Activity-Based Costing vs. Traditional Method

This assignment delves into the comparison between activity-based costing (ABC) and the conventional method of cost allocation. It presents a scenario involving two products, FRED and MARTHA, calculating their costs using both methods. The analysis reveals that the traditional approach can lead to mispricing due to its simplified allocation based on a single overhead rate. Conversely, ABC provides a more accurate representation of costs by considering the consumption of resources by specific activities.

Solution – b:
Calculation of Selling Price under Activity Based Costing
Particulars FRED MARTHA
Cost per unit (WN-1) 500 180
Add: Profit Margin (20% of
manufacturing cost) 100 36
Selling Price 600 216
WN-1: Calculation of cost per unit under activity based costing
(i) 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
(ii) Activity required by FRED and MARTHA
Overheads Cost driver
Budget
ed
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
(iii) 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

Solution- c
Conventional method or traditional approach refers to the allocation of manufacturing
overhead using a single rate known as blanket rate. This rate is calculated by dividing the
total manufacturing overhead with a common base. This method is simple to use but has
cons that its results are quite misleading due to allocation of cost using a blanket rate and
not considering the actual resources consumed by the products. As calculated in the
working note, the product cost as per traditional approach for FRED is coming to $ 166 and
for MARTHA at $249.
On the other hand, activity based costing is a scientific method for cost allocation as it
considers the consumption of resources by different activities and then costs are allocated
on the basis of this consumption of resources. Thus, this method is considered as accurate
and reliable method for cost allocation. The cost under this method is calculated by
allocating the activities on the basis of resources consumed to various products
manufactured or using those activities. Then, the cost per activity and cost per resources
are computed and allocated to the products.
Comparing the costs of products in the above scenario, the product cost under activity
based costing is $500 for FRED and $180 for MARTHA whereas the cost under traditional
method is $166 for FRED and $249 for MARTHA. So, to draw conclusion the product FRED is
under costed by $334 per unit and MARTHA is over costed $69. Hence, we can say that
conventional approach leads to mispricing of product.
WN-1 Calculation of cost under conventional approach:
(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
(i) Calculation of predetermined overhead rate:
Total Budgeted Manufacturing
Overhead = $816,000
Predetermined Overhead Rate =
Budgeted Manufacturing Overhead/Direct Labour
Hours
Predetermined Overhead Rate (per
hour) = $48 (816,000/17,000)
(ii) Calculation of Direct Labour Hours
FRED = 2,000 hours (1000*2)
MARTHA = 15,000 hours (5000*3)

Total hours = 17,000 hours