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Q. A. 1. – Calculate the Unit Costs for Product A and B using the traditional volume-based product costing system. The Overhead costs of Duo plc have been allocated using the Traditional costing system in table 1. The Overhead costs have been allocated using Direct Labour Hours (DLH) of production (Direct Labour Hour absorption approach). That is, Total Overhead costs were divided by the addition of all DLHs, giving us the overhead rate per labour hour (? 0. 345). This method was used since, firstly, it is the basic method of traditional volume-based costing, and secondly, we are not told how to apportion reciprocal services to the two departments; therefore since we can not apportion the costs between the two departments, we must apportion the total cost as a whole. This should not affect the end result, since the total cost to be allocated would of course be the same in both cases.
Then the DLHs for Part A were added (500000 hrs for the machine department and 150000 hrs for the fitting department), and multiplied by the overhead rate per labour hour, in order to find the overhead cost to be allocated to that department (? 6724146). This result was finally divided by the units produced to give us the overhead cost per unit (? 22. 41). The same procedure was done for Part B. The DLHs were added (600000 hrs for the machine department and 200000 hrs for the fitting department), and multiplied by the overhead rate per labour hour, in order to find the overhead cost to be allocated to that department (? 275872). This result was finally divided by the units produced to give us the overhead cost per unit (? 27. 59). Q. A. 2. Using ABC calculate the unit costs for A and B. The Overhead costs of Duo plc were now allocated using the Activity Based Costing (ABC) system, as seen in tables 2, 3 & 4. In table 2 the apportionment basis (cost drivers) for each overhead cost, and the proportion of the cost to go to each part of production was stated. In table 3 the proportion of the cost to go to each part of production was stated as a fraction.
In table 4 the fractions for each part of production (parts 1 to 4) were multiplied by the total costs, to give us the actual costs for each part of production. These were added to give us the total cost per part. Then the Product costs were calculated, by adding the part costs for each product – Product A = Part 1 + Part 2 Product B = Part 3 + Part 4 Lastly, the Product costs were divided by the number of units so as to give the the overhead cost per unit; Product A overhead cost per unit = 13. 1; Product B overhead cost per unit = 36. 9.
Finally, In table 5 you can see a comparison of the two methods. In the chart, on the left you can see the comparison for Product A overhead costs per unit using both methods, and on the right you can see the comparison for Product B overhead costs per unit using both methods. It can be seen that with the ABC method, the high volume product is charged less per unit, and the low volume product is charged more per product, than what they are charged using the Traditional method. This is consistent with economies of scale achieved through high volume. Q.
B “Traditional volume-based costing systems tend to overcost high-volume products and undercost low-volume products. ” Discuss the validity of this statement. Absorption or Traditional Costing is defined by CIMA as “the procedure which charges fixed as well as variable overheads to cost units” [1]. Traditional Absorption methods were used to spread overheads to products when factory overheads were relatively small compared to material and labour costs. The spread of overheads to products was based on the assumption that a specific work required either more labour hours or more machine hours to be carried out.
Based on that management choose direct labour hours or direct labour cost methods to charge the overheads to products when work was labour intensive. Similarly management chose machine hours rate when work required more machine hours than labour hours. A relatively new costing technique is Activity Based Costing (ABC). CIMA defines Activity Based Costing as “Cost attribution to cost units on the basis of benefit received from indirect activities e. g. ordering, setting-up, assuring quality, etc” [2].
Activity Based Costing evolved during the late 1980’s with the spread of advanced manufacturing technology. Nowadays the production processes are more complex since companies produce different ranges of products for a more sophisticated consumer. Consequently direct labour and material cost represent a smaller proportion of total cost than in the past. In addition to that companies have many support activities such as scheduling, stock handling, set-ups etc. which have little or any relationship with machine hour or labour hours.
Since they vary according to the range and complexity of the products manufactured traditional absorption methods are not useful. The following example can illustrate the above – (Question A used as example): Company X produces two types of products: Product A and Product B. Both products require the same amount of labour and machine hours. Product A is very popular and 500,000 units are produced annually. On the other hand product B requires a more complex environment to be produced. However the same amount of units are produced every year i. e. 500,000 units.
Support activities cause the following expenses: scheduling, set-ups, purchasing, material handling and product inspection which are much higher for product B than product A . If traditional methods are used than product A will be overcosted and product B will benefit from a smaller proportion of overheads since labour and machines hours are the same for both products. The above weakness of the traditional costing was recognised by Activity Based Costing which attempts to overcome it by relating overhead costs to the activities that cause or “drive” them i. e. ost drivers. The costs that are associated with the same cost drivers can be grouped into cost pools. The overheads are allocated in a better way since they are spread into the activities that cause them. Moreover the establishment of cost drivers can help management into the reappraisal of operations carried out in the business. As a result management can identify the activities that do not add value to the product and therefore it can discontinue or change them. It also helps eliminate waste, since it gives a more detailled brakedown of costs and cost allocation.
However the determination of the most appropriate cost drivers is a difficult one. Also a cost pool can be problematic if the chosen single cost driver cannot fully explain the cost behavior of all items in the particular cost pool; this would indicate that further brekedown is needed. However detailed brakedowns may not be cost effective or practical, so care must be taken not to overdo it, through a cost-benefit analysis. The comparison of the two methods i. e. Traditional and Activity Based Costing provides us with the following information: 1.
ABC use various cost drivers to allocate the overheads to the products whereas Traditional Absorption costing relies on a single or perhaps two, volume based rates i. e. direct labour and machine hours. ABC provides more accurate product costs since it associates overheads more closely to their origin. So better selling prices can be set, and cost control is more effective. 2. Traditional Based Costing overallocates overheads to high volume products and under allocates overheads to low volume products.
This can be proved by the results found in Part A (see Qustion A of the assignment). According to our calculations the results of Traditional Absorption Costing differ from the results of ABC: | |Product A |Product B | |Traditional Absorbtion costing |6723146 |8275872 | |ABC |3940104 |11069896 | |Difference: |2794042 |-2794024 |
Thus Product A, which is uniform product and is manufactured in high volume production runs each year, is overcosted if the Traditional Absorption Costing method is used. On the other hand Product B, which is manufactured in low volume customised batches is undercosted by Traditional Absorption Costing.
As we can see from all the above the ABC method can help management to control costs since the activities that drive them are identified and can be controlled. The primary assumption of ABC is that cost is caused by activities and not by products. Products only consume activities. The main advantage of ABC compared to Traditional Costing is that it provides that high volume products cost less than low volume products. Summarised Comparison of ABC with Traditional Costing: | | | |Traditional costing: | |Allocates indirect costs based on direct labor or machine hours | |Out of date because technology has reduced relative contribution of labor and material | |costs to total product cost while the relative cost of OH has increased | | | |ABC: | |Assigns costs to activities based on consumption of resources | |Assigns costs to different markets, distribution channels, and services | |Overcomes distortions of high versus low volume products or services | | | |(Source: ACTIVITY BASED COSTING (ABC) and MANAGEMENT (ABM), Internet, | |http://www. acq-ref. navy. mil/abc2. html ) | So as we have seen, due to its crude aproach, Traditional volume-based costing systems tend to overcost high-volume products and undercost low-volume products, and therefore the statement is valid. Bibliography: 1. Storey Roger, Introduction to Cost & Management Accounting, Macmillan Press Ltd, London, 1995 2.
Colin Drury, Management and Cost Accounting, 4rth edition, International Thompson Business press, 1996 3. Russell David, An Introduction to ABC, ACCA Newsletter, May 1995 4. David Stephenson, ACTIVITY-BASED COSTING, Internet, 1997, http://www. stephensonstrategies. com/tips/management_tips/activity-based_costing. html 5. ACTIVITY BASED COSTING (ABC) and ACTIVITY BASED MANAGEMENT (ABM), Internet, http://www. acq-ref. navy. mil/abc2. html ———————– [1] Storey Roger, Introduction to Cost & Management Accounting, Macmillan Press Ltd, London 1995, Page 64. [2] Storey Roger, Introduction to Cost & Management Accounting, Macmillan Press Ltd, London 1995, Page 178.