Table of Contents

1)

Explain what is mean by cost drivers? ............................................................................................ 2

2)

Describe the procedures used in an Activity Based Costing system. .............................................. 2

3) Compare and contrast the traditional product costing system used with Activity Based Costing
system. .................................................................................................................................................... 9
4)

Quote the list of references used in your assignment using the Harvard style of referencing. ..... 12

1) Explain what is mean by cost drivers?

A cost driver is a factor that directly causes a change in the cost of an activity, and
which is generally based on varying levels of activity. The term is used in activity-based
costing analysis, (Accounting Tools Copyright, 2014). Ideally, a cost driver is an activity
that is the root cause of why a cost occurs. In the past century, the root cause of indirect
manufacturing costs has changed from a single cost driver such as direct labour hours to
several cost drivers. Due to sophisticated manufacturing and increased demands from
customers, direct labour is no longer the main cost driver of indirect manufacturing
overhead.
In addition to direct labour, today's drivers of indirect manufacturing costs include the
number of machine setups required, the number of engineering change orders, the
demands from customers for special inspections, handling and storage, the number of
components in the units produced, and the number of production machine hours.
Manufacturers that want to know the true costs of their products need to know what is
driving their indirect manufacturing costs. For these companies, it is not sufficient to
merely spread overhead costs to products by using a single factor such as direct labour
hours or production machine hours. (Accounting Coach, 2014).

2) Describe the procedures used in an Activity Based Costing system.

Activity-based costing is a method of assigning indirect costs to products and
services which involves finding cost of each activity involved in the production process
and assigning costs to each product based on its consumption of each activity. Activitybased costing is more refined approach to costing products and services than the
traditional costing method, (Accounting Explained, 2011-2013). It involves the following
steps such as identify costs, load secondary cost pools, load primary cost pools, measure
activity drivers, allocate costs in secondary pools to primary pools, charge costs to cost
objects, formulate reports, and also act on the information. Below we can see the exact
process detail of each of the steps.

o Identify costs.
The first step in ABC is to identify those costs that we want to allocate. This is the
most critical step in the entire process, since we do not want to waste time with an
excessively broad project scope. For example, if we want to determine the full cost of a
distribution channel, we will identify advertising and warehousing costs related to that
channel, but will ignore research costs, since they are related to products, not channels.
o Load secondary cost pools.
Create cost pools for those costs incurred to provide services to other parts of the
company, rather than directly supporting a companys products or services. The contents of
secondary cost pools typically include computer services and administrative salaries, and
similar costs. These costs are later allocated to other cost pools that more directly relate to
products and services. There may be several of these secondary cost pools, depending upon
the nature of the costs and how they will be allocated.
o Load primary cost pools.
Create a set of cost pools for those costs more closely aligned with the production of
goods or services. It is very common to have separate cost pools for each product line, since
costs tend to occur at this level. Such costs can include research and development,
advertising, procurement, and distribution. Similarly, you might consider creating cost pools
for each distribution channel, or for each facility. If production batches are of greatly varying
lengths, then consider creating cost pools at the batch level, so that you can adequately assign
costs based on batch size.
o Measure activity drivers.
Use a data collection system to collect information about the activity drivers that are used to
allocate the costs in secondary cost pools to primary cost pools, as well as to allocate the
costs in primary cost pools to cost objects. It can be expensive to accumulate activity driver
information, so use activity drivers for which information is already being collected, where
possible.

o Allocate costs in secondary pools to primary pools.

Use activity drivers to apportion the costs in the secondary cost pools to the primary
cost pools.
o Charge costs to cost objects.
Use an activity driver to allocate the contents of each primary cost pool to cost
objects. There will be a separate activity driver for each cost pool. To allocate the costs,
divide the total cost in each cost pool by the total amount of activity in the activity driver, to
establish the cost per unit of activity. Then allocate the cost per unit to the cost objects, based
on their use of the activity driver.
o Formulate reports.
Convert the results of the ABC system into reports for management consumption. For
example, if the system was originally designed to accumulate overhead information by
geographical sales region, then report on revenues earned in each region, all direct costs, and
the overhead derived from the ABC system. This gives management a full cost view of the
results generated by each region.
o Act on the information.
The most common management reaction to an ABC report is to reduce the quantity of
activity drivers used by each cost object. Doing so should reduce the amount of overhead cost
being used, (Copyright, 2014).
An example of calculation on activity-based costing can be seen as shown below:
Alex Erwin started Interwood, a niche furniture brand, 10 years ago. He ran the
business as a sole proprietorship. While he has 50 skilled carpenters and 5 salesmen on his
payroll, he has been taking care of the accounting by himself. Now, he intends to offer 40%
of the ownership to public in next couple years, and is willing to make changes and has hired
you as the management accountant to organize and improve the accounting systems.
Interwood's total budgeted manufacturing overheads cost for the current year is $5,404,639
and budgeted total labour hours are 20,000. Alex applied traditional costing method during
all of the 10 years period, and based the pre-determined overhead rate on total labour hours.

Interwood's sofa range includes the 2-set, 3-set and 6-set options. Platinum Interiors
recently placed an order for 150 units of the 6-set type. The order is expected to be delivered
in 1 month time. Since it is a customized order, Platinum will be billed at cost plus 25%. You
are not a fan of traditional product costing system. You believe that the benefits of activitybased costing system exceeds its costs, so you sat down with Aaron Mason, the chief
engineer, to identify the activities which the firm undertakes in its sofa division. Next, you
calculated the total cost that goes into each activity, identified the cost driver that is most
relevant to each activity and calculated the activity rate. The results are summarized below:

Activity

Production

of

components
Assembly
components

of

C=A/B (in

A (in $)

Relevant Cost Driver

2,313,132

Machine hours

25,000

93

20,000

62

1,231,312

Number of labour
hours

$)

Packaging

213,123

Units

5,000

43

Shipping

231,230

Units

5,000

46

Setup costs

34,243

Number of setups

240

143

Designing

123,132

Designer hours

1,000

123

Product testing

24,234

Testing hours

500

48

Rent

1,234,233

Labour cost

$1,645,644

75%

Once the order was ready for packaging, Aaron gave you a summary of total cost incurred
and a statement of activities performed (also called the bill of activities) as shown below:
Customer:

Platinum

Interiors

Units:

150

Type:

unit

Amounts in $
Cost of direct materials

25,000

Cost of purchased components

35,000

Labour cost

15,600

Activity

Relevant Cost Driver

Activity Usage

Production of components

Machine hours

320

Assembly of components

Number of labour hours

250

Packaging

Units

150

Shipping

Units

150

Setup costs

Number of setups

15

Designing

Designer hours

70

Testing hours

22

Rent

Labour cost

4500

Part A
Calculate the total cost of the order and the invoice value of the order based on traditional
costing system.
Solution
In the traditional costing system, cost equals materials cost plus labour cost plus
manufacturing overheads charged at the pre-determined overhead rate. The pre-determined
overhead rate based on direct labour hours = $5,404,639/20,000 = $270 per labour hour. The
actual number of labour hours spent on the order is 250. Once we have this data, we can
estimate the manufacturing overheads and the total cost as follows:

Direct materials

25,000

Purchased components

35,000

Labour cost

15,600

Manufacturing overheads ($270 250)

67,500

Total cost under traditional product costing system

143,100

Platinum is billed at cost plus 25%, so the amount of sales to be booked would amount to
$178,875 (= $143,100 1.25).
Part B
You know activity-based costing is a more refined approach. Now, since you have all the
data needed, calculate the order cost using activity based costing.
Solution
In activity-based costing, direct materials cost, cost of purchased components and labour cost
remains the same as in traditional product costing. However, the value of manufacturing
overheads assigned is more accurately estimated. The following worksheet estimates the
manufacturing overheads that should be assigned to the order of Platinum Interiors:

(A)

(B)

(A B)

Activity

Activity Rate

Activity Usage

Activity Cost Assigned

Production of components

93

320

29,760

Assembly of components

62

250

15,500

Packaging

43

150

6,450

Shipping

46

150

6,900

Setup costs

143

15

2,145

Designing

123

70

8,610

Product testing

48

22

1,056

Rent

75%

15,600

11,700
82,121

Total cost of the order is hence:

US$
Direct materials

25,000

Purchased components

35,000

Labour cost

15,600

Manufacturing overheads

82,121

Total cost under activity-based costing

157,721

Based on the more accurate estimation of the order cost, the invoice should be raised at
$197,150 (=$157,721 1.25) instead of $178,875 calculated under traditional product costing
system.

3) Compare and contrast the traditional product costing system used with Activity
Based Costing system.
Costing is used in business accounting strategies as a way of determining the cost
of manufacturing a product in relation to the revenue generated by that product. Costing
systems determine the overhead of production and then allocate those overhead costs to a
business products.
There are two common methods for allocating these indirect costs to products.
Both of these methods assess overhead costs and then attach these costs to products based
on certain cost drivers. A cost driver is any component that costs money or any factor that
is related to a cost occurring, such as the volume produced or the number of labour hours.
The first of these methods is activity-based costing, which is sometimes referred as
ABC. Activity-based costing determines all activities associated with production,
assigns a cost to those activities and then determines the cost of the product. The other
method is traditional costing, which assigns costs to products based on an average
overhead rate. This method pools all indirect costs in production and applies those costs
equally across the board using one appropriate cost driver, such as machine hours,
(Hayden, 2014).
The difference between ABC or Activity Based Costing and TCA or Traditional
Cost Accounting is that ABC is complex whereas TCA is simple. The ABC system began
in 1981 whereas TCA methods were designed and developed between 1870 to 1920. In
the TCA system, the cost objects and used up resources are required to evaluate the cost
whereas in the ABC system the cost is dependent upon the activities used up by the cost
objects. Activity Based Costing is accurate and preferred over the TCA cost management
system. The ABC method of cost management system is adopted when the overheads of
the company are high and there are large numbers of miscellaneous products. Inaccuracy
or errors are most unwanted and undesirable because of the competitive rates set by the
competitors in the market. Due to this heavy and stiff competition, a highly reliable and
accurate method is required for the cost management.

TCA or Traditional Cost Accounting uses a single overhead pool and is not able to
calculate the true cost. The costs of the objects are allocated randomly based upon the
labour or machine hours etc. ABC costing includes identifiable products parts or labour
whereas TCA arbitrarily accumulates expenses, salaries, depreciations etc. Smaller
targeted costs that are built upon activities are calculated with the help of the ABC
system.
The ABC system is advantageous since it helps in simplifying the decision
making process and it makes management concepts become clear and target -oriented. It
also helps in evaluating performances and sets standards which can help the manager to
use this information for comparison purposes. In the Traditional Cost Accounting System,
the company determines the cost of production after the products have been produced
whereas in the target or Activity Based Accounting System, the value or cost of the
product is determined on the basis of customer feedback and pocket range. The ABC
system helps the company to determine whether to lower or raise the activities cost to
grab the consumers. The ABC system also helps in keeping up with the competitors
without sacrificing the quality and the quantity of the products.
o Advantages and Disadvantages of Traditional Costing
An advantage of using traditional-based costing is that it aligns with Generally
Accepted Accounting Principles, or GAAP. Easy implementation for companies that
provide one product also is a plus. However, traditional costing is an outdated costing
system in many companies because those manufacturing companies now use machines
and computers for much of their production. Computers and machines make the system
outdated because it often uses direct labour hours to calculate cost. Cost is not
appropriately assigned because direct labour hours are not the best cost driver to use.
Traditional costing negates other cost drivers that may contribute to the cost of an item.
Another disadvantage of solely using the traditional costing system is that it can lead to
bad management decisions because it excludes certain nonmanufacturing costs, (Johnson,
2014).

10

o Advantages and Disadvantages of Activity-Based Costing

Greater costing accuracy is the primary benefit of activity-based costing.
Companies assign cost only to the products that require the activity for production. This
method eliminates allocating irrelevant costs to a product. Other advantages of activitybased costing include an easy interpretation of cost for internal management, the ability to
enable benchmarking and a greater understanding of overhead costs. Implementing an
activity-based costing system within a company requires substantial resources. This can
prove a disadvantage for companies with limited funds. Another disadvantage of using
activity-based costing is that it is easily misinterpreted by some users, (Johnson, 2014).
As a conclusion, we can see that traditional cost accounting is obsolete whereas
Activity Based Accounting is used more by various target-oriented companies. The ABC
methods help the company to identify the needs of keeping or eliminating certain
activities to add value to the products. Besides, TCA methods focus on the structure
rather than on processes whereas ABC methods focus on the activities or processes rather
than on the structure. ABC provides accurate costs whereas TCA accumulates values
arbitrarily. Next, TCA is almost obsolete whereas ABC methods are largely in use since
1981, (COPYSCAPE, 2014).

11

4) Quote the list of references used in your assignment using the Harvard style of
referencing.

o Accounting Coach, 2014. Accounting Coach. [Online]

Available at: http://www.accountingcoach.com/blog/what-is-a-cost-driver
[Accessed 17 September 2014].
o Accounting Explained, 2011-2013. Accounting Explained. [Online]
Available at: http://accountingexplained.com/managerial/cost-systems/activity-basedcosting
[Accessed 21 September 2014].
o Accounting Tools Copyright, 2014. Accounting Tools. [Online]
Available at: http://www.accountingtools.com/definition-cost-driver
[Accessed 17 September 2014].
o Copyright, 2014. Accounting Tools. [Online]
Available at: http://www.accountingtools.com/activity-based-costing
[Accessed 21 September 2014].
o COPYSCAPE, 2014. Different Between net. [Online]
Available at: http://www.differencebetween.net/business/finance-business2/difference-between-abc-and-traditional-costing/
[Accessed 21 September 2014].
o Hayden, A., 2014. intuit QuickBooks. [Online]
Available at: http://quickbooks.intuit.com/r/pricing/activity-based-vs-traditionalcosting/
[Accessed 23 September 2014].
o Johnson, R., 2014. Chron. [Online]
Available at: http://smallbusiness.chron.com/traditional-costing-vs-activitybasedcosting-33724.html
[Accessed 24 September 2014].

12

13