Traditional Methods and Activity-Based Costing - Essay Example

Table of Contents Traditional methods and Activity based costing 2 Introduction 2 Cost allocation 2 Example 3 Cost apportionment 3 Example 3 Cost absorption 4 Example 4 Activity Based Costing 4 Approach of Activity Based Costing 5 Advantages of Activity based costing 5 Conclusion 6 Question 2 (a) 7 Question 2 (b) 9 Works Cited 11 Traditional methods and Activity based costing This report explains the traditional methods of cost accounting adopted by the management and the method of activity based costing as an alternative to the traditional methods for better costing of manufacturing and overhead costs. Introduction There are various methods used by managements for the costing of their manufactured products but the main methods which are used for costing of the overhead costs are: Cost allocation Cost apportionment Cost absorption These methods are explained in detail below and the modern method of activity based costing is also explained with brief advantages of the method for a clear estimation and allocation of overhead cost. Cost allocation Cost allocation is defined as the spreading of an overhead or other manufacturing related cost to numerous other direct costs or products. The method of allocation of cost is suitable when there is a clear separation of the most suitable components on basis of their cost or when the company can easily determine the quantity of cost which a particular product requires. (Accounting Tools) Example If a company produces 2 different products namely Pi and Chi, the Company has cost of overheads which is 500. The company can allocate the costs on the basis of material cost of each product. If material cost of each of Pi and Chi is 200 and 300 respectively then the allocation will be as follows: Cost to Pi = 200/500*500 = 200 Cost to Chi = 300/500*500 = 300 Cost apportionment Cost apportionment is a similar method to that of cost allocation and is another traditional way of allocating the overhead costs to the products. In this method the indirect and overhead costs are apportioned by allocating proportionate costs to the products. The indirect costs can be apportioned by proportionate allocation on the number of units etc. Example If a company produces two products, Pi and Chi. The Company may apportion the overheads on a proportionate basis, by apportioning the cost on basis on ratio of 2:3. If the total budgeted cost is £10,000. Cost to Pi = £10,000*2/5= £4,000 Cost to Chi = £10,000*3/5= £6,000 Cost absorption This method allocates the overhead costs to the manufacturing cost of products. The rates of absorption are used as benchmarks by the company and can be labor hour, machine hour or any other rate which suits the company’s overhead absorption. If the company is produces a product which requires labor for the production, then the company may apply labor hours of direct labor cost for the basis of absorption of the overheads to the cost of the product. The predetermined rate can be different for different products depending on the nature and utilization of the product by the company. Example If a company absorbs the overhead cost at a rate of £10 per machine hour and the produces two products i.e. Pi and Chi and the products require 200 and 300 machine hours respectively then the company may absorb the overheads as follows. Cost to Pi = 200 *£10 = £2,000 Cost to Chi = 300 *£10 = £3,000 Activity Based Costing The traditional approaches to costing of the overheads has not been beneficial to the companies as these approaches are unable to provide the accurate allocation of the manufacturing and overhead costs to the products as per their actual share. Activity-based costing (ABC) is a modern and more established costing model which is used to allocate the costs that are attributable to the activities according to the usage of respective resources in accordance with the actual utilization by the good or service. (Turney) Approach of Activity Based Costing Activity based costing (ABC) allocates the indirect costs as well as the manufacturing overheads to the products or class of products in a rational and logical way compared to the conventional ways of allocating these costs on the basis of labor hours, material or labor costs or machine hours etc. Activity based costing (ABC) primarily allocates the costs to such activities which are linked directly with the manufacturing overheads and are the actual cause of the overheads. Then it assigns the respective goods or services the cost of those activities only which are in fact consuming these activities. This method is based on the actual costing of a particular department as people who are connected to the department are involved in the costing process extract the data of cost to be allocated and allocate the cost to the production or service department as per the level of service provided. Advantages of Activity based costing The approach of Activity Based Costing has proven to be very beneficial in actual allocation of the costs of the products and for costing decision making. Some of the benefits of the approach are enlightened in detail below. The method aids in the accurate determination of the cost per unit of the product and thus helps in determination of the profitable sales price. The methods aids in the making of special order decisions as the company can decide whether to produce a certain product at the given value or not. (Managers, 2010) Since the costs are properly allocated to the respective departments in the correct proportion, therefore the company can look forward to more efforts where they can reduce the cost of those materials and services which are not generating enough profit for the company. (Value Based Management 2010) Conclusion It can be concluded that the traditional methods of costing have failed to properly allocate the overhead costs of the products as per the level of consumption and absorption of cost and the method of Activity Based Costing has provided a more convincing and accurate model for the accounting of overhead and indirect costs to the products which not only aids in accurate determination of the per unit cost but also helps in minimizing the cost and maximizing the profit. Question 2 (a) Absorption Shane Shaurez Shearer Direct Costs Units Sprayed 8,100 6,450 5,400 Cost of paint per unit £22.80 £16.77 £28.35 Cost of material £184,680 £108,167 £153,090 Machine attendant time in hours 0.8 1.1 1.9 Rate per hour £7.95 £7.95 £7.95 Labor cost £6 £9 £15 Overhead costs: Total overheads £290,543 £290,543 £290,543 Basis: Labor hours 0.75 1.13 1.88 £58,109 £87,550 £145,659 Manufacturing cost £242,795 £195,726 £298,764 Units 8,100 6,450 5,400 Cost per unit £29.97 £30.35 £55.33 Question 2 (b) Activity based costing Shane Shaurez Shearer Total Direct Costs Units Sprayed 8,100 6,450 5,400 Cost of paint per unit £22.80 £16.77 £28.35 Cost of material £184,680 £108,167 £153,090 Machine attendant time in hours 0.8 1.1 1.9 3.76 Rate per hour £7.95 £7.95 £7.95 Labor hours £6 £9 £15 Overhead costs: Paint stirring and quality control cost £36,122 £36,122 £36,122 Batches of paint 40.5 30 60 131 £11,210 £8,304 £16,608 Electricity per activity £157,050 £157,050 £157,050 Coats of paint 10.5 9 7.5 27 £61,075 £52,350 £43,625 Filling of spraying machines £97,371 £97,371 £97,371 Litres of paint 11.7 12.9 9.45 34 £33,458 £36,889 £27,024       £105,743 £97,543 £87,256 Manufacturing cost £290,429 £205,719 £240,361 Units 8,100 6,450 5,400 Cost per unit £35.86 £31.89 £44.51 Works Cited Accounting Tools, 2010. [online] Avilable at http://www.accountingtools.com/questions-and-answers/what-is-cost-allocation.html [Accessed December 2, 2011] Managers, 2010. [online] Available at http://www.managers-net.com/activityBC.html [Accessed December 1, 2011] Turney, P. B. An Emerging Foundation for Performance Management. Portland: Cost Technology. Value Based Management, 2010. [online] Available at: http://www.valuebasedmanagement.net/methods_abc.html. [Accessed December 1, 2011] Read More