Case Study: Activity Based Costing

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At a recent management meeting at Coverdrive Ltd, the members of the senior management team discussed the introduction of a new product to the company’s range of high quality, hand made cricket bats. A major agenda item was pricing. The management accountant, since his appointment, had given much thought to pricing policy and one of his concerns was that of dealing with the recovery of overhead within a full cost pricing policy.

The discussion centred around the traditional method currently in use, compared and contrasted with ABC, Activity Based Costing a technique which re-examines the problem that has faced accountants for decades – that of allocation and absorption of overhead.

Traditional pricing method has been based upon absorption costing and the treatment of overhead usually followed a set procedure.

Cost centres are identified and established within the organisation.

Cost centres may be producing or service centres.

Wherever possible a direct charge is made to a cost centre ie allocated overhead.

Where overhead is jointly incurred it is apportioned to the cost centres on an equitable base.

The overhead cost for the service centre is then transferred to producing centres.

The total overhead cost for each producing centre is then divided by for example, machine or labour hours per the cost centre.

An overhead recovery rate results.

This is then used to absorb the overhead to products.

If planned activity levels are actually achieved then overhead may be fully recovered in the short run.

Such method may successfully be used where there is a limited product range and predetermined rates are well planned on achievable production budget volumes.

Present situation – existing method

The firm has three major producing cost centres; Machining, Finishing and Packing.

The process of allocation and apportionment for the periods 1 – 3, 2003, had been complete and the predetermined figures were:

Cost CentreMachiningFinishingPacking

Overhead £140,000 £55,000 £30,000
Machine hours 26,000 12,500
Direct labour hours 6,500
Overhead recovery rate per hour or m/c hour £5.38 £4.40 £4.62

The new product the “Superdrive” is estimated to take the following standard hours to produce per unit:

Machining2.75
Finishing1.30
Packing0.50
4.55STD hours

The accountant and the planning engineer had agreed the following:

Standard (predetermined) costs per unit of output:

Direct Material £18.50.

Direct Labour:

Machining2.75 hours@£6.50/hr
Finishing1.30 hours@£6.50/hr4.55 hours @ £6.50/hr
Packing0.5 hours@£6.50/hr£29.58

The standard hourly rate paid to the employees in each cost centre is £6.50. Thus the production cost of one unit based on recovering overhead in a traditional manner would be:

£
Direct material18.50
Direct labour29.58
Prime cost 48.08

Production Overhead:

Machining:
2.75 m/c hours x £5.38 14.80

Finishing:
1.30 m/c hours x £4.40 5.72

Packing:
0.5 labour x £4.62 hours 2.31

PRODUCTION COST £70.91

The accountant had however recently done some additional work and research on ABC technique. He presented the following notes and comments to the meeting for consideration by the SMT:

Accountants Notes and Comment

However in the more sophisticated businesses in flexible and rapidly changing product ranges traditional techniques have proved to be in certain scenarios less than adequate.

Activity Based Costing or ABC offers a workable and more effective insight into overhead allocation and recovery.

A definition of ABC can be seen in CIMA Terminology of Financial and Management Accounting “cost attribution to cost units on the basis of benefit received from indirect activities – for example: ordering, setting up and assuring quality”.

Researchers such as Bromwich...
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