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Study is about the ABC Costing system that can be used to track the overheads and to monitor any expenses incurred

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Introduction

Since piece of information is required by the costing systems as parametric value to the user, they fall in the category of information systems as well. Costing systems can be used to track the overheads and to monitor any expenses incurred by the company. Moreover, itcan be integrated into any accounting system. The data acquisition is facilitated by the costing systems, and subsequently management reports are generated through this data along with the provision of the costs and expendituresofthe company in the shape of single inclusive report and dashboards. The customers, departments, services and products in addition to facilities, etc. are among the major areas of reporting.

The Conventional Absorption costing and Activity Based Costing are the two major types of the costing systems. The costs related to the production of a good or service is taken into account by the Conventional Absorption Costingand the company’s financial situation is also provided by this system in the form of a broad picture. A single, volume-based cost driver is employed by this system which is the source of adjustments when costing products. Based on their relative usage of direct labor, the product overheads in most cases are assigned by the traditional costing system. In contrast, a considerably different and primary assumption is likely to drive the Activity Based Costing. Here, as per this system, products have activities as basic fundamental cost objectsandcosts are triggered by the products. According to conventional costing systems, cost is basically assigned to productsinstead of activities in the beginning and then cost is assigned from the activities to product units. It is clarified that information on “what was disbursed”is not provided by the ABC costing system, but this system actually explainsthathow much amount is spent and why. Therefore, companies are enabled by this system for critical analysis of these activities besides justifying the cycle-time advancements.

Prepare and present budgeted profit statements using

Conventional absorption costing

As far as this case is concerned, the overhead cost is initially calculated on the basis of machine activity and the given below formula represents this mechanism:

Overhead cost per machine hour=(Total Overhead Cost (Machine Dept.))/(Budgeted Activity (Total Machine Hours))

For the machine department, almost £504,000 is the total overhead cost while, for the department, the total machine hours (in thousands) are determined as:

Total machine hours=(40*5hours)+(50*2 hours)+(30*4 hours)

Total machine hours=200 hours+100 hours+120 hours

Total machine hours (in thousands)=420 hours

Therefore, the overhead cost per machine hour is given as:

Overhead cost per machine hour=£504,000/(420,000 hours)

Overhead cost per machine hour=£1.2/machine hour

Afterwards, on the basis assembly activity, the overhead cost represented by the formula below is calculated as:

Overhead cost per machine hour=(Total Overhead Cost (Assembly Dept))/(Budgeted Activity (Total Labour Hours))

As far as the assembly department is concerned, the total overhead cost is given as £437,000, whereasfor the assembly department, the total labor hours (in thousands) are computed as:

Total labour hours=(40*3 hours)+(50*7 hours)+(30*2 hours)

Total labour hours=120 hours+350 hours+60 hours

Total labour hours (in thousands)=530 hours

Hence, the overhead cost per labor hour is:

Overhead cost per labour hour=£437,000/(530,000 hours)

Overhead cost per machine hour=£0.8245/ labour hour

The associated costs per unit of each product are computed for the establishing the profit statement:

 

Product XYI

Amount of £32 is thevariable cost per unit.We can compute the total variable cost as: Total variable cost=£32/unit*50,000 units

Total variable cost=£1,600,000

 

Both the machine and assembly departments are included in the total overhead costs:

The total overhead cost for the machine department is determined as:

Machine Dept.OH costs=50,000 *£1.2/machine hour*2 hours 

Machine Dept.OH costs=£120,000

 

The total overhead cost for the assembly department is computed as:

Assembly Dept.OH costs=50,000 *£0.82/labour hour*7 hours 

Assembly Dept.OH costs=£288,575

Therefore, the total overhead cost is given as: £120,000 + £288,575 = £408,575

 

Product YZT

Almost £84 is the variable cost per unit, and we can determine the total variable cost as: Total variable cost=£84/unit*40,000 units

Total variable cost=£3,360,000

 

Both the machine and assembly departments are involve in the total overhead costs:

The total overhead cost for the machine department is estimated as:

Machine Dept.OH costs=40,000*5 hours*£1.2/machine hour 

Machine Dept.OH costs=£240,000

 

The total overhead cost for the assembly department is calculated as:

Assembly Dept.OH costs=40,000 *£0.82/labour hour*3 hours 

Assembly Dept.OH costs=£98,940

Hence, the total overhead cost is: £98,940+ £240,000= £338,940

 

 

Product ABW

£65 is the variable cost per unit; the total variable cost is evaluated as: Total variable cost=£65/unit*30,000 units

Total variable cost=£1,950,000

 

Both the machine and assembly departments are included in the total overhead costs:

We can estimate the total overhead cost for the machine department as:

Machine Dept.OH costs=30,000 *£1.2/machine hour*4 hours 

Machine Dept.OH costs=£144,000

The total overhead cost for the assembly department is calculated as:

Assembly Dept.OH costs=30,000 *£0.82/labour hour*2 hours 

Assembly Dept.OH costs=£49,470

Accordingly the total overhead cost is given as: £49,470+ £144,000 = £193,470

 

The profit statements for the three products can then be represented as:

XYI YZT ABW

Selling pricing per unit £45 £95 £73

Sales volume                50,000 40,000 30,000

Total sales £2,250,000 £3,800,000 £2,190,000

 

Total variable cost £1,600,000 £3,360,000 £1,950,000

Variable cost per unit £32 £84 £65

Total contribution   £650,000   £440,000     £240,000

Assembly department overheads £288,575 £98,940 £49,470

Machine department overheads   £120,000 £240,000    £144,000

Profit per product     £241,425   £101,060 £46,530

Total profit = (XYI+YZT+ABW) £389,015

 

Activity Based Costing

Under this costing method, we calculate the unit overhead cost per cost pool identified as shown in the table below: 

Cost Pool Cost Cost drivers  Cost driver Rates

Assembly Service £ 318.000 / £ 530.000 = £ 0.60 / labour hour

Machine Service £ 357.000 / £ 420.000 = £ 0.85 / machine hour

Set-Up £ 26.000 / £ 520 = £ 50 / set-up

Purchasing £ 84.000 / £ 11.200 = £ 7.50 / suppliers' order

Order Processing £ 156.000 / £ 32.000 = £ 4.875 / customer order

 

For each cost pool per product, we can calculate the total cost as below:

Product XYI

We can compute the total machine service cost as: 

Total machine service cost=50,000*2hours*£ 0.85 / machine hour

Total machine service cost=£85,000

 

Also, we can determine the total assembly service as:

Total assembly service=50,000*7hours*£ 0.60 / labour hour

Total assembly service=£210,000

 

Moreover, the total setup cost is estimated as:

Total setup cost=120setups* £50 / setup

Total assembly service=£6,000

 

In addition, we can compute the total order processing cost as:

Total order processing cost=8,000 orders*£4.875 / order

Total order processing cost=£39,000

 

Ultimately, the total purchasing cost is computed as:

Total purchasing cost=3,000 orders*£7.5 / order

Total order processing cost=£22,500

 

 

Product YZT

Whereas, we can compute the total machine service cost as follows: 

Total machine service cost=40,000*5hours*£ 0.85 / machine hour

Therefore,Total machine service cost=£170,000

 

The total assembly service is computed as:

Total assembly service=40,000*3hours*£ 0.60 / machine hour

Hence, Total assembly service=£72,000

 

Also, we can determine the total setup cost as:

Total setup cost=200setups* £50 / setup

Thus, the Total assembly service=£10,000

 

Moreover, the total order processing cost is determined as:

Total order processing cost=8,000 orders*£4.875 / order

Therefore, 

Total order processing cost=£39,000

 

Finally, we can compute the total purchasing cost as:

Total purchasing cost=4,000 orders*£7.5 / order

Then,we get the total order processing cost,that is: 30,000

 

Product ABW

While, the total machine service costcan be computed calculated as: 

Total machine service cost=30,000*4hours*£ 0.85 / machine hour

Hence,Total machine service cost=£102,000

 

We can estimate the total assembly service as given below:

Total assembly service=30,000*2hours*£ 0.60 / machine hour

Total assembly service=£36,000

 

Moreover, we can compute the total setup cost as:

Total setup cost=200setups* £50 / setup

Hence,Total assembly service=£10,000

 

The total order processing cost is computed as:

Total order processing cost=16,000 orders*£4.875 / order

Therefore, 

Total order processing cost=£78,000

 

Eventually, the total purchasing cost is computed as:

Total purchasing cost=4,200 orders*£7.5 / order

Total order processing cost is: £31,500

 

 

The profit statements for the three products can then be represented as:

For the three products, the profit statements can subsequently be demonstrated as:

 

XYI YZT ABW

Selling pricing per unit £45 £95 £73

Sales volume                50,000 40,000 30,000

Total sales £2,250,000 £3,800,000 £2,190,000

Total variable cost £1,600,000 £3,360,000 £1,950,000

Variable cost per unit £32 £84 £65

Total contribution   £650,000   £440,000     £240,000

Overheads:

   Order processing £39,000 £39,000 £78,000

   Assembly services £210,000 £72,000 £36,000

   Machining services £85,000 £170,000 £102,000

   Set-up costs £6,000 £10,000 £10,000

   Purchasing £22,500 £30,000 £31,500

  Total overheads £362,500 £321,000 £257,500

Profit per product     £287,500   £119,000 £(17,500)

 

Comment on these results

The methodology, approach and scope of these two cost accounting systems determine the differences between Conventional Absorption Costing and Activity Based Costing (usually referred to as ABC costing). As compared to the conventional costing method, a higher profit is provided by the ABC costing method from the afore-mentioned profitability analysis. A profit of £ 389,900was recorded by the ABC method ascompared to the conventional method in which a profit of £ 389,015was recorded. The approach used by the two costing methods yieldedthis difference.£17,500is the amount for which product ABW would be getting lost.

The costs on one hand are allocated to product units by the conventional costing method,whereas, the costs of product units on the other hand are traced by ABC costing through cost pools. For the product overheads, understanding the cost drivers is an easy task from the ABC costing analysis unlike the conventional costing method in whichall these costs are integrated into broad cost groups. Regarding the profitability of the different products, different conclusions have been derived by both the two costing methods. All products are profitable under the traditional method and thereforethey should be maintained under the current company’s portfolio. Nonetheless, the only profitable products are identified by ABC costing as the XYI and YZT, whereas Product ABW has been assumed to be unsuccessful. With the help of ABC costing, it is obvious that the high order processing costs and the number of machine hours utilized by the product are the major cost drivers. Therefore, compared to the conventional method, ABC costing is helpful and beneficial, since it represents the major cost drivers and critically examines the different cost pools. 

 

Discuss

By allocating expenditure to the firm’s different operations or to the various stages of production, the systematic calculation of production costs is generally described as costing. Typically, allocation of costs is either for valuation purposes i.e., developing financial statements, or for reimbursement purposes or for decision-making objectives. The monitoring of costs incurred by a business can be facilitated through costing systems. This system entails procedures, controls,and a set of forms and reports that are developed and integratedfor the purpose of assisting the management (Braun, Tietz, 2012, p.65). Certain specific data / information are required by the costing systems through which we,on the basis of methodologyemployed,can determine the product costs and other information. Moreover, waste of resources can be curtailed through the valuable information provided by the costing systems. Therefore, the costing system itself should be economical and as compared to the benefit derived from using the system, fewer resources should be utilized in designing, implementing and maintaining a costing system 

Two well-known costing systems are usually observed so far:the Activity Based Costing and the Traditional Costing System. Provided that the same input data, the two systems yielded considerably different results and the basic assumptions of these systems are likely to drive this process. There are three major steps in the approach supported by the Traditional Costing System:to allocatenon-production department costs to production departments; to collect costs within a production or non-production department; and to assign the resulting (revised) productiondepartment costs to a number of services, products, or clients (Hopwood, Chapman, 2008, p.93). Since wrong and impartial costs are yielded by this approach when it is used for decision making purposes, it therefore is defective and also not comprehensive. For example, the cost of idle capacity is allocated to products by the conventional approach to costing,which suggests that the products are charged for resources which were not even utilized by them. The experts have developed this activity based costing approach in a persistent bid to improve such misrepresentations and many companies have adopted itover the traditional costing approach.  

There are two differentimportant steps inthe Activity Based Costing approach: the combination of overhead costs for eachorganizational activity is the first one, and afterwardsallocation of costs of theactivities to the services, products, or customers (costobjects) through which that activity is taken place (Libby, Libby, Short, 2010, p. 108). This is a completely different method as compared to the conventionalmethodin which overhead costs are allocated on the basis of single-volume measures,wherein the desired cost allocation principle of cause-and-effect is not then fulfilled despite adhering to the financial reporting requirements. The activity analysis is one of the significant activities to the success of ABC costing. In addition, it is the process, whereinsuitable output measures of resources and activities (costdrivers) are identified besidesconsidering their impact on the costs associated with a product or a service(Armstrong, 2002, p.89). Nonetheless, the misrepresentations can be rectified through activity analysis, which are in-built in the traditional costing method. 

ABC costing systems have the potential to generate special customized reports besides their flexibility levels andthrough which management can make effective decisions regarding certain cost activities. Unlike the conventional approach which accumulates costs via organization units, this approach (i.e.ABC system) accumulates costs through key activities and this particular fact further strengthens the flexibility of ABC system. Over the years, the ABC system has now become a scientific cost reduction method from an accurate product costing method, whichincorporates ABC management, ABC costing, Business process engineering and ABC budgeting, etc. 

Regarding the key areas of the firm, management is enabled to obtain better information with the help of ABC system. By sorting through additional overhead costs, the firm is enabledto evaluate customer productivity and can establishthe profitable customers as well. The company can therefore understand its customers in a better way through these comprehensionsbesides serving them in a fruitful way through their optimum resources.

Certain shortcomingsof ABC costing are associated with the system regardless of its various benefits. The large number of cost pools required to produce high quality information is one of the most important shortcomings. The cost of managing the system would be high, if the number of cost pools is larger.Usually, the number of cost pools can be kept at a controllable level through an investigationwith a view to understand the cost of maintaining each cost pool. Furthermore, depending on the number of product / service lines and the size of the company, ABC systems can run into several years and their installation is usuallya difficult task. Finally, complex production environments do target the ABC systems and a proper return on investment would not be generated by the installation of the system, if a company operates in a less complex environment.

As a final point, a sense of financial rationalityis offered by the ABC costing to the extensive management process. Regardless of the rigid and the bureaucratic nature of activity analysisbesides the time consuming procedures, the state-of-the-art cost reduction tools, process improvementand performance measurement have been admired and approved by the ABC costing methods in complex production situations.

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