THEORY QUESTIONS
Q1. Explain Activity Based Budgeting. [CA Inter Nov. 2018, 5 Marks]
Ans.
Activity Based Budgeting analyse the resource input or cost for each activity.
It provides a framework for estimating the amount of resources required as per the budgeted level of activity.
Actual results can be compared with budgeted results to highlight (both in financial and non-financial terms) those activities with major discrepancies from budget for potential reduction in supply of resources.
It is a planning and control system which seeks to support the objectives of continuous improvement.
It means planning and controlling the expected activities of the organisation to derive a cost effective budget that meet forecast workload and agreed strategic goals.
ABB is the reversing of the ABC process to produce financial plans and budgets.
Q2. What is the fundamental difference between Activity Based Costing System (ABC) and Traditional Costing System? Why more and more organisations in both the manufacturing and non-manufacturing industries are adopting ABC? [ICAI Module]
Ans. Fundamental difference between ABC and Traditional costing are as follows:
Activity Based Costing Traditional Absorption Costing
OH are related to activities grouped into cost pools. OH are related to cost centers/departments.
Costs are related to activities and hence are more realistic.
Costs are related to cost centers and hence not realistic of cost behaviour.
Activity-wise Cost Drivers are determined. Time (Hours) is assumed to be the only cost driver governing cost in all departments.
Activity Based CostingTraditional Absorption Costing
Specific activity-wise recovery rates are used. There is no concept of single overhead recovery rate.
Costs are assigned to Cost Objects, e.g. customers, services, distribution channels, products, departments, etc.
Essential activities can be simplified and unnecessary activities can be eliminated. Thus, corresponding costs are also reduced/minimized. Hence ABC aids cost control.
Q3. Explain the following terms:
(i) Cost Object
(ii) Cost Driver
Either multiple overhead recovery rates (for each department) or single overhead recovery rate may be used.
Costs are assigned to Cost Units, i.e. to products or jobs or hours.
Cost Centers/departments cannot be eliminated. Hence, not suitable for cost control.
(iii) Cost Pool. [ICAI Module]
Ans.
(i) Cost Object: It is an item for which cost measurement is required e.g. product or customer.
(ii) Cost Driver: It is a factor that causes a change in the cost of an activity.
Categories of cost driver:
Resource Cost Driver: It is a measure of quantity of resources consumed by an activity. It is used to assign the cost of a resource to an activity or cost pool.
Activity Cost Driver: It is a measure of the frequency and intensity of demand, placed on activities by cost objects. It is used to assign activity costs to cost objects.
(iii) Cost Pool: It represents a group of various individual cost items. It consists of costs that have same cause and effect relationship e.g. machine set-up.
Q4. Describe the various levels of activities under ‘ABC’ methodology. [CA Inter Nov. 2020, 4 Marks]
Ans.
1. Unit level activities: Those activities for which the consumption of resources can be identified with the number of units produced e.g. use of indirect materials/consumables tends to increase in proportion to the number of units produced.
2. Batch level activities: The activities such as setting up of a machine or processing a purchase order are performed in batches. The cost of batch
related activities varies with number of batches made, but is common (or fixed) for all units within the batch e.g. (i) Material ordering, where an order is placed for every batch of production; or (ii) Machine set-up costs, where machines need resetting between each different batch of production.
3. Product level activities: Activities which are performed to support different products in product line e.g. designing the product, producing parts specifications, keeping technical drawings of products up to date.
4. Facilities level activities: Those activities which cannot be directly attributed to individual products. These activities are necessary to sustain the manufacturing process and are common and joint to all products manufactured e.g. maintenance of buildings, plant security.
Q5. What are the advantages of ABC? [ICAI Module]
Ans.
More accurate costing of products/services. Overhead allocation is done on logical basis. Enables better pricing policies by supplying accurate cost information. Utilizes unit cost rather than just total cost.
Help to identify non-value added activities which facilitates cost reduction.
It is helpful to the organizations with multiple products. It highlights problem areas which require attention of the management.
Q6. State the limitations of ABC? [ICAI Module]
Ans.
It is more expensive, particularly in comparison with traditional costing system.
It is not helpful to the small organizations. It may not be applied to organizations with limited products. Selection of the most suitable cost driver may not be easy.
Q7. Which are the stages required in the implementation of ABC? [ICAI Module]
Ans.
(1) Staff Training: Workforce co-operation is essential for successful implementation of ABC. Staff training should be done to create an awareness on the purpose of ABC.
(2) Process Specification: Informal, but structured interviews with key members of personnel will identify the different stages of the
production process, the commitment of resources to each, processing times and bottlenecks.
(3) Activity Definition: The activities must be defined clearly in the early stage in order to manage the problems, if any, effectively.
(4) Activity Driver Selection: Cost driver for each activity shall be selected.
(5) Assigning Cost: A single representative activity driver can be used to assign costs from the activity pools to the cost objects.
Q8. What are the key elements of Activity Based Budgeting? [ICAI Module]
Ans.
The three key elements of activity based budgeting are as follows:
Type of work to be done
Quantity of work to be done
Cost of work to be done.
Q9. What are the benefits of Activity Based Budgeting? [ICAI Module]
Ans.
It can enhance accuracy of financial forecasts and increasing management understanding.
When automated, ABB can rapidly and accurately produce financial plans and models based on varying levels of volume assumptions. It eliminates much of the needless rework created by traditional budgeting techniques.
Q10. What is mean by cost driver? Give its different categories. Suggest suitable cost drivers (at least two) in the following business functions:
(i) Distribution
(ii) Research and Development
(iii) Customer services [Nov. 2023, 4 Marks]
Cost Driver–It is a factor that causes a change in the cost of an activity. There are two categories of cost driver.
Resource Cost Driver– It is a measure of the quantity of resources consumed by an activity. It is used to assign the cost of a resource to an activity or cost pool.
Activity Cost Driver–It is a measure of the frequency and intensity of demand, placed on activities by cost objects. It is used to assign activity costs to cost object
Distribution
Number of units distributed
Number of customers
Research and Development
Number of research projects
Personnel hours on a project
Customer Service
Number of service calls
Number of products serviced
Hours spent on servicing products
PRACTICAL QUESTIONS PRACTICAL
Q1. MNP suits is a ready-to-wear suit manufacturer. It has four customer wholesale-channel customers and two retail-channel customers. MNP suits has developed the following activity-based costing system:
ActivityCost DriverRate in 2021
Order processingNumber of purchase order1,225 per order
Sales visitsNumber of customer visits7,150 per visit
Delivery-regularNumber of regular deliveries1,500 per delivery
Delivery rushedNumber of rushed deliveries4,250 per delivery
List selling price per suit is 1,000 and average cost per suit is 550.
The CEO of MNP suits wants to evaluate the profitability of each of the four customers in 2020 to explore opportunities for increasing profitability of his company in 2021. The following data are available for 2020:
Total number of orders4462212250
Total number of sales visits8122220
Regular deliveries4148166190
Average number of Rush deliveries 3144660
Average No. of suits per order4002003025
Average selling price per suit ` 700 ` 800 ` 850 ` 900
Required:
(i) Calculate the customer-level operating income in 2020.
(ii) What do you recommend to CEO of MNP suits to do to increase the Company’s operating income in 2021?
(iii) Assume MNP suits’ distribution channel costs are ` 17,50,000 for its wholesale customers and ` 10,50,000 for the retail customers.
Also, assume that its Corporate sustaining costs are ` 12,50,000. Prepare Income statement of MNP suits for 2021. [CA Final Nov. 2004, 10 Marks]
Ans.
(i) Computation of Customer level operating income in 2020:
Revenues (at price list)
(44 400 1,000)
(44 400 300 (1,000 – 700))
(62 200 1,000)
(62 200 200 (1,000 – 800))
(250 25 1,000)
(212 30 150 (1000 – 850)) 6,25,000 (250 25 100 (1,000 – 900)) Revenue at actual price 1,23,20,00099,20,00054,06,00056,25,000
(44 400 550)
(62 200 550)
(250 25 550) Gross Margin26,40,00031,00,00019,08,00021,87,500 Customer level operating costs:
Total customer level operating cost1,85,3502,93,2508,61,5009,89,250
Customer level Operating income24,54,65028,06,75010,46,50011,98,250
Customer level
income as % of revenues income at actual prices
(ii) The key challenges that may be faced by CEO:
(1) Reduce level of price discounting, especially by the wholesale customer ‘W’.
(2) Reduce level of Customer level costs’, especially by retail customers R&T.
ABC cost system highlights some of the problem areas regarding the customers R and T. Such as:
high number of orders, high number of customer visits, high number of rushed deliveries.
The CEO needs to consider whether this high level of activity can be reduced without reducing customer revenues.
(iii) Income Statement of MNP suits for 2020:
Customer level operating income52,61,40022,44,75075,06,150 Less: Distribution channel cost17,50,00010,50,00028,00,000
channel level operating income 35,11,40011,94,75047,06,150
: Corporate sustaining cost--12,50,000 Operating income34,56,150
Q2. ABC Ltd. is a multiproduct company, manufacturing three products A, B and C. The budgeted costs and production for the year ending 31st March are as follows:
The budgeted direct labour rate was ` 10 per hour, and the budgeted material cost was ` 2 per kg. Production overheads were budgeted at ` 99,450 and were absorbed to products using the direct labour hour rate. ABC Ltd. followed the Absorption Costing System. ABC Ltd. is now considering to adopt an Activity Based Costing system. The following additional information is made available for this purpose.
1. Budgeted overheads were analysed into the following:
2. The cost drivers identified were as follows:
Material handlingWeight of material handled
Storage costsNumber of batches of material
ElectricityNumber of Machine operations
3. Data on Cost Drivers was as follows:
For complete production:
Batches of material10515
Per unit of production:
Number of Machine operations632
You are requested to:
1. Prepare a statement for management showing the unit costs and total costs of each product using the absorption costing method.
2. Prepare a statement for management showing the product costs of each product using the ABC approach.
3. State what are the reasons for the different product costs under the two approaches? [ICAI Module]
Ans.
1. Traditional Absorption Costing
Total budgeted direct labour hours:
4,000 × 30 min + 3,000 × 45 min + 1,600 × 60 min 60 min
Total joint cost Total sale value = 5,800 hours
Overhead rate per direct labour hour: = Budgeted overheads ÷ Budgeted labour hours = ` 99,450 ÷ 5,850 hours = ` 17 per direct labour hour
Unit Costs:
Number of units4,0003,0001,600
Total costs86,00096,75052,800
2. Activity Based Costing
ABCTotal
Quantity (units)4,0003,0001,600-
Material Weight per unit (Kg.)463-
Total material weight16,00018,0004,80038,800
Machine operations per unit632-
Total operations24,0009,0003,20036,200
Total batches of Material1051530
Material handling rate per kg. = ` 29,100 ÷ 38,800 kg. = ` 0.75 per kg.
Electricity rate per machine operations = ` 39,150 ÷ 36,200 = ` 1.081 per machine operations
Storage rate per batch = ` 31,200 ÷ 30 batches = ` 1,040 per batch
Unit Costs:
Direct
Total unit costs25.0928.9730.16
Number of units4,0003,0001,600 Total costs ` 1,00,360 ` 86,910 ` 48,256
3. The difference in the total costs under the two systems is due to the differences in the overheads borne by each of the products. The Activity Based Costs appear to be more precise.
