Background:

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).

Traditional costing:

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

  1. Readily quantifiable
  2. 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.

Conclusion:

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.

Appendix

Note: All values has been assumed and are in $ (Dollars), unless stated otherwise.

EXHIBIT 1
Mauna Kea Soap
Annual Budgeted Labor and Overhead Costs
Annual costs:
Labor (including benefits)
90 production employees 5,400,000
35 management employees        2,625,000
Total labor 8,025,000
Depreciation          950,000
Administrative overhead
Purchasing 480,000
Cost accounting           450,000
Buildings           520,000
Administration           600,000
Total administrative overhead       2,050,000
Taxes and insurance          360,000
Engineering and R&D       1,020,000
Utilities          665,000
Other          200,000
Total     13,270,000
Other Data
Small Regular Large Total
Number of units 1 Million 35 Million 15 Million 51 Million
Machine hours 50,000 1,400,000 568,000 2,018,000

 

EXHIBIT 2
Mauna Kea Soap
Labor and Overhead Allocation – Traditional Costing
Small Regular Large Total
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

 

Exhibit 3

25% making soap
20% setting up or shutting down equipment due to product changeovers
12% reworking defective products
12% personal breaks
11% repairing equipment breakdowns
11% inventory movement
4% team-building meetings
5% miscellaneous other activities

 

EXHIBIT 4
Mauna Kea Soap
Activity-Based Costing – First Stage Allocation Rates
Team Material Other
Making Downtime Changeover Rework Breaks meetings movement activities Total
Labor 25% 11% 20% 12% 12% 4% 11% 5% 100%
Depreciation 32% 14% 25% 15% 14% 100%
Administrative overhead 100% 100%
Taxes and insurance 25% 50% 25% 100%
Engineering and R&D 100% 100%
Utilities 32% 14% 25% 15% 14% 100%
Other costs 100% 100%

 

EXHIBIT 5
Mauna Kea Soap
Second Stage Drivers
Times
Machine Efficiency rates Changeover Pounds Dedicated handled Total bars
hours % uptime % downtime hours recycled employees per bar produced
Small             50,000 60% 40%                  288             25,000                      3                      3        1,000,000
Regular        1,400,000 64% 36%                  192             60,000                    70                      2      35,000,000
Large           568,000 67% 33%                  192             50,000                    15                      3      15,000,000
       2,018,000                  672           135,000                    88      51,000,000

 

6

7

8

9

References

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.

  1. Piper and P. Walley, ABC relevance not found, Management

Accounting, CIMA, UK (March) (1991), 42–44.

  1. Cooper and R.S. Kaplan, Measure costs right: make the right decisions, Harvard Business Review 66(5) (1988), 96–103.
  1. 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.

  1. 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.
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I’m an eCommerce Project Director at an agency in London and a consultant for a number of eCommerce start-ups. I founded Think etc 9 years ago which now lets me share my research and experience with all the interesting brands, people, places and projects that I have been privileged to work with.

My work on crowdsourcing was published by Oxford as part of a journal article and I have been obsessing over eCommerce and Magento over the past several years.

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