Question

1. 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.                                                          

Answer 1

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

Under the traditional costing system the manufacturing overheads or indirect expenses of a factory are allocated to the products manufactured based on an allocation basis that might be the number of units produced or the number of labor hours or number of machine hours etc. The traditional method is not suitable when the company consists of many production departments and manufactures diversified products for different customers.

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

For example let's say a company has 2 manufacturing departments M1 and M2 and the indirect costs are plant manager's salary $ 30,000 and plant depreciation $ 50,000. Also given are the labor 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 labor 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 labor 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 labor hour = 30000/10000 =$3   

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

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

Depreciation of plant 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 allocated to M1 and M2 under activity based costing is

M1 = $29000 (9000+20000)

M2= $51000(21000+30000)