Activity Based Costing Vs Traditional Costing System – A Case Study Of Sewing Easy Ltd

Computation of Cost per Unit using Traditional Costing System

1.

Computation of cost per unit for Basic model and Advance model as per traditional costing system –

Particulars	Basic Model	Advance Model Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper	Total
Units produced and sold	1600	1500
Direct material cost per unit	$                325.00	$                  560.00	$ 1,360,000.00
Direct labour cost per unit	$                150.00	$                  260.00	$    630,000.00
Direct cost per unit	$                475.00	$                  820.00	$ 1,990,000.00
Indirect cost
Inspection cost	$                    4.57	$                      8.46	$      20,000.00
Assembly cost	$                  20.63	$                    37.99	$      90,000.00
Production Schedule	$                  23.04	$                    45.43	$    105,000.00
Machine set – up	$                    7.70	$                    15.12	$      35,000.00
Selling and administration cost		$                    93.73	$    140,600.00
Interest expense		$                    16.80	$      25,200.00
Office rent		$                    23.93	$      35,900.00
Cost per unit	$                530.94	$               1,061.46	$ 2,441,700.00

It can be observed from the above calculation table that the cost per unit for Basic model as per the traditional costing system is $ 530.94. On the other hand, cost per unit for Advance model as per the traditional costing system is $ 1,061.46.

2.

Computation of cost per unit for Basic model and Advance model as per activity based costing system –

Particulars	Basic Model	Advance Model	Total
Units produced and sold	1600	1500
Direct material cost per unit	$         325.00	$                  560.00	$ 1,360,000.00
Direct labour cost per unit	$         150.00	$                  260.00	$    630,000.00
Direct cost per unit	$          475.00	$                  820.00	$ 1,990,000.00
Indirect cost
Inspection cost	$            2.63	$                    10.53	$      20,000.00
Assembly cost	$           32.34	$                    25.50	$      90,000.00
Production Schedule	$            5.97	$                    63.64	$    105,000.00
Machine set – up	$            6.25	$                    16.67	$      35,000.00
Selling and administration cost		$                    93.73	$    140,600.00
Interest expense		$                    16.80	$      25,200.00
Office rent		$                    23.93	$      35,900.00
Cost per unit	$         522.19	$               1,070.80	$ 2,441,700.00

It can be observed from the above calculation table that the cost per unit for Basic model as per the activity based costing system is $ 522.19. On the other hand, the cost per unit for Advance model as per the activity based costing system is $ 1,070.80

3.

Profit and loss statement for the Advance model for December 2017

Particulars	Traditional costing	ABC method
Units produced and sold	1500	1500
Selling price per unit	$             1,273.76	$               1,273.76
Total sales revenue	$      1,910,636.42	$        1,910,636.42
Direct material cost per unit	$                560.00	560
Direct labour cost per unit	$                260.00	260
Direct cost per unit	$                820.00	820
Indirect cost
Inspection cost	$                    8.46	10.53
Assembly cost	$                  37.99	25.50
Production Schedule	$                  45.43	63.64
Machine set – up	$                  15.12	16.67
Selling and administration cost	$                  93.73	93.73
Interest expense	$                  16.80	16.80
Office rent	$                  23.93	23.93
Cost per unit	$             1,061.46	1070.80
Profit per unit	$                212.29	$           202.96
Total profit	$         318,439.40	$     304,442.40

The selling price of advance model as per the traditional costing system is $ 1061.46 and as per the activity based costing system is $ 1070.80. However, the selling price for the advance model under both the system of costing is 20% above the cost as per traditional system that is $ 1,273.76 per unit. Therefore, the resultant profit for the month of December for Advance model under traditional costing system is $ 318,439.40 and under activity based costing system is $ 304,442.40.

The overseas buyer is interested to purchase the Advance model only due to various reasons. Generally the ABC costing system is more appropriate basis of allocating overheads as compared to the traditional costing system of allocation. It can be seen from the above calculation that the cost per unit for Basic model as per the traditional method is $ 530.94 whereas the same under ABC system is $ 522.19. Therefore, using the traditional system the company is showing the higher cost per unit as compared to ABC. Therefore, if the company add profit percentage on cost the cost of the product will be higher than actual as the company is using traditional system (Dale and Plunkett 2017). On the other hand, cost per unit for Advance model as per the traditional method is $ 1061.46 whereas the same under ABC system is $ 1070.80. Therefore, using the traditional system the company is showing the lower cost per unit as compared to ABC. Therefore, if the company add profit percentage on cost the cost of the product will be lower than actual as the company is using traditional system. Hence, the buyers will be in profitable position if they buy the Advance model and will be in a losing position if they buy the Basic model (Dong, Liu and Lin 2014).

4.

From the above calculation it can be seen that the actual overhead using the ABC system for Basic model is $ 47.19 per unit and for Advance model it is $ 116.33 per unit. On the other hand, the applied overhead per unit as per the traditional system for Basic model is $ 55.94 per unit and for Advance model it is $ 107.00 per unit. Therefore, the applied overhead differs from the actual overhead due to changes in the method.

Dealing with over / under applied overhead cost

As per the given scenario over applied overhead cost per unit for basic model is ($ 55.94 – $ 47.19) = $ 8.75 per unit. On the other hand, the under applied overhead cost per unit for Advance model is ($ 116.33 – $ 107.00) = $ 9.33. Over application or under application of overhead cost can be dealt in the following ways –

1. Adjustment in the cost of sales – the under absorbed or over absorbed overhead is closed and thereafter it is transferred to the account of cost of sales. This is performed by cost accountant at closing of each month or at the close of each accounting period. However, if transfer is made at closing of accounting period the amount of under absorption or over absorption is carried forward to the next period and it is treated as deferred income if it is over applied and as deferred charges if it is under applied (Lakmal 2014.).
2. Carry forward to the subsequent year – the over absorption or under absorption can be carried forward to next accounting period. This can be transferred to overhead reserve account and the overhead reserve account is shown under the balance sheet.
3. Writing off to the costing profit and loss account – if the amount of over absorption or under absorption is small, it can be written off through transferring it to costing account of profit and loss. If it is treated in this way, the valuation of the closing stock will be under stated or over stated (Novak et al. 2017).

5.

Benefits and limitations of ABC system

Various benefits of ABC system are as follows –

• Accurate cost of product – ABC helps in determining the cost of the product in reliable and accurate manner through focussing on the relationship of cause and impact that takes place while cost is incurred. It identifies the activities that involve cost and the product to which the cost is incurred (Hilton and Platt 2013).
• Details information regarding cost behaviour – it recognizes the cost behaviour nature and assists in reducing the costs and recognising the activities that does not add any value to product. With the ABC system, the managers will be able to have control on various fixed overheads through applying more control on the activities that caused the fixed overhead. This is possible as the fixed overhead cost will be more clear and visible (Özkan and Karaibrahimo?lu 2013).
• Better decision making – ABC system significantly improves the decision of the managers as they are able to use more reliable data with regard to the cost of product. It assists in fixing the selling price of the product as more accurate data can be available readily.

Various limitations of ABC system are as follows

• Complex and expensive – ABC system has various cost drivers and numerous cost pools. Thus, installation of the system can be more complex and costlier as compared to the traditional system.
• Driver selection – various issues arises while the ABC system is implemented. The issues involve may be allocation of common cost, cost drivers and variations in the rates of cost driver (Weygandt, Kimmel and Kieso 2015).
• Difficulties in measurements – another major difficulty associated with the ABC system is the requirement measurement for implementing the ABC system. It requires the management to project the costs for activity pool and recognise and measure the cost drivers for serving the method of cost allocation. Further, even the basic systems of ABC need various calculations for determining the cost of the services and products (Drury, 2013).

Therefore, irrespective of various limitations ABC can produce more accurate result if is used in proper way and the people who are using the system are trained properly.

References

Dale, B.G. and Plunkett, J.J., 2017. Quality costing. Routledge.

Dong, J., Liu, C. and Lin, Z., 2014. Charging infrastructure planning for promoting battery electric vehicles: An activity-based approach using multiday travel data. Transportation Research Part C: Emerging Technologies, 38, pp.44-55.

DRURY, C.M., 2013. Management and cost accounting. Springer.

Hilton, R.W. and Platt, D.E., 2013. Managerial accounting: creating value in a dynamic business environment. McGraw-Hill Education.

Lakmal, D., 2014. Cost Analysis for Decision Making and Control: Marginal Costing versus Absorption Costing.

Novak, R., Fong, M.H., Zhang, H. and Vrzic, S., Apple Inc, 2017. Methods and systems for resource allocation. U.S. Patent 9,614,650.

Özkan, S. and Karaibrahimo?lu, Y.Z., 2013. Activity-based costing approach in the measurement of cost of quality in SMEs: a case study. Total Quality Management & Business Excellence, 24(3-4), pp.420-431.

Weygandt, J.J., Kimmel, P.D. and Kieso, D.E., 2015. Financial & managerial accounting. John Wiley & Sons.