Activity Based Costing (ABC) Analysis

This assignment delves into a critical analysis of the drawbacks associated with Activity-Based Costing (ABC). It points out that ABC struggles to segregate certain overhead costs, such as CEO salaries, effectively. Additionally, it argues that ABC doesn't accurately account for non-productive employee time or costs related to business sustainability, leading to potential cost inaccuracies.

Running head: INTRODUCTION TO MANAGEMENT ACCOUNTING
Introduction to management accounting
Name of the student
Name of the university
Author note

1INTRODUCTION TO MANAGEMENT ACCOUNTING
Table of Contents
Answer A - Calculation of cost as per conventional approach..................................................2
Answer B - Cost per activity......................................................................................................2
Answer C - Calculation of cost of product as per activity based costing..................................3
Answer D – Price under ABC....................................................................................................4
Answer E – Mispricing under conventional approach...............................................................4
Answer F – Advantages associated with activity based costing................................................5
Answer G - Disadvantages associated with activity based costing approach............................7
Reference....................................................................................................................................9

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Answer A - Calculation of cost as per conventional approach
Particular Total cost Fred Martha
Units produced 1000 5000
Direct costs
Direct material cost per
unit $ 40.00 $ 60.00
direct labour cost per unit $ 30.00 $ 45.00
Total material cost $ 40,000.00 $ 3,00,000.00
Total labour cost $ 30,000.00 $ 2,25,000.00
Total direct cost $ 70,000.00 $ 5,25,000.00
Overhead cost
Machine related cost $ 4,50,000.00 $ 75,000.00 $ 3,75,000.00
Set up and inspection cost $ 1,80,000.00 $ 30,000.00 $ 1,50,000.00
Engineering $ 90,000.00 $ 15,000.00 $ 75,000.00
Plant related cost $ 96,000.00 $ 16,000.00 $ 80,000.00
Total over head cost $ 8,16,000.00 $ 1,36,000.00 $ 6,80,000.00
Total cost $ 2,06,000.00 $ 12,05,000.00
Cost per unit $ 206.00 $ 241.00
Selling price per unit $ 247.20 $ 289.20
Profit per unit $ 41.20 $ 48.20
Answer B - Cost per activity
Allocation rate
Total overhead
Machine related cost $ 4,50,000.00
Set up and inspection cost $ 1,80,000.00
Engineering $ 90,000.00
Plant related cost $ 96,000.00
Total $ 8,16,000.00
Total labour hours
Fred 2000
Martha 15000
Total 17000
Rate of allocation 48.00
Amount allocated to per unit of Fred 96.00
Amount allocated to per unit of Martha 144.0

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Answer C - Calculation of cost of product as per activity based costing
Particular Fred Martha
Units produced 1000 5000
Direct costs
Direct material cost per
unit $ 40.00 $ 60.00
direct labour cost per unit $ 30.00 $ 45.00
Total material cost $ 40,000.00 $ 3,00,000.00
Total labour cost $ 30,000.00 $ 2,25,000.00
Total direct cost $ 70,000.00 $ 5,25,000.00
Required data Fred Martha
Units produced 1000 5000
Machine hours required 4000 5000
Production runs 20 20
Engineering activity (Quarter) 3 1
Square foot for plant 1536 384
Overhead cost Total Fred Martha
Machine related cost $ 4,50,000.00 $ 2,00,000.00 $ 2,50,000.00
Set up and inspection $ 1,80,000.00 $ 90,000.00 $ 90,000.00
Engineering cost $ 90,000.00 $ 67,500.00 $ 22,500.00
Plant related cost $ 96,000.00 $ 76,800.00 $ 19,200.00
Total overhead cost $ 8,16,000.00 $ 4,34,300.00 $ 3,81,700.00
Total direct cost $ 70,000.00 $ 5,25,000.00
Total cost $ 5,04,300.00 $ 9,06,700.00
Cost per unit $ 504.30 $ 181.34
Selling price per unit $ 605.16 $ 217.61
Profit per unit $ 100.86 $ 36.27
The cost per unit as per the activity based costing for Martha is $ 181.34 and for Fred
is $ 504.30.

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Answer D – Price under ABC
Selling price for per unit of Fred is $ 605.16 and that of Martha is $ 217.61.
Answer E – Mispricing under conventional approach
Conventional strategy for distributing overheads prompt mispricing as under this
framework, the overhead is apportioned by taking into consideration of just a single factor
that is the machine hours or the work hours. To be more particular, the conventional approach
infer involves that there is just a single driver for apportioning the overhead and that is the
machine hours or the work hours (Marx 2013). However, for all intents and purposes there
are different drivers identified with the industrial factory overheads, for example, the machine
set-up cost, unique storage cost, examination cost, and cost related to special handling. A
greater amount of the contribution of assorted variety as to the items and client requests lead
to greater amount of the issues with respect to the allotment of overhead. Further, under the
conventional approach costs identified with execution of every assorted action are
incorporated under one cost pool and are isolated by generation machine hours and clearly
the outcome is the 1 normal rate that is utilized for every one of the items independent of
various exercises (Monroy, Nasiri and Peláez 2014). In this way, the portion of overhead
under ordinary technique prompts mispricing. Other disadvantages related to the traditional
cost approach are as follows –
 Recovery rates of overheads, for example, machine hour rate, work hour rate and so
forth are utilized for indirect cost absorption i.e. the overhead. These are very
reasonable for the closing stock valuation and revealing the same to the top executives
as the accounting data. Be that as it may, this is not valuable for taking any decisions
since the decisions have suggestions for more than 3 to 5 years. Besides, some fixed
expenses are variable over the long run (Oseifuah 2014).

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 The parting of cost into variable and fixed are often seems unrealistic. The reason is
that the parting of cost gives erroneous expenses of items if business develops.
 A few organizations are selling and manufacturing more than single item. In such a
case, these organizations are compelled to take choice on product mix, pricing,
advertisement campaign, technological process and advertisement on the basis of the
information of approximate cost. This is because of trouble in accumulation,
arrangement, portion and allocation of overheads to singular items precisely (Ruiz-de-
Arbulo-Lopez, Fortuny-Santos and Cuatrecasas-Arbós 2013).
Here in the given case, as per the conventional approach the cost per unit of Fred
came to $ 206 and that of Martha came to $ 241 per unit whereas as per the activity based
costing approach cost per unit of Fred calculated as $ 504.30 and that of Martha came to $
181.34 per unit. Therefore, it can be recognized that the conventional approach led to
mispricing of the product as the company earn 20% profit on the cost for selling the product.
Accordingly the selling price under conventional approach was set as $ 247.20 for Fred and $
289.20 for Martha whereas, under the activity based approach the selling price for Fred was
set as $ $ 605.16 per unit and that of Martha as $ 217.61 per unit. Therefore, it is clearly
evident that there is no match for the pricing system under two approaches.
Answer F – Advantages associated with activity based costing
Activity based costing is the method of allocating the cost on the basis of the amount
of resource consumed by the service or product. Though the implementation of ABC system
is associated with various challenges, it is advantageous to the business in the following ways
–
 Cost administration – the ABC framework offers the rate of cost driver and the data
on the volume of exchanges that are valuable for the administration for dealing with

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the cost and examination of the execution under the obligation focus. Further, the cost
drivers are utilized favourably to design the current and in addition new items
(Tibesku et al. 2013).
 Recognize the inefficient items – this framework thinks about the costs that is like the
manufacturing cost and enables the business to comprehend where the overhead
expenses are caused. Further, the data can perceive the inefficient items and
insignificant costs with the goal that the assets can be utilized effectively. The ABC
approach likewise helps with settling the cost of the administration or items that are
inaccurate or unbalanced. Additionally, the nature of services or products can be
enhanced as the issues can be settled utilizing the framework (Öker and Adıgüzel
2016)
 Improve the business forms –ABC technique allocates the indirect taking into
consideration the cost driver of the item or in light of the components that produces
the cost. As the expenses are allotted according to the item, it can be recognized by
the executives that which forms are productive and which are definitely not. The ABC
framework can additionally be utilized to perceive the exercises that are considered as
value added and can assist in better allotment of the resources for beneficial and
proficient exercises. Use of ABC can increase the value of persistent upgrade of the
business methods
 Flexibility of overhead application - An essential advantage of ABC approach that
overhead rates are figured in view of every activity pool, not simply utilizing the
whole processing plant. This takes into account overhead rates to be resolved with
more exactness and overhead application to happen in view of particular activities.
For instance, under the conventional costing framework, an independent company

7INTRODUCTION TO MANAGEMENT ACCOUNTING
may confirm that, when all is said in done, overhead is identified with coordinate
work hours and utilize guide work hours to ascertain the organization's overhead rate.
 Price fixation – ABC brings the reliability and accuracy in the cost of product through
focussing on the effect and cost relationship under the cost structure. It identifies the
activities that are the causes of cost and the product that consume these costs. Under
the advanced manufacturing technology and environment where the support function
for the overhead constitutes the large part of the total cost, the ABC approach delivers
more realistic costs of the product (Busse, Mahlendorf and Bode 2016).
 Information of cost behaviour – ABC system is able to recognize the real nature of the
cost behaviour and assists in minimizing the cost and recognizing the activities that do
not add any value to the product. With the help of ABC approach, the managers can
control various fixed cost related to overhead through exercising more control on the
activities that lead to the cost related to fixed overhead. This can be done as the
behaviour of various fixed overhead with regard to the activities can be more clear
and visible.
Answer G - Disadvantages associated with activity based costing approach
 Time of implementation - Notwithstanding for smaller organizations, the usage of
ABC framework can be a significant attempt. The additional exactness of the ABC
framework must be accomplished only if the entrepreneur will invest the effort to
analyze the assembling procedure with enough detail to decide how overhead
expenses are acquired. Because of the trouble of implementation, numerous
entrepreneurs do not trust that the advantage of a ABC framework exceeds the
expenses (Tsai et al. 2014).

8INTRODUCTION TO MANAGEMENT ACCOUNTING
 Duplication of the costing – unlike the conventional approach that are needed for
generally accepted accounting principles, the ABC approach are not compulsory
rather it is optional. Further, the ABC system is not able to take into consideration the
traditional costing approach (Khataie and Bulgak 2013).
 Segregation of cost – one of the main disadvantages associated with ABC is that some
overhead costs are not possible to segregate such as the salary of CEO cannot be
segregated on per product basis. In the same way, the employees are unlikely to
contribute 100% of their time to productive movements and not all the productive
activities are regarded as value added to the process or product of the company, for
example, the ABC approach does not take into consideration the leisure time spend by
the workers and it leads to considerable leak in cost. Further, no meaningful method is
there to allocate the cost related to sustainability of business that is the costs related to
products on pro-rata basis (Phan, Baird and Blair 2014).

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Reference
Busse, C., Mahlendorf, M.D. and Bode, C., 2016. The ABC for studying the too-much-of-a-
good-thing effect: A competitive mediation framework linking antecedents, benefits, and
costs. Organizational Research Methods, 19(1), pp.131-153.
Khataie, A.H. and Bulgak, A.A., 2013. A cost of quality decision support model for lean
manufacturing: activity-based costing application. International Journal of Quality &
Reliability Management, 30(7), pp.751-764.
Marx, C., 2013. Activity based costing (ABC) and traditional costing systems.
Monroy, C.R., Nasiri, A. and Peláez, M.Á., 2014. Activity Based Costing, Time-Driven
Activity Based Costing and Lean Accounting: Differences among three accounting systems’
approach to manufacturing. In Annals of Industrial Engineering 2012 (pp. 11-17). Springer
London.
Öker, F. and Adıgüzel, H., 2016. Time‐driven activity‐based costing: An implementation in a
manufacturing company. Journal of Corporate Accounting & Finance, 27(3), pp.39-56.
Oseifuah, E.K., 2014. Activity based costing (ABC) in the public sector: benefits and
challenges. Problems and Perspectives in Management, 12(4), pp.581-588.
Phan, T.N., Baird, K. and Blair, B., 2014. The use and success of activity-based management
practices at different organisational life cycle stages. International journal of production
research, 52(3), pp.787-803.
Ruiz-de-Arbulo-Lopez, P., Fortuny-Santos, J. and Cuatrecasas-Arbós, L., 2013. Lean
manufacturing: costing the value stream. Industrial Management & Data Systems, 113(5),
pp.647-668.

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Tibesku, C.O., Hofer, P., Portegies, W., Ruys, C.J.M. and Fennema, P., 2013. Benefits of
using customized instrumentation in total knee arthroplasty: results from an activity-based
costing model. Archives of orthopaedic and trauma surgery, 133(3), pp.405-411.
Tsai, W.H., Yang, C.H., Chang, J.C. and Lee, H.L., 2014. An Activity-Based Costing
decision model for life cycle assessment in green building projects. European Journal of
Operational Research, 238(2), pp.607-619.