Example

Deeside plc manufactures three products, A, B and C in their factory and uses a factory-wide absorption rate for absorbing overheads based on direct labour hours. The following information relates to Period 5 of Year 3. Product Production (units) Direct Material Cost p.u. Direct Labour Hours p.u. A 12,000 40 4 B 8,000 30 6 C 4,000 20 2

Direct labour is paid at 8 per hour. The overhead costs for Period 5 are as follows: 312,000 56,000 80,000 128,000 100,000 676,000

Machining Set-up Assembling Goods Receiving Dispatch

(a) (b)

Calculate the factory-wide absorption rate for Period 5. Calculate the cost p.u. of each product under the traditional approach to treatment of overheads.

The company is considering using ABC as a method of arriving at the cost per unit of their products and the following information is available for this purpose: The overheads have been investigated and while machining costs will be absorbed on the basis of machine hours, cost drivers have been identified f or the other overheads. Overhead Set-up Assembling Goods Receiving Dispatch Cost Driver No. of production runs No. of production orders No. of receipts No. of production orders

The following additional information is also available: Product Machine hours per unit No. of Production runs No. of Material receipts No. of Production orders (c) (d) A 2 1 3 3 B 3 2 5 2 C 1 5 24 5

Calculate a cost driver absorption rate for each of the above overheads. Calculate the cost per unit for each product under the ABC system.

This question contains a lot of information and lots of figures and therefore it is important to read it carefully with a view to deciding which information relates to each part of the question. The purpose of this question is to show how t he traditional method of overhead absorption works and then to demonstrate the Activity -Based Costing approach. At the end of the question we will compare the two methods and see if we can explain the differing results they produce.

Solution
(a) This opening part of the question asks us to calculate a factory -wide overhead absorption rate (sometimes called a blanket rate), based on labour hours.

You should recall that the calculation of an overhead absorption rate divides the relevant overhead (which may be for a cost centre or, as in this case, for the whole factory) by the relevant units of the base selected. (There were actually six possibilities, i.e. per unit, % on material, % on wages, % on prime cost, per labour hour or per machine hour). In this question we are using labour hours and therefore the calculation is as follows: Overhead Absorption Rate =

Factory Overheads Labour Hours

Although we know the total factory overheads we need to calculate the total labour hours, i.e. A B C = 48,000 = 48,000 = 8,000 104,000

We can now calculate the factory-wide rate

= 676,000 104,000

= 6.50 per labour hour

(b)

In this next part we are asked to calculate the total cost per unit for each product using the traditional approach.

This total cost will be the sum of the two direct costs material and labour, plus overheads. The question gives us the material cost p.u. for each product, but we will have to calculate the figures for labour and overheads . For labour this will be the number of labour hours per unit multiplied by the labour rate per hour. For overheads it will be the number of labour hours per unit multiplied by the overhead absorption rate calculated in part (a), i.e. Cost per unit Material Labour Overheads 98 117 49 A 40 32 (4 26 B 30 48 39 C 20 16 13

The remaining parts of the question now introduce the Activity -Based Costing technique. (c) This part asks us to calculate cost driver absorption rates for the separate overheads.

The total overhead of the factory has been broken down into five activities. For the first of these, machining, a traditional -style absorption rate is to be used, i.e. machine hour rate. Machine Hour Rate =

Machine Overhead Machine Hours

Once again we know the overhead but need to calculate the machine hours, i.e. A B C = 24,000 = 24,000 = 4,000 52,000

Therefore the calculation is

Machine Hour Rate =

312,000 52,000 = 6 per m/c hour

For the other activities, which comprise the factory overheads, appropriate cost drivers have been identified and we can use these to calculate the relevant absorption rate. The cost drivers identified are the number of production runs, the number of production orders and the number of receipts. Therefore before we go any further we must calculate the relevant figure for each driver. Production Runs A B C 1 2 5 8 3 2 5 10 3 5 24 32

Production Orders

A B C

Receipts

A B C

Now we can calculate the absorption rate for each activity, based on the relevant cost driver.

Set-up

56,000 8
80,000 10 128,000 32

= 7,000 per run

Assembling

= 8,000 per order

Goods Receiving

= 4,000 per receipt

Dispatch

100,000 10

= 10,000 per order

(d)

The final part requires us to use these figures to produce a cost per unit for each product. Therefore we need to calculate the overhead cost per unit to add to the material and labour costs which we calculated in part (b).

Machinery overhead is the simplest, i.e. machine hours per unit multiplied by machine hour rate. A B C 6 = 18

For the other overhead activities we need to relate the cost driver absorption rate to the units produced.
A 7,000 12,000 = 0.58 B 14,000 (7,000 8,000 = 1.75 16,000 8,000 = 2 20,000 8,000 = 2.50 20,000 8,000 = 2.50 C 35,000 4,000 = 8.75 40,000 4,000 =10 96,000 4,000 = 24 4,000 = 12.50 50,000

Set-up

Assembling 24,000 (8,000 12,000 =2 Goods Receiving 12,000 12,000 =1 30,000 12,000 = 2.50

Dispatch

Therefore using ABC total cost per unit for the products would be as follows: A B C 40 30 20 32 48 16 12 18 6 0.58 1.75 8.75 2 2 10 1 2.50 24 2.50 2.50 12.50 90.08 104.75 97.25 Contrast these figures with the ones produced in the answer to part (b) of the question. The most striking change is in the increase in the cost per unit of Direct Materials Direct Labour Machinery Set-up Assembling Goods Receiving Dispatch

Product C, although there is also a less substantial decrease in the cost per unit of the other two products. The increase in the cost of C has arisen because most of the charges relating to C were not identified under the traditional absorption system. The cost drivers identified in the ABC system are responsible for generating these charges and thu s we can suggest that the ABC system produces a more accurate cost for each product. The following examples will provide practice in applying the ABC system. Solutions are provided at the end of this section.

Question 1
Your company currently produces and sells 4 products, Alpha, Beta, Gamma and Delta. The following information relates to Period 3. Alpha 180 46 21 4 6 30 18 Beta 150 58 14 3 5 30 15 Gamma 120 35 7 2 4 30 12 Delta 180 70 14 3 6 30 18

Production (units) Costs per unit: Direct material Direct labour Machine hours per unit Number of production runs Number of requisitions raised Number of orders completed

Currently the production overhead is absorbed by the machine -hour rate method and the following are the total production ove rhead costs for Period 3. 24,540 6,300 7,200 3,150 7,560 48,750

Machine Department Set-up costs Receiving costs Inspection costs Despatch costs

Cost drivers have been identified as follows: Set-up costs Stores receiving Inspection Despatch Number Number Number Number of of of of production runs requisitions raised production runs orders completed

You are required to calculate: (a) (i) The machine-hour rate currently used to absorb the production overhead. The total cost per unit for each product if overheads are absorbed by the method in (a)(i).

(ii)

(b)

The cost per unit for each product using an ABC approach.

Question 2
Jomit plc has budgeted for the following overhead costs for Period 6. 31,200 39,000 27,300

Material receipt costs Power costs Material handling costs

The company produces 3 products, P, Q and R for which the following budgeted information is available for Period 6. Product Output (units) Material batches Per Unit Direct material (kg) Direct material () Direct labour (hours) Number of power operations Direct labour rate per hour P 4,000 20 Q 3,000 10 R 1,600 32

4 6 0.2 6 8

6 5 0.5 3 8

3 9 1.0 2 8

Currently the overhead costs are each absorbed using a rate per direct labour hour. However, the company is considering applying overheads using an ABC approach and has identified drivers for the activities as follows: Material receipt costs Power costs Material handling costs You are required to calculate: (a) The total cost per unit for each product using the current overhead absorption method. The total cost per unit for each product using the ABC method. number of batches of material number of power operations kg of material handled

(b)

Question 3
Your company currently produces a range of three products, D, E and F to which the following details relate for Period 2. D 1,500 18 1 3 E 2,500 10 3 2 F 14,000 20 2 6

Production (units) Material cost per unit Labour hours per unit Machine hours per unit

Labour costs are 8 per hour and production overheads are currently absorbed in the conventional system by reference to machine hours. Total production overheads for Period 2 have been analysed as follows: 327,250 187,000 140,250 280,500 935,000

Set-up costs Handling costs Machining costs Inspection costs

(a)

Calculate the cost per unit for each product using conventional methods.

The introduction of an ABC is being considered and to that end the following volume of activities have been identified with the current output levels. D 90 16 180 E 138 28 216 F 576 116 804

Number of set-ups Number of material issues Number of inspections (b)

Calculate the cost per unit for each product using the ABC approach.

Question 4
The following table summarises the details of the production le vels, costs and cost drivers for Abtronics Ltd who have traditionally absorbed overheads into production on the basis of a labour hour absorption rate. They wish to move to an ABC system. Product Material cost per unit Labour hours per unit Machine hours per unit Number of production runs Number of production orders Number of orders delivered Number of receipts Production (units) P 20 4 4 6 45 30 12 15,000 Q 15 6 3 14 30 20 28 10,000 R 10 3 6 40 75 50 80 4,000

Labour hours are paid for at 10 per hour. Overheads Machining Set-up costs Receiving costs Packing costs Engineering costs 684,000 60,000 240,000 300,000 450,000 1,834,000 Cost Driver machine hours production runs number of receipts number of orders delivered number of production orders

(a)

Calculate the cost per unit for each product using the traditional overhead absorption approach. Calculate the cost per unit using the ABC approach.

(b)

Question 5
Param plc has incurred the following overheads in its factory during Period 6. 90,000 135,000 105,000 120,000 150,000

Quality control Process set-ups Purchasing Order processing Occupancy costs

Param plc produces a range of products, two of which are Product X and Product Y. The following information relate to these two products. X 5 8 150 500 1,000 3 10,000 Y 8 12 210 300 800 2 6,000

Material costs per unit Labour cost per unit Number of process set-ups Number of purchase orders issued Number of customer orders Machine hours per unit Production (units)

Inspection takes place after each process set-up. The cost drivers which have been identified for the factory are: Quality control Process set-ups Purchasing Order processing Occupancy costs 450 inspections 450 set-ups 1,000 purchase orders 2,000 customer orders 75,000 machine hours

Calculate the cost per unit for Products X and Y using: (i) (ii) existing overhead absorption rate per machine hour an activity-based costing approach.

Solutions
Question 1 (a) (i) Total machine hours: Alpha Beta Gamma Delta 720 450 240 540 = 1950

Total overheads = 48,750

Machine hour absorption rate =

48,750 1,950 = 25

(ii)

Cost per unit Direct material Direct labour Production overhead

Alpha 46 21 100 167 Driver m/c hours Runs Requisitions Runs Orders

Beta 58 14 75 147

Gamma 35 7 50 92

Delta 70 14 75 159 Cost per driver 12.58 300 60 150 120

(b)

Cost Machine Dept Set-up Receiving Inspection Despatch

24,540 6,300 7,200 3,150 7,560

Driver transactions 1950 21 120 21 63

Overheads cost per unit Alpha Set-up Beta Gamma Delta

1800 = 10 180

1500 = 10 150

1200 = 10 120

1800 = 10 180

Receiving

1800 = 10 180

1800 = 12 150

1800 = 15 120

1800 = 10 180

Inspection

900 = 5 180

750 = 5 150

600 = 5 120

900 = 5 180

Despatch

2160 = 12 180

1800 = 12 150

1440 = 12 120

2160 = 12 180

Machine Dept

= 50.32

= 37.74

= 25.16

= 37.74

Total cost per unit Materials Labour Set-up Receiving Inspection Despatch Machine Dept

Alpha 46.00 21.00 10.00 10.00 5.00 12.00 50.32 154.32

Beta 58.00 14.00 10.00 12.00 5.00 12.00 37.74 148.74

Gamma 35.00 7.00 10.00 15.00 5.00 12.00 25.16 109.16

Delta 70.00 14.00 10.00 10.00 5.00 12.00 37.74 158.74

Question 2 (a) Direct labour hours: = = = 3,900 800 1,500 1,600

Overhead absorption rates: Material receipt

31,200 = 8 per labour hour 3,900 39,000 = 10 per labour hour 3,900

Power

Material handling

27,300 = 7 per labour hour 3,900

Overhead cost per unit Material receipt

P = 1.60 = 2

Q = 4 = 5 = 3.50

R = 8 10 = 10 = 7

Power

Material handling

= 1.40

Total cost per unit Direct material Direct labour Material receipt costs Power costs Material handling

P 6.00 1.60 1.60 2.00 1.40 12.60

Q 5.00 4.00 4.00 5.00 3.50 21.50

R 9.00 8.00 8.00 10.00 7.00 42.00

(b)

ABC absorption rates Material receipt

31,200 = 503.23 per batch 62

39,000 = 1.08 per operation 36,200 (W1) 27,300 = 0.70 per kg 38,800 (W2)

Power

Material handling

Overhead costs per unit Material receipts

P
503.23 20 4,000

Q
503.23 10 3,000

R
503.23 10 1,600

= 2.52 Power = 6.48 = 2.80 P 6.00 1.60 2.52 6.48 2.80 19.40

= 1.68 1.08 = 3.24 = 4.20 Q 5.00 4.00 1.68 3.24 4.20 18.12

= 10.06 1.08 = 2.16 = 2.10 R 9.00 8.00 10.06 2.16 2.10 31.32

Material handling

Total cost per unit Direct material Direct labour Material receipt costs Power costs Material handling costs

Question 3 (a) Number of machine hours = D = E = F 2,500 = = = = 4,500 5,000 84,000 93,500

Overhead absorption rate

935,000 93,500

= 10 per machine hour Cost per unit Material Labour Overhead D 18 8 30 56 E 10 24 20 54 = 90 + 138 + 576 = 804 F 20 16 60 96

(b)

Total number of set-ups

Absorption rate per set-up

327,250 804 = 407.03 per set-up =

= 16 + 28 + 116 = 160

Total number of issues

Absorption rate per issue

187,000 160 = 1,168.75 =

140,250 93,500 = 1.50 =

Absorption rate per machine hour

Total number of inspections

= 180 + 216 + 804 = 1,200

280,500 1,200 = 233.75 =

Absorption rate per inspection

Overheads per unit Set-up

D 90 407.03 1,500 = 24.42

E 138 407.03 2,500 = 22.47

F 576 407.03 14,000 = 16.75

Issue

16 1,168.75 28 1,168.75 116 1,168.75 1,500 2,500 14,000 = 12.47 = 13.09 = 9.68

Machining

1.50 = 4.50
180 233.75 1,500 = 28.05

= 3
216 233.75 2,500 = 20.20

= 9
804 233.75 1,400 = 13.42

Inspection

Total cost per unit Material Labour Set-up costs Handling costs Machine costs Inspection costs

D 18.00 8.00 24.42 12.47 4.50 28.05 95.44

E 10.00 24.00 22.47 13.09 3.00 20.20 92.76

F 20.00 16.00 16.75 9.68 9.00 13.42 84.85

Question 4 (a) Total labour hours = P Q R = 60,000 = 60,000 = 12,000 132,000

Total overheads = 1,834,000 Total absorption rate

1,834,000 132,000 = 13.89

Cost per unit Direct material Direct labour Production overheads

P 20.00 40.00 55.56 115.56

Q 15.00 60.00 83.34 158.34

R 10.00 30.00 41.67 81.67

(b)

Cost driver absorption rates Machining

684,000 114,000 = 6.00 per machine hour

Set-up costs

60,000 (6 + 14 + 40)
= 1,000 per production run

Receiving costs

240,000 (12 + 28 + 80)

= 2,000 per receipt

Packing costs

300,000 (30 + 20 + 50)

= 3,000 per order delivered

Engineering costs

450,000 (45 + 30 + 75)

= 3,000 per production order

Overhead cost per unit Machining

P 6.00 = 24.00
6 1,000 15,000 = 0.40
12 2,000 15,000 = 1.60 30 3,000 15,000 = 6 45 3,000 15,000 = 9

Q = 18.00
14 1,000 10,000 = 1.40
28 2,000 10,000 = 5.60 20 3,000 10,000 = 6 30 3,000 10,000 = 9

R = 36.00
40 1,000 4,000 = 10
80 2,000 4,000 = 40 50 3,000 4,000 = 37.50 75 3,000 4,000 = 56.25

Set-up costs

Receiving costs

Packing costs

Engineering costs

Total cost per unit Direct material Direct labour Machining Set-up Receiving Packing Engineering

P 20.00 40.00 24.00 0.40 1.60 6.00 9.00 101.00

Q 15.00 60.00 18.00 1.40 5.60 6.00 9.00 115.00

R 10.00 30.00 36.00 10.00 40.00 37.50 56.25 219.75

Question 5 (i) Total Factory Overheads = 90,000 135,000 105,000 120,000 150,000 600,000

Total machine hours Absorption rate

= 75,000
600,000 75,000 = 8 per machine hour

Cost per unit Material Labour Overheads

X 5.00 8.00 24.00 37.00

Y 8.00 12.00 16.00 36.00

(ii)

Cost Driver Absorption Rates Quality control

90,000 450

= 200 per inspection

Process set-up

135,000 450
105,000 1,000 120,000 2,000
150,000 75,000

= 300 per set-up

Purchasing

= 105 per order

Order processing

= 60 per order

Occupancy costs

= 2 per machine hour

Overhead cost per unit Quality control

X
150 200 10,000 = 3
150 300 10,000 = 4.50 500 105 10,000 = 5.25 1,000 60 10,000 = 6

Y
210 200 6,000 =7
210 300 6,000 = 10.50 300 105 6,000 = 5.25 800 60 6,000 = 8

Process set-up

Purchasing

Order processing

Occupancy

Cost per unit Material Labour Quality control Set-up Purchasing Order processing Occupancy

X 5.00 8.00 3.00 4.50 5.25 6.00 6.00 37.75

Y 8.00 12.00 7.00 10.50 5.25 8.00 4.00 54.75