Question

Question 4: Activity Based Costing (20 marks in total)

You have recently attended a seminar on activity-based costing (ABC). FOL's accounting system has three cost categories: direct materials, direct labour and overhead costs. FOL has allocated indirect production costs based on direct labour cost. The following is the 2019 budget for the Cattle Drench department. These costs are spread evenly over the 12 month period.

Materials		306000
Direct labour		201600
Overhead costs		54000

You are now suggesting to David that you experiment with the ABC system in the Cattle drench department. He agrees and together you identify the activities that cause overhead costs and select a cost allocation base for each activity. You also identify expected activity levels for the next month as follows:

Activity	Cost Allocation base	Predicted cost $	Predicted Activity level
Inward materials handling	No. of deliveries	1500	5
Research/Quality control	No. of Kgs of drench	5000	900
Outwards materials handling	No. of boxes shipped	2500	90

Required

Write a memo to David that:

1. Explains how overhead costs are allocated in the Cattle Drench department using the traditional system.
2. Explains how overhead costs would be allocated under the ABC system. Include a calculation of all the allocation rates used.
3. Calculates the cost of Cattle Drench production for the next month using the traditional system.
4. Calculates the cost of Cattle Drench production for the next month using the ABC system.
5. Explains to David why costs are different in the two costing systems.
6. Recommends one system giving reasons for your recommendation.

Answer 1

Question 4:

1. Overheads are allocated under traditional cost basis=$ 0.26 /dollar of labor cost

Note:

Total Overheads=$ 54000

Total Direct Labor Cost=$ 201600

Therefore Overheads allocated per dollar of the labor cost=$ 54000/$ 201600=$ 0.26 /dollar of labor cost

2. Calculation of the Overheads Allocation rates under ABC system

Particulars	Cost pool	Cost drivers	Cost/Cost driver
Inward materials Handling	$ 1500	5	$ 300/inward material handling
Research /quality control	$ 5000	900	$ 5.56/quality control
Outward materials Handling	$ 2500	90	$ 27.78/outward material handling
Total	$ 9000

3. Calculation of the Cost of Cattle Drench Production under the Traditional Costing system

Particulars	Amount
Direct Materials	$ 25,500
Direct Labor	$ 16,800
Overeheads	$   4,500
Total Costs	$ 46,800

4. Calculation of the Cost of Cattle Drench Production under the ABC system

Particulars	Amount
Direct Materials	$ 25,500
Direct Labor	$ 16,800
Overeheads	$   9,000
Total Costs	$ 51,300