Actual statistics for component X
1.3.10 Activity Based Budgeting (ABB)
Activity-based budgeting is a process of planning and controlling the expected activities for the organisation to derive a cost-effective budget that meets forecast workload and agreed strategic goals. An activity-based budget is a quantitative expression of the expected activities of the firm, reflecting management’s forecast of workload and financial and non-financial requirements to meet agreed strategic goals and planned changes to improve performance.
Thus, the key elements of ABB are:
• type of work/activity to be performed;
• quantity of work/activity to be performed; and
• cost of work/activity to be performed.
ABB focuses on the activity/business processes. Resources required are determined on the expected activities and workload. The objective is to bring in efficiency into the system. So, in the process of budget preparation, many key questions, need to be addressed and properly answered
Illustration
Having attended a CIMA course on activity-based costing (ABC) you decide to experiment by applying the principles to the four products currently made and sold by your company. Details of the four products and relevant information are given below for one period:
Product A B C D
Output in units 120 100 80 120
Costs per unit Rs. Rs. Rs. Rs.
Direct material 40 50 30 60
Direct labour 28 21 14 21
Machine hours (per unit) 4 3 2 3
The four products are similar and are usually produced in production runs of 20 units and sold in batches of 10 units.
The production overhead is currently absorbed by using a machine hour rate, and the total of the production over head has been analysed as follows:
Rs.
Machine department costs (rent, Business, rates, depreciation and
Supervision) 10,430
Set-up costs 5,250
Stores receiving 3,600
Inspection/quality control 2,100
Material handling and dispatch 4,620
You have identified ‘cost drivers’ to be used are as listed below for the overhead costs shown:
Cost Cost
Set-up costs Number of production runs
Stores receiving Requisitions raised
Inspection/quality control Number of production runs Materials handling and dispatch Orders executed
The number of requisitions raised on the stores was 20 for each product and the number of orders executed was 42, each order being for a batch of 10 of a product.
Requirements
(a) Calculate the total costs for each product if all overhead costs are absorbed on a machine hour basis.
(b) Calculate the total cost of each product, using activity-based costing.
(c) Calculate and list the unit product costs from your fingers in (a) and (b) above, to show the differences and comment briefly on any conclusions which may be drawn which could have pricing and profit implications.
Solution
(a) Overheads absorbed on machine hour basis Machine hour absorption rate = Total Overheads
Total machine hours =Rs.10,430+Rs.5,250+Rs.3,600+Rs.2,100+Rs.4,620
(120 X 4)+ (100 X 3)+(80 X 2)+(120 X 3) = Rs.26,000 = Rs.20 per machine hour 1,300
Total costs based on machine hour basis
A B C D
Rs. Rs. Rs. Rs.
Direct material 40 50 30 60
Direct labour 28 21 14 21
Production overhead 80 60 40 60
Production cost/unit 148 131 84 141
Out put in units 120 100 80 120
Total production cost Rs.17,760 Rs.13,100 Rs.6,720 Rs.16,920 (b) Overheads absorbed based on ABC
Overhead costs Level of activity Cost/activity
Rs.
Machine department costs 10,430 1,300 8.02/hour
Set-up costs 5,250 21* 250.0/run
Stores receiving costs 3,600 80** 45.00/requisition
Inspection/quality costs 2,100 21* 100.00/run
Material handling and dispatch 4,620 42 110.00/order
Workings
*No. of production runs = output in units/20 120+100+80 120
20 420 21
20 =
A B C D Rs. Rs. Rs. Rs.
Direct materials 40.00 50.00 30.00 60.00
Direct labour 28.00 21.00 14.00 21.00
Machine dept costs 32.09 24.07 16.05 24.07
Set-up costs 12.50 12.50 12.50 12.50
Stores receiving 7.50 9.00 11.25 7.50
Inspection 5.00 5.00 5.00 5.00
Material handling 11.00 11.00 11.00 11.00
Production cost/unit 136.09 132.57 99.80 141.07
Output in units 120 100 80 120
Total production costs Rs.16,331 Rs.13257 Rs.7,984 Rs.16,928 (c) Comparison of the two unit costs calculated in (a) and (b) above,
A B C D
Product Rs. Rs. Rs. Rs.
Based on machine
Hour rate 148.00 131.00 84.00 141.00
ABC method 136.09 132.57 99.80 141.07
Difference 11.91 (1.57) (15.80) (0.07)
Illustration
ABC Electronics Ltd makes audio player model AB 100. This model has 80 components. ABC sells 10,000 units each month at Rs. 3,000 per unit. The cost of manufacturing is Rs. 2,000 per unit or Rs. 200 lakhs per month for the production of 10,000 units. Monthly manufacturing costs incurred (in Rs. Lakhs) are as follows:
Direct materials costs 100.00
Direct manufacturing labour costs 20.00
Machining costs 20.00
Testing costs 25.00
Rework costs 15.00
Ordering costs 0.20
Engineering costs 19.80
Labour is paid on piece rate basis, therefore, ABC considers, direct manufacturing labour costs as variable cost.
The following additional information is available for AB 100:
• Testing and inspection time per unit is 2 hours
• 10 per cent of AB 100 manufactured are reworked
• It currently takes 1 hour to manufacture each unit of AB 100.
ABC places two orders per month for each component, each component being supplied by a different supplier.. ABC has identified activity cost pools and cost drivers for each activity.
The cost per unit of the driver for each activity cost pool is as follows:
Manufacturing Description of activity cost driver cost per unit cost driver Machining costs Machining components Machine hours of Rs. 200
Capacity
Testing costs Testing components and Testing hours Rs. 125
finished Products.
(each unit of AB 100 is
Tested individually)
Rework costs Correcting and fixing errors Units reworked Rs. 1,500 Ordering costs Ordering of components Number of orders Rs. 125
Engineering costs Designing and managing of Engineering hrs. Rs. 198
Products and processes
Over a long – run horizon, each of the overhead costs described above varies with chosen cost drivers.
In response to competitive pressure ABC must reduce the price of its product to Rs. 2,600 and to reduce the cost by at least Rs. 400 per unit. ABC does not anticipate increase in sales due to price reduction. However, if it does not reduce price it will not be able to maintain the current sales level.
Cost reduction on the existing model is almost impossible. Therefore, ABC has decided to replace AB 100 by a new model AB 200, which is a modified version of AB 100. the expected effect of design changes are:
• The number of components will be reduced to 50.
• Direct materials costs to be lower by Rs. 200 per unit.
• Machining time labour costs to be lower by 20%.
• Direct Manufacturing labour costs to be lower by Rs. 20 per unit.
• Testing time required to be low by 20%.
• Rework to decline to 5%
• Machining capacity and engineering hours capacity to remain the same.
ABC currently outsource the rework on defective units.
Required:
• Compare the manufacturing cost per unit of AB 100 and AB 200.
• Determine the immediate effect of design change and pricing decision on the operating income of ABC.
Ignore income tax. Assume that the cost per unit of each cost driver for AB 100’ continues to apply to ‘AB 200.
Solution
Units AB-100 AB-200
10,000 10,000
Rs./unit Rs./unit
Material 100 lakhs/10,000 1,000 800
Direct wages 20 L¸10,000 200 180
MC cost 200 160
Test cost 250 200
Rework cost 150 75
Ordering cost 2 1.25
Engineering cost 198 198
Total cost 2,000 1,614.25
Revised SP 2,600 2,600
Profit p.u 600 985.75
Total profit (Rs. In lakhs) 60 98.75
If the current products AB-100 is not replaced by new products AB-200 then profit will reduce by 38.75 lakhs. So, it is recommended to introduce AB-200.
1.4 TARGET COSTING