advancing from absorption costing to activity-based
TRANSCRIPT
ADVANCING FROM ABSORPTION COSTING TO ACTIVITY-BASED COSTING:
AN EXPLORATORY STUDY
by
Daniël Pieter Prinsloo
(908802493)
MINOR DISSERTATION
submitted in partial fulfilment of the requirements for the degree
MAGISTER
in
Business Management
in the
FACULTY OF BUSINESS MANAGEMENT
at the
UNIVERSITY OF JOHANNESBURG
SUPERVISOR: Prof G Els
OCTOBER 2008
EXECUTIVE SUMMARY
Every business owner wants his/her business to grow. With growth comes change and one of
the major changes in a business is the cost of the product and/or service the specific business
offers to its clients.
A lot of managers and small, micro and medium business owners do not know and/or
understand the basic principles of costing, the types of costing methods and how to
implement and execute a chosen costing method.
The first step is for the management of a business or business owner to choose a costing
method or methodology applicable to the organisation’s unique situation.
Choosing the best or most applicable costing method could therefore have a fundamental
impact on goals and objectives, revenue and reflected profits – which, in turn, could attract
investment and shareholders, but also increase stakeholder satisfaction.
This study explores the various types of expenses found in any organisation and applicable
costing methods. It specifically outlines and compares the traditional costing or absorption
costing (AC) methodology with activity-based costing (ABC) methodology in a real South
African company.
This study shows that a small, micro and medium enterprise, will have a better
understanding of costing but can also benefit, financially and otherwise, by moving from
absorption costing and implementing activity-based costing.
This study forms the basis of understanding costing and serves as a platform to enhance the
applicable business and its costing.
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TABLE OF CONTENTS
CHAPTERS
CHAPTER 1 PRELIMINARY ...................................................................................... 10
1. Introduction .................................................................................................................................. 10
2. Purpose and importance ............................................................................................................... 11
3. Problem statement ....................................................................................................................... 11
4. Objectives of this study ................................................................................................................. 12
5. Propositions .................................................................................................................................. 13
6. Demarcation ................................................................................................................................. 13
7. Summary ....................................................................................................................................... 14
CHAPTER 2 LITERATURE SURVEY ........................................................................ 16
1. Introduction .................................................................................................................................. 16
2. Terminology .................................................................................................................................. 16
2.1.1. Cost object ............................................................................................................................................... 16
2.1.2. Direct costs ............................................................................................................................................... 17
2.1.3. Prime costs ............................................................................................................................................... 17
2.1.4. Indirect costs ............................................................................................................................................ 17
2.1.5. Fixed costs ................................................................................................................................................ 17
2.1.6. Variable costs ........................................................................................................................................... 17
2.1.7. Relevant, irrelevant costs and revenues .................................................................................................. 18
2.1.8. Cost centres or cost pools ........................................................................................................................ 18
2.1.9. Cost units.................................................................................................................................................. 19
3. Assigning direct costs to cost objects ............................................................................................ 19
4. Cost apportionment of overheads ................................................................................................ 19
5. Assigning overheads ..................................................................................................................... 20
5.1 ABSORPTION COSTING (AC) ............................................................................................................ 21
5.2 ACTIVITY-BASED COSTING (ABC) ...................................................................................................... 22
6. Activity cost pools ......................................................................................................................... 25
7. Activity cost drivers ....................................................................................................................... 26
8. Advantages of ABC........................................................................................................................ 27
9. Disadvantages of ABC ................................................................................................................... 28
10. Under- and over recovery of overheads ........................................................................................ 30
11. Cost-volume-profit analysis .......................................................................................................... 30
12. Activity-based management ......................................................................................................... 31
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13. Summary ....................................................................................................................................... 32
CHAPTER 3 COMPANY PROFILE ............................................................................ 33
1. Introduction .................................................................................................................................. 33
2. Manufacturing .............................................................................................................................. 33
3. Infrastructure ................................................................................................................................ 34
4. Management ................................................................................................................................ 35
5. Summary ....................................................................................................................................... 37
CHAPTER 4 RESEARCH METHODOLOGY ........................................................... 38
1. Introduction .................................................................................................................................. 38
2. Research design ............................................................................................................................ 38
3. Absorption costing (AC) ................................................................................................................ 39
3.1.1. Direct costs ................................................................................................................................. 39
3.1.2. Overheads .................................................................................................................................. 40
4. Activity-based costing (ABC) ......................................................................................................... 42
4.1.1. Direct costs ................................................................................................................................. 44
4.1.2. Overheads .................................................................................................................................. 45
5. Results ........................................................................................................................................... 46
6. Summary ....................................................................................................................................... 47
CHAPTER 5 CASE STUDY .......................................................................................... 48
1. Introduction .................................................................................................................................. 48
2. Case financial statements ............................................................................................................. 48
3. Absorption costing (AC) ................................................................................................................ 50
3.1.1. Direct costs ............................................................................................................................................... 51
3.1.2. Overheads ................................................................................................................................................ 53
3.1.3. Forecast .................................................................................................................................................... 55
3.1.4. Comparative analysis ............................................................................................................................... 56
4. Activity-based costing (ABC) ......................................................................................................... 57
4.1.1. Direct costs ............................................................................................................................................... 57
4.1.2. Overheads ................................................................................................................................................ 62
4.1.3. Forecast .................................................................................................................................................... 69
4.1.4. Comparative analysis ............................................................................................................................... 71
5. Summary ....................................................................................................................................... 75
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CHAPTER 6 IN THE END ............................................................................................ 76
1. Introduction .................................................................................................................................. 76
2. Conclusion ..................................................................................................................................... 76
3. Implications ................................................................................................................................... 77
4. Recommendations ........................................................................................................................ 78
BIBLIOGRAPHY ......................................................................................................................................................................... 79
5
TABLES
Table 4.1 .................................................................................................................................. 41
Absorption Costing Product Costs ........................................................................................... 41
Table 4.2 .................................................................................................................................. 46
Activity Data for Product A and Product B ............................................................................. 46
Table 4.3 .................................................................................................................................. 46
AC and ABC Comparison ....................................................................................................... 46
Table 5.1 .................................................................................................................................. 49
XYZ Financial Statements for Two Consecutive Months ....................................................... 49
Table 5.2 .................................................................................................................................. 51
Information Obtained from Management ................................................................................ 51
Table 5.3 .................................................................................................................................. 52
Month 1 Direct Cost and Absorption Rate .............................................................................. 52
Table 5.4 .................................................................................................................................. 53
Month 1 Overheads .................................................................................................................. 53
Table 5.5 .................................................................................................................................. 55
Month 2 Forecasted Overhead ................................................................................................. 55
Table 5.6 .................................................................................................................................. 56
Month 2 Comparative Results of Forecasted and Actuals ....................................................... 56
Table 5.7 .................................................................................................................................. 56
Month 2 Actual Costs with Under Absorption ........................................................................ 56
Table 5.8 .................................................................................................................................. 58
Month 1 Output in Units .......................................................................................................... 58
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Table 5.9 .................................................................................................................................. 59
Month 1 Unit Absorption Rate ................................................................................................ 59
Table 5.10 ................................................................................................................................ 59
Month 1 Per Unit Rate ............................................................................................................. 59
Table 5.11 ................................................................................................................................ 60
Month 1 Weighted Absorption Rate ........................................................................................ 60
Table 5.12 ................................................................................................................................ 61
Month 1 Weighted Amount Absorbed of Direct Costs and Direct Labour ............................. 61
Table 5.13 ................................................................................................................................ 62
Month 1 Summary of Direct Costs Allocation ........................................................................ 62
Table 5.14 ................................................................................................................................ 63
Cost Pools, Overhead Percentage and Amounts ...................................................................... 63
Table 5.15 ................................................................................................................................ 64
Cost Pools, Cost Drivers and Overhead Absorption Rate ....................................................... 64
Table 5.16 ................................................................................................................................ 64
Cost Drivers Allocations .......................................................................................................... 64
Table 5.17 ................................................................................................................................ 65
Month 1 Overhead Absorption Rate ........................................................................................ 65
Table 5.18 ................................................................................................................................ 67
Month 1 Labour Hours Required for Total Units Manufactured ............................................. 67
Table 5.19 ................................................................................................................................ 68
Month 1 Summary ................................................................................................................... 68
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Table 5.20 ................................................................................................................................ 70
Month 2 Forecast ..................................................................................................................... 70
Table 5.21 ................................................................................................................................ 72
Month 2 Actuals ....................................................................................................................... 72
Table 5.22 ................................................................................................................................ 73
Month 2 Comparative Results of Forecasts and Actuals ......................................................... 73
Table 5.23 ................................................................................................................................ 74
Month 2 Comparative Results ................................................................................................. 74
Table 5.24 ................................................................................................................................ 75
AC and ABC per Hour Comparison ........................................................................................ 75
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FIGURES
Figure 2.1 ................................................................................................................................. 20
Expense Categories Hierarchical Tree ..................................................................................... 20
Figure 2.2 ................................................................................................................................. 23
ABC Flow Chart ...................................................................................................................... 23
Figure 2.3 ................................................................................................................................. 27
Overhead Allocation, Expense Categories, Activities and Products ....................................... 27
Figure 3.1 ................................................................................................................................. 37
Floor Plan of XYZ Furniture Manufacturers (Pty) Ltd ........................................................... 37
Figure 4.1 ................................................................................................................................. 42
Relationship among Expense Categories, Activities and Products ......................................... 42
Figure 4.2 ................................................................................................................................. 43
Relationship among Expenses, Activities and Products .......................................................... 43
Figure 5.1 ................................................................................................................................. 54
Pie Chart of Overheads Absorbed............................................................................................ 54
Figure 5.2 ................................................................................................................................. 58
Cost Pools and Cost Drivers .................................................................................................... 58
Figure 5.3 ................................................................................................................................. 62
Direct Costs Allocated Pie Chart ............................................................................................. 62
Figure 5.4 ................................................................................................................................. 66
Overheads Allocated to Products ............................................................................................. 66
Figure 5.5 ................................................................................................................................. 66
Overheads Allocated to Cost Pools.......................................................................................... 66
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My thanks to God, in whom I truly believe with all my
heart.
Thanks to Professor Els who assisted me and made the
choices and understanding this subject so much easier.
To my fellow students, it was great to experience the
University of Life with you.
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CHAPTER 1 PRELIMINARY
1. Introduction
A business is a living organism, and therefore every day is different. A business‟s
management team must ensure survival, growth and profit, and this requires constant
adaption, change, and sometimes a metamorphosis or even evolution of the organisation.
Furthermore, management not only demands dedication, knowledge, skill and experience, but
must also be sensitive to changes required by clients, suppliers and products (Grobler, 1996).
Traditionally there are four management tasks, namely planning, organising, leading and
controlling (Bateman & Snell, 2004:250). One of the many aspects that management will
have to attend to within these traditional management tasks, which will lead to survival,
growth and profit, is the costing of products and services and how various expenses are
attributed to the end product and/or service. Management must therefore choose a costing
method or methodology applicable to the organisation‟s unique situation.
Choosing the best or most applicable costing method could therefore have a fundamental
impact on management‟s goals and objectives, revenue and reflected profits – which, in turn,
could attract investment and shareholders.
This study will refer to the various types of expenses found in any organisation but more
specifically in a manufacturing entity. It will outline and compare the traditional costing or
absorption costing (AC) methodology with activity-based costing (ABC) methodology in a
real South African company, described as XYZ Furniture Manufacturers (Pty) Ltd (XYZ) for
purposes of anonymity. More specifically, this study explores whether XYZ, which falls
under the definition of a small, micro and medium enterprise (SMME), can benefit,
financially and otherwise, by moving from absorption costing and implementing activity-
based costing.
A theoretical background of key concepts and each costing method will be outlined after
which the actual data of XYZ will be used to construct and explore two costing scenarios
based on the same cost data. The practical example and calculations will demonstrate the
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difference in the application of the two methods and the different results that can be obtained.
They will also demonstrate the impact this can have on the resultant decision.
2. Purpose and importance
Costing is an iceberg (Friedman & Lyne, 1999:9). In an SMME the positive effects and/or
problems related to costing are neither visible nor understood by managers. This study
emphasises the difference between AC as a basic costing method and ABC, as the more
complex costing method. This practical knowledge should then assist a manager and/or
owner to understand why costing is so important, to determine whether absorption of costs
and/or costing of activities is adequate as a costing method for a specific SMME, to cost the
product, to assist with management decisions, to benefit the bottom line (i.e. profit) and to
successfully execute the business strategy.
The benefits for an organisation when specific emphasis is placed on the applicable costing
method should be enormous. For example, Hughes (2005:16) states that by simply examining
the activities involved in the manufacture of trousers it is clear that this is a much more
profitable activity than was previously thought. It can enable organisations to transform
themselves and will assist with the strategic thinking process of management; it can also
ensure that everyone involved is one hundred percent certain of his or her responsibilities and
how to actually convert such plans into actions. Even commitment without a costing
methodology will mean nothing without knowledge and how to transform the systems and
methods into workable results (Domm, 2001:39).
A business strategy in which the correct costing method is applied within the means, size and
objectives of the specific organisation can be the basis for decision making or at least can be
a very helpful tool to assist with decision making, strategic planning and management – and
can positively affect profits.
3. Problem statement
The problem in many SMMEs is that management, which is usually the proprietor of the
business as well, does not have the time, resources or inclination to give more attention to
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costing. Therefore management does not have the luxury – or what is deemed a necessity by
this study and also by Roztocki, Valenzuela, Porter, Monk, and Needy (1999:280) – of
having a more complex but practical costing model/methodology to assist in the making of
important decisions.
Hughes (2005:12) notes that the ABC process should not be a “once-off” event: it demands a
fundamental mind shift by the management (which may prove more difficult in SMMEs) – a
process of relentless and continuous improvement. Costing is but one of many aspects that
require constant attention, but it is definitely one of the most important (Hughes, 2005:9).
The cost of a product influences profit but can be of much more importance as a management
and decision-making tool (Stapleton, Pati, Beach & Julmanichoti 2004:584).
If one accepts that management does have the time, resources and inclination to implement a
proper costing system/methodology or change from one system to the other, will it benefit the
business? Will it be cost effective? Will it positively influence the bottom line? Will it assist
with management and decision making, over and above what the current methodology has
already achieved?
4. Objectives of this study
The primary objective of this study is to establish whether ABC is more advantageous than
AC, but it will explain this in such a manner that the management and/or proprietor of a
SMME will be able to understand and apply the costing methodology to the specific business.
As a secondary objective of this study, it will be shown that the information that the
appropriate costing method provides can be applied for a variety of purposes, including but
not limited to cost reduction, cost modelling, customer profitability (Wilks & Burke,
2005:274), employee motivation and involvement, change management and as a productivity
improvement technique.
In light of the objectives the question to be answered is whether ABC, as compared with AC,
will have a positive effect on margins, assist with decision making, benefit management,
increase productivity and readily deal with the change its execution may have on the
applicable business.
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5. Propositions
Costing has not received the attention that it deserves in SMMEs, because management
and/or owners do not realise its advantages. Albert Einstein
(http://www.bigpicturesmallworld.com/funstuff/bigquotes.shtml) said that the formulation of
the problem is often more essential than the solution.
When more emphasis is placed on costing, and more specifically the correct costing method
for the applicable organisation, a paradigm shift will be achieved. There will be a change of
how things are done and the organisation and its members will bear the fruit thereof.
Although there are other costing methods, for example direct and marginal costing, AC is
very well known and ABC is the “new kid” on the block. AC and ABC are appropriate for
this study, XYZ and many other organisations, as they will indicate the possible differences,
similarities and advantages of implementing an appropriate costing method in a specific
business.
6. Demarcation
The study made use of secondary internal data, collected from XYZ. This data was
economical to obtain and served as a quick source of background information. Analysis of
this historical/secondary data has assisted in clarifying and defining the nature of the costing
changeover, but has not provided conclusive evidence on all aspects, and subsequent research
is therefore necessary.
The data used was not always consistent with the requirements, but the units of measurement
were adaptable and enough information was obtained for analysis and could be used to find
facts that will support, confirm or deny the hypothesis that if more emphasis is placed on the
applicable costing method a paradigm shift will be achieved.
Chapter 2contains the literature survey where the applicable key concepts are described and
the similarities, differences and applications of AC and ABC are shown.
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Chapter 3 gives more information on XYZ, while chapter 4 describes the methodology of this
study and, more specifically, how the calculations in chapter 5 will be done.
Chapter 5 is the empirical part of this study and probably the most important chapter, as all
the theory is put into practice. Chapter 5 focuses on the differences/similarities between the
actual and applied costing methods.
Chapter 6 then takes the results and information obtained in chapter 5 to indicated whether
traditional absorption of overheads is still useable and the effect that the modern costing
method of ABC, with its activity cost pools and activity drivers, had on a specific
organisation and profits, stakeholders, management, decision making and investment in
general.
7. Summary
Costing systems can vary in terms of which costs are assigned to cost objects and their level
of sophistication (Drury, 2007:370). Typically, cost systems are classified as:
direct costing (applicable where indirect costs are a very low proportion of total cost);
traditional absorption costing; and
activity-based costing.
There are various benefits that an SMME can obtain from an appropriate costing
method/system. The mere exercise of identifying the appropriate costing method may
produce information that management did not even realise is at its disposal.
Roztocki et al. (1999:9) indicate that the implementation of a new cost system involves
investment in time and money. A cost system based on ABC requires organizational changes,
employee acceptance, investment in software and hardware, equipment for data collection,
and so on.
Although the method shown in this study is suitable for an SMME, as it provides a smooth
transition from a traditional costing system to ABC, it does not require a high investment in
15
sophisticated data collection systems, and it does not require a serious organisational
restructuring.
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CHAPTER 2 LITERATURE SURVEY
1. Introduction
The challenge facing any organisation today is to replace its current strategy, structure and
systems model with one that focuses on purpose, process and people (Grier, 1991:48). In this
individualised corporation people and methods are allowed to be the best they can be but they
do require a system within their specific environment. Adapting the appropriate costing
model or changing an existing but archaic costing model is a perfect example of how people
and a method are allowed to the best they can be. It may also mean that the current costing
method is the correct method but requires attention and adaption.
2. Terminology
Wilks and Burke (2005:1) define „cost‟ in two ways.
As a noun: the amount of expenditure (actual or notional) incurred on, or attributed to, a
specific thing or activity.
As a verb: to ascertain the cost of a specified thing or activity.
They go on to say that terminology can rarely stand alone and should be qualified as to its
nature and limitations. There are many different types of cost and those different costs and
costing techniques are appropriate in different circumstances.
It is important to cover the basic definitions of cost terms applicable to costing methods in
general, as these terms will be used throughout this study and a thorough understanding of
such key concept are paramount to understanding AC and ABC.
2.1.1. Cost object
A cost object is any activity for which a separate measurement of costs is desired (Drury,
2007:57). Examples include the cost of a product or the cost of rendering a service.
Costs that are assigned to cost objects can be divided into direct costs and indirect costs.
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2.1.2. Direct costs
Direct costs are those costs that can be specifically and exclusively identified with a
particular cost object (Drury, 2007:30). Direct materials and direct labour are considered
direct costs as the cost can specifically be traced to or identified with a particular product/cost
object.
2.1.3. Prime costs
The prime costs of a cost object consist of the direct labour costs and the direct material
costs.
2.1.4. Indirect costs
Unlike direct costs, indirect costs cannot be identified specifically and exclusively with a
given cost object. Therefore an estimate must be made of resources consumed by cost objects
for indirect costs (Drury, 2007:30).
In this study all overheads other than direct material or direct labour will be regarded as
indirect costs.
2.1.5. Fixed costs
Wilks and Burke (2005:5) define a fixed cost as “… a cost incurred for an accounting period,
and which, within certain output or turnover limits, tends to be unaffected by fluctuations in
the levels of activity (i.e. output or turnover)”. A typical overhead/fixed cost would be the
rent payable for business premises. Once the rental agreement has been signed, the company
will be liable to pay the agreed rent regardless whether any output or returns are realised as a
result of this cost.
For purposes of this study fixed cost and indirect cost will be treated as the same concept.
2.1.6. Variable costs
Variable costs are defined as “a cost which varies with a measure of activity”. A variable
cost can typically be attributed directly to a specific element of production and varies
accordingly to the units of the specific element produced. If a product uses R1 worth of raw
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material per unit of production, the variable cost of raw materials would be the number of
units produced multiplied by the variable cost per unit.
For purposes of this study variable cost and direct cost are treated as the same concept.
The nature of variable/direct and fixed/indirect cost and how these are incurred or assigned
are at the core of this study. Variable costs can be directly attributed to a specific level of
output. The amount of overhead assigned to every unit of production is not as easily
accounted for.
The challenge for management is therefore to decide how much overhead should be assigned
to every unit of output in order to make accurate decisions about business trade-offs that need
to be managed, with regard to the resources at hand, in order to maximise returns for the
resources invested.
2.1.7. Relevant, irrelevant costs and revenues
Relevant costs and revenues are those future costs and revenues that will be changed by a
decision, whereas irrelevant costs and revenues are those that will not be affected by the
decision (Drury, 2007:37).
Relevant and irrelevant costs are not specifically important for this study and it should be
assumed that all costs, whether direct or indirect, are relevant costs and therefore costs that
can be changed by a decision made by management.
2.1.8. Cost centres or cost pools
Cost centres are defined by Wilks and Burke (2005:3) as “… a production or service
location, function, activity or item of equipment for which costs are accumulated.” The cost
of operating a cost centre is calculated for a period. The total cost is related to the amount of
production or service units that were produced or passed through such a cost centre. In this
way, every unit of “production” accumulates a portion of the cost related to the amount of the
cost centre that it consumes.
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2.1.9. Cost units
Cost units are defined by Wilks and Burke (2005:2) as units of a product or service in
relation to which costs are ascertained. This means that a cost unit can be anything for which
a cost can be ascertained. Composite costs are costs that are of a more intangible nature and
that are made up of different components to get to one unit of cost. In such a case some
attributes are combined to give meaning to the cost. In the hotel business a cost unit could be
a “bed-night”. In passenger transport a cost unit can be a “passenger-mile” (Wilks & Burke,
2005:2).
3. Assigning direct costs to cost objects
According to Drury (2007:60), cost assignment involves the implementation of suitable
clerical procedures to identify and record the resources consumed by cost objects. For
example, source documents such as time sheets, job cards and materials requisition can be
used to assign the costs.
4. Cost apportionment of overheads
The question of how much cost must be assigned and how this is calculated remains. To
make the calculation, a decision must be made with regard to the most appropriate absorption
rate.
Cost apportionment happens when it is not possible to allocate/assign a cost to a specific cost
centre. In such a case the cost is shared over more than one cost centre in accordance with the
benefit that each cost centre derives from the cost. Through the process of allocation and
apportionment one can get to an estimated overhead cost for each cost centre.
Wilks and Burke (2005:14) also advise that the selection of the appropriate absorption rate
must be based on the practical applicability of the rate. Time-based methods – such as
machine hour rate and labour hour rate – should be used as far as is practical because
overheads consumed increase with time.
Overhead absorption rates are normally predetermined to enable planning and decision
making. Such overhead absorption rates are based on historical data and assume a constant
20
rate of overhead incurred in spite of possible fluctuations in the overhead cost incurred. If the
actual rate were used in product costing, such fluctuations would make planning very
difficult. The normalised overhead allocation therefore simplifies cost allocation and
planning.
Three levels of data accuracy can be used in estimating these proportions:
educated guess;
systematic appraisal; and
collection of real data.
All three levels were used to obtain the required data for XYZ, and the expenses, cost drivers,
activities and products that are more fully discussed are all shown in Figure 2.1.
Expense Categories Hierachiel Tree
Insurance Netstar
Activities
Receiving Delivering
Products
Miscellaneous Expenses
Expense Categories
Overhead Allocation
Repairs & Maintenance / Machinery Spray Painting
Bank Charges
Cleaning & Refreshments
Delivery Costs Telephone / Fax / Postages
Fuel, Oil & Toll
Vehicle Expenses/ Repairs Truck Repayment
Printing & Stationery Refuse Removal
Electricity, Water & Rates
Salaries
Quality ControlSanding
Baby Children Adult Office
Assembling
Source: Adapted from Roztocki (2001)
5. Assigning overheads
In a simplistic traditional costing system overheads are assigned or apportioned to cost
objects using a single overhead rate for the whole organisation. Drury (2007:62) calls this
blanket overhead rate or plant-wide rate. But more often than not it will be found that a
blanket rate is not applicable to most manufacturing entities as there are various cost objects,
departments, cost centres, and therefore varied overhead rates, and a blanket rate will
generally result in inaccurate product costs.
Figure 2.1
Expense Categories Hierarchical Tree
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Overheads can be assigned by linking overheads to:
number of units produced;
direct labour hours incurred;
direct machine hours applicable;
direct wage costs as a ratio;
direct material cost as a ratio;
prime cost as a ratio; etc.
According to Wilks and Burke (2005:13), cost allocation is possible when the cost can be
attributed to a specific cost centre. For example, the salary of the distribution manager can be
allocated completely to the distribution department.
5.1 Absorption costing (AC)
A two-stage allocation process is used to assign overhead costs to products/cost objects
(Drury, 2007:64).
In the first stage, overheads are assigned to cost centres. In the second stage the costs
accumulated in the cost centres are allocated to cost objects using selected allocation
bases/cost drivers. Typically direct labour and/or machine hours are the only cost drivers in
AC. Drury (2007:64) states that within the two-stage allocation process, ABC systems differ
from AC by having a greater number of cost centres in the first stage and a greater number
and variety of cost drivers in the second stage – but more about ABC later.
AC uses volume-based cost drivers only, and this results in distorted product costs when non-
volume-based cost drivers are assigned (Drury, 2007:375). Volume-based cost drivers
assume that a product‟s consumption of overhead resources is directly related to units
produced. Drury (2007:374) indicates that this means that in an AC or traditional cost system
it is assumed that the overhead consumed by products is highly correlated with the number of
units produced. Therefore typical volume-based cost drivers are units of output, direct labour
hours and machine hours.
22
Drury (2007:67) indicates that the two-stage allocation process requires the following four
steps:
First stage
Step 1. assigning all manufacturing overheads to production and service cost centres;
Step 2. reallocating the costs assigned to service cost centres to production cost
centres.
Second stage
Step 3. computing separate overhead rates for each production cost centre;
Step 4. assigning cost centre overheads to products or other chosen cost objects.
Traditional overhead absorption was designed for production companies and is less suitable
for service and retail organisations. Furthermore, the nature of production overheads is
changing. According to Wilks and Burke (2005:20), costs such as power, machine
maintenance and depreciation are becoming larger and more prevalent and the number of
labour hours is reducing. Fixed costs (overheads) apportionment is also of little use for
decision making. Therefore the trend is to implement ABC, or at least to investigate its
advantages and disadvantages.
Wilks and Burke (2005:268) state that traditional absorption costing systems are not accurate
enough to give adequate information for pricing purposes or other, long-run management
decision purposes. Furthermore, traditional absorption costing systems are limited in the
information they provide as they use a cause-and-effect allocation (Drury 2007:58). More is
needed, and ABC can provide this.
5.2 Activity-based costing (ABC)
ABC is a costing model that identifies the cost pools, or activity centres, in an organisation
and assigns costs to products and services (cost drivers) based on the number of events or
transactions involved in the process of providing a product or service (Letza & Gadd,
1994:59); this is illustrated in Figure 2.2.
23
Source: Adapted from Letza and Gadd (1994:60)
According to Stapleton et al. (2004:589), understanding ABC can lead to greater knowledge
of a firm‟s business processes and underlying expenses. They go on to say that ABC is a
budget and analysis process that evaluates overhead and operating expenses by linking costs
to customers, services, products and orders. It allows managers to distinguish between
profitable and non-profitable products or services. ABC helps fill in the gaps of traditional
costing by identifying all the work activities and costs that go into manufacturing a product,
delivering a service, or performing a process. When the individual costs are added, a clear
picture of the total cost of a process emerges. ABC can even distinguish the cost of serving
the different segment of customers.
Kaplan (1998:333) explains that the basic principle behind the ABC system is that resource
expenses must be assigned to the activities performed. Expenses identified in the financial
system are collected and distributed to these activities. This helps the firm to understand how
much they are spending on the activities that support the production of certain products or
services. With today‟s technology, costing information should be readily available to assess
the variable costs of a department, as well as the committed costs, in determining the
feasibility of a project.
According to Ferrara (1995:1), there are three elements of variable manufacturing under
ABC:
costs that vary with units of product;
costs that vary with product complexity, such as number of batches; and
Figure 2.2
ABC Flow Chart
24
costs that vary with product diversity, such as number of products.
The ABC methodology was established on the assumption that it is not the products that the
organisation produces that generate costs, but rather the activities that are performed in
planning, procurement and manufacturing the products. It is the activities performed during
the business processes that result in costs being incurred.
ABC could present a more realistic picture of costs incurred to deliver the products to the
point of demand in the value chain, as ABC reflects the numerous cost drivers related to
product manufacturing. The consequence is that traditional costing for various departments
may not be useful when applying ABC, as activities and their related cost drivers could
extend over a number of divisions or business units (products exploit activities which in
return exploit costs).
It could be argued that the ABC method computes a more rational and probably accurate
cost; however, the practicality of the method needs to be considered as well as the effort
required to compute the figures. Some benefits of ABC include:
recognising the most and least cost-effective and profitable customers, products and
channels;
determining accurate contributors to and detractors from financial accomplishments
and performance;
precisely forecasting costs, profits and resource requirements related to variations in
production volumes, organisational structure and resource costs;
straightforwardly identifying the causes of poor financial performance;
tracking costs of activities and work processes;
providing managers with cost intellect to steer improvements;
smoothing the progress of better product mix;
augmenting the bargaining power with the customer;
attaining better positioning of products;
furnishing employees with comparative scenarios; and
making changes based on identifiable percentages, amounts or figures (Kaplan,
1998:334; Wilks & Burke, 2005:20; Innes, 1999:80).
25
Wilks and Burke (2005:268) state that traditional absorption costing systems are not accurate
enough to give adequate information for pricing purposes or other, long-run management
decision purposes. Furthermore, traditional absorption costing systems are limited in the
information they provide. More is needed, and ABC can provide this.
The different stages in ABC calculations as suggested by Wilks and Burke (2005:270) are:
identify the different activities within the organisation;
relate the overheads to the activities;
support activities are then spread across the primary activities;
determine the activity cost drivers; and
calculate activity cost drivers rates.
6. Activity cost pools
As indicated earlier, AC overheads are first related to cost centres/pools and then to cost
objects/products. With ABC it is more complex.
Innes (1999:80) explains that with ABC overhead costs are firstly pooled on the basis of
activities which have consumed resources – such as purchasing and material handling.
Secondly, products consume activities and a link (known as a cost driver) is found between
each activity cost pool and product line, e.g. number of purchase orders and number of
material movements. The calculation of the cost driver (activity cost divided by the cost
driver volume) then allows overhead costs to be attached to products.
From this explanation it is clear that overheads are related to activities. Thereafter the
overheads are related to these activities, which in turn create cost pools. There should be
causality between the cost pools and the cost drivers as indicated above. The specific cost
pools will depend on the type of organisation, production line and other business specific
characteristics. ABC is different, as it uses activities instead of functional centres and
therefore gives a more realistic picture of the way in which costs behave.
26
7. Activity cost drivers
Cost drivers link the performance of activities to demands made by individual products. To
allocate a cost centre to products, simple drivers such as labour hours, machine hours,
material processed, or units produced are used. Even though there are only a few types of cost
drivers, they can produce a large variety of information. Wilks and Burke (2005:269) indicate
that there are only resource cost drivers and activity cost drivers.
The quantity of cost drivers is generally proportional to the physical volume of the product
produced, but some support departments or indirect resources are not used in these
proportions (Kaplan, 1998:336). Consequently, this method creates significant errors in the
costs assigned to individual products. To avoid such errors, traditional cost systems
emphasise four types of activities that link the number of units produced:
unit-level activities represent the work performed for every unit of product or service
produced;
batch-level activities represent resources required to perform a batch-level activity
and traditional cost systems view the expenses of this resource as fixed;
product-sustaining activities represent the work performed to enable the production
of individual products to occur (also called product level activities); and
customer-sustaining activities represent the work that enables the firm to sell to
individual customers. Wilks and Burke (2005:271) do not mention customer-
sustaining activities, but refer to these as facility level activities.
According to Wilks and Burke (2005:271), the first and last categories (unit-level and
facility-level activities) are the same as those in traditional absorption costing. So if a
business‟s costs are mainly made up of these two categories, ABC will not improve the
overhead absorption or analysis significantly. It follows that if the business‟s costs fall mainly
in the second and third categories (batch-level and product-level activities), ABC analysis
will provide a different and more accurate analysis.
The linkage between these activities and cost objects is done by activity cost drivers. For each
activity, there is an activity cost driver that links to the different activities. To calculate an
activity cost driver rate, the activity cost is divided by driver quantity. To avoid
27
miscalculation of this cost, the composition of this activity is considered and then all the
relevant parts of this activity are calculated before putting them together.
In the case of XYZ the expenses, cost drivers, activities and products that are more fully
discussed are all shown in Figure 2.3.
Expense Categories Hierachiel Tree
Insurance Netstar
Activities
Receiving Delivering
Products
Miscellaneous Expenses
Expense Categories
Overhead Allocation
Repairs & Maintenance / Machinery Spray Painting
Bank Charges
Cleaning & Refreshments
Delivery Costs Telephone / Fax / Postages
Fuel, Oil & Toll
Vehicle Expenses/ Repairs Truck Repayment
Printing & Stationery Refuse Removal
Electricity, Water & Rates
Salaries
Quality ControlSanding
Baby Children Adult Office
Assembling
Source: Adapted from Roztocki (2001)
8. Advantages of ABC
An advantage of ABC is the increased understanding of cost behaviour. The real benefit in
applying ABC may not lie in the product costing, but in activity-based management or ABM
(Wilks & Burke, 2005:274). See chapter 2 for more on ABM.
ABC is particularly needed by production organisations where overheads are high, where
there is diversity in the product range, products use different amounts of the overheads and
consumption of overhead resources is not primarily driven by volume (Wilks & Burke,
2005:273).
ABC employs volume-based cost drivers that will reflect the accurate product cost.
Furthermore, there are more cost centres to also help to show more accurate results and ABC
uses cause-and-effect whereas AC uses arbitrary allocation during second stage (Drury,
2007:65).
Figure 2.3
Overhead Allocation, Expense Categories, Activities and Products
28
ABC is a cause-and-effect costing allocation method that is distinguished from AC, which is
an arbitrary allocation costing method. ABC enables firms to focus on their activities and
products; it traces cost-to-cost drivers. The business then understands its business processes
in detail, the cost of process failures, the relationship of processes to customers, the
profitability of customer segments, and the affordable amount that can be spent on
influencing the preferred customer groups.
In using ABC, firms are able to control and manage overhead costs efficiently and
effectively. ABC increases managerial insights into how products, customers, or supply
channels consume work and resources. In both areas of marketing and logistics, ABC allows
firms to find the laggards and improve or drop them. This system also allows managers to
make decisions with more accurate information and lower chances for error in those
decisions. As mentioned before, many firms have to find new ways to stay competitive in the
current global, web-based economy. By understanding costs in more depth, firms are able to
strive for cost advantages while still maintaining a high quality product or service.
ABC can be refined over time to include all the products and all the activities and to enable
management to make short-term decisions based on actual absorptions costs. Management
will also be able to observe different scenarios when the input is manipulated in the model
and the various results displayed.
9. Disadvantages of ABC
A blanket overhead rate as applied in AC will result in an inaccurate assignment of overhead
rates (Drury, 2007:64). With AC a two-stage allocation process resulted in more accurate
assignment of overheads, but further improvement will be visible when the number of cost
centres is increased by establishing separate cost centres within a department in an ABC
application.
AC uses volume-based cost drivers only, and this results in distorted product costs when non-
volume-based cost drivers are assigned (Drury, 2007:375).
AC was not designed to make decisions of a short-term nature. Marginal or variable costing
is more suitable for this purpose. Long-term decisions are made by using long-run averages
29
that accurate absorption costing systems provide, whether traditional or activity-based. But
traditional absorption costing systems are limited in the information that they can provide.
ABC will provide a system to spread overheads but will also be a cost management system.
Although ABC has many advantages, it still comes with some disadvantages. ABC can really
only be used when overheads are high, products are diverse, costs of errors are high and
competition is stiff.
It is up to each individual firm to see that whether ABC should be implemented in one way or
another; it will not be just a different expensive and time-consuming system that spits out the
same information. If a firm can successfully implement this practice, the benefits might
quickly follow (Stapleton et al., 2004:596). It is true, however, that the size of the
organisation will also play a big role. In other words, small and medium organisations may
not be able to justify the time, effort and cost implications of implementing ABC. The
disadvantages may outweigh the advantages for costing and management purposes. This does
not mean that these small and medium organisations will not benefit from ABC, it just means
that it is part of management‟s responsibility to make informed decisions and to weigh the
options before spending money and time that will not justify the increase in profit and
consider whether the increased or supplementary information obtained through ABC is an
applicable decision-making tool.
Sustained criticism of ABC is referred to by Hughes (2005:18) cites the following instances
of sustained criticism of ABC:
the dangers of concentrating too much on costs, rather than on what activities should
actually be performed;
there are likely to be problems associated with the identification of the real source of
cost – “...tending to under-cost the complex and over-cost the simple drivers”;
implementing the process of ABC is costly in itself, and the resulting extra
information would need employees to deal with it;
the effectiveness of cost control is questioned as the only effective way to cut cost is
to cut out an activity; and
30
nothing is more wasteful than doing with great efficiency that which should not be
done. ABC is made to look superior because no alternatives to conventional
absorption costing are given consideration (Hughes, 2005:18).
ABC information, by itself, does not invoke actions and decisions leading to improved profits
and operating performance. Management must institute a conscious process of organisational
change and implementation if the organisation is to receive benefits from the improved
insights resulting from an ABC analysis (Hughes, 2005:18).
ABC systems are significantly more expensive than operating a direct costing or a traditional
costing /AC system (Drury, 2007:389).
10. Under- and over recovery of overheads
The AC and ABC method of determining and assigning an overhead will lead to over- or
under-absorption of overhead costs. This happens for example due to differences between
actual machine or labour hours and the number of hours used to assign the budgeted overhead
cost.
The actual production overhead cost may also differ from the budgeted cost and this will also
lead to a different actual overhead absorption rate. Since the predetermined overhead
absorption rates were calculated to plan and budget, the challenge is to derive an estimate that
is as accurate as possible and to continuously review the absorption rate for validity.
With ABC there will be an under- or over-recovery/absorption of overheads whenever actual
activity or overhead expenditure is different from budgeted overheads. When the actual
activity/amount is less than the estimated activity or amount there will be an under-recovery
of overheads. There will be an over-recovery when the actual overheads are more than the
estimated activity or overheads (Drury, 2007:78).
11. Cost-volume-profit analysis
Cost-volume-profit analysis (CVP) is used to provide the answers to why there was an over-
or under-absorption, how many units should be sold to break even, what will be the effect on
31
profits if the sale price is reduced or more units sold, what sales are required to meet the
additional overhead, etc. According to Drury (2007:263), this is a systematic method of
examining the relationship between changes in activity (i.e. output) and changes in total sales
revenue, expenses and profit. CVP is therefore a powerful tool for decision-making.
CVP specifically does not form part of this study, but is used to some extent to interpret,
analyse and compare the results of AC and ABC.
The results of this study could however be used to form the basis of a CVP analysis as a
further study.
12. Activity-based management
There may therefore be no benefit in using ABC as far as costing is concerned, but the real
benefit in applying ABC may not lie in the product costing, but in activity-based management
or ABM (Wilks & Burke, 2005:274).
ABM is a system of management which uses activity-based cost information for a variety of
purposes including reduction, cost modelling and customer profitability analysis. Wilks and
Burke (2005:274) go on to state that ABM measures the effectiveness of key activities by
identifying how activity costs can be reduced and value to customers can be increased. It also
focuses management‟s attention on key value-adding activities, key customers and key
products in order to maintain or increase competitive advantage.
It is when costs are to be assigned that the relevance of a specific type of cost to a decision
comes into play. Some costs are already sunk or irrelevant (Drury, 2007:38) and will have no
direct bearing on the course of action followed as they are already realised, whereas other
decisions will have very real and direct costs related to them.
ABM is a huge field of study on its own and does not specifically form part of this study, but
decision-making aspects of ABM are referred to from time to time during various phases of
ABC specifically.
32
13. Summary
The literature survey has given us a better understanding of the theory behind the various
costing methods. Reference was made to the direct costing as one of the three costing
methods, and AC and ABC were discussed in much more detail.
The important terms and key concepts were discussed as well. How direct costs and
overheads are assigned or apportioned for AC and ABC were given attention before AC and
ABC were surveyed in detail.
How cost pools and cost drivers fit into ABC was explained and the result of over or under
absorption/recovery for AC and ABC referred to.
CVP analysis and ABM were mentioned but do not form an integral part of this study. Both
of these concepts should be used by management to interpret the results of this study.
From the review it is seen that cost information has different purposes and applications. A
business must establish what cost system sophistication it requires through analysis of the
factors influencing choice of optimal costing system.
The theory is applied in chapter 4 and chapter 5 in a practical manner in order to explore the
move from an AC method to an ABC method.
33
CHAPTER 3 COMPANY PROFILE
1. Introduction
XYZ is a modern small furniture manufacturing company situated in Gauteng, South Africa.
XYZ manufactures four main category furniture products (Baby, Children, Adult and Office)
and supplies to multiple customers. Ongoing engineering work is prominent because of the
use of beam saws to cut big laminated and raw supawood sheets, CNC machines to
manufacture various parts of the products and spray painting techniques and products that
require certain environmental and safety standards. Four main customers are responsible for
more than 80% of the total business.
XYZ started as a small-garage, one-man-operation nearly twenty years ago. The company has
grown over time and has added employees, technology and bigger premises. The company in
its current form was bought from the previous owner, but it is still essentially the same
business. The decision by XYZ to buy the business came as a result of poor management,
inadequate financial controls and inefficient marketing strategies in the previous business.
Hence the initiative to purchase the assets and intellectual property, re-employ all the
employees and continue to service existing clients. Currently, its total work force is 30 full
time employees. The business was restarted and new operational procedures, software
systems and controls were implemented to ensure the success of the new business. This
obviously took time to implement. The company will in the future invest in the infrastructure,
systems and procedures to improve operational efficiency, quality, profitability, decision
making and service delivery.
2. Manufacturing
The manufacturing of niche modular furniture targets the middle to upper income segments
of society. Product offering covers a range of furniture ideal for nurseries, children‟s rooms,
lounges, and offices. All these products are made of supawood (mdf), providing clients with
advantages such as durability, quality, and real value for their money.
34
XYZ has a management team and staff that have knowledge and experience in the industry
and other areas of business. The mission of XYZ is to manufacture and supply high quality
furniture to clients by understanding their specific business needs and market requirements.
The business also strives to deliver a reliable, high standard service and product range to all
customers. Furthermore, the product range is modular, meaning that customers can add on to
the range that they purchase when and how they like.
3. Infrastructure
The company infrastructure consists of seven production units:
receiving;
machining: all parts are sent through to three beam saws and two CNC machines;
sanding: only parts that are spray painted are sanded;
spray painting: two booths are run continuously, one for primer the other for
coloured products;
assembling;
quality control; and
dispatch/delivery.
The manufacturing process is a combination of the Just in Time (JIT) process and Made to
Order System. Benefits include:
lower overhead cost;
fewer work-in-progress parts held in production area;
no redundant stock;
quicker reaction to market demands and trends;
contingency planning within the dynamic manufacturing environment; and
minimal shrinkage.
A JIT approach involves a continuous commitment to the pursuit of excellence in all phases
of manufacturing systems design and operations (Drury, 2007:967). The aim is to produce the
required items at the required quality and in the required quantities, at the precise time that
they are required.
35
Management and staff are constantly on a Total Quality Management (TQM) and
Management by Objectives (MBO) drive, which ensures:
quality product and service levels to clients;
proactive and accountable staff and departments;
systematic and measurable improvements in internal and external objectives;
improved employee morale through participation in goal setting;
improved clarity on outputs that need to be delivered; and
improved communication at all levels resulting from accountability and the
inclusive nature of goal setting.
TQM describes a situation where all business functions are involved in a process of
continuous quality improvement and MBO entails the communication, implementation and
measurement of strategically decided objectives to all employees of an organisation or
business unit.
4. Management
Despite the growth in earlier years, the profitability has declined during the last few years. In
the last two years, the company has experienced losses, and this has forced management to
rethink the profitability of the business in the long run and to consider strategic changes that
may turn around the current financial losses. Overheads were minimised and supply prices
bargained down. It was only at this point that it was realised that more must be done to save
the company from shutting its doors.
To enable management to make the right decision and decide on the right strategy, they
required more information. The only place that the necessary information could be obtained
from was from the financial statements of the company and from the production floor.
Management believed that costing by intuition or by applying traditional methods was no
longer appropriate. Therefore, they decided to introduce an ABC costing system to the
company. The data required for the ABC system already existed, albeit in a raw unprocessed
form, and the cost to collect all of it would have been be prohibitive for the company.
36
Management decided to use educated guesses, systematic appraisal, and actual data to enable
them to process and formulate the data.
Roztocki (2001: 3) indicates that the following typical situation in a small manufacturing
business may occur:
technical good products and service;
product/service delivered on time;
satisfied customers;
successful growth in the first year; and
unacceptable level of profitability.
The common beliefs are that there are not enough sales, that times are harder due to
economic and compliance climate and the end product are sold for too low a price. The
reality, however, is that:
an increase in sales does not necessarily increase profit;
some products are money makers and other are money losers;
nobody is sure where money is being made and lost; and
a new cost management system is needed to determine the “true” cost for a cost
object to new identify money makers/losers, find an economic break-even point and
compare different options, discover opportunities for cost improvement and improve
strategic decision making.
It is therefore clear that XYZ should implement a cost management system, as the other
known turnaround strategies have been exhausted and management possess “new”
information that will enable them to make decisions. This “new” information consists of real
data that is already available, but this data must first be processed in a manner that will
produce new information. Management experience will be used to fill in the gaps where real
data is not available. This personal-experience-information may not be applicable in a large
or multinational company with both human and financial resources, but is sufficient for a
SMME.
37
5. Summary
XYZ has an AC model in place that was adapted from the previous management. It made use
of a more direct costing model that was to a large extent non-existent and under-utilised.
Figure 3.1
Floor Plan of XYZ Furniture Manufacturers (Pty) Ltd Source: XYZ Management
38
CHAPTER 4 RESEARCH METHODOLOGY
1. Introduction
A research design is a blueprint for conducting a research project. It details the procedure
necessary for obtaining the required information, and its purpose is to design a study that will
test hypotheses or propositions of interest, determine possible answers to the research
questions and provide the information needed for decision-making (Malhotra, 2006:21).
This is an exploratory study, analysing historical or secondary data of XYZ as provided by
management during various interviews and analysis of data, processes and procedures. A
literature survey on costing methods and their application has been conducted (as detailed in
chapter 2).
Both qualitative and quantitative data were used. The qualitative research was subjective in
nature as obtained from the XYZ. The quantitative research determined the quantity and
extents of the outcome in numerical format.
The literature research included information on costing, costing methods, cost accounting,
financial management, short-term decision management, general management, strategic
planning, organisational structure and change management. The quantitative data was
obtained from the company‟s financial statements, management accounts and interviews with
the managing director of the company. The qualitative data was extracted from the financial
statements and management accounts.
The data analysis was done by importing the financial information into a Microsoft Excel
spreadsheet and using its functions to apply both absorption costing and activity-based
costing methods, as will clearly be shown in chapter 5.
2. Research design
The design of this study is based on a combination of the examples provided by Wilks and
Burke (2005:21), Drury (2007:377) and Roztocki‟s online presentation
(www.pitt.edu/~roztocki/abc).
39
The idea is that simple examples of both AC and ABC will be presented in this chapter, and
these will illustrate the basis of both AC and ABC methods. The steps as suggested by Wilks
and Burke (2005:21), Drury (2007:377) and Roztocki (www.pitt.edu/~roztocki/abc) are
combined to illustrate the various steps of a traditional costing approach and thereafter the
more complex process of ABC.
The actual processes and calculations are then applied in chapter 5 by using the XYZ
information on the same basis used by Wilks and Burke (2005:20), Drury (2005:377) and
Roztocki (www.pitt.edu/~roztocki/abc) and as illustrated in the simple examples.
3. Absorption costing (AC)
First the direct costs, consisting of direct materials and direct labour, are assigned to cost
objects. As indicated in chapter 2, cost assignment involves the implementation of suitable
clerical procedures to identify and record the resources consumed by cost objects. For
example, source documents such as time sheets, job cards and materials requisition can be
used to assign the costs.
Assigning the direct cost is a fairly simple process due to the fact that the resources required
can be directly associated with a cost object. The same process applies to both AC and ABC.
With traditional cost accounting or AC, overheads are allocated, assigned or apportioned to
cost objects. Total company overheads are allocated to the products based on volume type
measures, e.g. labour hours/machine hours, due to the assumption that there is a relation
between overheads and the volume-based measure. Through the process of allocation and
apportionment, one can get to an estimated overhead cost for each cost centre/object.
AC EXAMPLE
The following is an example of how AC will be applied.
3.1.1. Direct costs
First the direct cost allocation is allocated, assigned or apportioned. This information is
already available to management and must simply be presented in a required format.
40
There are two products: product A and product B. The demand in units is different and so are
the required direct labour hours. The example uses labour hours, which are then used to
calculate the direct cost per unit. A machine hour is another popular example but often a little
more complex than labour hours. The direct labour cost as provided by management is R20
per hour. Labour hours and then cost per unit will also be used when the overhead absorption
is calculated. The required labour hours for each of the two products are also provided by
management.
Product A - Demand: 100 units
1 hour direct labour
Direct labour cost: 1 hour @ R20/hour = R20.00 per unit
Product B - Demand: 950 units
2 hours direct labour
Direct labour cost: 2 hour @ R20/hour = R40.00 per unit
Product A and Product B
Total Direct Costs: (100 units x R20 per unit) + (950 units x R40 per unit)
= R40,000.00
In other words, the direct cost for Product A is R20 per unit and the direct cost for Product B
is R40 per unit. The total direct cost to manufacture 1,050 units will therefore be R40,000.00
(950 x 40 + 100 x 20).
3.1.2. Overheads
Secondly, the overhead cost allocation is calculated. In the case of a direct cost
apportionment, a percentage would have been allocated to each product or cost object. In this
example, an absorption rate is calculated making use of data already available.
As with direct cost, certain information – the total overheads in this case – is already
available and must now be transformed into decision-making data. The indicated total
41
overheads apply to both Product A and Product B, as both products are manufactured by the
same company. Labour hours will also be used as was done with the direct cost calculations.
First the total direct labour hours are calculated by multiplying the amount of units required
(A: 100 units and B: 950 units) by the total amount of hours required (A: 1 hour and B: 2
hours). The total number of labour hours required is then divided by the total overheads.
Total overheads: R100,000.00
Total direct labour: 2,000 hours (100 x 1 plus 950 x 2)
R100,000.00/2,000 hours = R50/hour
In the case of the overheads there is an allocation of R50 per hour. Product A requires 1 hour
of labour and Product B requires 2 hours of labour. These labour hours required are now
multiplied by the overhead rate of R50 per hour to establish the per unit overhead absorption
rate.
Product A: R50 per unit (1 hour x R50)
Product B: R100 per unit (2 hours x R50)
The AC method of determining and assigning an overhead does however lead to over- or
under-absorption of overhead costs. This happens due to differences between actual labour
hours and the number of hours used to assign the budgeted overhead cost.
As shown in Table 4.1, the total cost for Product A is R70.00 per unit and R140.00 per unit
for Product B.
Product A AC
Overhead R50.00
Direct Cost R20.00
Total R70.00
Product B AC
Table 4.1
Absorption Costing Product Costs
42
Overhead R100.00
Direct Cost R40.00
Total R140.00
Source: Adapted from Roztocki (2001)
As previously shown, the turnover or total cost for the company that manufactured Product A
and Product B were R140,000.00 (R40,000.00 for direct costs and R100,000.00 for
overheads). If the per unit cost of R70.00 for Product A and R140.00 for product B are
multiplied by the required units of 100 for Product A and 950 for product B, then the total
costs are confirmed as R140,000.00.
4. Activity-based costing (ABC)
The idea is now to use the same data that was available during the AC calculations for the
ABC calculations. There are a few aspects that have to be dealt with, however; as can be
expected, ABC is a little more complex than AC.
Roztocki (2001:2) did an internet ABC online presentation and describes two stages in the
ABC model as shown in Figure 4.1.
In the first stage, costs are assigned to cost pools within an activity centre, based on a cost
driver. There is no equivalent step in an AC approach. In the second stage, costs are allocated
from the cost pools to a product based on the product‟s consumption of the activities.
Source: Adapted from Roztocki (2001)
Figure 4.1
Relationship among Expense Categories, Activities and Products
43
Drury (2007:377) outlines four steps involved in designing an ABC system;
identifying the major activities that take place in an organisation;
assigning cost to cost pools/cost centres for each activity;
determining the cost driver for each major activity; and
assigning the cost activities to products according to the product‟s demand for
activities.
Roztocki‟s two stages are the same as Drury‟s steps two and four. Roztocki does not
specifically mention the first and third stages, but are these steps or stages also required and
clearly shown in Figure 4.1.
Roztocki‟s first stage and Drury‟s second step are similar to AC, except that with AC
volume-related characteristics of the product are used exclusively without consideration of
non-volume-related characteristics. Some examples of cost drivers not related to volume
include set-up hours, number of set-ups, ordering hours, and number of orders. Allocating
non-volume-related costs using volume-based methods will distort the product costs and
ABC should be more accurate when non-volume-costs are also incorporated into the
calculations.
For the purposes of XYZ the expenses, activities and products as indicated in Figure 4.1 are
reflected in Figure 4.2. More detail of the expenses, activities and products for the overhead
allocation of XYZ as well as the cost drivers are indicated and discussed in chapter 5.
Source: Adapted from Roztocki (2001)
Figure 4.2
Relationship among Expenses, Activities and Products
44
ABC is a more accurate cost management methodology as it focuses on the
overheads/indirect costs and traces each expense rather than allocate each expense to the
particular cost object. In other words, ABC makes “indirect” expenses “direct”.
According to Roztocki (2001:4), the basic premise is that cost objects consume activities,
activities consume resources, and this consumption of resources is what drives costs.
Understanding this relationship is critical to successfully managing overheads.
ABC EXAMPLE
The following is an example of how ABC will be applied.
4.1.1. Direct costs
As with AC, the direct cost allocation is allocated, assigned or apportioned. This information
is already available to management and must simply be presented in a required format.
There are two products: Product A and Product B. The demand in units is different and so are
the required direct labour hours. The example uses labour hours, which are then used to
calculate the direct cost per unit. The direct labour cost as provided by management is R20
per hour. Labour hours and then cost per unit will also be used when the overhead absorption
is calculated. The required labour hours for each of the two products are also provided by
management.
Product A - Demand: 100 units
1 hour direct labour
Direct labour cost: 1 hour @ R20/hour = R20.00 per unit
Product B - Demand: 950 units
2 hours direct labour
Direct labour cost: 2 hour @ R20/hour = R40.00 per unit
Product A and Product B
Total Direct Costs: (100 units x R20 per unit) + (950 units x R40 per unit)
= R40 000.00
45
In other words, the direct cost for Product A is R20 per unit and the direct cost for Product B
is R40 per unit. The total direct cost to manufacture 1050 units will therefore be R40,000.00
(950 x 40 + 100 x 20).
4.1.2. Overheads
The steps that will be followed in this example are to identify the activities, determine the
cost for each activity, determine cost drivers, assign activities to products and lastly attend to
the calculations to determine the per unit cost.
1. The following major activities that take place in the specific organisation were identified:
Set-up
Machining
Receiving
Packing
Engineering
2. The following costs were determine for each activity:
Set-up R10,000.00
Machining R40,000.00
Receiving R10,000.00
Packing R10,000.00
Engineering R30,000.00
3. The indicated cost drivers were determined for each major activity:
Set-up Number of Set-ups
Machining Machining Hours
Receiving Number of Receipts
Packing Number of Deliveries
Engineering Engineering Hours
46
4. Activities are now assigned to Product A and Product B as per Table 4.2:
Activity Cost Product A Rand Product B Rand
Set-up 10 000.00 1 2,500.00 3 7,500.00
Machining 40 000.00 100 2,000.00 1,900 38,000.00
Receiving 10 000.00 1 2,500.00 3 7,500.00
Packing 10 000.00 1 2,500.00 3 7,500.00
Engineering 30 000.00 500 15,000.00 500 15,000.00
24,500.00 75,500.00
Source: Adapted from Roztocki (2001)
5. Lastly, the information is used to calculate the product cost:
Overhead for Product A: R24,500.00/100 = R245.00
Overhead for Product B: R75,500.00/950 = R79.47
5. Results
The direct cost for AC and ABC is exactly the same as exactly the same data and calculations
were used. The real test will be in relation to the overheads.
As shown in Table 4.3, the results of both AC and ABC are now compared to show why
ABC should assist with decisions, strategy and profits: the information is much more accurate
when compared with the product cost when AC is applied.
Product A AC ABC
Overhead R50.00 R245.00
Direct Cost R20.00 R20.00
Total R70.00 R265.00
Product B AC ABC
Overhead R100.00 R79.47
Table 4.2
Activity Data for Product A and Product B
Table 4.3
AC and ABC Comparison
47
Direct Cost R40.00 R40.00
Total R140.00 R119.47
Source: Adapted from Roztocki (2001)
As shown in Table 4.3, ABC is a more accurate cost management system than AC, as AC is
unable to calculate the true cost of either Product A or Product B as far as the overhead
absorption or allocation is concerned. The per unit cost for Product A is nearly four times
more than AC (R70.00) when ABC (R265.00) is used to calculate the per unit cost.
With Product B there is not an enormous difference between AC and ABC methods if the
rand value is considered, but 950 units are required. This means R133,000.00 is absorbed
when AC is used, but only R113,496.50 when ABC is the applied method, a difference of
nearly R20,000.00.
6. Summary
The step-by-step process was followed and applied to the information furnished.
With the theoretical example used in chapter 4, the basis of AC and ABC was explained and
demonstrated. The results speak for themselves: ABC was shown to be a much more accurate
costing method that allows management to base their decisions on accurate and detailed
costing calculations.
The information and conclusions reached in chapter 4 will now be used in an actual business
with financial statements and other information supplied by management.
48
CHAPTER 5 CASE STUDY
1. Introduction
In the previous chapter the basic approach used for AC and ABC was illustrated by way of a
simple example. In this chapter the actual direct costs and overheads will be applied in a
similar way to calculate the required absorption of direct expenses as well as overheads.
The actual financial results of two consecutive months and other data that is required, which
was obtained from the XYZ management, are presented and will form the basis of the
proposed steps of an AC and ABC costing method.
As was the case in chapter 4 when the design of this study was shown by way of a theoretical
example, the AC calculations will be done first; these will be followed by the ABC
calculations. The calculations are done with the information provided by management and
shown in table form and the process explained with reference to each table.
With both the AC and ABC methods the direct costs calculations were done, whereafter the
overhead calculations and then the results were analysed and at the end the results obtained
through the costing process were compared.
2. Case financial statements
The illustrative actual financial statement analysed for this study is the actual income
statement of XYZ. The income statements for Month 1 and Month 2 are shown as Table 5.1.
These were two consecutive months and reflect an average monthly income when the
income, costs and expenses were compared with the annual financial statements of XYZ.
All the direct expenses as well as all the overheads were indicated, even if the specific item
was zero for the particular month.
49
XYZ FURNITURE MANUFACTURERS (PTY) LTD - MONTHLY INCOME STATEMENT
Month#1 Month#2
INCOME
SALES 362,074.93 382,154.00
Direct Variable Costs 194,212.98 176,085.02
Accessories 17,679.09 17,586.31
Beading / Foil 9,172.29 2,556.64
Board 110,119.23 86,622.06
Glass 1,656.19 489.21
Handles 6,199.51 6,869.93
Mattresses 5,215.61 19,819.70
Packaging 8,654.00 3,373.76
Paint & Sand Paper 35,517.06 37,077.93
Pipes 0.00 1,689.48
Direct Labour 87,598.90 68,119.06
Wages 87,598.90 68,119.06
COST OF SALES 281,811.88 244,204.08
GROSS PROFIT 80,263.05 137,949.92
Gross Profit % 22% 36%
EXPENDITURE 104,393.43 105,018.37
Accounting Fees 0.00 0.00
Advertising 0.00 0.00
Bank Charges 1,692.00 1,420.00
Cleaning & Refreshments 411.00 328.81
Delivery Costs 7,497.39 9,294.80
Electricity, Water & Rates 6,888.00 8,126.89
Entertainment 0.00 0.00
Fuel & Oil 3,340.00 2,480.00
Insurance 4,861.24 4,861.24
Interest 0.00 0.00
Loan Repayment 0.00 0.00
Netstar 116.00 116.00
Printing & Stationery 450.00 778.79
Refuse Removal 1,865.00 2,223.00
Repairs & Maintenance / Machinery 7,932.00 4,563.00
Table 5.1
XYZ Financial Statements for Two Consecutive Months
50
Salaries 60,300.00 59,450.00
Security 0.00 0.00
Telephone / Fax / Postages 4,320.00 4,743.00
Toll Fees 50.00 60.00
Training 0.00 0.00
Travel & Accommodation 0.00 0.00
Truck Repayment 3,054.82 3,054.82
Uniforms 0.00 0.00
Vehicle Expenses/ Repairs 1,021.98 958.02
Miscellaneous Expenses 594.00 2,560.00
TOTAL 386,205.31 349,222.45
NET PROFIT/LOSS BEFORE TAX (24,080.38) 32,991.55
CUMULATIVE PROFIT (24,080.38) 8,911.17
NET PROFIT % -7% 9%
TAXATION @ 29%
NET PROFIT/LOSS AFTER TAX (24,080.38) 32,991.55
Source: XYZ Management
3. Absorption costing (AC)
Not only pure financial information is required. Other information is also required to enable
the calculation of absorption rates, cost per hour, cost per unit etc. This information was
obtained from the XYZ management.
Table 5.2 reflects the number of employees, floor space and other data to enable the
calculation of the absorption rate for the required steps explained and illustrated later on. This
information was available, but never exploited and used in a format to assist management
with decisions to ensure survival, achieve growth and increase profits. Now the information
will be processed to show how useful data, which was always at the disposal of the company,
can be. The same data is also used later on for the ABC calculations.
For the purposes of AC, the business is divided into two divisions/cost objects, namely
manufacturing and distribution. Receiving was another possible cost object, but in the case of
XYZ, its role was insignificant in the bigger scheme and therefore these costs will be
absorbed by manufacturing.
51
Later it is shown that ABC has seven cost pools/divisions, compared with the two of AC.
This should already alert us that more information is required for the ABC cost process, but
ABC will also produce more data and more detailed decision-making information.
With the assistance of management and key employees, the total number of employees, floor
space and direct labour hours are allocated to manufacturing and distribution as reflected in
Table 5.2. Twenty-five of the 30 employees are directly involved with the manufacturing of
the products and only five employees are part of the distribution part of the company. In the
same way, 1,600 square meters of the 2,000 square meters floor space is used for
manufacturing and only 400 square meters for distribution.
Of the 6,210 direct labour hours, 5,175 were used for manufacturing and 1,035 for
distribution. This is information that was supplied by management after their previous
records were examined.
The information as shown in Table 5.2 is applied in Table 5.3.
Absorption Cost
Total Manufacturing Distribution
Number of Employees 30 People 25 5
Floor Space 2,000 M² 1,600 400
Direct Labour Hours 6,210 Hours 5,175 1,035
Work Days Month 1 23 Days 23
Source: XYZ Management
3.1.1. Direct costs
The direct costs are displayed in Table 5.1. The total direct costs for Month 1 amounted to
R281,811.88, and comprised the direct cost (accessories beading / foil, board, glass, handles,
mattresses, packaging, paint & sand, paper, pipes) of R194,212.98 and direct labour (wages)
of R87,598.90.
Table 5.2
Information Obtained from Management
52
The direct material cost of R194,212.98 was allocated to manufacturing only, as distribution
does not absorb any of the direct material costs. In other words, none of the direct materials
were attributable to distribution.
The allocation or distribution of the direct labour cost between manufacturing and
distribution has to be calculated. The calculation for direct labour made use of the total labour
hours of 6,210, supplied by management (Table 5.2). Yet again, this is information
management had, but never utilised to its fullest extent. The calculation for the manufacturing
portion of the direct labour was done with the information in Table 5.1 and Table 5.2 and
reflected in Table 5.3. The calculation is as follows:
5,175 / 6,210 x R87,598.90 = R72,999.08
The result after the distribution portion calculation was R14,599.82.
The prime cost for both manufacturing and distribution is also indicated in Table 5.3. The
overhead absorption rate was also calculated and displayed in Table 5.3 and will be used to
compare with the forecasted absorption rate and ABC absorption rate later on. The overhead
absorption rate was R16.80. This rate will specifically be used to calculate the Month 2
forecast. The total overheads (R104,343.43) was divided by the total labour hours
(6,210). The overhead absorption rate for manufacturing and distribution is calculated on the
same basis, and the rate can be used by management to test rates of previous months or to
forecast future overheads for a specific expense in either manufacturing and/or distribution.
Source: XYZ Management
Table 5.3
Month 1 Direct Cost and Absorption Rate
Direct Cost and Absorption Total Manufacturing Distribution
Direct Material 194,212.98 194,212.98 -
Direct Labour 87,598.90 72,999.08 14,599.82
Prime Cost 281,811.88 267,212.06 14,599.82
Overhead 104,343.43 72,168.99 32,174.44
Direct Labour Hours 6,210.00 5,175.00 1,035.00
Overhead Absorption Rate 16.80 13.95 31.09
53
3.1.2. Overheads
It will be noted from Table 5.4 that the overheads/expenses have been categorised into 15
types of expenses. The information was obtained from Table 5.1 and the various expenses
were allocated under the type of overhead item they constitute. For example, “Toll Fees”
were added to “Fuel & Oil”. Furthermore, only the expenses or overheads that were actually
incurred are indicated. In other words, no overhead with a zero balance is indicated.
In the same way as the direct costs were allocated to distribution and manufacturing, the
overheads are allocated in Table 5.4.
Actual Costs - Month 1
Overhead Item Total Manufacturing Distribution
Bank Charges 1,692.00 Labour Hours 1,410.00 282.00
Cleaning & Refreshments 411.00 Floor Space 328.80 82.20
Delivery Costs 7,497.39 Allocation - 7,497.39
Electricity, Water & Rates 6,888.00 Floor Space 5,510.40 1,377.60
Fuel, Oil & Toll 3,340.00 Allocation - 3,340.00
Insurance 4,861.24 Floor Space 3,888.99 972.25
Netstar 116.00 Allocation - 116.00
Printing & Stationery 450.00 Labour Hours 360.00 90.00
Refuse Removal 1,865.00 Allocation - 1,865.00
Repairs & Maintenance / Machinery 7,932.00 Floor Space 6,345.60 1,586.40
Salaries 60,300.00 Labour Hours 50,250.00 10,050.00
Telephone / Fax / Postages 4,320.00 Labour Hours 3,600.00 720.00
Truck Repayment 3,054.82 Allocation - 3,054.82
Vehicle Expenses/ Repairs 1,021.98 Allocation - 1,021.98
Miscellaneous Expenses 594.00 Floor Space 475.20 118.80
104,343.43 72,168.99 32,174.44
Source: XYZ Management
The overhead is allocated to either manufacturing or distribution. This absorption by one of
the two sections of the business may either indicate that the total overhead is absorbed (e.g.
“Delivery Costs”) or as a percentage by making use of the allocations referred to in Table
5.2. For example, “Electricity, Water & Rates” is divided between the two sections by using
the total floor space of 2,000 m² and dividing the floor space used by either manufacturing
Table 5.4
Month 1 Overheads
54
(1,600 m²) or distribution (400 m²) through the total floor space (1 600/2 000 or 400/2 000)
to calculate the relationship or percentage of the actual overhead it will absorb. “Cleaning &
Refreshments” for distribution is calculated as follows:
400 / 2,000 x R411.00 = R82.20
Note that the total overheads of R104,343.43 remain the same as in the actual financial
statements of Month 1 reflected in Table 5.1.
The various overheads/expenses shown in Table 5.4 are now displayed in Figure 5.1 to
reflect in a more visual way how the overheads are allocated to the various expenses. As is
the case with most businesses, salaries are the biggest portion of the monthly overheads.
Source: Table 5.4
Figure 5.1
Pie Chart of Overheads Absorbed
55
3.1.3. Forecast
In Table 5.5 the forecasted overheads for Month 2 are calculated from the Month 1 actual
overhead absorption rates.
The overhead absorption rate of R16.80 is multiplied by the expected labour hours of 5,670,
which produced the forecasted overhead for Month 2 as R95,270.09. The same formula is
used to calculate the manufacturing and distribution absorption rate for Month 2, being
R65,893.43 and R29,376.66, respectively. The labour hours and work days are the major
difference when compared with Month 1, or any other month for that matter, whereafter the
actual costs are used to see whether there is a under- or over-absorption.
Forecasted Overhead for Month 2 Total Manufacturing Distribution
Number of Employees 30 People 25 5
Floor Space 2,000 M² 1,600 400
Direct Labour Hours 5,670 Hours 4,725 945
Units Produced/Handled
Work Days Month 2 21 Days 21
Forecasted Overhead 95,270.09 65,893.43 29,376.66
Source: Table 5.2 and Excel Calculations
The actual costs for Month 2 are now extrapolated in exactly the same way as done with the
Month 1 actual costs, displayed in Table 5.3.
It can be calculated whether there is an over- or under-absorption. The forecasted overhead of
R95,270.09 is compared with the actual overhead of R104,958.37.
In the same way, the prime cost absorption rate can be calculated, which can then be
compared with the actual cost for Month 2. However, these calculations are not applicable for
the purposes of AC, as only the overheads absorption is shown. This is because the direct
labour and direct material can easily be allocated to manufacturing, distribution, or any other
cost object, as the case may be.
Table 5.5
Month 2 Forecasted Overhead
56
3.1.4. Comparative analysis
Table 5.6 indicates the AC results with the actual financial results achieved in Month 2
Source: XYZ Management
As reflected in Table 5.7, an under-absorption of R9,688.28 has occurred, which indicates
that the actual total overhead of R104,958.37 incurred is higher than the forecasted overheads
of R95,270.09 for the specified period (Month 2). The percentage difference between the
forecasted overheads and actual overheads can be ascribed to various disbursements,
including the difference in uncontrollable miscellaneous costs.
Actual Costs - Month 2
Overhead Item Total Manufacturing Distribution
Bank Charges 1,420.00 Labour Hours 1,183.33 236.67
Cleaning & Refreshments 328.81 Floor Space 263.05 65.76
Delivery Costs 9,294.80 Allocation - 9,294.80
Electricity, Water & Rates 8,126.89 Floor Space 6,501.51 1,625.38
Fuel, Oil & Toll 2,480.00 Allocation - 2,480.00
Insurance 4,861.24 Floor Space 3,888.99 972.25
Netstar 116.00 Allocation - 116.00
Printing & Stationery 778.79 Labour Hours 648.99 129.80
Refuse Removal 2,223.00 Allocation - 2,223.00
Repairs & Maintenance / Machinery 4,563.00 Floor Space 3,650.40 912.60
Salaries 59,450.00 Labour Hours 49,541.67 9,908.33
Telephone / Fax / Postages 4,743.00 Labour Hours 3,952.50 790.50
Truck Repayment 3,054.82 Allocation - 3,054.82
Vehicle Expenses/ Repairs 958.02 Allocation - 958.02
Miscellaneous Expenses 2,560.00 Floor Space 2,048.00 512.00
Overhead Incurred 104,958.37 71,678.44 33,279.93
Forecasted Overhead 95,270.09 65,893.43 29,376.66
Table 5.6
Month 2 Comparative Results of Forecasted and Actuals
Month 2 - Results (AC)
Total Manufacturing Distribution
Forecasted Overhead 95,270.09 65,893.43 29,376.66
Actual Overhead 104,958.37 71,678.44 33,279.93
Over/(Under) Absorbed (9,688.28) (5,785.02) (3,903.27)
Total Absorption Error (9,688.28)
Table 5.7
Month 2 Actual Costs with Under Absorption
57
Actual Overhead 104,958.37 71,678.44 33,279.93
Over/(Under) Absorbed (9,688.28) (5,785.02) (3,903.27)
Total Absorption Error (9,688.28)
Source: Excel Calculations
Management must consider this factor for short-term and long-term decision making so as to
ensure that the profit reflected on the income statement is not distorted.
4. Activity-based costing (ABC)
As indicated in this study, ABC is a much more accurate methodology, but also more
complex than AC.
4.1.1. Direct costs
The process and products were simplified, as is illustrated with the chosen cost pools and cost
drivers hereunder. For instance, as seen on the XYZ floor plan (Figure 3.1) and under the
cost pools, the cutting, CNC and foiling processes have been combined to represent
“manufacturing” or “machining” as referred to in the ABC financial analysis later in this
chapter.
XYZ manufactures in access of 50 products. For purposes of both costing models, the
different products have been simplified and consolidated into only four products, namely:
Baby
Children
Adult
Office
The activity cost pools that were identified with the help of management are:
Receiving
Parts Manufacturing/Machining (Cutting, CNC and Foiling)
Sanding
Spray Painting
Assembling
58
Quality Control
Delivering
With XYZ the cost drivers were linked to the different activities based on customer orders,
part per unit, number of parts and number of units as illustrated in Figure 5.2.
COST POOLS COST DRIVERS
Receiving Customers Orders
Manufacturing Parts per Unit
Sanding Number of Parts
Spray Painting Number of Parts
Assembly Parts per Unit
Quality Control Customer Orders
Delivery Number of Units
Source: XYZ Management
The actual output in units for each of the four products, for Month 1, is indicated in
Table 5.8. These figures were obtained from management. Previously these figures were
used to indicate profits. In other words, the more units manufactured, the more profit will be
made. This is a direct costing method with certain absorption elements. This remains a very
elementary indication and may not be accurate at all. Management must also know what the
direct costs and overheads are for each product to be able to access profitability and do
forecasts.
Output in Units
Baby Children Adult Office Total
63 52 28 15 158
Source: XYZ Management
The percentage or absorption rate for each product related to each cost pool is indicated in
Table 5.9. Again, this is information that was easily obtainable by management due to their
years of experience with XYZ and with previous similar businesses. They never obtained the
Figure 5.2
Cost Pools and Cost Drivers
Table 5.8
Month 1 Output in Units
59
information as they did not know how to analyse the data or even realise that it could be of
value.
The seven cost pools were extrapolated from the financial information in Table 5.1 and are
shown in Figure 5.2.
For example, in the cost pool “Accessories”, the baby product absorbed 30% of the total
accessories that were used for manufacturing. Also no “Pipes” are used for the baby products
as these products are all spray painted and, for safety reasons, no “Glass” is used.
Unit Level Direct Cost Absorption Rate
Baby Children Adult Office
Accessories 30% 20% 15% 35%
Beading / Foil 30% 35% 20% 15%
Board 20% 25% 25% 30%
Glass 0% 20% 30% 50%
Handles 30% 30% 20% 20%
Mattresses 50% 40% 10% 0%
Packaging 25% 25% 25% 25%
Paint & Sand Paper 30% 35% 35% 0%
Pipes 0% 30% 30% 40%
Labour 40% 40% 10% 10%
Source: XYZ Management
The indicated percentages/absorption rates of Table 5.9 were used to calculate a per unit rate
for each of the cost pools. As an example, 30% of all the pipes are used for the adult range.
When 30% percent is multiplied by the total units manufactured (28) (Table 5.8), a unit ratio
of 8.40 (Table 5.10) is calculated. There is no unit cost for the office products pertaining to
“Mattresses”, as these are not used in the manufacturing of office products.
Per Unit Rate
Baby Children Adult Office Total
Accessories 18.90 10.40 4.20 5.25 38.75
Table 5.9
Month 1 Unit Absorption Rate
Table 5.10
Month 1 Per Unit Rate
60
Beading / Foil 18.90 18.20 5.60 2.25 44.95
Board 12.60 13.00 7.00 4.50 37.10
Glass - 10.40 8.40 7.50 26.30
Handles 18.90 15.60 5.60 3.00 43.10
Mattresses 31.50 20.80 2.80 - 55.10
Packaging 15.75 13.00 7.00 3.75 39.50
Paint & Sand Paper 18.90 18.20 9.80 - 46.90
Pipes - 15.60 8.40 6.00 30.00
Labour 25.20 20.80 2.80 1.50 50.30
Total 160.65 156.00 61.60 33.75 412.00
Source: XYZ Management and Excel Calculations
The above rate does not include the actual cost of each direct material used or direct labour
amount. In Table 5.11 the unit rates in Table 5.10 are used to calculate a weighted average
absorption rate of the direct materials and direct labour. Now the costs, units and percentage
absorption for each product have been taken into account. Again, there will be no percentage
if the specific cost is not used towards manufacturing the product.
Weighted Absorption Rate
Baby Children Adult Office
Accessories 49% 27% 11% 14%
Beading / Foil 42% 40% 12% 5%
Board 34% 35% 19% 12%
Glass 0% 40% 32% 29%
Handles 44% 36% 13% 7%
Mattresses 57% 38% 5% 0%
Packaging 40% 33% 18% 9%
Paint & Sand Paper 40% 39% 21% 0%
Pipes 0% 52% 28% 20%
Direct Labour 50% 41% 6% 3%
Source: Excel Calculations
The weighted amount absorbed by direct costs and direct labour is now calculated from the
Month 1 financial statements and multiplied by the calculated weighted absorption rates.
The weighted absorption rate (Table 5.11) is now multiplied by the direct/prime costs,
namely, direct material and direct labour, for each of the four products shown in the financial
Table 5.11
Month 1 Weighted Absorption Rate
61
statements of XYZ (Table 5.1) to obtain the weighted amount absorbed of the direct material
and direct labour.
The direct labour is a total of R87,598.90 (Table 5.1 and Table 5.12). By applying the
weighted absorption percentage of 41% (Table 5.11) for the Children products as indicated
in Table 5.11, an amount of R36,223.80 (Table 5.12) will be absorbed of the total direct
costs of R87,598.90 (Table 5.1 and Table 5.12).
The total direct costs of R194,212.98 are again reflected. This amount must always be the
same for purposes of Month 1 to ensure accurate calculations when forecasts are done.
Weighted Amount Absorbed of Direct Costs and Direct Labour
Baby Children Adult Office Total
Accessories 8,622.83 4,744.84 1,916.19 2,395.23 17,679.09
Beading / Foil 3,856.65 3,713.81 1,142.71 459.12 9,172.29
Board 37,398.98 38,586.25 20,777.21 13,356.78 110,119.23
Glass - 654.92 528.97 472.30 1,656.19
Handles 2,718.58 2,243.91 805.50 431.52 6,199.51
Mattresses 2,981.70 1,968.87 265.04 - 5,215.61
Packaging 3,450.65 2,848.15 1,533.62 821.58 8,654.00
Paint & Sand Paper 14,312.85 13,782.74 7,421.48 - 35,517.06
Pipes - - - - -
Direct Costs 73,342.23 68,543.49 34,390.72 17,936.54 194,212.98
Direct Labour 43,886.53 36,223.80 4,876.28 2,612.29 87,598.90
Total 117,228.76 104,767.29 39,267.00 20,548.83 281,811.88
Source: Excel Calculations
The direct costs as reflected in Table 5.12 are also shown in graph form in Figure 5.3. It is
interesting to note that the baby products absorbed approximately 38% of the direct costs,
while the office products absorbed only about 9%. However, the baby products (63)
produced the most units and office products (15) the least (Table 5.8).
Table 5.12
Month 1 Weighted Amount Absorbed of Direct Costs and Direct Labour
62
Source: Table 5.11
Table 5.13 is a summary of the direct costs calculations shown in Tables 5.8 to 5.12. Table
5.13 also reflects the direct/prime cost per unit and the labour hours per unit.
Summary Baby Children Adult Office Total
Output in Units 63 52 28 15 158
Direct Costs
Direct Material 73,342.23 68,543.49 34,390.72 17,936.54 194,212.98
Direct Labour 43,886.53 36,223.80 4,876.28 2,612.29 87,598.90
Prime Cost 17,228.76 104,767.29 39,267.00 20,548.83 281,811.88
Direct Cost per Unit
Direct Material 1,164.16 1,318.14 1,228.24 1,195.77 1,229.20
Direct Labour 696.61 696.61 174.15 174.15 554.42
Prime Cost per Unit 1,860.77 2,014.76 1,402.39 1,369.92 1,783.62
Labour Hours 3,111 2,568 346 185 6,210
Labour Hours per Unit 49.38 49.38 12.35 12.35 39.30
Source: Tables 5.8 to 5.12
4.1.2. Overheads
Up to now the analysis has dealt with the direct/prime costs. The necessary calculations were
done that will later be used together with other data to forecast the Month 2 prime cost.
First we have to attend to and discuss the cost pools. The cost pools were identified and the
cost pools and their associated cost drivers listed in Figure 5.2.
Figure 5.3
Direct Costs Allocated Pie Chart
Table 5.13
Month 1 Summary of Direct Costs Allocation
63
It was calculated by management and key personnel that the various cost pools use the
percentage of the specific overhead as indicated in Table 5.14. These percentages were
obtained from management, who in turn collected the data by way of physical measurements
and consultation with production staff.
The percentage as indicated in Table 5.14 that corresponds to each cost pool is multiplied by
the total overhead expense of Month 1 to derive the indicated figures that will be used to
calculate the activity-based costing. For instance, “Sanding” will absorb 13% of the total
overhead cost of R104,393.43, and an amount of R13,571.15 is therefore allocated as an
overhead expense for “Sanding”. The same applies to the other cost pools.
Again it is noticeable that the total overhead cost remains R104,393.43, as was shown in
Table 5.1 and other tables. This amount cannot change and must remain the same, as it is an
actual cost of XYZ and can always be used to ensure that calculations and apportionments
were done correctly.
Cost Pools Percentage of Overheads Amount of Overheads
Receiving 2% 2,087.87
Parts Manufacturing 35% 36,537.70
Sanding 13% 13,571.15
Spray Painting 25% 26,098.36
Assembling 15% 15,659.01
Quality Control 5% 5,219.67
Delivering 5% 5,219.67
Total 100% 104,393.43
Source: XYZ Management and Table 5.2
The various overheads have now all been allocated to one of the cost pools by applying the
percentage as reflected in Table 5.14.
Note that the individual overhead costs as reflected in the financial statements (Table 5.1) or
as used by the absorption costing methodology are not applicable. Instead, seven cost pools
for XYZ are used, and this will vary from business to business. Instead of using a specific
overhead, for example “Repairs & Maintenance”, the percentage of a cost pool in relation to
Table 5.14
Cost Pools, Overhead Percentage and Amounts
64
the total overheads is used. Therefore it is again realised that the end results will be different
and provide more data for management decision making.
The cost drivers as identified (Figure 5.2) with the help of management and key employees
are shown in Table 5.15. The overhead absorption percentage is also indicated in brackets
and was discussed with reference to Table 5.14. These percentages are obtained from
management, who in turn have collected the data by way of physical measurements and
consultation with production staff. In the case of XYZ, four types of cost drivers were
identified. They were customer orders, parts per unit, parts, and number of units. It will be
noted that some cost pools have the same cost driver.
Cost Pools Overhead Absorption Amount Cost Drivers
Receiving (2%) 2,087.87 Number of Customer Orders
Parts Manufacturing/Machining (35%) 36,537.70 Number of Parts per Unit
Sanding (13%) 13,571.15 Number of Parts
Spray Painting (25%) 26,098.36 Number of Parts
Assembling (15%) 15,659.01 Number of Parts per Unit
Quality Control (5%) 5,219.67 Number of Customer Orders
Delivering (5%) 5,219.67 Number of Units
104,393.43
Source: XYZ Management and Table 5.3
Now amounts for the various cost drivers must be allocated with the assistance of
management. In Table 5.16 the actual number of customer orders is shown as part of the
“receiving” cost pool and thereafter the actual number of parts per unit, number of parts and
number of units for each of the four products/cost objects are indicated.
Cost Pools Cost Drivers Baby Children Adult Office Total
Receiving Number of Customer Orders 63 52 28 15 158
Parts Manufacturing/Machining Parts per Unit 63 70 53 48 234
Sanding Parts 47 58 10 0 115
Spray Painting Parts 47 58 10 0 115
Assembling Parts per Unit 63 70 53 48 234
Quality Control Number of Customer Orders 63 52 28 15 158
Delivering Number of Units 58 42 23 8 131
Source: XYZ Management
Table 5.15
Cost Pools, Cost Drivers and Overhead Absorption Rate
Table 5.16
Cost Drivers Allocations
65
In Table 5.17 the actual amounts and the calculated cost pool percentages of Month 1
overheads are calculated. For example, the Baby Receiving is calculated by dividing the
number of customer orders (63), by the total number of orders (158) ( as indicated in Table
5.16), and then multiplied by the cost pool amount (R2,087.87) (Table 5.15):
63/158 x R2 087.87=R832.50
or
R2 087.87/158 x 63=R832.50
Overhead Absorption Rate Baby Children Adult Office Total
Receiving 832.50 687.15 370.00 198.22 2,087.87
Parts Manufacturing/Machining 14,568.83 12,025.07 6,475.04 3,468.77 36,537.70
Sanding 5,411.28 4,466.45 2,405.01 1,288.40 13,571.15
Spray Painting 10,406.31 8,589.33 4,625.03 2,477.69 26,098.36
Assembling 6,243.78 5,153.60 2,775.02 1,486.62 15,659.01
Quality Control 2,081.26 1,717.87 925.01 495.54 5,219.67
Delivering 2,081.26 1,717.87 925.01 495.54 5,219.67
Total 41,625.23 34,357.33 18,500.10 9,910.77 104,393.43
Source: XYZ Management and Excel Calculations
The overheads allocated for each of the cost drivers are graphically displayed in Figure 5.4.
The “baby” product absorbed the largest portion of the overheads and the “office” product the
least.
It can be noted that the direct cost absorption rate shown in Figure 5.3 when AC overhead
absorption was calculated has a similar absorption rate to the ABC overhead absorption rate
displayed in Figure 5.4.
As with the AC costing method, the baby products (R41,625.23) absorbed the most
overheads, whereas the office products (R9,910.77) absorbed the least. The baby products
were 40% of the total overheads, the children 33%, the adult 18% and the office 9%.
Table 5.17
Month 1 Overhead Absorption Rate
66
Source: Table 5.17
The information used in Figure 5.4 is also used in Figure 5.5 to show how the overhead cost
of the various cost pools is distributed.
Manufacturing/machining is the most expensive overhead cost, as it absorbed R36,537.70 of
the total overheads of R104,393.43. This is approximately 35% of the total overheads. The
least absorption of overheads occurred with receiving (R2,087.87), which equates with 2%
of the total overheads. The other cost pools‟ absorption rates are indicated in Table 5.16.
Source: Table 5.16
In Table 5.19, a summary of all the data collected and calculated above is shown. First the
labour hours must be calculated and assigned to reflect certain absorption rates in Table 5.19.
Figure 5.4
Overheads Allocated to Products
Figure 5.5
Overheads Allocated to Cost Pools
67
The calculation of the labour hours is explained in Table 5.18 and the labour hours for each
of the cost objects are indicated. A total of 6,210 labour hours have been assigned. The total
labour hours are calculated with information furnished by management and reflected in Table
5.18. There were 23 working days in Month 1, as indicated in Table 5.2. The 30 employees
worked an average of 9 hours on each of these 23 days, during which they manufactured the
number of units for each of the four products as indicated in Table 5.12.
The calculation for the children‟s products will be:
(23 x 30 x 9) x (52 / 158) = 2,044 hours
Labour Hours per Total Units Manufactured
Baby Children Adult Office Total
2,476 2,044 1,101 590 6,210
Source: XYZ Management
The results in Table 5.18 are now extrapolated to calculate the Month 1 overhead absorption
rate per direct labour hour that forms part of the summary in Table 5.19.
In Table 5.19 the output in units, labour hours, labour hours per unit, prime cost and
overheads for the four cost objects/products and the total is indicated. The direct cost per unit
and the overhead absorption rate per unit are also calculated and reflected.
To calculate the production cost per unit the total direct and overhead costs are divided by the
output per units to calculate the production cost per unit. An example with the baby product
is:
158,853.99 / 63 = 2,521.49
The overhead absorption per direct labour, again for all four of the products and the total, is
also displayed. The prime cost per unit, overhead absorption per unit, production cost per
unit, overhead absorption per hour, direct material cost per hour, direct labour cost per hour
and prime cost per hour is shown and later on will be used to compare with Month 2 actual
costs and Month 2 forecasted costs. (See Table 5.22 and Table 5.24.)
Table 5.18
Month 1 Labour Hours Required for Total Units Manufactured
68
Summary Baby Children Adult Office Total
Output in Units 63 39 28 15 158
Labour Hours 3,111 2,568 346 185 6,210
Labour Hours per Unit 49.38 49.38 12.35 12.35 39.30
Direct Costs
Direct Material 73,342.23 68,543.49 34,390.72 7,936.54 194,212.98
Direct Labour 43,886.53 36,223.80 4,876.28 2,612.29 87,598.90
Prime Cost 17,228.76 104,767.29 39,267.00 20,548.83 281,811.88
Direct Cost per Unit
Direct Material 1,164.16 1,318.14 1,228.24 1,195.77 1,229.20
Direct Labour 696.61 696.61 174.15 174.15 554.42
Prime Cost per Unit 1,860.77 2,014.76 1,402.39 1,369.92 1,783.62
Overhead
Receiving 832.50 687.15 370.00 198.22 2,087.87
Parts Manufacturing/Machining 14,568.83 12,025.07 6,475.04 3,468.77 36,537.70
Sanding 5,411.28 4,466.45 2,405.01 1,288.40 13,571.15
Spray Painting 10,406.31 8,589.33 4,625.03 2,477.69 26,098.36
Assembling 6,243.78 5,153.60 2,775.02 1,486.62 15,659.01
Quality Control 2,081.26 1,717.87 925.01 495.54 5,219.67
Delivering 2,081.26 1,717.87 925.01 495.54 5,219.67
Overhead Absorption 41,625.23 34,357.33 18,500.10 9,910.77 104,393.43
Overhead Absorption per Unit 660.72 818.03 840.91 991.08 762.00
Prime Cost + Overhead
(Production) 158,853.99 39,124.62 57,767.10 30,459.60 386,205.31
Production Cost per Unit 2,521.49 2,675.47 2,063.11 2,030.64 2,444.34
Prime Cost per Unit 1,860.77 2,014.76 1,402.39 1,369.92 1,783.62
Overhead Absorption per Unit 660.72 818.03 840.91 991.08 762.00
Production Cost per Unit 2,521.49 2,675.47 2,063.11 2,030.64 2,444.34
Overhead Absorption per Hour 11.12 17.02 54.95 101.26 46.09
Direct Material Cost per Hour 23.57 26.69 99.49 96.86 31.27
Direct Labour Cost per Hour 14.11 14.11 14.11 14.11 14.11
Prime Cost per Hour 37.68 40.80 113.59 110.96 45.38
Source: XYZ Management
Table 5.19
Month 1 Summary
69
The total overhead absorption per product is now indicated and divided by the number of
units to display the overhead absorption rate per unit, as well as the overhead absorption rate
per hour. The production cost is also indicated, and is the total of the overhead absorption and
the prime cost. With this amount the production cost per unit can be calculated. Note that the
total amounts will always correspond with the total amounts reflected in the financial
statements for Month 1.
4.1.3. Forecast
The Month 1 totals will now be used to forecast Month 2. The total units to be produced were
forecasted as 165 (Table 5.20). The information was obtained from management, who
forecasted the amount based on previous annual production figures as well as prevailing
market conditions.
Direct materials and direct labour were calculated by multiplying the units to be produced by
the per unit direct cost that was initially shown in Table 5.12 and summarised in Table 5.13.
For example, 30 Adult units are to be produced. This amount is now multiplied by the direct
labour cost of R1,228.24.
30 x R1,228.24 = R36,847.2
Direct labour was calculated in the same way. For example, Office units totalling R2,612.29,
calculated as follows:
R174.15 x 15 = R2,612.29
The prime cost consisting of direct labour and direct materials were then calculated as well
and depicted in Table 5.20. Again the total prime costs of R294,382.48 will later be
compared with the actual prime costs of Month 2.
70
Source: XYZ Management
Overheads were calculated by using the same formula as when the direct cost was calculated.
The specific cost pool amount for Month 1 was divided by the number of units produced for
the product in Month 1, and thereafter multiplied by the number of units forecasted in Month
Table 5.20
Month 2 Forecast
Month 2 Forecast
Baby Children Adult Office Total
Units to be Produced 65 55 30 15 165
Labour Hours 2,234 1,890 1,031 515 5,670
Labour Hours per Unit 34.36 34.36 34.36 34.36 34.36
Direct Costs
Direct Material 75,670.56 72,497.92 36,847.20 17,936.54 202,952.22
Direct Labour 45,279.75 38,313.63 5,224.59 2,612.29 91,430.26
Prime Cost 120,950.31 110,811.55 42,071.79 20,548.83 294,382.48
Overhead
Receiving 858.93 899.83 504.55 297.32 2,560.64
Parts Manufacturing/Machining 15,031.33 15,747.11 8,829.59 5,203.15 44,811.19
Sanding 5,583.07 5,848.93 3,279.56 1,932.60 16,644.16
Spray Painting 10,736.67 11,247.94 6,306.85 3,716.54 32,007.99
Assembling 6,442.00 6,748.76 3,784.11 2,229.92 19,204.80
Quality Control 2,147.33 2,249.59 1,261.37 743.31 6,401.60
Delivering 2,147.33 2,249.59 1,261.37 743.31 6,401.60
Overhead Absorption 42,946.66 44,991.74 25,227.41 14,866.15 128,031.97
Prime Cost + Overhead
(Production) 163,896.97 155,803.30 67,299.20 35,414.98 422,414.45
Production Cost per Unit 2,521.49 2,832.79 2,243.31 2,361.00 2,560.09
Prime Cost per Unit 1,860.77 2,014.76 1,402.39 1,369.92 1,784.14
Overhead Absorption per Unit 660.72 818.03 840.91 991.08 660.72
Production Cost per Unit 2,521.49 2,832.79 2,243.31 2,361.00 3,083.32
Overhead Absorption per Hour 13.80 17.52 72.98 80.28 20.62
Direct Material Cost per Hour 33.88 38.36 35.74 34.80 35.79
Direct Labour Cost per Hour 20.27 20.27 5.07 5.07 16.13
Prime Cost per Hour 54.15 56.63 40.81 39.87 51.92
71
2 for each product. Therefore, the “Assembling” for Month 1 in the amount of R6,243.78 was
divided by 63, which are the units produced for the baby product, and multiplied by 65,
which is the forecasted number of units for Month 2. The total forecasted amount for
“Assembling” in Month 2 equals R6,442.00.
The total forecasted overheads of R128 031.97 will later be compared with the actual
overheads of Month 2.
The aggregate of the total prime cost and overheads is the production costs and amounted to
R422 414.45. This amount was divided by the total number of units forecasted for Month 2
(165) to indicate an average per unit production cost of R2 560.09. The per unit production
cost for each unit is specifically indicated to compare it with previous and future per unit
production cost.
The prime cost per unit, overhead absorption per unit, production cost per unit, overhead
absorption per hour, direct material cost per hour, direct labour cost per hour and prime cost
per hour were also calculated. These results will be compared with the actual amounts
achieved in Month 2. (See Table 5.22.)
4.1.4. Comparative analysis
To enable a proper analysis and comparison of the Month 2 forecasted absorption versus the
Month 2 actual cost, the prime cost, overheads and production cost had to be calculated by
way of activity-based costing methodology and the Month 2 actual results.
The output in units was not altered to take account of the change in amounts when the actual
cost is used. The calculations were exactly the same as when the costs and overheads were
calculated for Month 1 (see Tables 5.8 to 5.17). The percentage of overheads for each of the
cost pools remained at the indicated percentages (Table 5.21). The total prime costs and total
overheads are the same amounts as reflected in the Month 2 financial statements:
R244,204.00 and R105,018.37 respectively. The production cost is R349,222.45.
72
Month 2 Actuals
Percentage of Overheads Amount of Overheads
Receiving 2% 2,100.37
Parts Manufacturing 35% 36,756.43
Sanding 13% 13,652.39
Spray Painting 25% 26,254.59
Assembling 15% 15,752.76
Quality Control 5% 5,250.92
Delivering 5% 5,250.92
Total 100% 105,018.37
Summary Baby Children Adult Office Total
Output in Units 65 55 30 15 165
Labour Hours 2,261 1,866 1,005 538 5,670
Labour Hours per Unit 34.78 33.93 33.49 35.89 34.36
Direct Costs
Direct Material 69,701.71 62,647.05 29,443.02 14,293.24 176,085.02
Direct Labour 34,127.24 28,168.52 3,791.92 2,031.38 68,119.06
Prime Cost 103,828.95 90,815.56 33,234.94 16324.62 244,204.08
Direct Cost per Unit
Direct Material 1,072.33 1,139.04 981.43 952.88 1,067.18
Direct Labour 525.03 512.15 126.40 135.43 412.84
Prime Cost per Unit 1,597.37 1,651.19 1,107.83 1,088.31 1,480.02
Overhead
Receiving 827.42 700.12 381.88 190.94 2,100.37
Parts Manufacturing/Machining 14,479.81 12,252.14 6,682.99 3,341.49 36,756.43
Sanding 5,378.21 4,550.80 2,482.25 1,241.13 13,652.39
Spray Painting 10,342.72 8,751.53 4,773.56 2,386.78 26,254.59
Assembling 6,205.63 5,250.92 2,864.14 1,432.07 15,752.76
Quality Control 2,068.54 1,750.31 954.71 477.36 5,250.92
Delivering 2,068.54 1,750.31 954.71 477.36 5,250.92
Overhead Absorption 41,370.87 35,006.12 19,094.25 9,547.12 105,018.37
Overhead Absorption per Unit 636.47 636.47 636.47 636.47 2,545.90
Prime Cost + Overhead
(Production) 145,199.83 125,821.69 52,329.19 25,871.75 349,222.45
Production Cost per Unit 2,233.84 2,287.67 1,744.31 1,724.78 7,990.60
Table 5.21
Month 2 Actuals
73
Prime Cost per Unit 1,597.37 1,651.19 1,107.83 1,088.31 1,480.02
Overhead Absorption per Unit 636.47 636.47 636.47 636.47 636.47
Production Cost per Unit 2,233.84 2,287.67 1,744.31 1,724.78 2,116.50
Overhead Absorption per Hour 18.30 18.76 19.00 17.74 18.52
Direct Material Cost per Hour 30.83 33.57 29.30 26.55 31.06
Direct Labour Cost per Hour 15.10 15.10 3.77 3.77 12.01
Prime Cost per Hour 45.93 48.67 33.08 30.33 43.07
Source: XYZ Management
The total overhead absorption amount of R128,031.97 was compared with the actual
overhead of R105,018.37, and the actual total cost incurred of R349,222.45 was compared
with the forecasted overhead of R422,414.45, as shown in the financial statements of XYZ
(Table 5.1).
By making use of ABC the prime cost forecasted was under-absorbed by R50,178.40 and the
overheads were under-absorbed by R23,013.60. A total forecast error of R73,192.00 was
made.
The Month 2 forecasted results are compared with the actual results achieved. In Table
5.22.the prime cost, overheads and totals of the forecasted and the actual amounts are
reflected.
Month 2 - Comparative Results (ABC)
Prime Cost Forecasted 294,382.48
Actual Prime Cost 244,204.08
Prime Cost Over/(Under) Absorbed (50,178.40)
Overhead Forecasted 128,031.97
Actual Overhead 105,018.37
Overhead Over/(Under) Absorbed (23,013.60)
Forecasted Overhead 422,414.45
Actual Total Cost Incurred 349,222.45
Total Forecast Error (73,192.00)
Source: Tables 5.21 and 5.22
This under-absorption indicated in Table 5.22 may be the consequence of various factors. As
the actual costs and overheads were less than the forecasted costs and overheads, it may
Table 5.22
Month 2 Comparative Results of Forecasts and Actuals
74
indicate that the forecasted units to be produced are too few, due to the fact that the more
units that are produced the less the absorption of overheads per unit. This means that the per
unit cost absorbed will become less, as more units are manufactured. This is the point where
CVP analysis must be applied to enable management to employ changes, amend the strategic
plan and make long-term decisions that will ensure the survival of XYZ, and achieve growth
and increase profits.
A further comparison pertains to the forecasted per unit costs and the absorption per hour that
can be compared with the actual per unit costs and absorption per hour. When the different
total are compared in Table 5.23, it can immediately be seen that the entire forecasted totals
are higher than the actual totals, except for the overhead absorption per hour, which is lower.
For instance, the forecasted prime cost per hour is R51.92 per hour, compared with the actual
rate of R43.07 per hour.
Month 2 – Comparison
Forecasted Baby Children Adult Office Total
Prime Cost per Unit 1,860.77 2,014.76 1,402.39 1,369.92 1,784.14
Overhead Absorption per Unit 660.72 818.03 840.91 991.08 660.72
Production Cost per Unit 2,521.49 2,832.79 2,243.31 2,361.00 2,553.17
Overhead Absorption per Hour 13.80 17.52 72.98 80.28 17.56
Direct Material Cost per Hour 33.88 38.36 35.74 34.80 35.79
Direct Labour Cost per Hour 20.27 20.27 5.07 5.07 16.13
Prime Cost per Hour 54.15 58.63 40.81 39.87 51.92
Actual
Prime Cost per Unit 1,597.37 1,651.19 1,107.83 1,088.31 1,480.02
Overhead Absorption per Unit 636.47 636.47 636.47 636.47 636.47
Production Cost per Unit 2,233.84 2,287.67 1,744.31 1,724.78 2 116.50
Overhead Absorption per Hour 18.30 18.76 19.00 17.74 18.52
Direct Material Cost per Hour 30.83 33.57 29.30 26.55 31.06
Direct Labour Cost per Hour 15.10 15.10 3.77 3.77 12.01
Prime Cost per Hour 45.93 48.67 33.08 30.33 43.07
Source: Tables 5.20 and 5.22
Lastly, the per hour rate of AC and ABC is compared in Table 5.24. The production cost for
AC was R62.18. The actual production cost in Month 1 for ABC was R45.38, and R43.07 for
Table 5.23
Month 2 Comparative Results
75
Month 2. The forecasted amount for Month 2 was R56.41. The forecasted rate is more than
the actual amount, but less than the inaccurate AC rate.
Source: Table 5.8 and Table 5.23
5. Summary
Chapter 5 has provided data that can now be used and analysed with CVP analysis and/or
other methods. The data will enable the XYZ management to understand the costing of their
manufacturing business. Short-term decisions can be taken: for instance management can
decide to produce more baby product and less office product or attempt to make the office
product more cost effective by increasing the customer orders through a marketing campaign.
It is clearly shown that ABC has yielded much more accurate figures. The calculations were
much more complex, but, when the absorption amounts were compared, it was clear that the
effects were beneficial.
The various figures can be interpreted and applied for each specific requirement or analysis.
Management will now be able to understand why they have losses or why a certain product
that had a high sales volume effectively made the highest profit. But these are only some
scenarios of a multitude of possibilities and applications. The results speak for themselves, it
is now up to management to inter alia take these results to the factory floor and make the
required changes.
PER HOUR COMPARISON - AC vs. ABC
All Products AC ABC –Month 1 ABC - Forecast ABC – Month 2
Direct Cost R45.38 R31.27 R20.62 R31.06
Overhead R16.80 R14.11 R35.79 R12.01
Production Cost R62.18 R45.38 R56.41 R43.07
Table 5.24
AC and ABC per Hour Comparison
76
CHAPTER 6 IN THE END
1. Introduction
“If you do not know where you‟re going, any road will take you there.” -Theodore Levitt –
Roztocki et al. (1999:9) indicate that the implementation of a new cost system involves
investment in time and money. A cost system based on ABC requires organisational changes,
employee acceptance, investment in software and hardware, equipment for data collection,
and so on. Although ABC has been successfully used in many large companies, it does not
guarantee a payback in a short period of time. By using the proposed method for
implementing an ABC costing system, the risk of switching from a traditional costing system
to an extensive ABC system can be reduced significantly. The proposed method is more
suitable for smaller companies because it provides a smooth transition from a traditional
costing system to ABC, it does not require a high investment in sophisticated data collection
systems, and it does not require serious organisational restructuring. Therefore, the proposed
method can be used as an intermediate step for gradually implementing a full ABC system
where the estimated data is replaced by actual data. In addition, it assists in understanding
how overhead costs are generated and can also be used for recognising improvement
opportunities.
2. Conclusion
It is clear that management is able to do very accurate forecasts using ABC, as the difference
between actual and forecasted is very small when compared with monthly turnover. The
combined annual turnover will be exponentially more and should add to the bottom line.
In the case of XYZ, the difference of ABC compared with traditional AC is visible, but not
significant. Although there was an under-absorption or under-forecasting in both cases, the
numbers per unit or product is much more accurate as it is based on actual activities and not
on manufacturing and distribution only.
In terms of the primary objective it has been established that ABC is more advantageous than
traditional absorption costing in an SMME. It is accepted, however, that very few, if any,
77
SMMEs have the internal capability to investigate, apply and implement ABC. It can be
asserted with some assurance that a part time implementation will not yield the desired
results. Management will have to contract outside consultants or employ full time experts to
move from AC to ABC.
As regards the secondary objective of this study, it can be concluded that ABC will hold an
advantage for any business but will likely not be implemented due to the outcome of the
primary objective. It can be concluded that ABC can be implemented in an SMME, but there
will be no immediate advantages. The advantages will only become evident if the specific
organisation moves out of the SMME definition and become a bigger organisation.
3. Implications
It is true that the size of an organisation will also play a big role. In other words, small and
medium organisations may not be able to justify the time, effort and cost implications of
implementing ABC.
Furthermore, the disadvantages may outweigh the advantages for costing and management
purposes. It does not mean that these small and medium organisations will not benefit from
ABC, it just means that it is part of management‟s responsibility to make informed decisions
and to weigh the options before spending money and time that will not justify the increase in
profit, if any, and management decision-making tools due to more or supplementary
information obtained.
Preliminary qualitative results indicate that the difference in under/over-absorption and the
figures obtained when ABC is applied to the same financial information by using the cost
pools and cost drivers do not differ significantly. Given that the same ratio is applicable,
these figures will be different in a business with a higher turnover. Then the cost, effort and
time required may be justified and advantageous.
Activity-based information has great use among managers, between managers and
accountants; and between managers and both suppliers and customers, with the following
results (Innes,1999:81):
78
increased awareness and understanding of overhead costs;
better overhead cost control;
increased awareness of activities in the overhead area;
improved management of overhead resources;
better assessment of proposals (including capital investment proposals);
redesign of business processes; and
improved communication:
4. Recommendations
More research is required into the specific costs and time expended in implementing ABC or
changing from one costing method to another. These costs can then be applied to different
size organisations to determine when the costs will outweigh the disadvantages.
Studies showed that the adoption of the activity-based approach should not be undertaken
lightly. It may, in fact, be a longer road to getting it right than anticipated. However, the
rewards of getting it right far outweighed the stumble blocks, financial burden and time
expenditure anticipated.
THE END
79
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