Question

imagine that you are a business manager. Your board of directors has requested that you report on the significance and impact of utilizing activity-based costing (ABC) over a single plant-wide predetermined overhead rate (POHR).

   create a brief presentation for your investors analyzing the pros and cons of using ABC, including a comparison of at least two of the activity rates versus the single plant-wide POHR with calculations.

Here is the relevant information you need:

The product that you produce requires four different activities to complete.

The single plant-wide POHR is $25 per unit, and we produced 10,000 units.

Activity 1: Design Team – The estimated time spent on new ideas is 15,000 hours; we have 4 members of the design team that are paid $40,000 each.

Activity 2: Production Team – The estimated time spent producing the item is 30,000 hours, with 100,000 machine hours with associated costs of $150,000, and we have 8 employees who work 40 hours a week, 52 weeks a year, and they are paid $12 an hour.

Activity 3: Finishing Team – The estimated time spent finishing the product is 15,600 hours, with 20,000 machine hours with associated costs of $75,000, and we have 10 employees who work 30 hours a week each and are paid $20 an hour.

Activity 4: Quality Inspections – There are 200 estimated inspections; we have 2 inspectors with an annual salary of $75,000.

Answer 1

(A). Activity Based Costing:

The Companies move to Activity based costing to better understand the true costs of goods and services.

Activity based costing (ABC) is a method for assigning costs to products, services projects, tasks, or acquisitions, based on

1. Activities that go into them.

2. Resources consumed by these activities.

(B). Comparison of ABC with Traditional Costing:

ABC contrasts with traditional costing (cost accounting), which sometimes assigns costs using somewhat arbitrary allocation percentages for overhead or the so-called indirect costs.

As a result, ABC and traditional cost accounting can estimate cost of goods sold and gross margin very differently for individual products.

Contradictory and uncertain cost estimates can be a problem when management needs to know exactly which products are profitable and which are selling at a loss.

(C). Pros of ABC:

Cost accountants know that traditional cost accounting can hide or distort information on the costs of individual products and services—especially where local cost allocation rules misrepresent actual resource usage. As a result, the move to ABC is usually driven by a need to understand the "true costs" of individual products and services more accurately. Companies implement Activity Based Costing in order to:

Identify individual products that are unprofitable.

Improve production process efficiency.

Price products appropriately, with the help of accurate product cost information.

Reveal unnecessary costs that can be eliminated.

Businesses are moved to adopt ABC by a desire to improve costing accuracy, especially to get closer to the true cost and true profitability of individual products and services. And, they also move to ABC in order to understand better the true costs and return on investment from projects, programs, or other initiatives.

ABC pursues these objectives essentially by making direct costs out of many costs that traditional cost accounting treats as indirect costs.

Traditionally, indirect costs for firms are manufacturing overhead costs, they cannot assign directly to specific product units. Instead, they allocate these costs to specific production runs, batches, or time periods. These might include indirect costs such as the following:

Materials purchase order costs.               

Machine set up costs.

Product packaging costs.

Under Traditional Costing, these are normally allocated using Direct labor Hours, etc., But where as they actually have a cost driver and have been using different (in Traditional System) Overhead rate (POHR) derails the actual cost and which may have the effect on the Contribution per Unit and later on the Company as a whole.

Differences between ABC and Traditional Costing:

ABC	Traditional Costing
1. Activity based costing requires detailed knowledge of the activities and resources that go into overhead (or "indirect") support work.	1. Traditional cost accounting (production volume based allocation) requires only a total overhead cost and a simple allocation rule.
2. ABC recognizes that individual overhead components can be distributed differently for different products. One product may consume relatively more maintenance resources, for instance, while another product may consume relatively less maintenance resources but relatively more machine set up resources.	2. Traditional cost accounting typically puts overhead components into fewer categories, or even a single category, and uses a single allocation rate for all products
3. Activity based costing treats overhead costs essentially as direct costs, in that cost estimates reflect actual cost driver usage for each product. These costs, in turn can be reasonably be apportioned to individual product units.	3. In traditional cost accounting (production volume based allocation), the total overhead cost is known accurately. However, in traditional costing the distribution of that total to individual products is based on an indirect measure of that cost.
4. The Activity based costing results may be taken as the more accurate results—more closely reflecting the "true" production costs of products.	4. The Traditional Cost Accounting results may be taken as the less accurate results than ABC.

Activity Based Costing:

ABC is Expensive and Complex compared to Traditional Costing System.

Selection of Drivers poses a difficulty in ABC.

ABC has different levels of utility for different organization such as large manufacturing firm can use it more usefully than the smaller firms. Also, it is likely that firms depending on cost-plus pricing can take advantages from ABC as it gives accurate product cost. But those firms who use market based prices may not favor ABC.

The level of technology and manufacturing environment prevailing in different firms also affect the application of ABC.

The main costs and limitations of an ABC system are the measurements necessary to implement it. ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers to serve as cost allocation bases. Even basic ABC systems require many calculations to determine costs of products and services. These measurements are costly. Activity cost rates also need to be updated regularly.

Explaining ABC Using 2 Examples:

Activity	Amt in $	Relevant Cost Driver	Activity Usage	Cost ($)
Design	$ 160,000	No. of Hrs Spent on Ideas	15000 Hours	$ 10.6667 per Hour
Quality Inspections	$ 75,000	No. of Quality Inspection	200 Inspections	$ 375 per Inspection