Activity Based Costing: Merits, Demerits & Comparison

This assignment delves into the concepts of traditional and activity-based costing (ABC). It outlines the advantages and disadvantages of each method, with a particular focus on ABC's complexities and limitations. The assignment also highlights the importance of selecting appropriate cost drivers for accurate calculations.

Introduction to management
accounting

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
TASK...............................................................................................................................................1
a) Calculation of cost using conventional method......................................................................1
b) Calculation of cost of each activity.........................................................................................1
c) Calculation of per unit cost using ABC method.....................................................................2
d) calculation of price to be charged...........................................................................................2
e) Mispricing of product due to conventional method................................................................3
f) Advantages of ABC.................................................................................................................4
g) Disadvantage of activity based costing...................................................................................4
CONCLUSION................................................................................................................................4
REFERENCES................................................................................................................................5

INTRODUCTION
In business, it is very important that cost shall be calculated in an appropriate manner and
for that, various decisions will be made under management accounting (DRURY, 2013). By this,
the cost that can be avoided will be identified and this will lead to cost saving. In this report,
conventional and activity based costing will be discussed in context with Jackson limited which
is involved in the production of two products.
TASK
a) Calculation of cost using conventional method
In the earlier times, method with the help of which cost was calculated is conventional. In
this method, all the direct costs will be taken into consideration. Overheads incurred will be
calculated in total and then will be allocated among various products that are manufactured.
Below is provided calculation of cost with the help of this method.
Particulars Martha Fred
Direct material cost 60 40
Direct labour cost 45 30
Manufacturing overheads 136 136
Cost per unit 241 206
Manufacturing cost per unit = 816000/6000
= 136
b) Calculation of cost of each activity
In any business, there are various costs which are incurred and all of them are classified
in different groups which are known as cost pools (Lambert and Sponem, 2012). The production
cost will be calculated in proper manner as total cost that is incurred is divided on the basis of the
activities that are undertaken.
Particulars Setup and
inspection
cost
Machine
related cost
Plant related
cost
Engineering
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A Cost driver Number of
production
runs
Total machine
hours
Space in sq
foot
Number of
order changes
B Total cost 180000 450000 96000 90000
C Units of cost drivers 40 9000 1920 100
D Cost per activity pool
(B/C)
4500 per run 50 per hour 50 per Sq. ft. 900 per
change
So this is the manner in which cost will be calculated for each activity pool.
c) Calculation of per unit cost using ABC method.
This is the method in which cost of product will be ascertained by addition of all
expenses which are incurred in respect of various activities that are performed (Yigitbasioglu and
Velcu, 2012). By this, company will be able to have additional advantage over other competitors
and also effectiveness will be attained.
Particulars Fred Martha
Direct material cost 60 40
Direct labour cost 45 30
Inspection cost 90 18
Machine related cost 200 50
Engineering 12.5 2.5
Plant related cost 76.8 3.84
Cost of one unit 484.3 144.34
By the help of cost which is calculated above, company will be able to make the business
sustain for long period of time.
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d) Calculation of price to be charged
It has been provided that price that will be charged from customer shall be determined on
basis of cost which is calculated above using activity based costing. In this, mark-up of twenty
percent will be provided. It means that price will be 120 percent of total cost. Calculation in
relation to it is provided below:
Particulars Fred Martha
Total cost 484.3 144.34
Profit (20% of cost) 96.86 28.87
Price per unit 581.16 173.21
e) Mispricing of product due to conventional method.
In the calculation as per conventional method the cost which will be included is pre
decided and all the expenses will be considered on cumulative basis and allocation will be done
on the basis of total quantity of goods which will be manufactured. The main elements on which
cost will be distributed are labour or machine hours and units (Islam and Hu, 2012). But in case
of ABC cost will be bifurcated according to cost pools and cost drivers. They will be allocated to
each good on basis of this.
It can be seen that cost which are determined in both cases are different as in case of
ABC is 484.3 and 144.34 for Fred and Martha respectively. Whereas in conventional approach it
is 206 and 241. So, it can be seen that it will be good to use ABC in case of Martha and
conventional as per the Fred as in both cases cost will be lower. So the calculation will be made
by keeping these in notice.
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Illustration 1: ABC v/s Traditional costing
(Source: ABC v/s Traditional costing, 2017)
f) Advantages of ABC
In this method, cost of goods will be calculating by using technique to allocate overheads
on activity basis. By this, cost will be determined by taking in consideration cost which is
incurred in actual processes involved. By the help of it, actual price will be ascertained.
Advantages of activity based costing:
 The cost which will be calculated by this method will be accurate and this will be helpful
in deciding appropriate price.
 In this all overheads will be considered and not only those which are related to
production (Activity based costing, 2017).
 The cost will be controlled as by this wastage which is happening will be identified and
then eliminated.
g) Disadvantage of activity based costing
In addition to various merits which are described above, there are certain disadvantages
also which will be faced by company while using this method. Some of them are:
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 Application of this techniques will not be possible in small businesses as cost of each
activity will not be determinable.
 If the cost which is incurred on overheads is of small amount or is directly related to
product then ABC approach will not be required (Harris and Durden, 2012).
 The process which will be involved in this will be complex for stakeholders to understand
and if they will not be having knowledge regarding it then decisions made by them will
be affected.
 There are chances that chosen cost drivers may not be appropriate and if this happens the
whole calculation will prove to be a failure.
So, these are some of demerits which will have to be taken into consideration by any
organisations before they chose this technique.
CONCLUSION
From the above mentioned report, it can be concluded that cost can be calculated by
using any of the methods that will be providing company with maximum benefits. Above
conventional and ABC techniques are described and it has been identified that there are merits
and demerits with respect to them which will have to be analysed.
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