Ken Garrett demystifies Activity-based costing and provides some tips leading up to the all-important exams
Conventional costing distinguishes between variable and fixed costs. Typically, it is assumed that variable costs vary with the number of units of output (and that these costs are proportional to the output level) whereas fixed costs do not vary with output. This is often an over-simplification of how costs actually behave. For example, variable costs per unit often increase at high levels of production where overtime premiums might have to be paid or when material becomes scarce. Fixed costs are usually fixed only over certain ranges of activity, often stepping up as additional manufacturing resources are employed to allow high volumes to be produced.
Variable costs per unit can at least be measured, and the sum of the variable costs per unit is the marginal cost per unit. These are the extra costs caused when one more unit is produced. However, there has always been a problem dealing with fixed production costs such as factory rent, heating, supervision and so on. Making a unit does not cause more fixed costs, yet production cannot take place without these costs being incurred. To say that the cost of producing a unit consists of marginal costs only will understate the true cost of production and this can lead to problems. For example, if the selling price is based on a mark‑up on cost, then the company needs to make sure that all production costs are covered by the selling price. Additionally, focusing exclusively on marginal costs may cause companies to overlook important savings that might result from better controlled fixed costs.
The conventional approach to dealing with fixed overhead production costs is to assume that the various cost types can be lumped together and a single overhead absorption rate derived. The absorption rate is usually presented in terms of overhead cost per labour hour, or cost per machine hour. This approach is likely to be an over-simplification, but it has the merit of being relatively quick and easy.
See Table 1 below.
The budgeted labour hours must be 112,000 hours. This is derived from the budgeted outputs of 20,000 ordinary units which each take five hours (100,000 hours) to produce, and 2,000 deluxe units which each take six hours (12,000 hours).
Therefore, the fixed overhead absorption rate per labour hour is $224,000/112,000 = $2/hour.
The costing of the two products can be continued by adding in fixed overhead costs to obtain the total absorption cost for each of the products.
See Table 2 below.
For future reference, note that the total costs accounted for (if production goes according to plan) will be = 20,000 x 85 + 2,000 x 102 = $1,904,000.
The conventional approach outlined above is satisfactory if the following conditions apply:
- Fixed costs are relatively immaterial compared to material and labour costs. This is the case in manufacturing environments which do not rely on sophisticated and expensive facilities and machinery.
- Most fixed costs accrue with time.
- There are long production runs of identical products with little customisation.
Table 1, Example 1