Activity based costing system:the case of Tetra Pak Co - Essay Example

? Table of Contents Executive Summary 3 Introduction 4 Limitations of ABC 4 The Case of Tetra Pak Company 5 The Selection of Cost Drivers 8 Conclusion 9 References 10 Executive Summary This report aims to introduce a new costing system and analyze it in the light of two of the company’s products. The report aims at introducing Activity Based costing system and defines its relative merits and demerits. The stages involved in the calculation of profits and costs are implemented on two products of Tetra Pak as an example. The report clearly illustrates how this new costing system will affect the decisions of the management regarding continuity of producing some products and decisions based on the profitability of the products it produces. To: The CEO Tetra Pak Co. From: Trainee Accountant Date: 20/Mar/2011 Subject: Introducing ABC system Introduction Tetra Pak is one of the world's leading food processing and packaging solutions company. What makes Tetra Pak one of the leading companies is supported & enforced by many theories and systems but one of them is usage of Activity Based Costing System. Activity Based Costing brings a lot of advantages to company for example it provides an accurate costing system which in return helps in identifying real profitable and loss making divisions or products which after then would be given respective response that is improving the decision making process. Limitations of ABC Apart from merits and positive things it brings, there are following de merits: Heavy amount of information is needed to be gathered and maintained in efficient way. Development of System is hard and takes time and, once developed developers tend to lose interest in system and change is risky. Few costs still cannot be apportioned say for example salary provided to Chief Executive Officer. Selection of appropriate cost drivers is necessary to provide accurate results. Expertise is needed. The results produced may be completely distorting if the cost drivers selected are inappropriate It provides subjective results The ABC system is complex and time consuming, the costs related to adopting ABC and the profits it may bring should be matched with accordingly (Waygandt et al., 2009). Activity Based Costing which is also known as ABC costing system is the process of apportioning and allocating indirect costs to the products according to the level of activities being consumed. It is contrary to the traditional costing system where the unit cost is apportioned on the basis of volume. The assumption underlying the traditional costing system was that overhead expenditure is related to direct labor hours or machine hours in production departments. However, this is impracticable for vast number of companies in this modern age where the number of activities is high. Activity based costing provides more fair allocation of cost where numerous activities are involved in the production process, which helps in improving decision making process (Diamond 2006). The Case of Tetra Pak Company Tetra Pak is a huge company having so many products but for now let’s take two products that is packets of milk and juice beverages represented by M1 and J2. Both M1 and J2 are manufactured in batches. The batches differ more or less in that different designs and packaging of M1 and J2. 40000 and 20000 packages are made and sold at $1/packet in the year of 2011 for M1 and J2 respectively. The cost to make total packaging of 60000 comprises direct cost of $20,000 ($0.3/packaging) and overheads of $20,000. Overheads are to apportioned and allocated according to the steps of Activity Based Costing System: STEP 1: Identify the activities which give rise to the overheads. There are two activities that is machine set – ups and order dispatching. Totally 25 machine set ups and 60 dispatch orders are made in year 2011. STEP 2: Determine Cost Driver Cost Driver means the activity which drives the cost or in simple words would increase cost if one more activity is done like here is number of machine set – ups and number of orders dispatched. For one packaging, M1 takes 10 machine set ups and 35 order dispatching while J2 takes 15 machine set ups and 25 dispatch orders. STEP 3: Calculate total cost for each activity Cost pool is made which comprises total cost of each activity which is $ 16,000 for machine set ups and remaining $ 4,000 of total overheads relate to the order dispatching. STEP 4: Calculate absorption rate Absorption rate is calculated as: Cost Pool / Cost Driver Absorption rate for Machine Set ups is $ 640 ($ 16000 / 25), while absorption rate for dispatch orders is $ 66.67 ($ 4000 / 60). STEP 5: Calculate total overhead cost for each product M1 total overhead cost pertaining to Machine set is $ 6400($ 640 * 10), while Dispatch Order overhead cost is $ 2333 ($ 66.67 * 35). It calculates the Total of $ 8733 ($ 6400 + $ 2333). J2 total overhead cost pertaining to Machine set is $ 9600($ 640 * 15), while Dispatch Order overhead cost is $ 1667 ($ 66.67 * 25). It calculates the Total of $ 11267 ($ 9600+ $ 1667). STEP 6: Calculate overhead cost per unit of product M1 overhead cost per unit is $ 0.2183 ($ 8733 / 40000) J2 overhead cost per unit is $ 0.5634 ($ 11267 / 20000) STEP 6: Profitability analysis M1 J2 $ $ Selling price $ 1 $ 1 Less: Direct Cost (0.3) (0.3) Overheads (0.2183) (0.5634) Profit 0.4817 0.1366 STEP 6: Comparison If Tetra Pak used traditional costing system then overhead cost would have been apportioned in M1 as $ 13333.33 ($ 20000 / 60000 * 40000) and in J2 as $ 6666.66 ($ 20000 / 60000 * 20000) and profits would have been as: M1 J2 $ $ Selling price $ 1 $ 1 Less: Direct Cost (0.3) (0.3) Overheads (0.33) (0.33) Profit 0.37 0.37 As above it can be seen that under traditional costing system both products produce same profits per unit while on Activity Based Costing its different but shows the accurate and reality of the products. The Selection of Cost Drivers The selection of appropriate cost drivers is of immense importance in the ABC system. The costs are allocated on the basis of cost drivers and if wrong cost drivers are used, there is a danger of wrong allocation of costs to every product, department or process which abandons the objective of ABC system. Cost drivers help in identifying the accurate trade-off between use of resources and the processes involved at each activity level. The wrong selection of cost drivers may, hence, produce inaccurate results. For instance, if any other cost driver would have been used instead of machine set-ups, the profitability will be shown different from what is calculated now. Hence, the importance of selecting correct cost drivers for each activity is important in ABC system (Kaplan & Cooper 2008). The traditional costing system incorporated all costs related to different products and apportioned them on the basis of machine hours or labor hours or production volume etc. However, the ABC system uses cost hierarchy to allocate costs on the basis of Unit level, Batch level, Product Level or some other such measure. This helps in identifying the correct amount of costs to be allocated to each product or unit. Traditional costing system identified marketing and promotion costs as a period cost whereas, ABC apportions such costs on activity level basis. Conclusion In conclusion, it should be noted that although ABC is a conceptual aid to identify he true potentials of any product or service in isolation, it requires closer attention to a number of factors like identifying the appropriate cost drivers. The importance of cost hierarchy is of immense importance as it helps in allocating the costs in an appropriate manner. Tetra pak may benefit from ABC system if it keeps the drawbacks in view and implement this system efficiently. The most profitable products can be identified using this system and if some products or services are loss-making, they may be abandoned quickly. Such a system will help in keeping the company profitable and more resources will be available for the profit-making products by abandoning the loss-making projects and products. ABC will also be helpful in making pricing decisions more accurate and effective. References DIAMOND, J. (2006). Budget system reform in emerging economies: the challenges and the reform agenda. Washington, DC, International Monetary Fund. KAPLAN, R. S., & COOPER, R. (1998). Cost & effect: using integrated cost systems to drive profitability and performance. Boston, Harvard Business School Press. WEYGANDT, J. J. (2009). Managerial accounting: tools for business decision-making. Mississauga, Ont, J. Wiley & Sons Canada. Read More