Time-Driven Activity Based Costing Analysis

This assignment delves into the Time-Driven Activity Based Costing (TDABC) technique, analyzing its effectiveness in minimizing overheads for A, B, & C items to achieve maximum profitability. While acknowledging its benefits for managers, the analysis also highlights potential drawbacks such as high costs, time consumption, and data input flaws that could influence decision-making.

Management accounting
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TABLE OF CONTENTS
INTRODUCTION................................................................................................................................3
Case study.............................................................................................................................................3
A. Calculation of total cost of the product on the basis of using machine hour for the overhead
absorption.........................................................................................................................................3
B. Calculation of the total cost of every product using Activity-Based costing..............................5
C. Report using results of both the A & B and explaining the importance of ABC costing for
Diverse Limited to maximize profitability and drawbacks of introducing such a system..............6
CONCLUSION....................................................................................................................................9
REFERENCES...................................................................................................................................10
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INTRODUCTION
The process by which business administrators such as executives, managers and other
members of board of directors uses and analyze internal as well as external business information is
termed as the management accounting. It is really fruitful for businesses to make the most
appropriate decision for accomplishing targets and goals. Cost determination is one of the most
important integral information that is used by the administrators for employing best cost controlling
measures for the profit maximization purpose (Agrawal, 2013). The product and/or service cost can
be measured either through using traditional model or Activity Based Costing model. In the former,
it often uses direct labour hours and average overhead rate as a cost driver for the allocation of
overheads, in contrast to this, ABC costing uses a separate cost driver which is related to the
component cost for the overhead distribution. The aim of the present assignment is to differentiate
both traditional versus ABC making critical evaluation of pros and cons associated herewith.
CASE STUDY
In accordance with the scenario stated, Diverse Limited produces four types of products A,
B, C & D by using the same method of manufacturing and equipments. Now, company is using
traditional or conventional product costing system for determining the cost, although, managers are
looking to incorporate activity based costing for measuring cost accurately & proficiently.
A. Calculation of total cost of the product on the basis of using machine hour for the overhead
absorption
As Diverse Limited is being engaged in goods manufacturing process, therefore, it becomes
important for the policy makers to estimate their product cost so as to determine the amount of total
expenditures incurred. Companies use various costing methods to identify the total as well as unit
cost for each item produced or manufactured (Sandborn, 2017). There are two types of costs which
are often paid by a business and that are direct as well as indirect cost, described hereunder:
Direct cost: Those expenditures which are directly in connection with the goods or service
produced are called as the direct cost. It goes up with the high level of production and dropped
down at less output (Akyol, Tuncel and Bayhan, 2005). For instance, Diverse Limited needs to
purchase raw material and recruit labourers for the conversion of items into finished goods are
called direct cost.
Indirect cost: In contrast to the above, indirect expenditures comprises of those that cannot
be charged directly to every unit or item manufactured by the firm (Yang and Hao, 2017). In the
stated scenario, set-up costs, expending & scheduling, Material Handling & short-run variable costs
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are the perfect illustration of the indirect cost.
As per the scenario, in order to allocate overheads, Diverse Limited is using traditional
costing method and currently, in this practice, it uses machine hour as a base for cost allocation to
all the produced items, A, B, C & D. It is considered as an easier way of cost estimation as it uses
average overheads rate for each unit. It treats total overheads as a single pool or cost driver and
determines the overhead absorption rate using following formula:
OAR = Total overheads incurred/ Cost-driver
Particulars/Items Formula A B C D Total
Direct cost
Material cost Machine cost per unit*output units 120 480 800 3200 4600
Labor cost 60 120 400 800 1380
Total direct cost Material + Labor 180 600 1200 4000 5980
Indirect overheads
Short-run variable
cost
(12:24:80:160)/(OAR*Machine
hours used) 260.87 521.74 1739.13 3478.26 6000
Set-up costs
(12:24:80:160)/(OAR*Machine
hours used) 869.57 1739.13 5797.10 11594.20 20000
Expending &
scheduling cost
(12:24:80:160)/(OAR*Machine
hours used) 617.39 1234.78 4115.94 8231.88 14200
Materials
handling cost
(12:24:80:160)/(OAR*Machine
hours used) 652.17 1304.35 4347.83 8695.65 15000
Total indirect cost
2400.0
0 4800.00
16000.0
0 32000.00
55200.
00
Total costs Direct + Indirect
2580.0
0 5400.00
17200.0
0 36000.00
61180.
00
Working note: 1
Calculation of cost of material
Items Output units Material cost per unit Material cost
A 6 20 120
B 6 80 480
C 40 20 800
D 40 80 3200
Working note: 2
Calculation of cost of labor
Item
s
Labor
hours/unit Output units Total labor units
Labor
rate/hour
Labor
cost
A 2 6 12 5 60
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B 4 6 24 5 120
C 2 40 80 5 400
D 4 40 160 5 800
Working note: 3
Calculation of machine hours
Product Machine hours/unit Output units Total machine hours
A 2 6 12
B 4 6 24
C 2 40 80
D 4 40 160
Total 276
Working note: 4
Calculation of overhead rates
Items
Total
cost
Machine
hours
Overhead allocation rates (OAR) (Up to 2
decimals)
Short-run variable cost 6000 276 21.74
Set-up costs 20000 276 72.46
Expending & scheduling
cost 14200 276 51.45
Materials handling cost 15000 276 54.35
As per the results, it has been founded that overhead allocation rate for variable cost, set-up
cost, scheduling & material handling are £21.71, £72.46, £51.45 & £54.35 respectively. At these
rates, overheads have been allocated to £2400, £4800, £16000 and £32000 respectively. However,
total costs (TC) for A, B, C & D are determined to £2580, £5400, £17,200 & £36,000.
B. Calculation of the total cost of every product using Activity-Based costing
Traditional costing is not an accurate way of cost determination because it considers a single
cost driver for all the overheads. Therefore, companies started use of ABC providing a breakdown
framework of indirect costs. This costing technique traces their indirect overheads by taking into
considerations various costs driver. It is considered as more appropriate or accurate cost
measurement technique because it allocates overheads on the basis of the associated activity and use
the same for assigning costs (Chouhan, Soral and Chandra, 2017). This methodology identifies
relationship between various activities, products and overheads as well and chooses various costs
driver or pool for allocating overheads to their production function. According to this technique,
overhead absorption or allocation rate is calculated by using following formula, stated hereunder:
OAR = (Total costs or overheads incurred)/Total activities
As per the stated scenario, Diverse Limited’s managers are looking to employ ABC,
therefore, its total costs under ABC method is computed here as under:
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Particulars/Items Formula A B C D Total
Direct cost
Material cost
Machine cost per
unit*output units 120 480 800 3200 4600
Labor cost 60 120 400 800 1380
Total direct cost Material + Labor 180 600 1200 4000 5980
Indirect overheads
Short-run variable
cost
OAR*machine
hours 260.87 521.74 1739.13 3478.26 6000
Set-up costs
OAR*production
runs in a period 2857.14 2857.14 7142.86 7142.86 20000
Expending &
scheduling cost
OAR*production
runs in a period 2028.57 2028.57 5071.43 5071.43 14200
Materials
handling cost
OAR*production
runs in a period 2142.86 2142.86 5357.14 5357.14 15000
Total indirect cost 7289.44 7550.31 19310.56 21049.69 55200.00
Total costs 7469.44 8150.31 20510.56 25049.69 61180.00
Calculation of overhead absorption rate (OAR)
Indirect costs
Total
costs Cost driver
Total
activity
OAR
(Up to 2
decimals)
Set-up costs 6000 Machine hours 276 21.74
Expending & scheduling
cost 20000
Total production
runs 14 1428.57
Materials handling cost 14200
Total production
runs 14 1014.29
Total indirect cost 15000
Total production
runs 14 1071.43
Total costs 55200
Calculation of total production runs
Products Production runs
A 2
B 2
C 5
D 5
Total 14
C. Report using results of both the A & B and explaining the importance of ABC costing for
Diverse Limited to maximize profitability and drawbacks of introducing such a system
Calculation of cost per unit (Under traditional costing practice)
Products Total cost Units produced Cost each unit
A 2580.00 6 430
B 5400.00 6 900
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C 17200.00 40 430
D 36000.00 40 900
Total 61180.00
Calculation of cost per unit (Under Activity-based costing)
Products Total cost Units produced Cost each unit
A 7469.44 6 1244.91
B 8150.31 6 1358.39
C 20510.56 40 512.76
D 25049.69 40 626.24
Total 61180.00
Taking into accounts the results founded, it can be seen that under the traditional costing, per
unit cost for the D product is greater to £900, whilst, its accurate cost under ABC is founded
£626.24 comparatively less. The main reason behind this conventional costing method is that it use
machine hour as a single base for allocation of all overheads, allocated to £32000. However, under
the ABC, every item is absorbed to products on the basis of associated activity, and in the given
case, variable cost has been allocated as per machine hours whereas all the other elements have
been absorbed using production runs and for the item D, it is founded to £21049.69 (El Alaoui and
Lindefors, 2016). Thus, in future, if Diverse limited incorporate ABC method than it can minimize
per unit costs which will result in maximum profitability. On the contrary to this, currently, unit
costs for the item A, B & C are determined to £430, £900 & £430 relatively less than cost under
ABC method as it was computed to £1244.91, £1358.39 & £512.76 respectively. If we look at the
cost of product A & B, than it is founded very high, therefore, Diverse Limited’s policymakers have
to make smart and rational cost controlling measures for minimizing excessive overheads for such
items, however, as presently they are using traditional method and measured lower cost therefore,
they might not pay attention towards these items. As per the analysis, it can be seen that unit cost
under both the techniques found conflicting results; still, it must be suggested to Diverse Limited to
use ABC method. It is because, unlike conventional method, ABC uses an appropriate base for the
indirect allocation and measure cost accurately, because of following reasons:
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(Source: Akhavan, Ward and Bozic, 2016)
Advantages:
 It uses only one cost pool or driver for allocating indirect costs to goods or items produced,
whilst, ABC method uses variety of cost pool concerning the elements of overheads
incurred.
 Traditional costing uses volume-based cost drivers, whereas ABC costing uses activity-
based overhead allocation rate. It provides more realistic results and determines costs
authentically through focusing on costs and effect relationship (Akhavan, Ward and Bozic,
2016).
 ABC costing is also suggested to use because it enable the managers of firm to control
excessive overheads by putting better control procedures and regular and closure managerial
supervision. Moreover, it also assist Diverse limited to minimize their wastage through
better utilization of the resources which results in high yield (Laviana and et.al., 2016).
 It also helps the managers and executives for effective pricing mechanism, because,
entrepreneur use cost as a central base for deciding selling prices so as to generate audience
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traffic and gain maximum profitability.
Drawbacks:
Although, ABC costing is a best measurement tool for cost determination, still, it contains
several drawbacks which are stated below:
 High cost of implementation: For the successful implementation of ABC costing, Diverse
Limited managers have to hire experts who have expertise knowledge of new and modern
accounting practices and determine the cost and thus, it incur high cost (Johnson, 2014).
 Time-consuming process: Determining cost driver or pool for every activity and assessing
the causal relationship takes time, therefore, it can be said that it is a time-consuming
process for determining the cost per unit (Najjar, Strickland and Kaplan, 2016).
 Data flaws: ABC technique involves number of divisions and sub departments to gather &
input data in the system, thus, smallest flaw can give misleading results and affect quality of
managerial decisions adversely. Thus, it is one of the biggest risks involved in ABC
implementation (Agrawal, 2013).
CONCLUSION
In conclusion of the above project report, it becomes clear that ABC costing is more
accurate and realistic method of cost determination compare to the conventional technique as it uses
multiple of cost drivers and activities for the accurate cost determination. Applying both the
practices in Diverse Limited, it has been observed that currently, cost of A, B & C products are
under-valued by the company under traditional model whereas cost each of unit for the D item is
overvalued. However, ABC provided realistic & valuable insight towards cost and guide managers
to adopt best controlling measures for minimizing overheads for A, B & C items for getting
maximum profitability. Although, the technique is really helpful for company’s managers, still,
high cost, time & flaws in data input are the major drawbacks associated with this and may lead to
take decisions.
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REFERENCES
Books and Journals
Akhavan, S., Ward, L. and Bozic, K.J., 2016. Time-driven activity-based costing more accurately
reflects costs in arthroplasty surgery. Clinical Orthopaedics and Related Research®. 474(1).
pp.8-15.
Akyol, D.E., Tuncel, G. and Bayhan, G.M., 2005. A comparative analysis of activity-based costing
and traditional costing. World Academy of Science, Engineering and Technology. 3(2).
pp.44-47.
Chouhan, V., Soral, G. and Chandra, B., 2017. Activity based costing model for inventory
valuation. Management Science Letters. 7(3). pp.135-144.
El Alaoui, S. and Lindefors, N., 2016. Combining Time-Driven Activity-Based Costing with
Clinical Outcome in Cost-Effectiveness Analysis to Measure Value in Treatment of
Depression. PloS one. 11(10). p.e0165389.
Johnson, P.F., 2014. Purchasing and supply management. McGraw-Hill Higher Education.
Laviana, A.A. and et.al., 2016. Utilizing time‐driven activity‐based costing to understand the short‐
and long‐term costs of treating localized, low‐risk prostate cancer.Cancer. 122(3) pp.447-
455.
Najjar, P.A., Strickland, M. and Kaplan, R.S., 2016. Time-Driven Activity-Based Costing for
Surgical Episodes. JAMA surgery.
Sandborn, P., 2017. Activity-Based Costing (ABC). In Cost Analysis of Electronic Systems. 14(2).
pp. 77-92.
Yang, H.X. and Hao, J.Q., 2017. Evaluation and improvement of the supervision cost-efficiency to
project based on learning curve—Angle of time driven activity-based costing. Journal of
Interdisciplinary Mathematics. 20(1). pp.173-185.
Online
Agrawal, R., 2013. Traditional costing versus ABC Costing. [Online]. Available through:
http://www.yourarticlelibrary.com/accounting/costing/traditional-costing-and-activity-based-
costing-system-differences/52614/. [Accessed on 7th February 2017].
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