B4: ABC_February 2009

Taylor manufactures two products. The company has been using absorption costing techniques,
using direct labour hours to recover overheads.

The company has recently become aware of the potential use of activity based costing (ABC).

The company had provided the following data (for January 2009):

Overhead costs: $
Factory cleaning 2000
Power 20000
Factory insurance 28000
Supervisory salaries 12000
Canteen expenses 3000
Machinery depreciation 21000
Machinery maintenance 5000
Production consumables 6000
Other indirect labour costs 20000
117000

Total direct labour hours 5000

Product A Product B
Hours of direct labour per unit 1.00 1.50

$ $
Direct materials per unit 17.50 12.00
Direct labour per unit 7.00 10.50
Prime cost 24.50 22.50

Units produced 2000 2000

Activity Data:

Activity Cost Driver $ Product A Product B Total

Machining Machine hours 45000 2000 1000 3000 hours
Finishing Direct labour hours 25000 2000 3000 5000 hours
Materials ordering Number of orders 8000 16 9 25 orders
Materials issue to production Number of issues 12000 40 20 60 issues
Scheduling/planning Number of production runs 27000 40 10 50 runs
117000

0
Required:

a) Calculate the production cost (per unit) using traditional and ABC systems 15 Marks

b) Explain the significance of your calculations, in Part (a). 5 marks

b) Critically evaluate the adoption of Activity Based Costing. 10 Marks

Solution

Using Absorption Costing

Product X Product Y
Hours of direct labour per unit 1.00 1.50

Overhead recovery rate $ 23.40 23.40

$ $
Direct materials per unit 17.50 12.00
Direct labour per unit 7.00 10.50
Prime cost 24.50 22.50

Overheads 23.40 35.10

Production Cost - Traditional 47.90 57.60

Using ABC

Activity $ Product X Product Y Total ABC rates ($)

Machining 45000 2000 1000 3000 15
Finishing 25000 2000 3000 5000 5
Materials ordering 8000 16 9 25 320
Materials issue to production 12000 40 20 60 200
Scheduling/planning 27000 40 10 50 540
117000

Product X Product Y
Activity
Machining 30000 15000
Finishing 10000 15000
Materials ordering 5120 2880
Materials issue to production 8000 4000
Scheduling/planning 21600 5400
74720 42280

Units 2000 2000

Per unit 37.36 21.14

Prime Cost 24.50 22.50
Production cost ABC 61.86 43.64

Difference (T less ABC) -13.96 13.96

Benefits and constraints

Product X places significantly greater demand on the key activities.

ABC will take account of production processes that create work and are cumbersome.
Company needs to review the product design, production systems and the demand for each activity.
For example a greater focus on ordering might help to reduce the number of individual orders being raised.

ABC can help to reduce costs…by greater awareness of the drivers, involvement. Tend to be used with
other modern tools and techniques that also contribute to efficiency.
Has become more mature since 1980's

It can become expensive to administrate and adopt. Might be resistance from staff, might create/stimulate inefficient practices
to avoid a cost.
Complex systems will require a substantial period of review. Risk of too many or conflicting drivers.