Revise Activity Based Costing for Cambridge 9706 (4.1.1)

Traditional absorption costing allocates factory overheads to products using a single, volume-related basis, such as direct labour hours or machine hours. This works well when a business produces a narrow range of similar products and direct labour is a major part of the total cost. However, in today's automated and diverse manufacturing environments, this method can be misleading.

To understand ABC, you need to be familiar with three key terms:

Applying ABC involves a systematic, five-step process. Let's walk through it with a hypothetical scenario.

Scenario: AlphaBeta Ltd produces two products, the 'Alpha' and the 'Beta'. The company's management is considering switching from traditional absorption costing to ABC. Here is the relevant data:

• Annual Production: 1,000 Alphas, 4,000 Betas
• Direct Costs per unit: Alpha $50, Beta $40
• Total Overheads: $210,000

The total overheads are caused by three main activities:

Activity Cost Pools & Drivers:

Activity Consumption by Product:

Step 1 & 2: Identify Activities and Pool Costs This has already been done for us in the tables above. The three activities are Machine Set-ups, Quality Inspections, and General Factory costs.

Step 3: Calculate the Cost Driver Rate We need to calculate a rate for each activity. This rate represents the cost per unit of the cost driver.

$\text{Cost Driver Rate} = \frac{\text{Total Cost in Activity Pool}}{\text{Total Volume of Cost Driver}}$

• Machine Set-up Rate: $\frac{\text{\textdollar}90,000}{300 \text{ set-ups}} = \text{\textdollar}300 \text{ per set-up}$
• Quality Inspection Rate: $\frac{\text{\textdollar}70,000}{1,000 \text{ inspections}} = \text{\textdollar}70 \text{ per inspection}$
• General Factory Rate: $\frac{\text{\textdollar}50,000}{25,000 \text{ machine hours}} = \text{\textdollar}2 \text{ per machine hour}$

Step 4: Assign Overhead Costs to Products Now, we allocate the overheads to each product based on how many activities they consumed, using the rates we just calculated.

Overhead Allocation for Product Alpha:

• Set-ups: $\text{\textdollar}200 \text{ set-ups} \times \text{\textdollar}300/\text{set-up} = \text{\textdollar}60,000\text{\textdollar}$
• Inspections: $\text{\textdollar}700 \text{ inspections} \times \text{\textdollar}70/\text{inspection} = \text{\textdollar}49,000\text{\textdollar}$
• General Factory: $\text{\textdollar}5,000 \text{ hours} \times \text{\textdollar}2/\text{hour} = \text{\textdollar}10,000\text{\textdollar}$
• Total Overhead for Alpha: $60,000 + 49,000 + 10,000 = $119,000$

Overhead Allocation for Product Beta:

• Set-ups: $\text{\textdollar}100 \text{ set-ups} \times \text{\textdollar}300/\text{set-up} = \text{\textdollar}30,000\text{\textdollar}$
• Inspections: $\text{\textdollar}300 \text{ inspections} \times \text{\textdollar}70/\text{inspection} = \text{\textdollar}21,000\text{\textdollar}$
• General Factory: $\text{\textdollar}20,000 \text{ hours} \times \text{\textdollar}2/\text{hour} = \text{\textdollar}40,000\text{\textdollar}$
• Total Overhead for Beta: $30,000 + 21,000 + 40,000 = $91,000$

(Check: $119,000 + 91,000 = $210,000$, which matches the total overheads.)

Step 5: Calculate Total Cost and Selling Price per Unit Finally, we calculate the full cost per unit by adding the direct costs to the allocated overheads per unit.

Cost per unit for Alpha:

• Overhead per unit: $\frac{\text{\textdollar}119,000}{1,000 \text{ units}} = \text{\textdollar}119$
• Total Cost per unit: $\text{\textdollar}50 \text{ (Direct)} + \text{\textdollar}119 \text{ (Overhead)} = \text{\textdollar}169$

Cost per unit for Beta:

• Overhead per unit: $\frac{\text{\textdollar}91,000}{4,000 \text{ units}} = \text{\textdollar}22.75$
• Total Cost per unit: $\text{\textdollar}40 \text{ (Direct)} + \text{\textdollar}22.75 \text{ (Overhead)} = \text{\textdollar}62.75$

If the company uses a 20% mark-up on cost to set the selling price:

• Selling Price for Alpha: $\text{\textdollar}169$\times 1$.20 = \text{\textdollar}202.80$
• Selling Price for Beta: $\text{\textdollar}62.75$\times 1$.20 = \text{\textdollar}75.30$

Notice the result in our example. The low-volume product, Alpha, is a complex product requiring many set-ups and inspections relative to its production volume. ABC assigns it a high overhead cost per unit ($119). The high-volume product, Beta, is simpler and receives a much lower overhead cost per unit ($22.75).

A traditional method using, for example, machine hours as a single absorption basis would have produced a very different result. The single overhead rate would be $\text{\textdollar}210,000 / 25,000$\text{ hours} = $8.40$per machine hour$. Alpha would be allocated only $\text{\textdollar}8.40$\times 5$,000$\text{ hours} / 1$,000$\text{ units} = $42$in overheads per unit$, making it seem much more profitable than it really is. This demonstrates how different costing methods affect calculated costs and profits.

This more accurate cost information is vital for making strategic business decisions. With ABC data, management can:

• Set realistic prices: Avoid selling complex products at a loss.
• Analyse profitability: Accurately determine which products, customers, or channels are most profitable.
• Improve processes: Identify high-cost activities and find ways to make them more efficient (e.g., reduce set-up times).
• Make better product mix decisions: Decide whether to promote, redesign, or discontinue products based on their true profitability.

While powerful, ABC is not a perfect solution for every business. It's important to weigh its advantages against its disadvantages.