Activity Based Costing Report

This report provides a comprehensive analysis of Activity Based Costing (ABC), comparing it to traditional costing methods. It includes a case study of Angelo Limited, a laboratory equipment manufacturer, to illustrate the application of ABC in calculating overhead costs and profitability. The report also discusses the advantages and disadvantages of ABC for management accounting.

MANAGERIAL
ACCOUNTING

EXECUTIVE SUMMARY
This report is sited to define the meaning of ABC costing system. Concept of traditional
approach of costing and ABC costing elaborated subject to organisation. Managers would be
able to understand the use of ABC costing system in order to determine the cost of each activity
form under manufacturing and production process.

Table of Contents
EXECUTIVE SUMMARY.............................................................................................................2
INTRODUCTION ..........................................................................................................................1
MAIN BODY...................................................................................................................................1
Activity based costing ...........................................................................................................1
Traditional based costing........................................................................................................1
Comparison between ABC and traditional approach of costing............................................3
Calculation of overhead costs and profitability according to Activity Based Cost information.4
Conclusion in respect with advantages and disadvantages of ABC for management accounting
................................................................................................................................................8
CONCLUSION..............................................................................................................................12
REFERENCES..............................................................................................................................13

INTRODUCTION
Managerial accounting refers to the process that involves making reports, and with the
help of these reports managers take decisions. Activity based costing is a method of calculating
cost of operations by dividing the cost among different activities. This accounting concentrates
on internal performance of an organization which ultimately lead to success and growth (Dale
and Plunkett, 2017). This report is based on Angelo Limited, which manufactures parts of
laboratory equipments. Details of Activity based costing and its comparison with traditional
approach to costing has been given. After that, calculation of profits and comparison of profit
percentage have been done on the basis of information given about two parts. Lastly, advantages
and disadvantages of ABC for management accounting are discussed.
MAIN BODY
Activity based costing
This technique of costing also known as ABC costing, it determines all those activities
which are associated with the production, analyse the cost of those activities and determines the
cost of product. Activity based costing is a system to recognize the relation between costs,
activities and manufactured products and it is also identifies the cost which is assigned to
activities overhead and then it is assigned to those cost of product. This costing is mostly used in
manufacturing industries where they enhance the costing data. This costing system is used in
product, target, for analysing profits, customer profits etc. It is widely popular when an
organizations is developing a better focus on corporate and making cost strategies better. This is
based on the system where the unit of work, events, task with specified goals, setting new
machines for production, designs for new products, providing finished goods etc. It is helpful in
transferring the costing of high volume products to the lover volume products and raising the
unit cost of lower volume of products. This costing is used in accounting methods to
management, salaries to office members (DRURY, 2013).
Traditional based costing
This technique decides the cost of products based on average overhead rate. This method
includes all indirect costs in production and applies these costs equally across the board using a
consistent technique such as machine hour etc.
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Traditional costing is based on the volume of production resources in which it is
consumed from overhead to products. In this method the overhead costs is usually amounted on
either a direct labour or on machine hours used. In this costing the trouble made when the
overhead is higher than the allocation, but when there is a massive change in overhead applied
that makes a small change in the volume of resources consumed. It firstly assigned the indirect
costs either traced and allocated, but depends on the specific cost item which directly traced to
service departments which provide services to other departments. This costing system is used on
the basis of allocation overhead , direct labour hours. This system basic difficulty that is doesn't
gave the exact information of cost price of product and services to decision makers.
Importance of traditional based approach of costing:-
Activity based costing method is rather a broader concept than traditional costing
methods. Traditional costing method are less complex or simple in nature, involves low cost and
also less time consuming than other method. This method have its origin from longer time which
makes it easy to understand as it does not require so much expertise and knowledge. According
to this method of costing, overhead costs are allocated on the basis of volume of consumption of
resources. As coming to results, choice of method for every organization depends upon various
circumstances and situations (Christopher, 2016). For instance, in a smaller organisation where
departments are not there and in a larger organization where various departments are there, so
larger organisation will be more complex in nature and they mostly prefer to use ABC. But
smaller organisation may use traditional approach to costing.
Importance of Activity Based Costing:-
 They are using different variation in activity based costing method. Each one has the
unique characteristics but they follow the same principles in costing method.
 ABC method has nine basic steps that define the scope, identifying the activities,
collected data, build the model, lay out process, identify which type of ABC to use and
take action.
 ABC method is used for the cost assessment of scientific pricing the main principle. In
this the cost which assess priced scientifically.
 Homberg in 2002 did a study in depth about the use of activity based costing and founded
most effective ways to cut the overhead costs. As per perspective of Hoberg other ways
to use that costing in efficient manner and for reducing overhead.
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Comparison between ABC and traditional approach of costing
Activity Based Costing Traditional Costing
Activity based costing is more accurate than
traditional because it uses important factors
before assigning the cost of the product.
Traditional costing is won't always be accurate
because it doesn't use factor in non
manufacturing expenses or which it determines
overhead costs which affects specific products.
This costing is used when there is a crucial
accuracy,it is most precise & costly to
implement. But most of them preferred this
costing.
This costing is used when the accuracy won't be
affected by the production activity or when it is
considered that the time is limited.
Activity based costing is on internal use
because by this they can see all relevant
spending and can prepare on the basis of
relevant documents.
Traditional costing is on external use because it
is easy to determine the value of products for
outsiders.
Overhead cost remains high at that time the
small changes occurred in the cost of product
makes large differences in overall.
In Traditional costing when the cost of
overhead is lower as compared with the direct
costs, because it is done when it is most
accurate.
It determines all production relating activities,
assigning cost and to determine the cost of that
product.
In this, the cost of product is assigned by
averaging the overhead rates. This is used to
make out the indirect cost is in production and
applied those costs on equally bases on cost
driver ( machine hours).
Activity based costing should be used when
the priority is accuracy as ABC costing
ensures accuracy, because in case of high
overhead the small changes in the product
leads to large differences and by using this
method it becomes easy to analyse and
Traditional costing technique is beneficial when
all the priority is about the time and accuracy
becomes not so important in production
activities because in case when overhead is low
in comparison of direct costs, it will be more
accurate in this situation. It works good when
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understand all the indirect cost and activities.
From the view of internal use the decision
maker will be able to easily analyse the
spending and indirect cost accurately. This
technique ensures the effective and efficient
utilisation of funds because by this method it is
easy to find out the areas of wasteful
spendings.
the production is of single line or similar goods
are produced. Moreover, in this situation it
becomes easier for external use to identify and
evaluate the value of products.
Calculation of overhead costs and profitability according to Activity Based Cost information
Activity Cost Driver Rate
Particulars
Annual
budgeted cost
(£) Cost drivers Alpha Beta
Total
activity
Activity cost
driver rate (£)
Machine
department costs 180000 Machine hours 1200 2800 4000 45
Set-up costs 59000
Number of
production runs 24 35 59 1000
Inspection/quality
control 29500
Number of
production runs 24 35 59 500
Material handling 78000 Orders executed 120 140 260 300
Delivery 15000
Number of
shipments 35 40 75 200
Total overheads 361500
Profitability of two products under Activity Based Costing
Particulars Alpha (£) Beta (£) Total (£)
Sales revenue 720000 1102500 1822500
Direct material 252000 472500 724500
Direct labour 180000 210000 390000
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Total manufacturing
overheads 432000 682500 1114500
Manufacturing overheads:
Machine department costs
(45*1200;45*2800) 54000 126000 180000
Set-up costs
(1000*24;1000*35) 24000 35000 59000
Inspection/quality control
costs (500*24;500*35) 12000 17500 29500
Material handling
(300*120;300*140) 36000 42000 78000
Delivery (200*35;200*40) 7000 8000 15000
Total overheads 133000 228500 361500
Profit 155000 191500 346500
Per unit profit 6.53 3.24
% overheads 36.79% 63.21% 100.00%
overhead cost per unit 20.83 21.76
Interpretation:
From the above calculations, profitability has been evaluated on the basis of Activity
based costing. Using cost drivers, activity based cost driver rate is calculated. There are two parts
of product manufactured by Angelo limited namely alpha and beta. According to problem,
various manufacturing costs are mentioned such as direct labour and direct material along with
this selling prices per unit are also given. Total output in units of alpha are 7200 units and of beta
are 10500 units. Later, various heads under overhead costs have been mentioned such as machine
department costs, set-up costs, inspection/quality control costs, material handling costs and
delivery costs. For purpose of breaking down them according to profitability, cost drivers like
machine hours, number of production runs, orders executed and number of shipments have been
used. Firstly, activity based cost driver rate is calculated by annual budgeted costs of overheads
and cost drivers. After that profitability is ascertained for two given parts that are alpha and beta.
Profitability is calculated by deducting all the costs from total sales revenue. Here all the costs
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refers to direct labour, direct material which are knowns as manufacturing overheads if
combined. Also total overhead costs are deducted from sales revenue for deriving profit. Profit
per unit, percentage of overheads to total overheads and overhead cost per unit are presented
(Govindan, Khodaverdi and Jafarian, 2013).
Thus if one is concerned on comparison, then overhead cost per unit of Alpha is 20.83
and of Beta it is 21.76 which is greater than former part. Overhead costs refers to costs which are
not directly associated with specific product units. Ultimately, these overhead expenses impacts
on profit and loss statements. As and when these costs increases, profits of income statement
decreases. Balanced proportion of overhead costs can give competitive advantage to Angelo
limited. Most of organizations on monthly basis ascertain overhead costs. Calculation of
overhead costs is involves step by step process. This process starts with making list of all
business expenses, then categorization of each individual expense is done on the basis of direct
and indirect association with production, after that all overhead costs are accumulated and
compared to sales as well as to labour cost.
Profits per unit of alpha and beta are 6.53 and 3.24 respectively. As one can see that
profit per unit of alpha is more than from beta. Thus it implies that alpha part of product is more
beneficial to Angelo limited in terms of profitability. Profit is essential for an organization to
grow and expand. Expansion can be in form of diverse operations or in establishing new office.
Along with this, profit increases ability of an organisation to borrow money from financial
institutions and banks. As profitability of Angelo limited is disclosed for communication to
external users in financial statements. So this information of profit assists in attracting investors.
Also an enterprise can hire more personnels because of increment in affordability.
Now coming to next part that is percentage of overhead costs which is 36.79 of alpha and
63.21 of beta to overall overhead costs. One can see that percentage of overhead costs of beta is
more as compared with alpha which denotes that there is less profit in beta than alpha. Overall
profit of alpha is 155000 and of beta is 191500. So profit of former is less than latter but profit
per unit of former is more than latter.
Total overhead costs of alpha is 133000 and of beta is 228500. expenses that comprises
total manufacturing overheads are machine department costs, set-up costs, inspection/quality
control costs, material handling costs, and delivery costs which are divided according to cost
drivers of activity based costing.
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Types of Overhead
Administrative overhead:- In this overhead it includes the items such as utilities,
supporting functions, planning etc. These costs are overheads, are not directly related to any
particular function nor its results generating profits. These costs has the role of supporting
business other functions (Schaltegger and Burritt, 2017). Administrative overhead rates are
regularly charged by the universities on research. In accounting terms millions were wasted in
every year on overheads by universities administrators.
Example:-
Employee salary: In this it is considered that overheads as cost must paid
regardless of sales and profits of company. Salary differs from wage as salary but it is not
affected by working hours and time that's why it remain constant.
Office Equipment and supplies: In this it includes equipments like printer,
computers, refrigerator, fax machine etc. they are not directly result in sales and profit, they are
also in use for supporting functions and can provide business operations.
Manufacturing Overhead:- In this all costs are endured by a business that is in the
platform by which product and service is created (Cheung, 2016). It refers to those overheads
which is categorised with in a factory or office. In this there are cases in which the usage of
overheads that separates them.
Example:
Property taxes on production facilities:- Every property unless government owned is
subject to form of property tax. Taxes on production factories are categorised by manufacturing
overheads which may not be avoided.
Applications of business overheads:-Business overheads are calculated by accountant
for budgeting purpose, so the business has an idea how much they charge from consumers in
order to make profits.
Cost Classification:
Cost classification refers to the separation of expenses in different categories, in
economic terms it involves in fixed cost, variable cost, opportunity cost, production cost and
sunk costs. As per this, accounting costs are classified as either directly or indirectly for a
business. It define as the cost separates in expenses in various forms. Classification system uses
management attention in certain costs, that considered more crucial (Pentland and et. al., 2012).
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Significance
 On the basis of production and process: A factory may bear various types of costs in
production process. They are sub divided in direct and in direct expenditure. Direct
expenditure are those which is easily identified wholly with a unit cost. It includes
material, labour and direct expenses. Indirect expenses are those incurred advantage of
cost centre and not easily identified.
 On the basis of element or nature: In this cost is divided into material, labour and
expenses. It includes materials which are produces or provide services, labour which is
needed to convert raw material into finished goods and other expenses which are needed
in course of production and distribution (Chen and et. al., 2012).
 On the basis of function: in this the cost is classified in production, administration,
selling and distribution, research and development cost. In production it includes direct
material, labour, manufacturing activity. In administrative cost it incurred cost by policy
formulation and implementation, which is related to research, development.
Conclusion in respect with advantages and disadvantages of ABC for management accounting
Angelo Ltd manufacturers wants to install a plant to manufacture the laboratory
equipments. This plant will emphasise the production units and boost the efficiency. Managers
wants to calculate the cost of each and every activity. For this purpose users managers have
decided to install ABC costing system. This system will initiate following changes
characteristics within organisation.
Advantages of ABC:
 As in Activity Based Costing, products are categorized in different categories, so it helps
in realizing actual costs of manufacturing process of that specific categories.
 Better decision making: It improves the decision of any organisation manager's as they
may use the certain data of product cost. It also useful to fix the selling price as more
accurate product cost data is available.
 Tracing of overheads costs: It is used to trace the costs in field of managerial obligation,
departments, procedure, customers besides the product costs.
 Accurate Product Cost: In AB costing it is focusing on the causes and effects related in
cost incur which brings accuracy and reliability. Angelo Ltd. Manufactures recognises
the consuming activities by a product, activities which causes cost. It support functions in
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advanced manufacturing technology and environment with overhead constitute on large
share of total costs, this costing provides reliable, accurate or correct cost of product and
more realistic cost of products in this manufactured products such as high volume and
low volume products. Angelo Ltd. Manufactures uses both type of product for
manufacturing either lower volume or high volume in case of greater diversity takes
place in the manufactured products (Advantages and disadvantages of ABC costing,
2018). They uses activity based costing and found it reliable and accurate measure of cost
of product. This manufactures company has found less errors and approximation in cost
determination of product. So the company is focusing on the causes and effect relation
(Rezaei, Nispeling, Sarkis and Tavasszy, 2016). Using advanced technology and
environment in support with the functions where overhead constituting on large amount
of total cost. It defines the real nature to control the fixed overhead cost and by which
activities become more visible and clear. The company controls many of the fixed
overhead costs by exercising control over the activities. By focusing on the relation of
cause and effects in cost incurring, ABC produce more accurate and reliable results
while determining the product cost.
 Better control of High-Priority Inventory: In activity based costing inventory plays high
priority for better control. It places the tighter and frequent control. It uses class A
inventory where customers requests are m,ore often in use. This class A inventory is used
by Angelo Ltd. Manufactures because it is directly linked with the success of company
and it is helpful for monitoring the demand and ensure the stock level matches that
demand of customers. For analysing AB costing the company Angelo Ltd. Manufactures
uses resources and controlling priority from high priority inventory over that inventory
which has a lower impact in bottom line (Martin and Nakayama, 2013). Company uses
the high priority in inventory for allocating there resources more effectively and
efficiently. Company uses high priority which helps to save time, labour and more
frequent controls the inventory. In this inventory include most of the items in producing
goods and monitoring the demand for it which ensure the stock level which matches the
demand. The company often suggest class A for better control which is used for the
success of the company (Harrison and Lock, 2017).
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 Identification of wasteful products and easy to understand: In this costing it makes an
account for costs and in similar for the production work. It helps in understanding
business where overhead costs are heading. This costing allows data to manage and to
identify the unnecessary costs and wasteful products by using resources. This method is
helpful in fixing the prices of product and services which are incorrect and excessive.
Angelo Ltd manufactures uses it for improving service and quality of product which rely
on activity based costing. This costing is easy to be understood by the company so
Angelo Ltd. Manufactures opt this costing which require much understanding to be
implemented. They focus only on the reality to undertake this process and it depends on
the type of business aiming to consider this AB costing. The company uses it by focusing
on the costing of products and services, it is helpful to easily understood by any business
man or any manufacturer (Ashworth and Perera, 2015.). It is easily be used for the
implementation on the company products and reduces time consuming. Angelo Ltd.
Manufactures identify the non value added activities, proper allocation of resources and
profitable activities. It determines the processes on going well and at ones they needed
improvement.
 Improvement of Business Processes: In AB costing it allocates an indirect cost from each
product at that time business processes become clear and accurate. Angelo Ltd
manufacturers determines the process doing well or ones they need improvement. By
this process the activity based costing able to identify the non value added activities. In
business process activity based costing helps in proper allocation of resources for
profitable activities (Sarkis, 2012). It also provide to manufacturers company the
continuous improvement of a particular business process. The utilization allow business
many advantages. It is helpful for on going improvement in company programs. The
manufacturing company compare there utilization of per unit cost with the total cost. In
processing good business it facilitates or supports scorecards and performance
management. In this the continuous improvement occur by Angelo Ltd manufacturers in
business process is with the help of providing more value.
Disadvantages of ABC:
 In process of categorization, data is collected and then analysed thus it becomes time
consuming.
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 It also involves huge costs to accumulate and interpret information.
 Accounting reports that are prepared generally for management purpose does not contain
data for doing Activity Based Costing. Then manager has to collect data from different
sources.
 ABC reports often dose not follow generally accepted accounting principles, so they can
not be utilized and communicated to external stakeholders.
 Sometimes information exists in traditional approach of costings does not match with
data from ABC. This difference occurs due to performance standards of management that
were already established in traditional approach and on the basis of which traditional
costing has been done (Damhoff, Kuhn and Baker-Justice, 2014).
 This approach of costing might not be helpful for organizations where overhead costs
such as advertisement, repairs, rent, taxes etc. are low in proportion as compared to total
operating costs.
 This system is very complex in nature, because it involves many cost pools and cost
drivers, making it hard in understanding.
 Major difficulties occurs in area of measurement which is mandatory in implementation
of ABC. Measurements of these are also cost consuming.
 Angelo limited faces difficulties in implementation of this system because it expensive as
compared to other approaches. Organization which does not use ABC approach believes
that it is time consuming rather than expensive. In the process of analysing various
business activities for segregation, one needs to identify and classify each component in a
particular activity (Cao, Low, Yu and Jaroniec, 2015). Yet, the whole process of ABC is
able to utilize all precious resources in assembling, measuring and recording data in a
new system. Thus this process requires help of consultants expert in implementation of
ABC and along with that proper training is also needed. Sometimes, additional expenses
are also incurred in the usage of software.
 Activity based costing system can lead to data misinterpretation because this system
determine product margins that might differ from already adopted traditional costing
method. Sometimes, ABC can prove irrelevant in decision making criteria.
 Data fault can happen in ABC because for interpretation, data from different departments
have been collected. So even a unintentional smallest mistake can ruin entire information
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or data collection process. As a result, output will also be not appropriate. It is such a
biggest risk which is associated with this system of costing.
 Cost reduction is not easy in this method as if because of some reasons such as higher
sales, overhead cost increases then it not of so much relevance and efficient.
 Sometimes due to difference in costing method of traditional and ABC, it becomes of
unusual nature. And meaning of this is that data collected from both methods can be
compared.
CONCLUSION
On the basis of above information, it is concluded that Activity Based costing is more
beneficial than traditional approach to costing in a way that it gives more accurate results. By
comparing overall performance of product parts alpha and beta, some important information
derived about per unit overhead costs, profits per unit and percentage of overheads to total
overheads. These shows that sales revenue of beta is more than alpha and also total overhead
cost of beta is higher than alpha. Ultimately profit of beta is more than alpha but when come to
per unit profit, it is more of alpha.
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Advantages and disadvantages of ABC costing, 2018. [online]. Available
through:<https://greengarageblog.org/8-pros-and-cons-of-activity-based-costing>.
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