Calculation Of Cost Per Unit Under Traditional And Activity Based Costing System

Predetermined Overhead Rate Calculation

The Sewing Easy Ltd allocates the indirect cost using traditional method basis on machine hours. For this, firstly the predetermined overhead rate needs to be computed for allocation of indirect costs to the product. The formula for calculating the predetermined overhead rate is as below:

Predetermined Overhead Rate  =  Total Indirect Overhead/ Total Machine hours

Hence, the predetermined overhead rate of the company is $31.25 (250,000/ 8000).

Now, the next step is to allocate the indirect overheads to products using above calculated predetermined overhead rate.

Particulars Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper	Basic	Advance
Total machine hours	4,600	3,400
Units produced and sold	1,600	1,500
Machine hour per unit (total machine hours/ unit produced and sold)	2.88	2.27
Overhead per unit	89.84	70.83

Hence, the cost per unit of the models is as below:

Particulars	Basic	Advance
Direct material cost	325.00	560.00
Direct Labor cost	150.00	260.00
Allocated indirect overheads	89.84	70.83
Other costs* (201,700/1,500)		134.47
Total cost per unit	564.84	1,025.30

*Other costs includes the following costs directly attributable to Advance Model.

Selling & Admin expense	140,600
Interest expense	25,200
Office rent	35,900
Total expense	201,700

Hence, the cost per unit for Basic Model is $564.84 and for Advance Model is $1,025.30.

Solution-2

Calculation of cost per unit under the current activity based costing system

ABC or activity based costing system is the system for allocation of costs to the product on the basis of activities or resources consumed by the respective product. It is a more practical method and generally provides the accurate results. For allocation of costs under this system, first of all, the cost drivers are identified and then the costs are allocated on the basis of cost drivers consumed by respective products.

The calculation of allocation of indirect costs to product as per ABC is as below:

Particulars	Indirect Overheads	Activities Consumed			Cost allocation
Basic Model	Advance Model	Total	Cost Driver	Cost per activity	Basic Model	Advance Model
Inspection	20,000	200	750	950	Inspections	21.05	4,211	15,789
Assembly	90,000	4,600	3,400	8,000	machine hours	11.25	51,750	38,250
Production scheduling	105,000	50	500	550	Runs	190.91	9,545	95,455
Machine set-up	35,000	100	250	350	set up	100.00	10,000	25,000
Total Costs	250,000						75,506	174,494
No. of units							1,600	1,500
Cost per unit							47.19	116.33

Hence, the cost per unit of both the products is as below:

Particulars	Basic	Advance
Direct material cost	325.00	560.00
Direct Labor cost	150.00	260.00
Allocated indirect overheads	47.19	116.33
Other costs* (201,700/1,500)		134.47
Total cost per unit	522.19	1,070.80

Hence, the cost per unit for Basic Model is $522.19 and for Advance Model is $1,070.80.

Solution-3 (a)

December 2017 Profit and Loss Statement for the advance model using traditional costing

 

Particulars	Units	Per unit	Amount ($)
Sales  *	1,500	1,230	1,845,000
Expenses
Direct material cost	1,500	560	840,000
Direct Labor cost	1,500	260	390,000
Overhead cost	1,500	70.83	106,245
Other expenses – Selling & Admin expense			140,600
– Interest expense			25,200
– Office rent			35,900
Net Profit			307,055

* The selling price per unit is 20% plus cost. Hence, the selling price per unit is $1,230 (1025.30*120%).

Solution-3 (b)

December 2017 Profit and Loss Statement for the advance model using ABC

Particulars	Units	Per unit	Amount ($)
Sales  *	1,500	1,285	1,927,433
Expenses
Direct material cost	1,500	560	840,000
Direct Labor cost	1,500	260	390,000
Overhead cost	1,500	116.33	174,494
Other expenses – Selling & Admin expense			140,600
– Interest expense			25,200
– Office rent			35,900
Net Profit			321,239

* The selling price per unit is 20% plus cost. Hence, the selling price per unit is $1,285 (1070.80*120%).

Analysis of Overseas buyer behavior of purchasing advance model only

The traditional method allocates the overhead on the basis of common allocation resource be it labor hours or machine hours. This method does not take into account the actual usage of that common resource by the products. Hence, it allocates the cost on the basis of blanket rate and usually does not provides the accurate results.

On the other hand, the activity based costing allocates the overhead on the basis of actual resources consumed by the products and hence generally provides the accurate results.

Let’s compare the cost of the two products under above two defined methods.

The cost of the two products under traditional costing is $565 for Basic Model and $1,025 for Advance Model whereas the cost of the products under activity based costing is $522 for Basic Model and $ 1,071 for Advance Model. Hence, it can be seen that the Basic Model is overpriced by $43 ($565-$522) and the Advance Model is underpriced by $45 ($1025-$1071).

Since, the Advance model is underpriced than its actual price and might be possible that the Advance product is not available in the market at this price, since it is underpriced. That’s why the overseas buyer is interested in buying the advance product as it is underpriced and further, they are not interested in buying the basic product as it is overpriced.

Solution-4

The actual overheads refers to the amount of indirect overheads actually incurred by the business. The indirect overheads are those overheads which cannot be directly allocated to the products. Like factory rent, electricity of factory, supervisor’s salary, etc.

On the other hand, the applied overheads are those overheads which have been applied to the products using predetermined overhead rate which is calculated by dividing the estimated indirect overheads with estimated machine hours or labor hours. These applied overheads usually differs from actual overheads as the overheads used for the calculation of applied overheads are estimated and when the overheads are incurred in actual then they differs from estimated one.

However, rarely it happens that the applied overheads and the actual overheads are the same. This is when the estimates becomes actuals. That is, the estimated overheads are same as actual overheads and the estimated machine or labor hours are the same as actual machine or labor hours.

The three ways to deal with over or under applied overheads are:

• Supplementary rate– To calculate a supplementary rate on the basis of difference between applied and actual overheads and then using this supplementary rate the difference is charged to the products.
• To write off – The difference of applied and actual overheads can also be directly written off to the profit and loss account.
• Carried forward – the amount of difference between actual and applied overheads can be carried forward to the next year and can be settled off in the next year itself.

Solution-5

The ABC is a very popular method and has the following advantages: (Money Matters | All Management Articles, 2018)

• Accurate product cost– The product cost calculated using ABC are generally accurate. Since, the ABC method is a realistic method and works on the practical base, i.e. on the basis of cost drivers and activities actually consumed by the products. Hence, ABC provides more realistic product cost.

• Tracing of overheads– Under ABC, the overheads are traced as per their cost drivers, which makes the process transparent and more reliable. Hence, the overheads can be easily allocated to the products.

• Cost Management– Since, the overheads are traced with the transactions, hence managing costs become easy and the management can easily decides which is the avoidable cost and can be reduced without affecting the whole production process. On the basis of these information, it becomes easier for the management to make various decisions and productivity improvement approaches.

• Multiple products– the ABC is best to use when the business manufactures multiple products.

Apart from the advantages, ABC has some disadvantages as well. Some of the disadvantages of ABC method are: (Your Article Library, 2018)

• Costly– ABC method is a costly method, since its process is complicate. It involves the identification of costs and their cost drivers, which makes the process costly. Hence, the small business cannot adopted ABC. Further, if the overheads amount is small, then also implementation of ABS is not useful and not recommended.

• Complicated / Specialized Knowledge– ABC is a complicated process since it has 3 to 4 steps. Further, the business implementing ABC needs to hire ABC professional for its implementations, which increases its costs and even after implementation, the trained professionals are required for proper running of ABC System. Hence, the specialized knowledge is required for ABC.

• Not for single product– ABC method is not useful for companies producing single product as there is no need to allocate the overheads and the entire overheads belong to one product produced.

References:

1. Money Matters | All Management Articles. (2018). Advantages and Disadvantages of Activity Based Costing. [online] Available at: https://accountlearning.com/advantages-and-disadvantages-of-activity-based-costing/ [Accessed 9 May 2018].

1. Your Article Library. (2018). Advantages and Demerits of Activity Based Costing (ABC). [online] Available at: https://www.yourarticlelibrary.com/accounting/costing/advantages-and-demerits-of-activity-based-costing-abc/52617 [Accessed 9 May 2018].