Activity Based Costing Vs Traditional Costing – An Overview

Cost per unit of the two models of sewing machines under the current traditional costing system

Discuss About The Journal Of Corporate Accounting Finance.

Activity based costing can be defined as the costing in which the activities are identified by the firm and accordingly its indirect cost of the product. These indirect costs includes the management and office staff salaries, rent etc. these costs are find allocate to assign in the manufacturing sector. From ABC costing, allocation of indirect cost can be made easily. The company Sewing Easy Ltd. is dealing in providing the manufacturing of sewing machines. At present company is using the traditional costing system and machine hours for assigning the indirect cost. The Company can allocate its cost accurately and can reduce its per unit cost of machines using ABC costing.  ABC costing establishes the relationship between the cost, activities, indirect cost and its products. The cost assigned in the ABC costing is low as compared to the traditional costing. 

In the traditional method the allocation of overhead is done on the basis of the direct labour,  the total cost will be divided by the total direct labour. In the traditional costing system, all the cost whether it is direct or indirect cost are distributed in same way (Bartelsman, Haltiwanger and Scarpetta, 2013). No matter what the expense is. The cost allocation is done on the basis of overall cost. No individual activity cost is distributed in traditional system of costing. The cost per unit in basic and advance model are as follows:

Requirement (1): Cost per unit of the two models of sewing machines under the current traditional costing system
Overhead recovery rate Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper	4,51,700.00	Machine hours	8000	Rate	56.46
Particulars	Models of machine
	Basic(in $)	Advance($)
Direct material	5,20,000.00	8,40,000.00
Direct labour	2,40,000.00	3,90,000.00
Overheads
Machine hours	4600	3400
Rate per hour	56.46	56.46
Over heads allocated	2,59,727.50	1,91,972.50
Total cost	10,19,727.50	14,21,972.50
Total unit	1600	1500
Per unit cost	637.33	947.98

Activity based costing is a costing methodology which identifies the different cost centres for distribution of cost. Identifying the activities and distributing the cost of individual activity with resources to all products and service department according to the actual consumption done by each department is the work of ABC costing (Chryssolouris, 2013). ABC system of costing assigns more indirect overheads into direct overheads as compared to the traditional costing.

Requirement (2): 2) Cost per unit of the two models of sewing machines under Activity based Costing
Particulars	Models of machine
	Basic(in $)	Advance(in $)
Direct material	5,20,000.00	8,40,000.00
Direct labour	2,40,000.00	3,90,000.00
Overheads
selling and administration		1,40,600.00
interest expense		25,200.00
office rent		35,900.00
Inspection	4,210.53	15,789.47
Assembly	51750	38250
Production Scheduling	9545.454545	95454.54545
Machine Set up	10000	25000
Total Cost	8,35,505.98	14,04,494.02
Total Unit	1600units	1500units
Per unit Cost	522.19	936.33

In this method of costing opted by the Sewing, Machine Ltd. is selling at 20% more than the cost to the overseas buyer and others. The overseas buyer prefers to have the advance model as it shows all the necessary expenses in the costing. In advance model, some extra expenses are taken into consideration like office rent, interest expense and selling and administration expenses. These costs are not included in the basic model which shows that it does not take into account all the necessary expenses into account (Lee et al., 2013). The buyers are interested in the advance model as it includes all expenses into account so that the actual profits can become into consideration by the businessman. The accurate costing of a product should be done as it has many advantages which are discussed below:

•    Accurate product costing helps in matters related to the decision making of a product, a sale of a product. Analysing the product cost helps to increase the productivity and accuracy of the project and there will be an optimum utilization of resources with less wastage of resources.
•    Accuracy is important in evaluating the product cost. Accuracy can be defined as how effectively and efficiently the business can analyse its expenses using the product costs and its current value.
•    Tracking of project or proposal can be made with effectiveness if the organization is doing the costing of product correctly and it also keeps a focus on the budgets and estimates of product to know whether the costs are matching the expectations or not (Tsai et al., 2014).
•    Accuracy product costing is also important for making the budget. The budget includes the calculation of all the expenses which are going to incur in the production and budget records all the estimated incomes as well. This will help in the forecasting for the next production to the company.

Cost per unit of the two models of sewing machines under Activity based Costing

Financial statement of basic Model
Particulars		($)
	Traditional	ABC
Sales(unit)	1,500.00	1500
Sales price (cost + 120%)	1,137.58	1123.595215
Sales Price (a)	17,06,367.00	1685392.823
Direct material cost	8,40,000.00	8,40,000.00
Direct labour cost	3,90,000.00	3,90,000.00
Total direct cost	12,30,000.00	12,30,000.00
Overhead costs	1,91,972.50
selling and administration		1,40,600.00
interest expense		25,200.00
office rent		35,900.00
Inspection		15,789.47
Assembly		38,250.00
Production Scheduling		95,454.55
Machine Set up		25,000.00
Total	1,91,972.50	3,76,194.02
Total cost (b)	14,21,972.50	16,06,194.02
Profit(a-b)	2,84,394.50	79,198.80

Overheads are usually the indirect cost incurred by the manufacturing companies like Sewing Machine Ltd. These are the manufacturing cost other than the direct material and direct labor. The actual overhead is nothing but the indirect manufacturing cost occurs in real and recorded in the books. These overheads include the electricity, gas, water, rent etc. whereas the applied overheads are those overheads which have been allocated to the manufactured goods. Manufacturing overhead is usually applied, assigned or allocated according to the annual overheads rate. Actual overhead and applied overheads are not similar to each other as one is the actual cost and other is the cost assigned or allocated to the goods (Huang et al., 2013).

In the organization, allocations of overheads are done. This allocation sometimes can be under-allocated or over-allocated. If too much overhead has been applied to the jobs then it is called the problem of over applied overheads. If too little overhead has been applying then it is called the problem of under applied overheads. This over and under overheads are arises because of the wrong allocation of the resources. This should be corrected and this correction can be made through the use of the proper system of costing in the business (McIvor, 2013). The reasons for over applied overheads are the increase in the labor cost that is not used directly in the production of products. Another reason can be the method of absorption can be wrong.

•    This problem can be rectified by the measuring the difference between the actual and applied overhead. This will be the amount the business has to adjust through the cost of goods sold to bring it to the actual cost of the product. If the overhead is over applied then it should be subtracted from the cost of goods sold to nullify the effect and if the overheads are under applied then it should be added back to the cost of goods sold (Öker and Ad?güzel, 2016). This should be done at the end of the accounting period so that the books will show the true and fair view.
•    If the transfer is made at the end of the financial period then the under or over absorbed cost or overhead should be carried forward to the next month. This carried forward will be done in the month to month basis treating it as a deferred income if applied and deferred expenses if over applied overheads are there.
•    Another way to deal with the under or over applied overheads can be the use of the supplementary rates which is calculated by dividing by the over and under-absorbed amount by the actual base. If over recovered, then it will be adjusted by using the supplementary rate in case of over absorption.  
•    The over and under overheads can be adjusted through by writing off in Profit and loss account.

Accurate Product cost

Calculation of product cost is more realistic and practical by using the ABC costing in the business operation. ABC costing brings reliability and accuracy in the calculation of the product cost. ABC recognizes the activities cause to root for not evaluating the right cost of the product. It brings results when there is the high number of differentiation among the manufactured goods such as low volume products, high-value products (Joung et al., 2013).

Tracing of overhead cost

ABC costing traces all the cost related to the areas of managerial responsibilities, processes, customers, departments besides the product costs. It also sets the standards and benchmarks for the other methods to calculate the cost. As ABC is a unique way of calculating the cost (Javid et al., 2016).

ABC analysis helps to know about the real nature of the costs and helps in decrease them by analysing and knowing those activities which are not relevant or make increase in the product value. Using ABC managers can able to reduce its fixed overhead cost by having more control over the activities. This can be done because the cost in relation to the fixed costs  are now more visible and gives clear image to the managers (Ríos-Manríquez, Colomina and Pastor, 2014).

Actual overhead and Applied overhead

Better Decision Making

The use of ABC costing in the business improves the process of decision making in the managers as they can use the reliable product data and cost data. It also takes into consideration the six sigma and other continuous improvements programs.

Cost Management

ABC costing provides the cost driver rates and the other information related to the cost of the products which helps a manager to have control over the cost. This will also help firmly in the performance appraisal of responsibility centres. In Sewing Machine Ltd, the cost drivers are also helped to maintain the design of the new product or existing product as they indicate the overhead costs that are likely to be applied in the costing of the product (Kastalli and Van Looy, 2013).

Use of Excess capacity and reduction in cost

Through the process of pooling activity done in cost, helps to reduce the overhead expenses. The cost of the activity and identification of cost, drivers can lead to a range of applications. The cost drivers are there to reduce to identify the cost and try to find the ways for reducing the cost. The resources are also saved from wastage by using the ABC costing. The expenditure on unnecessary expenses can be saved by using the cost pool and cost drivers (Goodrich et al., 2013).

Expensive in nature

Implementing the ABC costing in the business is quite an expensive way. It involves various other hidden costs. As Sewing machine Ltd. Activities are analyses, they must be broken into small tasks or jobs. This entire process can value up against the resources, as data are collected, measured and entered into the new system. As this type of costing is not simple in nature, the experts are hired for the same. It will also increase the cost and some training is given to the employees of the organization so that they can use this type of cost without any mistakes (Wittbrodt et al., 2013).  

Time taken and complex

ABC costing is also the time taking the process as the calculations in this required a bit more time than the traditional as it believes in the concept of accuracy. ABC costing is also complex in nature as it includes many cost drivers and cost pools which make the working complex than the traditional product costing system (Kapi?, 2014). This cost technique will become time taking, costly and complex to the Sewing Machine Ltd.

Reasons for undervaluation of stock by the Traditional Costing System

Misinterpretation of the data

Reports made by an ABC costing include information which can differ from the information given in the traditional costing system. It is the possibility that some activities are found to be irrelevant in a certain process of decision-making.

For example:

 ABC costing does not agree with the concepts of the accounting standards and they are also not used for the external reporting.

Before ABC costing, mostly organization is using the traditional way of cost analysis. So there are chances of misinterpretations of figures and facts that the manager can do while interpreting the accounts. It will also lead to the bad decision making in analyzing the cost (Monroy, Nasiri, and Peláez, 2014).

Selection of Drivers

It became a difficult task to select a driver from many drivers available. Many difficulties can emerge from the use of ABC system of costing. Cost drivers selection, assigning of common cost, different cost driver rates etc.

Measuring Difficulties

Measuring difficulties in the implementation in ABC Costing is done by the management. The management estimates the cost involved in the pooling of activity in the ABC system of costing. To identify and measure cost drivers to serve as cost allocation base. The measurement is also found to be costly and requires time to time updates (Petrick and Simpson, 2013).

References

Bartelsman, E., Haltiwanger, J. and Scarpetta, S. (2013) Cross-country differences in productivity: The role of allocation and selection. American Economic Review, 103(1), pp.305-34.

Chryssolouris, G. (2013) Manufacturing systems: theory and practice. United States: Springer Science & Business Media.

Goodrich, A., Hacke, P., Wang, Q., Sopori, B., Margolis, R., James, T.L. and Woodhouse, M. (2013) A wafer-based monocrystalline silicon photovoltaics road map: Utilizing known technology improvement opportunities for further reductions in manufacturing costs. Solar Energy Materials and Solar Cells, 114, pp.110-135.

Huang, S.H., Liu, P., Mokasdar, A. and Hou, L. (2013) Additive manufacturing and its societal impact: a literature review. The International Journal of Advanced Manufacturing Technology, 67(5-8), pp.1191-1203.

Javid, M., Hadian, M., Ghaderi, H., Ghaffari, S. and Salehi, M. (2016) Application of the activity-based costing method for unit-cost calculation in a hospital. Global journal of health science, 8(1), p.165.

Joung, C.B., Carrell, J., Sarkar, P. and Feng, S.C. (2013) Categorization of indicators for sustainable manufacturing. Ecological indicators, 24, pp.148-157.

Kapi?, J. (2014) ACTIVITY BASED COSTING-ABC. Business Consultant/Poslovni Konsultant, 6(32).

Kastalli, I.V. and Van Looy, B. (2013) Servitization: Disentangling the impact of service business model innovation on manufacturing firm performance. Journal of Operations Management, 31(4), pp.169-180.

Lee, J., Lapira, E., Bagheri, B. and Kao, H.A. (2013) Recent advances and trends in predictive manufacturing systems in big data environment. Manufacturing Letters, 1(1), pp.38-41.

McIvor, R. (2013) Understanding the manufacturing location decision: the case for the transaction cost and capability perspectives. Journal of Supply Chain Management, 49(2), pp.23-26.

Monroy, C.R., Nasiri, A. and Peláez, M.Á. (2014) Activity Based Costing, Time-Driven Activity Based Costing and Lean Accounting: Differences among three accounting systems’ approach to manufacturing. In Annals of Industrial Engineering 2012 (pp. 11-17). Springer, London.

Öker, F. and Ad?güzel, H. (2016) Time?driven activity?based costing: An implementation in a manufacturing company. Journal of Corporate Accounting & Finance, 27(3), pp.39-56.

Petrick, I.J. and Simpson, T.W. (2013) 3D printing disrupts manufacturing: how economies of one create new rules of competition. Research-Technology Management, 56(6), pp.12-16.

Ríos-Manríquez, M., Colomina, C.I.M. and Pastor, M.L.R.V. (2014) Is the activity based costing system a viable instrument for small and medium enterprises? The case of Mexico. Estudios gerenciales, 30(132), pp.220-232.

Tsai, W.H., Yang, C.H., Chang, J.C. and Lee, H.L. (2014) An Activity-Based Costing decision model for life cycle assessment in green building projects. European Journal of Operational Research, 238(2), pp.607-619.

Wittbrodt, B.T., Glover, A.G., Laureto, J., Anzalone, G.C., Oppliger, D., Irwin, J.L. and Pearce, J.M. (2013). Life-cycle economic analysis of distributed manufacturing with open-source 3-D printers. Mechatronics, 23(6), pp.713-726.