# Costing Method And The Activity Based Costing Accounting Essay

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The objective of doing this Management Accounting Assignment is to understand how to do a proper calculation of traditional costing method and the Activity-based Costing. It is important to have this basic practice to help us in the experience of doing this calculation while we are studying other topic. Through the process of calculation of both methods, I have done by given the history of both method, the definition of both method, and the explanation of both methods. Other than that, I also have given the differences of the traditional costing method and activity-based costing.

## TABLE OF CONTENT

PAGE NO.

1.

EXECUTIVE SUMMARY

1

2.

1.0 TRADITIONAL / CONVENTIONAL METHOD(CURRENT METHOD)

1.1 PRODUCT COST PER UNIT

3

3

3.

2.0 ACTIVITY-BASED COSTING METHOD

2.1 PRODUCT COST PER UNIT

4

5

4.

3.0 TRADITIONAL COSTING METHOD

6-9

5.

4.0 ACTIVITY-BASED COSTING(ABC)

10-13

6.

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5.0 DIFFERENCE BETWEEN TRADITIONAL AND ABC SYSTEMS

14-15

7.

REFERENCES

16-17

## 1.0 TRADITIONAL / CONVENTIONAL METHOD (CURRENT METHOD)

OAR = Budgeted Production Overhead

Budgeted Activity level

OAR =

OAR =

OAR =

## A(RM) B(RM) C(RM)

Direct material (RM) 10 4 2

Direct labour (minutes) 1.25 2.5 3.75

Prime cost 11.25 6.5 5.75

Production overhead 12.26 24.52 36.78

OAR =

OAR =

OAR =

OAR =

OAR =

OAR =

OAR =

OAR =

## A(RM) B(RM) C(RM)

Direct material (RM) 10 4 2

Direct labour (minutes) 1.25 2.5 3.75

Prime cost 11.25 6.5 5.75

Production overhead

Material inspection cost 0.58 1.25 3.5

Material handling cost {RM 1.55} 7.5 {RM 1.58} 12 {RM 1.54} 6

Power cost {RM 2.00 8} 16 {RM2.005} 10 {RM2.003) 6

## 3.0 TRADITIONAL COSTING METHOD

During the most of the 1900s, almost all companies used traditional costing systems that those do not accumulate or report costs of activities or processes (Anderson, 1995). Traditional absorption costing methods attribute production overheads to units of output without attempting to allocate administration, selling or distribution overheads and many activities are not directly related to production volume(e.g. ordering, delivery, transportation, equipment set-up, machining and administration) (Miller and Vollman, 1985).

These require non-volume based cost drivers if costs are to be appropriately traced and provide the motivation for the development of activity based costing (ABC) systems(Horngren, Sandem, Stratton, Burgstahler and Schatzberg, 2008). Direct material and direct labour costs can be easily be traced to jobs and processes, but manufacturing overhead may bear no obvious relationship to individual units of product and assignment of overhead made through a volume-based activity base (or cost driver), attempt to ensure that products which cause large amounts of overheads costs correspond with those which require large amounts of the cost driver (Sizer, 1989).

The allocation of manufacturing overhead (indirect manufacturing costs) to products on the basis of a volume metric such as direct labor hours or production machine hours(Sizer, 1989). As manufacturing becomes more sophisticated the manufacturing overhead costs usually increase while the direct labor hours or production machine hours decrease therefore, the direct labor or machine hours are unlikely to be the root cause of the manufacturing overhead(Hilton, 1994).

There are four stages can be identified in traditional costing system (Anderson, 1995). First is allocating and apportioning the overheads to cost centers, then absorbing them into cost units (Hilton, 1994). The stages explained such as :-

Stage 1 is the various factory overhead costs are allocated or apportioned to the production and service cost centers (Argyris and Kaplan, 1994).

Stages 2 is the cost of the service are re-apportioned to the production centers (Anderson, 1995).

Stage 3 are appropriate departmental overhead absorption rates are calculated (Hilton, 1994).

Stage 4 is the overhead costs are absorbed into cost units by applying the absorption rates to job passing through each centre (Anderson, 1995).

According to several author, stage 1 till 4 explain like this. Stage 1 is Allocation and Apportionment (Hilton, 1994). Those costs which are wholly identifiable with one cost center are allocated to that center (Cooper, 1990). For example, the salary of a machine supervisor can be allocated to the machining department, the wages of a cook to the canteen (Hilton, 1994). There are some overheads however which cannot be charged to just one center, because the benefit of the expenditure is felt by several centers, example rent and rates (cooper, 1990). The total has to be shared or apportioned over the cost centers on some equitable basis (Hilton, 1994). With rent and rates since the charge is a function of area, relative areas covered by the cost centers is a fair basis of apportionment (Cooper, 1990). Other occupancy costs such as light and heat should also be shared by floor space (Hilton, 1994). With depreciation of fixed assets and insurance, book value might be the best basis. The cost of power and electricity should be related to usage (Cooper, 1990).

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Stage 2 is Re-apportionment (Horngren, Sandem, Stratton, Burgstahler and Schatzberg, 2008). Since the beneficiaries of a service of a service department are not actual products but production departments, their costs must be charged to those departments (Smith, 1995). In this there is again more than one method and the chosen one should be that which best reflects the relative benefits derived by the other departments (Horngren, Sandem, Stratton, Burgstahler and Schatzberg, 2008). For example the total cost of operating a canteen could be charged on the basis of number of employees in each department, the cost of stores on the basis of value of materials or number of stores requisitions issued (Smith, 1995). In some question the relative benefits of a service department to other departments is given in percentage, these should then form the basis of re-apportionment (Horngren, Sandem, Stratton, Burgstahler and Schatzberg, 2008). A difficulty arises here since the costs of service department written off to other department may be re-activated by being charged its share of costs of another service department from which it benefits and this charge must now be re-apportionment back to the user departments so doing another service departments whose costs have been written off can be re-activated and so on (Smith, 1995). This process can continue for a long time before it is complete (Horngren, Sandem, Stratton, Burgstahler and Schatzberg, 2008). There are three methods of re-apportionment such as continuous or repeated distribution method, elimination method, and simultaneous equation or reciprocal method (Smith, 1995).

Stage 3 and 4 is Absorption (Anderson, 1995). The amount of overheads charged to each production cost center it only remains for him to establish rates for their recovery through the jobs which pass through them (Miller and Vollman, 1985). In this there is again more than one method in fact there are six (Anderson, 1995).

The problem with this approach is that for most overhead activities, the proportions of the activity actually consumed by a specific product, does not universally correspond with a single cost driver, this holds true for most modern companies where products are produced by a combination of manpower and technology (Ward, 1992). The traditional cost accounting model employs a volume-based driver, such as direct labour hours or machine hours for the assignment of all manufacturing overhead costs (Dyson, 2007). The conventional cost accounting model ends up with a cost of goods sold based on absorption costing and includes only product costs as defined in financial accounting (Ward, 1992). Fundamentally, traditional costing systems try to assign cost directly to products, rather than to activities first and then from the activities to product units (Dyson, 2007).

This type of traditional management accounting system provides two main type of usage to the organization (Hopper, Northcott and Scapens, 2007). First, the analysis and planning process sets out the forecast financial outcome of the proposed business strategies for the planning period and this enables the managers to decide whether this outcome is satisfactory or not, however, if the outcome is not acceptable, the plan can be modified until the best potential result is obtained (Drury, 2004). Also, if the critical success factors have been properly highlighted in the analysis process, the sensitivity analysis on these critical success factors can be applied to the financial plan so that manager can identify the key risks and opportunities which may occur (Hopper, Northcott and Scapens, 2007). This can again enable the plan to be modified prior to implementation, if this is considered to be appropriate, or the business may try to reduce its exposure to any particular key risk by adopting some appropriate hedging strategy (Drury, 2004).

Second, once the plan has been implemented the control process provides a method of comparing actual performance against planned performance (Hopper, Northcott and Scapens, 2007). This comparison enables changes to be made to the plan as necessary in the light of the actual outcomes of the initial strategic decisions (Drury, 2004). These subsequent decision should, as always, be based on the latest information available and this requires that the plan should be updated to take account of material changes since it was formulated, hence many businesses how use a rolling forecast system as the basis against which actual performance is compared (Hopper, Northcott and Scapens, 2007).

## 4.0 ABC (Activity-based Costing)

ABC (Activity-Based Costing) arise in the 1980s from the increasing lack of relevance of traditional cost accounting methods (Weetman,2006). The traditional cost accounting methods were designed around 1870 - 1920 and in those days industry was labor intensive, there was no automation, the product variety was small and the overhead costs in companies were generally very low compared to today, from the 1960s - particularly 1980s - this changed rapidly (Whitehead and Upson, 1982). For these reasons, and more, traditional cost accounting has been called everything from 'number 1 enemy of production' and questions whether it is 'an asset or a liability' have been raised (Innes and Mitchell, 1998).

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ABC has been promoted by Johnson(1988), Kaplan(1988) and Cooper (1988), among others, as a means of improving the quality of management accounting information when traditional methods of allocation overhead costs might be misleading to the users of product cost information (Smith, 1995). Harvard Business School Professor Robert S. Kaplan was an early advocate of the ABC system, while mainly used for private businesses, ABC has recently been used in public forums, such as those that measure government efficiency (Cooper, 1990). ABC recognizes that many significant overheads are related to activities which are independent of volume and identifies those cost drivers which consume resources to determine process and product costs (Innes and Mitchell, 1998).

ABC is an alternative to traditional accounting where business overhead (indirect costs such as lighting, heating, and marketing) provided in the percentage of direct costs of the activities but this is not satisfactory because the two activities that absorb the costs are directly can use very different amounts of overhead (Izhar, 1990). An industrial robot is a large scale, for example, can use the same amount of labor and materials as a robot. But the specific robot uses far more time (overhead) engineers from a mass production company (Johnson and Kaplan, 1987).

ABC is an accounting method that allows businesses to gather data about their operating costs and they are assigned to specific activities such as planning, engineering, or manufacturing and then the activities are associated with different products or services (Jones and Dugdale, 2002). In this way, the ABC method enables a business to decide which products, services, and resources are increasing their profitability, and which are contributing to losses (Johnson and Kaplan, 1987). Managers are then able to generate data to create a better budget and gain a greater overall understanding of the expenses that are required to keep the company running smoothly (Izhar, 1990). Generally, activity-based costing is most effective when used over a long period of time, as opposed to shorter-term solutions such as the theory of constraints (Smith, 1995).

ABC is a method of allocating costs to products and services (Izhar, 1990). It is generally used as a tool for planning and control and it was developed as an approach to address problems associated with traditional cost management systems that tend to have the inability to accurately determine actual production and service costs, or provide useful information for operating decisions (Hopper, Northcott and Scapens, 2007). With these defiencies managers can be exposed to making decisions based on inaccurate data. The higher exposure is for companies with multiple products or services (Innes and Mitchell, 1998).

There are two primary stages in ABC which are first, tracing costs to activities, second, tracing activities to products (Garrison and Noreen, 1997). The different steps in the two stages of ABC are explained such as:-

Step 1 is identifying the main activity in the organization (Whitehead and Upson, 1982). Example include: materials handling, purchasing, receipt, dispatch, maching, assembly and so on (Whitehead and Upson, 1982).

Step 2 is identifying the factors which determine the costs of an activity and these are known as cot drivers (Garrison and Noreen, 1997). Examples include: number of purchase orders, number of order delivered, number of setups and so on (Izhar, 1990).

Step 3 is collecting the costs of each activity (Garrison and Noreen, 1997). These are known as cost pools and are directly equivalent to conventional cost centers (Whitehead and Upson, 1982).

Step 4 are charge support overheads to products on the basis of their usage of the activity, expressed in terms of the chosen cost drivers (Izhar, 1990).

The usage of ABC systems are this is difference that cannot be seen in traditional costing systems (Weetman, 2006). Therefore, a company that is making more and more specific products (and basing the price on historic costings) can soon find themselves making huge losses (Drury, 2004). As new technologies make it easier for firms to customize products, the importance of the indirect costs of providing accurate up, ABC allows managers to attribute costs to activities and products more accurately than traditional cost accounting methods (Weetman, 2006).

The activities responsible for the costs can be identified and passed on to users only when the product or service uses the activity (Drury, 2004). Some of the advantages ABC offers are an improved means of identifying high overhead costs per unit and finding ways to reduce the costs (Cooper, 1990). Introducing activity-based costing is not a simple task, it is by no means as easy as ABC (Weetman, 2006). For a start, all business activities must be broken down into their discrete components (Drury, 2004).

Large firms should try a pilot scheme before implementing the system throughout their organisation (Drury, 2004). The information essential for ABC may not be readily available and may have to be calculated specially for the purpose such as involves making many new measurements (Smith, 1995). Larger companies often hire consultants who are specialists in the area to help them get a system up and running (Weetman, 2006).

The easy approach is to use ABC software in conjunction with a company's existing accounting system (Drury, 2004). The traditional system continues to be used as before, with the ABC structure an extra to be called upon when specific cost information is required to help make a particular decision (Lal and Srivastava, 2009). The development of business accounting software programs has made the introduction of activity-based costing more feasible while setting up an activity-based costing system is a prerequisite for improving business processes and for any re-engineering programme and many firms also use ABC data for the measures required for a balanced scorecard (Hilton, 1994).

Activity-based costing became popular in the early 1980s largely because of growing dissatisfaction with traditional ways of allocating costs, however, it fell into a period of disrepute (Lal and Srivastava, 2009). Even Robert Kaplan, a Harvard Business School professor sometimes credited with being its founding father, has admitted that it stagnated in the 1990s (Cooper, 1990). The difficulty lay in translating the theory into action. Many companies were not prepared to give up their traditional cost-control mechanisms in favour of ABC (Argyris and Kaplan, 1994).

In 2007 Kaplan brought out a new book that tried to make activity-based costing easier that called TDABC (time-driven activity-based costing), it attempted to relate the measurement of cost to time (Argyris and Kaplan, 1994).

## 5.0 DIFFERENCES BETWEEN TRADITIONAL AND ABC SYSTEMS

There is a basic philosophical difference between the traditional and the ABC approaches. Traditionally sees overheads as rending a service to cost units, the cost of which must be charged to those units (Atrill and Laney, 2007). ABC sees overheads as being caused by activities, and so it is the cost units that cause the activities that must be charged with the cost cause (Drury, 2005).

It is not always easy to see how and why some overheads costs have arisen (Atrill and Laney, 2007). This has traditionally made them more difficult to control that direct labour and materials costs, if, however an analysis of overheads can identify the cost drivers, question can be asked about whether the activity driving certain costs is necessary at all, and whether the cost justifies the benefit (Warren, Reeve and Fess, 2005).

Adopting ABC requires that most overheads can be analysed and the cost drivers identified (Drury, 2005). This means that it might be possible to gain much cleaner insights about the overheads costs that are caused, activity by activity, so that fairer and more accurate product costs can be identified, and costs can be controlled more effectively (Warren, Reeve and Fess, 2005).

Under ABC, an overheads cost pool is established for each cost driver in which all of the costs caused by that driver are placed (Atrill and Laney, 2007). All costs associated with this activity would be allocated to that cost pool and the total costs in that pool would then be allocated to output, using the cost driver identified, according to the extent to which each unit of output 'drove' those costs (Warren, Reeve and Fess, 2005).

Allocating overheads costs to cost pools, as is necessary with ABC, contrasts with the traditional approach, where the overheads are normally allocated to production departments (cost centers) (Atrill and Laney, 2007). In both cases, however, the overheads are then charged to cost units (goods or service) (Drury, 2005).

With the traditional approach, overheads are apportioned to product departments (cost centers) (Dyson, 2007). Each department would then derive an overhead recovery rate, typically overheads per direct labour hour (Weetman, 2006). Overheads would then be applied to units of output according to how many direct labour hours were worked on them (Abraham, Glynn, Murphy and Wilkinson, 2008).

With ABC, the overheads are analysed into cost pools, with one cost pool for each cost driver (Drury, 2005). The overheads are then charged to units of output, through activity cost driver rates, and these rates are an attempt to represent the extent to which each particular cost unit is believed to cause the particular part of the overheads (Abraham, Glynn, Murphy and Wilkinson, 2008).