Comparative Evaluation of Traditional and Activity-Based Costing System

This study focuses on the comparative evaluation of traditional and activity-based costing system. It discusses the benefits, limitations, and cost of applying activity-based costing. The study also recommends the adoption of activity-based costing for better understanding of product cost and accurate decision making.

BUACC 2613
Semester 2, 2018
Group Assignment

TABLE OF CONTENTS
Part A...............................................................................................................................................3
Part B...............................................................................................................................................4
Part C...............................................................................................................................................4
Part D...............................................................................................................................................4
Benefits........................................................................................................................................4
Limitations...................................................................................................................................5
Cost..............................................................................................................................................6
References........................................................................................................................................7

LIST OF TABLES
Table 1: Statement showing computation of profitability is done as be activity based costing
system..............................................................................................................................................4

INTRODUCTION
Cost accounting is considered to be the significant part of any business. It is considered by the
managerial authorities of the business as an accounting strategy which deals with ascertaining
the cost of the product to make various decisions related to the sale of products in the market.
There are various methods that can be used for the allocation of the overhead to the product
(Shields, 2015). Moreover, determination of the method for allocation of the overhead depends
on the circumstances of the business. It is a very typical task to ascertain the method of costing
adopted in the organization. Activity based costing is a costing method of that identifies the
connection between overhead activities, costs and manufactured products, and with the help of
this connection, it assigns the indirect costs to products less randomly as compare to traditional
methods. Apart from this accountant should also follow all the rules, regulations, principles
which are prescribed under the code of ethics standard and the decision of the accountant should
not be influenced by any other person. By considering these factors the present study focus on
the comparative evaluation traditional system of costing and the activity based system of the
costing.
PART A
For the given case scenario computation of profitability is done as be activity based costing
system:
According to CIMA (Chartered Institute of Management Accounting) Activity Based Costing is
a method of costing and monitoring of activities in which it involves tracing resource
consumption and costing of final outputs. In this, resources are allocated to activities and
activities to cost objects that are based on consumption estimation (Ax, & Greve, 2017).
Table 1: Statement showing computation of profitability is done as be activity based costing
system
Particulars Monarch Regal Total
Revenues 19800000.00 4560000.00 24360000.00

(-) Cost of Goods Sold 11322100.00 4459900.00 15782000.00
Gross Margin 8477900.00 100100.00 8578000.00
(-) Selling and Administrative Exp. 5830000.00 978000.00 6808000.00
Operating Profit 2647900.00 -877900.00 1770000.00
Units Produced and Sold 22000.00 4000.00
Net Income/ unit sold 120.36 -219.48
Working note 1
Particulars Monarch Regal
Output 22000 4000
Direct Materials 4576000 2336000
Direct Manufacturing Labour 396000 192000
Machine Cost 3168000 288000
Manufacturing Overhead (Working Note 2) 3160100 1639900
Cost of Goods Sold 11322100 4459900
Working note 2
Computation of Manufacturing Overhead of the Products
Particulars Cost Centre Monarch Regal Total
Soldering Number of solder points 711000 231000 942000
Shipments Number of Shipments 696600 163400 860000

Quality Control Number of Inspection 899200 340800 1240000
Purchase Order Number of Orders 400500 549900 950400
Machine Power Machine Hours 52800 4800 57600
Machine set-ups Number of set-ups 400000 350000 750000
Total 3160100 1639900
PART B
From the above calculation, it has been seen that there is a significant difference between the
amounts of profit as given in the case study and as calculated profit as per activity-based costing.
It is due to the difference in the method of costing; since in the case study allocation of the
overhead is based on the traditional method of costing while the above calculation is based on
the activity-based costing (Plank, 2018).
Further, the activity-based costing differs from the traditional method of costing, which assign
the cost using the predetermined allocation rate for the allocation of the overhead. As a result,
activity-based costing measured the cost of goods sold and the gross margin of the product very
differently. Moreover, if the manager wants to know the exact profitability and ascertain the
selling price of the product, then traditional costing methods may create the problem because this
method does not take into account all the factors which affect the cost of the product.
Essendon Electronics apply the existing costing system for the allocation of the overhead which
is based on the volume of production resources consumed. Normally in this system overhead is
allocated on the basis direct labour hours or the machine hours. Therefore a small change in the
volume leads to a major change in the amount of overhead applied. On the other hand under the
activity-based costing allocation of the overhead is based on the activities of that product.
Therefore adoption of different costing method leads to a difference in the amount of profit of
the product (Ax, & Greve, 2017). Traditional costing system uses the single overhead rate for

allocation of the overhead, while in activity-based costing cost is assigned to the product
according to their activities.
PART C
The profit is calculated by applying the activity-based costing for allocation of the overhead
which leads to a decrease in profit as compared to the traditional costing method, therefore the
manager does not want to apply the activity-based costing system and comment to the accountant
that there are various activities apart from those applied and if all the activities included then
result will be different. Moreover, the bonus of the manager was also based on the revenue of the
product. Therefore this method of costing will adversely affect the bonus of the manager.
The comment of the manager was not correct, although it is very simple to allocate the cost
according to the existing method, the result is not accurate as compare to the activity-based
costing. In the activity-based costing all the activities associated with the product is ascertained
and after that cost is allocated to the product. This method takes various important factors before
assigning the cost to the product (Kihn, & Ihantola, 2015). Therefore it is recommended to
implement the activity-based costing method in the organization so that allocation of the cost can
be in a precise manner which leads to better understanding about the product and accurate
decision by the manager. Further Activity-based costing enables improved product and customer
profitability analysis and also supports performance management techniques (Bromwich, &
Scapens, 2016). Although the cost of implementation of the activity-based costing is more viable
than the traditional system of costing. However activity-based costing is also useful for the
internal use as decision maker is able to observe the all relative expenses and can keep the
record. Therefore wasteful spending can be found. Further, in the case of high overhead, this
method leads to understanding the all indirect cost and activities associated with the product
(Van der Stede, (2015).
The company should move towards the activity-based costing method so that the cost of the
product can be measured more accurately. The opinion of the managers is not good, and it is
possible that manager is commented this, as the bonus of the manager is depended on the
revenue of the product and due to the activity-based costing the profitability of the product
decreased; therefore the manager did not want to apply this costing method.

The traditional method of costing also leads in overvaluation and undervaluation of the overhead,
because this method uses the predetermined rate for the allocation, which is decided already and
on the basis of this rate overhead is allocated on the product. Therefore the difference arises.
Further in the activity-based costing method uses more detailed analysis with respect to the
overhead cost and the cost driver so that it is better to adopt the activity-based costing system in
the organization (Kokubu, & Kitada, 2015).
Apart from the above, it is given in the study, the accountant of the company feels the pressure
from the manager to change in the method of costing, although accountant adopted the best
method for the allocation of the overhead. On the basis of the rules prescribed under the code of
ethics standard, it is the duty of accountant to work in the public interest, if the decision of the
accountant has been influenced by the manager, then accountant should safeguard his interest
and take the necessary action to remove them or to minimize them and if it is not possible then
an accountant should resign from the work.
PART D
Benefits
There are multiple benefits of applying Activity-Based Costing; it comes with accuracy and
relevancy in terms of the determination of product cost through considering on the relationship
of cause and effect in the occurrence of cost, thereby providing highly realistic product cost.
Along with this, it generates correct and dependent product cost if there is the context of higher
diversity mid the manufactured products. While it also identifies the actual cost behaviour nature
and assist in making a reduction in costs and determining activities which are not relevant and
valuable to the product value. In addition, the ABC makes use of various cost key drivers,
wherein most are based on transactions instead of volume of product (Oseifuah, 2018).
Moreover, ABC gives consideration towards each and every activity all over the factory in order
to track more overheads as possible to the products which are very advantageous. The most
significant advantage of applying ABC costing is that the rate of overhead is gauged on the basis
of all pooled activities, regardless of making use of the overall factory, this enables for the
overhead rates to be identified with higher preciseness and application of overhead to incur on
particular actions. On the other hand, the ABC system enables business owners to eliminate the

costs that can affect decision making or are irrelevant. ABC system benefits from tracking
overhead costs and traces costs to management responsibility, procedures, and consumers away
from the cost of products. It also allows better decision making for managerial pursuits, which
are useful in setting product price. ABC offers cost key drivers rate as well as information in the
volume of the transaction which is beneficial in managing the cost management and
responsibility of performance appraisal (Arjmand, Shah, Edward Reece MD, Hollier Jr, Faryan
Jalalabadi BBA, Hoxworth & Milewicz, 2018). Additionally, the rate of cost drivers can be
highly advantageous for the new product design as they are capable of indicating overhead costs
that are expected to be implied in the product costing.
Limitations
Activity-based costing has various cost pools and numerous cost drivers, and thus it can create
much of complexity and is evidenced to be costly to be maintained and managed. The integrated
accuracy of the ABC system is only applicable in a situation where the business owner is likely
to manage the time for analysing the manufacturing procedures with adequate details to identify
the manner by which there is the occurrence of overhead costs (Al-Sayed & Dugdale, 2016).
Because of this among of complexity, most of the small business does not provide preference to
this method and consider it as less worthy. There is another limitation that, the managerial
authorities which are willing to apply this method require an intense amount of experience in the
same field.
There is also a limitation in that it requires a vast amount and application of information
technology; it is not possible to perfectly apply ABC system in the absence of information
technology (Woodruff, 2018). It necessities a higher amount of data to be collected, clarified and
converted into real-time information, with the critical analyses of the same to find out rationales
of the applications of specified decisions (Lavia López, & Hiebl, 2014). Generally, most of the
small firms do not consider the benefits of the ABC system to be more important than the costs.
Certain complexities take place while the ABC system is being adopted as the selection of the
key costs drivers, allocation of the general costs and differing rates of costs drivers.
Some of the limitations are inclusive of difficulty identifying the entire activities that create an
impact on costs. Unease selection of the best suitable costs drivers, complexity in evaluating the
cost based on activities and non-reliability for the concerns of small manufacturers.

Cost
The major cost and drawback of the application of activity-based costing are stated as the
measurements which are required to adopt it. It is considered that the ABC system highly
demands management to predict and calculate the activity pools cost while to determine and
estimate the key cost drivers to deliver on the basis of cost allocation. In the case of fundamental
ABC system also, there is a need for major calculations to identify the actual costs of related
products or services (Van der Stede, 2016). It is proved that the whole process of measurement
and application of ABC system are expensive also its limits in regular updating of the rate of
activity costs (Schmidt, 2018). Furthermore, the ABC systems are not able to eradicate the
traditional costing system, due to the design, implement and maintenance which is highly cost
incremental as compared to the traditional system of the company. However, this makes the
application of the ABC system more costly, specifically for the small-size business. However,
contradictory and vague estimates of costs can create problem while the management urge to
consider precisely whether the products are profitable or are incurring losses.
CONCLUSION
On the basis of the above study, it has been concluded that in the traditional method of costing
the allocation is based on the single overhead rate, which is generally calculated by the direct
labour hours or the machine hours. On the other hand, activity-based costing uses the cost driver
for allocation of the overhead as per the activity associated with the product. Moreover, different
costing method results in different cost and profit analysis of the product. In the present study,
the company should implement the activity-based costing system in the organization, which
leads to more accurate and precise result so that management can take the right decisions. Along
with this accountant should follow the basic principles which are prescribed under the code of
ethics standard, so that the public can get informed about the true picture of the company.

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