Traditional and ABC costing

Question 1

Explain the Two-Stage Allocation Process under traditional costing method or
Activity Based Costing

Answer 1

Traditional:
Stage 1: allocate overhead to cost centres
- production cost centres (cutting, assembly)
- service/ support cost centres (maintenance / HR)
- done by using reasonable bases (sq ft for rent)

Stage 2:
Allocate overhead to products
- overhead from production. cost centres is assigned to products using a single overhead absorption rate such as:
-direct lab hrs
-machine hrs

ABC costing

Stage 1:
Allocate overheads to activities
- overhead costs are grouped by activities (e.g machine set up, quality control)
-costs are assigned to each activtiy based on cost drivers (e.g no. of set ups, inspections)

Stage 2: Allocate activity costs to products
- activity costs are then allocated to products based on how much each activity the product uses

Question 2

Discuss the main similarities and differences between traditional and ABC costing

Answer 2

Similarities

• Both systems aim to allocate indirect (overhead) costs to products or services.
• Both help in determining product costs for pricing, profitability analysis, and decision-making.
• Both rely on cost pools (grouping of overhead costs).

Differences - see notes

Question 3

Four steps in abc system

Answer 3

Step 1: Identifying activities in ‘overhead’ departments
⚫ The activities chosen should be at a reasonable level of
aggregation based on cost/benefit criteria.
⚫ Choice of activities influenced by the total cost of the
activity centre and the ability of a single cost driver to
provide a satisfactory determinant of the cost of the
activity.

Step 2: Assigning costs to activity cost pools
⚫ Using causal relationships where possible – ‘resource
cost drivers’.
⚫ Both direct and indirect costs are assigned to activity
cost pools.
⚫ Reliability of cost information will be reduced if arbitrary
allocations are used to assign a significant proportion of
costs to activities.

Step 3: Selecting appropriate cost driver for assigning
the activity costs to the cost object.
 Select appropriate activity cost drivers or activity measures
⚫ Significant determinants of the cost of activities
⚫ Should be easily measurable and explains the behaviour of
costs
⚫ Data should be easy to obtain and identifiable with the product
⚫ Transaction (per activity) or duration drivers (or time it takes
for the activity)

Step 4: Assigning the activities costs to products (cost
object)
 Mechanism needed to monitor the use of one activity to the
product.
 Easier for transaction drivers vs. duration drivers.

Question 4

4 main levels of activities in ABC costing

Answer 4

Unit level – performed each time a unit is produced
⚫ Resources are consumed in proportion to the number
of units produced or sold
⚫ Examples — Direct materials and labour, energy costs
and expenses consumed in proportion to machine
processing time.

Batch level
⚫ Performed each time a batch of goods is produced
⚫ Costs vary with the number of batches made
⚫ Including setting-up, purchasing, moving materials
etc.
⚫ Examples include set-ups, purchase ordering and
first-item inspection activities.

Product/service/customer sustaining
⚫ Performed to enable the production of individual products or
services or customer.
⚫ Examples include activities related to maintaining an accurate
bill of materials, preparing engineering change notices.
⚫ If cost object is a specific customer - market research and
support activities

Facility/Business sustaining - not included in product
costs
⚫ Performed to support the organisation as a whole.
⚫ Examples include plant management, property costs and
salaries of general administrative staff.
⚫ Common to all products and services – not allocated to
products/services