Overhead Absorption and Activity-Based Costing Systems - Assignment Example

Overhead Absorption and Activity Based Costing Systems Table of Contents Table of Contents 2 Overhead Absorption costing 3 Calculation of overhead absorption costing 4 Calculation of ABC 5 Analysis of results 8 ABC statement analysis: Justified or not 9 Reference list 12 Overhead Absorption costing In an industry in order to produce the final output, large numbers of expenses are incurred. The cost of production not only includes prime costs but also the variable costs and overhead expenses. In simpler words it can be explained that absorption costing is a method by which fixed costs and variable expenses are apportioned to individual products. A product absorbs different types of expenses. These are not reflected in the financial statement as expenses at the time when they are incurred. Instead they remain in the financial statements as cost of inventory, in the asset side of the balance sheet. They are only recognized as expenses when they are sold and at that time they are recognized as cost of goods sold (Drury, 2008). According to the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP) it is essential that a firm uses absorption costing to record the value of inventory in the books of accounts (Accounting Tools, 2014). The main components of this type of costing methods are: 1. Direct materials that are included in the finished product. 2. Cost of direct labor. 3. Variable manufacturing related expenses that vary with the level of operational activities. 4. Fixed manufacturing expenses that do not change with the level of operations. It is however possible to allocate expenses with the help of activity based costing method. But it is considered to be a more elaborate method and therefore more time consuming and costly. The costs allocated under the method of overhead absorption costing method may be over absorbed or under absorbed. The costs are allocated on the basis of rates of overhead. It may be seen that the actual expenses incurred and that which is recorded might not be the same. Also there might be costs that cannot be directly be traced to the products as they might not fall under the overheads. Under such circumstances direct costing is more helpful as it does not require any allocation. Absorption costing is also referred to as full costing or full absorption (Izhar and Hontoir, 2001). Calculation of overhead absorption costing First the over head rates required to be calculated: Overhead rate for Machine Department: =Machine Department/Machine Hours = 504,000/420,000 = £1.20 per machine hour Overhead rate for Assembly Department: =Assembly Department/ Direct labor Hours = 437,000/ 530,000 = £0.82 per direct labor hour Overhead Costs- The next step is to calculate the over head costs of each department. This is done by multiplying overhead rate with the hours per unit. The obtained figure is again multiplied with the units produced of each product (Lucey, 2007). Table 1: Total overhead cost Particulars XYI YZT ABW assembly machine assembly machine assembly machine A. Overhead rate 0.82 1.20 0.82 1.20 0.82 1.20 B. Hours per unit 7 2 3 5 2 4 C. Units produced 50,000 40000 30000 Overhead cost (A*B*C) 2,87,000 1,20,000 98,400 2,40,000 49,200 1,44,000 Sales and Variable cost Table 2: Sales value for each department Particulars XYI YZT ABW Units sold 50,000 40,000 30,000 Sale price per unit 45 95 73 Total sales value 22,50.000 38,00,000 21,90,000 Table 3: Variable cost for each department Particulars XYI YZT ABW Units produced 50,000 40,000 30,000 Variable cost per unit 32 84 65 Total variable cost 16,00,000 33,60,000 19,50,000 Table 4: Statement showing profit or loss Particulars XYI YZT ABW A. Sales 22,50,000 38,00,000 21,90,000 B. Variable cost (16,00,000) (33,60,000) (19,50,000) Contribution (A-B) 6,50,000 4,40,000 2,40,000 Less- machine overhead cost (2,87,000) (98,400) (49,200) Less- assembly overhead cost (1,20,000) (2,40,000) (1,44,000) profit 2,43,000 1,01,600 46,800 Calculation of ABC Rates per unit calculation- Under ABC costing, the first step is to calculate the rate per activity. As per the given problem, it is known that there are five activities. The total units in terms of each activity are known. The total cost is also known. Therefore it is possible to calculate the rate per unit. They are calculated by dividing cost pools by cost drivers given in the problem (Jain and Khan, 2006) Machine rate per hour= machine services / machine hours= 357,000 / 420,000= 0.85 Assembly rate per hour= assembly services / direct labor hours= 318,000 / 530,000= 0.60 Set up cost per unit= set up costs / set ups= 26,000 / 520= 50 Ordering cost per unit= order processing / customer orders= 156,000 / 32,000= 4.875 Purchase cost per unit=purchasing / suppliers orders= 84,000 / 11,200= 7.50 Total units in terms of each activity for each product- The next step is to find out the total units consumed by each product for each activity. This is calculated below. Table 5- Total units for each activity particulars XYI YZT ABW Machine service hours 50,000*2= 100,000 40,000*5= 200,000 30,000*4= 120,000 Assembly service hours 50,000*7= 350,000 40,000*3= 120,000 30,000*2= 60,000 Number of Set up 120 200 200 Customer orders 8,000 8,000 16,000 Suppliers orders 3,000 4,000 4,200 Total Cost for each activity- Now that the rates are known and the total units for each product for each activity are also known, it is possible to calculate the total cost in respect of each product for each activity. Table 6: Total cost in respect of each activity for XYI Product XYI Unit Rate Total cost (unit*rate) Machine services 100,000 0.85 85,000 Assembly services 350,000 0.60 210,000 Set up 120 50 6000 Order processing 8000 4.875 39,000 Purchasing 3000 7.50 22500 Table 7: Total cost in respect of each activity for YZT Product YZT Unit Rate Total cost (unit*rate) Machine services 200,000 0.85 170,000 Assembly services 120,000 0.60 72,000 Set up 200 50 10,000 Order processing 8,000 4.875 39,000 Purchasing 4,000 7.50 30,000 Table 8: Total cost in respect of each activity for ABW Product ABW Unit Rate Total cost (unit*rate) Machine services 120,000 0.85 102,000 Assembly services 60,000 0.60 36,000 Set up 200 50 10,000 Order processing 16,000 4.875 78,000 Purchasing 4,200 7.50 31,500 Now, the total sales and variable costs are calculated. This was also done above while calculating absorption overheads. Table 9: Sales value for each department Particulars XYI YZT ABW Units sold 50,000 40,000 30,000 Sale price per unit 45 95 73 Total sales value 22,50.000 38,00,000 21,90,000 Table 10: Variable cost for each department Particulars XYI YZT ABW Units produced 50,000 40,000 30,000 Variable cost per unit 32 84 65 Total variable cost 16,00,000 33,60,000 19,50,000 Preparation of profit statement Table11: Profit statement Particulars XYI YZT ABW A. Sales 22,50,000 38,00,000 21,90,000 B. Variable cost (16,00,000) (33,60,000) (19,50,000) Contribution (A-B) 6,50,000 4,40,000 2,40,000 Less- cost of Machine services (85,000) (170,000) (102,000) Less- cost Assembly services (210,000) (72,000) (36,000) Less- cost of Set up (6000) (10,000) (10,000) Less- cost of Order processing (39,000) (39,000) (78,000) Less- cost of Purchasing (22500) (30,000) (31,500) Profit 287,500 119,000 17,500 Analysis of results Below the profits ascertained under absorption costing and ABC are shown below. Table 12: Summary of Profits Particulars XYI YZT ABW Profit on the basis of absorption costing 2,43,000 1,01,600 46,800 Profit on the basis of ABC 287,500 119,000 17,500 It can be seen that there is considerable difference between the results under the two methods. The reason for this is the difference in the costs allocated. Under absorption costing all the costs are allocated as per the machine rate or the rate of assembly rate. In ABC all costs are apportioned and allocated on the basis of different activities. In absorption costing the different activity costs are absorbed to the department of machine or assembly and then the calculation are done. This is not the case for ABC analysis. Hence the difference arises. Management should accept ABC analysis as it is more in depth analysis of costs than absorption costing. ABC statement analysis: Justified or not It has been said that modern developments such as ABC are sometime implemented because they are fashionable and not because they provide extra information to management. The validity of this statement is depends upon the in depth analysis of ABC system. The production process involves numerous different types of activities such as manufacturing, assembling, servicing, packaging and so on. They all incur costs at different levels for different commodities that are manufactured by the company. ABC is the process by which we analyze how much activity was required to be undertaken for each type of product manufactured by the company and assigning expenses on the proportion of activities incurred for producing each type of product. For example, if for the manufacturing of light bulbs, the packaging department incurs a total cost of $200.000. There are two type of light bulbs that the company manufactures; 30 watt and 60 watt. For packaging, 40% of the activities are incurred for 30 watt bulb and 60% of the activities are incurred for 60 watt bulb. Therefore the cost of packaging for 30 watt bulb would be $80,000 (40% of $200,000) and for 60 watt bulb it would be $120,000 (60% of $200,000). Therefore we can see how expenses are apportioned to each type of product based on the proportion of activities involved in making them (Kaplan and Anderson, 2013). The steps involved in ABC analysis are as (Jawahar and Srivastava, 2009): 1. Identification of the total number of activities involved in the production process. 2. Indentifying total costs of each activity. They are the cost pools. 3. Identification of the appropriate cost drivers for each activity. For instance the cost driver for packaging can be the number of units produces. 4. Identify the proportion of units of each cost driver for each activity. 5. Calculation of the activity rate. This is calculated by dividing the total activity cost by the total units of cost driver. This is done individually for each product. 6. Segregating the total cost for each activity for each product. 7. Determination of profits by preparation of profit statement where costs (both variable and overhead) are deducted from sales. The circumstances under which ABC costing can be undertaken are: 1. When a company is manufacturing different types of products. 2. When there are different processes involved in manufacturing different types of products. 3. When overhead costs are significantly incurred. The main objective of ABC analysis is to accurately understand how much cost pertaining to a particular type of activity is gone into making a product. It is basically the cost segregation based on division of activity. When costs are identified correctly it is easy to analyze how much price should be charged. Accordingly return on investment can be effectively calculated. It also helps to identify if there is over emphasis of a particular type of expense in manufacturing a product. Management can also decide amongst different types of production policies, such as whether to opt for in house production or outsource it (CliffsNotes, 2013). However this method is followed differently by different organizations as the cost drivers are chosen differently based on the type of activities. Therefore the industry to industry comparison based on this method is not quite possible. This method is only suitable for the in depth analysis of the costing structure by the management for its own firm. This method is seen to be followed extensively in manufacturing industry. Also financial industry and services industry undertake this method to allocate costs to different activities. When a company wants to resize or change it production system, ABC analysis results are more helpful for decision making. However not all industries use this process if their production processes are simpler. This system is mainly followed by those firms which have a complex system of manufacturing products or services. To state that this system is only fashionable and does not render much help to the management is not really correct. It proves to be really helpful when the firm is considering resizing any of its service facilities or in its pricing decisions. Many companies however avoid using this method as it is a little complex. If firms do follow other method of costing, they can avoid this method. However this method should be followed in manufacturing industries having diverse production lines and activities. Therefore for this type of industry ABC method of costing may be highly useful. Simpler organizations might not find this method to be of much help (Accounting Coach, 2014). Reference list Accounting Coach, 2014. Activity Based Costing. [online] Available at: < http://www.accountingcoach.com/activity-based-costing/explanation> [Accessed 18 March 2014]. Accounting Tools, 2014. Absorption Costing. [online] Available at: < http://www.accountingtools.com/absorption-costing> [Accessed 18 March 2014]. CliffsNotes, 2013. Activity-Based Costing Activities. [online] Available at: [Accessed on 18 March]. Drury, C., 2008. Management and Cost Accounting. London: Cengage learning EMEA. Izhar, R. and Hontoir, J., 2001. Accounting, Costing and Management. Oxford: Oxford University Press. Jain, P. K. and Khan, M. Y., 2006. Management Accounting. New Delhi: Tata McGraw-Hill Education. Jawahar, L. and Srivastava, S., 2009. Cost Accounting. New Delhi: Tata McGraw-Hill Education. Kaplan, R. and Anderson, S. R., 2013. Time-Driven Activity-Based Costing. Massachusetts: Harvard Business Press. Lucey, T., 2007. Costing. London: Thompson learning. Read More