Activity Based Costing: Overcoming Deficiencies of Traditional Costing System

The report explores the deficiencies of traditional costing system and how Activity Based Costing overcomes them. It compares the advantages and disadvantages of both methods and concludes that modern costing is more accurate and practical. The report includes examples and calculations to support the findings.

ACCOUNTING AND FINANCE- Management Accounting
Executive Summary
The report seeks to explore that traditional method of allocation of cost over products and services are
outdated and no longer serve the needs in the fast changing world. Further, the report highlights how
Activity Based Costing overcomes those deficiencies.
1

Contents
Executive Summary...............................................................................................................................1
Table of Content....................................................................................................................................2
Introduction...........................................................................................................................................3
History...................................................................................................................................................3
Traditional Costing System- Cost Allocation..........................................................................................3
Advantages........................................................................................................................................4
Disadvantages....................................................................................................................................4
Allocation of Cost under Modern Costing System.................................................................................4
Advantages........................................................................................................................................4
Disadvantages....................................................................................................................................4
Traditional Cost System Vs Modern Costing System.............................................................................4
Conclusion.............................................................................................................................................7
References.............................................................................................................................................7
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Introduction
The term costing shall be defined as allocation of cost to objects based on parameters which vary from
enterprise to enterprise. The term has its origination back dated 20th Century where in traditional
costing was coined on account of surging demand for allocation of cost based on parameter like
labour hour, material cost. The method held its importance till end of 20th Century where in need was
felt for greater accuracy on account of technological updation and need for true cost computation was
felt.
Further, with the changing market scenario, the market became competitive and driven by consumers.
Thus, changing price of product became difficult and the only way to earn profit was estimating the
true cost of product and minimising the same. The surge for ascertaining the true cost of production
gave birth to modern costing which is popularly known as Activity based costing. (Gowthorpe, 2011)
Further, in today world the most common traditional costing method is absorption costing where in
the indirect cost of production are absorbed over different products.
Traditional Costing System- Cost Allocation
Traditional Costing System is slowly losing out its relevance in today’s market on advent of change in
technology and need for greater accuracy. The traditional costing system allocates cost of products
on the basis of direct and indirect cost wherein the direct cost is allocated based on true marching
where in the cost incurred for that is truely matched with that product. However, indirect cost are
allocated based on arbitrary manner on the basis of parameters like labour, wage rate etc. (Davies,
2002)
Generally, under this method the allocation of indirect cost is not properly matched with the product
displaying incorrect result and profits. Further, the rate of allocation is determined based on an
Overhead Allocation rate which is computed in the following manner:
OAR= Total Indirect Manufacturing Cost/ Cost Allocation Base.
Advantages
The advantage are that it is in legal requirement of GAAP and User friendly and widely known along
with easy to use
Disadvantages
The main disadvantage are unbalanced inventory as stock shall be counted as asset, Revenue report
shall be inaccurate and Poor management and forecasting shall be inaccurate.
Allocation of Cost under Modern Costing System
Under the modern system of costing, the deficiencies identified under traditional system of costing
where overcome by means of allocation of indirect cost of production over different products through
identifying different drivers of that cost and thus identifying the true cost of product and its true
profitability. (Dyson, 2004)
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Under this mechanism, the focus is on processes rather than product, thus the main criteria under
activity based costing is that “Products consume activities and activities consume resources:.
Thus, the entire concept of modern costing relies on how efficient different drivers of cost are
identified and how these drivers help in allocating the indirect cost of production of goods over
different products and services.
Advantages
The advantages are better matches revenue with cost, proper management and forecasting shall be
accurate, better strategic decision making.
Disadvantages
The main disadvantages are not suitable for smaller companies, Complex mechanism, too many
driver may distort results. Further, the results shall vary when different drivers are used and ABC
costing is a costly affair. (Higson, 2003)
Traditional Cost System Vs Modern Costing System
Traditional Costing
Sl
No Products Compared Product A Product B Total
1 Unit Produced and Sold 800000 2000000 2800000
2 Selling Price per Unit 3.5 2.5
3 Direct Labour Cost/unit 0.5 0.5
4 Direct Materials Cost/ Unit 0.75 0.75
5 Sales Revenue(=1*2) 2800000 5000000 7800000
Direct Cost
6 Direct Labour Cost(=1*3) 400000 1000000 1400000
7 Direct Materials Cost (=1*4) 600000 1050000 1650000
8 Total Direct Costs (=6+7) 1000000 2050000 3050000
Traditional Costing : Finding Indirect or Overheads Cost
Sl
No Indirect Components Prod A & B indirect % of Total Indirect
1 Materials Purchasing 182500 12.8%
2 Machine Setups 373000 26.2%
3 Product Packaging 280000 19.7%
4 Machine testing and calibration 300000 21.1%
5 Machine Maintenance and Cleaning 287000 20.2%
Total indirect 1422500 100.0%
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Allocation of Cost on the basis of Direct Labor Costs
Sl No Particulars Brief
1 Total Indirect Cost 1422500
2 Total Labour Cost Rate 1400000
3 OAR 101.61%
4 Product A- Direct Labor Cost 400000
5 Proportion of indirect Cost 406428.5714
6 Product B- Direct Labor Cost 1000000
7 Proportion of indirect Cost 1016071.429
Sl No Products Compared Product A Product B Total
9 Unit Produces and Sold 800000 2000000
280000
0
10 Total Direct Cost 1000000 2050000
305000
0
11 Total indirect Cost 406428.5714 1016071.429
142250
0
12 Revenue per Unit 3.5 2.5
13 Direct Cost (=10./9) 1.25 1.025
14 Indirect Cost (=11/9) 0.51 0.51
15 Gross Profit 1.74 0.97
16 Gross Profit Margin (=15/12) 49.77% 38.68%
Thus, on the basis of above, one can draw the inference that Product A is more profitable based on
allocation of cost both direct and indirect. However, in the present case indirect cost plays a pivotal
role. Further, the indirect cost of production has been allocated in the above example on the basis of
direct labour costs.
ABC Costing
Sl No Products Compared Product A Product B Total
1 Unit Produced and Sold 800000 2000000 2800000
2 Selling Price per Unit 3.5 2.5
3 Direct Labour Cost/unit 0.5 0.5
4 Direct Materials Cost/ Unit 0.75 0.75
5 Sales Revenue(=1*2) 2800000 5000000 7800000
Direct Cost
6 Direct Labour Cost(=1*3) 400000 1000000 1400000
7 Direct Materials Cost (=1*4) 600000 1050000 1650000
8 Total Direct Costs (=6+7) 1000000 2050000 3050000
5

Sl
No Activity Pool Cost Driver (CD)
Activity Units
CD Unit
Cost
Total
Actvit
y
Prod
uct A
Total
indir
ect
Cost
A
Total
Actvit
y
Prod
uct B
Total
indir
ect
Cost
B
1 Purchase Orders No of Purchase Orders 1800 75
1350
00 25
4500
0
2 Machine Setups No of Set ups 1500 150
2250
00 100
1500
00
3 Product Packaging
No of product
packages packed 0.2
9000
00
1800
00
5000
00
1000
00
4
Machine Test and
Calibration No of tests 100 1000
1000
00 2000
2000
00
5
Maintenance and
Cleaning No of Batch runs 1150 200
2300
00 50
5750
0
Total
8700
00
5525
00
Sl No Products Compared Product A Product B Total
9 Unit Produces and Sold 800000 2000000
280000
0
10 Total Direct Cost 1000000 2050000
305000
0
11 Total indirect Cost 870000 552500
142250
0
12 Revenue per Unit 3 2
13 Direct Cost (=10./9) 1.25 1.025
14 Indirect Cost (=11/9) 1.09 0.28
15 Gross Profit 0.66 0.70
16 Gross Profit Margin (=15/12) 22.08% 34.94%
Thus on the basis of above, it can be seen that Product B stands more profitable than Product A when
cost are allocated in a much more rational and practical manner.
Conclusion
Finally it can be concluded that the modern system of accounting is deals with things more sensibly
and realistically and more practical in approach rather than theoretical in consideration and present a
more accurate and proper picture when compared to traditional method of costing and on such
decision the true view regarding product A is more profitable stands reversed.Thus the traditional
method of costing gives us a misleading or false information and modern system of costing gives us a
clear and accurate picture by apportionment of all indirect cost on the basis of various driver rather
than single rate.
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Bibliography
Davies, T. &. P. B., 2002. Business Accounting and Finance. s.l.:McGraw-Hill .
Dyson, J. R., 2004. Accounting for Non-Accounting Students Pitman. s.l.:s.n.
Gowthorpe, 2011. Business Accounting & Finance. 3rd ed. Cengage: s.n.
Higson, A., 2003. Corporate Financial Reporting: Theory & Practice.. s.l.:Sage.
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