Mauna Kea, is a fictitious soup manufacturing company, has a vast range of soaps and one of the products is the ‘Most common seller’. In the past year, ‘Most common seller’ had introduced a ‘Small’ bar (1.5 oz.) of soap to compliment the ‘Regular’ (3.0 oz.) and ‘Large’ (5.0 oz.) bars.
Since the launch of ‘Small’ bars the overall profit of ‘Most common seller’ has been affected. The sales of ‘Regular’ and ‘Large’ soap has been unaffected and ‘Small’ bars have added to the sales figures, however, this doesn’t seem to compliment the overall profits. ‘Most common seller’ has been costing its products using the traditional way and now has decided to re-cost using activity based costing method, to find out the difference in the cost of production of the ‘Small’ soap, if any.
Estimated annual budgeted labour and overhead costs are shown in Exhibit 1 (Appendix).
The common costs have to be apportioned between the cost centres, by developing an apportionment basis, derived from the relevant cost drivers, based on the criteria that it is
- Readily quantifiable
- Meets the cost / benefit criterion (Upchurch, A. 2002:123)
As shown in Exhibit 2 (Appendix),
Depreciation is allocated by the machine hours. This is done as we have the machine hours and the value of the machines will depreciate depending on the number of hours it runs. The calculation is done is the following way.
For the ‘Small’ bar, we know that the machine runs for 50,000 hours and the total number of hours is 2,018,000.
So (50,000 / 2,018,000) X 950,000 (i.e. depreciation cost) = 23538.15659068385
We round it up to 23, 538.
The same is done for ‘Regular’ and ‘Large’ and entered in the table of Exhibit 2 (Appendix).
Labour costs are allocated by labour hours and all other costs will be allocated by volume.
The total number of units produced is 51 Million. The total cost of ‘other cost’ is 4,295,000.
For ‘Small’ bar the calculation is:
(4,295,000 / 51) X 1 (i.e. the unit of Small bar produced) = 84,216
Similarly we calculate the value for Regular and Large soaps, which can be seen in the Exhibit 2 (Appendix).
Calculating per unit cost:
The Total labour and overhead costs of each kind of soap is divided by the number of units produced, as shown in Exhibit 1 (Appendix).
e.g.: for Small:
409, 445 / 1,000,000 = 0.41 (approximated to the nearest round)
This way we find the cost incurred to produce each unit of Small, Regular and Large soaps using the traditional method of costing. Now, let’s calculate the cost using the Activity Based Costing method.
For activity based costing the process of manufacturing has to be reduced in different activities in which the employees engaged, over different potential cost centre. The list of activities is indicated in Exhibit 3 (Appendix).
Using this list we deduce First Stage Allocation Rates which is shown in Exhibit 4 (Appendix). For instance the labour is involved in all of the activities mentioned so it is distributed evenly. However Depreciation is not applicable to activities like breaks and team meeting, so it is distributed in only the remaining activities. Similarly we allocate a certain percentage which meets the cost / benefit criterion. Thus, for each major activity indentified, we create an ‘overhead cost pool’ to collect the associated cost. We will find out the cost of each activity at a later stage.
Before we can develop absorption rates for each cost pool, we need to identify each activity’s cost drivers. Using the data in Exhibit 1 (Appendix) and Exhibit 4 (Appendix) we have a table of our cost drivers (the remaining data is assumed), i.e Exhibit 5 (Appendix).
The costing activity begins now. We have the total labour cost and we have also apportioned a percentage weightage to each activity. We, hence, distribute the total cost to each activity according to the weightage it carries.
e.g.: ‘Making’ carries 25% of the total cost (Exhibit 4 – Appendix).
Hence, making = (25/100) x 8,025,000 = 2,006,250
Similarly we calculate the cost of each activity, as shown in details, and create Exhibit 6 (Appendix) and Exhibit 7 (Appendix).
Once this is calculated, we have the Total Labour and Overhead distributed to each activity. This is simply the addition of each activity in various departments. We also have a percentage that each value carries to it.
The final stage is to assign the cost of activities to the products. The first step in this stage is to calculate the driver base and the Driver rate ($ per base units).
The Driver base in our case is calculated with the following formula:
Uptime of machine hour for Small soap + Uptime of machine hour for regular soap + Uptime of machine hour for Large soap
i.e. (60% of 50,000) + (64% of 1,400,000) + (67% of 568,000) = 1,306,560
The total labour and overhead cost of an activity when divided by its driver base gives its Driver rate. For instance, the Total overhead cost of Making i.e. 3,633, 050 when divided by its driver base i.e. 1,306,560 gives the driver rate i.e. 2.78.
Similarly we calculate the driver base and driver rate and get the results as shown in Exhibit 8 (Appendix) and Exhibit 9 (Appendix).
The product of the Driver rate of an activity to its respective cost driver gives the total dollar of each kind of soap manufactured. For instance, (Driver rate of making Small soap) x (uptime machine hour of it) = 2.78 x (60% of 50,000) = 0.08 i.e. the total Dollars spent cost of it. Similarly we calculate this value of all kind of soaps manufactured and for all its activity, as shown in Exhibit 8 (Appendix) and Exhibit 9 (Appendix). When the Dollar cost of each activity of a certain type of soap is summed up then it gives us the actual cost per unit of that product. Exhibit 9 (Appendix) shows that Small soap costs $1.37 to be produced, while Regular costs $0.23 and Large costs $0.26
Analysis and comparison of the calculations
In traditional costing method we allocated the total labour cost based on direct labour. However, we had in the given data that 35 out of 125 employees were managers. They are paid a different wage and are not necessarily a part of production. Also, different employees allocate different time to an activity. In traditional method, there was no provision of calculating the time when the staff were in team meetings or were on a break. In addition, we had arbitrarily allocated $4,295,000 incurred by other activity, based on the volume of bars produced.
In activity based costing, the cost was allocated to each activity and the above mentioned problems were dealt with.
The cost of producing a small bar came to mere $ 0.41, while the cost of the same product was a lot more when calculated in detail using Activity Based Costing method, which is $1.37. So while traditional costing might have suggested a revision of pricing or marketing strategy of Small bars, ABC suggested that the production of small bars should be reduced or, even better, stopped.
Merits, Demerits and Decision making
If we were dealing with a manufacturing plant producing only one type of soap or an establishment like an ice-cream parlour which charges per scoop of ice-cream and its cost varies directly to the scoops served, then in that case the complex, expensive and time consuming ABC will prove meaningless.
ABC method proved useful in the above example as it was a medium scale operation. In real-world large-scale operations ABC method loses power (Harvard Business School website).
With an intention to support strategic decision, ABC’s purpose is to focus attention on resource consumption. Its benefits are:
- Managers perceive data generated by ABC to be more accurate and reliable than those by traditional method. For instance, Chrysler, a car manufacturer, claimed that it saved hundreds of millions of dollars by introducing ABC as it showed that the true cost of certain parts that Chrysler made was 30 times what had originally been estimated (Economist website).
- ABC focuses management attention on the way resources are consumed by activities and supporting effective management of these activities (Cooper & Kaplan, 1988). This makes ABC suitable for financial and service organizations, and 51% of them use ABC method (Drury & Tayles, 2000).
- ABC, being a refinement of absorption costing, suffers from the weaknesses typical of absorption costing. It may be criticized as:
- ABC is based on subjective arbitrary cost allocation with cost drivers as it main differentiator (Upchurch, A. 2002:162). Traditional method needs subjective selection of absorption and allocation criteria and volume assumption. ABC is more complicated but not necessarily accurate (Piper & Walley, 1991). ABC’s inability to predict profits with the change in production volumes makes it inadequate for decision – making
- ABC ignores a firm’s internal capacity constraint, i.e., if the demand for its products is greater than its production capacity (Ronen & Pass, 2004).
- ABC ignores the discontinuities of costs and regards the relation between activities and resource consumption as linear, absolute and certain.
Allocation of all kind is arbitrary and hence both traditional and ABC method, as they are based on full allocation, may cause a mis-leading decision making process. The proliferation of ABC during early 1990’s was probably due to the disappointment with the traditional methods and the lack of alternatives (Eden & Ronan, 2002). However, with the weakness of ABC becoming apparent most firms which tried ABC ultimately abandoned it. ABC seemed favourable as the case-studies and other literature advocated it (Cooper & Kaplan, 1991). Maybe that is the reason that only 15% of manufacturing industries use ABC (Drury & Tayles, 2000)
Firms benefitted not merely from the cost allocation data but probably also because ABC involved thorough analysis of processes and costs, and drew attention to neglected aspects of organizational activities. This resulted in improvements that were attributed to ABC and thus enhanced its positive image.
Note: All values has been assumed and are in $ (Dollars), unless stated otherwise.
|Mauna Kea Soap|
|Annual Budgeted Labor and Overhead Costs|
|Labor (including benefits)|
|90 production employees||5,400,000|
|35 management employees||2,625,000|
|Total administrative overhead||2,050,000|
|Taxes and insurance||360,000|
|Engineering and R&D||1,020,000|
|Number of units||1 Million||35 Million||15 Million||51 Million|
|Mauna Kea Soap|
|Labor and Overhead Allocation – Traditional Costing|
|Labor and overhead costs:|
|Labor (allocated by labor hours)||$ 301,691||$ 5,752,256||$ 1,971,053||$ 8,025,000|
|Depreciation (allocated by machine hours)||23,538||659,068||267,394||950,000|
|All other costs (allocated by volume)||84,216||2,947,549||1,263,235||4,295,000|
|Total labor and overhead costs||$ 409,445||$ 9,358,873||$ 3,501,682||$ 13,270,000|
|Labor and overhead cost per bar||$ 0.41||$ 0.27||$ 0.23|
|20%||setting up or shutting down equipment due to product changeovers|
|12%||reworking defective products|
|11%||repairing equipment breakdowns|
|5%||miscellaneous other activities|
|Mauna Kea Soap|
|Activity-Based Costing – First Stage Allocation Rates|
|Taxes and insurance||25%||50%||25%||100%|
|Engineering and R&D||100%||100%|
|Mauna Kea Soap|
|Second Stage Drivers|
|Machine||Efficiency rates||Changeover||Pounds||Dedicated||handled||Total bars|
|hours||% uptime||% downtime||hours||recycled||employees||per bar||produced|
Ronen and S. Pass, Focused Management, Hod-Ami, Herzelia, Israel, 2004.
Drury, C. and Tayles, M. Cost system Design and Profitability Analysis in UK Companies
Institute of Chartered Management Accountants, London, 2000 ISBN 1 85971 457 9.
Economist website: http://www.economist.com/node/13933812 – Accessed on 12th March 2011.
Harvard Business School website: http://hbswk.hbs.edu/item/4587.html – Accessed on 14th March 2011.
- Piper and P. Walley, ABC relevance not found, Management
Accounting, CIMA, UK (March) (1991), 42–44.
- Cooper and R.S. Kaplan, Measure costs right: make the right decisions, Harvard Business Review 66(5) (1988), 96–103.
- Cooper and R.S. Kaplan, The Design of Cost Management Systems, Prentice Hall, Englewood Cliffs, NJ, 1991.
Upchurch, A. (2002). Cost accounting : principles and practice. 2nd ed. Harlow: FT – Prentice Hall.
- Eden and B. Ronen, Activity Based Costing (ABC) and Activity Based Management (ABM) – are they the same thing in a different guise? Financial Management Accounting Committee (FMAC) Articles of Merit, Issued by The International Federation of Accountants, 2002, pp. 47–58.