Chapter 10- Activity based costing calculations:
Revision from Man Acc 278: Allocation of overhead costs:
Direct costs can be accurately traced to cost objects because they can be exclusively
and specifically traced to a particular cost object.
However, indirect costs cannot directly be traced back to a cost object because they
are common to several cost objects.
Therefore, indirect costs are ALLOCATED to cost objects.
Hence, indirect costs are allocated based on an allocation base / cost driver
Where the allocation bases are significant determinants of the costs we shall describe
them as cause and effect allocations (much more accurate).
Where a cost allocation base is not a significant determinant of the cost, an arbitrary
allocation will be used. Therefore, it is not likely that an inaccurate allocation of
indirect costs to cost objects takes place.
Differences between ABC and Traditional costing methods:
278- Traditional system 378- ABC
Cost centres = Departments Cost centres = activities (because there are
usually more activities than departments-
more cost pools)
Allocation base = arbitrary Cost driver = cause of cost (therefore more
accurate than traditional costing system)
Both systems use the same approach to assign costs to cost centres in the first stage of
the two step allocation process.
ABC systems then use cause and effect second stage allocations (Example on pg. 59-
61):
o Cost driver rates are computed by dividing the activity centre cost by the
quantity of the cost driver used.
o ABC systems create separate costs for each major support activity (requires
more support activity resources)
o Therefore, the major distinguishing feature of the ABC systems within the 2
stage allocation process is that they rely on:
A greater number of cost centres
A greater number and variety of second stage cost drivers
Examples of activities and cost drivers within ABC (merely examples, differs for each
Exhibit 3.3 in Chapter 3 in preparing for today’s lecture [p.61]
question- must be able to identify cost drivers for activities based on the question):
Activities Cost drivers
Production scheduling Number of orders
Machine and equipment set-up Number of set-ups (example of volume
driven)
Inspection of products (quality control) Inspection hours
Handling of raw material Number deliveries
Maintenance Maintenance hours (example of non-volume
driven is when assets must be serviced after a
particular number of days)
, NB!! Sometimes a department can also be an activity (they can be the same thing)
Cost drivers for departments were only volume based:
o Using only volume based cost drivers to assign non volume related overhead
costs can result in the reporting of distorted product costs.
But with the ABC system, they can be volume-based or non-volume based and it is
therefore more accurate.
Profit figure for ABC and Traditional costing system:
The profit shown by each system should be the same:
o The expense will remain the same. Just where the expense is allocated
changes.
Both systems are overhead allocation systems
Therefore, it doesn’t change the overhead expense for a period; but it differs in terms
of the apportionment of the the same overhead expense to cost objects. ABC does this
more accurately than the Traditional system.
Which system should be used – ABC or Traditional costing systems?
Simplistic system Highly sophisticated system
Inexpensive to operate Expensive to operate
Extensive use of arbitrary cost allocations Extensive use of cause and effect cost
allocations
Low levels of accuracy High levels of accuracy
High cost of errors Low cost of errors
Improvements should be made in the level of sophistication of the costing system set
up to the point that the marginal cost of the improvement = the marginal benefit from
the improvement.
In practice, usually in the middle of these two
A simplistic system may be reasonably accurate in organizations that have the
following characteristics:
o Low levels of competition
o Non volume related indirect costs that are a low proportion of total indirect
costs
o A fairly standardised product range all consuming resources in proportion
A sophisticated system (ABC) may be more optimal when an entity has the following
characteristics:
o High levels of competition
o Non volume related indirect costs that are a high proportion of total indirect
costs
o A diverse range of products, all consuming resources in different proportions
Simplistic vs. Sophisticated:
o Depends on the cost structure & cost-benefit-considerations
Example:
90% of total costs = overheads (indirect) Cost structure
10% of total costs = direct (easy)
[If it were the other way round, it would be easy to trace the cost]
Profit margins = small (cost of errors?)
The smaller the profit margin, the higher the cost of errors
The higher the profit margin, the lower the cost of errors
Revision from Man Acc 278: Allocation of overhead costs:
Direct costs can be accurately traced to cost objects because they can be exclusively
and specifically traced to a particular cost object.
However, indirect costs cannot directly be traced back to a cost object because they
are common to several cost objects.
Therefore, indirect costs are ALLOCATED to cost objects.
Hence, indirect costs are allocated based on an allocation base / cost driver
Where the allocation bases are significant determinants of the costs we shall describe
them as cause and effect allocations (much more accurate).
Where a cost allocation base is not a significant determinant of the cost, an arbitrary
allocation will be used. Therefore, it is not likely that an inaccurate allocation of
indirect costs to cost objects takes place.
Differences between ABC and Traditional costing methods:
278- Traditional system 378- ABC
Cost centres = Departments Cost centres = activities (because there are
usually more activities than departments-
more cost pools)
Allocation base = arbitrary Cost driver = cause of cost (therefore more
accurate than traditional costing system)
Both systems use the same approach to assign costs to cost centres in the first stage of
the two step allocation process.
ABC systems then use cause and effect second stage allocations (Example on pg. 59-
61):
o Cost driver rates are computed by dividing the activity centre cost by the
quantity of the cost driver used.
o ABC systems create separate costs for each major support activity (requires
more support activity resources)
o Therefore, the major distinguishing feature of the ABC systems within the 2
stage allocation process is that they rely on:
A greater number of cost centres
A greater number and variety of second stage cost drivers
Examples of activities and cost drivers within ABC (merely examples, differs for each
Exhibit 3.3 in Chapter 3 in preparing for today’s lecture [p.61]
question- must be able to identify cost drivers for activities based on the question):
Activities Cost drivers
Production scheduling Number of orders
Machine and equipment set-up Number of set-ups (example of volume
driven)
Inspection of products (quality control) Inspection hours
Handling of raw material Number deliveries
Maintenance Maintenance hours (example of non-volume
driven is when assets must be serviced after a
particular number of days)
, NB!! Sometimes a department can also be an activity (they can be the same thing)
Cost drivers for departments were only volume based:
o Using only volume based cost drivers to assign non volume related overhead
costs can result in the reporting of distorted product costs.
But with the ABC system, they can be volume-based or non-volume based and it is
therefore more accurate.
Profit figure for ABC and Traditional costing system:
The profit shown by each system should be the same:
o The expense will remain the same. Just where the expense is allocated
changes.
Both systems are overhead allocation systems
Therefore, it doesn’t change the overhead expense for a period; but it differs in terms
of the apportionment of the the same overhead expense to cost objects. ABC does this
more accurately than the Traditional system.
Which system should be used – ABC or Traditional costing systems?
Simplistic system Highly sophisticated system
Inexpensive to operate Expensive to operate
Extensive use of arbitrary cost allocations Extensive use of cause and effect cost
allocations
Low levels of accuracy High levels of accuracy
High cost of errors Low cost of errors
Improvements should be made in the level of sophistication of the costing system set
up to the point that the marginal cost of the improvement = the marginal benefit from
the improvement.
In practice, usually in the middle of these two
A simplistic system may be reasonably accurate in organizations that have the
following characteristics:
o Low levels of competition
o Non volume related indirect costs that are a low proportion of total indirect
costs
o A fairly standardised product range all consuming resources in proportion
A sophisticated system (ABC) may be more optimal when an entity has the following
characteristics:
o High levels of competition
o Non volume related indirect costs that are a high proportion of total indirect
costs
o A diverse range of products, all consuming resources in different proportions
Simplistic vs. Sophisticated:
o Depends on the cost structure & cost-benefit-considerations
Example:
90% of total costs = overheads (indirect) Cost structure
10% of total costs = direct (easy)
[If it were the other way round, it would be easy to trace the cost]
Profit margins = small (cost of errors?)
The smaller the profit margin, the higher the cost of errors
The higher the profit margin, the lower the cost of errors
