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Abc Is An Approach For Allocating Overhead Costs Accounting Essay

Section 1: Introduction

According to the Jamaliah Abdul Majid and Maliah Sulaiman (2008), they stated that activity-based costing is a good system because it has been used in different way, for instance customer profitability analyses (Bellis-Jones, 1989), cost reduction (Brimson, 1991), cost modelling (Cooper, 1994), product-range decisions (Johnson and Kaplan, 1987) and budgeting (Kaplan, 1994). Activity-based costing system appoints costs to cost objects such as products and services and calculates the costs of personal activities on the fundamental of the activities engage to produce each product or services.

According to the John C. Lere (2000), he stated that activity-based costing is a powerful tool for industrial marketing decision makers because activity-based costing has appeared over the past 20 years. Activity-based costing (ABC) is an approach for allocating overhead costs and it is a system measure the cost of activities and provided useful, timely and accurate information to the related management.

Activity-based costing (ABC) is an approach for allocating overhead costs. Activity-based costing (ABC) is a system measure the cost of activities and provided useful, timely and accurate information to the related management.

According to the Jamaliah Abdul Majid and Maliah Sulaiman (2008), they stated that measuring the cost and the performance of cost object and activity which are the ways of the activity-based costing. He agreed that cost object for instance jobs, project, customer, service, product that management are trying to cost is the idea behind the activity-based costing. Resource driver and activity driver respectively measure the consumption of resource and consumption of activity. In addition, he also claimed that activity-based costing try to define what is cost drivers and charge a cost object for only overhead it actually consume.

Section 2: Background Research

According to the Jesper Thyssen, Poul Israelsen, Brian Jorgensen (2004), they stated that the origin of activity-based costing trace back to1983 – 1984((Kaplan 1983; 1984a,b; 1985a,b; 1986) although the term of activity-based costing haven’t create yet. Due to resentful of the traditional costing system, this was dispute to be obsoleted in modern manufacturing environments. Robin Cooper and Robert S. Kaplan was involved into a series of ‘innovative actions research cycles’ (Kaplan 1998) in 1987 – 1992 which is activity-based costing was developed. The current state-of-threat of ABC is reflected in Kaplan’s and Cooper’s book “Cost and Effect” (1998) to in search for an improved full-cost product-cost calculation the model grew into a more fullfledged costing system for hierarchies of activities and cost objects.

According to the Rotch (1990);Cooper(1994); King et al(1994)Cooper and Kaplan(1998), they stated that company in USA and UK for instance telecommunication , information service, transportation and marketing of service sectors also using activity-based costing.

According to Jamaliah Abdul Majid & Maliah Sulaiman (2008), they stated that traditional costing system allocates overhead to products on the basic of predetermined plant wide that is using labor costs and machine hours and that is why the relation between indirect costs and the individual product rarely reflected the real cause and effect. Activity-based costing has been used by every company because of labor hours and machine hours of the traditional costing method is not fulfilling to allocating all the overhead cost. In another words, it can say that activity-based costing is a system to solve the limitations of traditional costing system.

Section 3: Literature Review

Activity Based Costing

Limitation of ABC

Advantages of ABC

According to the chart, Activity Based Costing has the advantages and limitation when we are implementing in an organization. Hence, we will further explain about it as follows.

Advantages of of ABC

According to Carles Griful (2001), he states that several authors have described the main advantages and benefits of using ABC costing [Innes and Mitchell, 1990; Bellis-Jones and Develin, 1995; Malmi, 1997], which as follows:

It reduces the risk of the company and provides more useful decisions in the future. Therefore, it is not only depending on the analysis but also depending on its ability to using a correct diagnosis in the company’s situation to make an organization successful.

Focuses on the value-added activities, which are those activities that create value to customers. On the other hand, the company should identify the non-value-added activities and try to eliminate them although the non-value-added activities that enables value adding activities to occur at the same time.

The product and service costing is more accurate, especially the non-volume -related overhead in the organization.

It is a cost behavior that makes people more understand. It is also identifying the costs of complexity, variety, and change inherent in both kind of service offered and customer-specific requirements.

To help to analyze customer profitability, activity-based costing is used to analyze costs by areas of managerial responsibility and customers. It helps to recognize the way in which customers directly influence the cost structure of the business.

We will use the practical capacity, in order to performing capacity analysis which measures the costs of resources used rather than the costs of resources supplied because

that has the big difference being excess capacity.

Limitations of ABC

Activity-based costing is a system to solve the limitation of traditional costing system but does not represent it is perfect. Below is the limitation of the activity-based costing.

The limitation of activity-based costing is difficulties in collecting the accurate data of the amount of work because several activities cross department bonder. Besides that, execute activity-based costing is a multi-step process and it requiring not only collect and processing of data, also need to interpreting the result.

According to Peter F.Druker (1999), some companies that activity-based costing will cause spending too much time, effort and even money on gathering and going over the data that is collected. The manager annoyed in an organization because there have too many details that involve in ABC. On the other hand, insufficient data will occur when we are lacking of details. The data provides in an organization will affect the results when using ABC. This will happens in businesses that were no intention of using ABC costing as main approach.

Besides that, an article aimed at certified public accountants who hard to support the new approach (activity-based costing) was written by Cokins (1999). Hence, in his articles, he explained that activity-based costing usually will show the best with small amount of detail and estimated more cost figures. However, he stated that when accountants try to apply ABC, they will try to achieve and obtain more accurate information that is both difficult to accomplish and need time to accomplish it. However, it will be likely to be a failure when people are going to apply it.

Furthermore, another article entitled "Overcoming the Obstacles to Implementing Activity-Based Costing” was also written by Cokins (2000). Hence, he noted that the managers ignore the cardinal rule so the activity based costing usually leads to a failure. Moreover,the advantage of average cost rates, many overly detailed information and the failure to connect information to action that proved that it also interferes with ABC projects. By knowing these concepts, Cokins (2000) agreed that CPAs can improve their roles as business partners and consultants.

In addition, another limitation is that activity-based costing software can be costly. Mark Henricks (1999) stated that most ABC practitioners find that special-purpose ABC software is required to make the task manageable and easy to undergo in an organization.

Moreover, time can also be a factor for businesses seeking a quick fix which means that ABC costing can be successful in a short run .Continuingly, Henricks (1999) noted that although some companies see results almost instantly, it typically long time to experience the benefits of ABC.

According to Peter (1999), he stated that some overhead costs, such as chief executive salary, are difficult to be assigned to products and customers. 'Business sustaining' which are termed by the costs and are not assigned to products and customers because it is not meaningful to an organization. Although someone may argue that costs cannot trace to activities should be "arbitrarily allocated" to products and it is important to realize that the main purpose of ABC is to provide accurate information to management. Hence, it cannot deny that any cost of the organization by using ABC approach, should be assigned in an arbitrary manner.

Steps in implementing activity based costing

According to Mr. Ian, an ABC system involves the following stages as follows:

Identify the major activities which happen in an organization.

Determine the cost driver for each main activity (for example, number of set-ups, machine hours, number of inspections etc.)

Create a cost pool for each major activity

Trace the costs of activities to products (goods or services) according to the products

consumption of these activities (Using the extent to which the cost drivers are used as a

measure of this demand).

Example:

Thus, the examples will further explain how the steps are undergone.

Assume Henry’s Company produces two products, which are product ‘A’ and ‘B’. Both of them are produced on the same equipment and undergoing same processes. The products will vary with the volumes in which they are sold and therefore the volumes in which they are produced.

Product ‘A’ is a high volume product whereas product ‘B’ is a low volume item. Details of products’ inputs and outputs and the costs of activities involved are as follows:

Products

Machine hours per unit

Direct labor per unit

Annual output units

Total Machine Hours

Total Direct Labor Hours

No. of purchase orders

No. of “set-ups”

Product A

4

8

12,000

40,000

40,000

120

60

Product B

4

8

1,200

20,000

30,000

100

50

Total

60,000

70,000

220

110

The cost of these activities as follows:

RM

Volume related

120,000

Purchase related

100,000

Set up related

200,000

Total

420,000

An ‘Activity Based Costing system would handle it this way:

Activities

Volume related

Purchase related

Set-up related

Cost Traced to activities

RM120,000

RM100,000

RM200,000

Consumption of activities

60,000 machine hrs

220 purchase orders

110 set-ups

Cost per unit of consumption

RM6 per machine hrs

RM500 per order

RM2,000per set-up

Cost trace to product

A

RM72,000

(12,000XRM6)

RM60,000

(120XRM500)

RM120,000

(60XRM2000)

B

RM7,200

(1,200XRM6)

RM50,000

(100XRM500)

RM100,000

(50XRM2,000)

Hence,cost per unit under ABC:

For product A=RM21{(RM72,000+RM60,000+RM120,000)/12,000units}

For product B=RM131{(RM7,200+RM50,000+RM100,000)/1,200units}

A Traditional volume based costing system would handle it this way:

Cost centre allocated costs RM420,000

Overhead rate per machine hour RM7 (RM420,000/60,000 hrs)

Overhead rate per direct labour hour RM6(RM420,000/70,000hrs)

Cost per unit of ‘A’ = RM28 (4 machines hours at RM7)

Cost per unit of ‘B’= RM24 (RM6X 4,at RM6per hour)

Thus total cost allocated to product ‘A’ = RM336,000 (12,000 X RM28)

And total cost allocated to product ‘B’= RM28,800(1,200 X RM24)

From the calculations,it shows the big difference by using the traditional volume based costing and ABC.

Section 4: Analyses and Discussion

Other than ABC costing system, there have another system called traditional costing system. Traditional costing system allocates overhead through a very direct way that is based on the basic of predetermined such as machine hours or the labor costs. Activity-based costing (ABC) is provided information more accurate than traditional costing system, because its assign overhead costs using the following steps that we mentioned at section 3.

Traditional costing system allocates overhead to products on the basic of predetermined plant wide that is using direct cost and machine hours. In the rapid development environment, the total overhead cost such as depreciation on expensive plant, property and equipment, maintenance has increased. On the other hand, the amount of direct labor used in industries has reduced. In this situation, it is inappropriate to use the basic predetermined overhead rates based on direct labor because direct labor and overhead have no correlation.

It will happen product cost distortions because the companies are using overhead rates based on direct labor. Companies prevent the distortion by using the machine hours as the basic to allocate overhead in an automated manufacturing. Manufacturing process is involutes and complex, only machine hour is not fulfilling to allocating all the overhead cost. In this situation, managers decide to us “activity based costing”.

Michael H. Granof Professor, David E. Platt Assistant Professor and Igor Vaysman Assistant Professor (2000) had done some researches about the ABC. They had analyzed about the difference between ABC and traditional costing.

The table below shows the differences between traditional costing and activity-based costing.

Traditional Costing System

ABC Costing System

Cost pools

Accumulates costs into department pools is heterogeneous. The costs are not cause by single factor and it is caused of many major processes.

Company allocates overhead costs to activity cost pools, after that company uses ‘cost driver’ to determine the costs to assign to the individual product based on each product’s use of each activity.

Allocation base

Company allocates costs to products using basic predetermined plant wide, which are units, direct labor input, machine hours.

Allocates cost product from the activity cost pools using allocates corresponding to cost driver of activity costs

Cost object

Focuses on single cost object (e.g. unit of product or service)

Focuses on many cost objects of interest (e.g. Batches, business processes).

Cost

Not expensive to implement, cost are lower than ABC costing

Expensive to implement.

Decision support

Leads to overcosting and undercosting problems.

As they unable to align allocation bases with cost drivers

Provided accurate information to support the decision made by organization.

Cost control

Can be considered as departmental exercise rather than a cross functional effort.

Organization activities provided the summary cost which allows the priority of cost management efforts.

Example of ABC and Traditional costing

Now we will have an example for making decision to pricing and production by using ABC and traditional costing.

Assume that the Craze Ball Company produces two types of bouncing balls; one has a hollow center and the other has a solid center. The same equipment is operated to produce the balls in different runs. Between batches, the equipment is cleaned, maintained and set up in the proper form for the next batch. The hollow center balls are packaged with two balls per package whereas the solid center balls are packaged one per package. During the year, Craze Ball expects to produce 1,200,000 hollow center balls and 1,400,000 solid center balls. The overhead costs incurred have been allocated to activity pools as follows:

Activity

RM

Purchasing of materials

220,000

Setup of machines

300,000

Packaging

360,000

Testing

240,000

Cleaning and maintenance

280,000

Total overhead costs

1,,380,000

By analyzing the activity pools,we have to identify the cost drivers, estimated the total expected units for each product and calculated the unit cost for each cost driver.

Activity

Cost Driver

Total Expected Units for Cost Driver (1)

Total Cost (2)(RM)

Unit Cost per Cost Driver (3) = (2)÷ (1)(RM)

Purchasing of Materials

No. of purchase orders

120

240,000

2,000

Set up of Machines

No. of setups

300

300,000

1,000

Packaging

No. of containers filled

2,600,000

360,000

0.14(rounded up)

Testing

No. of tests

4,000

240,000

60.00

Cleaning and maintenance

No. of runs

240

280,000

1,166.67(rounded up)

The activity by product is shown in the following table.

Expected Use

ABC Cost Assigned

Activity

Cost Driver

Unit Cost (3) (RM)

Hollow Center (4)

Solid Center (5)

Hollow Center (3) × (4)

Purchasing

No. of purchase orders

2,000

50

50

RM100,000

Setup

No. of setups

1,000

120

120

120,000

Packaging

No. of containers filled

0.14

400,000

2,400,000

56,000

Testing

No. of tests

60.00

1,600

2,500

96,000

Cleaning and maintenance

No. of runs

1,166.67

80

160

93,333,60

Totals

RM465,333.60

To calculate the per unit overhead costs under ABC system, the costs assigned to each product are divided by the number of units produced. Hence,the unit cost for a hollow center ball is RM0.39 and the unit cost for a solid center ball is RM0.64.

Overhead costs assigned to hollow center balls/Number of hollow balls

=465,333.60/1,200,000

=0.39(RM)

Overhead costs assigned to solid center balls/Number of solid balls

=892,667.20/1,400,000

=0.64(RM)

Under the traditional method, the total costs for all balls would be divided by total direct labor costs for all balls to determine per unit cost. Estimated direct labor costs for the year are RM1,500,000, which are RM500,000 and RM1,000,000 respectively. Thus, per unit direct labor costs are RM0.42 for hollow center balls (RM500,000 ÷ 1,200,000) and RM0.71 for solid center balls (RM1,000,000 ÷ 1,400,000). Per unit cost to produce balls incurred two steps:

Calculate the predetermined overhead rate by dividing total overhead costs by total direct labor dollars.

Allocate overhead to each type of product by multiplying the overhead cost per direct labor cost by the per unit direct labor costs for the two balls.

Step 1 : Calculate the direct labor cost

Total overhead costs/Total direct labor costs=1380,000/1,500,000

=0.92 per direct labor cost

Step 2 : Allocation of overhead

Overhead cost per direct labor cost X per unit direct labor cost

For hollow balls: 0.42 X 0.39=0.16 overhead per unit

For solid balls : 0.71 X 0.64=0.45 overhead per unit

A comparison of the overhead per unit calculated using the ABC and traditional methods often shows a different result:

Craze Ball Company 20X0 Overhead per Unit

ABC method(RM)

Traditional method (RM)

Hollow Ball

0.39

0.16

Solid Ball

0.64

0.45

In this example, the overhead charged to the hollow ball using ABC is RM0.39 and much higher than the RM0.16 calculated under the traditional method. The RM0.39 is a more accurate cost for making decisions about pricing and production. For the solid center ball, the overhead calculated is RM0.64 per unit using ABC method and RM0.45 per unit using traditional method. The reason for the differences is the traditional method determines the cost allocation using direct labor costs only. Hence, a product with high direct labor costs will allocate more of the overhead costs than a product with low direct labor costs. The number of orders, setups, or tests the product actually uses does not affect the allocation of overhead costs when direct labor dollars are used to allocate overhead.

Section 5: Conclusion

ABC is an approach that helps us in an organization when we make decision. On the other hand, it also has the limitations of the ABC approach. Besides that, according to Mr. Ian, ABC systems recognize that some activities are unrelated to the volume of the product, by using cost drivers that are independent of volume.

He stated that the activities are divided into three major categories at the product level:

Unit level

Batch-related

Product sustaining

Product costs are accumulated by these categories.

In the past 10years, product costing, planning and forecasting have completely changed under activity-based costing.

According to the John C. Lere (2000), we know that activity-based costing is a powerful tool for the decision makers. Financial data from general ledger are not same with the financial data from the activity-based costing. Consequently, activity-based costing provides useful financial supporting data when the company implements the activity-based costing.

Associating cost to the activity is beneficial to the distributor such as wholesaler , franchiser know that what the start-up cost is, measures the costs incurred in which part, and where to apply efforts to curb the cost of inflation.

It is a special value that enables to track new products and customers.

As last but not least, we can see that activity-based costing improves the traditional costing in the following approach:

Differentiates the parts of traditional costing and activity-based costing which is the former cost of the product. The costs are not according to accepted accounting principles (GAAP) and the latter collect costs that under accepted accounting principles (GAAP).

Activity-based costing gives expression to the hierarchical structure of the variable costs.

Indirect costs under the activity-based costing are assigned to activity pools that reflect the main business process and cross the boundaries of the enterprise’s functional department.

Luckily, we feel familiar about the topic because in the previous trimester we had learned about the topic. However, the more challenge part is we had gone through the journals by finding via website or in library online database. In the process, many journalists, specialist of accounting fields had done their research by using ABC system on their industry such as universities, manufacturing companies and hospitals .In addition, we had searched about the ABC that is implemented in the other way. Therefore, the examples we are given is slightly different from the textbook that we learned.

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