SCM-ABC

Activity Based Costing

Conventional Allocation of Common Costs

Service and Product

Production Lines
Production
Department
Overheads

Assigning Costs using

Measures of service Allocating Costs using
usage a measure of Volume

P U
Prime Costs
R S
Direct Material I
O Product N
D Direct Labour G
U Cost
Direct Expenses
C A
T B
Overheads
C C
Non
O Production
Product
S Administrative Costs
T
Marketing
I
N Sales
G Distribution

R &D

Poonam Namjoshi Page 1

SCM-ABC

Main Activities and its Cost Drivers

Main Activities Main Cost Drivers

Customer order processing Order value
Oder source(old/ new customer)
Order Source(location)
Material planning/ acquisition No. of Material transactions
Volume of Material receipts
Volume of material order
Inspection Gauge Usage
Inspection Plans
No. of problem Suppliers
Lack of good quality
Production Control Engineering Changes
Supplies performance
No. of Parts operational
Make versus buy policy
Over board changes
Production No. to be supervised
Shift patterns
Industrial relations issue
Flow of product from assembly
Volume of service part/ kit Packing
Maintenance No. of Machine breakdowns
Maintenance schedule
Capital expenditure
Activity Levels
Systems No. of system operational
No. of systems devices
Adequacy of existing system
Control Quality Inspection Plan
Financial Accounting No. of accounting Transactions
No. of times accounts produced
Volume of activity
Coordinated shipping process
Management Accounting Accuracy of feeder system
Management Requirements
Corporate requirements
Activity levels
Personnel Recruitment Activity
Industrial relations climate
Training requirements

Poonam Namjoshi Page 2

SCM-ABC

Allocation of Overhead cost under ABC

Service department Activity Cost Pools Product Lines

and factory
overheads

Assigning costs of Application of

individual activities cost driver rates

Poonam Namjoshi Page 3

SCM-ABC

Characteristic Of ABC
a. Simple traditional distinction made between fixed and variable cost is not enough
guide to provide quality of information to design a cost system.
b. The more appropriate distinction between cost behavior patterns are volume(scale)
related diversity(scope) related, events (decisions) related and time related
c. Cost drivers need to be identified. A cost driver is a structural determinant, of cost
related activities. The logic behind is that the cost behavior pattern must be
understood so that behavior patterns is dictated by cost drivers. In tracing overhead
cost to product, a cost behavior patterns must be understood so that appropriate cost
driver could be identified.

How to develop an ABC system?

Three Key areas

a. Product Cost Differentiation

b. Activities and their cost driver
c. Identification of non value added cost
In ABC system a cost centre is established for each cost driver and identification,
measurement and control of cost drivers is essential in ABC. ABC is planned and
systematic study and determination of cost of each of the branches of business
activities that add to the value of product and services. The matrix of activities
showing the short term and long term cost strategy is presented as follows:

Short Term Long Term

Product Value Value addition
Pricing Corporate growth

Steps to develop ABC system

a. Identify the main activities performed in the organization, such as manufacturing,
assembly etc., as well as support activities including purchasing, packing, and
dispatching.
b. Identify the factory which influence the cost of each activity-the cost drivers
c. Collect accurate data on direct labour, material and overhead costs.
d. Establish the demands made by particular products on activities using cost drivers
as a measure of demand.
e. Trace the cost of activities to products according to a products demand for each
activity
THE rules developed by Kaplan and Cooper for this process are:

Poonam Namjoshi Page 4

SCM-ABC

a. Focus on expensive resources, thus directing attention to resource categories

where the new costing process has the potential to make big differences on
product cost.
b. Emphasise resources whose consumption varies significantly by product and
product type- look for diversity, and
c. Focus on resources whose demand patterns are un- correlated with traditional
allocation measures.

How to implement ABC system?

In ABC the hidden weaknesses and high cost segments are identified for maximum
effectiveness of cost accounting system. The process of designing and implementing an
ABC system for support departments usually by way of interviewing the concerned
departmental heads to have an insight into the departmental operations and into the
factors that trigger departmental activities. Subsequent analyses trace the activities to
specific products. Suppose the inventory control department is responsible for raw
material and purchased components. The relevant questions that could be asked are:
 How many people work in the department?
 What do they do?
 What determines the time required to process an incoming shipment? Does it
matter if the shipment is large and small?
 Do you usually disburse the total amount of material required for a production run
all at once or does it go out in smaller quantities?
After the interview the system designer can use the number of people involved in each
activity to allocate the departments cost. ABC calls for high level costing policy, cost
technology and modules for activities effectiveness in a competitive economy for
survival and prosperity.

Poonam Namjoshi Page 5

 SCM-ABC

GAINING COMPETITIVE ADVANTAGE THROUGH ABC

Which Products should we

promote?

Analyse the profit

contribution and impact of
inter-relationship of
product/service

Which customers
What prices should are profitability
we set? and why?

Identity the true Identity the true

cost/ profitability of cost/ profitability of
products and customers or type of
services customers
Gaining
Competitive
Advantage
How should we Which distribution
measure channel should we
performance? set?

Identity Analyse the cost and

accountability/respo performance of
nsibility the cost alternative
behavior services distribution channels

How ABC system supports Corporate Strategy?

ABC supports corporate strategy in many ways such as:

1. ABC system can effectively support the management by furnishing data, at the
operational level and strategic level. Accurate product costing will help the
management to compare the profits that various customers, product lines brands or

Poonam Namjoshi Page 6

SCM-ABC

regions generate and to decide on pricing strategies dropping unprofitable product,

lines etc.,
2. Information generated by ABC costing can also encourage management to redesign
the product
3. ABC system can change the method of evaluation of new process technologies, to
reduce setup times, rationalization of plant lay out in order to reduce or lower
material handling cost and improve quality etc.,
4. ABC system will report on the resources spending vis-à-vis resources consumption
and reduced demand in organizational resources lead to increase profits.
5. ABC analysis helps managers focus their attention and energy on improving activities
and the actions allow insights from ABC to be translated into increased profits.
6. The cost driver rates established by the system can be used to measure activity
performance and efficiency and provide a more suitable basis for budgeting.
7. The accurate feedback can be provided to cost centre managers on their managers on
their performance based their consumption of resources during a period rather than
the allocation of cost over which they have no control, and
8. The provision of accurate information on product costs enables better decisions to be
made on pricing, marketing, product design and product mix.

When to use ABC?

Ways of achieving cost Conventional Cost centers Activity Based cost centres
reduction

1. Reducing the set up Ignore or reduce Direct Reduce set up time to

time labour achieve cost

2. Eliminating material Ignore or reduce Direct Eliminating activities to

handling activities labour reduce cost of handling

3. Choosing an insertion Pick alternative with lowest Pick lowest cost

process unit level activities alternatives

4. Using common Using common components Use common components

components achieves the cost saving wherever possible.
Using non-common
components creates no cost
penalty

Class Assignment on ABC

Poonam Namjoshi Page 7

SCM-ABC

1. The budgeted overheads and the cost driver volume of XYZ ltd. are as follows

Cost pool Budgeted Cost driver Budgeted volume

Overheads(Rs.)

Material 580000 No. of orders 1100

procurement

Material handling 250000 No. of movements 680

Set up 415000 NO OF SET UPS 520

Maintenance 970000 Maintenance hrs 8400

Quality control 176000 No. of inspections 900

Machinery 720000 No. of Machine hrs 24000

The company has produced a batch of 2600 components of AX-15, its material cost was
Rs.130000 and labour cost was Rs.245000. the usage activities of the said batch are as follows.

Material orders 26 Maintenance hrs 690

Material Movements 18 Inspections 28

Setups 25 Machine hrs 1800

Required:
i. Calculate cost drivers rate that are used for tracing appropriate amount of
overheads to the said batch
ii. Ascertain the cost of batch component using ABC.
2. A company manufacturing two products furnishes the following data for the year

Product Annual Output Total Machine Total no. of Total no. of

(units) hrs purchase orders setups

A 5000 20000 160 20

B 6000 120000 384 44

The annual overheads were as under:

Volume related activity based cost Rs.550000
Set up costs Rs.820000
Purchase related cost Rs.618000
You are required to calculate the cost per unit of each product A and Product B based on
i. Traditional method of charging Overheads
ii. Activity based costing method.

Poonam Namjoshi Page 8

SCM-ABC

3. A company manufactures two products X and Y. the product X is low volum and its
sales are only 5000 units p.a. Product Y is high volume and labour intensive, its sales are
25000 units p.a. Product X tales 6hrs to make one unit and product Y takes 8 hrs /unit.
Details of cost for material and labour for each product are:
Product A Product B
Direct Material Rs.200 100
Direct Labour (@Rs.10/hr) 60 80
The company works 100000 direct labour hrs p.a. The total manufacturing OHs are
Rs.1750000 p.a.
Other information

Activity Total Ohs(Rs.) Frequency of activity Ratio X:Y

Machine Set up 450000 10000 3:2

Quality inspection 300000 15000 2:1

Production Ohs 180000 600 1:2

Machine Hrs 625000 50000 12:38

Material receipts 195000 1500 1:4

You are required to compute per unit of each product using

i. Direct labour rate method
ii. ABC method.

4. Family store wants information about the profitability of individual product line: soft drinks,
fresh produce, and packaged food. The Family store provides the following data for the year for
each product line:

Particulars Soft Drinks Fresh produce Packaged Food

Revenue Rs.793500 Rs.2100000 Rs.1209900

COGS Rs.600000 Rs1500000 Rs.900000

Cost of bottles Rs.12000

returned

No. of purchase 360 840 360

orders

No. of deliveries 300 2190 660

recd.

Hrs of shelf stock 540 5400 2700

Poonam Namjoshi Page 9

SCM-ABC

timing

Items sold 126000 1104000 306000

The family store also provides you with following information

Activity Description of Total Cost(rs.) Cost allocation base

activity

Bottles returned Returning empty 12000 Direct tracing to the

bottles soft drinkline

Ordering Placing orders for 156000 1560 puchase orders

purchase

Delivery Physical delivery 252000 3150 deleveries

and receipt of goods

Shelf stocking Stocking goods on 172800 8640hrs

stores shelves and
on going restocking

Customer support Assistance provided 307200 1536000 items sold

to customers

Required:
i. Family store currently allocates support cost (all costs other than goods sold to
product lines o basis of COGS of each product line. Calculate the operating
income and operating income as % of revenues for each product line
ii. If family store allocates cost(all costs other than COGS) to product lines using
ABC, calculate the operating income and operating income as% of revenues for
each product line
iii. Comment on your answers in requirement of (i) and (ii).

5. Bombay Steel Ltd. Manufactures four products, namely A, B, C and D, using the same plant and
processes. The following information relates to a production period:

Product Volume Material cost Direct Machine Labour Cost

Per Unit Labour Per time Per unit per unit
unit
A 500 5 ½ hr ¼ hr 3
B 5000 5 ½ hr ¼ hr 3
C 600 16 2 hr 1 hr 12
D 7000 17 1 ½ hr 1 ½ hr 9
Total production overhead recovered by the cost accounting system is analysed under
following headings:

Poonam Namjoshi Page 10

SCM-ABC

Factory overheads applicable to machine oriented activity Rs.37424

Set costs Rs.4355
Cost of ordering Rs.1920
Handling material Rs.7580
Administration for spare parts Rs.8600
The overheads cost are absorbed by products on machine hour rate of Rs4.80 per hour
giving an overhead cost per product of A: Rs.1.20, B: Rs.1.20, C: Rs.4.80, D: Rs.7.20
However, investigation into the production overhead activities for period reveals the following
totals:

Product No. of Set ups No. of Material No. of Times No. of Spare
Order material was parts
handled
A 1 1 2 2
B 6 4 10 5
C 2 1 3 1
D 8 4 12 4
You are required:
i. To compute an overhead cost per unit Activity Based Costing, tracing overheads
to production units by means of cost driver
ii. To comment briefly on the differences disclosed between overheads traced by the
present system and those traced by Activity Based Costing.

6. Having attended a SCM courses on Activity Based Costing you decide to experiment by
applying the principles of ABC to four products currently made sold by your company.
Details of the four products and relevant information are given below for one period:

Product A B C D
Output in units 120 100 80 120
Cost per unit
Direct Material Rs.40 Rs.50 Rs.30 Rs.60
Direct labour Rs.28 Rs.21 Rs.14 Rs.21
Machine Hours 4 3 2 3
per unit
The four products are similar and are usually produced in production runs of 20 units and
sold in batches of 10 units. The production overhead is currently absorbed by using a
machine hour rate and the total of the production overhead for the period has been
analysed as follows:
Machine department cost (rent, business, rates, depreciation and supervision)Rs.10430

Set up costs Rs.5250.

Stores receiving Rs.3600
Inspection/Quality Control Rs.2100

Poonam Namjoshi Page 11

SCM-ABC

Materials Handling and dispatch Rs.4620

You have ascertained that the “cost driver:” to be used are as listed below for the
overhead costs shown:
Set up Costs =No. of production runs
Stores receiving=Requisition raised
Inspection and Quality control=No. of production run
Material handling and Dispatch = orders executed
The No. of requisition raised on the stores was 20 for each product and No. of orders
executed was 42, each order being for batch of 10 of a product.
You are required:
a. To calculate the total costs for each product if all overhead costs are absorbed on a
machine hour basic;
b. To calculate the total costs for each product, using activity based costing;
c. To calculate and list the unit product costs from your figures in (a) and (b) above, to
show the difference and to comment briefly on any conclusion which may be drawn
which could have pricing and profit implications.
7. Relevant data relating to a company are:

Particulars Product
P Q R Total
Production/Sales(units) 60000 40000 16000
Raw Material usage in units 10 10 22
Raw material costs Rs.50 Rs.40 Rs.22 2476000
Direct Labour Hours 2,5 4 2 342000
Machine hours 2.5 2 4 294000
Direct Labour Cost Rs.16 Rs.24 Rs.12
No. production costs 6 14 40 60
No. of Deliveries 18 6 40 64
No of receipts 60 140 880 1080
No of production orders 30 20 50 100
Set up Rs.60000
Machines Rs1520000
Receiving Rs.870000
Packing Rs.500000
Engineering Rs.746000
The company operates a JIT inventory policy and receives each component once per
production run.
Required:
i. Compute the product cost based on on direct labour hour recovery rate of
overheads
ii. Compute the product cost using ABC

Poonam Namjoshi Page 12

SCM-ABC

8. ABC electronics makes audio player model “AB100”. It has 80 components. ABC sells 10000units
each month at Rs.3000 per unit. The cost of manufacturing is Rs.2000 per unit or Rs.200lakhs
per month for the production of 10000units. Monthly manufacturing costs incurred are as
follows:

Rs. lakhs
Direct Material Costs 100.00
Direct Mannufacturing labour Cost 20.00
Machine Costs 20.00
Testing Costs 25.00
Rework Costs 15.00
Ordering Costs 0.20
Engineering Costs 19.80
200.00
Labour is paid on piece rate basis. Therefore, ABC considers direct manufacturing labour
cost as variable cost. The following additional information is available for AB100

i. Testing and inspection time per unit is 2 hrs

ii. 10% of AB100 manufactured are reworked
iii. It currently takes 1 hr to manufactures each unit of AB100
iv. ABC places two orders per month for each month component. Each component is
supplied by a different supplier

ABC has identified activity cost pools and cost drivers for each activity. The cost per unt of cost
driver for each activity cost pool is as follows:

Manufacturing Description of Cost driver Cost per unit of cost

Activity activity driver
1.Machining Costs Machining Machine hours of Rs.200
Component capacity
2. Testing costs Testing component Testing Hrs Rs.125
and finished
goods(each unot of
AB100 is tested
individually)
3.Rework cost Correcting and Units of AB100 Rs.1500 per unit
fixing errors and reworked
defects
Ordering costs Ordering of No. of orders Rs125 per order
components
Engineering costs Designing and Engineering hours Rs1980 per
managing of engineering hour
products

Poonam Namjoshi Page 13

SCM-ABC

Over a long run horizon, each of the overhead costs described above vary with chosen
cost drivers

In response to competitive pressure ABC must reduce the price of its product to Rs.2600
and to reduce the cost by atleast Rs.400 per unit. ABC does not anticipate increase in
sales due to price reduction. However, if it does not reduce price it will not be able to
maintain the current sales level.

Cost reduction on the exciting model is almost impossible. Therefore, ABC has decided
to replace ‘AB100’ by new ‘AB200’. The expected effect of design modifications are as
follows:

i. The No. of components will be reduced to 50

ii. Direct material costs to be lower by Rs.200 per unit
iii. Direct Manufacturing Labour costs to be lower by the Rs.20 per unit
iv. Machining time required to be lower by 20%
v. Rework to Decline to 5%
vi. Machining capacity and engineering Hours capacity remain the same
vii. Testing time required to be lower by 20%

ABC currently outsources the network on defective unit

Required:

a. Compare the manufacturing cost per unit of AB100 and AB200.

b. Determine the immediate effect of design change and pricing decision on operating
income of ABC
Ignore income Tax. Assume that cost per unit of each cost driver for AB100
continues to apply to AB200.
9. XYZ ltd. manufactures three different products for an industrial market. The cost
accounting system used by XYZ is a traditional one in the sense that is very much like
the systems literally thousands of firms have used for many years.
The exhibit 1 data is regard to sales prices and sales volume for three product are shown
along with basic production and standard cost statistics. There is only one production
department machines and it takes a little more than 1 labour hour for each machine
(11250/10000) at current production mix. Labour is paid at Rs.20/hr including fringe
benefit and machine cost is Rs.71/hr.

Exhibit 1

Three products Total

A B C

Poonam Namjoshi Page 14

SCM-ABC

Production 10000 units in 15000 units in 5000 units in 10

1 run 3 runs runs

Shipments 10000 units in 15000 units in 5000 units in 20

1 shipments 5 runs shipments

Selling prices

 Target Rs.162.61 Rs.134.09 Rs.81.31

prices

 Selling Rs.162.61 Rs.125.96 Rs.105.70

Prices

Raw Material 5 6 10components@

components@ components@ rs.1/ component
rs.4/ rs.5/ =Rs.10
component component
=Rs.20 =Rs.30

Labour usage

Set up labour 10 hrs per 10 hrs per 11 hrs per 150 hrs
production run production run production run

Run labour ½ hr per part 1/3 hr per part ¼ hr per part 11250hrs

Machine usage 1/4hr per part 1/3 hr per part 1/2hr per part 10000hrs

Other overheads

Receiving dept 30000

Engineering dept 500000

Packing dept 200000

The total overheads distribution to the driver to the three products produced in the
machine department(as is present done) shown in exhibit 2. Overhead is assigned to
products on direct labour costs.
Exhibit 2: Calculation of unit costs

A B C

Raw Material 20.00 30.00 10.00

Direct labour 10.00 6.67 5.00

Poonam Namjoshi Page 15

SCM-ABC

Overheads(labour
Rs.basis)

Set up RS.3000

Machines Rs.700000

Receiving Rs.300000

Engineering Rs.500000

Packing Rs.200000

Total Rs.1703000 105.70 87.16 52.85

Overhead rate = Total OHs/Total Direct Labor cost=Rs.1703000/225000=757%

1. Do you think that there is anything wrong with present costing system?
2. IF XYZ ltd. was aware of ABC, do you think that would have given dramatic
different assessment of the opinion under consideration?

10. What are the areas in which Activity Based information is used for decision making?
11. Explain briefly four different categories of activities that drive the expenses at product
level.

12. Tithi (P) Ltd. has the following activities and associated cost behaviours:

Activities Cost Behaviour

Labour Rs.10 per direct labour hr.
Set Up Variable Rs.100 per set up
Step fixed- Rs.30000 per step set up =10set
ups
Receiving Step-Fixed- Rs.40000 per step set up
=2000hrs
Activities with step cost behavior are being fully utilized by existing products. Thus any
new product demands will increase resources spending on these activities.
Two designs are being considered for a new product- Design I and II. The following
information is provided about each design (1000 units of the product will be produced).

Cost Driver Design I Design II

Direct labour Hrs 3000 2000
No. of set ups 10 20
Receiving Hrs 2000 4000
The Co. has recently developed a cost equation for manufacturing costs using direct
labour hrs as the driver. The equation had R2= 0.60 and is given below
Y= Rs150000+ Rs.20X

Poonam Namjoshi Page 16

SCM-ABC

Required:
1. Compute the cost of each design (based on the direct labour cost equation). If the
design engineering is told that only direct labour hours drive manufacturing costs.
Which design would be choen based on this unit based cost assumption?
2. Now compute the cost of each design using all driver and activity information. Which
design will now be choose? Are there any other implications associated with use of
more complete activity information set?
3. Consider the following statement: “Strategic Cost Analysis should exploit internal
Linkages”. What does this mean? Explain, using the results of requirements (a) and
(b)
4. What other information would be useful to have concerning the two design? Explain

Poonam Namjoshi Page 17