ABC & Material Variances

What is the ABC cost driver rate and how do you calculate it?

The rate used to assign overhead costs to products. Calculated as: Total cost pool ÷ Total cost driver quantity. E.g. Setup costs £110,000 ÷ 402 setups = £273.63 per setup.

What is a cost driver?

The activity that causes an overhead cost to be incurred. E.g. number of setups drives setup costs, number of batches drives material handling costs.

What is a cost pool?

A group of overhead costs linked to the same activity. E.g. all setup-related costs grouped together before being divided by the number of setups.

What is the key flaw of traditional absorption costing?

It uses a single volume-based driver (e.g. labour hours) to allocate all overheads. This assumes every product consumes overhead in proportion to volume — which is rarely true.

What type of products does traditional costing over-charge?

High-volume, simple products — they absorb too much overhead just because of their volume, even if they don't cause many complex activities.

What type of products does traditional costing under-charge?

Low-volume, complex products — they cause lots of expensive activities (setups, inspections, special parts) but don't get charged enough under a volume-based system.

How does ABC fix the traditional costing flaw?

It identifies the activities that actually cause overhead costs and assigns costs to products based on how much of each activity they consume — not just how many units they make.

What did ABC reveal in the Cocoa Inc. (Q22 2018) example?

Under ABC, Mint made a profit of £1.38/unit and Orange made a loss of £36.83/unit. Traditional costing would have hidden this because Orange's high volume masked how many costly activities it triggered.

Why does Orange make a loss under ABC despite high sales volume?

Orange uses 100 batches, 400 setups, 80,000 special ingredients and 350 invoices vs Mint's 2 batches, 2 setups, 20,000 ingredients and 50 invoices — it consumes far more of every activity.

What is the material price variance formula?

(Standard price − Actual price) × Actual quantity purchased. Favourable if you paid less than standard.

What is the material usage variance formula?

(Standard quantity for actual production − Actual quantity used) × Standard price. Favourable if you used less than standard.

Common trap in usage variance calculations?

Always use actual production (not budgeted) to calculate standard quantity. E.g. if actual production is 1,130 units, standard quantity = 1,130 × 6kg = 6,780kg — not 1,100 × 6kg.

What are three causes of a favourable material price variance?

1. Changed to a cheaper supplier. 2. Bulk purchase discount from buying larger quantities. 3. Standard price is out of date and was set too high.

What are two causes of a favourable material usage variance?

1. Higher grade material purchased — less wastage in production. 2. More skilled workers — less material wasted. 3. Standard allowance is too generous.

What does it mean if both price AND usage variances are favourable?

The causes are likely independent. Lower quality material (which saves on price) would normally cause adverse usage — so if usage is also favourable, quality has probably not been compromised.

What is the first limitation of ABC?

Some overheads still can't be linked to any specific activity — e.g. rent, CEO salary. These still have to be allocated arbitrarily, so ABC doesn't fully solve the problem.

What is the second limitation of ABC?

It's expensive and complex to implement — requires detailed data collection, more staff time, and significant system changes. The cost may outweigh the benefit for smaller firms.

When is traditional absorption costing still appropriate?

When products are simple and homogeneous (consuming resources in similar proportions), when overheads are a small proportion of total costs, or when the business lacks resources to implement ABC.

Why don't some organisations adopt ABC — give four reasons?

1. High cost of running the system. 2. Lack of staff expertise. 3. No senior champion or management support. 4. Resistance to change — existing systems are embedded and employees fear redundancies.

What is the "cross-subsidy" problem in traditional costing?

When one product (e.g. high-volume simple product) absorbs too much overhead and appears less profitable than it is, while another (low-volume complex) appears more profitable — distorting pricing and production decisions.