Activity Based Costing for P1

8/10/2019 Activity Based Costing for P1

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Activity Based Costing ABC)

Q2. Triple Limited makes three types of gold watch the Diva (D), the Classic (C) and the Poser (P). A traditional productcosting system is used at present; although an activity based costing (ABC) system is being considered. Details of the threeproducts for a typical period are:

Hours per unit Material ProductionLabour hours Machine hours Cost per unit ($) UnitsProduct D 1 20 1 ,750Product C 1 1 12 1,250Product P 1 3 25 7,000Direct labour costs $6 per hour and production overheads are absorbed on a machine hour basis. The overhead absorptionrate for the period is $28 per machine hour.Required:(a) Calculate the cost per unit for each product using traditional methods, absorbing overheads on the basis of machinehours.Total production overheads are $654,500 and further analysis shows that the total production overheads can be divided asfollows:

%

Costs relating to set-ups 35Costs relating to machinery 20Costs relating to materials handling 15Costs relating to inspection 30Total production overhead 100

The following total activity volumes are associated with each product line for the period as a whole:Number of Number of movements Number ofSet ups of materials inspections

Product D 175 112 1,150Product C 115 121 1,180Product P 480 187 1,670

670 120 1,000

Required:(a) Calculate activity based recovery rates (4 marks)(b) Calculate the cost per unit for each product using ABC principles (work to two decimal places). (C) Discuss why absorption costing gives better result as compared with traditional absorption costing in todaysmanufacturing environment. (4 marks)

Q3.Linacre Co operates an activity-based costing system and has forecast the following information for next year.Cost Pool Cost Cost Driver No of DriversProduction set-ups 105,000 Set-ups 300Product testing 300,000 Tests 1,500Component supply and storage 25,000 Component orders 500Customer orders and delivery 112,500 Customer orders 1,000General fixed overheads such as lighting and heating, which cannot be linked to any specific activity, are expected to be

900,000 and these overheads are absorbed on a direct labour hour basis. Total direct labour hours for next year areexpected to be 300,000 hours.Linacre Co expects orders for Product ZT3 next year to be 100 orders of 60 units per order and 60 orders of 50 units perorder. The company holds no stocks of Product ZT3 and will need to produce the order requirement in production runs of900 units. One order for components is placed prior to each production run. Four tests are made during each production runto ensure that quality standards are maintained.The following additional cost and profit information relates to product ZT3:Component cost: 100 per unitDirect labour: 10 minutes per unit at 780 per hourProfit mark up: 40% of total unit costRequired:Calculate cost per unit of Product ZT3 by using ABC


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Q4. Jola Publishing Co publishes two forms of book.

The company publishes a childrens book (CB), which is sold in large quantities to government controlled schools. The bookis produced in only four large production runs but goes through frequent government inspections and quality assurancechecks. The paper used is strong, designed to resist the damage that can be caused by the young children it is producedfor.

The book has only a few words and relies on pictures to convey meaning.The second book is a comprehensive technical journal (TJ). It is produced in monthly production runs, 12 times a year. Thepaper used is of relatively poor quality and is not subject to any governmental controls and consequently only a smallnumber of inspections are carried out. The TJ uses far more machine hours than the CB in its production.

The directors are concerned about the performance of the two books and are wondering what the impact would be of aswitch to an activity based costing (ABC) approach to accounting for overheads. They currently use absorption costing,based on machine hours for all overhead calculations. They have accurately produced an analysis for the accounting yearjust completed as follows:

CB TJ$per unit $per unit $per unit $per unit

Direct production costsPaper 075 008

Printing ink 145 447Machine costs 115 195

335 650Overheads 230 395Total cost 565 1045Selling price 905 1385Margin 340 340The main overheads involved are:

Overhead % of total overhead Activity driverProperty costs 750% Machine hoursQuality control 230% Number of inspectionsProduction set up costs 20% Number of set ups

If the overheads above were re-allocated under ABC principles then the results would be that the overhead allocation to CB

would be $005 higher and the overhead allocated to TJ would be $030 lower than previously.Required:(a) Explain why the overhead allocations have changed in the way indicated above.(b) Briefly explain the implementation problems often experienced when ABC is first introduced.

The directors are keen to introduce ABC for the coming year and have provided the following cost and selling price data:1.The paper used costs $2 per kg for a CB but the TJ paper costs only $1 per kg. The CB uses 400g of paper for eachbook, four times as much as the TJ uses.2.Printing ink costs $30 per litre. The CB uses one third of the printing ink of the larger TJ. The TJ uses 150ml of printing inkper book.3. The CB needs six minutes of machine time to produce each book, whereas the TJ needs 10 minutes per book. Themachines cost $12 per hour to run.4.The sales prices are to be $930 for the CB and $1400 for the TJ As mentioned above there are three main overheads,

the data for these are:Overhead Annual cost for the coming year$

Property costs 2,160,000Quality control 668,000Production set up costs 52,000Total 2,880,000

The CB will be inspected on 180 occasions next year, whereas the TJ will be inspected just 20 times. Jola Publishing willproduce its annual output of 1,000,000 CBs in four production runs and approximately 10,000 TJs per month in each of 12production runs.

Required:(c) Calculate the cost per unit and the margin for the CB and the TJ using machine hours to absorb the overheads.(d) Calculate the cost per unit and the margin for the CB and the TJ using activity based costing principles to

absorb the overheads.


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The first thing to point out is that the overhead allocations to the two products have not changed by that much. For examplethe CB has absorbed only $005 more overhead. The reason for such a small change is that the overheads are dominatedby property costs (75% of total overhead) and the driver for these remains machine hours once the switch to ABC is made.

Thus no difference will result from the switch to ABC in this regard.

The major effect on the cost will be for quality control. It is a major overhead (23% of total) and there is a big difference

between the relative number of machine hours for each product and the number of inspections made (the ABC driver). TheCB takes less time to produce than the TJ, due to the shortness of the book. It will therefore carry a smaller amount ofoverhead in this regard. However, given the high degree of government regulation, the CB is subject to frequentinspections whereas the TJ is inspected only rarely. This will mean that under ABC the CB will carry a high proportion of thequality control cost and hence change the relative cost allocations.

The production set up costs are only a small proportion of total cost and would be, therefore, unlikely to cause much of adifference in the cost allocations between the two products. However this hides the very big difference in treatment. The CBis produced in four long production runs, whereas the TJ is produced monthly in 12 production runs. The relative proportionsof overhead allocated under the two overhead treatments will be very different. In this case the TJ would carry much moreoverhead under ABC than under a machine hours basis of overhead absorption.

(b) There are many problems with ABC, which, despite its academic superiority, cause issues on its introduction.

Lack of understanding. ABC is not fully understood by many managers and therefore is not fully accepted as a means ofcost control.

Difficulty in identifying cost drivers. In a practical context, there are frequently difficulties in identifying the appropriatedrivers. For example, property costs are often significant and yet a single driver is difficult to find.

Lack of appropriate accounting records. ABC needs a new set of accounting records, this is often not immediatelyavailable and therefore resistance to change is common. The setting up of new cost pools is needed which time isconsuming.

Q5.An analysis of the companys indirect production costs shows the following: $ Cost driver

Machine setup costs 120,600 Number of batchesMaterial ordering costs 64,800 Number of supplier orders

General facility costs 337,500 Number of machine hoursThe following additional data relate to each product:Product W X YPrime cost 15 24 35Machine hours per unit 5 8 7Batch size (units) 500 400 1,000Supplier orders per batch 4 3 5Demand 8,000 6,000 5,000Required:(a) Calculate the full cost per unit of each product using Activity Based Costing. (8 marks)(b) Explain how Activity Based Costing could provide information that would be relevant to the management team when it ismaking decisions about how to improve KLs profitability. (4 marks)


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Q6. Duff Co manufactures three products, X, Y and Z. Demand for products X and Y is relatively elastic whilst demand forproduct Z is relatively inelastic. Each product uses the same materials and the same type of direct labour but in differentquantities. For many years, the company has been using full absorption costing and absorbing overheads on the basis ofdirect labour hours. Selling prices are then determined using cost plus pricing. This is common within this industry, with mostcompetitors applying a standard mark-up.Budgeted production and sales volumes for X, Y and Z for the next year are 20,000 units, 16,000 units and 22,000 units

respectively.The budgeted direct costs of the three products are shown below:Product X Y Z

$ per unit $ per unit $ per unitDirect materials 25 28 22Direct labour ($12 per hour) 30 36 24In the next year, Duff Co also expects to incur indirect production costs of $1,377,400, which are analysed as follows:Cost pools $ Cost driversMachine set up costs 280,000 Number of batchesMaterial ordering costs 316,000 Number of purchase ordersMachine running costs 420,000 Number of machine hoursGeneral facility costs 361,400 Number of machine hours

1,377,400

The following additional data relate to each product:Product X Y ZBatch size (units) 500 800 400No of purchase orders per batch 4 5 4Machine hours per unit 15 125 14Duff Co wants to boost sales revenue in order to increase profits but its capacity to do this is limited because of its use ofcost plus pricing and the application of the standard mark-up. The finance director has suggested using activity basedcosting (ABC) instead of full absorption costing, since this will alter the cost of the products and may therefore enable adifferent price to be charged.Required:(a) Calculate the budgeted full production cost per unit of each product using Duff Cos current method of

absorption costing. All workings should be to two decimal places. (3 marks)(b) Calculate the budgeted full production cost per unit of each product using activity based costing. All workingsshould be to two decimal places. (11 marks)(c) Discuss the impact on the selling prices and the sales volumes OF EACH PRODUCT which a change to activitybased costing would be expected to bring about. (6 marks)

(20 marks)

Q7. F Company supplies pharmaceutical drugs to drug stores. Although the company makes a satisfactory return, the

directors are concerned that some orders are profitable and others are not. The management has decided to investigate a

new budgeting system using activitybased costing principles to ensure that all orders they accept are making a profit.

Each customer order is charged as follows. Customers are charged the list price of the drugs ordered plus an additional

charge for overheads. A profit margin is also added, but that does not form part of this analysis and can therefore be

ignored.Currently F Company uses a simple absorption rate to absorb these overheads. The rate is calculated based on the

budgeted annual overhead costs divided by the budgeted annual total list price of the drugs ordered.

An analysis of customers has revealed that many customers place frequent small orders with each order requesting a

variety of drugs. The management of F Company has examined more carefully the nature of its overhead costs, and the

following data have been prepared for the budget for next year:

Total list price of drugs supplied $8m

Number of customer orders 8,000

Overhead costs $000 Cost driverInvoice processing 280 See Note 2Packing 220 Size of packagesee Note 3Delivery 180 Number of deliveriessee Note 4

Other overheads 200 Number of ordersTotal overheads 880


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Notes:1.Each order will be shipped in one package and will result in one delivery to the customer and one invoice (an order neverresults in more than one delivery).2.Each invoice has a different line for each drug ordered. There are 28,000 invoice lines each year. It is estimated that 25%of invoice processing costs are related to the number of invoices, and 75% are related to the number of invoice lines.3. Packing costs are $32 for a large package, and $25 for a small package.

4. The delivery vehicles are always filled to capacity for each journey. The delivery vehicles can carry either 6 largepackages or 12 small packages (or appropriate combinations of large and small packages). It is estimated that there will be1,000 delivery journeys each year, and the total delivery mileage that is specific to particular customers is estimated at350,000 miles each year. $40,000 of delivery costs are related to loading the delivery vehicles and the remainder of thesecosts are related to specific delivery distance to customers.The management has asked for two typical orders to be costed using next years budget data, using the current method,and the proposed activity-based costing approach.Details of two typical orders are shown below:

Order A Order BLines on invoice 2 8Package size Small LargeSpecific delivery distance 8 miles 40 milesList price of drugs supplied $1,200 $900

Required:(a) Calculate the charge for overheads for Order A and Order B using:(i) the current system; and (3 marks)(ii) the activity-based costing approach. (12 marks)(b) Write a report to the management of F Company in which you assess the strengths and weaknesses of the proposedactivity-based costing approach for F company; (5 marks)

(Total: 20 marks)


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A major company sells a range of electrical, clothing and homeware products through a chain of department stores. Themain administration functions are provided from the companys head office. Each department store has its own warehousewhich receives goods that are delivered from a central distribution centre.The company currently measures profitability by product group for each store using an absorption costing system. Alloverhead costs are charged to product groups based on sales revenue. Overhead costs account for approximately one-thirdof total costs and the directors are concerned about the arbitrary nature of the current method used to charge these costs to

product groups.A consultant has been appointed to analyse the activities that are undertaken in the department stores and to establish anactivity based costing system.The consultant has identified the following data for the latest period for each of the product groups for the X Town store:

The consultant has also obtained the following information about the support activities

Required:(a) Calculate the total profit for each of the product groups:

(i) using the current absorption costing system; (4 marks)(ii) using the proposed activity based costing system. (9 marks)

(b) Explain how the information obtained from the activity based costing system might be used by the management of thecompany. (6 marks)

(c) Explain the circumstances under which an activity based costing system would produce similar product costs to thoseproduced using a traditional absorption costing system. (6 marks)

(Total for Question Three = 25 marks)


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A company sells and services photocopying machines. Its sales department sells the machines and consumables, includingink and paper, and its service department provides an after sales service to its customers. The after sales service includesplanned maintenance of the machine and repairs in the event of a machine breakdown. Service department customers arecharged an amount per copy that differs depending on the size of the machine.The companys existing costing system uses a single overhead rate, based on total sales revenue from copy charges, to

charge the cost of the Service Departments support activities to each size of machine. The Service Manager has suggested

that the copy charge should more accurately reflect the costs involved. The companys ac countant has decided toimplement an activity-based costing system and has obtained the following information about the support activities of the

service department:

The following data have also been collected for each machine size:

Each customer has a service contract for two machines on average.

Required:(a) Calculate the annual profit per machine for each of the three sizes of machine, using the current basis for charging thecosts of support activities to machines. (4 marks)

(b) Calculate the annual profit per machine for each of the three sizes of machine using activity-based costing.(14 marks)

(c) Explain the potential benefits to the company of using an activity-based costing system. (7 marks)(Total for Question Three = 25 marks)

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Activity Based Costing for P1