Cost Approach Explanation - Assignment Example

Running header: ACCOUNTING Student’s name: Instructor’s name: Subject code: Date of submission: 1. Explanation of the cost approach Wallen uses. Wallen manufacturing uses the traditional volume based product costing approach which uses only single item (cost determinant) to come up with the rate to be used in apportioning or assigning the overheads to our three products. As such,, we accumulate all overheads resulting in total overheads. It is out of the total overheads that we determine what cost is to be associated with each product using the single cost determinant deemed to be most closely related to causing the overheads (For Wallen, we use direct labor). Shortcomings Using a single cost driver to allocate overheads may result in inaccurate product costs the assumption that products consume overheads at the same rate is wrong. For instance, we can’t use labor cost in apportioning engineering and material handling costs since engineering cost is determined by the number of change orders that may differ among the products while material handling is determined by raw material costs for each product and not labor cost. Hence, the two cost determinants or drivers should be used in order to allocate cost accurately. Using the volume based costing approach therefore results in over costing the products produced in large quantities e.g. Jaza and Nance while under costing products like Meliss which are produced in low quantities. As such, volume based costing results in assigning the wrong selling prices to products. 2. Explanation of activity based approach to costing Activity based costing traces the overhead activities to the products which use the activities. The method therefore considers the cause and effect relationship between the overhead activity and the product/ cost driver. Using ABC, an overhead cost is only assigned to the caused/ used the activity e.g. the engineering costs will only be assigned to the products that benefited from the test orders. Therefore, the method is more reasonable and accurate in allocating overheads to products. The advantages of ABC costing include; a) With ABC, it is possible to estimate the costs of individual products more precisely. b) The method enables equitable and scientific pricing through reducing prices of products that use less of an activity while increasing the price of products that use more of the overhead activities. c) The method enables elimination of the cost of producing non profitable products and allocation of more funds to profitable products thus increasing l profitability. d) The method aids in exposing of wastes and inefficiencies hence boosting productivity. e) The method will provide quantifiable figures for future planning and budgeting. 3. How ABC will help us eliminate the problems identified with volume based approach; The volume based approach has been giving us inaccurate product costs since it uses a single rate in cost assignment. However, activity based costing will enable us get accurate product costs since overheads costs will be realistically assigned to products using the relevant cost determinants/drivers. Furthermore, products produced in higher quantities will no longer be over costed since the extent to which an activity driver is consumed by a product will considered in allocating overheads. For instance, if Jaza used 20% of raw material, only 20% of the material handling cost will be assigned to it. Thus if we have accurate product costs, our products will be sold at their right prices. Production of non profitable products will be stopped and more volumes of the more profitable products produced. Hence, no product will be sold at a loss. Profitability of products under Volume based approach Profitability = actual selling price-production cost. Therefore profitability will be as shown below; product a) product cost b)Actual selling price c)=(b-a) Profitability under actual selling price Jaza $573.00 $639.00 $66 Nance $508.50 $762.75 $254.25 Meliss $286.50 $600.00 $313.50 Profitability under an ABC system Computation of cost of production NB// The direct costs remain the same under both the systems as follows; Jaza Nance Meliss Direct materials $105 $157.50 $52.50 Direct labor $48 $36 $24 Determination of overhead under ABC system NB// in determining the total amount of overhead to be allocated to each of the products, we apply the cost drivers consumed by each of the products as compiled by Jamie as follows; Overhead Jaza Nance Meliss Machinery =$3,675,000×24%=882000 =3,675,000×50%=1837500 3,675,000×26%=955500 Machine set up =$15,750×22%= 3465 =15,750×30%= 4725 15,750×48%= 7560 inspection =1,575,000×16%= 252000 =1,575,000×44%= 693000 1,575,000×40%=630000 Material Handling =2,625,000×25%= 656250 =2,625,000×69%=1811250 2,625,000×6%= 157500 Engineeri =1,034250×35%=361987.50 = 1,034,250×10%=103425 1,034,250×55%=568837.50 Total overhead = 2,155,702.50 =4,449,900 =2319397.50 NB/ Unit overhead = total product overhead/ total product units. Thus; Jaza =$2,155,702.50 = $269.46/unit 8,000 Nance =$4,449,900 = $296.66/unit 15,000 Meliss =$2,319,397.50 = $ 579.85/unit 4,000 Therefore the cost of production for products is; cost Jaza Nance Meliss Direct materials $105.00 $157.50 $ 52.50 Direct labor $ 48.00 $ 36.00 $ 24.00 overheads $269.46 $296.66 $579.85 Total cost $ 422.46 $490.16 $656.35 Therefore, the profitability of the products under ABC costing will be as follows; Product a)Production cost b) Actual selling price c) =b-a) profitability under actual selling price Jaza 422.46 639.00 216.54 Nance 490.16 762.75 272.59 Meliss 656.35 600.00 56.35(loss) Profitability varies across the two approaches as follows; i) Using the traditional volume based costing approach; Jaza makes the lowest contribution to profit while meliss makes the highest contribution to profit. ii) When ABC costing is used, Meliss actually makes a negative contribution to profit (loss) Nance contribution becomes the highest. The differences in the profitability observed in using different approaches are as a result of the allocation bases used. In the volume based approach, labour coast was used in cost allocation .This was unrealistic since it assumed the overheads are consumed at the same rate. On the other hand, the ABC method was realistic and gave accurate results since each activity was matched to its cost driver in assigning overhead. As such products were accurately costed unlike in the previous approach where Jaza was over costed due to its high volume of production while Meliss was under costed due to its low volume of production resulting in wrong pricing. 4. Based on my review of costing above, we should adopt the ABC approach since it has resulted in more accurate product costs and hence resulting in more accurate product pricing. Furthermore, ABC approach has helped discover that Meliss was being sold at a loss hence the high demand while Jaza was overpriced hence the low demand. b) NB/ Selling is 150% of product cost. Using the ABC approach, the new prices should be; Jaza = 150%× 422.46 =$633.69 Nance= 150%× 490.16 =$ 735.24 Meliss = 150% × 656.35 = $984.53 Therefore, the current selling prices are inappropriate for our products. Only Nance should continue being sold at its current selling price of 762.75. Jaza’s price should be lowered to $633.69 and Meliss’ price increased to $984.53. c) The strategic actions In future, Jaza’s and Nance prices should be reduced to $633.69 and $735.24 respectively while Meliss price should be increased to $984.53 or its production stopped altogether. 5 potential limitations the ABC costing system; a) As observed in our case ABC is very complex compared to the volume based costing. Volume based costing only used labor in assigning overhead. However, with ABC, we estimated the cost of each overhead activity and identified the cost drivers for the activities. Furthermore, all this data has to be regularly updated implying increased time and cost. b) ABC may make Wallen lose sight of strategic long-term objectives in pursuit of small savings e.g. although Meliss was sold at a loss, it may have been produced to achieve a strategic depth hence stopping its production obscures this objective. c) ABC costing does not conform to the generally accepted accounting principles (GAAP). 6. The following books will help you to understand my answers for question 1 and 2 above. a) James, K2010, Cost accounting in the modern organization, Journal of management accounting research, Vol.8, No.125, Pp14-26. In this article, the author gives alternative approaches to costing. A detailed account of the volume based costing system is given. The system is presented as an outdated one and one that leads to inaccurate cost allocation. The limitations of the volume based costing are outlined in detail. Finally, the author presents an alternative approach (ABC costing) to cost assignment that could lead to more accurate product costing. b) Oleg, D2011, Method time driven activity based costing, Journal of applied Economic sciences, Vol.5, No.15, Pp7-15. In this article, activity based costing is presented as a tool to better overhead allocation to activities in comparison with volume based costing method. The author shows how the method can be implemented in most economic sectors. As such, the author outlines the benefits of ABC costing and also its potential limitation. Furthermore, case studies are used to portray ABC costing as a superior costing approach. References: James, K2010, Cost accounting in the modern organization, Journal of management accounting research, Vol.8, No.125, Pp14-26 Oleg, D2011, Method time driven activity based costing, Journal of applied Economic sciences, Vol.5, No.15, Pp7-15. Read More