Page 21 - DCOM202_COST_ACCOUNTING_I

Unit 1: Nature and Scope of Cost Accounting

Activity-based Costing Systems Notes
Costs in most manufacturing operations can be divided into three categories: materials
labor, and overhead. Materials, sometimes referred to as direct materials, are the major raw
inputs that go into producing a product or service for sale. For example, Mhlume’s main
raw material is sugar cane. Labor, sometimes referred to as direct labor, represents the
salaries/wages and related costs of employing the workers directly involved with physical
production. In Mhlume’s case, the wages paid to the workers who harvest the cane is an
example of a direct labor cost. Through time-and-motion studies and related physical
measures of a firm’s overall operation, it is a relatively simple matter to link direct materials
and direct labor costs to the final product. The third category of cost, factory overhead, is
more problematic. Factory overhead, sometimes referred to as factory burden, comprises
all the related costs of producing product or service. For example, Mhlume would incur the
following overhead costs in it operation: equipment depreciation, processing chemicals,
water, power for the factory, and supervisor salaries. Unlike direct materials and direct
labor costs, which can be linked to the product by direct attribution, overhead costs must
be linked through a process of allocation. Naturally, that allocation must be done in some
consistent, rational, logical manner. Activity-based costing is one way to allocate overhead
to a product or service. Activity-based costing begins with establishing cost pools. Cost
pools are groups of related costs in a production operation. Some of the cost pools
employed at Mhlume include: land preparation, fertilizing, weed control, and irrigating.
Costs are assigned to a cost pool on the basis of a common cost driver. In activity-based
costing, a cost driver is anything which causes (drives) a cost in the production operation.
For example, in a typical company purchasing costs might be a cost pool, with number of
purchase orders processed being the cost driver. Once the cost pools and cost drivers are
established, accountants can determine the amount of cost absorbed by each unit of the
cost driver. For example, if the total cost of a purchasing department during a period was
$10,000, and the department processed 5,000 purchase orders, the cost per purchase order
would be $2. To tie purchasing costs to the product or service, then, accountants (working
with production staff) must determine how many purchase orders were processed to
move a certain group of goods through the factory. If given lot of goods required five
purchased orders, the accounting system would allocate in purchasing costs to that order.
A similar process would be performed for each cost pool, thus building up the overhead
costs associated with a given group of goods.
Accounting Issues at Mhlume
Mhlume’s operation raises at least three accounting issues: (1) the application of activity
based costing, (2) product pricing and cost control, and (3) transfer pricing.

Activity-based Costing
In general, companies establish activity-based costing systems to gain a more accurate
perception of their product’s cost. Knowing a product’s cost, naturally, is key to setting
its price in the market. However, in Mhlume’s case, the motivation for establishing an
ABC system was different. As previously noted, cultivating, harvesting and processing
sugar is a labor-intensive operation. In other words, most of Mhlume’s costs are labor
costs (prior to the introduction of activity-based costing in the harvesting operation, all
of Mhlume’s harvesting labor costs were aggregated in a single general ledger account.
Thus, managers had a difficult time determining which parts of the cultivating operation
were more expensive and which were relatively less expensive. Mhlume introduced ABC
to help managers of the cultivating operation control their costs more effectively and
efficiently. (Note, however, that activity-based costing has only been applied to cultivating
the sugar cane. The harvesting and milling operations have not adopted ABC, nor have
they asked for it to be introduced.) For external accounting purposes, salaries and wages

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