In the traditional costing method, there is a pre determined rate that is calculated based on a particular factor such as machine hours or labour hours. This rate is charged among all the products that are produced by the company (Boyd, 2013). However, if there is existence of any kind of joint costs then such costs is allocated to all the products so that unit cost of each product is determined.
As the name suggests, this method is considered to be old and obsolete because this method ignores the actual consumption of the resources. This costing method is preferred by the companies that produce a single product and also when there are not many activities involved in the production process (Easton, 2010). In the recent times, a company usually has a modern production process that involves production of multiple products that involve many activities. It is a complex process and therefore, traditional costing method is not used for such companies.
It has been observed that when this accounting method is followed the burden of overhead costs shifts from one product to another (Datar, 2015) . The overhead costs are not distributed in an equal proportion because the amount of resource that is utilised is not the same. If the costs are distributed evenly then it will lead to wrong pricing of the product. Some products may be over price whereas some products may be underpriced.
In order to overcome the drawback of traditional costing method, many companies has started using Activity Based Costing which also taken into consideration the amount of resources used (Holtzman, 2013).
The modern way of allocating cost among various products is also known as Activity Based Costing. This method has been introduced in order to overcome the disadvantages of the traditional costing system (Datar, 2016). In order to allocation costs based on this method, the company need to collect and analyse the cost data available. The number of units that are consumed and the amount that has been spent on such units are recorded. Cost per unit is calculated with the help of this information. On the basis of the rate per activity, the total costs is distributed among various products (Datar, 2016).
This system of costing is considered to be more appropriate because it allocates costs only to the product if it has utilised that specific function and only to the extent the consumption has been done (Horngren, 2012). So, this costing method is considered to be more accurate and reliable. The management is able to price the product correctly using the Activity Based Costing.
In order to take correct decisions, the management of the company must choose the cost allocation method wisely. In order to understand this statement better let us taken into consideration the scenario provided to us. In the given situation, the management is thinking of phasing out the production of one model of printer which is called Lexon because it is generating low operating income (McLaney & Adril, 2016). But if we use correct cost allocation method and evaluate the data properly then the results obtained will be completely opposite.
It is very important for the management of the company to choose a cost allocation method which is appropriate. The product pricing decisions taken by the management is reliable on the method that is adopted (Menifield, 2014). If the information on the basis of which the decision is made is incorrect then the decision taken up by the management may also prove to be wrong. Any wrong decisions taken up by the company may hurt its financial viability.
The following table shows the income statement of the company:
|
Beztec Limited |
|||
|
Income statement for the financial year ended 31December 2017 |
|||
|
Lexon |
Protox |
Total |
|
|
Revenues |
$23 760 000 |
$7524 000 |
$31 284 000 |
|
Cost of goods sold |
15 048 000 |
5 266 800 |
20 314 800 |
|
Gross margin |
8 712 000 |
2 257 200 |
10 969 200 |
|
Selling and administrative expense |
6 996 000 |
1 613 700 |
8 609 700 |
|
Operating income |
$1 716 000 |
$643 500 |
$2 359 500 |
|
Units produced and sold |
24 000 |
6 000 |
|
|
Operating income per unit sold |
$71.50 |
$107.25 |
The operating income for Lexon and Protox is $71.50 per unit and $107.25 per unit respectively. On the basis of this information, the company decided to shut down production of Lexon printers.
In order to check whether the decision taken up by the management was correct or not, operating income using Activity based costing should be calculated. The activity rate per unit consumed and information about various activity consumed should be used to evaluate the decision (Noreen, 2015).
The total cost activities on the basis of these rate per activity which are consumed are as follows:
|
Activity-cost-driver quantities |
|||
|
Activity-cost driver (driver quantity) |
Lexon |
Protox |
Total |
|
Soldering (number of solder points) |
13,33,125 |
4,33,125 |
17,66,250 |
|
Shipments (number of shipments) |
18,225 |
4,275 |
22,500 |
|
Quality control (number of inspections) |
63,225 |
23,963 |
87,188 |
|
Purchase orders (number of orders) |
90,113 |
1,23,727 |
2,13,840 |
|
Machine power (machine-hours) |
1,98,000 |
18,000 |
2,16,000 |
|
Machine set-ups (number of set-ups) |
18,000 |
15,750 |
33,750 |
|
Calculation of activity rate |
|||
|
Activity-cost driver |
Total activity costs |
Total Number of Activities |
Rate per unit |
|
Soldering |
11,65,725 |
17,66,250 |
0.66 |
|
Shipments |
10,64,250 |
22,500 |
47.30 |
|
Quality control |
15,34,500 |
87,188 |
17.60 |
|
Purchase orders |
11,76,120 |
2,13,840 |
5.50 |
|
Machine power |
71,280 |
2,16,000 |
0.33 |
|
Machine set-ups |
9,28,125 |
33,750 |
27.50 |
Using this cost allocation rate we have recalculated the operating income per unit from both the products:
|
Allocation of Activity Cost |
||||
|
Activity-cost driver |
Lexon- Activity |
Lexon – Amount |
Protox-Activity |
Protox-Amount |
|
Soldering |
13,33,125 |
8,79,862.50 |
4,33,125 |
2,85,862.50 |
|
Shipments |
18,225 |
8,62,042.50 |
4,275 |
2,02,207.50 |
|
Quality control |
63,225 |
11,12,753.62 |
23,963 |
4,21,746.38 |
|
Purchase orders |
90,113 |
4,95,621.50 |
1,23,727 |
6,80,498.50 |
|
Machine power |
1,98,000 |
65,340.00 |
18,000 |
5,940.00 |
|
Machine set-ups |
18,000 |
4,95,000.00 |
15,750 |
4,33,125.00 |
|
Total |
39,10,620.12 |
20,29,379.88 |
The actual amount of costs that are consumed by each product can be observed. The overhead cost that was allocated based on the traditional system made the product overpriced because the overhead allocated was more than what was actually consumed. The reason for the low operating income of Lexon and high operating income of Protox was wrong costing method of cost allocation (Piper, 2015).
The new cost allocation rate has been used to recalculate the operating income of each of the product:
|
Beztec Limited |
|||
|
Income statement for the financial year ended 31December 2017 |
|||
|
Lexon |
Protox |
Total |
|
|
Revenues |
237,60,000 |
75,24,000 |
312,84,000 |
|
Cost of goods sold |
136,78,620 |
66,36,180 |
203,14,800 |
|
Gross margin |
100,81,380 |
8,87,820 |
109,69,200 |
|
Selling and administrative expense |
69,96,000 |
16,13,700 |
86,09,700 |
|
Operating income |
30,85,380 |
-7,25,880 |
23,59,500 |
|
Units produced and sold |
24,000 |
6,000 |
|
|
Operating income per unit sold |
129 |
-121 |
After the calculation under Activity based costing, we can observe that the operating income form per unit of Lexon was $ 129 per unit and the operating loss from Protox was $ 121 per unit. The operating income under traditional system for Lexon and Protox was $71.50 and $107.25 respectively.
The management would have taken a wrong step by stopping the production of Lexon printers as it would result in operating losses.
Beztec limited has an accountant whose name is Sue Smith. As we know, it is the responsibility of an accountant to make sure that the financial statements that are prepared by the company for the interest of the stakeholders must reflect a true and fair view about the company. It should be prepared in such a manner that the users of the financial statement gets clear picture of the company’s financial performance and position (Seal, 2012).
Smith is a knowledgeable person as he has specialised skills in the field of accounts and finance. According to him, the company must adopt activity based costing and made decisions based on that results as it will help the management to take correct decisions (Siciliano, 2015). The CEO of the company wanted smith to adopt traditional costing because there was some personal interest.
It is the duty of the accountant to fulfil her responsibilities with professionalism and integrity. The accountant must look for the benefits of the company and act accordingly. It is her duty to look after the financial health of the company and maintain financial stability. She was forced to not carry out his work independently because there was a personal interest of the CEO of the company. The bonus that the CEO receives is dependent on the revenues of the different departments so he does not want that production of any product stops.
Smith is one of the employees of the company and should act for the best interest of the company. It will be unethical on his part to attain financial benefits or provide financial benefit to any other employee at the cost of the company. Based on the principles that are laid down by the authorities the accountant must work with honesty.
Therefore, sue must calculate the cost based on both the cost allocation method and then explain his view to the management of the company based on the results obtained (Taillard, 2013).
The gross profit margin for both the models of printers is calculated using Traditional costing system and Activity Based Costing. The calculation is as follows:
|
Gross Profit analysis |
||
|
Gross profit margin under traditional costing |
36.67 |
30.00 |
|
Gross profit margin under Activity Based costing |
42.43 |
11.80 |
From the above table, we can observe that the GP margin for Lexon under activity based costing resulted to 42.43% whereas it was 36.67% under traditional costing. However, it was seen that GP margin for Protox under activity based costing was 11.8% but under traditional costing method it was 30%. Therefore, we can conclude that the choice of costing method can have a great impact on the decision making process of the management (White, 2009).
As we know, traditional cost allocation method ignores the utilisation of resources and only focuses on the distribution of the pre determined rate. It is not necessary that the pre determined rate that is charged is correct and therefore, there might arise a difference in the actual overhead per unit and the overhead recovered per unit from the customers.
When the overhead recovered from the customers is more than the actual overhead, and then it is a situation of over recovery. Similarly, when the actual overhead is more than the amount of overhead recovered it is known as under recovery. Such under or over recovery has to be treated in the books of accounts.
The treatment of under/over recovery is explained below:
Conclusion and Recommendation
It is clear from the above discussion that the company must adopt correct costing methods in order to avoid mispricing of a product. If the decisions made by the management are based on any incorrect data or information then the company might suffer. It is the duty of the management to take into consideration all the alternatives, evaluate them deeply and then take a final decision. The decisions should be taken for the benefit of the company.
We conclude that the company must adopt activity based costing and should also stop the production of Protox printers so that there are no operating losses that the company has to suffer.
Atkinson, A. A. (2012). Management accounting. Upper Saddle River, N.J.: Paerson.
Berry, L. E. (2009). Management accounting demystified. New York: McGraw-Hill.
Boyd, W. K. (2013). Cost Accounting For Dummies. Hoboken: Wiley.
Datar, M. S. (2015). Cost accounting. Boston: Pearson.
Datar, S. (2016). Horngren’s Cost Accounting: A Managerial Emphasis. Hoboken: Wiley.
Easton, P. (2010). Financial statement analysis & valuation. Cambridge, UK: Cambridge Business Publishers.
Holtzman, M. (2013). Managerial Accounting For Dummies. Hoboken, NJ: Wiley.
Horngren, C. (2012). Cost accounting. Upper Saddle River, N.J.: Pearson/Prentice Hall.
McLaney, E., & Adril, D. P. (2016). Accounting and Finance: An Introduction. United Kingdom: Pearson.
Menifield, C. E. (2014). The Basics of Public Budgeting and Financial Management: A Handbook for Academics and Practitioners. Lanham, Md.: University Press of America.
Noreen, E. (2015). The theory of constraints and its implications for management accounting. Great Barrington, MA: North River Press.
Piper, M. (2015). Accounting made simple. United States: CreateSpace Pub.
Seal, W. (2012). Management accounting. Maidenhead: McGraw-Hill Higher Education.
Siciliano, G. (2015). Finance for Nonfinancial Managers. New York: McGraw-Hill.
Taillard, M. (2013). Corporate finance for dummies. Hoboken, N.J.: Wiley.
White, T. S. (2009). The 60 minute ABC book. Bedford: Consortium for Advanced Manufacturing International.
Essay Writing Service Features
Our Experience
No matter how complex your assignment is, we can find the right professional for your specific task. Contact Essay is an essay writing company that hires only the smartest minds to help you with your projects. Our expertise allows us to provide students with high-quality academic writing, editing & proofreading services.
Free Features
Free revision policy
$10Free bibliography & reference
$8Free title page
$8Free formatting
$8How Our Essay Writing Service Works
First, you will need to complete an order form. It's not difficult but, in case there is anything you find not to be clear, you may always call us so that we can guide you through it. On the order form, you will need to include some basic information concerning your order: subject, topic, number of pages, etc. We also encourage our clients to upload any relevant information or sources that will help.
Complete the order form
Once we have all the information and instructions that we need, we select the most suitable writer for your assignment. While everything seems to be clear, the writer, who has complete knowledge of the subject, may need clarification from you. It is at that point that you would receive a call or email from us.
Writer’s assignment
As soon as the writer has finished, it will be delivered both to the website and to your email address so that you will not miss it. If your deadline is close at hand, we will place a call to you to make sure that you receive the paper on time.
Completing the order and download