Activity Based Costing vs Conventional Method

This assignment examines the differences between activity-based costing (ABC) and the conventional method of allocating manufacturing overhead costs. It analyzes how each method impacts product pricing for two products, FRED and MARTHA, highlighting the inaccuracies that can arise from using a conventional approach. The assignment further discusses the advantages and disadvantages of ABC, emphasizing its benefits in providing accurate cost allocation, identifying wasteful activities, and enabling better decision-making through informed pricing strategies.

Solution:
(a) Calculation of cost per unit of products using the conventional approach
Particulars Fred Martha
Direct Material 40 60
Direct Labour 30 45
Manufacturing overhead 96 144
Cost per unit 166 249
1. Calculation of predetermined overhead rate:
Total Budgeted Manufacturing
Overhead = $816,000
Allocation basis = Direct Labour Hours
Predetermined Overhead Rate =
Budgeted Manufacturing Overhead/Direct Labour
Hours
Predetermined Overhead Rate (per
hour) =
$816,000/17,00
0
Predetermined Overhead Rate (per
hour) = $48
2. Calculation of Direct Labour Hours
FRED = (1000*2) = 2,000 hours
MARTHA = (5000*3) = 15,000 hours
Total hours = 17,000 hours
(b) Calculation of cost per activity using Activity Based Costing
Overheads Cost driver
Budgete
d Level
Overhead
Amount
Cost per
activity
Machine related
costs Machine hours 9,000 450,000 50
Setup and
inspection
Number of production
runs 40 180,000 4,500
Engineering
Engineering change
order 100 90,000 900
Plant related costs
Square footage of
space 1,920 96,000 50

816,000 5,500
(c) Calculation of cost per unit of products using the Activity Based Costing
Particulars
Fred Martha
Units Rate per
unit Total Units Rate per
unit Total
Direct Material 1,000 40 40,000 5,000 60 300,000
Direct Labour 1,000 30 30,000 5,000 45 225,000
Manufacturing
overhead
Machine related costs 4,000 50 200,000 5,000 50 250,000
Setup and inspection 20 4,500 90,000 20 4,500 90,000
Engineering 75 900 67,500 25 900 22,500
Plant related costs 1,536 50 76,800 384 50 19,200
Total Costs 504,300 906,700
No. of Units 1,000 5,000
Cost per unit 504.30 181.34
Cost per unit (rounded
off) 500.00 180.00
WN-1: Calculation of activity required by products
Overheads Cost driver Budgete
d Level
Overhead
Amount
Cost
per
activity
Activity Required
FRED MARTHA
Machine related
costs Machine hours 9,000 450,000 50 4,000 5,000
Setup and
inspection
Number of production
runs 40 180,000 4,500 20 20
Engineering
Engineering change
order 100 90,000 900 75 25
Plant related
costs
Square footage of
space 1,920 96,000 50 1,536 384
816,000 5,500 5,631 5,429
(d) Calculation of Selling Price under Activity Based Costing
Particulars FRED MARTHA
Cost per unit 500 180

Add: Profit Margin (20% of
manufacturing costs) 100 36
Selling Price 600 216
(e) The prices of the products under conventional method are $ 166 for FRED and $249 for
MARTHA whereas the prices of products under activity based costing are $500 for
FRED and $180 for MARTHA. Thus, we can see that under conventional approach the
FRED was under costed by $334 per unit and MARTHA was over costed $69. This is
because, the conventional approach has allocated the manufacturing overhead using
direct labours hours and not considering whether the product has actually consumed
the resources or not. Since product MARTHA uses 3 direct labour hours and product
FRED uses 2 direct labour hours, the burden of manufacturing overhead is more on
product MARTHA rather than on product FRED and hence, the cost per unit of product
MARTHA is higher than product FRED.
On the other hand, the activity based costing has allocated the manufacturing overhead
on the basis of actual resources consumed. In this method, the different costs are
identified and then the relevant cost drivers are allocated to the costs. Then these costs
are allocated on the basis of actual level of activities consumed by both the products.
For example, the plant related costs is allocated on the basis of Square foot of space.
The product FRED has used 1536 sq. ft of space whereas the product MARTHA has
used only 384 sq. ft. of space. Hence, the cost of 96,000 has been allocated in the ratio
of 1536:384.
From the above, it is clear that the conventional method is not a realistic method and
hence allocates the overhead on a wrong basis, which in turns gives the wrong cost and
hence, gives the wrong selling price.
(f) The following are the benefits of using activity based costing:
a. Activity based costing provides the accurate results i.e. cost pf products as it is
based on actual consumption of resources rather than allocating the costs on a
blanket rate.
b. Activity based costing is based upon deep analysis of different costs and their
behaviors. Hence, one should know about the non value added activities and can
eliminate them to reduce the costs.

c. As it involves the analysis of data, thus it helps in finding out the long or wasteful
processes and thus reduces the costs.
d. Activity based costing by pooling the various costs with their cost drivers helps in
identifying the wasteful activities and then it allocates the costs according to
consumption by products. Thus, the management can plan the utilization of
resources appropriately after knowing these activities.
e. Reduction in costs make the product prices competitive and thus the management
can make appropriate pricing strategies.
(g) The following are the disadvantages of using activity based costing:
a. Activity based costing is an expensive costing method which involves high
implementation costs.
b. The input data required for implementation of this method, is of very high
importance. Thus, accuracy of input data is of greater priority and importance.
c. It involves collecting, verifying and examining the input data, hence it is a time
consuming and a lengthy process.
d. Due to higher implementation and collection costs, this method is not useful for
smaller enterprises.