This report analyses the profitability of Essendon Electronics under traditional and ABC methods. It discusses the rationale for change in profitability, response to comments, benefits, costs and limitations of using ABC. The report is a BUACC 2613 Group Assignment for Semester 2, 2018.
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BUACC 2613 SEMESTER 2, 2018 GROUP ASSIGNMENT REPORT ON PROITABILITY OF ESSEDON ELECTRONICS
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TABLE OF CONTENT Executive Summary...............................................................................................................................2 INTRODUCTION...................................................................................................................................3 Profitability under Traditional Method....................................................................................................4 Profitability under ABC Method..............................................................................................................4 Rationale for change in profitability........................................................................................................7 Benefit, Cost and Limitation of using ABC.............................................................................................8 Advantages of Activity Based Costing................................................................................................8 Disadvantages of Activity Based Costing...........................................................................................9 References:.........................................................................................................................................10
Executive Summary The report seeks to examine the difference in overhead cost allocation on account of change in method of overhead allocation. The report examines difference in cost allocation over two products via traditional method and ABC analysis. Further, the impact of such action on the profitability of two products have been analysed. Thus, in short the report deals with the following: (a)Analysis of the profitability of the products under traditional method; (b)Analysis of the profitability of the products under ABC method; (c)Rationale for change in profitability; (d)Response to comments of Mr. Lockett’’s; (e)Recommendation for using ABC: (f)Benefit, cost and limitation of adopting ABC.
INTRODUCTION Essendon Electronics is engaged in manufacture of electric products. The company manufactures range of product including LCD screens. The name of these LCD screens is Regal and Monarch. The selling price of these screens is 1140 dollar and 900 dollar. Further, ithas been stated that Regal is the newer version and company managers are contemplating the expansion of Regal and gradually phasing out the manufacturing of Monarch which is an older version. Essendon Electronics has long been following traditional method of accounting for the purpose of computation of cost of product. On the basis of the existing accounting method, company is forecasting higher profits on sale of Regal Model and is looking for a promising future in this product. Beforecarryingouttheabovevisionandtobeinalignmentinwiththechangingbusiness environment an Activity Based Costing of the overheads of the company shall be carried out. Accordingly, the report deals with the same. Profitability under Traditional Method Essendon Electronics presently follow traditional method of accounting for computation of cost of its two famous products namely Regal and Monarch. The cost incurred and the profit earned from the sales have been projected below for the two products on the basis of details provided: Profit Budget under Traditional System Sl NoParticularsMonarchRegal 1Direct Material208584 2Direct Manufacturing Labour1842 3Machine Cost14472 4Manufacturing Overhead200.00100.00 5Selling and Administrative Expense265.00244.50 5Total Cost835.001042.50 6Sales Price9001140 7Profit per unit65.0097.50 8Profit Percentage on cost7.78%9.35% 9Quantity sold220004000 10Total Profit1430000390000 On perusal of the above table, one can understand that both the products are profitable and the margin under each stands at $ 65 and $97.5 for Monarch and Regal respectively. Further, it may be seen that manufacturing overhead cost has been allocated on the basis of Machine hours under traditional method and stands at $ 200 and $100 for Monarch and Regal respectively. The machine hours incurred on production of Monarch and Regal stands at 8 hours and 4 hours. Accordingly, the rate of $25 has been charged per hour to each product and the profit has been derived at $14,30,000 and $3,90,000 respectively for Monarch and Regal.
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Profitability under ABC Method Essendon Electronics presently follow traditional method of accounting for computation of cost of its two famous products namely Regal and Monarch and the same has been followed over 20 years. Further, the company is wishing to analyse cost of Regal and Monarch on the basis of ABC Method and accordingly cost drivers have been determined with respect to different activity involved under manufacturing overheads. The cost incurred and the profit earned from the sales have been projected below for the two products on the basis of details provided: Profit Budget under ABC Sl NoParticularsMonarchRegal 1Direct Material208584 2Direct Manufacturing Labour1842 3Machine Cost14472 4Manufacturing Overhead on basis of ABC143.64409.98 5Selling and Administrative Expense265.00244.50 5Total Cost778.641352.48 6Sales Price9001140 7Profit per unit121.36-212.48 8Profit Percentage on cost15.59%-15.71% 9Quantity sold220004000 10Total Profit2669900-849900 On perusal of the above table, one can understand that only one product is profitable and the margin under each stands at $ 121.36 and $-212.48 for Monarch and Regal respectively. Further, it may be seen that manufacturing overhead cost has been allocated on the basis of cost drivers under Activity Based Costing method and stands at $ 143.64 and $409.98 for Monarch and Regal respectively. Further, the profit has been derived at $26,69,900 and $-8,49,900respectively for Monarch and Regal. Further, the driver for each activity under the manufacturing overheads have been analysed here- in – below:
Sl NoActivity Centre TotalActivity Cost Monarc hRegalTotal Costallocated to Monarch Costallocatedto Regal 1Soldering- No of Solder Points942000 118500 03850001570000711000231000 2Shipments-Number of shipment batches86000016200380020000696600163400 3Quality Control- Number of Inspections1240000562002130077500899200340800 4Purchase Orders-Number of order batches95040080100109980190080400500549900 5Machine Power-Machine Hours5760017600016000192000528004800 6 MachineSetups-NumberofSet-ups batches750000160001400030000400000350000 7Total480000031601001639900 8Unit produced and sold220004000 9Per Unit Cost Allocated (7/8)143.64409.98 On perusal of the above table, one may see that cost has been allocated to products based on activity and cost driver rather than basis the same on simply machine hours. The activity involved has been segregated and the respective amount incurred for such activity has been determined. Post that the cost of these activities has been allocated on products based on cost drivers associated with each activity. Thus giving a more clear and accurate picture for ascertaining the cost of overheads allocable to each product. The same stands at $ 143.64 and $409.98, thereby creating a huge difference between the traditional model and ABC model cost allocation of overhead.
Rationale for change in profitability Essendon Electronics overall profit under the two method remained consistent and stood at $ 1.82 Million. Further, going for an in-depth analysis it has been observed that under the first method i.e. traditional method both products are profitable while under the second method i.e, ABC only Monarch is profitable on account of change in allocation of overhead manufacturing cost. Under Traditional Method, manufacturing overheads have been allocated on the basis of machine hours and on account if which greater cost has been allocated towards Monarch which consume greater proportion of Machine hours compared to Regal and accordingly the cost allotted stands at 200 and 100 based on rate 25$ per machine hour for Monarch and Regal respectively. Under ABC analysis, cost are not allocated on the basis of one parameter rather the same is allocated base on stream of activities under which such cost can be attributed. Post attribution of such cost, cost drivers of each activity is ascertained and cost is allocated over the product based on such cost driver. Thus, giving a microscopic view of the cost incurred over each activity for both products. Accordingly, the total manufacturing overheads is allocated over two products and the cost per product allocates stands at $ 143.64 and $ 409.98 respectively for Monarch and Regal respectively. The difference sheet has been provided here-in- below: Sl. NoParticularsMonarchRegal 1Traditional Method200.00100.00 2Activity Based Costing Method143.64409.98 3Difference (1-2)56.36-309.98 Thus, overhead cost allocated has reduced by $ 56.36 for Monarch and has increased by dollar 309.98 for Regal, thereby resulting in losses on the Regal sale as the cost of such product has increased sales. Thus, in short the change in profitability over two products is mainly on the basis of change in cost allocated under the head manufacturing overheads. Response to comments of Mr. Lockett’s As Mr. Lockett has provided his views of using different cost driver and commented that the present ABC shall result in phasing out the product. In this regard, one should not just phase out the product on the basis of total cost rather a variable cost analysis needs to be considered before phasing out a product from manufacturing line. In this regard, variable cost analysis has been presented here-in- below: Contribution Budget Sl NoParticularsMonarchRegal 1Direct Material208584 2Direct Manufacturing Labour1842 3Machine Cost14472 5Total Cost370.00698.00 6Sales Price9001140 7Contribution per unit530.00442.00
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Further, the comment of Monarch being loss making under Traditional Method does not hold good.In regard to change in cost driver can impact the allocation analysis.Every Costing system has its own limitations and advantages but in case of Activity Based Costing each and every cost driver is allocatedand every costs is recognised to arrive at the final figure of the product so we can say that ABC costing system is a better tool compared to traditional costing system.In a traditional system on the basis of single parameter cost is allocated butin case of ABC stream of parameter is considered for allocation of cost so it presents a better and microscopic view of allocation of cost.Further with respect of bonus to division manager shall not be basis for decision making process. Benefit, Cost and Limitation of using ABC ABC stands for Activity Based Costing.It is a method of accounting used to identify and allocate the cost of overhead activities to cost of individual products based on particular driver of that cost. Further, it recognises the relationship among cost, overhead activities and manufactured products and via these relation assign indirect cost incurred for manufacturing of product to individual product, (MyAccountingCourse.com, 2018)department, segment etc. Further, the cost assigned are less arbitrarily than traditional methods. The advantage and disadvantage of Activity Based Costing has been highlighted here-in-below: Advantages of Activity Based Costing (a)Activity Based costing helps in ascertaining accurate cost of product reliably by focussing on cause and effect relationship on the basis of incurrence. Under this method, it is realised that it is the activity which is responsible for incurring cost and not the products and product consume activities.Further,ActivityBasedCostingaremoreusefulinadvancedmanufacturing environment and technology where the overheads forms large chunk of total cost. Further, it ensures accurate and reliable cost of product data in case wide range of products are manufactured encompassing low and high volume product. Further, traditional costing system is prone to error and in accurate result under such environment.(eFinanceManagement.com, 2018) (b)Activity Based Costing helps in ascertaining the information about the cost behaviour and understands the real nature of cost. Thus, it helps in reducing cost by identifying activities which do not contribute to value addition. By using this methods, decision makers are able to control many fixed overheads by exercising a greater control over those activities. This is possible on account of transparency of cost relation to activities;(Agarwal) (c)ABC enable better tracing of costs to areas of responsibility of managers, processes, clients, departments in addition to the cost of product; (d)It helps in better tracing of various activities for cost object as it uses multiple cost driver many of which are based on transaction rather than volume;(Agarwal) (e)ABC enables better decision making as the managers of the company are able to access more reliable data regarding cost data and hence able to fix accurate sales price for the individual products;
(f)Management of cost by providinginformation on transaction volume which are helpful to cost managersinascertainingthecostmanagementandperformanceappraisalofthe responsibility centres; (g)It helps in utilisation of excessive capacity and reduction in cost; Disadvantages of Activity Based Costing (a)Activity Based Costing is a very complex process and it involves a lot of spending on it ,it is complex becauseit has many drivers related to cost which makes it complicatedwhen compared to a traditional costing accounting system so to manage activity based costing system can be a bit expensive. (b)Activity Based Costing usefulness may vary from a small organisation to a big manufacturing firm as the greater benefit of ABCcan be taken by large organisation compared to smaller firm and the firm who use the costing technique cost plus pricing can reap the maximum benefit out ABCand can utilise it effectively as it gives us the proper product cost but those larger organisation or firm who use price based on market cannot reap benefit out of ABC .The different application in different industry and manufacturing areaalso proves ABC to be highly expensive and does not favour it.(Woodruff, 2018) (c)In Activity Based Costing system each and every costs needs to be measured so to manage ABC system effectively one is required to estimate thecost of each and every activity pool and cost drivers associated with it and accordingly cost is allocated to it .Even a normal ABC system requires too many permutations and combinations in itto arrive at the final cost of products and services ,to measure so much involves a lot of cost which is too expensive and it has to done on a regular basis. (d)The main problem which crops in ABC system is that it has many cost drivers and allocating cost to each and every cost driver which lead to numerous ratesanda lot of management process.
References: Agarwal, R. (n.d.).Advantages and Demerits of Activity Based Costing (ABC). Retrieved September 20, 2018, from http://www.yourarticlelibrary.com: http://www.yourarticlelibrary.com/accounting/costing/advantages-and-demerits-of-activity- based-costing-abc/52617 eFinanceManagement.com. (2018).Activity Based Costing. Retrieved September 19, 2018, from efinancemanagement.com: https://efinancemanagement.com/costing-terms/activity-based- costing MyAccountingCourse.com. (2018).What is Activity Based Costing (ABC)?Retrieved September 20, 2018, from www.myaccountingcourse.com: https://www.myaccountingcourse.com/accounting-dictionary/activity-based-costing Woodruff, J. (2018, june 27).The Disadvantages & Advantages of Activity-Based Costing. Retrieved September 20, 2018, from smallbusiness.chron.com: https://smallbusiness.chron.com/disadvantages-advantages-activitybased-costing-45096.html