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Uncover Activity Based Costing. Learn what it is, where it comes from (hint - absorption costing) and how to calculate it. And all is presented in a manageable 12-minute video!
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Hello and welcome to this Practice Test Academy video.
That's going to be looking at activity-based costing which is a key technique that needs to be mastered by any student looking to pass an exam in management accounting.
Let's start off by just reminding ourselves how traditional absorption costing works and then we'll see how activity-based costing can improve on the answer that traditional absorption costing gives.
Suppose we have the standard cost card for product A and it's made up as follows:
We've got materials.
2 kilos of materials at $10 a kilo is $20.
Labour, half an hour at $20 an hour.
Add those two together that gives us a prime cost of thirty.
We're now looking to add an element of our absorbed overheads to give us a total cost.
Because often it makes sense to relate fixed production overheads to an individual item being produced even though fixed overheads don't actually vary with production.
For example, if we're looking to price a product, we need to make sure that the price we charge will aim to cover not just our prime cost but also cover ultimately our overheads as well.
It's also useful for inventory valuation where International Accounting Standards require us to include an element of absorbed production overheads in cost per unit when we're valuing inventory.
Let's remind ourselves of the traditional approach to absorption costing, summarized in a diagram such as this.
We get our total production costs and they can be split between those direct costs like labour and materials and they're relatively easy to link to cost per unit.
And then, we have our indirect production overheads.
Traditionally the approach with absorption costing is to, first of all, identify cost centres in the factory.
Production cost centres physically see items being produced.
Service cost centres don't.
For example, a canteen or a maintenance department.
We allocate an apportion costs between those cost centres using some reasonable basis.
For example, for rents, we might use floor space.
We then reapportioned.
Step 2, reapportioned the service costs enter to production cost centres because remember we're aiming to calculate the cost per unit and the service cost centres don't actually see any items being produced.
So we share their costs between the production cost centres.
And, once we've got all our production overheads into production cost centres, we then absorb using some reasonable basis like labour hours in those production cost centres or machine hours.
We add those costs to the prime costs and that gives us a full cost per unit.
Suppose in our factory where we are producing product A we have 1 million dollars worth of overheads to absorb.
Traditionally, we might absorb these using say labour hours.
If 50,000 labour hours are worked in a year, that would equate to 1 million dollars divided by 50,000 labour hours is $20 an hour to absorb our fixed overheads.
And our cost card would read as follows.
You'd have our prime cost as before of $30 but our absorbed overheads we've now calculated to be half an hour times $20 an hour is $10 to give us a total cost of $40.
And if we base prices on say our total cost plus 25% margin that would be implied that would be pricing product A at $40 total cost times 1.25 equals $50.
This is the traditional approach to coming up with full cost per unit.
However, in many ways, it's overly simplistic.
That 1 million dollars overhead probably had a lot of different sub-components.
For example, it may have set up costs of $500,000 and warehousing costs of $500,000.
The fact is that labour hours were used as the basis of absorption but they don't drive set up costs and warehousing.
Therefore, the overheads we absorbed won't reflect the amount of effort or cost that goes into making an item.
The result is an estimated cost per unit that's inaccurate and as a result, we may make mistakes in decision-making such as charging the wrong price.
The $50 we charge here could be too high or too low.
Too high and people won't buy the product as competitors maybe cheaper.
Too low and we might sell a lot but we won't make any money.
Activity-based costing or ABC seeks to improve the quality of the calculation by using the amount of activity involved in making the item as a basis for absorbing the overheads.
It therefore keeps a close connection between the activity that drives the cost and the cost itself.
Suppose in our example, we make two products in our factory.
Product A that we've met already and product B.
Here's some information about the activity that goes into making each product.
We aim to make 40,000 A's and 60,000 B's.
The A's, we plan to make in 10 production runs and the B's in 30 production runs.
Issues from the warehouse for components and raw materials to make product A over the year is estimated to be 300 issues and for B, 700 issues.
Rather than have one absorption rate for the whole million dollars worth of overhead, we'll break it down into setups and warehousing costs.
The first thing we need to do is to decide what drives each overhead.
So for setup costs, let's say the number of production runs drives the overhead.
Because the more production runs we have, the more machine setups that are required.
And for warehousing costs, let's suppose the number of issues from the warehouse drives those costs.
Then, we work out a mini overhead absorption rate for the activity that drives those costs.
So for setup costs where we had a total overhead there of $500,000, we divide that by the total number of setups which is 10+30 which is 40.
So, 500,000 divided by 40 is $12,500 per production run.
And for warehousing costs, the $500,000 there divide that by the total number of issues from the warehouse which is 300+700 is a thousand.
So 500,000 divided by a thousand is $500 per issue.
We now use these mini overhead absorption rates to apportion the individual overheads between the different products as follows.
So for product A, for which we had 10 production runs, the set-up cost that we would apportion there would be 10 runs times twelve thousand five hundred per run is $125,000.
For product B, that has 30 runs, 30 times twelve thousand five hundred is $375,000 going to product B.
So, you'll notice that the total five hundred thousand is now split between product A and product B.
But, it's not split on the basis of say labour hours is split on the number of setups which drives that $500,000 worth of cost.
With warehousing costs, product A had three hundred issues from the warehouse.
So three hundred times $500 is $150,000 worth of cost going to product A and for product B seven hundred issues times five hundred dollars per issue is $350,000.
So again, coming back to the $500,000 worth of warehousing costs in total but the apportionment split between product A and product B reflects the number of issues, so therefore the effort gone into warehousing costs.
So the total apportioned costs for product A, 125,000 setup plus 150,000 warehousing costs a total of two hundred and seventy-five thousand dollars.
And incidentally for product B, 375,000 setup costs, 350,000 warehousing, so 725,000 costs in total.
So that's our total overheads of a million dollars split between the two different products according to the activity that drives the production of those items.
If we then take those total overheads and divide by the number we are producing.
So for product A that's 40,000, 275,000 divided by 40,000 gives us a cost per item, an overhead cost per item of $6.875 and as you can see a similar calculation for product B, $12.08.
So, let's see how our cost card for product A now becomes amended using ABC.
We still have our prime cost of 30, but now we have an overhead absorbed of 6.88 as opposed to the $10 we had originally with traditional absorption costing.
So this gives a revised total cost of 36.88.
We said $40 before, so 36.88 is 8% lower than that.
This could have serious implications for the business.
For example, it might mean that we charge now 3688 without 25% margin on top, $46.10 instead of the $50 we said before.
And this could make all the difference between our price being competitive or not competitive.
We may well have been overcharging before and that was purely due to the simplistic way we were absorbing overheads.
So, as we can see ABC gives a better cost per unit information but only in certain circumstances.
When overheads are large and overheads are driven by a wide variety of different activities and we produce a wide range of different products each of which involves different levels of those activities in the manufacturing process.
We need to make sure if we're going to be using ABC that drivers can be readily identified and measured.
This isn't always easy.
Some overheads aren't particularly driven by anything.
For example, factory rent isn't driven by anything.
It's just driven by the fact we signed a rental agreement several years ago.
So the driver chosen to absorb them will end up being fairly arbitrary anyway.
Something like floor space occupied by manufacturing that product which at the end of the day it's not massively different to what we would have done with traditional absorption costing.
Activity-based costing is expensive to implement, given the amount of information that's required on cost drivers.
So as a business you should only consider using ABC if the conditions are right.
An ABC would end up giving a significantly different answer in terms of cost per unit when compared to traditional absorption costing.
In your exam, be prepared to calculate the full range of numbers we've talked about here.
Even though that in any one question, you might only need to do a part of what we've talked through.
Activity-based costing is a cornerstone concept in management accounting and one that needs to be mastered by anyone looking to pass exams in the subject.
Best of luck and thanks for listening.
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