A Comparative Analysis of Traditional Costing Method with ABC Costing Method - Essay Example

Running Head: Accounting and finance Accounting and finance [The of the appears here] [The of the appears here] Table of Contents 1. Introduction..3 Traditional costing..3 2. Activity Based Costing..4 I. The calculation step of ABC..5 II. ABC process..6 3. A comparative analysis of traditional costing method with ABC costing method..7 Conclusion/Recommendation.11 4. References 5. Appendix Accounting and finance 1. Introduction: In this paper we are going to prepare the income statement on traditional based costing and activity based costing. After that the report tells about the differences in the product line profitability. The report will reveal the contrasting views on the tow approaches of allocating with respect to Manufacturing company and also discuss the benefits that will come up using activity based costing. 2. Traditional costing: The traditional absorption costing used in typically manufacturing company is still allocated overhead into products using direct labor or machine hour as the driver. They are often allocated largest overhead cost based on smallest direct labor. (www.theacagroup.com/activitybasedcosting.htm) traditional costing method V FOH per dlh 4 F FOH per dlh 4.75 total cost per case of Hinkels Quirts Direct labor 2400000 800000 Direct materials 2000000 1000000 Variable factory overhead 960000 320000 Fixed factory overhead 1140000 380000 Other Fixed Costs 1600000 400000 total cost 8100000 2900000 compute the volume sales 8400110.528 3682236.618 variable costs 5360110.528 2602236.618 contribution margin 3040000 1080000 fixed costs 2740000 780000 profit 300000 300000 volume desired 400000 122741 3. Activity Based Costing: ABC is a system of accounting that focuses on activities as the fundamental cost objects and uses the costs of these activities as building blocks for compiling the costs of other cost objects (Such as product or department).ABC seeks not only to allocate over heads to product costs on more realistic basis, than simply production volume, but also attempts to show relationship between overheads costs and activities that cause them It is also called activity-bases costing or activity accounting. (Charles T. Horngren p150) Manufacturing company only produced a few types and high quantities of products before, traditional costing method which focused on direct costs were much more important than the production overheads, traditional costing would be accurate before While the production structure has changed, the times demand that flexibility and love of change replaced absorption costing method in Manufacturing company I. The calculation step of ABC Our company is a Manufacturing company. The company has a processing system that is used to manufacture two products: Hinkels and Quirts. Cost drivers are the real factors that decide the cost incurred and the resource consumed. Unlike the traditional method plagued by inaccuracy in manufacturing overheads allocation, ABC need not adopt two-stage cost allocation process to figure out the each target cost, in order to achieve cost information accuracy. Therefore, ABC adopts multi activities to distribute costs. It demonstrates that choosing proper cost drivers is the most important and key step. In practice the ABC system uses many drivers as allocation bases in the second stage of the cost allocation system whereas the traditional cost systems tend to use, at the most, two second-stage allocation bases. (Colin Drury, 2002, p298) II. ABC process: Activity-based costing has the following five steps: a. Identify the different activities performed by the business. b. Calculate the total cost of each activity over the financial period(cost pool) c. Identify a cost driver (i.e. a causation factor) for each activity. d. Calculate the cost driver rate(i.e. the average cost of one occurrence of the cost driver) e. Assign part of the cost each activity to different products based to the extent to which each product has caused the activity to occur (i.e. apply the cost driver rate)(Proctor R. 2000, p67) For example in MANUFACTURING COMPANY, first of all, overheads expensed can be allocated into four activities that include Purchases related, Material move related, Machine related and direct labor related. Secondly, we can work out the total cost of each activity according to the cost pool we just allocated into. Thirdly, identifying cost drivers for four activities, they are purchase order for purchase related, material move for material related, and machine hours for machine related and direct labor hour for direct labor related. After getting the figures of activity costs and cost drivers, we can work out the cost driver rate, and at last, we assign the cost rate to the part which has caused the activity to occur. Activity Based Costing system total factory overhead cost Hinkels Quirts Purchases related 330000 110000 Material move related 451000 164000 Machine related 159000 106000 Direct labor related 720000 240000 total variable factory over head 1660000 620000 total cost Direct labor 2400000 800000 Direct materials 2000000 1000000 Variable factory overhead 1660000 620000 Fixed factory overhead 390000 130000 Other Fixed Costs 1600000 400000 total cost 8050000 2950000 compute the volume sales 8222621.185 4293843.766 variable costs 5932621 3463843 contribution margin 27.85%,19.33% 2290000 830000 fixed costs 1990000 530000 profit 300000 300000 volume desired 391553.3898 143128.1255 4. A comparative analysis of traditional costing method with ABC costing method. 1. Measurement of cost by traditional costing method and ABC costing method are greatly different. ABC allocates the activity costs into products by cost drivers, while traditional costing method uses quantity drivers (direct labor cost) to allocate costs. Since the use of the traditional costing method was not avoided of products loss, we may as well say then that its continual use would be a wrong economic decision. 2. It is impossible to get correct activity information of each activity and the activity channeled towards production by using traditional costing method, while this can be achieved easily and accurately by ABC method. With the use of ABC, Manufacturing company could now analyze which activity is tends towards loss of products, in order to discuss the possibility of reduction of such activities. 3. The product loss, measured by traditional costing method, was not encountered by ABC method since ABC could accurately allocate cost information. 4. Through the calculation of ABC, we are able to know the production of which good consumes activity most, which cost of activity is highest, helping us knows how to decrease cost and enhance efficiency. In that case ABC method brought a great advantage for the Manufacturing Company. If it used absorption costing systems normally calculate their product costs to on direct labor cost which is not according to the activities. This gives the impression of a high degree of accuracy but it is really an example of mathematical precision. Because of the arbitrary correlations used by this traditional approach, it is quite possible that the two products have nearly the same over head, i.e. Hinkels and Quirts. If this is so, the calculation shows that it is a waste of resources, giving a misleading answer. A traditional absorption costing system may be cheaper to operate than an activity-based costing system but the cost of the errors resulting from its inaccuracies can be far greater. One important factor affecting the cost effectiveness of ABC systems is the continuous fall in the price of information technology. The rapid revolution in information systems is greatly reducing their operating costs whilst, at the same time, greatly increasing their effectiveness (Proctor R. 2000, p72). ABC overcomes all these disadvantages which absorption costing system has, as we can see, the reason of adopting ABC method is not only for costing calculation purpose, but also focus on customer service, management decision etc., everything in a company will be considered into costing, activities will be the core for costing calculation, these will make ABC system more accurate for the modern style manufacturing definitely. After the above discussion now we are going to analyze that why the product cost and the profitability is different in two approaches. As we have discussed that the traditional costing is based on direct labor hour i.e. 0.6hr for hinkels and 0.8 hrs for Quirts and if we allocate the over head costs by the above base the two products have the same unit costs but in actually the two products are manufactured in different processes and the process for the two products is different so this problem is resolved by using activity based costing. In the traditional costing system the product cost of Hinkels is allocated to Quirts because of the wrong base for allocation of overheads. Actually the costs associated with the product Hinkels is allocated to the Quirts which will raise the product cost. This point is very important to the company as the management has cash flows problem so they have to make decision that which product is loss generating products so to reduce or ends up the production fir that product. But that problem is solved by using the activity based costing. By using the traditional costing income statement the overheads allocated to the two products line costs are 8100000 and 2900000 for HInkels and Quirts respectively and using activity based costing the product line costs are 8050000 and 2950000 which shows that the product costs are allocated arbitrary and have the huge differences in the overheads costs. The overheads are allocated to the production on the basis of labor costs in traditional costing and in ABC method the base is used is the purchase and material move base in which the products are produced. 5. Conclusion/Recommendation: The above discussion reveals the fact that the traditional based costing is not so realistic than activity based costing. Manufacturing company can make decisions about the pricing and how to reduce the costs associated with the product line and run with the current market situation. The profitability of the company can be increased by producing greater no. The ABC method opens the new doors for the profitability for the Manufacturing Company. As the method is very significant for the manufacturing companies because the manufacturing products are made according to the activities done on them so the overhead is allocated to the products on more realistic bases and the pricing mechanism will work effectively. References Mats and Usry. Costing: Activity Based Costing. 2004 (Colin Drury, 2002, p298) (www.theacagroup.com/activitybasedcosting.htm) (Charles T. Horngren p150) Appendix: Calculation steps: traditional costing method V FOH per dlh 1280000/320000=4 F FOH per dlh 1520000/320000=4.75 total cost per case of Hinkels Quirts Direct labor 6*400000=2400000 8*100000=800000 Direct materials 5*400000=2000000 10*100000=1000000 Variable factory overhead 4*240000=960000 4*80000=320000 Fixed factory overhead 4.75*240000=1140000 4.75*80000=380000 Other Fixed Costs 2000000/500000*400000=1600000 2000000/500000*100000=400000 total cost 8100000 2900000 compute the volume sales 8400110.528 3682236.618 variable costs 5360110.528 2602236.618 contribution margin 36.19%,29.33% 3040000 1080000 fixed costs 2740000 780000 profit 300000 300000 volume desired 84000000/21=400000 3682236/30=122741 Calculation steps for ABC: Activity Based Costing system total factory overhead cost Hinkels Quirts Purchases related 440000/200000*150000=330000 440000/200000*50000=110000 Material move related 615000/150000*110000=451000 615000/150000*40000=164000 Machine related 265000/100000*60000=159000 265000/100000*40000=106000 Direct labor related 960000/320000*240000=720000 960000/320000*80000=240000 total variable factory over head 1660000 620000 total cost Direct labor 400000*6=2400000 100000*8=800000 Direct materials 5*400000=2000000 100000*10=1000000 Variable factory overhead 1660000 620000 Fixed factory overhead 520000/320000*240000=390000 520000/320000*80000=130000 Other Fixed Costs 2000000/500000*400000=1600000 2000000/500000*100000=400000 total cost 8050000 2950000 compute the volume sales 8222621.185 4293843.766 variable costs 5932621 3463843 contribution margin 27.85%,19.33% 2290000 830000 fixed costs 1990000 530000 profit 300000 300000 volume desired 8222621/21=391553 4293843/30=143128 Read More