Page 5 - CIMA MCS Workbook November 2018 - Day 1 Suggested Solutions

SUGGESTED SOLUTIONS

CHAPTER FOUR

1. ACTIVITY BASED COSTING AND ACTIVITY BASED

MANAGEMENT

Activity based costing

Activity based costing (ABC) is a form of absorption costing. Grapple’s current method of
absorption costing is done using a traditional method of absorption, based upon machine hours.

This makes the assumption that the majority of overheads spent on production are driven by the
number of machine hours worked. The overhead costs are therefore charged on the basis of how
many machine hours it takes to make a product.
The products that spend the longest on the machines will be the ones that have the most cost
charged to them.

Under an ABC approach, instead of making the assumption that machine hours are the main
driver of overheads, overhead costs are broken down into cost pools. For each cost pool, a
separate cost driver is determined. The cost driver is the thing that genuinely drives the cost in
the cost pool to be spent. The cost driver is usually tied to a specific activity undertaken.

For instance, Grapple’s production is done in batches. Every time a new batch is run there will be
a need for cleaning, set‐up, etc. These activities cause overhead to be spent, for example the
cleaning costs and the set‐up and testing costs. Quality control is done on the first batch of a
production run, regardless of how many units are in the batch.

These kinds of costs will not be driven directly by the number of machine hours used in
production but by the number of batches or batch changeovers. ABC recognises this and charges
the overheads on the basis of the real drivers of cost, such as the number of set‐ups undertaken
or the number of quality control checks done.

In this way, the overhead will be absorbed, or charged, on a more accurate basis. This will give
better information about the profitability of individual products. Those that are more ‘activity
hungry’ will get more cost charged to them and may appear less profitable than before. Those
that use proportionally fewer activities in their production than others (perhaps those that can be
made in larger batches) will be a more efficient use of those activities and will have less cost
charged to them than before and appear more profitable.

Note that this in itself doesn’t improve overall profitability. The rigorous application of ABC only
ensures that existing costs are spread more fairly across the products produced.

The main disadvantage with the introduction of ABC for a business is the time, effort and cost that
is needed to introduce and apply ABC. Full introduction of ABC would mean that every activity
undertaken would need to be identified. In a factory environment there could be thousands of
different activities. Once identified their cost drivers would also need to be determined.

Some costs may not be driven by activity at all. The factory rent or its depreciation (if owned) is
fixed, regardless of the activity done in the factory. If non‐activity related costs form the bulk of
the overheads then ABC becomes less useful.

It may be that to make the introduction of ABC more cost effective, only the significant activities
(those that incur the most overhead) are identified and analysed.

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