ACTIVITY BASED COSTING: HIERARCHICAL PROFITABILITY - Math Problem Example

The cost that has been calculated shows that traditional cost systems report less accurate costs because they use cost drivers where no cause-and-effect relationships exist to assign support costs to cost objects. These costs of two different packages of boxes have been calculated on the basis of Activity based costing system, in which the overhead costs are allocated to products on the basis of cost drivers. The Direct Material and Direct Labour costs of the two packages of boxes have been calculated on the basis of number of production units.

The overheads have been allocated to products on the basis of cost drivers. i.e., the machine department costs have been calculated on the basis of machine hours, whereas the setup cost has been calculated on the basis of number of production runs. With the traditional costing system misleading information can be reported. A small loss can be reported for a product and if it were discontinued the costing system mistakenly gives the impression that overheads will decline in the longer term. Furthermore, the message from the costing system is to concentrate on the more profitable specialty products.

In reality this strategy would be disastrous because low volume products are made in small batches and require more people for scheduling production, performing set-ups, inspection of the batches and handling a large number of customer requests for small orders. The long-term effect would be escalating overhead costs.In contrast, the ABC system allocates overheads on a cause-and-effect basis and more accurately measures the relatively high level of overhead resources consumed by a product. The message from the profitability analysis is the opposite from the traditional system; that is, the product concerned is profitable and the other product is unprofitable.

If that product is discontinued, and assuming that the cost driver is the cause of all the overheads then a decision to discontinue than the product should result in the reduction in resource spending on overheads.The boots plc's case is very helpful in this regard. It is assumed that the organization has established only a single cost centre or cost pool, when in reality many will be established with a traditional system, and even more with an ABC system. Some organizations market groupings of products within their product lines as separate brands.

A typical example of the difference between product brands and product lines is Procter and Gamble who market some of their products within their detergent product line under the Tide label and others without this label.Where products are marketed by brands, all expenditure relating to a brand, such as management and brand marketing is for the benefit of all products within the brand and not for any specific individual product. Therefore, such brand-sustaining expenses should be attributed to the brand and not to individual products within the brand.

The same reasoning can be applied to the next level in the hierarchy. For