Performance Management and Control - The Advantages and Disadvantages of ABC Costing System - Assignment Example

Question One

• The advantages and disadvantages of ABC costing system

ABC costing is differrent from the traditional costing method in the sense that ABC utilizes different cost drivers to come up with the total cost, while the traditional costing method only uses a single cost driver such as labour and machine hours(Kumar , 2016). The advantages and disadvantages of ABC costing compared to the traditional costing method are as follows:

ABC costing system is more realistic in the sense that it puts into consideration realistic costs that apply in advances manufacturing companies where the overhead costs account for a large portion of the total costs. Traditional method on the other hand may include other costs in the calculation of the unit cost, thus showing higher costs of a product. ABC costing also allows for tracing of overheads to the product. For example costs of non-floor activities like administration can be traced to the final product; this is unlike the traditional costing technique where the non-floor activity costs are not considered in calculating the cost per unit of the product.

Furthermore, ABC costing method puts recognition on the fact that activities cause costs, but not products, products consume activities, unlike the traditional costing method, which uses activities as cost drivers in the calculation of the absorption rate. Contrary to the Traditional costing method, ABC costing pays close attention to the real nature of behaviours of costs. This helps in pin pointing and eliminating the non-value activities, which result in cost reduction(Edwards & Technical Information Service, 2008).

The other advantage of ABC costing system is that it put recognition to the level of complexity and diversity in the modern production activities before the transaction based rather than production volume based drivers. ABC costing system also offers reliable variable cost information which is important in decision making and setting strategic goals. It is also a flexible costing system as it traces the true costs to products, processes, customers and management responsibilities. ABC costing also offers useful information for performance measurement, both financial and non-financial: financial measures include cost drivers while the non-financial measures include the volume of transactions. ABC costing is not only applied in manufacturing companies but also service industries.

ABC costing is used when the lines of production differ in terms of output volume and complexity. It can also be used if there are many product lines and if the total overhead costs constitute a large proportion of the total cost. It can also be used if there has been a significant change in the process of manufacturing and when the existing management team do not put into consideration the data provided by the system of accounting under use in the period. Traditional costing may only be used when there is one cost drive. It may not accommodate significant changes in the firm such as changes in the manufacturing processes. Traditional costing cannot be used to cost so many product lines and highly complex activities.

Traditional absorption costing method tends to allocate a larger portion of the overhead costs to products that require more labour hours of production and under allocate overhead costs to products that require fewer labour hours of production. In reality however, products which require less hours of production might have more operation costs like supervision and insurance compared to products that require more labour hours. This leads to under absorption of costs for products that require more hours of production and over absorption of costs for products that need more labour hours. Ultimately, this leads to an inaccurate cost per unit and the estimated price per unit is also inaccurate especially if the company uses the cost plus margin method of pricing. In the long run, the demand of the product is also affected which interferes with the revenue estimation of the firm.

The ABC Costing is also disadvantageous in the following ways: First, it is more complex compared to the traditional methods of costing. It is also costly to implement and run, which may lead to increased operational costs (Rojas, 2006). There is also a high probability that not all overhead costs relate to specific activities (Dury, 1992). ABC costing also ignores any potential conflict in areas of more than one cost driver, any common cost and any form of non-linearity in the rates of cost drivers.

Furthermore, ABC costing goes against the accounting standards on stock and inventory, especially because it charges selling and distribution costs to the cost of finished goods and Work in Progress. The international standards require that the cost of work in progress and finished goods to include producton costs upto the stage of production that has been reached, this means that the selling and administration costs should be excluded from the cost of inventory (IFRS Foundation, 2016).

Both ABC and Traditional costing method however are not the best methods of costing since they do not provide useful information for decision of making in terms of pricing and demand reflection. This is because a large percentage of overhead costs do not vary with output. For example, if a firm absorbs building insurance cost based on the floor area and absorbed based on the output produced; it means that the fixed cost of insurance is treated as a variable cost which is not the right treatment. A budget plan based on this information will be inaccurate, as a result, the wrong price will be arrived at, and the wrong revenues will be estimated.

Usefulness of ABC and Traditional costing method is only limited to management accountants and cost accountants.Management Accountants use these costing methods in decision management while the cost accountants use them in determining the cost of a product and variance analysis. There is need for firms to adopt new and better ways of costing. This is because there are many changes in manufacturing industry, decrease in the amount of labour usage due to introduction of technology in production costs. The total overhead costs of production are also increasing, which may lead to absorption of unrelated overhead costs.

• Unit Costs for the models using traditional costing method

Product

M

C

Annual production volume (units)

8,000

24,000

Selling price per unit

£350.00

£140.00

Direct labour and material cost per unit

£170.00

£60.00

Annual direct labour hours

20 000

60 000

Total annual overhead is

£2,480,000

Table 1: Traditional costing information

Absorption Rate = Budgeted Overheads / Budgeted Activity level. In this question, the activity level is labour hours and the total overhead cost is £2,480,000.

The unit overhead cost can be calculated as:

Absorption Rate Calculation

Direct Labour Hours

2480000/(20000+60000) = £31 per Hour

Product

M

C

Total Overhead Cost

£31*20000 = 620,000

£31*60000 = 1,860,000

Overhead Cost Per Unit

= 620,000/8000 = £77.5 per unit

= 1,860,000/24000 = £77.5 per unit

Table 2: Calculation of the overhead cost per Unit

Note: The direct labour hours act as the cost driver on which the absorption rate is based. The total overhead cost is arrived at by multiplying the absorption rate by the labour hours for each product. The overhead cost per unit is arrived at by dividing the total overhead cost by the number of units.

Total Cost per unit

Product

M

C

Direct labour and material cost per unit

£170.00

£60.00

Overhead Cost Per Unit

£77.5

£77.5

Total Cost per unit

£247.5

£137.5

Table 3: Total unit Cost Calculation

Note: The total cost per unit is equal to the sum of the direct labour and material cost, plus overhead cost per unit, as calculated in table 2 above. The total cost per unit of M is higher than that of Product C. this is attributed to the high cost of direct labour and material cost for product M.

• Unit cost calculation using ABC costing system

Activity

Budgeted Cost

Cost Driver

Engineering and Maintenance

£155,000

Engineering hours

Setups

£350,000

Number of setups

Machine related set up

£1,800,000

Number of machine hours

Packaging and Shipping

£175,000

Number of shipments

Total overhead

£2,480,000

Table 4: ABC costing Information on possible cost drivers

Cost driver

M

C

Engineering hours

6,000

8 000

Number of Setups

300

50

Machine hours

80,000

80 000

Number of shipments

7 000

9 000

Table 5: ABC costing information on the cost drivers

The absorption rates for each activity are as follows:

Activity

Budgeted Cost

Absorption Rates

Engineering and Maintenance

£155,000

155000/(6000+8000) = £11.07 per Engineering Hour

Setups

£350,000

350000(300+50) = £1000 per set up

Machine related set up

£1,800,000

1800000(80000+80000) = £11.25 per Machine Hour

Packaging and Shipping

£175,000

175000(7000+9000) = £10.94 per shipment

Table 6: Absorption rate calculation using ABC costing system

The first step in calculating the cost per unit in ABC costing is calculating the absorption rate. This is arrived at by dividing the budgeted overhead cost by the related cost driver. For example the absorption rate for the packaging and shipping cost is arrived at by dividing the budgeted cost of £175,000 by the total number of shipments for both products M and C (7000+9000) shipments. The absorption rate is equal to £10.94 per shipment. Another example is the machine related setup costs whose cost driver is the machine hours. The total machine hours are equal to 160,000, while the budgeted overhead cost is equal to 1,800,000. The absorption rate is equal to 1,800,000/160,000. This gives £11.25 per machine hour as the absorption rate for the machine setup cost.

Activity

Absorption Rates

M

C

Engineering and Maintenance

155000/(6000+8000) = £11.07 per Engineering Hour

=11.07*6000 = £66,420

= 11.07*8000 = 88,560

Setups

350000(300+50) = £1000 per set up

= 1000*300 = 300,000

= 1000*50 = 50,000

Machine related set up

1800000(80000+80000) = £11.25 per Machine Hour

= 11.25*80000 = 900,000

= 11.25*80000 = 900,000

Packaging and Shipping

175000(7000+9000) = £10.94 per shipment

= 10.94*7000 = 76,580

= 10.94*9000 = 98,460`

Total Overhead Cost

£1,343,000

£1,137,020

Total Output

8,000

24,000

Overhead Cost per Unit

167.875

47.376

Table 7: Overhead cost per unit

The overhead cost per unit of each product is arrived at by multiplying the absorption rate by the cost drivers. For the case of packaging and shipping costs, the absorption rate calculated was £10.94 per shipment. The related cost driver is the number of shipments: 7000 and 9000 for product M and respectively. Therefore, the total packaging and shipment cost for product M and C are (10.94*7000) = 76,580 and (10.94*9000) = 98,460`respectively. Another example is the setup cost whose cost driver is the number of setups. The total number of setups is 350, while the absorption rate for setup costs calculated in table 6 is equal to £1000 per setup. The setup costs for product M and C are arrived at by multiplying the absorption rate of £1000 by the number of setups for product M and C of 300 and 50, respectively. Therefore the total setup cost is equal to 300,000 (300*1000) and 50,000 (50*1000), respectively.

The total overhead cost is the arrived at by summing up the overhead costs separately for each product. The total overhead costs for product M and C are £1,343,000 and £1,137,020 respectively. These values are then divided by the total number of output units of 8,000 and 24,000 for product M and C respectively. The resultant figure is the overhead cost per unit for each product. The overhead cost per unit for Product M is higher than that of Product C. This difference may be attributed to the fact that product M has higher overhead costs, especially setup costs, which are allocated to less number of units produced, compared to product C. This may also be attributed to low volume of output of product M compared to product C. as discussed above, ABC costing tends to allocate more overhead cost to low volume output compared to high volume output.

Product

M

C

Direct labour and material cost per unit

£170.00

£60.00

Overhead Cost per Unit

167.875

47.376

Total Cost Per Unit

£337.875

£107.376

Table 8: Total cost per unit using ABC Costing

The total cost per unit for each product is arrived at by summing up the direct labour, direct material and overhead cost per unit. The cost per unit of product C is lower than that of product M, mainly due to the high overhead costs allocated to product M (£167.875) compared to Product C of £ 47.376 (As discussed in the discussion on table 7). Further explanation and comparison is discussed below:

• Comparison of ABC costing and Traditional absorption costing

Product

M

C

Cost per unit using traditional method

£247.5

£137.5

Cost per unit using ABC costing method

£337.875

£107.376

Table 8: Comparison of cost per unit calculation using ABC and traditional costing method

Table 8 indicates that the ABC costing method produces a higher cost per unit for Product M compared to the cost produced using the traditional method. On the other hand, the traditional costing method produces a higher cost per unit for product C compared to the cost per unit produced using the ABC costing method. This difference may be attributed to how the overhead costs were treated (Schmidt, 2014). However, in both cases, the costof product M is higher than the cost of Product C. Further comparison is shown in the report below:

Costing Method

Traditional Method

ABC Costing method

Product

M

C

M

C

Number of units produced

8,000

24,000

8,000

24,000

Selling Price per Unit

350.00

140.00

350.00

140.00

Direct Labout and Material Cost per unit

170.00

60.00

170.00

60.00

Sales Revenue

2,800,000.00

3,360,000.00

2,800,000.00

3,360,000.00

Direct Labout and Material Cost per unit

1,360,000.00

1,440,000.00

1,360,000.00

1,440,000.00

Indirect Costs Components:

620,000.00

1,860,000.00

-

-

Engineering and Maintenance

-

-

66,420.00

88,560.00

Setups

-

-

300,000.00

50,000.00

Machine related set up

-

-

900,000.00

900,000.00

Packaging and Shipping

-

-

76,580.00

98,460.00

Total Overhed Cost

620,000.00

1,860,000.00

1,343,000.00

1,137,020.00

Total Gross Profit

820,000.00

60,000.00

97,000.00

782,980.00

Gross Profit Margin

29.29%

1.79%

3.46%

23.30%

Table 9: Comparison of Gross Profit

Product M shows a higher gross profit when calculated using the traditional method compared to the cross profit calculated using the ABC costing method. On the other hand, Product C has a lower gross profit calculated using the traditional method compared to the gross profit calculated using the ABC costing method.

ABC costing is differrent from the traditional costing method in the sense that ABC utilizes different cost drivers to come up with the total cost, while the traditional costing method only uses a single cost driver such as labour and machine hours(Kumar , 2016).In ABC costing, the overhead costs are transferred from the high volume product (Product C) to the low volume product (Product M). This is mainly because low volume output requires special handling. Using ABC costing method usually assigns more overhead costs to low volume output.ABC costing is used when the lines of production differ in terms of output volume and complexity. It can also be used if there are many product lines and if the total overhead costs constitute a large proportion of the total cost. It can also be used if there has been a significant change in the process of manufacturing and when the existing management team do not put into consideration the data provided by the system of accounting under use in the period.

Question Two

• Labour Hours required to produce the fourth Batch

The learning curve equation is Y = abx ; Where Y is the cumulative labour hours for each batch, a represents the labour hours taken to complete the first batch, b is the cumulative number of units produced, and x represents the improvement exponent, also called the learning index( Brookfield, 2005). The learning index is calculated as the log of the learning curve percentage divide by Log 2. In this question, the learning index will be calculated as Log 80% divide by log 2 which gives a value of -0.322. The labour hours required to produce the fourth batch will be calculated as:

Y = 100 * (4-0.322)

Log Y = Log 100 + (-0.322*Log 4)

Log Y = 2 - 0.322*0.6021

Log Y = 2 – 0.1939

Log Y = 1.8061

Y = 63.99 Hours

It will therefore take 63.99 hours to produce the fourth Batch.

• The suitability of the LC for cost estimation and the prime cost per calculator for the fourth batch.

Prime cost refer to the sum of all direct costs = Direct Labour Cost + Direct Materials + Direct Labour Hours. The prime cost per unit for the fourth batch is equal to Direct Material (£300) + Direct Labour Cost (£200) + Direct Labour Hours (£90*63.99/100)= £557.591. The LC is suitable in estimating the labour hour cost. This is because; fewer hours are required in producing an extra unit due to the learning curve effect(Anon., 2016).

• Direct labour Hours required to prepare the extra units ordered by the wholesaler

Cumulative Hours for Making the 4th Batch = 63.99*4 = 255.96

Labour Hours to make the 5th Batch = Y = 100 * (5^-0.322)

Log Y = Log 100 + (-0.322*Log 5)

Log Y = 2 + (-0.322*0.6989)

Log Y = 1.7749

Y = 59.55

Cumulative hours in making the 5th Batch = 59.55 * 5 = 297.784

Therefore, the labour Hours required to prepare the extra 100 units will be equal to 297.784 – 255.96 = 41.82 Direct Labour Hours.

• Price of the batch sold to the wholesaler

The prime cost per calculator = Direct Material (£300) + Direct Labour Cost (£200) + Direct Labour Hours (£90*41.82/100) + Variable Overheads (0.75*200) = £687.638

The Price of each Calculator = Cost + Margin = £687.638 + Margin. The margin is given as a percentage of the cost. If the margin percent is β, then the Price of each calculator will be given as 687.638 + β687.638 = 687.638 (1+ β).

• Uses of the Learning Curve by Management

The Learning curve theory is applied in many stages of production thus it may affect costs of operations which are functions of time such as labour costs in terms of hours, indirect labour hours and supervisory time. When managers estimate costs, they should put the impact of learning into consideration. This theory also affects costs incurred in inventory valuation, decision making and performance evaluation. However, it is only applied during the early stages of production upto the steady phase, where the costs of production tend to become stable (Novick, 1951).

The learning curve theory helps management in identifying the impact of learning on the cost of products. As workers gain the skill of producing a particular product, it is expected that they will spend less time on producing subsequent products. This implies that with time, the cost of production will reduce gradually upto a point where no more learning takes place. At this point, the costs of production cannot fall any further, which allows management to set standard costs for the budget. Therefore the learning curve is also useful in variance analysis by comparing the actual product cost to the standard cost.

If management knows the learning rate, they will be able to estimate the labour hours required to produce a particular number of products. This information will eventually be used in budgeting for the cost of inventory purchasing. They will be able to allocate available resources in the most optimum way, thereby minimizing wastage. This way, they will be able to achieve the planned inventory levels and other objectives set.

Failure to consider the learning effect in inventory valuation, decision making and performance measurement, may lead to unexpected results. For example, in decision making, a newly launched product may appear unprofitable, but as time progresses, due to the learning effect, the variable costs drop and in the end, the product becomes profitable. Another example is in performance management in a bank whose activities (especially for clerks) are based on the learning curve effect(Grahame , 2009).

Question Three

• Premium Paints Plc

Production cost Report for the month of March

• Physical Flow of units

Units in Beginning Work in Progress (Gallons)

40,000

Units started during the period (Gallons)

70,000

Total Units to Account for

110,000

Units Competed and Transferred Out (40000+20000)

60,000

Units in Ending Work in Progress

50,000

Total Units Accounted For

110,000

• Equivalent units Computation

Mixing

Units Completed and Transferred Out

60,000

Units in Ending Work in Progress

50,000

Equivalent Units

110,000

• Summary of flow of cost

Costs relating to Beginning Work in Progress

Direct Material

£98,000

Direct Labour

£41,000

Overheads

£90,000

Total

£229,000

• Equivalent Cost Per Unit

Cost Incurred

£229,000

Equivalent Units

110,000

Equivalent Cost Per Unit

229,000/110000 = £2.082 per gallon (Equivalent Unit)

• Cost Summary Schedule

Equivalent Units

Cost

Units started and Completed

60,000

124,909

Units in Ending Work in Progress

50,000

124,920

Source:(SA Technical, 2011).

The question only requires that the calculation of production costs for mixing department. In calculation of equivalent units, the units completed and transferred out is equal to the 40,000 units completed and transferred out plus the 20,000 units transferred to the packaging departments. The equivalent cost per unit is arrived at by dividing the total cost (direct labour, materials and overhead) by the total number of equivalent units. The total cost for the equivalent units is then calculated as the product of the equivalent cost per unit and the equivalent units (number of gallons). This cost can be further separated as shown in the cost summary.

• Suitability of process costing

Process costing is suitable for a product like paint because first, they are produced in bulk amounts in a continuous process from production to packaging. Process Costing allows managers to obtain a detailed report on the statistics of the production process within each department (In this question the departments are mixing and Packaging). Process Costing is therefore suitable for continuous manufacturing process and other utility companies. Process Costing also provides simple record keeping techniques because it bases its calculations on statistics rather than the actual value of outputs. Within a factory, more time is saved when the cost of materials are calculated based on average number of units produced. Finally, process costing will allow for performance management and control through comparisons of different departments’ costs and revenues (Ingram, 2016).

• Explain how the revenue of a by-product is treated in process costing and why it is treated in this way.

A by-product can be defined as an item which is produced as a result of producing another item ( Cambridge Advanced Learner’s Dictionary & Thesaurus , 2016). It is a secondary product with a relatively minor total sales value is relatively minor compared to the main product’s sales value. By-products should be accounted for in order to determine the income derived from the by-product and the inventory costs, in accordance with IAS 2. However, the by-products are not very significant hence they do not require cost allocation. The factors which influence the valuation and accounting of by-products include: one, the level of uncertainty of by-product during the production process, two, the usage of the by-product in other processes within the company, three, the usage of the by-product as an alternative to the main products, four, the need to segregate calculations of profit for the purposes of incentives or for performance measurement and control.

By-Products can be amounted for using non-cost methods like other income or the by-product revenue subtracted from the cost of the main product. Cost methods for Accounting for by-products include: replacement cost methods(Finance Management, 2016), Joint Cost proration Method (Dutta, 2003), and total cost less the value of by-products at standard Price(Periasamy, 2010).

Reference List

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Cambridge Advanced Learner’s Dictionary & Thesaurus , 2016. Campbridge Dictionary Online. United Kingdom: Campbridge University Press.

Anon., 2016. Setting Standards - The Learning Curve. Managerial Accounting and Information, pp. 247-252.

Dury, C. M., 1992. Management and Cost Accounting. 3rd ed. s.l.:Chapman & Hall Ltd..

Dutta, M., 2003. Joint Products and By-Products - Costing and Other Aspects. In: Cost Accounting Princiles and Practice. s.l.:Pearson, pp. 9.1-9.70.

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Finance Management, 2016. Replacement Value Method of Equity Valuation. [Online] Available at: https://www.efinancemanagement.com/investment-decisions/replacement-value-method-of-equity-valuation[Accessed 09 June 2016].

Grahame , S., 2009. The learning curve: The key to future management?. CIMA: Research executive summary series, VI(12), p. 4.

IFRS Foundation, 2016. IAS 2 — Inventories, s.l.: IFRS Foundation.

Ingram, D., 2016. Advantages & Disadvantages of Job Order Costing & Process Costing. Houston Chronicle.

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Novick, D., 1951. Use of the Learning Curve. In: Santa Monica: The Rand Corpotation, p. 267.

Periasamy, P., 2010. Joint Product and By-product. In: A Textbook of Financial Cost and Management Accounting. s.l.:s.n., pp. 471-490.

Rojas, E., 2006. The Disadvantages & Advantages of Activity-Based Costing. Small Business Chron, June.

SA Technical, 2011. Relevant to foundations in accountancy paper fma. In: management accounting. s.l.:ACCA, pp. 4-8.

Schmidt, M., 2014. Activity Based Costing ABC, and ABC Management Explained, s.l.: Solution Matrix Limited.