CA – INTERMEDIATE: COST & MANAGEMENT ACCOUNTING BY CA. CS. ANSHUL A.

AGRAWAL

CHAPTER-5
OVERHEADS COST - Under
Activity Based Costing Method
TABLE OF CONTENTS:
1. Activity Based Costing – The Concept
2. Difference between ABC and Traditional Absorption Costing
3. Stages in Activity Based Costing
4. Practical Problems
5. Past Exam Theory Questions

1. ACTIVITY BASED COSTING – THE CONCEPT

MEANING AND DEFINITION:

Activity Based Costing is an accounting methodology that assigns costs to activities rather than products or
services. This enables resources & overhead costs to be more accurately assigned to products & services that
consume them. ABC is a technique which involves identification of cost with each cost driving activity and
making it as the basis for apportionment of costs over different cost objects/ jobs/ products/ customers or
services.

ABC assigns cost to activities based on their use of resources. It then assigns cost to cost objects, such as
products or customers, based on their use of activities. ABC can track the flow of activities in organization by
creating a link between the activity (resource consumption) and the cost object.
CIMA defines ‘Activity Based Costing’ as “An approach to the costing and monitoring of activities which
involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and
activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs
to outputs.”

SOME IMPORTANT TERMINOLOGIES:

(i) ACTIVITY: Activity, here, refers to an event that incurs cost.
(ii) A COST OBJECT: It is an item for which cost measurement is required e.g. a product or a customer.
(iii) A COST DRIVER: It is a factor that causes a change in the cost of an activity. There are two categories of
cost driver.
• A Resource Cost Driver: It is a measure of the quantity of resources consumed by an activity. It is
used to assign the cost of a resource to an activity or cost pool.
• An Activity Cost Driver: It is a measure of the frequency and intensity of demand, placed on
activities by cost objects. It is used to assign activity costs to cost objects.
(iv) COST POOL: It represents a group of various individual cost items. It consists of costs that have same
cause effect relationship. Example Machine set-up.

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 BUSINESS FUNCTIONS COST DRIVER
Research and Development ➢ Number of Research Projects
➢ Man-Hours on Project
Design of Product, Service or Procedures ➢ Number of Products in design
➢ Number of parts per product
➢ Number of Engineering Hours
Customer Service ➢ Number of Service Calls
➢ Number of products services
➢ Hours spent on servicing product
Marketing ➢ Number of advertisements
➢ Number of sales personnel
➢ Sales Revenue
Distribution ➢ Number of units distributed
➢ Number of customers

2. DIFFERENCE BETWEEN ABC AND TRADITIONAL ABSORPTION

COSTING
3.
ACTIVITY BASED COSTING TRADITIONAL ABSORPTION COSTING
Overheads are related to activities and grouped into Overheads are related to cost centers/departments.
activity cost pools.
Costs are related to activities and hence are more Costs are related to cost centers and hence not
realistic. realistic of cost behavior.
Activity–wise cost drivers are determined. Time (Hours) are assumed to be the only cost driver
governing costs in all departments.
Activity–wise recovery rates are determined and Either multiple overhead recovery rate (for each
there is no concept of a single overhead recovery rate. department) or a single overhead recovery rate
may be determined for absorbing overheads.
Cost are assigned to cost objects, e.g. customers, Costs are assigned to Cost Units i.e. to products, or
products, services, departments, etc. jobs or hours.
Essential activities can be simplified, and unnecessary Cost Centers/ departments cannot be eliminated.
activities can be eliminated. Thus, the corresponding Hence not suitable for cost control.
costs are also reduced/ minimized. Hence ABC aids
cost control.

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3. STAGES IN ACTIVITY BASED COSTING

The different stages in ABC calculations are listed below:

(1) Identify the Different Activities within the Organisation: Usually the number of cost centres that a
traditional overhead system uses are quite small, say up to fifteen. In ABC the number of activities
will be much more, say 200; the exact number will depend on how the management subdivides the
organisation’s activities. It is possible to break the organisation down into many very small activities. But
if ABC is to be acceptable as practical system it is necessary to use larger groupings, so that, say, 40
activities may be used in practice. The additional number of activities over cost centres means that ABC
should be more accurate than the traditional method regardless of anything else. Some activities may be
listed as follows:-
•Production schedule changes •Customer liaison
•Purchasing •Production process set up
•Quality control •Material handling
•Maintenance
(2) Relate the overheads to the activities, both support and primary, that caused them. This creates ‘cost
pools’ or ‘cost buckets’. This will be done using resource cost drivers that reflect causality.
(3) Support activities are then spread across the primary activities on some suitable base, which reflects
the use of the support activity. The base is the cost driver that is the measure of how the support
activities are used.
(4) Determine the activity cost drivers that will be used to relate the overheads collected in the cost pools
to the cost objects/products. This is based on the factor that drives the consumption of the activity. The
question to ask is – what causes the activity to incur costs? In production scheduling, for example,
the Driver will probably be the number of batches ordered.
(5) Calculate activity cost driver rates for each activity, just as an overhead absorption rate would be
calculated in the traditional system.

Total Cost of Activity

Activity Cost Driver Rate = Activity Driver
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 4. PRACTICAL PROBLEMS

Q1. Cost Statement under Absorption Costing & ABC REG. PAGE NO.
ABC Ltd. is a multiproduct company, manufacturing three products A, B and C, the budgeted costs and
production for the year ended 31st March 2018 are as follows:
PARTICULARS A B C
Production Quantity (Units) 4,000 3,000 1,600
Resources Per Unit:
- Direct Material (Kgs.) 4 6 3
- Direct Labour (Minutes) 30 45 60
The budgeted direct labour rate was Rs. 10 per hour, and the budgeted material cost was Rs. 2 per kg.
Production overheads were budgeted at Rs. 99,450 and were absorbed to products using the direct
labour hour rate. ABC Ltd. followed an Absorption Costing System. ABC Ltd. is now considering to adopt
an Activity Based Costing system. The following additional information is made available for this
purpose.
1. Budgeted Overhead were analysed into the following:
Material Handling Rs. 29,100
Storage Cost Rs. 31,200
Electricity Charges Rs. 39,150
2. The cost drivers identified were as follows:
Material Handling – Based on material handled
Storage Cost – Number of Batches of Material
Electricity Charges – Number of Machine operations
3. Data on Cost Drivers was as follows:
PARTICULARS A B C
For Complete Production:
- Batches of Material 10 5 15
Per Unit of Production:
- Number of Machine operators 6 3 2
You are requested to:
1. Prepare a statement for management showing the unit costs and total costs of each product using
the absorption costing method.
2. Prepare a statement for management showing the product costs of each product using the ABC
approach.
3. What are the reasons for the different product costs under the two approaches?
Q2. Cost Statement under ABC REG. PAGE NO.
MST Limited has collected the following data for its two activities. It calculates activity cost rates based
on cost driver capacity.
ACTIVITY COST DRIVER CAPACITY COST
Power Kwh 50,000 Kwh Rs. 2,00,000
Quality Inspections No. of Inspections 10,000 Inspections Rs. 3,00,000

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The company makes three products M, S and T. For the year ended March 31, 20X4, the following
consumption of cost drivers was reported:
Product Kwh Quality Inspections
M 10,000 3,500
S 20,000 2,500
T 15,000 3,000
Required:
(i) Compute the costs allocated to each product from each activity.
(ii) Calculate the cost of unused capacity for each activity.
(iii) Discuss the factors the management considers in choosing a capacity level to compute the
budgeted fixed overhead cost rate.

Q3. Cost Statement under ABC REG. PAGE NO.

ABC Ltd. Manufactures two types of machinery equipment Y and Z and applies/absorbs overheads on the
basis of direct-labour hours. The budgeted overheads and direct-labour hours for the month of
December, 20X6 are Rs. 12,42,500 and 20,000 hours respectively. The information about Company’s
products is as follows:
PARTICULARS EQUIPMENT-Y EQUIPMENT-Z
Budgeted Production Volume 2,500 units 3,125 units
Direct Material Cost Rs. 300/unit Rs. 450/unit
Direct Labour Cost
Y: 3 Hours @ Rs. 150/Hour
Rs. 450 Rs. 600
X: 4 Hours @ Rs. 150/Hour
ABC Ltd.’s overheads of Rs. 12,42,500 can be identified with three major activities:
Order Processing (Rs. 2,10,000), machine processing (Rs. 8,75,000), and product inspection
(Rs.1,57,500). These activities are driven by number of orders processed, machine hours worked, and
inspection hours respectively. The data relevant to these activities is as follows:
Machine Hours
Product Orders Processed Inspection Hours
Worked
Y 350 23,000 4,000
Z 250 27,000 11,000
TOTAL 600 50,000 15,000
Required:
(i) Assuming use of direct-labour hours to absorb/apply overheads to production, compute the
unit manufacturing cost of the equipment Y and Z, if the budgeted manufacturing volume is
attained.
(ii) Assuming use of activity-based costing, compute the unit manufacturing costs of the equipment Y
and Z, if the budgeted manufacturing volume is achieved.
(iii) ABC Ltd.’s selling prices are based heavily on cost. By using direct-labour hours as an application base,
calculate the amount of cost distortion (under-costed or over-costed) for each equipment.

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Q4. Cost Statement under ABC REG. PAGE NO.
RST Limited specializes in the distribution of pharmaceutical products. It buys from the pharmaceutical
companies and resells to each of the three different markets.
(i) General Supermarket Chains
(ii) Drugstore Chains
(iii) Chemist Shops
The following data for the month of April, 2007 in respect of RST Limited has been reported:
General Supermarket Drugstore Chemist
Chains Chains Shops
Average revenue per delivery 84,975 28,875 5,445
Average cost of goods sold per delivery 82,500 27,500 4,950
Number of deliveries 330 825 2,750
In the past, RST Limited has used gross margin percentage to evaluate the relative profitability of
its distribution channels.
The company plans to use activity –based costing for analysing the profitability of its distribution
channels.
The Activity analysis of RST Limited is as under:
Activity Area Cost Driver
Customer purchase order processing Purchase orders by customers
Line-item ordering Line-items per purchase order
Store delivery Store deliveries
Cartons dispatched to stores Cartons dispatched to a store per delivery
Shelf-stocking at customer store Hours of shelf-stocking
The April, 2007 operating costs (other than cost of goods sold) of RST Limited are Rs. 8,27,970. These
operating costs are assigned to five activity areas. The cost in each area and the quantity of the cost
allocation basis used in that area for April, 2007 are as follows:
Total Units of Cost
Total costs in
Activity Area Allocation Base used in
April, 2007 (Rs.)
April, 2007
Customer purchase order processing 2,20,000 5,500 orders
Line-item ordering 1,75,560 58,520 line items
Store delivery 1,95,250 3,905 store deliveries
Cartons dispatched to store 2,09,000 2,09,000 cartons
Shelf-stocking at customer store 28,160 1,760 hours
Other data for April, 2007 include the following:
General
Drugstore Chemist
Supermarket
Chains Shops
Chains
Total number of orders 385 990 4,125
Average number of line items per order 14 12 10
Total number of store deliveries 330 825 2,750
Average number of cartons shipped per store delivery 300 80 16
Average number of hours of shelf-stocking per store delivery 3 0.6 0.1

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 CA – INTERMEDIATE: COST & MANAGEMENT ACCOUNTING BY CA. CS. ANSHUL A. AGRAWAL
Required:
(i) Compute for April, 2007 gross-margin percentage for each of its three distribution channels and
compute RST Limited’s operating income.
(ii) Compute the April, 2007 rate per unit of the cost-allocation base for each of the five activity areas.
(iii) Compute the operating income of each distribution channel in April, 2007 using the activity-based
costing information. Comment on the results. What new insights are available with the activity-
based cost information?
(iv) Describe four challenges one would face in assigning the total April, 2007 operating costs of
Rs. 8,27,970 to five activity areas.

Q5. Cost Statement under ABC REG. PAGE NO.

Alpha Limited has decided to analyse the profitability of its five new customers. It buys bottled water at
Rs. 90 per case and sells to retail customers at a list price of Rs. 108 per case. The data pertaining to five
customers are:
CUSTOMERS
PARTICULARS
A B C D E
Cases Sold 4,680 19,688 1,36,800 71,550 8,775
List Selling Price Rs. 108 Rs. 108 Rs. 108 Rs. 108 Rs. 108
Actual Selling Price Rs. 108 Rs. 106.20 Rs. 99 Rs. 104.40 Rs. 97.20
No. Of Purchase Orders 15 25 30 25 30
No. Of Customer Visits 2 3 6 2 3
No. Of Deliveries 10 30 60 40 20
Kms. Travelled per delivery 20 6 5 10 30
No. Of expedited deliveries 0 0 0 0 1

Its activities and their cost drivers are as follows:

Order Taking Rs. 750/Purchase Order
Customer Visits Rs. 600/Customer Visit
Deliveries Rs. 5.75/Delivery Kms. Travelled
Product Handling Rs. 3.75/Case Sold
Expedited Deliveries Rs. 2,250/Expedited Delivery

Required:
(i) Compute the customer-level operating income of each of five retail customers now being examined
(A, B, C, D and E). Comment on the results.
(ii) What insights are gained by reporting both the list selling price and the actual selling price for each
customer?

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Q6. Ascertainment of product cost under ABC REG. PAGE NO.
ABC Bank operated for years under the assumption that profitability cab ne increased by increasing
volume of business. But, that has not been the case. Cost analysis has revealed the following:
ACTIVITY ACTIVITY COST ACTIVITY DRIVER ACTIVITY CAPACITY
Providing ATM Services Rs. 1,00,000 No. of Transactions 2,00,000
Computer Processing Rs. 10,00,000 No. of Transactions 25,00,000
Issuing Statements Rs. 8,00,000 No. of Statements 5,00,000
Customer Inquiries Rs. 3,60,000 Telephone Minutes 6,00,000
The following annual information on three products was also made available:
PARTICULARS PRODUCTS
CHECKING ACCOUNTS PERSONAL LOANS GOLD VISA
Units of Product 30,000 5,000 10,000
ATM transactions 1,80,000 0 20,000
Computer Transactions 20,00,000 2,00,000 3,00,000
Number of Statements 3,00,000 50,000 1,50,000
Telephone Minutes 3,50,000 90,000 1,60,000
Calculate the rates for each activity and thereafter for each product.

Q7. Ascertainment of product cost under Absorption and ABC REG. PAGE NO.
M/s HMB Ltd. Is producing in 10 batches each of 15,000 units in a year and incurring following
overheads thereon:
Material Procurement Rs. 22,50,000
Maintenance Rs. 17,30,000
Setup Rs. 6,84,500
Quality Control Rs. 5,14,800
Total Prime Cost for the year Rs. 3,01,39,000

The company is currently using the method of absorbing overheads on the basis of Prime Cost. Now it
wants to shift to Activity Based Costing. Information relevant to activity drivers for the year are as under:
ACTIVITY DRIVER ACTIVITY VOLUME
No. of Purchase Orders 1500
Maintenance Hours 9800
No. of Set-Ups 2250
No. of Inspections 2710

The company has produced the batch of 15,000 units and has incurred Rs. 26,38,700 and Rs. 3,75,200 on
material and wages respectively.

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 CA – INTERMEDIATE: COST & MANAGEMENT ACCOUNTING BY CA. CS. ANSHUL A. AGRAWAL
The usage of activities of the said batch are as follows:
Material Orders 48 Orders
Maintenance Hours 810 Hours
No. of Setups 40
No. of Inspections 25
You are required to:
(i) Find out cost of product per unit on absorption costing basis for the said batch.
(ii) Determine cost driver rate, total cost and cost per unit of output of the said batch on the basis of
Activity Based Costing.

5. PAST EXAM THEORY QUESTIONS

Q1. Explain Activity Based Budgeting (ABB).

Ans. Activity based budgeting analyse the resource input or cost for each activity. It provides a framework for
estimating the amount of resources required in accordance with the budgeted level of activity. Actual
results can be compared with budgeted results to highlight both in financial and non-financial terms
those activities with major discrepancies from budget for potential reduction in supply of resources. It is
a planning and control system which seeks to support the objectives of continuous improvement. It
means planning and controlling the expected activities of the organization to derive a cost-effective
budget that meet forecast workload and agreed strategic goals. ABB is the reversing of the ABC process
to produce financial plans and budgets.

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“Every passing day turns another page of our life. Now, it’s on us what we write on
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it – Good or Bad or we keep it Blank”. -ANSHUL A. AGRAWAL

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