,783 13,300

Total 6,865 15,799 11,837 34,501

Overhead cost per unit Rs.228.83 Rs.131.66 Rs.78.91

Product cost statement

Comfort Relaxer Scand.

Rs. Rs. Rs.

Selling price 395 285 225

Less: Material costs 85 60 50

Labour costs 120 100 80

Contribution 190(48%) 125(44%) 95(42%)

Less: Overheads 229 132 79

Profit/(Loss)) (39 ) (7 ) 16

Problem 7 Having attended a ICAI course on activity-based costing (ABC) you decide to experiment by

applying the principles of ABC to the four products currently made and sold by your company. Details of the four products and relevant information are given below for one period :

Product A B C D


Output in units 120 100 80 120Cost per unit ; Rs. Rs. Rs. Rs.Direct material 40 50 30 60Direct labour 28 21 14 21Machine hours (per unit) 4 3 2 3

The four products are similar and are usually produced in production runs of 20 units are sold in batches of 10 units.

The production overhead is currently absorbed by using a machine hour rate, and the total of the production overhead for the period has been analysed as follows :

Rs. Machine department costs (Rent, business rates, depreciation and supervision) 10,430

Set-up costs 5,250Stores receiving 3,600Inspection / Quality control 2,100Materials handling and dispatch 4,620

You have ascertain that the ‘cost drivers’ to be used are as listed below for the overhead costs shown :

Cost Cost Driver

Set up costs Number of production runs Stores receiving Requisition raisedInspection / Quality control Number of production runs

Materials handling and dispatchOrders executed

The number of requisition raised on the stores was 20 for each product and the number of orders executed was 42, each order being for a batch of 10 of a product, You are required.

(a) to calculate the total costs for each product if all overhead costs are absorbed in a machine hour basis;

(b) to calculate the total costs for each product, using activity-based costing ;

(c) to calculate and list the unit product costs from your figures in (a) and (b) above, to show the differences and to comment briefly on any conclusions which may be drawn which could have pricing and profit implications.

Solution (a) Total machine hours = (120 X 4 hrs.) + (100 X 3 hrs) + (80 X 2 hrs) + (120 X 3 hrs.) = 1300 hrs.

Rs.10,430 + Rs.5250 + Rs.3600 + Rs.2100 + Rs.4620Machine hour overhead rate =

1300 hours


= Rs.20 per machine hour

Product A B C DRs. Rs. Rs. Rs.

Direct material 40 50 30 60Direct labour 28 21 14 21

Overhead at Rs.20 per machine hour80 60 40 60

148 131 84 114

Units of output 120 100 80 120Total cost Rs.17,760 Rs.13,100 Rs.6,720 Rs.16,920

(b) Costs Cost driver Cost driver Cost perTransactions unit

Rs. Rs.Machine department 10,430 Machine hours 1300 hours 8.02Set-up costs 5,250 Production runs 21 250Stores receiving 3,600 Requisitions raised 80 ( 4 X 20 ) 45Inspection/ quality control2,100 Production runs 21 100Materials handling 4,620 Number of orders

executed 42 110

Note:Number of production runs = Total output (420 units) / 20 unit per set-up. Number of orders executed = Total output (420 units) / 10 units per order.

The total cost for each product are computed by multiplying the cost driver rate per unit by the quantity of the cost driver consumed by each product.

A B C D Prime Costs 8,160 (Rs.68 X 120) 7,100 3520 9,720Set-up 1,500 (Rs.250 X 6) 1,250 (Rs.250 X5)1000 1500Stores/ receiving 900 (Rs.45X20) 900 900 900Inspection/quality 600 (Rs.100X6) 500 400 600Handling dispatch 1320 (Rs.110 X 12) 1100 (Rs.110 X 10)880 1320Machine dept. cost 3851 2407 1284 2888

Total Costs 16,331 13,257 7984 16,928

Note: aA = 120 units X 4 hrs X Rs.8.02; B = 100 units X 3 hrs X Rs.8.02

(c) Cost per unit

Costs from (a) 148.00 131.00 84.00 141.00Cost from (b) 136.00 132.57 99.80 141.07

(11.91) 1.57 15.80 0.07


Product A is over-costed with the traditional system. Production B and C are under costed and similar costs are reported with Product D. It is claimed that ABC more accurately measures resources consumed by products (see ‘Errors arising from relying on misleading product costs’ in Chapter 10). Where cost-plus pricing is used, the transfer to an ABC system will result in different product prices. If activity-based costs are used for stock valuations then stock valuation and reported profits will differ.

Problem 8 The following budgeted information relates to Brunti for the forthcoming period ;

Products

XYI YZT ABW Sales and production (unit) 50 40 30

Rs. Rs. Rs.Selling price (per unit) 45 95 73Prime cost (per unit) 32 84 65

Hours Hours HoursMachine department 2 5 4 (Machine hours per unit)

Assembly department 7 3 2 (direct labour hours per unit)

Overhead allocated and apportioned to production departments (including service cost centre costs) were to be recovered in product costs as follows :

Machine department at Rs.1.20 per machine hours

Assembly department at Rs.0.825 per direct labour hours

You ascertain that the above overheads could be reanalyzed into ‘cost pools’ as follows :

QualityFor the

Cost pool Rs.000 Cost driver period Machine services 357 Machine hours 420,000Assembly services 318 Direct labour hours 530,000Set-up costs 26 Set-up 520Order processing 156Customer order 32,000Purchasing 84 Suppliers’ orders 11,200

941

You have also been provided with the following estimates for the period ; Products

XYI YZT ABW

Number of set-ups 120 200 200

Customers orders 8000 8000 16,000


Suppliers’ orders 3000 4000 4200

Required :

(a) Prepare and present profit statements using; (i) conventional absorption costing ; (ii) Activity – based costing;

(b) Comment on why activity-based costing considered to present a fairer valuation of the product cost per unit.

Solution (a) (i) Conventional Absorption Costing Profit Statement :

XYI YZT ABW(1) Sales volume (000 units) 50 40 30

Rs. Rs. Rs.(2) Selling pricing per unit 45 95 73

(3) Prime cost per unit 32 84 65

(4) Contribution per unit 13 11 8

(5) Total contri. is Rs.000 is (1 × 4) 650 440 240

(6) Machine department overheads a 120 240 144

(7) Assembly department overhead b 288.75 99 49.5

Profits (Rs.000s) 241.5 101 46.5

Total profit = Rs.388,750

Note : a XYI = 50,000 X 2 hrs. X Rs.1.20, ; YZT= 40,000 X 5 hrs. X Rs.1.20 b XYI = 50,000 X 7 hrs. X Rs.0.825 ; YZT = 40,000 X 3 hrs. X Rs.0.825

(ii) Cost pools ; Machine Assembly Set-up Order Purchasing Service service processing

Rs.000 357 318 26 156 84

Cost drivers 420,000 530,000 520 32,000 11,200

Machine direct set-ups customer suppliers’ Hours labour hours orders orders

Cost driver Rs.0.85 Rs.0.60 Rs.50 per Rs.4.875 per Rs.7.50 per Rates machine direct set-up customer suppliers’

Hour labour hour order orderABC Profit Statement :

XYI YZT ABW (Rs.000) (Rs.000) (Rs.000)

Total contribution 650 440 240Less overheads ; Machine department at Rs.0.85 per hour 85 170 102Assembly at Rs.0.60 per hour 210 72 36Set-up costs at Rs.50 per set-up 6 10 10


Order processing at Rs.4.875 per order 39 39 78Purchasing at Rs.7.50 per order 22.5 30 31.5

Profit (Loss) 287.5 119 (17.5)

Total profit = Rs.389,000

Problem 9 Repak Ltd. Is a warehousing and distribution company which receives products from customers, stores the products and then re-packs them for distribution as required. There are three customers for whom the service is provide – Jhon Ltd, George Ltd and Paul Ltd, The products from all three customers are similar in nature but of varying degree of fragility. Basic budget information has been gathered fro the year to 30 June and is shown in the following table :

Product Handled

(Cubic metres) Jhon Ltd. 30,000

Geoge Ltd. 45,000

Paul Ltd 25,000Costs

(Rs.000)Packing materials 1950

(see note 1)Labour -- basic 350 -- overtime 30

Occupancy 500

Administration and management 60

Note 1 : Packing materials are used in re-packing each cubic meter of production for John Ltd, George Ltd. and Paul Ltd. In the ratio 1 : 2 : 3 respectively. This ratio is linked to the relative fragility of the goods for each customer.

Additional information as been obtained in order to enable unit costs to be prepared for each of the three customers using an activity- based costing approach. The additional information for the year to 30 June has been estimated as follows :

(i) Labour and overhead costs have been identified as attributable to each work centres – receipt and inspection, storage and packing as follows ;

Cost allocation proportions

Receiptand

inspection Storage Packing% % %


Labour -- basic 15 10 75-- Overtime 50 15 35

Occupancy 20 60 20Administration and management 40 10 50

(ii) Studies have revealed that the fragility of different goods affects the receipts and inspection time needed for the products for each customer. Storage required is related to the average size of the basis incoming product units from each customer. The re-packing of goods for distribution is related to the complexity of packing required by each customer. The relevant requirements per cubic metre of product for each customer have been evaluated as follows :

Jhon George PaulLtd. Ltd. Ltd.

Receipt and inspection (minutes) 5 9 15Storages (square metres) 0.3 0.3 0.2Packing (minutes) 36 45 60

Required;

(a) Calculate the budgeted average cost per cubic metre of packing products for each customer for each of the following two circumstances;

Additional information has been obtained in order to enable unit costs to be prepared fro each of the three customers using and activity-based costing approach. The additional information for the year to 30 June has been estimated as follows:

(i) Labour and overhead costs have been identified as attributable to each of three work centres – receipt and inspection, storage and packing as follows :

Cost allocation Proportions

Receiptand

Inspection Storage Packing % % %

Labour -- basic 15 10 75

-- overtime 50 15 35

Occupancy 20 60 20Administration and management 40 10 50

(ii) Studies are revealed that the fragility of different goods affect the receipts and inspection time needed for the product for each customer. Storage required is related to the average size of the basis incoming product units from each customer. The re-packing of goods for distribution is related to the complexity of packaging required by each customer. The relevant requirements per cubic metre of product for each customer have been evaluated as follows :

Jhon George PaulLtd. Ltd. Ltd.


Receipt and inspection (minutes) 5 9 15

Storage (square metres) 0.3 0.3 0.2

Packing (minutes) 36 45 60

Required (a) Calculate the budgeted average cost per cubic metre of packaged products for each customer for each of the following two circumstances ;

(i) where only the basis budget information is to be used,

(ii) where the additional information enables an activity- based costing approach to be applied.

Solution(a) (i) The package material requirements are as follows :

John Ltd. 30,000 units (30,000 X 1)

Gorge Ltd. 90,000 units (45,000 X 2)

Paul Ltd. 75,000 units (25,000 X 3) 195,000 units

Cost per unit of packing = Rs.1,950,000 / 195,000 = Rs.10

Product costs per cubic metre John Ltd. George Ltd. Paul Ltd.

Rs. Rs. Rs.Packaging materials 10 (1 xRs.10) 20 (2 XRs.10) 30 (3 X Rs.10)

Labour ad overhead a 9.40 9.40 9.40 19.40 29.40 39.40

Note a Labour and overhead average cost per metre = Rs.940,000 / 100,000 meter

= Rs.9.40

(ii) The costs are assigned to the following activities

Receipt and Inspection Storage Packing

Rs. Rs. Rs. Labour: Basic 52,500 (15%) 35,000 (10%) 262,500 (75%)

Overtime 15,000 (50%) 4,500 (15%) 10,500 (35%)

Occupancy 100,000 (20%) 300,000 (60%) 100,000 (20%)Administration & management 24,000 (40%) 6,000 (10%) 30,000 (50%)


191,500 345,000 403,000

The resource usage for each of the cost drivers is :

Receipt and inspection hour storage (m2) Packing hours

John Ltd. 2,500 (30,000 X 5 mins.) 9,000 (30,000 X 0.3) 18,000 (30,000X 36min)

George Ltd. 6,750 (45,000 X 9 mins.) 13,500 (45,000X 0.3) 33,750 (45,000X 45 mins)

Paul Ltd. 6,250 (25,000 X 15 mins.) 5,000 (25,000 X 0.2) 25,000 (25,000X1hrs.) 15,500 27,500 76,750

The driver rates are :

Rs.12,355 per receipts and inspection hour (Rs.191,500 /15,500 hours)

Rs.12,564 per m2 of materials stored (Rs.345,500 / 27,500 m2 )

Rs.5.251 per packing hours (Rs.403,000 / 76,750 hrs. )

Product cost per cubic metre

Jhon Ltd. George Ltd. Paul Ltd. Rs. Rs. Rs.

Packing materials 10.00 20.00 30.00

Receipts and inspection a 1.03 1.85 3.09

Storage cost b 3.77 3.77 2.51

Packing cost c 3.15 3.94 5.25

17.95 29.56 40.85

Notes a Rs.12,355 X 5/60 hrs. = Rs.1.03 ;

Rs.12,355 X 9/50 hrs. = Rs.12,355 X 15/60 hrs. = Rs.3.09

b Rs.12,564 X 0.3 m = Rs.3.77 ; Rs.12,564 X 0.2m = Rs.2.51.

c Rs.5.25 X 36/60 hrs. = Rs.3.15 ; 5.25 X 45/60 hrs. = Rs.3.94 ; Rs.5.25 X 1 hrs.

Problem 10XYZ plc. Manufactures four products, namely A, B, C and D, using the same plant and processes. The following information relates to a production period ;

Material Direct Machine Labourcost labour time cost

Product Volume per unit per unit per unit per unit

A 500 Rs.5 ½ hour ¼ hours Rs.3


B 5,000 Rs.5 ½ hour ¼ hours Rs.3

C 600 Rs.16 2 hours 1 hours Rs.12

D 7,000 Rs.17 1 ½ hours 1 ½ hours Rs.9

Total production overhead recorded by the cost accounting system is analysed under the following headings:

Factory overhead applied to machine-oriented activity is Rs.37,424

Set –up costs are Rs.4,355

The cost of ordering materials is Rs.1920

Handling materials -- Rs.7580 Administration for spare parts --Rs.8600.

These overhead costs are absorbed by products on a machine hour rate of Rs.4.80 per hour, giving an overhead cost per product of .

A = Rs.1.20 B = Rs.1.20 C = Rs.4.80 D = Rs.7.20

However, investigation into the production overhead activities for the period reveals the following totals;

Number of

Number times NumberNumber of materials of

of materials was spareProduct set-up orders handled parts

A 1 1 2 2

B 6 4 10 5

C 2 1 3 1

D 8 4 12 4

You are required :

(i) to compare an overhead cost per product using activity-based costing tracing overheads to production units by means of cost drivers.

(ii) To comment briefly on the differences disclosed between overheads traced by the present system and those traced by activity-based costing.

Solution

(a) For the answer to this question see Chapter 10.

(b) Machine-related costs

Machine hours for the period :

A = 500 X ¼ = 125


B = 5000 X ¼ = 1,250C = 600 X 1 = 600D = 7000 X 1 ½ = 10,500

12,475

Machine hours rate = Rs.3 per hours (Rs.37424/12,475 hrs.)

Set-up related costs

Cost per set-up = Rs.256.18 (Rs.4355 / 17)

Set-up cost per unit of output :

Product A (1 X Rs.256.18) / 500 = Rs.0.51B (6 X Rs.256.18) / 5000 = Rs.0.31C (2 X Rs.256.18) / 600= Rs.0.85D (8 X Rs.256.18) / 7000 = Rs.0.29

Materials ordering related costs Costs per order = Rs.1920 / 10 orders = Rs. 192 per order Materials ordering cost per unit of output:

Product A (1 X Rs.192) /500 = Rs.0.38B (4 X Rs.192) / 5000 = Rs.0.15C (1 X Rs.192) / 600 = Rs.0.32D (4 X Rs.192) / 7000 = Rs.0.11

Materials handling related costs Cost materials handling = Rs.7,580 / 27 = Rs.280.74 Materials handling cost per unit of output :

Product A (2 X Rs.280.75) / 500 = Rs.1.12B (10 X Rs.280.74) / 5000 = Rs.0.56C (3 X Rs.280.74) / 600= Rs.1.10D (12 X Rs.280.74) /7000 = Rs.0.48

Spare parts Cost per part = Rs.8,600 / 12 = Rs.716.67Administration of spare parts cost per unit of output :

Product A (2 X Rs.716.67) / 500 =Rs.2.87 B (5 X Rs.716.67) / 5000 = Rs.0.72C (1 X Rs.716.67) / 600= Rs.1.19D (4 X Rs.716.67) / 7000 = Rs.0.41

Overhead cost per unit of output

Product A B C D Rs. Rs. Rs. Rs.

ABC overhead cost;Machine overheads 0.75 0.75 3.00 4.30

Set-ups 0.51 0.31 0.85 0.29


Materials ordering 0.38 0.15 0.32 0.11

Materials handling 1.12 0.56 1.40 0.48

Spare parts 2.87 0.72 1.19 0.41

5.53 2.49 6.76 5.79 Present system 1.20 1.20 4.80 7.20

Difference +4.43 +1.29 +1.96 -- 1.40

Production D is the low volume product, and thus the present volume-based recovery shows a large share of overheads for the product. In contract, the ABC system recognizes that product D consumers overheads according to activities consumption and traces to low amount of overhead to this product, as a result proper pricing of the product can be made.

Problem 11 During the last 20 years, KL’s manufacturing operation has become increasingly automated with

computer-controlled robots replacing operatives. KL currently manufacturers over 100 products of varying levels of design complexity. A single, plan-wide absorption rate (QAR), based on direct labour hours, is used to absorb overhead costs.

In the quarter ended March, KL’s manufacturing overhead cost were :

(Rs.000) Equipment operation expenses 125Equipment maintenance expenses 25Wages paid to technicians 85Wages paid to store men 35Wages paid to dispatch staff 40

310

During the quarter, RAPIER Management Consultants were engaged to conduct a review of KL’s cost accounting systems. RAPIER’s report includes the following statement :

‘In KL’s circumstance, absorbing overhead costs in individual products on a labour hour absorption basis is meaningless. Overhead costs should be attributed to product using an activity based costing (ABC) system. We have identified the following as being the most significant activities.

(1) Receiving component consignments from suppliers (2) Setting up equipment for production runs (3) Quality inspections(4) Dispatching goods orders to customers.

Our research as indicated that, in the short term, KL’s overheads are 40% fixed and 60% variable. Approximately half the variable overheads vary in relation to direct labour hours worked and half vary in relation to the number of quality inspections. This mode applies only to relatively small changes in the level of output during a period of two years or less’.

Equipment operation and maintenance expenses are apportion able as follows :

Component stores (15%), manufacturing (70%) and goods dispatch (15%).

Technician wages are apportion able as follows :


Equipment maintenance (30%), setting up equipment for production runs (40%) and quality inspections (30%).

During the quarter A total of 2000 direct labour hours were worked (paid at Rs.12 per hours).

980 component consignments were received from suppliers,

1020 production runs were set up,

640 quality inspection were carried out, and

420 goods orders were dispatched to customers.

Part One

Kl’s production during the quarter included components r, s and t. the following information is available:

Component Component Componentr s t

Direct labour hour worked 25 480 50

Direct materials costs Rs. 1,200 Rs.2,900 Rs.1,800

Component consignments Received 42 24 28

Production runs 16 18 12

Quality inspections 10 8 18

Goods order dispatched 22 85 46

Quantity produced 560 12,800 2,400

In April 2001 a customer asked KL to quote fro the supply of a new component (z) to a given specification. 1000 units of z are to be supplied each quarter for a two-year period. They will be paid fro in equal installments on the last day of each quarter. The job will involve an initial design cost of Rs.40,000 and production will involve 80 direct labour hours, Rs.2000 materials, 20 component consignments, 15 production runs, 30 quality inspections and 4 goods dispatches per quarter.

KL’s Sales Director comments :

‘Now we have a modern ABC system, we can quote selling prices with confidence. The quarterly charge we should be the forecast ABC production cost of the units plus the design cost of the z depreciated on a straight-line basis over the two ears of the job-to which we should add a 25% mark-up for profit. We can base out forecast on costs experienced in the quarter ended March.

Requirement : (a) Calculate the unit cost of components r, s and t using KL’s existing cost accounting system

(single factory labour hour OAR).


(b) Explain how an ABC system would be developed using the information given, Calculate the unit cost of components r, s and t using this ABC system.

(c) Calculate the charges per quarter that should be quoted for supply of component z in a manner consistent with the Sale Director’s comments. Advise KL’s management on the merits of this selling price, having regard to factors you consider relevant. Note : KL’s cost of capital is 3% per quarter.

Solution(a) Single factory labour hour overhead rate = Rs.310,000 ÷ 2000 hours = Rs.155 per direct labour

hours

Component r s tRs. Rs. Rs.

Direct labour costs at Rs.12 per hour 300 5,760 600 Direct materials 1,200 2,900 1,800Overheads (direct labour hoursXRs.155 per hr.)3,875 74,400 7,750

Total costs 5375 83,060 10,150

Cost per unit Rs.9.60 Rs.6.49 Rs.4.23

The consultants have already identified the most significant activities. They are receiving component consignments from suppliers, setting up equipment for production runs, quality, inspection and dispatching orders to customer. This following shows the assignment of the costs to these activities.

Receiving Set-up Quality Dispatching Total Suppliers inspection(Rs.000) (Rs.000) (Rs.000) (Rs.000) (Rs.000)

Equipment operation exp. a 18.75 87.50 18.75 125.00

Maintenance a 3.75 17.50 3.75 25.00

Technicians wages initially Allocated to maintenance (30% of Rs.85 =Rs.25,50) and then reallocated to activities on the same basis as maintenance a 3.83 17.85 3.82 25.50

Technicians wages allocation (excluding portion allocated tomaintenance ) b 34.00 25.50 59.50

Stores wages c 35.00 35.00Dispatch wages d 40.00 40.00

Total 61.33 156.85 25.50 66.32 310.00

Notes a Allocated on the basis 15%, 70% and 15% as specified in the question

b Allocated on the basis 30%, 40% and 30% (of Rs.85) as specified in the question

c Directly attribution to the receiving component suppliers activity


d Directly attributed to the dispatching activity

The next stage is to identify cost drivers for each activity and establish cost driver rates by dividing the activity costs by a measures of costs driver usage for the period. The calculations are as follows :

Receiving set-up (Rs.156,850 / 1020) =Rs.62.85 per component consignment received

Performing set-ups (Rs.156,850 / 1020) = Rs.153.77 per set –up

Quality inspection (Rs.25,500 / 640 ) =Rs.39.84 per quality inspection

Dispatching goods (Rs.66,320 / 420) =Rs.157.93 per goods order dispatched

Finally, the costs are assigned to components based on their cost driver usage. The assignment are as follows :

r s tRs. Rs. Rs.

Direct labour 300.00 5,760.00 600.00Direct materials 1,200.00 2,900.00 1,800.00Receiving suppliers 2,628.36 1,501.92 1,752.24Performing set-ups 2,460.32 2,767.86 1,854.24Quality inspection 398.40 318.72 717.12Dispatching goods 3,474.46 13,424.05 7,264.78

10,461.54 26,672.55 13,979.38

Number of unit produced 560 12,800 2,400

Cost per unit Rs.18.68 Rs.2.08 Rs.5.82

For component r the overhead costs have been assigned as follows Receiving suppliers (42 receipts at Rs.62.58)Performing set-ups (16 production runs at Rs.153.77)Quality inspection (10 at Rs.39.84) Dispatching goods (22 at Rs.157.93)

(c) Cost assigned to component z

Quality charges (for 1000 units) Rs.Design cost Rs.40,000 8 5,000

Direct labour 80 X Rs.12 960

Direct materials 2,000

Overheads : Receiving suppliers Rs.62.58 X 20 1,252Set-ups Rs.153.77 X 15 2,307 Quality inspection Rs.39.84 X 30 1,195Dispatching goods Rs.157.93 X 4 632

Total 13,346

25% mark up 3,337


Charges per quarter 16,683

According to the information provided in the question the short-term incremental cost attributable to the order is as follows :

( Rs.Design cost (Rs.40,000 / 7 / 2 annuity factor2) 5,698

Direct labour (80 hours at Rs.12) 960

Direct materials 2,000

Labour related variable overheads b 3,720

Inspection related variable overhead b 4,359

16,737 Notes a Represents the value of Rs.8000 received in 8 quarterly installments by dividing Rs.40,000 by the annuity factor for 8 period at 3% (present values are explained in Chapter 13.)

b The question states that 40% of the overheads are variable in the short-term and 50% of these costs vary with direct labour hours and the remaining 50% vary with the number of quality inspections. Therefore the variable overhead rates are :

Labour related = (310,000 X 0.6 X 0.5) / 2000 = Rs.46.50 per direct labour hour Inspection related = (310,000 X 0.6 X 0.5 ) / 640 = Rs.145.31 per quality inspection

Charge to Component Z

Labour related = 80 hours at Rs.46.50 = Rs.3720

Inspection related = 30 inspection at Rs.145.31 = Rs.4359

The method suggested by the sales manager results in a reported product cost that is lower than the short-term incremental costs of the order. This suggestion that the proposed costing system does not accurately assign costs object or that the variable cost analysis implied in the question is incorrect. The discrepancy between the above reported costs should be investigated and the design of the costing system reviewed.

Problem 12Frolin Chemicals Ltd. Produces FDN. The Standard ingredients of 1 kg. of FDN are:

0.65 kg. of ingredient F @ Rs. 4.00 per kg.0.30 kg. of ingredient D @ Rs. 6.00 per kg.0.20 kg. of ingredient N @ Rs. 2.50 per kg.1.15 kg

Production of 4,000 kg. of FDN was budgeted for April. The production of FDN is entirely automated and production costs attributed to FDN production comprise only direct materials and


overheads. The FDN production operation works on a JIT basis and no ingredient or FDN inventories are held.

Overheads were budgeted for April for the FDN production operation as follows:

Activity Total amount Receipt of deliveries (Standard deliveryFrom suppliers quantity is 460 kg) Rs. 4,000

Dispatch of goods (Standard dispatchTo customers quantity is 100 kg) Rs. 8,000

Rs. 12,000In April, 4,200 kg. of FDN were produced and cost details were as follows:

Materials used:2,840 kg. of F, 1,210 kg of D and 860 kg of NTotal cost Rs. 20,380

Actual overhead costs:12 supplier deliveries (cost Rs. 4,800) were made, and 38 customer dispatches (Cost Rs, 7,800) Were Processed.

Frolin Chemicals Ltd.’s budget committee met recently to discuss the preparation of the financial control report for April, and the following discussion occurred:

Chief Accountant: ‘The overheads do not vary directly with output and are therefore by definition “Fixed”. They should be analyzed and reported accordingly:

Management Accountant: ‘The overheads do not vary with output, but they are certainly not fixed. They should be analyzed and reported on an activity basis.’

Requirements:Having regard to this discussion,

(a) prepare a variance analysis for FDN production costs in April: separate the material cost variance into price, mixture and yield components; separate the overhead cost variance into expenditure, capacity and efficiency components using consumption of ingredient F as the overhead absorption base;

(b) Prepare a variance analysis for FDN production overhead costs in April on an activity basis;

(c) Explain how, in the design of an activity – based costing system, you would identify and select the most appropriate activities and cost drivers.

Solution Standard Actual BRAI or 1 kg. 4,200 kg Ac cost driverMaterial Rs./unit kg.

F =0.65@4 2.6 F 2,840 2,8404 = 11,363D = 0.3 kg.@6 1.8 D 1,210 1,2106 =7,260N =0.2 kg. @ 2.5 0.5 N __860 ______ 8602.5 = 2,150

Input 1.15 kg. 4.9 4,910 20,380 20,770

mailto:kg.@6

mailto:0.65@4


Overhead activityReceipt of delivery @ 460 kg./delivery 12 delivery 4,800 12400 =4,800i.e. 10 delivery @ 400-4,000 38 Dispatch 7,800 38200 = 7,600 12,600

Dispatch 100 kg. /dis.i.e. 40 dis. @ 200 _8,000

12,000Budgeted output 4,000 kg.Input 4,600 4,0001.15

(a) MCV = Budgeted cost for Actual output –Actual cost= 4.94,200-20,380 = 200 F

MUV = 4.9 4,200 –20,770 = 190 (A)MYV = Budgeted cost for Actual output –BC (TAI/TBA)

= 4.94,200 – (4.94,600/1.5) = 490/4,600 = 341 (A)

BS = 4,600 kg. M mix variance = BC TAI/TBI –BR AINF = 4,600 (0.65/1.15)4D = 4,6000.3/1.15 6 4.9(4,910/4,600) (4,600/1.15) –20,770 = 151 (F)N = 4,6000.2/1.152.5

MPV = 20,770 –20,380 = 390 (F)MUV = MYV + M mix variance190 (A) = 342 –151 (F)

Basis of recovery of Overhead = Budgeted consumption of F4,600(0.651.15) = 2,600 kg.

Fixed overhead recovery rate = 12,0002,600 = 4.62/kg. Of F

Cost variance = Budgeted cost for Actual cost –Actual Fixed overhead= 12,000(4,200/4,000) –12,600 = Nil

Volume variance = Budgeted cost for Actual cost –Budgeted Fixed overhead= 12,600 –12,000 = 600 (F)

Expenditure variance = BFO –AFO= 12,000 –12,600 = 600 (A)

Efficiency variance = Budgeted cost for Actual output –Budgeted cost/kg. Of F Actual Qty. of F

= 12,600 –4.62 2,840 = 521 (A)

Capacity variance = BR kg. Of F AQ of F –BFO= 4.622,840 –12,000 = 1,120.8 (F)

(b) Overhead variance on ABC basisFor Activity receipt

Cost variance = Budgeted cost for Actual output –Actual cost = 4,000(4,200/4,000) –4,800 = 600 (A)

Volume variance = Budgeted cost for Actual output –BFO= 4,200- 4,000 = 200 (F)


Exp. Variance = BFO –AFO= 4,000 –4,800 = 800 (A)

Effi. Variance = Budgeted cost for Actual cost –BR/cost driver Actual cost driver= 4,200 -40012 = 600 (A)

Capacity variance = BR/CD AC.CD – BFO=40012 –4,000 = 800 (F)

For Activity dispatchCost variance = Budgeted cost for Actual output –Actual cost

= 8,000 (4,200/4,000) –7,800 = 600 (F)

Volume variance = Budgeted cost for Actual cost-BFO = 8,400 –8,000 = 600 (F)

Exp. Variance = BFO –AFO= 8,000 –7,800 = 200 (F)

Effi. Variance = BC for Actual output- BR/cost driver Actual CD= 8,400- 20038= 800 (F)

Capacity variance = 7,600 –8,000= 400 (A)

Problem 13Ah! Big & Complex (ABC) Electronics makes audio player model AB 100. This model has 80 components. ABC sells 10,000 units each month at Rs. 3,000 per unit. The cost of manufacturing is Rs. 2,000 per unit or Rs. 200 lakhs per month for the production of 10,000 units. Monthly manufacturing costs incurred (in Rs. Lakhs) are as follows:

Direct materials costs 100.00Direct manufacturing labour costs 20.00Machining costs 20.00Testing costs 25.00Rework costs 15.00Ordering costs 0.20Engineering costs 19.80

Labour is paid on piece rate basis, therefore, ABC considers, direct manufacturing labour costs as variable cost.

The following additional information is available for AB 100: Testing and inspection time per unit is 2 hours 10 per cent of AB 100 manufactured are reworked It currently takes 1 hour to manufacture each unit of AB 100. ABC places two orders per month for each component. Each component is supplied by a

different supplier.

ABC has identified activity cost pools and cost drivers for each activity. The cost per unit of the driver for each activity cost pool is as follows:

Manufacturing Description of activity cost driver cost per unitActivity of cost driver Machining costs Machining components Machine hours of Rs. 200


Capacity

Testing costs Testing components and finished Testing hours Rs. 125Products. (each unit of AB 100 isTested individually)

Rework costs Correcting and fixing errors and units reworked Rs. 1,500Defects

Ordering costs ordering of components Number of orders Rs. 125Engineering costs Designing and managing of engineering hrs. Rs. 198 Products and processes

Over a long – run horizon, each of the overhead costs described above varies with chosen cost drivers.In response to competitive pressure ABC must reduce the price of its product to Rs. 2,600 and to reduce the cost by at least Rs. 400 per unit. ABC does not anticipate increase in sales due to price reduction. However, if it does not reduce price it will not be able to maintain the current sales level.

Cost reduction on the existing model is almost impossible. Therefore, ABC has decided to replace AB 100 by a new model AB 200, which is a modified version of AB 100. the expected effect of design changes are:

The number of components will be reduced to 50. Direct materials costs to be lower by Rs. 200 per unit. Machining time labour costs to be lower by 20%. Direct Manufacturing labour costs to be lower by Rs. 20 per unit. Testing time required to be low by 20%. Rework to decline to 5% Machining capacity and engineering hours capacity to remain the same.

ABC currently outsource the rework on defective units.

Required: Compare the manufacturing cost per unit of AB 100 and AB 200. Determine the immediate effect of design change and pricing decision on the operating

income of ABC.

Ignore income tax. Assume that the cost per unit of each cost driver for AB 100’ continues to apply to ‘AB 200.’

Solution AB-100 AB-200Units 10,000 10,000

Rs./unit Rs./unitMaterial 100 lakhs/10,000 1,000 800Direct wages 20 L10,000 200 180MC cost 200 160Test cost 250 200Rework cost 150 75Ordering cost 2 1.25Engineering cost _198 _198 Total cost 2,000 1,614.25Revised SP __2,600 __2,600 Profit p.u 600 985.75


Total profit (Rs. In lakhs) 60 98.75

If the current products AB-100 is not replaced by new products AB-200 then profit will reduce by 38.75 lakhs. So, it is recommended to introduce AB-200.

Problem 14S&P Products plc purchases a range of foods quality gift and household products from around the world. If then sells these products through “mail order” or retails outlets. The company receives “mail order” by post. Telephone and Internet. Retails outlets are either department stores or S & P Products plc’s own small shops. The company started to set up its own shops after recession in the early 1990s and regards them as the flagships of its business; sales revenue has gradually built up over the last 10 years. There are now 50 department stores and 10 shops.

The company has made goods profits over the last few years but recently trading has been difficult. As a consequence, the management team has decided that a fundamental reappraisal of the business is now necessary if the company is to continue trading.

Mean while the budgeting process for the corning year proceeding. S & P Products plc uses an activity-based costing (ABC) system and the following estimated cost information for the coming year is available:

Retails outlets costs Activity Cost driver Rate per cost Number each year for each outlet driver department store own shop

Rs.Telephone Calls 15 40 350Request to S & PSales Visit to shops and Visits 250 2 4Stores by S & P sales staffShop orders Orders 20 25 150Packing Deliveries 100 28 150Delivery to shops Deliveries 150 28 150 Staffing, rental and service costs for each of S & P Product plc’s own shops cost on average Rs.300,000 a year. Mail order costs:

The total number of orders through the whole “mail order” business for coming year is expected to be 80,000. The maintenance of the internet link is estimated to cost Rs.80,000 for the coming year.

Other Information DepartmentStore Own shop Post Telephone Internet

Activity Cost driver Rate per cost driver Post Telephone Internet

Processing “mail order”

Dealing with “mail order”Queries

Orders

Orders

Rs.5

4

Rs.6

4

Rs.3

1

Packing and deliveries for “Mail orders” – cost per Package Rs.10

PackagesNumber of packages per order

2 2 1


Sales revenue per outlet

Sales revenue per order

Gross margin: mark-up on Purchase cost

Number of outlets

Percentage of “mail orders”

Rs.50,000

30%

50

Rs.1,000,000

40%

10

Rs.150

40%

30%

Rs.300

40%

60%

Rs.100

40%

10%

Expected Head Office and warehousing costs for the coming year: Rs.

Warehouse 2,750,000IT 550,000Administration 750,000Personnel 300,000

4,350,000 Required :

(i) Prepare calculation that will show the expected profitability of the different types of sales outlet for the coming year.

(ii) Comment briefly on the results of the figures you have prepared.

Solution Statement of profit (unit basis) Dept. Own shop post tele Internet(a) Numbers 50 10 24,000 48,000 8,000

Rs./dept Rs./sale Rs./order(b) Sales /rev. 50,000 10,00,000 150 300 100(c) Gross margin 30% 40% 40% 40% 40%(d) Gross profit

[50,000(30/130) 11,538 2,85,714 42.86 85.71 28.57

(-) S & D overhead:Tele requd. @ 15 600 5,250 -- -- --Sales visit @ 250 500 1,000 -- -- --Shop order @ 20 500 3,000 -- -- --Packing @ 100 2,800 15,000 -- -- --Delivery @ 150 4,200 22,500 -- -- --Staff & rent -- 3,00,000 -- -- --Processing & Maintenance -- -- 5 6 3Delivery mailOrder -- -- 4 4 1Packing & Delivery @ 10 -- -- 20 20 10

____ ____ _____ ____ _____(e) Profit/outlet 2,938 (61,036) 13.86 55.17 4.57(f) Total profit 1,46,900 6,10,360 3,32,640 26,74,080 36,560

(ae)

Total profit = 25,79,820 Statement of total profit Department 1,46,900


Own ship (6,10,360)Post 3,32,640TelephoneInternet ________

25,79,820Less: Ho expenses 43,50,000 Loss 17,70,180

Note-1:Total mail order = 80,000. Post 30% of 80,000 = 24,000 & etc.

Note-2:Internet cost 80,000 for 8,000 orderCost per order 10/-.Re-management should adopt restricting & cost control policy immediately particularly with the following items.

(i) Staff & Rent per own outlet i.e. shop Rs. 3,00,000(ii) HO expenses 43,50,000.

Points to remember before Examination

1. Allocate & apportion the cost per activity2. Select the cost driver 3. Compute rate of recovery per cost driver4. Overhead for the product = activity consume by the product × rate of recovary

Problems for self assessment

Question 1A company manufactures several product of varying levels of designs and models. It uses a single overhead recovery rate based on direct labour hours. The overheads incurred by the company in the half of the year are as under:

Rs. Machine operation expenses 10,12,500 Machine maintenance expenses 1,87,500 Salaries of technical staff 6,37,500 Wages and salaries of stores staff 2,62,500

During this period, the company introduced activity based costing system and the following significant activities were identified:

- receiving materials and components- set up of machines for production runs- quality inspection.

It is determined that:


- The machine operation and machine maintenance expenses should be apportioned between stores and production activity in 20:80 ratio.

- The technical staff salaries should be apportioned between machine maintenance , set up and quality inspection in 30:40:30 ratio.

The consumption of activities during the period under review are as under:

- Direct labour hours worked 40,000- Direct wage rate Rs.6 per hour- Production set-ups 2,040- Material and component consignments from received from suppliers 1,960- Number of quality inspections carried out 1,280

The data relating to two product manufactured by the company during the period the are as under:

Products

P Q Direct material costs Rs. 6,000 4,000

Direct labour hours 960 100

Direct material consignments received 48 52

Production runs 36 24

Number of quality inspections done 30 10

Quantity produced (units) 15,000 5,000

A potential customer has approached the company for the supply of 24,000 units of a component K to be delivered in lots of 3,000 units per quarter. The job will involve an initial design cost of Rs. 60,000 and the manufacture will involve the following per quarter:

Direct material costs Rs. 12,000 Direct labour hours 300

Production runs 6

Inspections 24

Number of consignments of direct materials to be received 20

The company desires a mark up of 25% on cost.

Required:(i) Calculate the cost of product P and Q based on the existing system of single overhead

recovery rate.

(ii) Determine the cost of product P and Q using activity based costing system.

(iii) Compute the sales value per quarter of component K using activity based costing system. Solution


P QCost per unit on single rate Rs 4,144 1,97

Cost per unit on ABC (Rs.) 3.58 7.31

Selling price per unit of K = Rs. 14.34

Question 2

XYZ Ltd. manufactures four products, namely A, B, C and D using the same plant and process. The following information relates to a production period: 11

Product A B C D Output in units : 720 600 480 504Cost per units : Rs. Rs. Rs. Rs.Direct Material 42 45 40 48Direct Labour 10 9 7 8Machine hours per units 4 hrs 3hrs 2hrs 1 hr

The four products are similar and are usually produced in production runs of 24 units and sold in batches of 12 units. Using machine hour rate currently absorbs the production overhead. The total overheads incurred by the company for the period is as follows :

Rs.Machine operation and Maintenance cost 63,000Setup costs 20,000Store receiving 15,000Inspection 10,000Material handling and dispatch 2,592

During the period the following cost drivers are to be used for the overhead cost :

Cost Cost Driver

Setup cost No. of production runsStore receiving Requisition raisedInspection No. of production runsMaterial handling and dispatchOrder executedIt is also determined that :

Machine operation and maintenance lost should be apportioned between setup cost, store receiving and inspection activity in 4:3:2.

Number of requisition raised on store is 50 for each product and the no. of order executed is 192, each order being for a batch of 12 of a product.

Required :

(a) Calculate the total cost of each product, if all overhead costs are absorbed on machine hour rate basis.

(b) Calculate the total cost of each product using activity base costing.

(c) Comment briefly on differences disclosed between overhead traced by present system and those traced by activity base costing.(8 marks)

Solution(a) A B C D


Rs. Rs. Rs. Rs.Total cost 89,280 64,800 39,840 37,296

(ii) Activity based costing systemTotal cost 69,750 60,825 47,100 53,541Per unit cost 96.875 101.375 98.125 106.23

(iii) A B C D(Rs) (Rs) (Rs) (Rs)

Cost per unit (a) 124 108 83 74Cost per unit (b) 96.88 101.38 98.13 106.23Difference (27.12) (6.62) 15.13 32.23

The total overheads which are spread over the four products have been apportioned on different bases, causing the product cost to differ substantially in respect of product A and D. A change from traditional machine hour rate to an activity system may have effect on price and profits to the extent that pricing is based on cost plus approach.

Documents

319 Resource 1(b) Activity Based Cost Management