Question

Criticize the traditional costing systems used to allocate manufacturing overhead to cost objects. Explain how did activity based costing overcome the shortcomings of the traditional costing system and support your discussion with numerical examples through comparing cost per unit under the two systems.

Demonstrate the concept of EUP and its calculation under Weighted Average and FIFO method with an illustration. (Use imaginary figures of your own).   

Prepare a format of the Contribution Income Statement with imaginary figures. Also use the information of this contribution income statement to find BEP in sales.

Answer 1

(1) Traditional cost allocation system vs Activity based cost allocation

Under the traditional cost allocation method the manufacturing overheads or indirect expenses of a factory are allocated to the products manufactured based on an allocation basis which may be the number of units produced or no.of labour hours or number of machine hours etc. The traditional method is not suitable when the plant has many producing departments and produces diverse products for different customers.

The activity based costing overcomes the shortcomings of the traditional costing method by allocating different indirect costs/activities based on different cost drivers instead of relying on a single cost driver.

For eg, if a company has 2 manufacturing departments M1 and, M2. Lets say the indirect costs are plant manager's salary $ 30,000 and plant depreciation $ 50,000. Also given are the labour hours for M1 and M2 as 3000 and 7000 hours respectively. The space occupied by M1 is 2000 sq feet and M2 is 3000 sq. feet.

If labour hours is considered as the allocation basis under the traditional method then the total indirect costs of $80,000(30000 + 50000) will be allocated as follows.

Cost per labour hour = 80000/10000 = $8

Allocation to M1 = 3000 x 8 =$ 24,000

Allocation to M2 = 7000 x 8 =$56,000.

Under activity based costing, indirect cost allocation will be as follows:-

Plant manager's salary will be allocated based on labour hours and plant depreciation will be based on space occupied by each manufacturing department.

Plant managers salary per labour hour = 30000/10000 =$3

Plant managers salary allocated to M1 = 3000 x 3 = $9000

Plant managers salary allocated to M2 = 7000 x 3 = $21000

Plant depreciation per sq ft = 50000/5000 = $10

Plant depreciation allocated to M1 = 2000 x 10 = $20000

Plant depreciation allocated to M2 = 3000 x 10 = $30000

Thus total indirect cost allocation to M1 and M2 under activity based costing is

M1 = $29000 (9000+20000)

M2= $51000(21000+30000)

(2) Equivalent units in production (EUP)

Equivalent units is a concept in process costing and refers to expressing both fully completed units and partially completed units in terms of fully completed units in a process at the end of an accounting period. A product passes through different stages in a processes before it is fully completed. As a result at the end of an accounting period some units may be fully completed and some partially completed. The main costs involved in a process are material costs and conversion costs which is nothing but labour and manufacturing overhead costs. Equivalent units can be computed either using the FIFO method or the weighted average method. The following illustration will explain the concept. lets assume the Beginning WIP and the Ending WIP are completed 35% and 25% respectively for both material and conversion costs

(3) Contribution Income statement and BEP sales

Contribution Income Statement
	$
Selling price per unit	10
Variable cost per unit	4
Contribution per unit	6
Fixed Costs	84000
Break Even sales units = Fixed costs/contribution per unit =84000/6 =14000 units
Break Even sales ($) =14000 x 10 =$140000