Traditional Costing Method
Discuss about the Advantage & Disadvantage Of Activity Based Costing.
In the field of management accounting the two main costing methods used to allocate the indirect (Overhead) costs are activity based costing and traditional method. In both these methods cost overhead rate of the production are calculated are assign to the total cost of product using the cost driver rate. Traditional costing system uses only one cost driver rate while activity based costing uses many cost driver rate to allocate the overhead cost to the total production cost.
In this report a typical case scenario has been given to calculate the cost per unit of products using both traditional costing and activity based costing system. The given case scenario is of Sewing Easy Limited that manufactures two models of sewing machines and these models are basic model and advance model. In the given case problem management at Sewing Easy Limited is concerned why oversea buyers are interested only in advance model not in the basic model. Company currently is using the traditional method for allocating the cost and wants to move to activity based costing system. In order to find out the reason why oversea buyer are interested in advance model not in basic model, calculation has been made to find out cost per unit using both traditional costing method and activity based budgeting method.
The traditional method of cost accounting is used for allocation of manufacturing overhead costs as per the manufactured products. The method is used for allocation of indirect costs as per the volume of products manufactured. The method is highly useful for the business managers to gain an overview of the overall indirect costs involved in the manufacturing process of the company. The indirect costs are allocated on the basis of number of units produced or on the basis of direct labor or the machine hours. The method involves identifying the indirect cost related to the manufacturing process of the company on a regular basis (Tulsian, 2006).
The most significant advantage of the method is that it is relatively simple to be applied as it is easy for the business managers to identify the indirect costs as per the products produced or labor and machine hours consumed. The method also has a significant drawback that the method is less reliable to be sued in the firms involved in manufacturing of large volume of few products. This is because the increase in the amount of overhead expenses can increase the chances of error occurrence in allocating the overhead costs to different products (Drury, 2008).
|
Particulars |
Basic |
Advance |
|
Direct material cost |
325.00 |
560.00 |
|
Direct Labor cost |
150.00 |
260.00 |
|
Allocated indirect overheads |
89.84 |
70.83 |
|
Other costs* (201,700/1,500) |
134.47 |
|
|
Total cost per unit |
564.84 |
1,025.30 |
Activity Based Costing Method
The cost per unit for Basic Model is $564.84 and for Advance Model is $1,025.30.
*Other costs include the following:
|
Selling & Admin expense |
140,600 |
|
Interest expense |
25,200 |
|
Office rent |
35,900 |
|
Total expense |
201,700 |
WN-1 – Calculation of predetermined overhead rate
Predetermined Overhead Rate = Total Indirect Overhead/ Total Machine hours
= 250,000/8000
= $31.25
|
Particulars |
Basic |
Advance |
|
Total machine hours |
4,600 |
3,400 |
|
Units produced and sold |
1,600 |
1,500 |
|
Machine hour per unit (total machine hours/ unit produced and sold) |
2.88 |
2.27 |
|
Overhead per unit |
89.84 |
70.83 |
The business manager at present adopts the use of activity based costing in comparison to traditional costing method to overcome from the significant disadvantages of the traditional costing method. The activity based costing method is developed for gaining an in-depth analysis of the relation between overhead costs and cost drivers (Crosson and Needles, 2010). The method involved identification of all the activities in the manufacturing process and then attributing the costs as per the activities identified. The method of costing proves to be highly efficient in controlling the overheads as it is highly flexible for identifying the overhead cost on the basis of fluctuation of the customers. The cost of each activity involved in the manufacturing process is used in compiling the overall cost of the manufacturing process (Bradtke, 2007). The method is regarded as the most accurate method of identification of overhead costs and identification of the wasteful activities that lead to the occurrence of operational inefficiencies. Thus, it enables the operational managers for developing an effective method of improving the manufacturing cycle-time. The product cost is determined on the basis of cost incurred in development of each activity and thus accurately measures the resources consumption in each activity. This facilitates the managers in providing sufficient information relating to the nature of resources consumed by various activities involved in the manufacturing process (Maingi, 2013).
|
Particulars |
Basic |
Advance |
|
Direct material cost |
325.00 |
560.00 |
|
Direct Labor cost |
150.00 |
260.00 |
|
Allocated indirect overheads |
47.19 |
116.33 |
|
Other costs* (201,700/1,500) |
134.47 |
|
|
Total cost per unit |
522.19 |
1,070.80 |
The cost per unit for Basic Model is $522.19 and for Advance Model is $1,070.80.
WN-3 – Calculation of allocation of indirect overheads
|
Particulars |
Indirect Overheads |
Activities Consumed |
Overhead allocation |
|||||
|
Basic Model |
Advance Model |
Total |
Cost Driver |
Cost per activity |
Basic Model |
Advance Model |
||
|
Inspection |
20,000 |
200 |
750 |
950 |
Inspections |
21.05 |
4,211 |
15,789 |
|
Assembly |
90,000 |
4,600 |
3,400 |
8,000 |
machine hours |
11.25 |
51,750 |
38,250 |
|
Production scheduling |
105,000 |
50 |
500 |
550 |
Runs |
190.91 |
9,545 |
95,455 |
|
Machine set-up |
35,000 |
100 |
250 |
350 |
set up |
100.00 |
10,000 |
25,000 |
|
Total Costs |
250,000 |
75,506 |
174,494 |
|||||
|
No. of units |
1,600 |
1,500 |
||||||
|
Cost per unit |
$ 47.19 |
$116.33 |
Profit and Loss Statement for the advance model using traditional costing
As on December, 2017
|
Particulars |
Units |
Per unit |
Amount ($) |
|
Sales (WN-4) |
1,500 |
1,230 |
1,845,000 |
|
Less: Direct material cost |
1,500 |
560 |
840,000 |
|
Less: Direct Labor cost |
1,500 |
260 |
390,000 |
|
Less: Overhead cost |
1,500 |
70.83 |
106,245 |
|
Less: Other expenses Selling & Admin expense |
140,600 |
||
|
Interest expense |
25,200 |
||
|
Office rent |
35,900 |
||
|
Net Profit |
307,055 |
WN-4 – Calculation of selling price under traditional costing
The selling price per unit is 20% plus cost.
Selling price per unit = 1025.30*120%
= $1,230
As on December, 2017
|
Particulars |
Units |
Per unit |
Amount ($) |
|
Sales (WN-5) |
1,500 |
1,285 |
1,927,433 |
|
Less: Direct material cost |
1,500 |
560 |
840,000 |
|
Less: Direct Labor cost |
1,500 |
260 |
390,000 |
|
Less: Overhead cost |
1,500 |
116.33 |
174,494 |
|
Less: Other expenses Selling & Admin expense |
140,600 |
||
|
Interest expense |
25,200 |
||
|
Office rent |
35,900 |
||
|
Net Profit |
321,239 |
WN-5 – Calculation of selling price under traditional costing
The selling price per unit is 20% plus cost.
Selling price per unit = 1070.80*120%
= $1,285
Analysis on why the overseas buyer is interested only in Advance Model
The overseas buyer is interested in the Advance Model only since it is underpriced as compared to market. The Advance Model is underpriced by $45 ($1025-$1071) and the Basic Model is overpriced by $43 ($565-$522).
Comparison of Traditional Costing and Activity Based Costing
This is because the company has been allocating the costs using the traditional costing method which is not the correct method to allocate costs, since it allocates the cost using blanket rate. On the other hand, the ABC costing is an appropriate method and produces accurate allocation of costs as it allocates the cost on the basis of activities consumed by the products.
Hence, as the advance model is underpriced, so the overseas buyer are interested in purchasing the advance model and since the Basic Model is overpriced that’s why the overseas buyer is not interested in basic model.
Hence, it is very much necessary for the company to allocate the costs properly so that the products are priced accurately.
The actual overheads and applied overheads will be same when the actual overheads and actual resources (i.e. labor hours or machine hours) are same as budgeted. But this situation happens very rarely as there is always difference between the budgeted and actual overheads and budgeted and actual resources consumed.
The three ways to deal with over or under applied overheads are:
- One way is to calculate a supplementary rate of the difference between actual and applied overheads. Then this difference is charged to the products.
- Second way is to write off the difference of applied and actual overheads in the profit and loss account.
- The last way is to carry forward the difference of actual and applied overheads in the next year.
Activity based costing method is a popular and most used methods for the cost allocation. It has the following advantages (Your Article Library, 2018):
- The ABC method allocates the costs on a systematic basis and hence the product costs are generally accurate and error free.
- Since, the allocation of costs is correct and error free, the product cost or selling price assigned to the products is also correct.
- ABC is best for the organizations having multiple products and various indirect overheads. As it involves systematicallocation of overheads by allocating the costs to the activities and mapping those activities with the cost drivers.
- It helps the management in managing the costs. As it gives the clear picture of costs and there related activities, the management can easily identify the performing activities or divisions and non-performing activities and division. On the basis of this information, the management can take various decisions.
The disadvantages of ABC are as below (Money Matters | All Management Articles, 2018):
- The ABC method is very costly system for its implementation as it involves through understanding of the process and identifying the related costs and cost drivers.
- Since, it is a costly system, it is not advisable for smaller firms.
- It is a complicated system to understand, and only the professionals or high level people can understand this. Hence, specialized knowledge or professionals are required for implementation and use of ABC.
Conclusion
It has been found on the basis of overall analysis that traditional costing system does not accurate cost allocation and also leads to wrong decision making. Under traditional costing system one can face issue of over pricing or under pricing of products as overheads is divided using single recovery rate without giving effect of actual resources (activity consumption) by each product. This create many issues while making the decision of profitability provided by each product as traditional costing does not give any actual profit provided by each product. On the contrast activity based costing method uses actual consumption of resources used by each product to allocate the overhead costs. Activity based costing helps to ascertain overhead rate of each activity in order to allocate each overhead cost to each product on the basis of actual consumption of activity in production of each product.
References
Bradtke, D. 2007. Activity-Based-Costing. GRIN Verlag.
Crosson, S. and Needles, B. 2010. Managerial Accounting. Cengage Learning.
Drury, C. 2008. Management and Cost Accounting. Cengage Learning EMEA.
Maingi, J. 2013. Advantages & Disadvantages of activity based costing with reference to economic value addition. GRIN Verlag.
Money Matters: All Management Articles. 2018. Advantages and Disadvantages of Activity Based Costing. [Online] Available at: https://accountlearning.com/advantages-and-disadvantages-of-activity-based-costing/ [Accessed on: 9 May 2018].
Referenceforbusiness.com. 2018. Activity-Based Costing – type, benefits, How activity-based costing works. [Online] Available at: https://www.referenceforbusiness.com/small/A-Bo/Activity-Based-Costing.html [Accessed on: 11 May 2018].
Tulsian. 2006. Cost Accounting. Tata McGraw-Hill Education.
Your Article Library. 2018. Advantages and Demerits of Activity Based Costing (ABC). [Online] Available at: https://www.yourarticlelibrary.com/accounting/costing/advantages-and-demerits-of-activity-based-costing-abc/52617 [Accessed on: 9 May 2018].
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