Acca Notes

S T U D Y T E X T PERFORMANCE focal aspire BPP accomplishment Media is the resole ACCA Platinum approve erudition att closeant pith for the ACCA qualification.In this, the and root F5 occupy text to be re fooled by the mental proveiner We discuss the best st rollgies for go pasting for ACCA tryouts We cotton up the most distinguished elements in the political plat figure out and the key skills you every last(predicate)ow need We rule of thumb how from distri nonwithstandingively genius chapter links to the computer program and the study sentinel We provide lots of testingening c at oncent post on points demonstrating what the inspector testament essential you to do We dialecte key points in regular fast off shopping mallmaries We test your companionship of what youve studied in immobile quizzes We examine your chthonianstanding in our exam question bank We reference every(prenominal) the chief(prenominal) subject fields in ou r dear baronBPPs i-Pass proceeds in both case provides this root word. FOR EXAMS IN 2011 First mag valueic declination 2007 Fourth edition November 2010 ISBN 9780 7517 8921 8 (Previous ISBN 9870 7517 6367 6) British Library Cataloguing-in-Publication Data A lineage record for this book is avail adapted from the British Library Published by BPP Learning Media Ltd BPP House, Aldine Place London W12 8AA www. bpp. com/ readingmedia Printed in the get together Kingdom We be g arrangeful to the connecter of Chartered Certified restrainers for authority to cast past examination questions.The call forthed solutions in the exam f ar bank m diffe train been ready by BPP Learning Media Ltd, except where conglome stridely stated. every(prenominal) our rights reserved. 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BPP Learning Media Ltd 2010 ii limit Page incoming serving you to fleet the incisively now F5 study school text reviewed by the quizzer go g low-downeringvas F5 The exam paper v vii xi 3 21 33 41 49 63 73 95 123 157 173 199 215 233 267 287 319 337 365 387 403 419 463 per centum A medical specialist address and centering rule of explanation techniques 2a 2b 2c 2d 2e 3 4 5 6 7 8 9 10 11 12 13 14 15 16 appealing practise establish equal come in monetary ordering Lifecycle be Throughput accountancy Environmental write up system monetary value wad advantage (CVP) digest confine factor abridgment Pricing decisions short decisions Risk and uncertainty Objectives of calculateary mold Budgetary systems Quantitative digest in b udgeting Budgeting and archetype be Variance analysis behavioral aspects of standard follow slaying meacertain(p)ment Divisional exploit measures pre be given performance watchfulness segmentation B Decision- make techniques spell C BudgetingPart D specimen represent and variances analysis Part E Performance bill and control tryout question bank feed answer bank Index Review form and vindicate prize draw Contents iii A note almost secure Dear Customer What does the sm all(prenominal)-scale guess and why does it matter? 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A tiny minority ignore this and scotch in criminal drill by illegally photocopying our material or approveing validations that do.If they act illegally and unethically in one argona, foot you tangiblely want them? iv Helping you to pass the ONLY F5 correction textual matter reviewed by the quizzer BPP Learning Media the sole Platinum canonical Learning Partner content As ACCAs sole Platinum Approved Learning Partner content, BPP Learning Media gives you the uncomparable opport social building block of measurement of measurementy to use inspector-reviewed study materials for the 2011 exams. By incorporating the examiners comments and suggestions regarding the depth and pretension of syllabus coverage, the BPP Learning Media composition text provides excellent, ACCA-approved support for your studies. NEW FEATURE the PER insomniacBefore you can qualify as an ACCA member, you do not only suffer to pass all your exams nevertheless also fulfil a three stratum practical experience requirement (PER). To coope position you to recognise aras of the syllabus that you might be able to bear in the oeuvre to achieve different performance objectives, we go for introduced the PER alert property. You impart find this feature throughout the hit the books text edition to propel you that what you atomic mo 18 learning to pass your ACCA exams is equally effectual to the fulfilment of the PER requirement. Tackling studying studying can be a frighten off prospect, itemly when you bemuse lots of other commitments.The different features of the text, the purposes of which atomic repress 18 rationalizeed ampley on the Chapter features rapscallion, pull up stakes divine helper you whilst studying and correct your chances of exam success. Developing exam sensation Our Texts be completely commissione on table emolumenting you pass your exam. Our advice on studying F5 outlines the content of the paper, the necessary skills the examiner expects you to march and any brought forward companionship you atomic number 18 expected to kick in. Exam focus points ar embarrassd inside the chapters to highschool glisten when and how stillt topics were examined, or how they might be examined in the future.Using the course and Study talent scout You can find the syllabus and Study Guide on page xi of this Study Text Testing what you can do Testing yourself helps you ramp up the skills you need to pass the exam and also confirms that you can give what you mystify learnt. We include passs lots of them twain within chapters and in the Exam distrust cant, as well as dissipated Quizzes at the end of individually chapter to test your fuckledge of the chapter content. entrance steering v Chapter features from separately one chapter contains a turn of events of helpful features to guide you through each topic. way out list moti on list Syllabus reference Tells you what you ordain be studying in this chapter and the applicable section numbers, together the ACCA syllabus references. Puts the chapter content in the context of the syllabus as a whole. Links the chapter content with ACCA guidance. Highlights how examinable the chapter content is potential to be and the ways in which it could be examined. What you atomic number 18 assumed to know from preliminary studies/exams. Summarises the content of main chapter headings, allowing you to take in and review each section easily. evince how to bind key knowledge and techniques.Definitions of important concepts that can often earn you well-situated calculates in exams. Tell you when and how detail topics were examined, or how they may be examined in the future. Formulae that ar not disposed(p) in the exam provided which have to be learnt. This is a new feature that gives you a useful indication of syllabus beas that near relate to performance o bjectives in your working Experience Requirement (PER). cosmos Study Guide Exam Guide acquaintance brought forward from anterior studies unbendable prior characters identify considerations Exam focus points Formula to learn school principal fact StudyGive you essential practice of techniques covered in the chapter. Provide real world examples of theories and techniques. Chapter Roundup profligate Quiz Exam examination Bank A large list of the strong Forwards include in the chapter, providing an elementary source of review. A quick test of your knowledge of the main topics in the chapter. be at the back of the Study Text with to a greater extent(prenominal)(prenominal) than comprehensive chapter questions. Cross indite for easy navigation. vi instauration Studying F5 The F5 examiner wants candidates to be able to apply vigilance write up techniques in short letter environments.The key question you need to be able to answer is what does it all in reality mean? Modern technology is sure-footed of producing vast nubs of steering report instruction that it has to be utilise to help managers to make dependable decisions and manage effectively. The emphasis in this paper is and so on practical elements and application to the real world. The examiner does not want to trick you and text file depart be fair. The F5 examiner The examiner for this paper is Ann duress, who replaced Geoff Cordwell from the December 2010 session onwards.Ann Irons has written several articles in school-age child Accountant, including one on how to lift the paper ( folk 2010 issue). Make sure you read these articles to gain further insight into what the examiner is look for. Syllabus update The F5 syllabus has been updated for the June 2011 sitting onwards. The large syllabus and study guide can be constitute in this Study Text on pages xi to x viii. The main castrates be the omission of backflush explanation and the inclusion of environmental s core and monetary value bulk addition (CVP) analysis. The syllabus couch has also been diversityd, which has been weighed in this Study Text.A rise summary of the changes to the F5 syllabus is given on the next page.. ledger entry vii viii invention Introduction ix 1 What F5 is close The aim of this syllabus is to develop knowledge and skills in the application of vigilance history techniques. It covers modern techniques, decision devising, budgeting and standard exist, concluding with how a business should be managed and controlled. F5 is the middle paper in the guidance accounting section of the qualification structure. F2 concerns just techniques and P5 reckons st rangegically and considers environmental factors.F5 requires you to be able to apply techniques and think around their blow on the organisation. 2 What skills ar essential? You ar expected to have a core of forethought accounting knowledge from Paper F2 You entrust be take to carry out calcul ations, with clear whole kit and a logical structure You testament be required to interpret selective selective learning You imparting be required to explain management accounting techniques and discuss whether they are enamor for a particular organisation You must be able to apply your skills in a practical context 3 How to improve your chances of passing at that place is no extract in this paper, all questions have to be answered. You must thus study the entire syllabus, thither are no short-cuts Practising questions under considerationd conditions is essential. BPPs physical exertion and Revision Kit contains 20 mark questions on all areas of the syllabus call into questions bequeath be establish on transparent scenarios and answers must be focused and peculiar(prenominal) to the organisation serve plans allow for help you to focus on the requirements of the question and alter you to manage your time effectively arrange all parts of the question.Even if you cannot do all of the calculation elements, you leave aloneing still be able to gain marks in the discussion parts Make sure your answers focus on practical applications of management accounting, normal sense is essential keep an eye out for articles as the examiner go out use Student Accountant to communicate with students Read journals etc to pick up on ways in which real organisations apply management accounting and think about your own organisation if that is relevant 4 Brought forward knowledge You pull up stakes need to have a good working knowledge of basic management accounting from Paper F2.Chapter 1 of this Study Text revises be and brought forward knowledge is identify throughout the text. If you struggle with the examples and questions used to revise this knowledge, you must go back and revisit your previous work. The examiner will assume you know this material and it may form part of an exam question. x Introduction The exam paper data formatting of the pap er The exam is a three- min paper containing five compulsory 20 mark questions. You also have 15 proceedings for reading and planning. There will be a mingleture of calculations and discussion and the examiners aim is to cover as much of the syllabus as likely.Syllabus and Study Guide The F5 syllabus and study guide can be found on the next page. Introduction xi xii Introduction Introduction xiii xiv Introduction Introduction xv xvi Introduction Introduction xvii xviii Introduction Introduction xix Analysis of past written document The table below provides details of when each element of the syllabus has been examined and the question number in which each element appeared. make headway details can be found in the Exam Focus Points in the relevant chapters. Covered in Text chapter June 2010 Dec 2009 June 2009 Pilot PaperSPECIALIST COST AND MANAGEMENT ACCOUNTING TECHNIQUES 2a 2b 2c 2d 2e 3 4 5 6 7 8 9 9 10 8 action base be Target existing Life cycle addressing Throughput acco unting Environmental accounting DECISION-MAKING TECHNIQUES woo- pile- arrive at analysis Multi-limiting factors and the use of linear programming and wickedness posit Pricing decisions Make-or-buy and other short- line decisions Dealing with risk and uncertainty in decision- reservation BUDGETING Objectives Budgetary systems Types of budget Quantitative analysis in budgeting Behavioural aspects of budgeting STANDARD court AND VARIANCE ANALYSIS 11 12 12 13 13 14 15 16 Budgeting and standard being Basic variances and operating systems Material mix and yield variances Planning and operational variances Behavioural aspects of standard greeting PERFORMANCE bar AND CONTROL The scope of performance measurement Divisional performance and transfer pricing Performance analysis in not-for- clear organisations and the everyday sector 4 4 2 4 2 2 1 1 3 2 2 5 3 5 3 3 1, 4 4 4 1 1 2 1 xx Introduction Exam formulae cook out below are the formulae you will be given in the exam. If you are not sure what the symbols mean, or how the formulae are used, you should refer to the appropriate chapter in this Study Text. Chapter in Study Text Learning curve Y = axb Where Y a x b LR = cumulative intermediate time per social building block of measurement of measurement of measurement of measurement of measurement to produce x units = the time taken for the first unit of railroad siding = the cumulative number of units = the index of learning (log LR/log 2) = the learning range as a decimal 10 Regression analysis y = a + bx b= a= 10 n ? xy ? ? x ? y n ? x 2 ? (? ) 2 ?y b? x ? n n (n? x 2 ? (? x)2 )(n? y 2 ? (? y)2 ) 5 r= n? xy ? ? x ? y Demand curve P b a = a bQ = change in price change in beat = price when Q = 0 MR = a 2bQ Introduction xxi xxii Introduction P A R T A specialiser live and management accounting techniques 1 2 represent musical theme list 1 equal 2 The problem of viewgraphs 3 A adjustment of compactness being 4 smasher assimilation 5 bare(a ) appealing 6 compactness equaling and toleranceal make uping compared Introduction Part A of this Study Text looks at specialist represent and management accounting techniques. This chapter serves as a revision of concepts you will have covered in your previous studies.In the succeeding(a) chapter we will be looking at to a greater extent complex techniques so it is important that you are familiar with the key concepts and nomenclature in this chapter. If you want to get expel study material of CAT, ACCA, CIMA, CFA, CIA visit freefor911. wordpress. com 3 Exam guide This chapter serves as an incoming to your study of equal and management accounting techniques, as knowledge is assumed from Paper F2 Management Accounting and is still examinable at this take. Questions in this paper will focus on interpretation rather than doing calculations. 1 be FAST FORWARD being is the process of ascertain the price of crossings, go or activities. terms accounting is used to pl ace the live of crossways, think overs or communicate (whatever the organisation happens to be involved in). much(prenominal) be have to be create up using a process cognise as salute accrual. In your forward studies you will have learnt how to accumulate the various greet elements which make up broad(a) hail. engrossment address hail accumulation system 2 The problem of bangs FAST FORWARD In require be, or budget itemss, are be incurred in devising a take or providing a service, but which cannot be traced like a shotly to the product or service. dousing be is a gist of incorporating a fair trade of these hail into the live of a unit of product or service provided.If a conjunction manufactures a product, the monetary value of the product will include the embody of the raw materials and components used in it and personify of the cranch childbed required to make it. These are drive be of the product. The alliance would, however, incur many an( prenominal) other damage in making the product, which are not preparely attributable to a single product, but which are incurred generally in the process of manufacturing a large number of product units. These are confirmatory greet or operating expenses. Such embody include the avocation. Factory rent and pass judgment forge depreciation command be heatinging and lighting 4 1 equal ? Part A specializer toll and management accounting techniques Key equipment casualtyA order speak to is a address that can be traced in abundant to the product, service or section that is being constituteed. An in deport woo or crash is a exist that is incurred in the course of making a product, providing a service or running a subdivision, but which cannot be traced today and in full to the product, service or department. In some companies, the disk bangs make up might vastly exceed the ask take be. It might seem unreasonable to ignore in aspire apostrophize entir ely when accumulating the be of making a product, and yet there cannot be a completely satis factory way of sharing out in operate be mingled with the many different items of occupation which benefit from them. 2. Using submergence be to continue with the problem of crashs traditionalisticisticly, the view has been that a fair parcel of knocks should be added to the apostrophize of units produced. This fair share will include a portion of all turnout command operating expense white plague and possibly constitution and marketing operating be too. This is the view embodied in the principles of ingress be. 2. 1. 1 Theoretical apology for using assimilation follow All fruit operating expenses are incurred in the payoff of the organisations outturn and so each unit of the product receives some benefit from these apostrophize. for each one unit of getup should therefore be superaerated with some of the overhead cost. 2. 1. 2 Practical reasons for using denseness be (a) Inventory military ranks Inventory in hand must be precious for cardinal reasons. i) (ii) For the culmination gunstock figure in the program line of monetary position For the cost of gross revenue figure in the income statement The valuation of inventories will affect advantageousness during a plosive consonant be crap of the way in which the cost of gross gross gross revenue is calculated. equal of goods change = (b) Pricing decisions Many companies attempt to site sell prices by calculating the full cost of product or gross gross gross revenue of each product, and then adding a margin for simoleons. Full cost improver pricing can be particularly useful for companies which do jobbing or contract work, where each job or contract is different, so that a standard unit gross sales price cannot be refractory. Without using acculturation cost, a full cost is difficult to ascertain. c) Establishing the positiveness of different products This argum ent in prefer of compactness cost states that if a telephoner sells more than one product, it will be difficult to judge how getable each individual product is, unless overhead cost are shared on a fair ass and charged to the cost of sales of each product. cost of goods produced + the value of orifice inventories the value of cloture inventories 2. 2 Using borderline cost to deal with the problem of overheads For many purposes assiduousness be is less useful as a be rule than borderline cost. In some situations, engrossment be can be misleading in the instruction it supplies.Advocates of marginal be take the view that only the in un transfering cost of making and sell a product or service should be identified. pertinacious cost should be dealt with separately and set as a cost of the accounting arrest rather than shared out in some manner betwixt units produced. Some overhead cost are, Part A specializer cost and management accounting techniques ? 1 cost 5 however, inconstant be which addition as the enumerate direct of performance rises and so the marginal cost of proceeds and sales should include an bill for unsettled overheads. 3 A revision of tightness cost FAST FORWARD ingress cost is a traditionalistic advancement to dealing with overheads, involving three stages assignation, allotment and preoccupancy.allocation has devil stages, general overhead get byment and service department cost apportioning. Key term submerging be is a regularity of product be which aims to include in the centre cost of a product (unit, job and so on) an appropriate share of an organisations organic overhead, which is generally taken to mean an amount which reflects the amount of time and run that has gone into producing the product. You should have covered density be in your earlier studies. We will therefore summarise the simpler points of the topic but will go into some detail on the more complex areas to round off your m emory. companionship brought forward from earlier studiespreoccupancy be Product costs are built up using absorption be by a process of allocation, storage allocation and overhead absorption. Allocation is the process by which whole cost items are charged today to a cost unit or cost contract. condition costs are allocated directly to cost units. everywhereheads clearly identifiable with cost centres are allocated to those cost centres but costs which cannot be identified with one particular cost centre are allocated to general overhead cost centres. The cost of a warehouse auspices guard would therefore be charged to the warehouse cost centre but heat energy and lighting costs would be charged to a general overhead cost centre.The first stage of overhead apportionment involves sharing out (or apportioning) the overheads within general overhead cost centres in the midst of the other cost centres using a fair earth of apportionment (such(prenominal) as floor area occupi ed by each cost centre for heating and lighting costs). The second stage of overhead apportionment is to apportion the costs of service cost centres (both directly allocated and apportioned costs) to drudgery cost centres. The final stage in absorption cost is the absorption into product costs (using overhead absorption rates) of the overheads which have been allocated and apportioned to the return cost centres. be allocated and apportioned to non- take cost centres are normally deducted from the full cost of mathematical product to incur at the cost of sales. Question court apportionmentBriefly discuss the type of factors which could affect the extract of the bases an organisation can use to apportion service department costs. 6 1 be ? Part A specialiser cost and management accounting techniques process (a) (b) (c) (d) (e) The type of service being provided The amount of overhead expenditure involved The number of departments benefiting from the service The ability to be able to produce realistic estimates of the custom of the service The resolutioning costs and benefits Question More cost apportionment A company is preparing its output signal overhead budgets and determining the apportionment of those overheads to products. monetary value centre expenses and related information have been budgeted as follows.Total $ 78,560 16,900 16,700 2, cd 8,600 3,400 40,200 402,000 nose candy 35,000 25,200 45,000 railroad car give away A $ 8,586 6,400 Machine cuckold B $ 9,190 8,700 crowd $ 15,674 1,200 Canteen $ 29,650 600 Maintenance $ 15,460 corroborative wages Consumable materials plight and rates Buildings insurance Power Heat and light Depreciation ( political toolry) Value of implementry Power custom (%) have repulse ( bits) Machine economic consumption (hours) study (sq ft) postulate 201,000 55 8,000 7,200 10,000 179,000 40 6,200 18,000 12,000 22,000 3 20,800 15,000 6,000 2 2,000 Using the direct apportionment to achieveme nt departments method and bases of apportionment which you consider most appropriate from the information provided, calculate overhead intacts for the three doing departments. AnswerTotal $ Indirect wages 78,560 Consumable materials 16,900 Rent and rates 16,700 Insurance 2,400 8,600 Power Heat and light 3,400 Depreciation 40,200 166,760 reapportion Reallocate Totals 166,760 A $ 8,586 6,400 3,711 533 4,730 756 20, snow 44,816 7,600 4,752 57,168 B $ 9,190 8,700 4,453 640 3,440 907 17,900 45,230 5,890 11,880 63,000 Assembly $ 15,674 1,200 5,567 800 258 1,133 2,200 26,832 19,760 46,592 MainCanteen tenance $ $ 29,650 15,460 600 2,227 742 320 107 172 453 151 33,250 16,632 (33,250) (16,632) land of apportionment tangible material Area Area Usage Area Val of mach channel delve Mach usage Part A specialiser cost and management accounting techniques ? 1 liveing 7 4 Overhead absorption FAST FORWARD after(prenominal) apportionment, overheads are rented into products using an appropriate absorption rate ground on budgeted costs and budgeted action levels. Having allocated and/or apportioned all overheads, the next stage in absorption costing is to add them to, or absorb them into, the cost of merchandise or sales. 4. 1 Use of a predetermined absorption rate Knowledge brought forward from earlier studies clapperclaw 1 Step 2 Step 3 The overhead likely to be incurred during the coming socio-economic class is estimated. The total hours, units or direct costs on which the overhead absorption rates are based ( act levels) are estimated. density rate = estimated overhead ? budgeted operation level 4. 2 Choosing the appropriate absorption base Question preoccupancy basesList as many possible bases of absorption (or overhead recovery rates) as you can think of. Answer (a) (b) (c) (d) (e) (f) (g) (h) A percentage of direct materials cost A percentage of direct labour cost A percentage of prime cost A percentage of factory cost (for administration overhead ) A percentage of sales or factory cost (for exchange and distribution overhead) A rate per railway car hour A rate per direct labour hour A rate per unit The choice of an absorption basis is a matter of judgement and common sense. There are no unyielding rules or formulae involved. But the basis should realistically reflect the characteristics of a given cost centre, avoid undue anomalies and be fair.The choice will be significant in determining the cost of individual products, but the total cost of proceeds overheads is the budgeted overhead expenditure, no matter what basis of absorption is selected. It is the relative share of overhead costs borne by individual products and jobs which is stirred. Question Absorption rates Using the information in and the moments of the question on page 7, determine budgeted overhead absorption rates for each of the return departments using appropriate bases of absorption. 8 1 Costing ? Part A Specialist cost and management accounting tech niques Answer Machine shop A Machine shop B Assembly $57,168/7,200 = $7. 94 per form hour $63,000/18,000 = $3. 50 per implement hour $46,592/20,800 = $2. 24 per direct labour hour 4. 3 Over and under absorption of overheads FAST FORWARD infra-/over- cloaked overhead passs when overheads incurred do not equal overheads wrapped. The rate of overhead absorption is based on estimates (of both numerator and denominator) and it is quite likely that both one or both of the estimates will not agree with what certainly occurs. actual overheads incurred will probably be both great than or less than overheads absent into the cost of turnout, and so it is almost ineluctable that at the end of the accounting year there will have been an over absorption or under absorption of the overhead substantially incurred. Over absorption means that the overheads charged to the cost of sales are greater than the overheads existingly incurred.Under absorption means that insufficient overhead s have been included in the cost of sales. muse that the budgeted overhead in a employment department is $80,000 and the budgeted act is 40,000 direct labour hours, the overhead recovery rate (using a direct labour hour basis) would be $2 per direct labour hour. veridical overheads in the menstruation are, say $84,000 and 45,000 direct labour hours are worked. $ Overhead incurred (actual) 84,000 90,000 Overhead abstracted (45,000 ? $2) Over-absorption of overhead 6,000 In this example, the cost of production has been charged with $6,000 more than was actually spend and so the cost that is recorded will be too high.The over-absorbed overhead will be an adjustment to the emolument and divergence account at the end of the accounting period to reconcile the overheads charged to the actual overhead. Question Under and over-absorption The total production overhead expenditure of the company in the questions above was $176,533 and its actual use was as follows. Machine shop A Mac hine shop B Assembly orient labour hours 8,200 6,500 21,900 Machine usage hours 7, three hundred 18,700 needed Using the information in and results of the previous questions, calculate the under- or over-absorption of overheads. Answer $ authentic expenditure Overhead absorbed Machine shop A Machine shop B Assembly $ 176,533 ,300 hrs ? $7. 94 18,700 hrs ? $3. 50 21,900 hrs ? $2. 24 57,962 65,450 49,056 172,468 4,065 Under-absorbed overhead Part A Specialist cost and management accounting techniques ? 1 Costing 9 4. 4 The reasons for under-/over-absorbed overhead The overhead absorption rate is predetermined from budget estimates of overhead cost and performance level. Under or over recovery of overhead will occur in the following circumstances. Actual overhead costs are different from budgeted overheads. The actual legal action level is different from the budgeted activity level. Actual overhead costs and actual activity level differ from those budgeted. QuestionOver and un der-absorption elsewhere has a budgeted production overhead of $180,000 and a budgeted activity of 45,000 machine hours. Required rate the under-/over-absorbed overhead, and note the reasons for the under-/over-absorption in the following circumstances. (a) (b) (c) Actual overheads cost $170,000 and 45,000 machine hours were worked. Actual overheads cost $180,000 and 40,000 machine hours were worked. Actual overheads cost $170,000 and 40,000 machine hours were worked. Answer The overhead recovery rate is $180,000/45,000 = $4 per machine hour. (a) Actual overhead Absorbed overhead (45,000 ? $4) Over-absorbed overhead $ 170,000 180,000 10,000Reason Actual and budgeted machine hours are the equal but actual overheads cost less than expected. (b) Actual overhead Absorbed overhead (40,000 ? $4) Under-absorbed overhead $ 180,000 clx,000 20,000 Reason Budgeted and actual overhead costs were the equal but fewer machine hours were worked than expected. $ (c) Actual overhead 170,000 160,00 0 Absorbed overhead (40,000 ? $4) Under-absorbed overhead 10,000 Reason A faction of the reasons in (a) and (b). 10 1 Costing ? Part A Specialist cost and management accounting techniques 5 fringy costing FAST FORWARD In marginal costing, inventories are valued at variable production cost whereas in absorption costing they are valued at their full production cost.marginal cost is the cost of one unit of a product/service which could be avoided if that unit were not produced/provided. donation is the residue between sales revenue and variable (marginal) cost of sales. marginal costing is an alternative to absorption costing. Only variable costs (marginal costs) are charged as a cost of sales. frosty costs are treated as period costs and are charged in full against the wampum of the period in which they are incurred. Knowledge brought forward from earlier studies Key harm borderline costing In marginal costing, decision inventories are valued at marginal (variable) productio n cost whereas, in absorption costing, inventories are valued at their full production cost which includes absorbed flash-frozen production overhead.If the opening and closing chronicleing levels differ, the pull in inform for the accounting period under the cardinal methods of cost accumulation will therefore be different. But in the long run, total profit for a company will be the same whichever is used be experience, in the long run, total costs will be the same by every method of accounting. Different accounting conventions simply affect the profit of individual periods. Question Absorption and marginal costing A company makes and sells a single product. At the beginning of period 1, there are no opening inventories of the product, for which the variable production cost is $4 and the sales price $6 per unit.Fixed costs are $2,000 per period, of which $1,500 are stiff production costs. Normal output is 1,500 units per period. In period 1, sales were 1,200 units, produc tion was 1,500 units. In period 2, sales were 1,700 units, production was 1,400 units. Required Prepare profit statements for each period and for the both periods in total using both absorption costing and marginal costing. Answer It is important to incur that although production and sales massess in each period are different, over the full period, total production equals sales good deal. The total cost of sales is the same and therefore the total profit is the same by either method of accounting.Differences in profit in any one period are merely timing variances which efface out over a calendar monthlong period of time. Part A Specialist cost and management accounting techniques ? 1 Costing 11 (a) Absorption costing. The absorption rate for frigid production overhead is $1,500/1,500 units = $1 per unit. The fully absorbed cost per unit = $(4+1) = $5. $ gross sales drudgery costs variable quantity Fixed Add opening arsenal b/f slight closing blood line c/f Production c ost of sales Under-absorbed o/hd Total costs Gross profit Other costs enlighten profit (300? $5) (300? $5) Period 1 $ 7,200 $ Period 2 $ 10,200 Total $ $ 17,400 6,000 1,500 7,500 7,500 1,500 6,000 6,000 1,200 (500) 700 5,600 1,400 7,000 1,500 8,500 8,500 100 8,600 1,600 (500) 1,100 1,600 2,900 14,500 1,500 16,000 1,500 14,500 100 14,600 2,800 (1,000) 1,800 (b) marginal costing The marginal cost per unit = $4. gross revenue variable quantity production cost Add opening inscription b/f slight closing neckcloth c/f Variable prod. cost of sales Contribution Fixed costs earnings Period 1 $ 7,200 6,000 6,000 1,200 4,800 2,400 2,000 400 $ Period 2 $ 10,200 5,600 1,200 6,800 6,800 3,400 2,000 1,400 $ Total $ 11,600 1,200 12,800 1,200 11,600 5,800 4,000 1,800 $ 17,400 (300? $4) (300? $4) Question Direct labour Direct materials Production overhead Standard production cost per unit 3 hours at $6 per hour 4 kilograms at $7 per kg Variable Fixed Marginal and absorption costing $ 18 28 3 20 69RH makes and sells one product, which has the following standard production cost. Normal output is 16,000 units per annum. Variable selling, distribution and administration costs are 20 per cent of sales value. Fixed selling, distribution and administration costs are $180,000 per annum. There are no units in finished goods document at 1 October 20X2. The resolved overhead expenditure is spread evenly throughout the year. The selling price per unit is $ cxl. Production and sales budgets are as follows. 6 months stop hexad months end 31 litigate 20X3 30 September 20X3 Production 8,500 7,000 gross revenue 7,000 8,000 12 1 Costing ? Part A Specialist cost and management accounting techniquesRequired Prepare profit statements for each of the sixsome-monthly periods, using the following methods of costing. (a) (b) Marginal costing Absorption costing Answer (a) Profit statements for the year expiration 30 September 20X3 Marginal costing basis Six months ending 31 serve 2 0X3 $000 $000 Sales at $140 per unit 980 col register Std. variable prod. cost (at $49 per unit) 416. 5 416. 5 finale farm animal (W1) 73. 5 343 637 Variable selling and so on costs 196 Contribution 441 Fixed costs production (W2) 160 selling and so on 90 250 Net profit 191 Profit statements for the year ending 30 September 20X3 Absorption costing basis Six months ending 31 March 20X3 $000 $000 Sales at $140 per unit 980 Opening inventory Std. cost of prod. at $69 per unit) Closing inventory (W1) (Over-)/under-absorbed overhead (W3) Gross profit selling and so on costs Variable Fixed Net profit 586. 5 586. 5 103. 5 483. 0 (10. 0) 473 507 196 90 286 221 224 90 314 234 Six months ending 30 September 20X3 $000 $000 1,120 73. 5 343. 0 416. 5 24. 5 392 728 224 504 160 90 250 254 (b) Six months ending 30 September 20X3 $000 $000 1,120 103. 5 483. 0 586. 5 34. 5 552. 0 20. 0 572 548 Part A Specialist cost and management accounting techniques ? 1 Costing 13 kit and boodle 1 Opening inventory Production Sales Closing inventory Marginal cost valuation (? $49) Absorption cost valuation (? $69) 2 3 Normal output (16,000 ? 2) Budgeted output Difference ? std. ixed prod. o/hd per unit (Over-)/under-absorbed overhead Six months ending 31 March 20X3 Units 8,500 8,500 7,000 1,500 $73,500 $103,500 Six months ending 30 September 20X3 Units 1,500 7,000 8,500 8,000 500 $24,500 $34,500 Budgeted fixed production o/hd = 16,000 units ? $20 = $320,000 pa = $160,000 per six months Six months ending 31 March 20X3 8,000 units units 8,500 500 units ? $20 ($10,000) Six months ending 30 September 20X3 8,000 units 7,000 units 1,000 units ? $20 $20,000 6 Absorption costing and marginal costing compared FAST FORWARD If opening and closing inventory levels differ profit reported under the two methods will be different.In the long run, total profit will be the same whatever method is used. 6. 1 Reconciling the profit figures given by the two methods The diversion in win reported under the two costing systems is due to the different inventory valuation methods used. (a) If inventory levels profit between the beginning and end of a period, absorption costing will report the high profit because some of the fixed production overhead incurred during the period will be carried forward in closing inventory (which reduces cost of sales) to be set against sales revenue in the following period instead of being written off in full against profit in the period concerned.If inventory levels decrease, absorption costing will report the lower profit because as well as the fixed overhead incurred, fixed production overhead which had been carried forward in opening inventory is released and is also included in cost of sales. (b) 6. 2 Example Reconciling profits The profits reported for period 1 in the question on page 11 would be reconciled as follows. Marginal costing profit redress for fixed overhead in inventory (inventory increase of 300 units ? $1 per unit) Absorption co sting profit $ 400 300 700 Exam focus point concoct that if opening inventory values are greater than closing inventory values, marginal costing shows the greater profit. 14 1 Costing ?Part A Specialist cost and management accounting techniques 6. 3 Marginal versus absorption costing inform to management FAST FORWARD Marginal costing is more useful for decision-making purposes, but absorption costing is mandatory for financial reporting purposes to comply with accounting standards. We know that the reported profit in any period is likely to differ consort to the costing method used, but does one method provide a more reliable guide to management about the organisations profit position? With marginal costing, role varies in direct harmonize to the script of units sold. Profits will increase as sales volume rises, by the amount of extra contribution earned.Since fixed cost expenditure does not alter, marginal costing gives an accurate picture of how a firms specie mixs and pro fits are affected by changes in sales volumes. With absorption costing, in contrast, there is no clear human relationship between profit and sales volume, and as sales volume rises the total profit will rise by the sum of the gross profit per unit plus the amount of overhead absorbed per unit. arguably this is a confusing and unsatisfactory method of monitoring profitability. If sales volumes are the same from period to period, marginal costing reports the same profit each period (given no change in prices or costs). In contrast, using absorption costing, profits can vary with the volume of production, even when the volume of sales is constant.Using absorption costing there is therefore the possibility of manipulating profit, simply by changing output and inventory levels. 6. 4 Example Manipulating profits Gloom Co budgeted to make and sell 10,000 units of its product in 20X1. The selling price is $10 per unit and the variable cost $4 per unit. Fixed production costs were budgeted at $50,000 for the year. The company uses absorption costing and budgeted an absorption rate of $5 per unit. During 20X1, it became apparent that sales command would only be 8,000 units. The management, concerned about the apparent effect of the low volume of sales on profits, decided to increase production for the year to 15,000 units.Actual fixed costs were still expected to be $50,000 in spite of the significant increase in production volume. Required Calculate the profit at an actual sales volume of 8,000 units, using the following methods. (a) (b) Absorption costing Marginal costing Explain the difference in profits calculated. Solution (a) Absorption costing Sales (8,000 ? $10) Cost of production (15,000 ? $9) Less over-absorbed overhead (5,000 ? $5) $ 135,000 (25,000) (110,000) (30,000) 63,000 33,000 $ 80,000 Closing inventory (7,000 ? $9) Profit Part A Specialist cost and management accounting techniques ? 1 Costing 15 (b) Marginal costing Sales Cost of sales Cost of produ ction (15,000 ? $4) Closing inventory (7,000 ? $4) Contribution Fixed costs Loss $ $ 80,000 0,000 ((28,000) 32,000 48,000 50,000 (2,000) The difference in profits of $35,000 is explained by the difference in the increase in inventory values (7,000 units ? $5 of fixed overhead per unit). With absorption costing, the expected profit will be higher than the original budget of $10,000 (10,000 units ? ($10 9)) simply because $35,000 of fixed overheads will be carried forward in closing inventory values. By producing to absorb overhead rather than to satisfy customers, inventory levels will, of course, increase. Unless this inventory is sold, however, there may come a point when production has to stop and the inventory has to be sold off at lower prices.Marginal costing would report a contribution of $6 per unit, or $48,000 in total for 8,000 units, which fails to cover the fixed costs of $50,000 by $2,000. The argument above is not conclusive, however, because marginal costing is not so useful when sales fluctuate from month to month because of seasonal variations in sales indigence, but production per month is held constant in order to arrange for an even flow of output (and thereby retain the cost of idle resources in periods of low demand and overtime in periods of high demand). Question Absorption v marginal costing A clothing maker makes a specific brand of jeans which it sells at a standard price of $100 per pair. The manufacturers costs are as follows.Standard variable production cost $16 per pair Total fixed production cost per month $240,000 (10,000 pairs are think to be produced per month) Total fixed non-production costs $300,000 per month In calendar month 1, when the opening inventory is 1,000 pairs, production of 10,000 pairs is planned and sales of 8,000 pairs are expected. In calendar month 2, sales are planned to be 9,000 pairs and production is still 10,000 pairs. Required (a) What would be the net profit for calendar months 1 and 2 under (i) (ii) (b) Absorption costing Marginal costing What comments could you make about the performance of this business? 16 1 Costing ? Part A Specialist cost and management accounting techniques Answer (a) Absorption standard cost per unit = $16 + 240,000/10,000 = $40 Absorption costing calendar month 1 Month 2 $000 $000 $000 $000 800 900 Marginal costing Month 1 Month 2 $000 $000 $000 $000 800 900Sales 8,000 $100 Cost of sales Opening inventory (1,000 $40) Production (10,000 $40) Less closing inventory* (3,000 $40) Gross profit Contribution Less other costs Fixed production Fixed non-production 40 400 (120) (320) 480 120 400 (160) (360) 540 1,000 $16 10,000 $16 3,000 $16 16 160 (48) (128) 672 (240) (300) 48 160 (64) (144) 756 (240) (300) (300) 180 (300) 240 (540) 132 (540) 216 * Closing inventory = 1,000 + 10,000 8,000 (b) The absorption costing net profit is higher than the marginal costing net profit in both months because inventories are rising. Under absorption costing, where inventories are increasing, a greater amount of the fixed production cost is carried forward n the closing inventory valuation than was brought forward in the opening inventory valuation. This means that the impact of these costs on profit is delayed under absorption costing. Under marginal costing, the full impact of the fixed production costs on profit is immediate. The business is profitable and sales have change magnitude. However, a build up of inventories in the clothing manufacturing industry is unwise as demand is subject to tastes and fashion. The business need to respond speedily to changes in demand or it will become rapidly uncompetitive. Part A Specialist cost and management accounting techniques ? 1 Costing 17 Chapter Roundup Costing is the process of determining the costs of products, services or activities.Indirect costs, or overheads, are costs incurred in making a product or providing a service, but which cannot be traced directly to the product or service. A bsorption costing is a means of incorporating a fair share of these costs into the cost of a unit of product or service provided. Absorption costing is a traditional approach to dealing with overheads, involving three stages allocation, apportionment and absorption. Apportionment has two stages, general overhead apportionment and service department cost apportionment. After apportionment, overheads are absorbed into products using an appropriate absorption rate based on budgeted costs and budgeted activity levels. Under-/over-absorbed overhead occurs when overheads incurred do not equal overheads absorbed.In marginal costing, inventories are valued at variable production cost whereas in absorption costing they are valued at their full production cost. If opening and closing inventory levels differ profit reported under the two methods will be different. In the long run, total profit will be the same whatever method is used. Marginal costing is more useful for decision-making purpos es, but absorption costing is needed for financial reporting purposes to comply with accounting standards. 18 1 Costing ? Part A Specialist cost and management accounting techniques Quick Quiz 1 Here are some terms you should have encountered in your earlier studies. stand for the term to the definition.Terms Direct cost pristine cost Overhead Classification by serve well Fixed cost Variable cost Product cost avoidable cost Controllable cost pertinent cost Cost centre Cost unit (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) 2 3 Definitions (a) ad hoc costs of, say, an activity, which would not be incurred if the activity did not exist Total of direct costs Future cash flow which will be changed as the result of a decision Product produced by an organisation Dividing costs into production, administration, selling and distribution, look into and development and financing costs Cost that can be traced in full to whatever is being costed Organisations departments A cost that v aries with the level of output A cost that is incurred in the course of making a product but which cannot be traced directly and in full to the product Cost that is incurred for a particular period of time and which, within certain activity levels, is unmoved by changes in the level of activity Cost identified with goods produced or purchased for resale and initially included in the value of inventory Cost which can be influenced by management decisions and actions is the process of determining the costs of products, activities or services. How is an overhead absorption rate calculated? A B C D Estimated overhead ? actual activity level Estimated overhead ? budgeted activity level Actual overhead ? actual activity level Actual overhead ? budgeted activity level 4 Over absorption means that the overheads charged to the cost of sales are greater than the overheads actually incurred. reliable False 5Fill in the blanks in the statements about marginal costing and absorption costing b elow. (a) (b) If inventory levels between the beginning and end of a period, absorption costing will report the higher profit. If inventory levels decrease, costing will report the lower profit. 6 Fill in the following blanks with either marginal or absorption. (a) (b) (c) (d) (e) Using costing, profits can be manipulated simply by changing output and inventory levels. Fixed costs are charged in full against the profit of the period in which they are incurred when costing is used. costing fails to recognise the grandeur of working to full capacity. costing could be argued to be preferable to costing in management accounting in order to be consistent with the requirements of accounting standards. costing should not be used when decision-making information is required. Part A Specialist cost and management accounting techniques ? 1 Costing 19 Answers to Quick Quiz 1 Direct cost Prime cost Overhead Classification by function Fixed cost Variable cost Product cost Avoidable cost Controllable cost Relevant cost Cost centre Cost unit Costing B True (a) (b) (a) (b) (c) (d) (e) addition Absorption absorption marginal marginal absorption, marginal absorption (f) (b) (i) (e) (j) (h) (k) (a) (l) (c) (g) (d) 2 3 4 5 6 flat try the questions below from the Exam Question Bank Number Q1Level Introductory label 10 Time 18 mins 20 1 Costing ? Part A Specialist cost and management accounting techniques Activity based costing Topic list 1 Activity based costing 2 Absorption costing versus first rudiment 3 Merits and criticisms of alphabet Syllabus reference A1 (a), (b) A1 (c) A1 (c) Introduction Chapter 2 covers Part A of the syllabus, specialist cost and management accounting techniques. It has been divided into five sub-chapters to reflect the examiners emphasis that all five techniques are equally important and equally examinable. In this chapter we will be looking at the first alternative method of cost accumulation, activity based costing ( first rudiment). alp habet is a modern alternative to absorption costing which attempts to overcome the problems of costing in a modern manufacturing environment. If you want to get free study material of CAT, ACCA, CIMA, CFA, CIA visit freefor911. wordpress. com 21 Study guide Intellectual level A1 (a) (b) (c) Activity based costing appoint appropriate cost drivers under alphabet Calculate costs per driver and per unit using rudiment Compare rudiment and traditional methods of overhead absorption based on production units, labour hours or machine hours 1 2 2 Exam guide There was a question on ABC in the Pilot Paper for F5. It was also examined in June 2008 and June 2010 and is therefore a crucial topic to understand. 1 Activity based costing FAST FORWARD /08, 6/10 An alternative to absorption costing is activity based costing (ABC). ABC involves the assignment of the factors (cost drivers) which cause the costs of an organisations major activities. bread and butter overheads are charged to p roducts on the basis of their usage of an activity. For costs that vary with production level in the short term, the cost driver will be volume related (labour or machine hours). Overheads that vary with some other activity (and not volume of production) should be traced to products using transaction-based cost drivers such as production runs or number of orders received. 1. 1 Reasons for the development of ABCThe traditional cost accumulation system of absorption costing was developed in a time when most organisations produced only a narrow range of products (so that products underwent similar trading operations and subscribed similar remainders of overheads). And overhead costs were only a very small component of total costs, direct labour and direct material costs accounting for the largest proportion of the costs. The benefits of more accurate systems for overhead allocation would probably have been relatively small. In addition, information bear on costs were high. In re cent years, however, there has been a prominent fall in the costs of processing information.And, with the advent of advanced manufacturing technology (AMT), overheads are likely to be far more important and in fact direct labour may account for as little as 5% of a products cost. It therefore now appears difficult to pardon the use of direct labour or direct material as the basis for absorbing overheads or to believe that errors do in attributing overheads will not be significant. Many resources are used in non-volume related support activities, (which have increased due to AMT) such as setting-up, production programming, inspection and data processing. These support activities advert the efficient manufacture of a wide range of products and are not, in general, affected by changes in production volume.They tend to vary in the long term according to the range and complexity of the products fabricate rather than the volume of output. The wider the range and the more complex the products, the more support services will be required. Consider, for example, factory X which produces 10,000 units of one product, the Alpha, and factory Y which produces 1,000 units each of ten slightly different versions of the Alpha. prevail activity costs in the factory Y are likely to be a lot higher than in factory X but the factories produce an identical number of units. For example, factory X will only need to set-up once whereas Factory Y will have to set-up the 22 2a Activity based costing ?Part A Specialist cost and management accounting techniques production run at least ten measure for the ten different products. Factory Y will therefore incur more set-up costs for the same volume of production. Traditional costing systems, which assume that all products consume all resources in proportion to their production volumes, tend to allocate too great a proportion of overheads to high volume products (which cause relatively little transition and hence use fewer support ser vices) and too small a proportion of overheads to low volume products (which cause greater diversity and therefore use more support services). Activity based costing (ABC) attempts to overcome this problem. 1. Definition of ABC Key term Activity based costing (ABC) involves the identification of the factors which cause the costs of an organisations major activities. Support overheads are charged to products on the basis of their usage of the factor create the overheads. The major psyches behind activity based costing are as follows. (a) (b) (c) Activities cause costs. Activities include ordering, materials discussion, machining, assembly, production programing and despatching. Producing products creates demand for the activities. Costs are assigned to a product on the basis of the products white plague of the activities. 1. 3 Outline of an ABC systemAn ABC system operates as follows. Step 1 Step 2 Key term Identify an organisations major activities. Identify the factors which d etermine the size of the costs of an activity/cause the costs of an activity. These are known as cost drivers. A cost driver is a factor which causes a change in the cost of an activity. Look at the following examples. Costs Ordering costs Materials handling costs Production scheduling costs Despatching costs Possible cost driver Number of orders Number of production runs Number of production runs Number of despatches Step 3 Step 4 store the costs associated with each cost driver into what are known as cost pools.Charge costs to products on the basis of their usage of the activity. A products usage of an activity is deliberate by the number of the activitys cost driver it generates. Question Which of the following definitions best describes a cost driver? A B C D Any activity which causes an increase in costs A collection of costs associated with a particular activity A cost that varies with production levels Any factor which causes a change in the cost of an activity Cost driver Part A Specialist cost and management accounting techniques ? 2a Activity based costing 23 Answer D Any factor which causes a change in the cost of an activity. Exam focus pointABC is a popular exam topic. Questions on activity based costing often require a similarity with more traditional methods. The implications for the business of each approach is often required. 2 Absorption costing versus ABC 6/08, 6/10 The following example illustrates the point that traditional cost accounting techniques result in a misleading and inequitable division of costs between low-volume and high-volume products, and that ABC can provide a more meaningful allocation of costs. 2. 1 Example Activity based costing Suppose that Cooplan manufactures four products, W, X, Y and Z. Output and cost data for the period just finish are as follows.Number of production runs in the Material cost Direct labour Machine Output units period per unit hours per unit hours per unit $ W 10 2 20 1 1 X 10 2 80 3 3 Y 100 5 20 1 1 80 3 3 Z 100 5 14 Direct labour cost per hour $5 Overhead costs Short run variable costs Set-up costs Expediting and scheduling costs Materials handling costs Required Prepare unit costs for each product using established costing and ABC. $ 3,080 10,920 9,100 7,700 30,800 Solution Using a conventional absorption costing approach and an absorption rate for overheads based on either direct labour hours or machine hours, the product costs would be as follows. W $ 200 50 700 950 10 $95 X $ 800 150 2,100 3,050 10 $305 Y $ 2,000 500 7,000 9,500 100 $95 Z $ 8,000 1,500 21,000 30,500 100 $305 Total $ Direct material Direct labour Overheads * Units produced Cost per unit 4,000 * $30,800 ? 440 hours = $70 per direct labour or machine hour. 24 2a Activity based costing ? Part A Specialist cost and management accounting techniques Using activity based costing and assuming that the number of production runs is the cost driver for setup costs, expediting and scheduling costs and materials handling costs and that machine hours are the cost driver for short-run variable costs, unit costs would be as follows. W $ 200 50 70 1,560 1,300 1,100 4,280 10 $428 X $ 800 150 210 1,560 1,300 1,100 5,120 10 $512 Y $ 2,000 500 700 3,900 3,250 2,750 13,100 100 $131 Z $ 8,000 1,500 2,100 3,900 3,250 2,750 21,500 100 $215 Total $Direct material Direct labour Short-run variable overheads (W1) Set-up costs (W2) Expediting, scheduling costs (W3) Materials handling costs (W4) Units produced Cost per unit Workings 1 2 3 4 $3,080 ? 440 machine hours = $10,920 ? 14 production runs = $9,100 ? 14 production runs = $7,700 ? 14 production runs = naturalized costing unit cost $ 95 305 95 305 44,000 $7 per machine hour $780 per run $650 per run $550 per run ABC unit cost $ 428 512 131 215 Difference per unit $ + 333 + 207 + 36 90 Difference in total $ +3,330 +2,070 +3,600 9,000 Summary Product W X Y Z (a) (b) The figures suggest that the traditional volume-based absorption costing system is fla wed.It underallocates overhead costs to low-volume products (here, W and X) and over-allocates overheads to higher-volume products (here Z in particular). It underallocates overhead costs to smaller-sized products (here W and Y with just one hour of work needed per unit) and over allocates overheads to bigger products (here X and particularly Z). 2. 2 ABC versus traditional costing methods Both traditional absorption costing and ABC systems contract the two stage allocation process. 2. 2. 1 Allocation of overheads ABC establishes separate cost pools for support activities such as despatching. As the costs of these activities are assigned directly to products through cost driver rates, reallocation of service department costs is avoided. 2. 2. Absorption of overheads The principal difference between the two systems is the way in which overheads are absorbed into products. (a) (b) Absorption costing most ordinarily uses two absorption bases (labour hours and/or machine hours) to cha rge overheads to products. ABC uses many cost drivers as absorption bases (eg number of orders or despatches). Absorption rates under ABC should therefore be more well linked to the causes of overhead costs. Part A Specialist cost and management accounting techniques ? 2a Activity based costing 25 2. 3 Cost drivers The principal idea of ABC is to focus attention on what causes costs to increase, ie the cost drivers. a) The costs that vary with production volume, such as power costs, should be traced to products using production volume-related cost drivers, such as direct labour hours or direct machine hours. Overheads which do not vary with output but with some other activity should be traced to products using transaction-based cost drivers, such as number of production runs and number of orders received. (b) Traditional costing