The key characteristics of the activity base costing theory

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It is a method where the allocation of the costs is done for the products and services. This method was established in order to solve the problem associated with the traditional costs management method. The main advantage for using this method is that it is a device for control and planning. Traditional method where unable to exploit the information service cost, production and also fails to provide necessary information and advice for the operation department of the company or the firm. Activity base costing theory allows the firm to feature the products and services more accurately and properly. The key characteristics of the Activity base costing theory is that it helps to reduce the high overheads costs per unit. The only disadvantage it has is the identification of the processes and the activities which have to be allocated properly and this is sometimes very hectic and takes lots of time.

Solution to question 1: Analysis and advice of the problem

First of all we will simplify this case study of 3 pools of cost into two homogeneous cost pools i.e. one cost pools will consists of non-production volume related costs and other will consists of production volume related costs. This can be done because the utilization or expenditure amount for the non-production volume related cost pools like receiving/purchasing, setups and engineering are the same and the expenditure amount for the production volume related cost pools like machining, power, maintenance and material handling are the same. Moreover the cylinder manufacturing company produces two products one is standard product with high volume and the other is specialised product with low volume.

In this case study the pool for non-production volume cost will consist of set ups and engineering support and the pool for production volume cost consists of machines and material handling.

According to the information provided by Davina we have the following:

Budgeted overhead costs per month

In £



Setup and engineering support


Materials handling


Total overheads


Direct labour hours


Total manufacturing cost excluding direct materials


Distribution of the cost pools:

Activity pool

monthly costs in (£)

Measure of activity

Non-production volume cost (NPVC)


Number of purchase orders

Production volume cost (PVC)


Number of direct labour hours

Total overhead cost



Now we calculate the Activity base costs for Cylinder manufacturing company.

First we calculate the Non-production volume cost

= monthly costs of NPVC/total purchase order

= £200,200/460 = £435.22 purchase per order

Now we calculate the Product volume cost

= monthly costs of PVC/total direct labour hours

= £399,100/4000 = £99.775 per direct labour hours

Now we do the calculation for each rate:

Machine hour overhead rate =total for machines overhead cost/total

machine hour

= £399100/6500

= £61.4 (total for machines and

Machine handling i.e. £279500+£119600=£399100)

Setup overhead rate= total for setup overhead cost/total number of


= £200,200/280 = £715

Now we come to the final stage of ABC procedure:

Unit costs for the company:

Different costs

Standard product in (£)

Specialised product in (£)

Direct labour hours*



Machine overheads*



Setups overheads*



Direct labour hours*= total number direct labour hours/labour hours for

standard product

Machine overheads*= total machine hour overhead*machine hour for

the standard product/ specialised product

Setups overheads*= total setups hour overhead* number of setups for

the standard product/ specialised product

Cost traced to products for cylinder manufacturing company for two products


Activity rate multiplied by quantity of activity measure in(£)

Total monthly cost in (£)

Total unit cost in (£)

Non product volume cost (Standard product)




Non product volume cost (Specialised product)




product volume cost (Standard product)




product volume cost (Specialised product)




Direct labour (Standard product)




Direct labour (Specialised product)




Product wise cost:


Total cost in (£)

Total Unit cost in (£)

(Standard product)










(Specialised product)










Here we are given total cost per labour hour i.e. £ 192.325 and the budgeted labour hour are 4000.

Total overhead for the Standard product for the cost traced is £319072.7 (£69635.2+£249437.5) and the unit cost is £127.615. For the Specialised product for cost traced is £280228.5 (£130566+£149662.5) and the unit cost is £186.819. Further direct labour cost for standard product is £32695250 and for specialised product is £32974516.88 and for the unit direct labour cost is £13078.1 and £21796.19225 for standard and specialised product respectively. The main advantage for Davina to switch to the machine hours is to reduce the overhead burden for her company.

Solution to question 2: Analysis depended on Activity based system

The main concept of using ABC (Activity based costing) is to produce, design and distribute the products and services require by the various activities to be performed. Due to this while performing this activities it requires to capital to use and purchase things. After this the activities of the company's are identified and the cost is traced to this activities. By doing this Activity base costing is use to solve the problem that are cause by traditional cost method and inventory valuation method.

In this example of Davina's cylinder manufacturing company which produces two types of products that is standard and specialised. From the calculation done in solution to question 1, it can be seen that the cost of producing specialised product is less than the cost of producing standard product. The reduction in the cost is 0.12% (£39805.82). Also the total unit cost for specialised product is more than standard product, but specialised product produces 300 number of store orders compared to 160 of standard product. This means that unit cost of standard product is £27.84 and its produces 160 store orders where unit cost of specialised product is £87.044 and its produces 300 orders of stores which is twice as much as standard product and that to at the 1500 labour hours which is 1000 labour hours less than standard product. Further the unit cost for machine overheads for the standard product is £214900 which is more than unit cost of specialised product, £184200. This increase is about 16.66%, which could be said that Davina's company is making a loss of 16.66% by not focusing more in preparing specialised product. The setup overhead for specialised product is more than twice than compare to the standard product. But it also setups more than twice the number of setups than the standard product. Although the total unit cost for Specialised product is 66.46% more than standard product but it generates 353.50% more profit than standard product. (£39805.82-£8777.29625/£8777.29625)

Solution to the question 3: Conclusion and recommendation

As mention before that the Activity base costing method is much easy and advanced than traditional cost method and inventory valuation method. Davina should implement this method because Activity base costing method contains all the four important steps which are either overlooked or not taken into consideration by the other methods. Those four steps are as follows:

Identifying the main activities of the company in which it is engaged.

Shaping the drivers of primary and secondary activities.

Combining company's activities into the homogenous pools of cost

Choosing the measures for activity to represent each pool.

Due to this reasons Davina should adopt this method of Activity base costing and also should hire the staff who knows this method and can implement it for her Cylinder manufacturing company and could help her to gain profit.

The greatest fear that Davina has is that its sales target are met but her profit margin is decreasing. This is because of improper allocation of machine hours and labour hours. As in solution to question 1 and 2, we have obtain and justified that cost spend in producing standard product is less but its profit margin is also less whereas the total cost incurred in producing specialised product is less and its profit margin is more. But the drawback of producing specialised product more is that its total unit cost is more than standard product. So Davina should allocated machine hours and labour hours in such a way that specialised product is manufactured more by the company in order to generate more profit and increase the value of the firm along with this Davina should try to reduce the cost of producing standard product in order to increase profit margin by implementing proper machine and labour hours such that the number of setups and number of store orders are increase accordingly. Besides this the budgeted overhead burden is £149.825/labour hour which is quite more than the actual cost for spend on producing specialised product which is just £113.33/ labour hour. Hence in order to get the company out of problems and make to make the operations of the company smooth and steady, Davina should start manufacturing specialised product wherein she could generate more profit. Also if she spends a bit more say for example £80/labour hour behind standard product and increase its productivity and quality than she might be able to increase her profit in standard product as well. Thus for Davina there are various options available but the according to results obtain in solution to question 1 and 2, the best one would be to start producing more specialised product as it has more profit margin than standard product and utilisation of resources is also affordable to Davina's cylinder manufacturing company.