Relationship Between Activity Based Costing And Traditional Product Costing For Genre Company

Definition of Key Concepts

Discuss about the Relationship Between Activity Based Costing.

Management accounting is a discipline of accounting that is primarily concerned with data gathering (from internal or external sources) analyzing, processing, and interpretation according to Tsai et al. (2011, p. 7275). The result is then communicated to the resulting information for use within the organization so that the management can plan more efficiently or even make decisions that will ensure efficient control operations that can meet the objectives of an organization (Podobedova 2014, p. 15). In this paper, a detailed examination and analysis of different approaches used in cost accounting are presented with Genre Company as the case study for the research. The paper mainly focuses on the traditional product costing also referred to as traditional costing as well as the Activity Based Costing (ABC).These two methods are essential in providing solutions which can be used by the CEO of Genre Company to make pricing decisions for its advanced product services. The paper as well defines some of the key concepts that will be used in the calculation and analysis in the report.

Different key concepts are essential in the accounting process while analyzing the case study. These include;

• Cost Unit – refers to a unit of product or service about which costs are ascertained. The chosen unit is what is most relevant for the activities of the company.
• Direct costs, they comprise of direct materials, direct labor and direct expenses, are those which can be identified directly with a job, product or a service (Tan & Ferreira, 2012, p. 408).
• (Direct materials + Direct labor+ direct expenses =prime cost).
• The indirect cost refers to all material, labor, and expense expenditure which cannot be identified with the product; while the total of indirect costs is known as overhead (Phan, Baird, & Blair 2014, p.789).
• Cost center refers to a production or service location, function, activity or item of equipment for which costs are accumulated.
• Cost allocations are assigning a full item of value or revenue to a single charge unit, cost center, account, or period (Zang 2012).
• Short – term variable costs are costs that do not vary with production volume. They change in direct relationship to the product size.
• Long – term variable costs, are costs which do not vary with the amount of production but vary with other measures of activity, but not immediately such as the setup costs as denoted by Tan and Ferreira (2012, p. 408).
• Fixed costs are classified as costs which do not vary, for a given period with any activity indicator.

The traditional overhead costing will help us analyzes the predetermined overhead rate, product cost per unit for both Basic and Advanced products and the price that would be charged for the products according to Feng and Ho (2016). The conventional product costing which absorbs support overhead costs simply on production volume tends to over cost high volume products, which cause relatively little diversity, and under cost, low volume products, which produce a greater variety and so calls more upon the support services.

Product moment’sunits producedtotal machine hours

Basic                     2hrs                     2000                        (2×2000) = 4000hrs

Advanced             3hrs                     10000                      (3×10000) = 30000hrs

34000hrs.

These are the total machine hours used in the determination of overhead rates under the traditional product costing.

To determine the predetermined overhead rate then;

OAR based on machine hours = 1632000(total manufacturing overhead budget)/34000 (total machine hours).

=1632000÷34000 =$ 48 per machine hours.

Solution b: Cost summary using (traditional) costing.

Basic                   advanced                          total

$                              $                                     $

Direct materials            80,000                     600,000

Direct labor                   60000                     450000

Prime cost                     140,000                  1,050,000                         1,190,000

Overheads @ 48 per

Machine hours              192,0001,440,0001,632,000

Total Cost                       332,000                  2,490,000                       2,822,000

Units produced              2,00010,000

Cost per unit$166$249

It thus means that the product cost per unit for the Basic product is $166 while that of the Advanced product is $249.

Solution a: Traditional Overhead Costing

Direct materials, (direct material × production units), for basic= 40×2000 =80,000

Advanced, 60×10000=600,000

Direct labor, (direct labor hours × direct labor cost × units produced), for Basic, (2×15×2000) =60,000, advanced; (3×15×10000) =450,000

Overheads @ 48 per machine hours, for basic (48×4000) = 192,000, advanced(48×30000)= 1,440,000.

Solution c: Advanced price

The price charged for the Basic and Advanced products under the traditional costing is 120 percent of the manufacturing cost, therefore;

For basic, price = (120÷100) ×166 =$199 (rounded).

Advanced, price= (120÷100) ×249=$299 (rounded).

In using the Activity based costing, we need to identify the main activities in the company, the cost drivers which refer to the factors which determine the value of the activity. And also examine the costs of each activity also known as the cost pools and finally charge the support overheads to products by their usage of the activity, expressed regarding the chosen cost driver.

ABC method uses many drivers as absorption bases. Therefore ABC cost driver produces more realistic product costs, particularly when support overheads are high.

In this case, our cost pool and cost drivers are outlined as below;

Activity cost pool (ACP)          Cost driver(CD)Budgeted amount of Cost driver

Set up costs(SP)                      Number of production runs         80

Engineering costs            Engineering changes                      200 design changes

Machine related expenses    machine hours                                18000 hours

Plant-associated costs          Floor space in sq.ft                          3840 sq.ft.

Focusing on the drivers who cause overheads and tracing costs to products on the usage of cost drivers enables a higher proportion of expenses to product related. When using traditional systems, most support costs cannot be linked to products except in the most arbitrary way. It is this feature of ABC which, it is claimed, produces greater realism.

It will be seen that ABC charges more overheads to lower volume production and tends to cost relatively less to higher volume production. From the calculations above, it is clear that the Basic product has been undercharged while the advanced product has been overcharged. It thus means that the CEO of the Genre Company can price the superior product at $226 which will ease competition from the new competitor entering the market.

According to Matherly and Burney (2013), the implementation of an ABC can be very expensive for an organization and time consuming as well. The entire process can as well require valuable resources as it involves data collection, measurement, and entry into a new system. In such a point, small businesses may need the assistance of a specialist who has a proper understanding in setting up the ABC system. Data can as well be misinterpreted since reports like the profit margin can vary from the traditional reporting methods and others. However, despite the challenges, activity based accounting improves the performance of the business in many different ways according to Martin-Diener et al. (2016, p. 1050). These include;

• ABC recognizes that it is activities which cause loss, not products and it is products which consume events.
• It also focuses attention on the real nature of cost behavior, and it helps in reducing costs and identifies activities which do not add value to the product.
• ABC recognizes the diversity and complexity of current production by the use of some cost drivers(CD), many of which are transaction based rather than based solely on production volume (Karagiorgos 2016, p. 67).
• It provides a reliable indication of long-run variable product cost which is relevant to strategic decision making.
• The method is flexible enough to trace costs to processes, customers, areas of managerial responsibility, as well as product costs.
• It also provides useful financial measures such as the cost driver rates and non -financial measures such as the transaction volumes.
• Its principle of using activities to trace costs can be applied across a range of service industries as well as manufacturing firms.
• More losses can be attributed to the product. In modern factories, there are a growing number of non – factory floor activities. Activity-based costing (ABC) is concerned with all activities so takes product costing beyond the traditional factory floor basis.
• ABC seeks not only to attribute overheads to product costs on a more realistic basis than simply production volume but also attempts to show the relationship between overhead costs and the activities that cause them.
• ABC is equally applicable to service organizations and activity- based analysis can be used in budgeting.

Calculations of Total Machine Hours in the Period

Conclusion

Activity Based Accounting is a strategy of allocating costs with the base on some resources a service per product consumers. Using ABC is mainly essential to business operations that open away for a customized services or products. The report above shows evident that the activity-based costing (ABC); is a more realistic and reliable method of costing products. It is clear that unlike the traditional product costing, activity based costing is more sensible pricing decision. It also does not over cost or under cost the product because it employs the use of more cost driving tools, unlike traditional method which only uses either machine hours or direct labor to make its pricing decisions.

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