Traditional Costing Approach - Essay Example

Running Head: Finance Assignment Finance Assignment – ABC Approach v Traditional Costing Approach of of Professor 18 July 2008 MEMORADUM To: Director of Finance From: Management Accountant Subject: Product Costing Date: 23 December 2002 In relation to your memorandum dated December 16, 2002 please find my analysis, discussion and recommendations of what are needed to address the issues raised for Agostino plc. Using our company’s budgeted cost for next year and some activity data that had been recorded during this year for other purposes, this paper will show the impact an activity based costing (ABC) approach on the unit cost of our services. The results of the use of ABC will be made with our current approach by calculating indicative unit costs for next year, using a labour absorption rate for all overheads. The assumptions made include cost driver assumptions I made as follows: number of machine hours is used for equipment maintenance; number of set-ups is used for production scheduling; number of set-ups is also used for setting up activity; and number of direct labour hours is used for other indirect cost since case facts required cost river for “other indirect cost” to be the % proportion that they represent relative to the best of the indirect cost. This researcher has interpreted that the best basis is still the number of direct labour hours in the absence of other cost driver that could be used for other indirect cost. In applying the ABC approach for Agostino plc, there was a need to get first the estimated number cost driver units and the estimated share of activities from the unallocated total direct cost. The estimated number of cost driver units was based on the given total annual activity data which can be assumed to stay constant for next year from the three distinct services provided by the company. The data is as summarized in Table I below: Table I- Estimated Overhead Cost Per Type Activity It may be observed from above about the need to identify the services for purpose of applying ABC for Agostino plc. It may be further observed that the real issue on the use of ABC costing in on how to have a more rational basis of allocation for purposes of enhancing control on the indirect cost of rendering service (Roztocki, N., 1999; Saldarini, K., 2000). With control comes responsibility for the behaviour of the cost of services. With responsibility for cost comes the responsibility for profits of important departments or components of the organization which render the various laundry services by Agostino plc. After initial data as organized in Table I above there is need to get the drive rate per cost driver and the results are shown in Table II below: Table II – Estimation of driver per rate After getting the cost driver rate, the same could now be multiplied with the actual cost number driver units. Since the case facts do not appear to have provided the actual number of cost driver units, this paper made use of the forecasted level of activity for next years for the three kinds of services and assume the same to be actual. The process resulted to allocation of the total actual indirect costs based on activities identified to have influence on said indirect costs for Agostino plc. The results of the allocation are shown in Table III below: Table III- Cost Allocated based on Actual Driver Units After making the further calculations, a comparison of proposed ABC approach with the current approach could now be done based on the results of analysis of the cost as show in Table IV below: Table IV- Comparison of Results between ABC and Traditional Costing The implication of results is that the unit cost of Services A, B and C differ if activity based costing is used as compared with traditional approach of merely providing for indirect cost or factory overhead using labour rate. There is proof to the assertion that activity based costing (ABC) is better than traditional costing in terms of better allocation. ABC has the capacity of assigning cost to activities instead of putting them in cost pools. Moreover, the appropriate activities are defined after careful analyses are made and cost drivers are also extracted for each kind of appropriate activity. Such careful analysis of relationship of the activities with the indirect must be assumed to be based on careful study and observation since the purpose is to identify the controllability of the cost in terms of driver of activities. As contrasted to traditional costing, based on the Table IV results above, ABC effectively allocated unallocated fixed cost within the various activities that consume resources. This has the effect of redefining the behaviour of the fixed cost into variable cost and therefore more costs have become relevant for decision making. The application above as done for Agostino plc is that it would afford management to know what costs are controllable. This in turn will help Agostino to implement a better responsibility accounting that could hold managers responsible for their decisions that would produce goal congruence for company. It could be observed above that total cost for Service A, Service B and Service C under traditional costing and activity based costing differ by £93,500.00, £2,083.33 and £(95,583.33) respectively. This means that it is cheaper to have service cost under activity based costing for Services A and B while it is costlier to have the same ABC method for Services C. From one point view the shift to ABC method may be justified because it is a more rational basis of costing the services because controlling the activities associated with the indirect cost would definitely have an effect on the cost. Relying purely on direct labour cost as basis of allocation may not be rational because some of the indirect costs are really more closely related to cost drivers. From another management point of view, the difference may not justify in order to convince the company to shift to activity costing due to possible complexity of the use of the ABC costing. This includes the additional cost because of the need to have additional activities in determining the relevant activities. This exercise confirms also one of the basic tenets of decision making, that is, the application of cost-benefit analysis. In this particular case, there is no mention about the cost of having to implement ABC costing as there is need to have conducted a study that would establish the relation of the activities to the indirect cost (Grieco and Pilachowski, 1994). Management should therefore carefully weigh option to shift to ABC approach given these considerations. As to whether the company should adopt ABC for the company should be based on cost benefit analysis after careful study of the factors. It is therefore concluded that if the cost of producing additional data for applying ABC approach will not outweigh the benefits that may be derived in terms of more reliable basis for decision making and better control on activities that would control the level of cost, by all means Agostino plc should move to the adoption of the ABC approach. The benefits of ABC approach could go as far as deciding whether the company should accept additional order for services when it determines that the contribution is positive since given the new allocation approach, the company may consider other cost to be in effect variable rather fixed. The company could further use the same in designing responsibility accounting that would promote responsibility for profits from its managers (OGuin,1992; Hicks, 2002). It is recommended that the company weigh first the cost of shifting to ABC and compare the same with the expected benefits based on results of the analyses made here and whether the shift would be sustainable before any decision should be made. References: Grieco and Pilachowski (1994) Activity Based Costing: The Key to World Class Performance, PT Publications Hicks (2002) Activity-Based Costing: Making It Work for Small and Mid-Sized Companies, John Wiley and Sons OGuin (1992)The Complete Guide to Activity-based Costing; CCH Tax and Accounting Roztocki, N. (1999) Introduction to Activity Based Costing (ABC) Internet ABC Online Presentation, {www document} URL http://www.pitt.edu/~roztocki/abc/abctutor/, Accessed July 18, 2008 Saldarini, K. (2000). Scholars tout benefits of activity-based costing, {www document} URL http://www.govexec.com/dailyfed/0200/022300k1.htm, Accessed July 18, 2008 Read More