Activity Based Costing 22

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Activity Based Costing
Worked Example

The following information provides details of the costs, volume and transaction cost drivers for a period in respect of XYZ Ltd:

A B C Total
Sales and production (units) 90,000 30,000 15,000 135,000 Raw materials usage (units) 10 7 14 1,320,000
Direct materials cost (£) 30 40 15 4,125,000
Direct labour hours 2.5 3 1.5 337,500
Machine hours 5 3 7.5 652,500
Direct labour cost (£) 20 30 10 2,850,000
Number of production runs 5 10 50 65
Number of deliveries 18 7 50 75
Number of receipts 50 70 700 820
Number of production orders 45 25 60 130

Overhead costs £
Set up 75,000
Machines 1,000,000
Receiving 900,000
Packing 650,000
Engineering 750,000
Total 3,375,000

You are required to

(a) calculate the total costs for each product if all overhead costs are absorbed on a labour hour basis; (b) calculate the total costs for each product, using activity based costing; (c) calculate and list the unit product costs from your figures in (a) and (b) above to show the differences between them and to comment briefly on any conclusions which may be drawn which could have pricing and profit implications.

Solution to the worked example

There is more extensive treatment of Activity Based Costing in my book

Cost and Management Accounting (1996)
Prentice Hall
ISBN 0-13-205923-1

We will be working through these data three times. Firstly to see how traditional cost accounting methods might deal with them; secondly to look at the multiple volume based overhead method; and, finally, to look at the ABC method itself. Of the three approaches we will be looking at, only ABC will be using all of the data in any great detail. This is consistent with the general nature of the traditional method, and the only slightly more advanced multiple volume method. Traditional direct labour hours basis

The direct labour hour rate is £10, calculated by dividing the total overheads by the total number of direct labour hours:

total overheads
total number of direct labour hours


£10 per dlh

Since we are using the direct labour hour rate method for the absorption of all overheads, the product costs per unit must be:

Direct Materials 30 40 15
Direct Labour 20 30 10
Overheads 30 15 15
Total Product Cost 25 30 40

The overheads recovered are, of course:

Direct labour hour rate x number of direct labour hours per product

For product A, for example, the calculation is:

£10 per dlh x 2.5 dlh = £25

Multiple volume based allocation method

The multiple volume allocation method is an advance on the traditional allocation method in that it does make some allowance for activities to influence the absorption of overheads. In this example, we have two absorption rates to apply here: the receiving department overhead rate, and the "other" overhead rate

The reasoning here is that the organisation we are simulating is using a two rate basis of apportioning overheads: firstly, a material handling overhead rate is used to assign overhead to a separate cost centre and then charge it to production on the basis of the number of receipts; secondly all of the other overheads are assigned using a general machine hour rate on the basis that the number of machine hours far exceeds the number of labour hours.

Notice here, the rate we are using to assign the materials handling overheads is based on the number of receipts of materials into a department. The reason we are using this rate is that the activity of receiving dominates the reason for the existence of the overhead. Drury uses an overhead rate expressed as a percentage of direct materials cost. This is not a rate to be recommended particularly since tying the assignment of an overhead to the cost of a material is not...
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