Cost Accounting- Traditional vs. ABC Essay

Cost Accounting- Traditional vs. ABC

The allocation of manufacturing overheads has been normally done using traditional costing method where the costs were allocated based on the direct labor hours.  This leads to wrong cost determination that consequently results in inaccurate product cost and prices as well.  The emergence of activity based costing avoided the problems associated with traditional costing methods.

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            ABC assigns overheads to activities that actually lead to the incurrence of the costs.

Awnings manufacturing

            The manufacture of awnings involves the following stages:  the fabric is firstly cotton made according to the specifications of the order.

  The fabric is then de signed and engineered to fit the shape and size requested by the customer.  The next process involves the designing of the poles and its holders according to the shape of the desired awning. The last step involves the packaging of the awning.

            The costs to be incurred in the manufacturing process include direct material, direct labor, machine set up costs, engineering, packaging cost and machine hour costs

Consider the following data for the above company

Item

Total
Sales (unit)
5
5
Direct materials ($)
100
500
Direct labor hours
50
250
Machine hours
20
150
Direct labor cost ($)
10
2500
Number of production runs
5
5
Number of deliveries
5
5
Number of orders
5
5

Overheads
Amounts ($)
Set up
500
Packaging
50
Machines
1000
Engineering
1200

Traditional costing method

As seen earlier seen, the tradition method allocates the overheads based on a single activity e.

g. the number of direct labor hours consumed in the manufacturing process.

            The product unit cost will then be calculated as follows:

Overhead absorption rate = Total overheads

                                            Total number of direct labor hours

                                        = $2,750

                                                250

                                        = $11 per direct labor

            The overhead absorption rate is then multiplied with the per indirect labor costs.

The per unit direct labor costs =2500

5              = 100

Therefore the total overhead per unit = 11×100 = $1100

Unit costs

Direct materials                      100

Direct labor                            10

Overheads                              1100

                                               $1210

Activity Based Costing

Activities

            The activities involved are custom engineering and designing, machine set up and packaging.

Cost pools

            The cost pools will then be set up, machines, packaging and engineering

Workings

            The activities and allocation of costs to cost pools has been done above.

The activity rates are determined as follows

Rate = overhead amount

            Number of activity

Set up rate

=$500

5        = $100 per set up

Packaging rate

= $50

5        = $10 per package

Machines hour rate

= $1000

150                      = $6.67 per machine hour

Engineering

= $1200

5                          = $240 per order

The various overhead costs are calculated as follows:

=Overhead x number of activities

For set up costs

Set up costs = 100×5  = $500

Therefore set up cost per unit = $500

                                                  5 units = $100

Packaging rate

Packaging costs = $10×5       = $50

Packaging cost per unit = $50

                                         5 unites = $10

Machine costs

=$6.67 x 150 = $1000

Machine cost per unit      = $1000

                                          5 units = $100

Engineering costs

Costs = $240 x5 = $1200

Engineering cost per unit = $1200

                                               5 units = $240

            Therefore, the product unit cost is arrived at by adding the individual direct costs as well as the indirect costs (overheads)

Unit costs                                  $

Direct materials                      100

Direct labor                            50

Set up costs                            100

Packaging costs                      10

Machine cost                          100

Engineering cost                    240

                                               $550

Comparison

From the calculations it is clear that the product unit cost under ABC is much lower than under the traditional costing method. The difference is so substantial such that the cost determined using the traditional cost method is twice that calculated using activity based costing.

If these costs are then to be used in the determination of product selling price, then, the use of traditional costing may lead to fixing of highly exorbitant price that can harm the company’s sales in the long run. The selling price will eventually be uncompetititive in the long run.

The traditional cost allocation allocates costs based on the number of direct labor hours such that the product with the highest labor hours gets higher allocation of overheads. This may be wrong in the case of a highly customized product that require numerous set ups. Such products are usually slow moving and hence less hours are spent in their production yet they are costly in that the cost of the set ups and engineering are high in the long run.

Reference:

Williamson, D (2008). Activity Based Costing. Retrieved on 6/5/2008 from http://business.fortunecity.com/discount/29/abcworkex.htm

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