The Activity Based Costing System - Research Paper Example

 ACTIVITY-BASED COSTING Subject: Activity Based Cost Accounting Pursuant to your request for basic and detailed information regarding an alternative costing method known as the Activity Based Costing system, I wish to submit the results of my research as follows. Activity-based costing (ABC) is an approach to cost assignment that calculates a more accurate product cost than the traditional method by categorising all indirect costs by activity, tracing the indirect costs to products using a cost driver that is related to the cause of the cost (Needles et al, 1999). Thus production-related activities are identified as well as the events and circumstances that cause, or drive, those activities (e.g., number of inspections, number of maintenance hours, and the like).The manufacturing overhead cost is applied to a product by calculating a predetermined overhead rate, also called cost pool rate, for each cost pool and using that rate and a cost driver amount to determine the portion of the manufacturing overhead cost to apply. ABC is used by organisations that produce and sell different types of products or use varying amounts of production related activities to complete them. It is not used where only one type of product is produced. The traditional method uses only one predetermined overhead rate based on a single activity measure such as product volume. Applying this method in an environment where there are several products can only produce distorted price information that can affect the quality of managerial decisions. Where multiple products are concerned, the use of ABC will yield accurate information that can be used as basis for making critical decisions as regards product pricing, making bids, or determining the product mix. According to one survey (Dauber et al 1996), about a third of all companies used activity-based costing to replace their existing traditional systems. Later, in another survey, it was learned that 54 percent of companies use ABC for decision making outside of the accounting function and 89 percent of those companies said that it was worth the implementation costs. (Management Accounting Journal 1998, cited in Jackson and Sawyers 2001). Allow me to demonstrate hereunder the application of Activity-based costing based on a set of given data. After determining the overhead cost pools and their individual costs (second column below) we identify the drivers, which could be the number of machine hours, number of set-ups, and so on. The level or quantity as given by the case are shown and divided into the overhead cost in order to derive the predetermined overhead rate. This rate will be used subsequently for budgeting the overhead costs of each activity. Cost pool Overhead cost ($) Cost driver Quantity/level Predetermined rate Machining services 357,000 No. of machine hours 420,000 0.85 Assembly services 318,000 Direct labor hours 330,000 0.60 Set-up costs 26,000 No. of set-ups 520 50.00 Order processing 156,000 No. of customer orders 32,000 4.88 Purchasing 84,000 No. of suppliers' orders 11,200 7.50 T o t a l Table 1: Deriving the predetermined rate from cost pool data. We were given the following budgeted information relating to our company for the next period, as follows: Products XYI (000) YZT (000) ABW (000) Sales and production (units) 50 40 30 $ $ $ Selling price (per unit) 45 95 73 Variable cost (per unit) 32 84 65 Hours Hours Hours Machine department (machine hours per unit) 2 5 4 Assembly department (direct labour hours per unit) 7 3 2 Table 2: Raw data to be used for conversion under the ABC system. It will be noted that if we use direct labor hours as our cost driver under the traditional method, the following would result: For XYI (7 x 50,000 units) = 350,000 labour hours x .6 = $210,000 For YZT (3 X 40,000 units) = 120,000 x .6 = $72,000 For ABW (2 x 30,000 units) = 60,000 x .6 = $36,000 Total number of labour hours = 530,000 x .6 = $318,000 The total of $318,000 overhead allocated to the three departments would understate the true overhead cost based on ABC. This constitutes only 26 percent, or roughly one-fourth of the more accurate allocation method. This type of big discrepancy discovered when using direct labour hours as the sole cost driver has been pointed out in Dauber et al. (1996). However, by using Activity-Based Costing, we will identify and use several cost drivers and apply the predetermined rate that we earlier derived in Table 1 above. Dept XYI .YZDeptT Dept ABW Cost drivers Predetermined rate Estimate Overhead allocation Estimate Overhead allocation Estimate Overhead allocation No. of set-ups 50 120 $6,000 200 $10,000 200 $10,000.00 Customer orders 4.88 8000 $39,000 8000 $39,000 16000 $78,000.00 Suppliers' orders 7.5 3000 $22,500 4000 $30,000 4200 $31,500.00 Machining services n.a. 50000 x 2 $100,000 40000 x 5 $200,000 30000 x 4 $120,000.00 Assembly services n.a. 50000 x 7 $350,000 40000 x 3 $120,000 30000 x 2 $60,000.00 Total $517,500 $399,000 $299,500.00 Table 3: Applying the Activity-Based Costing method on given data. Analysis: ABC Overhead allocation per unit: Dept XYI = 5170000/ 5000 units = 10.35 Dept.YZT = 399000/ 40000 units = 9.975 Dept ABW = 299500/ 30000 units = 9.98 Total budgeted overhead cost is 517500 + 399000 + 299500 = $1,216,000 Divide this figure by 120,000 units produced by the three departments. We obtain 10.133 per unit, which we will use in the Income Statements for the demonstration of the traditional allocation costing method. We use the given data on selling price, unit variable cost, and volume, and then apply the individual overhead allocations that resulted from the earlier computation. The income statement by unit is then converted into one that reflects the volume of products produced and sold. The first department (XYI) shows the biggest profit mainly because of relatively lower variable cost compared to the other departments. YZT has a net profit that is one-third the size of the first department, whilst the third department (ABW) shows a loss principally because of high unit variable cost. A. Income Statement – ABC Allocation system Item Dept XYI YZT Dept Dept ABW Selling price per unit 45.00 95.00 73.00 Less: Variable cost per unit 32.00 84.00 65.00 Allocated overhead 10.35 9.98 9.98 Margin per unit 2.65 1.03 -1.98 Volume 50,000.00 40,000.00 30,000.00 Net profit (loss) 132,500.00 41,000.00 -59,490.00 Net profit – whole plant – $114,010 Table 4: Income Statement – ABC B. Income Statement – Traditional Allocation Costing: On account of the absurd results we earlier obtained when using the direct labour hours as the single cost driver under the traditional method, we have to use the number of units instead for comparative purposes. A total overhead of $1,216,000 is divided by 120,000 units in order to obtain the overhead cost per unit to be applied across the board, as follows: Item Dept XYI .YZDeptT Dept ABW Selling price per unit 45.00 95.00 73.00 Less: Variable cost per unit 32.00 84.00 65.00 Allocated overhead 10.13 10.13 10.13 Margin per unit 2.87 0.87 -2.13 Volume X 50,000.00 X 40,000.00 X 30,000.00 Net profit (loss) 143,500.00 34,800.00 -63,900.00 Net profit – whole plant – $114100 (Difference is due to rounding). Table 5: Income Statement -Traditional allocation costing Analysis: The allocated overhead per unit under the traditional allocation costing method is uniform for all departments because it is based on the number of units produced. Overhead is allocated differently under the Activity-Based Costing method because the usage-intensity in the machining and assembly units differed. The high-volume Dept XYI used more of these services than the others and thus had higher allocated cost per unit. The loss shown by Dept ABW and the relatively low profit margin of Dept YZT were attributed to their higher variable costs, and not by the overhead cost allocated to them. Difference between traditional absorption costing and activity-based costing. Absorption costing, as an accounting terminology and concept, refers to a costing method that treats overhead as a product cost such that if the product remains unsold it remains in the books as being attached to an asset, not expensed (Jackson & Sawyers et al 2001). It is expensed only when the product is sold – as cost of goods sold. Thus when production is greater than sales, and there is an increase in finished goods inventory, the income statement would would look better under absorption costing. This is different from variable costing because in variable costing overhead is treated as a period cost – that is, it is expensed during the period it is incurred. The impact of this difference in treatment is manifested in the income statement: variable costing results in less reported profit than absorption costing. The case being analyzed says that production and sales are identical, so that there is no difference between absorption costing and variable costing as far as solving the case problem is concerned. The concept of traditional volume-based allocation is perhaps more relevant when discussing how the treatment of overhead can affect the cost of products. Where there is only one product type, no problem occurs when we use the traditional cost allocation method. However, where there are two or more products involved, such as two or more types of housing projects addressed to markets of different income levels or preferences, the traditional method gives rise to cost distortion. Where a housing constructor, for example, builds housing projects for lower income, middle income which use standard housing designs with very few options and high-income buyers for housing which have to be customised and which therefore require more inspections and change orders, each of these projects would require different intensity or frequency of inspection for quality checking, or set-ups of equipment, and other activities. If unit costing would depend more on direct labor hours as cost driver, applied to all types of housing, the lower-priced housing may bear the brunt of overhead, and the higher-costing housing units will be undercharged. Standard allocation may result in inaccurate costing that may hamper good decision making with regard to pricing. Lack of accurate information may also affect production control because management may have no idea where inefficiencies and repetitive or non-value creating activities may lie. In organisations where labor plays a less significant part than in labor-intensive processes, the use of activity-based costing system would be appropriate. The same can be said for manufacturing that uses Just-in-Time (JIT) system because a lot of inefficient non-value creating activities would be eliminated. Even professional business service companies can gain from the adoption of activity-based costing. ABC also helps companies in performing their control functions – in determining which product lines need to be reinforced and which to drop. Principal distinctions. The distinction between traditional cost method and the ABC method has been discussed by various authors in managerial accounting. Dauber et al have, however, succinctly and systematically identified and categorised them along four different aspects. In terms of cost pools, the traditional system uses only one or at most a very limited number, whereas the ABC system employs multiple or many cost pools in order to reflect different activities. In terms of the applied (predetermined) rate, the traditional method uses volume-based rates, whilst ABC uses activity-based ones. In terms of relevance, the traditional method is appropriate for labor-intensive and low-overhead companies whereas ABC is more suitable to capital-intensive high-overhead, and product-diverse companies. Finally, in terms of benefits and costs , the traditional method is simple and inexpensive; ABC, on the other hand, gives more accurate results for costing purposes and can lead to decisions to eliminate non-value-added activities. The search for the best cost drivers can be quite expensive, sometimes offsetting any benefits that can be obtained. Management may have to look for substitute or proxy cost drivers provided there is a high correlation between the desirable cost driver and the substitute. Conclusion and Recommendations Because our company is engaged in the production of multiple product lines, the Activity-Based Costing system, owing to its advantages in terms of accuracy, is the appropriate system to use. We need to appoint a Committee to formulate a realistic and sensible plan to update our cost system to ABC as soon as possible, to the end that overall managerial decision making in manufacturing will be improved. Bibliography Needles, Jr BE, Powers, M, Mills, SK & Anderson, HR 1999, Managerial accounting, 5th edn., Houghton Mifflin, Boston, MA Dauber, NA, Siegel, JG, & Shim, JK 1996, The vest pocket CPA, 2nd edn., Prentice Hall, Paramujs, NJ Jackson, S & Sawyers R 2001, Managerial accounting, Harcourt Inc., Orlando, FL Read More