Activity Based Costing Of Rock Widget Organisation

This presentation explains Activity Based Costing (ABC) and its advantages and disadvantages. It also describes how ABC is implemented in Rock Widget Ltd organisation. The presentation covers topics such as definition of ABC, comparison with other costing systems, resources, resource drivers, activities, activity drivers, activity cost drivers, cost objects, advantages and disadvantages of ABC, traditional costing techniques, and why ABC might be recognized as beneficial in preference to traditional costing techniques.

BMP5006 Financial Management & Decision
Making
Assessment 1 - Presentation

Activity Based Costing Of Rock
Widget Organisation
Name: xxxxxxx
ID: xxxxxxx

Content
• Definition of Activity Based Costing
• Comparison with other costing systems
• Activity Based Costing of Rock Widget Ltd organisation
Resources
Resource Drivers
Activities
Activity Drivers
Activity Cost Drivers
Cost Objects

Content
• Advantages of the business using ABC
• Disadvantages of the business using ABC
• Traditional Costing Techniques
• Why Activity Based Costing (ABC) might be recognised as beneficial in
preference to Traditional Costing Techniques

Definition of Activity Based Costing (ABC)
• An accounting system known as "Activity Based Costing" allocates costs to activities
rather than to goods or services. As a result, resources and administrative costs can be
more precisely allocated to the goods and services that use them. The ABC technique
entails identifying the costs associated with each action that drives expenses and using
those costs as the foundation for allocating costs among various cost objects, products,
jobs, or services.
• Based on how many resources they consume, ABC allocates costs to various activities.
Then, based on the utilisation of activities by cost objects, such as consumers or items,
cost is assigned to those things. By establishing a connection between the activity and the
cost object, ABC can keep track of the flow of activities within the company.

Comparison with other costing systems
•A crucial piece of data for a company's decision-making is the accurate calculation of
production costs for each product. For instance, understanding the cost to produce a unit of a
product has an impact on how a company budgets to manufacture that product and is
sometimes the starting point for calculating the sales price.
•The price of gathering and processing data should also be taken into account when choosing
between the two main ways of overhead allocation. The business must take into account
these time and financial considerations when deciding which approach to use. The ABC
technique is frequently more expensive in terms of time and other expenses.
•It takes into account more factors than just the number of cost drivers to distinguish between
the classic technique (which uses one cost driver) and the ABC method (which uses several
cost drivers). When direct labour accounts for a sizable amount of the product cost, overhead
costs frequently follow a single cost driver, which is typically direct labour or machine
hours; the conventional technique allocates those costs correctly. Utilizing several cost
drivers in the ABC technique allows for a more accurate allocation of overhead when
technology accounts for a significant amount of the product cost.

Activity Based Costing of Rock Widget Ltd organisation - Resources
A company that manufactures widgets intends to implement an ABC system. The management decides that
the only three cost factors for all overhead expenses will be the amount of purchase orders, direct labour
hours, and machine hours. The following overhead expenses are listed in the company's general ledger.
•General Ledger Amount
•Payroll taxes 1,000
•Maintenance of machine 500
•Purchase of Dept. labour 4,000
•Fringe benefits 2,000
•Purchase of Dept. Supplies 250
•Depreciation of equipment 750
•Electricity 1,250
•Unemployment insurance 1,500
•Total 11,250

Activity Based Costing of Rock Widget Ltd organisation – Resource Drivers
•Cost Driver: A factor that affects how much an activity costs. The two types of cost
drivers are as follows.
•Resource Cost Driver
•Activity Cost Driver
•Cost Pool: This is a collection of different individual cost elements. It consists of
expenses with the same cause and effect. For instance, machine configuration (set up).
•Resource drivers: This metric measures how many resources an activity uses. It is used
to allocate a resource's cost to a certain activity or cost pool.

Activity Based Costing of Rock Widget Ltd
organisation – Activities
Activities: An event that costs money is referred to as an "activity" in this context.
•The following is a list of the several steps in ABC calculations:
•List the many activities carried out by the organisation: A traditional overhead system typically uses
only a few cost centres, perhaps as few as fifteen. The exact number of activities in ABC will
depend on how the management splits up the organization's tasks, but it will be significantly higher,
perhaps 200. The organisation can be divided up into numerous really minor operations. However,
in order for ABC to be considered a useful method, larger groupings—like 40 activities—must be
used. Regardless of other factors, ABC should be more accurate than the conventional technique
because there are more activities than cost centres. The following set of activities is possible: -
Modifications to the production schedule; Customer relations; Purchasing; Establishment of the
production process; Quality Control; Material Handling; and Maintenance.

Activity Based Costing of Rock Widget Ltd
organisation – Activity Drivers
• Relate the overheads to the primary and supporting activities that produced them.
"Cost pools" or "cost buckets" are the result of this. The resource cost drivers that
reflect causality will be used for this.
• The utilisation of the support activity is then reflected by the distribution of the support
activities over the primary activities on an appropriate base. The base is the expense
that serves as a benchmark for how support activities are employed.

Activity Based Costing of Rock Widget Ltd
organisation – Activity Cost Drivers
Activity cost driver: This metric measures how frequently and intensely cost-related items
require specific tasks. It is employed to link cost objects to activity expenses.
•For each activity, determine the activity cost driver rates, exactly as you would do for an
overhead absorption rate in a conventional system.
•Activity cost driver rate = Activity total cost / Activity driver
•The activity driver rate can be utilised to expense other cost items, such as
customers/customer segments and distribution routes, in addition to identifying costs for
products, as in standard absorption costing. One advantage of ABC is the potential for
costing things other than products. The various amounts of every activity that are
consumed by each product or other cost object will be multiplied by the activity cost
driver rates.

Activity Based Costing of Rock Widget Ltd
organisation – Cost Objects
Cost objects: Cost objects are things like products or customers for which
measurement of cost is necessary.
• To connect the overheads gathered in the cost pools to the cost objects/products,
identify the activity cost drivers that will be employed. This is based on the
element that motivates the activity's consumption. What causes the action to incur
expenditures is the question to ask. The amount of ordered batches, for instance,
will probably be the driving factor in production scheduling.

Advantages of the business using ABC
ABC systems are not always the ideal option because they are more expensive to use and do not always
appropriately distribute expenses depending on the different resources needed to manufacture the product.
Management must take into account how each system will function within its own company. Several
benefits of ABC comprises:
•There are various pools for overhead costs, and each has a different way of measuring activity. Although
it requires more time to develop and is more expensive, this offers rates for adding overhead that are
more precise.
•The bases for allocation, or measures of activity, frequently diverge from those employed in conventional
allocation. Having multiple cost pools enables management to aggregate expenses affected by
comparable drivers and take into account cost drivers other than the standard labour or machine hour. As
a result, the overhead application rate is improved.
•Instead of using the budgeted level of activity, the activity rates may take the level of activity at capacity.
•Products may be given both manufacturing and nonmanufacturing expenses. The relation between the
product and cost serves as the primary justification for cost assignment. It is seen as part of overhead if
the cost rises as the volume of the product does.

Disadvantages of the business using ABC
When deciding which approach to utilise, management must take ABC costing's
drawbacks into account. These negative aspects include:
•The price of the product may not include all manufacturing costs. Because it does not
fall within one of the activity-driven cost pools despite being necessary for production,
the cost to heat the plant, for instance, might not be included as a product cost.
•It is more expensive because there are expenses associated with gathering and analysing
information on cost drivers and allocating overhead based on numerous cost factors.
•Because objective data on cost drivers must be gathered, an ABC system is more
complex to develop and maintain.

Traditional Costing Techniques
The conventional allocation technique is best used when there is a relationship between the activity base and overhead. It
allocates manufacturing overhead based on a single cost driver, such as direct labour hours, direct labour dollars, or
machine hours. This most frequently happens when the cost of the product is largely comprised of direct labour.
According to the principle that underlies the single cost driver, additional study is both expensive and ineffective as
overhead rises. The foundation of a conventional costing method is the calculation of overhead rates and their
application to a particular variable. Estimated overhead rates are used as a cost driver in traditional costing
methodologies. The six steps of the conventional costing approach are used to calculate costs. They are as follows:
•Calculating indirect overhead expenses, such as building rent and maintenance staff salaries.
•Calculating overhead costs for a set tracking period, such as a month or every six months.
•Choose a cost driver that is connected to the manufacture of your good or service.
•Calculate the cost of the driver at a specific level. If you are utilising man hours (labour hours) for a single month, for
instance, you would multiply the number of employees by the number of hours worked each week. Next, divide that
sum by 12 and multiply it by 52 (the number of weeks in a year) (the number of months in a year).
•Apply the following calculation to determine the overhead rate: Overhead Rate = Overhead costs / Estimated Cost
Driver
•Using the overhead rate to product

Why Activity Based Costing (ABC) might be recognized as beneficial in preference to Traditional Costing Techniques
The cost centres (Service & production Centres) and cost objects, or products, come first in
classical absorption costing. Overheads in ABC are associated with activities or gathered into
cost pools. They then relate to the expensive goods, such as products. Since functional
departments are not used in the initial stage of the two processes, they are fairly similar
overall (cost centres). The issue with functional departments is that they frequently consist of
a variety of activities, each of which has a unique set of costs and behaviours. Activities also
frequently cross functional boundaries; for instance, a requisition note raised in a
manufacturing department is frequently part of the purchase of materials. Where the majority
of procurement expenditures are incurred, the purchasing department, it is not brought up.
Since they share the same cost driver, activity costs often behave similarly to one another. As
a result, ABC paints a more accurate picture of how costs behave.

Summary
On the basis of comparable activity bases, overhead costs are assessed and
grouped. For each cost grouping, a cost driver is chosen, such as inspections,
machine settings, or order taking. Analysis of cost drivers enables more accurate
allocation of overhead and better choice of real overhead cost drivers. Costs can be
tracked down to the batch or unit level. The ABC method consists of five steps:
identify the production-related activities, assign overhead costs, assign cost drivers
to each expense, establish a predefined overhead rate, and distribute overhead to
every product. While ABC allocates overhead based on many cost pools and the
activities that drive expenses, traditional allocation bases it on a single overhead
rate. When the manufacturing process is labour-intensive and overhead increases are
based on conventional activity bases, such as direct labour hours, direct labour
dollars, or machine hours, traditional allocation is the best option. When the
manufacturing process is technology-driven and overhead rises as a result of
multiple activities that vary for each product, ABC costing is ideal.

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