Calculating Production Costs using Conventional Method and ABC Costing Method
The selling prices per unit by allocating overhead costs under conventional method are computed in the following table:
It can be inferred from the calculations that Martha’s production cost using conventional method is more compared to ABC costing. Fred’s production cost on other hand is higher under ABC system as against conventional method. Under ABC method, Fred’s selling price would be higher as against conventional methods and reverse would happen for Martha as per unit product form the basis of calculation of both the products selling price. There is a difference between the manufacturing overhead cost allocations between two products that has lead to the variations in products pricing. Allocation of overhead under conventional method is done based on direct labor hours and under ABC system, allocation is done based on cost pool of each activity of benefits derived from products. Overhead cost actual consumptions are not the part of conventional method. Hence, it can be said that Martha’s selling price would be higher and Fred’s selling price is lower compared to their actual production cost.
The allocation of overhead using the conventional volume based approach leads to mispricing products sold by organization. Single allocation base is used for allocating total overhead cost to products. Actual case and effect relationship between overhead and cost drivers is not reflected by single allocation base used in costing of products. Only one basis for allocation is used by conventional approach to product costing and capturing the cause of overhead incurrence is not captured by overhead base. This would lead to error in determining the costs and when prices are set based on cost, and then there arises the problems of mispricing of assets. Products can be overpriced and underpriced using the system of traditional costing and this would in turn influence the profitability and sales volume of company. Indirect costs are applied to products based on pre-determined overhead rate and it is optimal to use traditional method when direct costs are more than indirect cost.
This particular method of cost accounting that is ABC system is widely applicable to numerous business costing, financing and costing needs to business. Modelling process of ABC helps in assessing the full scope of expenditures of business and is applicable to whole view of practices of company. Such costing system helps in identification of inefficient activities, department, and products across the whole spectrum of practices of business. Management of organization would be assisted in developing of comprehensive picture of expenditure and costs relating to services and products with the help of activity based costing (Wanderley et al. 2017).
Implementation of ABC system would provide an organization with the listed advantages and they are as follows:
- ABC system provided company with the facility of accurately calculating cost of production by establishing cause and effect relationship with each activity.
- Ascertaining and elimination of extraneous cost through the employment of ABC system would help in increasing efficiency of business. It also helps in controlling the distribution of resources at any product level and identifying places that would support unprofitable areas of business.
- Such cost that does not contribute to adding value to business can be understood by ABC system as it helps in understating different business behavior costs.
- Performance appraisal process and cost management department receives assistance from the ABC system as it helps in recognition of cost drivers.
- It deals with the identification of reason for incurring of costs and the cost pool activities have proper control through the implementation of such system and thereby reducing cost and providing assistance to management.
- The cost of products will be accurately determined by employing the system of activity based costing that helps in bringing reliability and accuracy and emphasizing on cause and effect relationship in incurrence of cost. It helps in recognition of the fact that activities consume products and activities that are responsible for incurring of costs.
- The real nature of cost behavior is identified by implementing ABC system along with activities that does not help in adding value to products and cost reduction. An organization experience increase in fixed overhead cost due to many activities and managers are able to exercise control over such activities and thereby reducing fixed overhead costs. Reason is attributable to the fact that it become possible for management to identify the behaviors and activities that results in rising overhead costs becomes clear and visible (Groot and Selto 2013).
- There exists greater diversity among the products that are manufactured such as high volume products, low volume products. In such event, correct and reliable product cost data produces by implementing the system of ABC costing. On other hand using traditional method of costing, make use of arbitrary absorption and apportionment methods that is likely to bring approximation and errors in determining cost of products (Quinn 2014).
- Relevant and useful information are provided to the management of organization with the help of ABC system and performance appraisal of responsibility centers. Information on transaction volume and rate of cost drivers are provided by such system. Rate of cost drivers can be advantageously used for designing existing and new products as costing of products include the overhead costs (Anderson et al.2015).
- Multiple cost drivers are used by ABC costing and rather than product based they are based on transaction. Overhead cost to products are traced as the system is concerned beyond and within the activities.
- The cost of products and data becomes readily available as ABC system usefully helps in fixation of products selling prices.
- Decision making by managers is improved as the system of ABC helps in employing reliable cost product data.
- Costs of products are managed by the mechanisms provided by ABC system along with providing the base for calculating the cost of products more accurately.
- Besides tracing the cost of products, employment of ABC system helps in tracing cost in other areas of organization such as process, areas of managers’ responsibility, departments and customers.
- Management can be convinced to take steps for sustaining in competitive environment with the help of an assessment provided by ABC system. This would enable them reduce the cost of products while focusing on improving the quality of products. Such system would help in analyzing the process of manufacturing, the cost associated with it,and this helps in stimulating the organizing process activities, reducing costs (Soin and Collier 2013).
- Transparent system of ABC would help in determining which costs are relevant and areas of irrelevant cost can be identified and eliminated (Bromwich and Scapens 2016).
- There can be accurate analysis of volume of production by management with an improved cost analysis that is needed to achieve break even on products of low volume. Analysis of activity would help in continuously improving the support by providing corrective actions against less efficient and non-value added activities. This is closely related to the productivity problems of organization.
- Growth of non-product factory activity is growing in the manufacturing sector and overhead factory cost can be traced using the system of ABC. Since there can be tracking of activity leading non-factor cost, analysis of system of SBC cost pays attention to all such aspects.
ABC system comes with some disadvantages that are listed below:
- One of the complications of ABC system is related to appropriate cost driver selection for each cost of overhead.
- Employment of ABC system is not suitable for small manufacturing organizations and evaluating costs based on activities is difficult. An activity that influences the overall costs is also difficult to identify.
- An organization manufacturing few products are not capable of deriving benefits from ABC system as it is beneficial to organization that producing multiple products.
- ABC system is not affordable to small enterprises as it involves huge expenses.
- System of ABC is more complex compared to traditional product costing system as the former employs multiple cost drivers and several cost pool.
- Some of aspects of activity based costing that can act as road blocking for firms involves subsequent running cost and capital expenditure involved in running the system.
- Reports prepared by organization for internal and external purposes require using traditional as well as system of activity based costing. This is so because system of activity based costing do not comply with General accepted accounting principles.
- Allocation of cost under the system of activity based costing is done based on cost drivers and there is an accurate cost allocation for products manufactured. There exists a danger of over running and under running the products costs in event when irrelevant activities and irrelevant cost drivers are assigned to products.
- System of activity based costing is not suitable to all organizations and it is certainly possible that small organizations does not have resources for adapting such systems. They might have complex activities and transactions might be too low.
- Implementation of ABC system would led to emergence of difficulties such as assigning common cost, selecting the cost drivers and varying rates of cost drivers.
- System of ABC can be used more efficiently by larger manufacturing organizations as compared to smaller organizations as it has different level of utility for different types of organizations. An accurate cost of products is given by employing ABC system and this feature of costing system provides advantage to firm depending upon cost plus pricing (Bhimani et al.2013). However, ABC system is not favored by organization making use of market based prices. Application of ABC system is also affected by manufacturing environment and technology level prevailing in different firms.
- The determination of cost drivers, analysis of activities occurring in activity centers and tracing of cost of such activities requires additional costs. Significant amount of cost and time is required for implementation of activity based costing system.
- Implementation of ABC system requires creation of environment of change (Ax and Greve 2017). Several barriers faced by organization environment, individual should be overcome for the application of such system. Some of the barriers that needs to be overcome involves loss of potential status, shift in status quo and shift to unknown and a need to learn new skills.
- It is essential on part of management of organization to investigate the existence of barriers and the cause of barriers should be investigated. How, what and why of ABC system should be communicated by organization to all concerned parties. This is one of limitation of ABC system.
- Implementation of non-traditional techniques such as ABC system requires education of managers and employees that involves new concepts, new terminology and performance measurements.
Reference
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