Costing and Traditional Costing - Essay Example

Introduction: This exercise dwells on activity based costing and traditional costing. Cost allocation in companies can provide inaccurate information about the profitability of their goods and services. Traditional cost allocation methods allocate overhead cost outlays with the aid of one driver like direct labour hours, direct labour dollars, or machine hours. Sales-related costs are usually ignored. While it’s theoretically correct, in most organisations a single overhead cost driver is not enough to accurately allocate the group of overhead cost outlays to the outputs that are produced through them or the customers who are receiving service. Numerous firms in all fields of businesses have opted to use Activity based cost allocation systems after realising that traditional costing methods in firms can give some misleading information regarding the product lines, profitability of products, markets and clients. Activity based costing is a process that measures the cost and performance of cost objects, activities and resources. Costs objects take in activities and activities take in resources. Factor (or resource) cost outlays are allocated to activities on the basis of their utlisation of those resources as well as activity cost outlays are assigned to cost outputs based on the cost objects relative to their utilisation of those activities. Activity based costing incorporates causal relationship between activities and costs as well as between resources and activities. (Stenzel, C and Stenzel J, 2001) Using Activity based costing tools has helped these organisations to appreciate profitability more clearly, and has provided meaningful information about processes and costs associated with manufacturing and delivering goods and services. Thus a well-made and implemented Activity based costing system is a great aid to management evaluation and decision-making, thereby improving organisational performance. A brief snap shot of how it works is enumerated below: Activity Based Costing is two-phased as a costing method where overhead cost outlays are allocated to pools of overhead costs as well as the costs per pool are used to outputs based upon the magnitude of activities they call for. A single activity in ABC taken as an event, which leads to the consumption the resources of overheads. Activity based costing affects only overhead costs i.e. direct labour and direct materials are the same under Absorption Costing Method. A single activity pool of cost is referred to as a “cost bucket” where cost outlays for a specific activity are garnered. A measure for an activity is applied as a basis for allocation while using overhead costs. A rate of activity rate refers to the predetermined rate of overhead in Activity based costing. Activities’ Hierarchy: Guides the way costs are supposed to be grouped into various pools as well as the nature activities assigned per given cost pool Unit-level activities – done every moment a unit is produced. Batch- level activities – performed each time a batch is processed. Product- level activities – must be done regardless of the number units or batches of the output are being manufactured. Facility-level activities- have to be done regardless of the products to be produced. Task 1 Full costing and Activity based costing A) Calculations using Full costing Revenue and direct costs of products Skel Foss Total Units produced and sold 15000 units 18000 units 33000 Selling price/unit 52 91 Direct labour cost/unit (2hrs*10=20) (5hrs*10=50) Direct Material cost/unit 25 30 Sales revenue (1*2) 780000 1638000 2418000 Direct labour cost (1*3) 300000 900000 1200000 Direct Materials cost (1*4) 375000 540000 915000 Total direct cost (6+7) 675000 1440000 2115000 Calculations on Overheads and indirect costs. Indirect component Products (Skel + Foss) % of Total products Bought in parts handling costs 96000 40% Materials handling costs 38000 15.83% Sales invoicing costs 20000 8.33% Machine set up costs 26000 10.84% All other overheads 60000 25% Total Indirect overheads 240000 Overheads are absorbed on the basis of direct labour hours:- Skel 15000*2= 30000 Foss 18000*5=90000 Total 30000+90000=120000 =Total overheads/total direct labour hours Skel Foss Total Total units produced and sols 15000 18000 33000 Total direct cost 675000 1440000 2115000 Total indirect costs (2*30000*10=600000) (2*90000*10=1800000) 2400000 Revenue per unit 52 91 Direct cost per unit (675000/15000=45) (1440000/18000=80) Indirect cost per unit (600000/15000=40) (1800000/18000=100) Gross profit(loss) per unit (52-45-40=-33) (91-80-100=-89) Gross profit(loss) margin (-33/52=-63.46%) (-89/91=-97.8%) B) Calculations using Absorption costing Activity pool Cost drivers Skel indirect cost Foss indirect cost Bought in parts handling cost Number of bought in parts (2/3*96000=64000) (1/3*96000=32000) Materials handling costs Number of production batches (750/1750*38000=16286) (100/1750*38000=21714) Sales invoicing costs Number of invoices issued (200/1000*20000=4000) (800/1000*20000=16000) Machine set up costs Number of machine set ups (2/7*26000=7429) (5/7*26000=18571) All other over heads Labour hours (2/7*60000=17143) (5/7*60000=42857) Totals 108858 131142 Calculating the cost per product unit Activity pool Indirect cost for Skel Cost per product unit Indirect cost for Foss Cost per product unit Bought in parts handling cost 64000 (64000/15000=4.27) 32000 (32000/18000=1.78) Materials handling costs 16286 (16286/15000=1.09) 21714 (21714/18000=1.21) Sales invoicing costs 4000 (4000/15000=0.27) 16000 (16000/18000=0.89) Machine set up costs 7429 (7429/15000=0.50) 18570 (18571/18000=1.03) All other over heads 17143 (17143/15000=1.14) 42857 (42857/18000=2.38) Totals 108858 7.27 131142 7.29 Skel Foss Totals Units produced and sold 15000 18000 33000 Total direct costs 675000 1440000 2115000 Total overhead costs 108858 131142 Revenues per unit 52 91 Direct cost per unit (675000/15000=45) (1440000/18000=80) Overhead costs per unit (108858/15000=7.26) (131142/18000=7.29) Gross profit per unit (52-45-7.26= -0.26) (91-80-7.29=3.71) Gross profit margin (-0.26/52= -0.5%) (3.71/91=4.08%) Profitability for each item in the two different methods, Product Profitability (Gross profit margin) Skel Foss Full costing method -63.46% -97.8 Absorption costing method -0.5 4.39 Comment From the comparison full costing shows a loss on both Skel and Foss while Absorption costing shows a loss on Skel and a profit on Foss. This difference in results is from the different treatment of overhead costs. (Schmidt, Marty J, 2011) Task 2 Discussion on the suitability of Absorption costing as opposed to full costing. Activity based costing is accurate and realistic to production in a business set up. It works as an economic model that identifies the cost pools or activity centers in an organisation and assigns cost outlays to the given cost drivers relying on the magnitude of each activity utilised. This accuracy is achieved by tracing costs to products through activities as activities consume resources and products consume activities. It further includes indirect costs in the costing bracket as opposed to traditional costing which treats them differently. (Akyol, Derya Eren et al, 2005) This system is mainly helpful in identifying profit making or loss making products and, thus, it is key to decision making on pricing of products, adding or deleting items on product portfolio, evaluating improvement initiatives and choosing between in-house production and out sourcing. This system works in an exceptionally way with other performance management systems as well, which are used by a majority departments of human resources in contemporary businesses. This process gives companies an opportunity to implement strategies of costing across another of the firm’s diagonals as business operation process, value addition channels and supply chains are optimally as well as ably analysed in this process. This system helps in the benchmarking process, which forms an integral portion of business. Full costing allocates overheads on the basis of a single predetermined overhead rate, while Absorption costing allocates overheads to identified activity cost pools, and then assigns costs to products using related cost drivers that measures resources consumed. Absorption costing recognises all costs involved in production as opposed to traditional method which spreads indirect costs to total revenue. Thus, absorption cost is in a position to monitor the losses that are hidden and the profits associated with the traditional costing methods. While using Activity based costing the firm’s performance is put into comparison with other similar companies that have an outstanding performance. Activities with the biggest room to improve are identified. This is not the case with traditional costing methods. In Activity based costing costs are accumulated for each major activity as compared to traditional costing where costs are generalised. All costs in Activity based costing in a cost pool pertain to a single activity, thus, proper classifications which translates to accurate data for end users of the financial data. As opposed to traditional costing method which generalises costs allocation Absorption costing utilises a variety of measures to assign overhead costs, thus, all categories are catered for in Activity based costing. Activity based costing highlights activities that could benefit most from improvements. Activity based costing is in line with the work of business process reengineering by aiding managers in putting price tags upon non value-added types of activities, like rework or waste. To realise profits costs must be monitored, Activity based costing is focused upon process cost outlays and the way they interact with the segments of productivity. Equipped with measurements that are explicit with regards to the cost outlays of processes and activities, management can communicate about that putting into account these factors is vital. In other words, what gets measured gets managed. Task 3 Fixed overheads absorption rate (F.O.A.R) = Fixed overheads per unit/Standard time per unit F.O.A.R = (3.3*7.1) / (30/60) = 46.86 Budgeted fixed overheads per unit 10000/19800=0.51 Fixed overheads absorbed=0.51*46.86*20000=473400 = (473400*67350)/138890=229560. Actual Budgeted Variance Sales revenue (10.26*19800=203146) (10.5*20000=210000) (203146-210000=-6854) Direct Materials (38000*0.73=27740) (2*1.5*20000=60000) (27740-60000=-32260) Direct Labour (10000*4.38=43800) ((30/60)*2.3*20000=23000 (43800-23000=20800) Fixed Overheads incurred 67350 59000 (67350-59000=8350) Profit 64258 68000 Reconciliation Statement Actual Profit 64258 Budgeted profit 68000 Variance -3742 Add back Sales variance 6854 Direct labour 20800 Fixed overheads 8350 Less Direct materials -32260 Reconciling balance 0 Possible causes for variances include 1. Unexpected Flactuations in fixed overheads expenditure levels thus resulting in variances in between the budgeted and actual expenditure on fixed overheads expenditure. 2. Differences in volumes produced by the management vis a vis budgeted units for production. This results in variances as different volumes absorb different levels of overheads. 3. Differences in levels of efficiency too results in variances as inefficiency results in wastage increasing cost of overheads while high efficiency minimises expenditure on overheads. 4. Operating at different levels of capacity results in usage of different levels of overheads thus resulting to variances. 5. Inaccurate budgets by the management will mean that the outcomes will not give a true picture of the budget, thus, variances. 6. Unexpected changes in prices of inputs or other expenditure that are part of production. Any change in prices of inputs will mean that actual cost of units produced will differ from budgeted units thus creating variances.(Drury, Colin, 2007 p 448) Recommendations to the Management 1. Fixed overhead expenditure should be keenly monitored by the management to avoid Flactuations which results in variances. They may avoid this by competitive bidding of every fixed assets purchase made and hedging on currency fluctuations especially on import purchases. 2. Volumes produced should be uniform to enable comparability. The management should endeavor to produce under the guidance of the budget this will ensure that only budgeted units are produced thus avoiding variances. 3. Efficiency levels provided by management should be high and similar between the budgeted and actual production thus minimising the variances. The management should seal any loop holes that might result to wastage this in return will enhance efficiency levels in production process thus minimising variances. 4. The management should endeavor to produce at the same capacity levels as budgeted. Ife the capacity of production is altered by the management then output produced changes and variances occur. 5. Accuracy of the budgets should be worked on to ensure that they give a true picture of the business. Normally after production is done, comparison is done later thus if initial budgets were wrong then variances are bound to appear. 6. The management should bargain hunt for similar prices to those used in budgeting or find other ways of hunting for fair prices. (Shim, Jae K. and Siegel, Joel G. 1998, p154) Task 4 Activity based costing (ABC) is a method of allocating costs to products, services., projects, tasks, or acquisitions, based on (1) the resources consumed by these activities and (2) the activities that go into them. Activity based costing contrasts with full or traditional costing as traditional costing assigns costs using some arbitrary allocation methods for overheads and other indirect costs. Activity based costing as a costing approach is used by management for decision support and planning. Absorption costing for such a division with one product helps to improve on costing accuracy, thus, getting the management closer to the true cost and true profitability on products and services as well as the true value of returns on investments. Absorption costing gains this by transforming numerous cost outlays that traditional cost accounting takes as indirect costs into direct costs. (accountingformanagement.com, 2011) Activity based costing does not alter overall profitability in a company, it better aligns cost assignment to the causes of those costs and with correct allocation of costs we avail better information, thus, more apt decisions are possible in a firm so as to improve the levels profitability. This is the strength of Absorption costing. Glossary As indicated earlier, Activity based costing is a technique that determines the performance and cost of objects of costs, resources and activities. Costs objects take in activities and activities take in resources. Resource cost outlays are allocated to activities based upon their utilisation of the mentioned resources, while activity cost outlays are allocated to cost outputs with the basis being cost objects in proportion to utilisation of those activities. Activity based costing puts into account causal relationship between costs and activities and between activities and resources Using Activity based costing management technique can considerably improve the financial health of a firm as it presents the real picture or the factsheet, as the Activity based costing technique tracks the cost objects utilised in the activities and, thus, the fcators consumed in the same activities, to determine correct individual overheads instead of simply linking on the volume. The Activity based costing concept as a costing technique takes into consideration both factors. That is, the activity drivers as well as the resource drivers to come up with the product’s price or service. It is essential to realise that the profitability of a firm not only relies on the sales of the service or product, but also on the expenses concerned in the making of that specific service or product. In a given case study of parts of an Automotive manufacturing firm located in the nation by the name Norway, it was then proven that just a minute portion of their line of products had a positive Economic Profit as well as Return upon Sales. As a matter of fact when the Economic Profit and Operational profitability of their line of products were classified and columned side by side, that was an eye opener. As the firms usually mix up their overhead cost outlays with the direct cost outlays, this may not be completed with the setting of an accurate price method of the given product. Therefore, a scrutinising of the given accounts upon Bill of Materials (BOM) has to be done. It was realised that the firm’s largest line of products had a very minute operational profitability, which then gave negative returns. Honestly a disposal of such products has to be terminated. In another study that was done on these same products, the SWOT (strengths, weaknesses, Opportunities and threats) method was applied. It was realised that the products that brought a positive return had more weaknesses than strengths. In conclusion, one can say that Activity Based forecasting as a model is one of the most effective financial tools firms’ management. (first.emeraldinsight.com, 2011) Reference list: accountingformanagement.com. (2011). Advantages, Disadvantages and Limitations of Activity Based Costing (ABC) System: Retrieved 11 December 2011 http://www.accountingformanagement.com/limitations_of_activity_based_costing.htm Akyol, Derya Eren et al. (2005). A comparative analysis of activity-based costing and traditional costing. Retrieved 11 December 2011 http://www.waset.org/journals/waset/v3/v3-11.pdf Drury, Colin. (2007). Management and Cost Accounting. Edition 7, Illustrated. Cengage Learning EMEA. p 448. first.emeraldinsight.com. (2011). Using Activity Based Costing and Economic Profit to Grow the Bottom Line. Retrieved 13 December 2011 http://first.emeraldinsight.com/case_studies/pdf.htm?PHPSESSID=33g4vo57bg3mr61hs 4u02mtep7&id=3300080606 Schmidt, Marty J. (2011). The Meaning of Activity Based Costing (ABC). Retrieved 11 December 2011 http://www.solutionmatrix.com/activity-based-costing.html Shim, Jae K. and Siegel, Joel G. (1998). Schaum's outline of theory and problems of managerial accounting. Edition 2, illustrated. McGraw-Hill Professional. p 154. Stenzel, Catherine and Stenzel, Joe. (2001). A blueprint for organizational development. Edition Illustrated. John Wiley and Sons. p 303. Read More