All you need to know about activity based costing

Our AAT guru Teresa Clarke explains all, with the help of an example

Activity based costing uses activities to absorb costs. It groups costs into cost pools and absorbs these by the activities that cause the costs.

For example, the costs associated with setting up machinery to produce a product would be driven by how many set-ups were needed. Or the costs associated with processing orders would be driven by how many orders need to be processed.

With activity costing we group together the costs into activities and then identify what drives or causes that cost. By dividing the cost by the driver, it will give us the cost driver rate for the absorption of the cost. The cost driver rate is the term used for the overhead absorption rate with activitybased costing.

Once we have the cost driver rate, we use this in the same way as the traditional machine hours and labours hours methods.

The steps for this are just about the same as the traditional methods:

1. Calculate the budgeted cost driver rate for the activity-based costing using the budgeted costs/budgeted number of drivers or activity.

2. After production has finished, calculate the overheads actually absorbed. Actual activity x cost driver rate (just like the traditional method of actual activity x OAR).

3. Calculate the over or under-absorption of overheads. Actual overheads less overheads actually absorbed equals over or under-absorption.

Example

Our factory produces toy trains. The overheads associated with the manufacture of the toy trains have been grouped together by activity: Cost pool (activity)Budgeted overheadsCost driver (cause of cost) Budgeted number of drivers

Machinery set up costs £3,000Number of set ups200

Invoicing costs £28,000Number of sales invoices issued 800

Machinery set up costs

Overheads £3,000 divided by the number of cost drivers, the set-ups, 200. 3,000 / 200 = 15 per set up.

Cost driver rate = £15 per set up.

Invoicing costs

£28,000 divided by the number of cost drivers, sales invoices issued, 800. 28,000 / 800 = 35

Cost driver rate = £35 per invoice issued.

After production has finished, we are given the following actual costs and driver numbers:

Cost pool (activity)Actual overheadsCost driver (cause of cost) Actual number of drivers

Machinery set up costs

£3,200Number of set ups180

Invoicing costs £27,000Number of sales invoices issued 820

From this we can calculate whether we have over or under absorbed the overheads. Note that this is sometimes referred to as over or under recovery of overheads.

Overheads Actual overheads Overheads absorbed Over/under absorption of overheads

Machine set-up costs £3,200[180 hours x OAR £15] £2,700

[£3,200 - £2,700] £500 under-absorbed

Invoicing costs£27,000[820 x OAR £35] £28,700 [£27,000 - £28,700] £1,700 over-absorbed

The machine set-up costs were under absorbed because we absorbed less than the actual overheads.

The invoicing costs were over absorbed because we absorbed more than the actual overheads.

If you like my way of explaining things, you might like my workbooks, which are all available from Amazon in both paperback and as eBooks. The links to all my workbooks can be found at https://www.teresaclarke.co.uk/

• Teresa Clarke FMAAT