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PAC FINANCIAL CONSULTANTS

CPA REVIEW CLASSES
INTERMEDIATE & FINAL STAGE
B5: PERFORMANCE MANAGEMENT
TOPIC: ACTIVITY BASED COSTING (ABC)
Absorption Costing - revisited
In order to full understand Activity Based Costing (ABC), we need to remind ourselves about the
principles of traditional absorption costing first of all.
ABSORPTION COSTING
When using absorption costing, we aim to calculate a full production cost per unit. Direct costs such as
materials or labor can clearly be ‘attached’ to each unit of production. Overhead costs are indirect costs
which cannot clearly be charged to individual units of production (for example factory rent and rates).
For overheads we have to adopt a process to estimate an amount of overhead that we can charge to
each cost unit.

Overheads were identified in total and then usually apportioned or shared between cost centers (usually
departments such as assembly or finishing). For example factory rent and rates could be shared
between cost centers on the basis of floor area (square meters).
Once accumulated in a cost center the overheads could then be absorbed into cost units on an hourly
basis – often either labour hours (if the cost centre is labour intensive) or machine hours (if the cost
centre is machine intensive).
Overhead Absorption Rate (OAR) = Total budgeted OHs/Budgeted activity level
The absorption costing per unit can then be used to:
 Assess the costs incurred per unit for performance assessment (e.g. variance analysis);
 Value inventory for financial accounting purposes;
 Calculate sales prices based on a cost-plus basis.
PROBLEMS ASSOCIATED WITH ABSORPTION COSTING
There are problems for modern manufacturing businesses in using absorption costing methods.
1. Increased product complexity.

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Modern manufacturers tend to produce a wide range of products at quite different volumes. There is a
high risk that some products may be charged too much overhead and others too little. This in turn could
lead to inappropriate pricing of products if the business pursues a cost plus pricing methodology.
2. Increasing capital intensity of modern manufacturing techniques
Many modern manufacturers are highly machine intensive. This means that only a small portion of direct
labor is involved in the manufacturing process hence a very small proportion of the overall costs
involved. This can lead to extremely high absorption rates that bear little resemblance to the underlying
overhead and how it is incurred.
EXAMPLE:
Armstrong manufactures small hand held hammers and 12 metre containers used in the transportation
of goods by road, rail and sea. It operates a highly mechanised production system. Overheads are
calculated on a direct labour hour basis.
The following information is available for the manufacture of these products over a period.
Hand held Containers
hammers
Direct material/unit 5/= 300/=
Direct Labour/unit:
0.5 hours @ Tshs.20/hour: 10/=
2 hours @ Tshs.20/hour: 40/=
Budgeted Production (units) 20,000 1,000
Total Factory overhead 960,000/=
REQUIRED:
(a) Calculate the amount of overhead to be absorbed into each product.
(b) Calculate the sales price of each product if the business uses a full cost plus 40% basis.
SOLUTION:
OAR = 960,000/(20,000×0.5) + (1,000×2) = Tshs.80/hr
(a) The standard cost card for each product becomes:
Hand held Containers
hammers
Direct material/unit 5/= 300/=
Direct Labour/unit:
0.5 hours @ Tshs.20/hour: 10/=
2 hours @ Tshs.20/hour: 40/=
Prime cost/unit 15/= 340/=
Overhead/unit:
0.5hrs×Tshs.80/hr 40/=
2hrs×Tshs.80/hr 160/=
Total production cost/unit 55/= 500/=

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(b) The sales price of each product becomes:

Hand held Containers
hammers
Full production cost/unit 55/= 500/=
40% profit mark-up 22/= 200/=
Sales price 77/= 700/=
OBSERVATION:
It appears strange for the case of containers, such a large and bulky product, only 32% of the product’s
cost is made up of overhead. Each container appears relatively ‘cheap’ to make in overhead terms
because of the relatively small amount of direct labour required to make it. Practically the bulk of the
productive input to make the container is machine overhead, yet the absorption rate does not recognize
this.

ACTIVITY BASED COSTING (ABC)

ABC tackles the problems of absorption costing by adopting a much more accurate way of charging
overhead to cost units.
In essence the business carefully considers what the primary activities of the business are. In making
units of production what does the business actually do to be able to make those units?
Traditional absorption costing collects all of the activities together in a cost centre. Any factory
overheads are then apportioned to that cost centre.
Under ABC, overheads are (wherever possible) specifically allocated to a cost pool relating to a
particular activity. Rather than absorbing all overheads from a cost pool under one uniform basis (e.g.
labour hours), ABC then absorbs overhead into cost units by identifying the relevant cost driver (what
cause changes in the cost). This is likely to mean that there will in essence be multiple absorption rates
within a business.
Examples of cost drivers would be: -
 Ordering costs – no. of orders
 Set-up costs – no. of set-ups
 Packing costs – no. of packing orders
NOTE: One of the most important attributes of ABC is that to control costs, the business needs to focus
on reducing the amount of cost drivers.
OVERALL SUMMARY OF ABC
 ABC addresses overhead costs only. Direct costs can be specifically calculated and accurately
attributed to each product. In the Armstrong example above, we could accurately identify the
direct material and labour costs attributable to each product;
 We are seeking to identify an accurate product cost;

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 Under ABC, cost centres are replaced by cost pools. Cost pools reflect an accumulation of
overhead relating to specific activities undertaken by the business;
 We replace OARs with cost driver rates. Individual cost driver rates are used to charge activity
overheads to individual cost units on the basis of specific usage.

STEPS IN ESTABLISHING AND APPLYING ABC:

There are 5 main steps in establishing and applying ABC: -
1. Identify activities that consume resources and incur overhead costs.
2. Allocate overhead costs to the activities that incur them.
3. Determine the cost driver for each activity or cost pool.
Each group of costs which are influenced by a particular cost driver is referred to as a 'cost
pool'.
4. Collect data about actual activity for the cost driver in each cost pool
5. Calculate the overhead cost of products or services.
This is done by calculating an overhead cost per unit of the cost driver. Overhead costs are then
charged to products or services on the basis of activities used for each product or service.
The Advantages of ABC
1. More realistic product costs are provided when support overheads are a significant proportion of
total costs.
2. More overheads can be traced to the product. In modern factories there are a growing number
of non-factory floor activities. ABC is concerned with all activities so takes product costing
beyond the traditional factory floor basis.
3. ABC recognizes that it is activities, which cause cost, not products and it is products, which
consume activities.
4. ABC focuses attention on the real nature of cost behaviour and helps in reducing costs and
identifying activities, which do not add value to the product.
5. ABC recognizes the complexity and diversity of modern production by the use of multiple cost
drivers, many of which are transaction based rather than based solely on production volume.
6. ABC provides a reliable indication of long-run variable product cost which is relevant to strategic
decision-making.

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7. ABC is flexible enough to trace costs to processes, customers, areas of managerial

responsibility, as well as product costs.
8. ABC provides useful financial measures (e.g. cost driver rates) and non-financial measures (e.g.
transaction volumes).
9. The principle of using activities to trace costs can be applied across a range of service
industries as well as manufacturing firms.

The Disadvantages of ABC

ABC may not be universally beneficial. There are four major issues to be considered:
1. Cost vs benefit
The need to analyze costs on a radically different basis will require resources, which will lead to
additional costs. Clearly the benefits which will be obtained must exceed these costs.
In general terms, an organization which has little competition, a stable and standardized product
range and for which overheads represent a small proportion of total cost, will not benefit from
the introduction of ABC.
2. Need for informed application
While ABC is likely to provide better information for decision makers, it must still be applied with
care. ABC is not fully understood by many managers and therefore is not fully accepted as a
means of cost control.
3. Difficulty in identifying cost drivers
In a practical context, there are frequently difficulties in identifying the appropriate drivers. ABC
costs are based on assumptions and simplifications. The choice of both activities and cost
drivers might be inappropriate.
4. Lack of appropriate accounting records
ABC needs a new set of accounting records, this is often not immediately available and
therefore resistance to change is common. The setting up of new cost pools is needed which is
time-consuming

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PRACTICE QUESTIONS
QUESTION 1 (NBAA MAY 2018)
Pan African is a reputable law partnership offering a variety of legal services to clients. The managing
partner has recently sought advice in relation to improving the accuracy and efficiency of its billing
system. The advisor, CPA Leo Bulali, suggested the introduction of activity based costing (ABC) to
replace the existing traditional overhead costing method used by Pan African. The current costing
method allocates overhead costs to clients based on total labour hours (for partners, junior clerks and
secretarial support). Clients are billed based on cost plus a markup of 60%. In order to introduce ABC
the managing partner assigned a team, comprising one partner and two junior clerks, to ascertain the
cost and activity relationships, and corresponding cost data, and this is shown below:
Cost activity relationships:
Cost pool Cost driver
Legal search Number of searches conducted
Documentation Number of pages printed/copied
Office administration (telephone, postage, etc.) Secretarial support time spent on case
Cost and activity data: TZS.
Partner salary cost 38,640,000
Junior clerk wages cost 18,320,000
Secretarial support wages cost 5,225,600
Legal search costs 1,818,000
Printing and stationery costs 4,830,000
Office administration costs 3,661,600

Partner labour hours 6,440

Junior clerk labour hours 7,680
Secretarial support labour hours 3,680
Total number of searches conducted 1,212
Total number of document pages printed/copied 1,610,000

Details relating to two legal cases:

Case 1406 Case 2655
Number of searches 5 1
Partner time spent on case 2 hours 1 hour
Junior clerk time spent on case 5 hours 3 hours
Document pages printed/copied 215 pages 86 pages
Secretarial support time spent on case 1 hour 1 1 hour
REQUIRED:
(a) Calculate the total cost of each of the cases noted above using:
(i) The existing costing method;
(ii) Activity based costing. (17 marks)
(b) Comment briefly on your answers at (a) (i) and (ii) above. (3 marks) [Total: 20 Marks]

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QUESTION 2 (NBAA NOV 2017)

HAPA KAZI Solutions Ltd produces three different products using two production departments. The
company currently uses absorption costing to establish products cost and profitability. The directors
have recently attended a conference on Activity-Based Costing (ABC) and are examining whether ABC
might provide a better system for HAPA KAZI Solutions Ltd.
The following budgeted information for the period ending 31 st December 2018 has been collected for
each of the three products:
Tunda one Tunda two Tunda three
Production and sales 8,750 units 4,000 units 6,000 units
Unit sales price TZS 56 TZS 106 TZS 84
Direct materials 1.5 kg 6 kg 7 kg
Direct labor:
- Machining Dept 1 hour 8 hours 6 hours
- Assembly Dept 4 hours 3 hours 1 hour
Direct expenses TZS 2 TZS 6 TZS 3
Machine Dept (machine hours per unit) 2 hours 5 hours 4 hours
Raw material cost TZS 4 per kilo and the hourly rate for all labor is TZS 5. The direct expenses relate
entirely to specialized packaging which is uniquely designed for each of the products and is therefore
directly attributed to that product alone.
The current costing system absorbs overheads to the Machine and Assembly Departments on the basis
of a recovery rate of TZS 3.50 per machine hour and TZS 1 per labour hour respectively
The following is an analysis of the overheads by department:
Department Overheads in TZS
Purchase Department 22,400
Production Set-up & Design Department 34,500
Customer Service Department 32,600
Machine Department 123,000
Assembly Department 26,500

The Department Managers have provided the following additional information about operations in their
departments:
Tunda one Tunda two Tunda three Total
Number of set-ups 10 10 30 50
Number of customer orders 80 86 160 326
Number of purchase orders 30 32 50 112
The Machine Department is a capital intensive and Assembly Department is labour intensive.
REQUIRED:
(a) Calculate the prime cost of each product. (2 marks)
(b) Calculate profit per unit for each product if overheads are absorbed on the current costing basis
(4 marks)

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(c) Calculate profit per unit for each product if overheads are absorbed using an Activity-Based
Costing approach and identify any cost drivers you assign. (12 marks)
(d) Comment on why there is a difference between the profit/loss shown on an absorption costing
basis and that shown using Activity-Based costing. (2 marks) (Total: 20 marks)

QUESTION 3
Hensau Ltd has a single production process for which the following overhead costs have been estimated
for the period ending 31 December 2010:
Tshs.
Material receipt and inspection costs 15,600
Power costs 19,500
Material handling costs 13,650
Three products - X, Y, and Z are produced by workers who perform a number of operations on material
blanks using hand held electrically powered drills. The workers are paid 4/= per hour.
The following budgeted information has been obtained for the period ending 31 Dec. 2009:
Product X Product Y Product Z
Production quantity (units) 2,000 1,500 800
Batches of Material 10 5 16
Data per product unit:
Direct material (square metres) 4 6 3
Direct material cost (/=) 5 3 6
Direct labour (minutes) 24 40 60
No. of power drill operations 6 3 2
Overhead costs for material receipt and inspection, process power and material handling are presently
each absorbed by product units using rates per direct labour hour.
An activity based costing investigation has revealed that the cost drivers for the overhead costs are as
follows:
Material receipt and inspection: Number of batches of material
Process power: Number of power drill operations
Material handling: Quantity of material (square metres) handled
Required:
(a) Prepare a summary which shows the budgeted product cost per unit for each product of X, Y,
and Z for the period ending 31 December 2010 detailing the unit costs for each cost element
using:
(i) The existing method for the absorption of overhead costs and
(ii) An approach which recognizes the cost drivers revealed in the activity based costing
investigation. (14 marks)
(b) Assuming Hensau ltd operates under a 40% cost-plus pricing strategy, determine sales prices
for each product under both absorption and ABC technique (6 marks) (Total 20 marks)

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QUESTION 4
Pinnacle ltd operates an activity-based costing system and has forecast the following information for
next year.
Cost Pool Cost Cost Driver Number of Drivers
Production set-ups 105,000/= Set-ups 300
Product testing 300,000/= Tests 1,500
Component supply and storage 25,000/= Component orders 500
Customer orders and delivery 112,500/= Customer orders 1,000
General fixed overheads such as lighting and heating, which cannot be linked to any specific activity, are
expected to be 900,000/= and these overheads are absorbed on a direct labour hour basis. Total direct
labour hours for next year are expected to be 300,000 hours.
Pinnacle Co expects orders for the Product next year to be 100 orders of 60 units per order and 60
orders of 50 units per order. The company holds no inventories of the product and will need to produce
the order requirement in production runs of 900 units. One order for components is placed prior to each
production run. Four tests are made during each production run to ensure that quality standards are
maintained. The following additional cost and profit information relates to the product:
Component cost: 1/= per unit
Direct labour: 10 minutes per unit at 7.8/= per hour
Profit mark up: 40% of total unit cost
Required
(a) Calculate the activity-based recovery rates for each cost pool. (4 marks)
(b) Calculate the total unit cost and selling price of Product ZT3. (10 marks)
(c) Discuss the reasons why activity-based costing may be preferred to traditional absorption
costing in the modern manufacturing environment. (6 marks) (20 marks)

QUESTION 5
Triple Limited makes three types of gold watch – the Diva (D), the Classic (C) and the Poser (P). A
traditional product costing system is used at present; although an activity based costing (ABC) system is
being considered.
Details of the three products for a typical period are:
Hours per unit Materials Production
Labor hours Machine hours Cost/unit (/=) Units
Product D 0.5 1.5 20 750
Product C 1.5 1 12 1,250
Product P 1 3 25 7,000
Direct labour costs 6/= per hour and production overheads are absorbed on a machine hour basis. The
overhead absorption rate for the period is 28/= per machine hour.
Total production overheads are 654,500/= and further analysis shows that the total production
overheads can be divided as follows:

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%
Costs relating to set-ups 35
Costs relating to machinery 20
Costs relating to materials handling 15
Costs relating to inspection 30
Total production overhead 100
The following total activity volumes are associated with each product line for the period as a whole:
Number of Number of movements Number of
Set ups of materials inspections
Product D 75 12 150
Product C 115 21 180
Product P 480 87 670
670 120 1,000
REQUIRED:
(a) Calculate the cost per unit for each product using traditional methods, absorbing overheads on
the basis of machine hours. (3 marks)
(b) Calculate the cost per unit for each product using ABC principles (work to two decimal places).
(12 marks)
(c) Explain why costs per unit calculated under ABC are often very different to costs per unit
calculated under more traditional methods. Use the information from Triple Limited to illustrate.
(4 marks)
(d) Discuss the implications of a switch to ABC on pricing and profitability. (6 marks)
(Total 25 marks)

QUESTION 6 (NBAA NOV 2015)

Mwanga Manufacturing Company is a famous Company for manufacturing and distribution of soap
products in all East African countries. The company manufactures two soap brands known as ‘Red
soap’ and ‘Dark soap’.
According to production manager. The company applies overhead on the bases of direct labour hours
throughout the factory and the company anticipate that overhead and direct time for the upcoming
accounting period are TZS. 3,200,000 and 50,000 hours respectively
Information about the company’s products are as follows:
Red Soap Dark Soap
Estimated production volume 3000 units 4000 units
Direct material cost TZS 56/unit TZS 84/unit
Direct labour per unit 6 hours @ TZS 30 per hours 5 hours @TZS 30 per hour
The company overhead cost of TZS. 3,200,000 can be identified with three major activities: order
processing (TZS. 500,000) machine processing (TZS. 2,400,000) and product inspection (TZS.
300,000). These activities are driven by number of orders processed, machine hours worked, and
inspection hours respectively. Data relevant to these activities are as follows:

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Order Processed Machine Hours worked Inspection Hours

Red Soap 640 32,000 8,000
Dark Soap 360 48,000 12,000
Total 1000 80,000 20,000
REQUIRED:
(a) Compute the overhead absorption rates that would be used for order processing, machine
processing, and product inspection in an activity-based costing system. (3 marks).
(b) Assuming use of activity-based costing, compute the unit manufacturing costs of Red soap and
dark soap if the expected manufacturing volume is attained. (6 Marks)
(c) Compute:
(i) How much overhead costs would be applied to a unit of red soap and Dark soap if the
company would have used traditional costing and applied overhead solely on the basis
of direct labour hours?
(ii) Using the answers in (i) above, show which of the two products would be undercosted
or overcosted by this procedure. (6 Marks)
(d) State the major limitations of activity based costing? (5 Marks) (Total 20 Marks)

QUESTION 7 (NBAA MAY 2015 – REVISED)

(a) Explain the key differences between the Traditional costing systems and modern day activity
based costing system (4 Marks)
(b) Explain the necessary steps to be followed when designing an effective Activity based costing
system. (6 Marks)
(c) XY provides accountancy services and has three different categories of client: Currently the
costs are attribute to each client based on the hours spent on preparing accounts and providing
advice.
XY currently charges its clients fees by adding a 20% mark-up to total costs. Currently the
costs are attributed to each client based on the hours spent on preparing accounts and
providing advice.
XY is considering changing to an activity based costing system.
The annual costs and the causes of these costs have been analyzed as follows:
Tshs. ‘000’
Accounting preparation and advice 580,000
Requesting missing information 30,000
Issuing fee payment reminders 15,000
Holding client meeting 60,000
Travelling to meet clients 40,000

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The following details relate to three of XY’s clients and to XY as a whole:

Client XY
A B C
Hours spent on preparing accounts and providing advice 1,000 250 340 18,000
Requests for missing information 4 10 6 250
Payment reminders sent 2 8 10 400
Client meetings held 4 1 2 250
Kilometers travelled to meet clients 150 600 0 10,000
Required:
Make calculations to show the effect to changing to the new costing system on fees charged to each of
these three clients. (10 Marks) (Total = 20 marks)

Laurian, Vicent CPA(T), MSc, Bcom.