ABC Costing vs Conventional Costing Method - Assignment Example

Running header: Costing Student’s name: Instructor’s name: Subject code: Date of submission: 1a) Income statement using the traditional absorption costing method; Determination of production overhead absorption rate This is based on the machine hours in machine department and labor hour in assembly department. The absorption rate is determined as follows; In the machining department, the total number of hours is Product hours per unit total units Total hours XYI 2 50,000 100,000 YZT 5 40,000 200,000 ABW 4 30,000 120,000 Total hours 420,000 hours Overhead absorption rate for machining department is given by total overhead for the department /total number of hours = $504,000/420,000hrs = $1.2/hr In the assembly department, the total number of hours is Product Hours per unit Total units Total hours XYI 7 50,000 350,000 YZT 3 40,000 120,000 ABW 2 30,000 60,000 Total hours $530,000 Absorption rate in the assembly department is given by total overheads /total hours for the department = $437,000/530,000 hrs =$0.82/hr Overhead allocation Product Total hours machine Department rate machining Total machining Department rate assembly Total hrs assembly Total assembly Total overhead XYI 100,000 $1.2/hr $120,000 350,000 $0.82/hr $288,585 $408,585 YZT 200,000 $1.2/hr $240,000 120,000 $0.82/hr $98,943 $338,943 ABW 120,000 1.2/hr $144,000 60,000 $0.82/hr $49,472 $193,472 Total overhead $504,000 $437,000 $941,000 RIPTIDE PLC ABSORPTION COSTING PRFOT STATEMENT XYI YZT ABW Sales $2,250,000 $3,800,000 $2,190,000 Variable cost $1,600,000 $3,360,000 $1,950,000 Production overheads $408,585 $338,943 $193,472 Profit $241,415 $101,057 $46,528 ABC Costing system Absorption rate per cost driver Cost driver Total quantity Total cost Absorption rate Machine hours 420,000 357,000 $0.85/hr Direct labor hours 530,000 318,000 $0.6/hr Set-ups 520 26,000 $50 Customer orders 32,000 156,000 $4.88 Suppliers’ orders 11,200 84,000 $7.5 Riptide PLC Budgeted Profit Statement XYI YZT ABW Sales 2,250,000 $3,800,000 $2,190,000 Variable cost $1,600,000 $3,360,000 $1,950,000 Production overheads Machine hours $85,000 $170,000 $102,000 Direct labor hours $210,000 $72,000 $36,000 Set -ups $6,000 $10,000 $10,000 Customer orders $39,000 $39,000 $78,000 Suppliers orders $22,500 $30,000 $31,500 Profit $287,500 $119,000 ($17,500) A comment on the results From the results, it can be observed that XYI realized a profit of $241,415 using absorption costing which increases to $287,500 on using activity based costing. Using absorption costing, YZT realizes a profit of $101,057 which increases $119,000 on applying ABC costing. Finally, product ABW realizes a profit of $46,528 using absorption costing but on applying ABC costing, the product realizes a loss of $17,500. The differences occur as a result of change in the methods of accounting. While in absorption costing the overheads are allocated based on the volume of output, activity based costing uses the activities that cause costs to allocate the costs (Marx, 2015). Thus, although XYI had a higher volume and hence more overhead costs using absorption costing, this was not the case when activity drivers were used. On the other hand, product ABW had been allocated less overheads using absorption costing based on it smaller volume of output. However, based on the cost drivers, this cost went up to an extent of resulting to losses. In other words, activity based costing may charge more amount of overheads for lower production volume depending on the cost drivers while absorption costing pegs cost allocation strictly on volume of production. This explains the differences observed above. 2. The Managing Director at Riptide plc has commented that he believes that Activity Based Costing is often implemented because it is fashionable and not because it provides extra information to management (Business teacher, 2015). However, his belief is not based on facts since ABC costing evolved in early 90s with its main reason being to address the shortcomings of the traditional absorption costing. In the real sense, Activity Based Costing provides extra information to the management and this is one reason behind its evolvement. Activity based costing is better described as a methodology of costing and monitoring of activities that unlike the traditional costing methods involves tracing consumption of resources and costing of final products. It assigns resources to activities while the activities are assigned to cost objects which use cost drivers in attaching activity costs to outputs. As stated above, activity based costing was developed as a modern alternative to the traditional absorption costing since it has the ability to allow managers to understand in a better manner the product as well as customer net profitability. As such, it gives better information for making value based and hence effective decisions to the business unlike other methods (CIMA, 2015). Activity based costing focuses its attention on cost drivers which are the activities that cause increases in costs. This is unlike the traditional costing methods such as absorption costing that mainly makes use of volume related drivers which include such drivers as labor hours. Unlike the traditional absorption costing method, activity based costing drivers can be explained. This is because of its use of transaction based drivers which may include the number of orders received hence enabling one to trace long-term variable overheads that were traditionally considered as fixed costs to products. Through activity based costing, it is proved that the cost of producing a unit of a product does not rely on the units/volume of the products produced but on the activities that cause the costs/cost drivers. Some of the advantages of activity based costing and hence the problems of absorption costing it overcomes are discussed below; Unlike the traditional costing methods, ABC costing results in a more accurate final costing figure. This is because it makes use of more than one cost driver when allocating costs. For instance in the above case, although product ABW is a low volume item, it requires more machine set ups, customer orders and supplier orders than the rest of the products despite the fact that the other products are high volume products. When the traditional absorption costing method was used, only machine and labor hours were used as cost drivers and hence products XYI and YZT incurred relatively higher costs since the two products use the most labor and machine hours despite their having required far less additional activities of machine set up, customer and supplier orders than product ABW. This exposes the weakness of the traditional absorption costing in that it was not appropriate when the organization dealt with many products or services that required differing activities (Nayab, 2010). As can be seen above, the activity based costing method assigns costs more accurately to products due to its ability to trace all activities that it then assigns to the products using multiple cost drivers. In addition, the method allocates usage of business resources considered common to each product using such drivers as labor hours. In this regard, it ensures that no product is assigned more cost than it should unlike the traditional absorption costing which has been noted to allocate more costs to high volume products while assigning less costs to low volume products thus resulting in inaccurate costs. In the same vein, it has been observed that the traditional absorption costing method resulted in a profit for the product ABW while the other products reported less profits. However, on using activity based costing, it is discovered that product ABW actually incurred a loss while the other two products had been more profitable. In this regard, activity based costing has been helpful in identifying the product that is too much costly to be profitable (Rodrigo, 2012). Although with absorption costing product ABC seemed to generate some profits, ABC costing revealed that it was using too many set ups, customer and supplier orders activities for it to be profitable. The implication of this is that activity based costing is able to provide value based information for accurate decision making. If the company above would want to improve its profitability, it will have to re-price its products or stop the production of ABW. Such value based decision valuable information is only achieved using activity based costing as opposed to the traditional absorption costing that assumes that costs increase with volume of production. As can be seen above, activity based costing helps one understand the core activities involved in the production process. This understanding is useful for the firm since it can be able to decide whether to outsource some of its activities or move to another place within the value chain. Given that such costs as branding, packaging and delivery costs are customer driven, it is impossible to account for them through the traditional absorption costing approach. Accounting of such costs is made possible by ABC costing (Ray, 2012). Using the traditional absorption costing, it would be possible for the firm to be serving its customers at a loss as seen in the case of product ABW where the company is not aware. However, ABC makes it possible to assess these costs and hence the company is able to know the true state of affair. In this regard, the company is able to undertake corrective measures. Where the customers were being undercharged hence low sales volumes, the company can reduce prices. Where products were being produced at a loss, the company can either decide to increase prices or stop the production altogether. The company could also use ABC in conjunction with customer profitability analysis to accurately analyze the profits that the company earns as a result of dealing with certain clients/products. This would help the firm boost its profitability by focusing on the lifespan of cost and performance (Nitin and Mahto, 2013). This will result in constant improvement in quality while linking the company’s strategy to operational decision making while facilitating waste elimination through enabling reflectivity of other non-value activities. Unlike traditional absorption costing method, activity based costing makes the costly as well as non-value adding activities more visible. This allows the management to focus on such activities with the sole aim of reducing or eliminating them. For instance in the above case, the management can be able to look at those non-value adding activities for product ABW with an aim of eliminating them and hence making the product profitable (Idiko, 2011). Unlike the traditional absorption costing method, ABC results in enriched data which the company can use to identify the cost of its untapped capacity and hence develop a separate accounting system for the cost. This is based on the fact that manufacturing companies often experience recurrent and cyclical deviations in production and hence sales which means the firms capacity is not fully engaged. This implies that the firm will incur costs at the batch, facility and product level activities that are not engaged. As such, ABC will help control capacity levels giving the firm the room to downsize and hence reduce the cost of underutilized capacity and hence appropriately price its products. This would imply more revenue and hence profit for the company. However, comments such as the one by the manager could have been triggered by the few shortcomings of the activity based costing as well as his failure to understand how it operates. One of the shortcomings of ABC costing is that unlike the traditional absorption costing, the method requires high volume of specific data that must be accurately collected (Narcyz, 2015). This would prove to be extremely time consuming while it is in itself cost incurring and hence costly to implement. It should be noted that just as in the above example; absorption costing only uses one or two cost drivers in allocating overheads unlike ABC which has to use multiple cost drivers. However, this is the cost that has to be paid for more accurate cost results and hence better pricing of the company’s products. As can be observed above, activity based costing is not only costly but is difficult in implementing unlike absorption costing which is fairly easier to implement and run. This is because less data is required owing to the less cost drivers that have to be accounted for. As can be seen in the above case, absorption costing only required machine hours and labor hours as the cost drivers while three more drivers of machine set ups, customer and supplier orders were needed for the activity based costing (Boris, 2015). The need to use more drivers increases the difficulty of implementing and running the activity based costing system. Another limitation of ABC is that not all costs have proper / corresponding activity or cost drivers. As such some costs have to use volume measures as they are hard to understand how they lead to cost. Such costs would include factory insurance, rent, manager’s salary and factory depreciation. Conclusion It has been established that activity based costing was developed for the purpose of overcoming the limitations of the traditional absorption costing. It has been also established that activity based costing results in more accurate costing and hence results in better pricing of company’s products. The ABC system has been noted to assign costs to the various cost drivers in comparison to traditional absorption costing which assigns costs to overheads on the bases of volume of production. This results in better costing and hence pricing. Though implementation of ABC system is both difficult and expenses due to the amount of data required, this is the price that has to be paid for more accurate costing and hence better managerial decisions. As such, the comment by the manager that activity based costing is often implemented because it is fashionable and not because it provides extra information to management is not true. It has been established that not only is ABC fashionable but it also provides management with extra information that is not only accurate but also useful for decision making. References Marx, D2015, Activity based costing and traditional costing systems, Retrieved on 9th April 2015, from; http://financialsupport.weebly.com/activity-based-costing-abc-and-traditional-costing- systems.html Business teacher, 2015, Operational differences between ABC and Absorption costing, Retrieved on 9th April 2015, from; http://www.businessteacher.org.uk/essays/accounting/operational-differences-between- abc-and-absorption-costing.php CIMA, 2015, Activity based costing, Retrieved on 9th April 2015, from; http://www.cimaglobal.com/Documents/ImportedDocuments/cid_tg_activity_based_costi ngnov08.pdf.pdf Nayab, N2010, Absorption costing Vs. Activity based costing, Retrieved on 9th April 2015; http://www.brighthub.com/office/finance/articles/86649.aspx Rodrigo, 2012, What are the differences between absorption costing and ABC?, Retrieved on 9th April 2015, from; http://writepass.com/journal/2012/12/why-does-the-company-need-either-absorption- costing-or-abc/ Ray, S2012, Relevance and applicability of activity based costing: An appraisal, Journal of Expert Systems, vol. 1, no. 3, pp. 1-8. Idiko, R2011, Activity based costing and activity based management, Retrieved on 9th April 2015, from; http://www.focusintl.com/RBM104-2011-1-9.pdf Narcyz, R2015, Adoption and implementation of activity based costing: A web based survey, Retrieved on 9th April 2015, from; http://www2.newpaltz.edu/~roztockn/portland03.pdf Boris, p2015, Specifics of the activity based applications in hospital management, International Journal of Collaborative Research on Internal Medicine & Public Health, vol. 5, no. 3, pp.179-185. Nitin, K&, Mahto, D2013, Current trends of application of activity based costing (ABC): A review, Global Journal of Management and Business Research Accounting and Auditing, vol. 13, no. 3, pp. 1-15. Read More