Activity-Based Costing (ABC) Analysis

This assignment delves into the concept of Activity-Based Costing (ABC) analysis, examining its advantages and disadvantages. It discusses how ABC differs from traditional costing methods, highlighting the potential for more accurate cost allocation and informed decision-making. The text also acknowledges the challenges associated with ABC implementation, such as data collection accuracy and employee bias in reporting time. Ultimately, it emphasizes that the suitability of ABC depends on factors like business size, industry nature, and the importance placed on precise cost accounting.

MANAGEMENT ACCOUNTING

(a) It is important to have a brief description of manufacturing overheads first. Also known as
production cost, factory overhead & factory burden, manufacturing overheads are incurred in a
factory’s manufacturing processes. The cost incurred in the factory for the production purpose
other than direct Labour and direct materials cost is termed as manufacturing overhead cost.
This is why, it is often referred to as an indirect cost. According to accounting principles,
valuation of inventory & cost of goods sold should be made on the basis of direct material cost,
direct Labour cost and manufacturing overheads (Berman, Knight and Case, n.d.) . However, it is
to be stated that the expenses occurring outside the factory in relation to the said product such as
selling & administrative costs, general expenses, etc doesn't form a part of product cost and are
not inventorial. Such expenses are charged in the income statement in the respective accounting
year in which it occurred. Examples of such costs are depreciation on the factory equipment,
plant related expenses, inspection costs, etc (Shim and Siegel, 2008).
Because manufacturing overheads are considered to be an indirect cost, accountants face the task
of assigning or allocating overheads cost to each of the product units if there are more than one
product. There can establish no direct relationship (Bruner, Eades and Schill, 2017). For
example, the depreciation of the machine is based on the value of the machine and not the units
actually manufactured (Saltelli, Chan and Scott, 2008).
Thus, there are numerous methods of allocating overheads and businesses adopt the method
based on their operations & the market forces. Two most common approaches are conventional
or traditional costing and activity - based costing (Taylor, 2008)..
Coming to conventional approach, it refers to the allocation of manufacturing overheads to
products on the basis of volume metric such as direct labour hours or production machine hours
or certain percentage of prime costs etc (Clarke and Clarke, 1990).. With a decrease in labour
hours or machine hours, the overhead cost increases. As per this approach, accountants derive
one cost for all the activities of the manufacturing excluding direct labour costs and materials
costs and multiples such unit cost with the respective cost driver be it direct labour hours or
machine hours. Such overhead rate is also referred to as 'overhead absorption rate' or 'single
blanket rate' (Fairhurst, 2015).
As per the given question, we are required to compute the cost of product unit of Fred and
Martha on the basis of single overhead rate (Galbraith, Downey and Kates, 2002).. The single
overhead rate is calculated by dividing budgeted costs by total hours required as shown in the
notes. The overhead rate comes out as $48/product unit and also, manufacturing overhead costs
are to be valued on the basis of direct labour hours (Saunders and Cornett, 2017). So one unit of
Fred costs $96 ($48*2 hours for one unit) and one unit of Martha costs $144 ($48*3 hours for
one unit).
CACLCULATION OF COST PER UNIT USING CONVENTIONAL
APPROACH :

(In $)
PARTICULARS
FRE
D MARTHA
Production units 1000 5000
Direct materials 40 60
Direct labours 30 45
Manufacturing overheads 96 144
Total Cost Per Unit 166 249
Notes :
Total Manufacturing Costs $8,16,000
Total Hours Required 17000 hours
(1000 units of Fred *2 + 5000 units of
Martha*3 hours)
Manufacturing Overhead Per Hour =
Total Manufacturing
Costs
Total Hours
Manufacturing Overhead Per Hour = 816000
17000
=$48/hour
(b) As per the question asked, we are required to compute the cost of each of the cost activity on
the basis of their respective cost drivers (TULSIAN, 2016).. Thus, it is better to first state the
meaning of all the terms used. Cost activities, also referred to as cost pools, refers to the different
types of activities undertaken for the manufacturing processes. Such costs are indirect in nature
but forms the part of cost of the product. Examples of such activities includes equipment related
expenses, machine related expenses, inspection costs, setup costs, etc. 'Cost Driver' refers to the
different factors on which the cost of an activity depends. It triggers a change in the activity's
costs (Galbraith, Downey and Kates, 2002).. It is used basically in activity based costing to
allocate the specific overhead costs to the product. Usually, such concept is adopted when the
business operations are vast in nature and correct costing of their products is mandatory or when
the activities undertaken for manufacturing ae large in number. Business operations that look for
minimum accounting requirements or doesn't involve too many activities go for a single blanket
rate for calculating overheads absorbed.
Each cost pool has its own cost driver on the basis of which the rate is being calculated. For
example, production runs, machine hours, time taken for inspection, etc. Let us consider some
cost pools & their drivers : quality assurance cost depends on the number of visits for quality

check, depreciation depends on the value of machine, electricity depends on the light points,
machine insertion costs depends on the number of parts inserted, etc (Holland and Torregrosa,
2008)..
The given table shows the rate of each of the activity as per the cost driver. For example, the first
one, machine related expenses $450000 is divided by the budgeted cost driver 9000 hours and
therefore, the rate of absorption for machine related expenses comes out as $50/machine hour. In
a similar way, the rate of absorption has been calculated for each of the activity based on their
respective cost drivers (Khan and Jain, 2014).
CACLCULATION OF COST PER ACTIVITY :
ACTIVITY COST($
) COST DRIVER Budgeted Level RATE
($)
Machine Related
Costs 450000 Machine hours 9000 hours 50/hour
Setup & Inspection 180000 Number of production
runs 40 runs 4500/run
Engineering 90000 Engineering change orders 100 change
orders 900/order
Plant Related Costs 96000 Square footage of space 1920 sq. ft. 50/sq.ft
TOTAL 816000
(c) Activity Based costing is an opposite method of the conventional approach (Phillips, 2014). It
is an approach for allocation of overheads in a more precise manner to those items that are
actually being used (Reilly and Brown, 2012). This methodology is mostly used in complex
environments, where there are a good number of machines & equipments and a number of
related & non-related processes and a single rate would lead to wrong costing of the product.
This approach identifies the relationship between products and the activities undertaken & the
associated costs and this is how indirect costs are assigned to products which is less arbitrarily
than tradition approcahes.
Usually, activity costing is used in manufacturing sectors as it enhances the reliability of the cost
data and hence, thereby, produce the true costs and leadsto better classification of costs.
As per the five question, we are asked to calculate the product cost of each unit using ABC
approach and using the data given in part (b), the overhead costs have been calculated for the
purpose of product cost (Palepu, Healy and Peek, 2016)..

CACLCULATION OF PRODUCT COST PER UNIT USING ACTIVITY-BASE COSTING
APPROACH :
(In $)
PARTICULARS FRED MARTHA
Production units 1000 5000
Direct materials 40 60
Direct labours 30 45
OVERHEADS :
Machine related costs 200
(50*4 hours/unit)
50
(50*1 hour/unit)
Setup & Inspection 900
(4500/50 units)
18
(4500/250 units)
Engineering
67.50
(900*75 orders/1000
units)
4.50
(900*25 orders/5000
units)
Plant Related Costs
76.80
(50*1536 sq.ft./1000
units)
3.84
(50*384 sq.ft./5000
units)
TOTAL COST PER UNIT 504.3 181.34
(d) Initially, the firm priced its product @120% of manufacturing costs that made them to price
one unit of Fred @ $199.20 and one unit of Martha @ $298.80. Using the same pricing method
of valuing at 120% of manufacturing costs, let us calculate the price to be charged for per unit of
each of the product when the cost is being calculated on activity based costing.
Price of one unit of Fred : 120% of $504.30 = $605.16/unit.
Price of one unit of Martha : 120% of $181.34 = $217.608/unit.
Thus, where previously the profit from one unit of Fred was $33.20, ABC approach gives a
profit of $100.86. Similarly, where profit from one unit of Martha was $49.80, ABC analysis
gives a profit of $36.268.
(e) Allocation of overheads on the basis of conventional approach is often based on the volume
such as the number of direct labour hours, or production units. However, there are certain costs
that are not always based on volume of production. For example, a few of manufacturer's low
volume products requires significant amounts of engineering costs, setup costs, inspection costs,

etc. Allocation of such costs on the basis of production hours instead of on the basis of their root
causes will result in the inaccurate & misleading costing valuation of products.
Conventional approach is usable if the business operations aren't very complex and the activities
engaged aren't so much in number. In such a case, a single overhead absorption rate would work
for valuation. However, in case of a number of business activities, it is better to develop a rate
for every cost driver so as to do a proper valuation of products. Inaccurate results leads to taking
of wrong decisions by the top management be it the case of control purposes, of pricing of the
product or sending quotations. Also, conventional approach doesn't reflect the true cost of the
resources consumed by the end products. Conventional approach includes splitting of cost into
fixed & variable costs which is often unrealistic because if business grows, the splitting of costs
gives inaccurate product cost.
Conventional approach is not suitable for manufacturing sector as manufacturing sectors
includes the valuation on the basis of degree of completion of work with accurate indirect costs
incurred.
(f) The fundamental benefit of adopting ABC analysis is to determine the overhead rate more
precisely. This costing also serves a number of other benefits as stated below :
 Activity costs : ABC's job is to identify the activities and track its costing individually so
as to see whether such costs are in line with industry standards. If not, then ABC analysis
shows a clear picture of ongoing costs and provides the management an opportunity of
focusing on cost reduction.
 Customer Profitability : Usually, the costs incurred for individual customers are simply
product costs, there are certain other unusual overhead costs such as product return
handling, high customer service costs, etc. ABC analysis can sort such costs and
provixesan assurance whether the customers are paying reasonable profit.
 Make or Buy : Abc analysis provides a detailed allocation of costs associated with the in-
house manufacturing of a product, so that a firmcan judge on that basis to eliminate those
items if the outsourcing of such an item would be more reasonable.
 Margins : With ABC analysis, margins can be determined of various products, product
lines and entire subsidiaries. This is useful in a sense to determine the position of the
company resources to earn the largest margins.
 Production facilities : It is usually better to segregate overhead costs at the plant wide
level so as to compare the costs of production between different facilities.

(g) With the above explanations, it is clearly visible that the ABC approach provides a better
costing process than conventional approach and helps in an accurate allocation of indirect costs.
However, thereare alot of problems associated with ABC analysis :
 Cost Pool Volume : While its an advantage that such an analysis provides high quality of
information, it is also disadvantageous in a sense that it comes with the cost of using a
large number of cost pools and with involvement of large number of cost pools, the cost
of managing such cost pools is higher.
 Installation time : ABC systems are difficult to install with multi year installations being
the norm that the company wants to install it across all product lines & facilities. It
becames difficult to maintain the budgetary support & management support as months
goes by but installation remains incomplete. Thus, success rates are higher than smaller
& more targeted ABC installations.
 Multi-deparmental data sources : ABC system requires data from multiple departments
and each of this department may have high priorities. Thus, the larger number of
departments are involved, the greater is the risk that the input data will fail.
 Project basis : Many ABC projects are based on a project basis, so that the collection of
information takes place only once and such information is useful only for the current
year's operational situation. However, the usefulness of such information declines as the
operational structure changes. So, ABC tends to be done and discarded
 Reporting of unused time : When a company asks its employees to report about the time
spent on each activity, the employees have a very strong urge that the reported time
equals to 100%of their time. However, it is not possible to entirely devote 100% time by
the employees as there are good number of idle time in anyone's work say lunch hours,
breaks, administrative meetings, playing games, Internet usage, gossips with other
members, etc. In such a case, employees mask their idle time on one activity by
apportioning it to the other activity. This leads to misallocation of costs under ABC
analysis and sometimes, by large amounts.
Thus, an adoption of system involvs both advantages and disadvantages. It all depends on the
nature & size of the business as well as how much important it is for them to comply with the
accounting principles & standards. Looking into such matters relating to business operations, the
approach of costing is adopted thereon as the ultimate goal of every business is to show a true
reflection of its costs and to charge a reasonable price from its customers.

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