ACTIVITY BASED COSTING

 ACTIVITY BASED COSTING
Unlike the first cost allocation criterion, activity based costing uses a number of cost pools, organized by activity, to allocate the overhead costs (Hirsch, 2006; Cokins, 2001). The main aim of this type of costing is to allocate costs to each cabinet based on their individual use of the costly activities (Heisinger, 2008). Activity based costing is generally implemented in five steps. The first step is to identify the costly activities required to complete the products. In this case the costly activities are all summarized in the table below.

Costly Activity	 Total Cost of Activity
Set up costs (6 set ups in march)	   12,200
Purchasing and checking wood edging	     8,000
Purchase of wood	     5,100
Quality inspection of wood edging	     7,400
Dispatch and Transport	   12,000
Administration and personnel costs	          27,600
   72,300
 

Notice that the overall total cost for all the activities corresponds to the total cost of overheads in the original profit statement.

The second step is to assign the overhead costs to the activities identified in the first step. This has already been done in the table above.  The third step is to identify the cost drivers for each activity. These drivers are summarized in the table below.

Cost Driver	Impero	Escana	Driftwood	Total
Wood (metres) per cabinet	15	15	10	40
Wood edging (metres) per cabinet	4	4	0	8
Labour (hours) per cabinet	48	40	32	120
No. of set ups	2	2	1	5
No. of dispatches	30	120	150	300
 

After matching the cost drivers, the next step is to determine the overhead application rate for each activity. This is summarized in the table below

Activity	Cost Driver	Total Overhead Cost	Total Consumption by Cost Driver	Overhead Application Rate
Set up costs (6 set ups in March)	No Set Ups	   12,200	6	2033.33
Purchasing and checking wood edging	Wood edging	     8,000	8	1000
Purchase of wood	Wood	     5,100	40	127.5
Quality inspection of wood edging	Wood edging	     7,400	8	925
Dispatch and Transport	No. of Dispatches	   12,000	300	40
Administration and personnel costs	Labour hours	          27,600	120	230
 

The reason why the number of set ups and the number of dispatches were chosen as the cost drivers for the set up costs and dispatch and transport costs respectively, is rather obvious. The number of sets has without a doubt the most significant influence on the set up costs and so does the number of dispatches with regard to the dispatch and transport cost. The same applies to wood and purchase of wood; and wood edging and purchase and checking of wood edging. Because quality inspection of wood edging cannot take place when the products being inspected do not contain any wood edging, it was also more prudent to use wood edging as a cost driver for the inspection as opposed to labour hours. If this were the case, then the cost of the inspection would also apply to Driftwood, which is not made out of any wood edging. Finally, labour hours were selected for the administrative and personnel costs because the latter are incurred when paying the workers who engage either directly or indirectly in production of the cabinets and paying for the utilities they used in order to achieve these tasks. Additionally, the work performed by personnel is traditionally measured in labour hours (Chapman, et al., 2007).

Once the overhead application rates have been established, overhead costs are allocated to each individual product as illustrated below

Impero
Materials	Application Rate	Cost Driver Activity	Cost
Set up costs	2,033.33	2	4,066.67
Purchasing and checking wood edging	1,000.00	4	4,000.00
Purchase of wood	127.50	15	1,912.50
Quality inspection of wood edging	925.00	4	3,700.00
Dispatch and Transport	40.00	30	1,200.00
Administration and personnel costs	230.00	48	11,040.00
25,919.17
 

Escana
Materials	 Application Rate	Cost Driver Activity	Cost
Set up costs	        2,033.33	2	     4,066.67
Purchasing and checking wood edging	        1,000.00	4	     4,000.00
Purchase of wood	            127.50	15	     1,912.50
Quality inspection of wood edging	            925.00	4	     3,700.00
Dispatch and Transport	              40.00	120	     4,800.00
Administration and personnel costs	            230.00	40	     9,200.00
  27,679.17
 

Driftwood
Materials	 Application Rate	Cost Driver Activity	Cost
Set up costs	        2,033.33	1	     2,033.33
Purchasing and checking wood edging	        1,000.00	0	                  –
Purchase of wood	            127.50	10	     1,275.00
Quality inspection of wood edging	            925.00	0	                  –
Dispatch and Transport	              40.00	150	     6,000.00
Administration and personnel costs	            230.00	32	     7,360.00
  16,668.33
 

The Revised Profit statement will appear as shown below

Sales Revenue		167,100		
Material Costs	      37,000.00			
Labour Costs	      57,600.00			
Overheads	      70,266.67	          164,867		
Profi