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Chapter 14
Activity Based Costing

Traditional absorption costing systems share overheads across all products based on a single cost
driver (usually machine or labour hours).
It is argued that a modern manufacturing environment requires a more sophisticated and intelligent
costing system.
Under ABC costing, overhead costs are given greater attention and visibility because they are
assigned to different products based on the extent to which each product ‘drives’ or causes that cost.
This costing system can be relatively time-consuming and costly to implement but can be useful, if
manufacturing overhead expenditure is significant and a diverse product range exists. ABC can also
be applied to costing within service industries

re
Steps in ABC

1. Identify the major ‘activities’ that give rise to overheads (e.g. quality testing, ordering costs etc)

tu
2. Determine what causes the cost of each activity – the cost driver (e.g. number of inspections,
number of orders)
3. Calculate the total costs for each activity – the cost pools.
4. Calculate a cost per cost driver.
c
5. Allocate the overhead costs to products based on their usage of cost driving activities.
Le
6. Calculate the overhead cost per unit for each item of output

These are some examples of cost pools and cost drivers

Cost pools Cost drivers

a

Purchasing department cost Number of purchase orders

Materials handling Number of material requisitions
eg

Setup costs Number of machine setups

Inspection costs Number of inspection
Supervisors Number of direct labour hours
M

Advantages of ABC

 ABC provides more reliable information for product costing, i.e. it is based on activity cost
driver.
 ABC facilitates pricing decision
 ABC recognizes that overhead costs are not all related to production and sales volume.

Disadvantages of ABC

 It is time consuming to implement ABC

 Determining the cost driver may be difficult.
 It is not possible to attribute all costs to activities

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 Measuring the quantity of each cost driver consumed may be difficult.

 It is costly because it may be necessary to employ a specialist to implement the ABC system

Worked example

1. Una manufactures three products: A, B, and C.

Data for the period just ended is as follows:

A B C
Production (Units) 20000 25000 2000
Sales price (per unit) $20 $20 $20
Material cost (per unit) $5 $10 $10
Labour hours (per unit) 2 1 1

re
(Labour is paid at the rate of $5 per hour)

Overheads for the period were as follows:

tu
Set-up costs 90,000
Receiving 30,000
Dispatch
Machining
c
15,000
55,000
Le
$190,000

Cost driver data:

A B C
a

Machine hour per unit 2 2 2

Number of set ups 10 13 2
eg

Number of deliveries received 10 10 2

Number of orders dispatched 20 20 20

Required
M

(a) Calculate the cost (and hence profit) per unit, absorbing all the overheads on the basis of labour
hours.
(b) Calculate the cost (and hence profit) per unit absorbing the overheads using an Activity Based
Costing approach.

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Past Paper Questions

Q # 1 Jumal Limited manufactures two products, Alpha and Beta.
The following budgeted information is available.

Fixed production overhead is $540 000 and is allocated to the products by machine hours.

REQUIRED

re
(a) Calculate for each product:
(i) Total budgeted production cost [2]
(ii) Budgeted unit cost. [2]

tu
Additional information

c
The directors of Jumal Limited will add 50% on to the total production cost to set the selling price
Le
for each product.

REQUIRED

(b) Calculate the unit selling price of each product. [2]

a

Additional information
eg

Meena is a management accountant newly recruited by Jumal Limited. She suggests that the
company should adopt activity based costing to allocate production overheads. She has identified
that the production comprises four major activities. The cost of each activity and the activities
consumed by each product are as follows:
M

REQUIRED

(c) State one benefit of adopting activity based costing. [1]

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(d) Prepare a table to show the allocation of the total budgeted production overheads between
Alpha and Beta if Jumal Limited changes to activity based costing. [4]

(e) Calculate the budgeted unit cost and budgeted unit selling price of Alpha and Beta if activity
based costing is adopted. [5]

(f) Discuss the factors the directors of a business should consider before possibly changing the
selling price. [6]

(g) Recommend whether or not the directors of Jumal Limited should change the selling price of the
products. Justify your answer. [3]
March 2016

Q # 2 Chetna runs a business printing logos on sweatshirts. The sweatshirts come in two types,

re
Standard and Superior. The selling price is set at cost plus 30%.
The following information is available for the year.

c tu
Le
a
eg

REQUIRED

(a) Calculate an overhead absorption rate based on labour hours. [2]

M

Additional information

Staff printing the logos are paid $10 an hour

REQUIRED

(b) (i) Calculate the total cost allocated to each type of sweatshirt. [4]
(ii) Calculate the selling price for each sweatshirt. [2]

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Additional information

Chetna has suggested that it would be better to allocate the machine set up cost to each product
based on the number of times the machine is set up. The machine has to be set up each time there is
a different logo.
During the year the machine was set up 600 times for Standard sweatshirts and 975 times for
Superior sweatshirts. Other overheads are still allocated on the basis of labour hours.

REQUIRED

(c) (i) Calculate the total costs allocated to each type of sweatshirt when machine set up costs are
allocated using the number of set up times. [4]
(ii) Calculate the revised selling price for each type of sweatshirt. [2]
(iii) Calculate the change in selling price for each type of sweatshirt. [2]

re
(d) Explain three differences between activity based costing and absorption costing. [6]

tu
(e) Advise Chetna which method she should use. Justify your answer. [3]
June 2016

c
Q # 3 Explorer Limited produces two products, Y and Z, and has always used absorption costing to
allocate overheads to each product. The directors are now considering adopting activity based
Le
costing (ABC).

REQUIRED

(a) Compare how overheads are apportioned using absorption costing and ABC. [4]
a

Additional information
eg

The budgeted data for the two products for the year ending 31 December 2017 is as follows:
M

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REQUIRED

(b) Calculate the cost per unit for each product using absorption costing. [7]

Additional information

REQUIRED
(c) Calculate the cost per unit for each product using ABC. [7]

re
(d) (i) Compare the total profit per product using absorption costing and ABC. [4]
(ii) Comment on the results. [1]
(e) Advise the directors whether or not ABC should be adopted. Justify your answer. [2]

tu
June 2016

Q # 4 “The idea behind this method of costing is that it is the cause of a cost which is important and
not whether it is fixed or variable.”
c
Le
REQUIRED

(a) Identify the costing method described in the quotation. [1]

Additional information
a

Haruka Limited produces a single product.

eg

The factory is operational 5 days a week for 50 weeks a year. It produces one batch of 200 units
each day.
Overheads amount to $79 000 a year
M

REQUIRED

(b) Calculate the overhead cost per unit to two decimal places. [2]

Additional information

These overheads comprised:

$
Machine set-up costs 2 000
Production quality inspections 5 000
Production stoppage costs 4 000
Machine maintenance 8 000
Machine running costs 60 000

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The machines were set up at the start of each working day.

There was a quality inspection every week.

The machines were maintained each day.
Production was stopped on average once every 4 weeks for unexpected maintenance.
Samir, the finance director, asks Sara, the factory accountant, to analyse the overhead cost per unit
across each of the five overheads incurred.

REQUIRED

(c) Prepare an analysis showing how the total overhead cost per unit (from part b) is split between
each of the individual overheads. [12]

Additional information

re
Sara has complained to Samir that producing this analysis is not worthwhile.

tu
REQUIRED

(d) Advise Samir whether or not he should continue to ask for this analysis in the future years.
c
Justify your answer by considering the benefits and drawbacks of this costing method. [10]
Nov 2016
Le
Q # 5 Ahmed manufactures two products. He has recently started using Activity Based Costing
(ABC) for allocating the overhead costs to these products. The budgeted data for one month is
available as follows:
a
eg
M

Required

(a) Calculate the full cost per unit for product X and product Y using ABC [10]

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Additional Information

Ahmed previously used direct labour hours as a basis to charge overheads to each product.

Required

(b) Calculate the overhead charged to each product using the direct labour hour rate. [3]

(c) Explain the effect that changing the method has had on the overhead cost of each product. [4]

Additional information

A customer requires 50 units of Product X and has offered to pay Ahmed a total of $8450 for
them. Ahmed uses 40% mark-up on all his products.

re
Required

tu
(d) Recommend whether or not Ahmed should accept the offer. Justify your decision using
appropriate calculations and considering both financial and non-financial factors. [6]

c
(e) State two reasons why a business may use ABC for allocating overhead costs. [2]
June 2017
Le
Q # 6 PMW Limited produces and sells two products, A and B. It provided the following
information for a year:
a
eg

Total overheads amounted to $300000. These are currently apportioned to the two products on
the basis of total sales value.
M

REQUIRED

(a) Calculate the value of overheads apportioned to each product. [3]

(b) Calculate the profit or loss per unit for each product. [5]

Additional information

Beryl, the accountant, has analysed the overheads. She discovered that the total of $300000
included costs for delivery to customers and order processing costs. The following information was
available.

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1 Analysis of orders received

2 Costs of delivery amounted to $30 per order for orders received for more than 100 units, and $20
per order for orders of 100 units or fewer.

3 Order processing costs amounted to $25 per order irrespective of size.

4 Remaining overheads should now be apportioned to sales units.

re
REQUIRED

(c) Calculate the total overheads apportioned to each product in accordance with the accountant’s
analysis. [5]

tu
(d) Calculate the revised profit or loss per unit for each product. [5]

Additional information c
Le
Beryl believes that her method of apportioning overheads is more realistic than the current method.
She has recommended to the directors that the method be changed in the future.

REQUIRED
a

(e) Discuss whether or not the directors should change the method of apportioning overheads.
Justify your answer using both financial and non-financial factors. [5]
eg

(f) State what is meant by the terms ‘cost driver’ and ‘cost pool’. [2]
Nov 2017
M

Q # 7 B Limited manufactures two products Alpha and Omega. The following budgeted figures are
available.

The fixed overheads are forecast as $396 000 and are allocated on the basis of labour hours.

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(a) Calculate for each product:

(i) The total production costs [3]
(ii) The production cost per unit [1]

Additional information

The sales price per unit is calculated by adding 50% to the cost.

(b) Calculate the selling price per unit for each product. [2]

Additional information

The directors of the company have been advised that they should adopt activity based costing to
allocate the production overheads. They have identified the four major activities involved in the

re
production cycle as machine set-up, materials handling, maintenance of machinery and production
inspection and packing. The costs of each activity have been established and the overheads
apportioned between the activities as follows:

c tu
Le
(c) State two disadvantages to a business of adopting activity based costing. [2]

(d) Calculate the total production overhead to be allocated to each product using activity based
a

costing. [4]
eg

(e) Recalculate the cost per unit and selling price of each product maintaining the 50% mark-up. [3]

(f) Explain three reasons why B Limited should change the method of allocating overheads to using
activity based costing. [6]
M

Additional information

It has been suggested that customers will not accept the increase in price of Omega. The directors
are therefore considering changing the profit margins to 60% on Alpha and 30% on Omega.

(g) (i) Calculate the new total profit for each product if this change is adopted. [2]

(ii) Give two reasons why B Limited should adopt this change. [2]
June 2018

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Q # 8 F Limited was planning to introduce two new products, Product X and Product Y.
The relevant data were as follows.

re
tu
Total factory overheads arising from the introduction of Product X and Product Y are expected to
be: c
Le
The directors’ policy is to set a selling price based on a mark-up of 50% on total cost per unit.
a

The directors asked two employees, Abdul and Brian, each to prepare a calculation of the selling
eg

price which should be set.

Abdul decided to apportion the purchasing costs of direct material on the basis of the number of
kilos purchased, and to apportion the employment overheads for direct labour on the basis of hours
M

worked.
Abdul decided to apportion other factory overheads on the basis of units produced.

Required

(a) Prepare a statement to work out the proposed selling price per unit for both Product X and
Product Y as calculated by Abdul. [11]

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Additional information

Brian decided to apportion the purchasing costs of direct material on the basis of the number of
orders being made, and to apportion the employment overheads for direct labour on the number of
employees working in production.

Brian also decided to apportion other factory overheads on the basis of units produced.

(b) Prepare a statement to work out the proposed selling price per unit for both Product X and
Product Y as calculated by Brian. [9]

(c) Explain to the directors how to proceed with the setting of the selling price. Support your answer
with reference to your calculations in parts (a) and (b) together with any other factors. [4]

re
(d) State one reason why selling and distribution costs are not included in a valuation of inventory
suitable for inclusion in a statement of financial position. [1]
Nov 2018

tu
Q # 9 B Limited produces two products – Premier and Standard. The budgeted cost information for
the month of June 2019 is as follows:
c
Le
a

Budgeted fixed overheads $480000 for 2019 are allocated to products based on 40 000 budgeted
total direct labour hours.
eg

(a) Calculate the cost per unit for each product using absorption costing. [3]

Additional information
M

A newly recruited management accountant suggests that B Limited should adopt activity based
costing (ABC). He has provided an analysis of fixed overheads as follows:

Budgeted use of cost driver for each product for June 2019 is as follows:

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(b) Explain the meaning of the term ‘cost driver’. [2]

(c) State two advantages and three disadvantages of ABC. [5]

(d) Calculate the cost per unit for each product if ABC is adopted. [8]

Additional information

re
The selling price of each product is cost plus 40%.

tu
(e) (i) Calculate the selling price of each product using absorption costing. [2]

(ii) Calculate the selling price of each product using ABC. [2]
c
(iii) Explain, using suitable calculations, why your answers in (i) and (ii) are different. [3]
Le
March 2019

Q # 10 Young manufactures two products, Product X and Product Y. The following budgeted
information is available
a
eg
M

Total production overheads, $180 000, are to be allocated to each product on the basis of machine
hours. A 50% mark-up will be added to the production cost of each product to set the selling price

(a) Calculate for each product the unit production cost and unit selling price. [7]

Additional information

On the advice of the management accountant, Young is considering using activity based costing
(ABC) to allocate the production overheads to both products. The following information is available

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(b) State what is meant by ‘Activity Based Costing (ABC)’. [1]

(c) Recalculate for each product the unit production cost and the unit selling price using ABC. [7]

(d) (i) Calculate the difference between the unit production overhead charged to Product X and to

re
Product Y using each method. [3]

(ii) Calculate the difference between the unit selling price using the two costing methods for
Product X and Product Y. [2]

tu
(e) Advise Young whether or not he should change the method of allocating production overhead
costs to ABC. Justify your answer. [5]
c Nov 2019
Le
a
eg
M

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