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.
ABC assigns overheads to activities that actually lead to the incurrence of the costs.
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
Direct materials ($)
Direct labor hours
Direct labor cost ($)
Number of production runs
Number of deliveries
Number of orders
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
= $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
Direct materials 100
Direct labor 10
Activity Based Costing
The activities involved are custom engineering and designing, machine set up and packaging.
The cost pools will then be set up, machines, packaging and engineering
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
5 = $100 per set up
5 = $10 per package
Machines hour rate
150 = $6.67 per machine hour
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 costs = $10×5 = $50
Packaging cost per unit = $50
5 unites = $10
=$6.67 x 150 = $1000
Machine cost per unit = $1000
5 units = $100
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
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.
Williamson, D (2008). Activity Based Costing. Retrieved on 6/5/2008 from http://business.fortunecity.com/discount/29/abcworkex.htm