Understanding the Advantages and Disadvantages of ABC Method

Activity-Based Costing (ABC) is a method that aims to allocate costs more accurately by identifying the root cause of expenses and allocating them based on cost drivers. This approach addresses the weaknesses of traditional absorption costing, which focuses on volume-based drivers like labor hours. ABC, on the other hand, employs transaction-related drivers like total order received, allowing for the tracing of long-run variable overheads to specific products. The advantages of ABC include improved understanding of expenses and drivers of costs, highlighting expensive and non-value activities, enabling better decision-making, and promoting product development and analysis of customer profitability.

MANAGEMENT ACCOUNTING

Table of Contents
Question A.................................................................................................................................1
Question B..................................................................................................................................1
Question C..................................................................................................................................3
Question D.................................................................................................................................3
Question E..................................................................................................................................4
Question F..................................................................................................................................6
Question G.................................................................................................................................7
REFERENCES...........................................................................................................................9

List of Table
Table 1: Table presenting calculation of cost per unit and total labour hours...........................1
Table 2: Table representing manufacturing overhead rate as per conventional method............1
Table 3: Table representing allocation of cost as per ABC method..........................................2
Table 4: Allocation of cost to in accordance with cost driver....................................................2
Table 5: Calculation of total cost as per ABC method...............................................................3
Table 6: Calculation of selling price after allocating overhead as per ABC method.................4

QUESTION A
Calculation of cost per unit using conventional approach
FRED: $166
MARTHA: $249
Table 1: Table presenting calculation of cost per unit and total labour hours
Particular FRED MARTHA
(Amount in $) (Amount in $)
Direct Material 40 60
Direct Labour 30 45
Manufacturing Overhead 96 144
Total cost per unit 166 249
Direct labour hour for one product 2 hrs 3 hrs
Total hours 100*2 500*3
2000 15000
Calculation of Manufacturing Overhead Rate
Table 2: Table representing manufacturing overhead rate as per conventional method
Particular Amount in $
Total Hours 2000+15000
17000
Total Manufacturing Overhead 816000
Rate 816000/17000
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QUESTION B
Machine related cost 450000 50
Set up and Inspection 180000 4500
Engineering 90000 900
Plant related cost 96000 50
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Calculation of cost per activity for each activity cost pool
Table 3: Table representing allocation of cost as per ABC method
Activity Cost Cost Driver
Total Units for
Cost Driver
Total
Cost
(Amount
in $)
Unit
cost
per
cost
driver
Machine-related cost Machine Hours 9000 hours 450000 50
Set up and Inspection No. of production runs 40 runs 180000 4500
Engineering Engineering change order 100 change order 90000 900
Plant-related cost Square footage of space 1920 sq. feet 96000 50
Total Manufacturing
cost 816000
Activity Cost per product
Table 4: Allocation of cost to in accordance with cost driver
Expected Use Cost Assigned
Activity
Cost
Driver
Unit
Cost
FR
ED
MART
HA FRED MARTHA Total Cost
Machine
related
cost
Machine
Hours 50
720
0 1800 360000 90000 450000
Set up and
Inspection
No. of
production
runs
450
0 20 20 90000 90000 180000
Engineeri
ng
Engineerin
g change
order 900 75 25 67500 22500 90000
Plant
related
cost
Square
footage of
space 50
153
6 384 76800 19200 96000
Total 594300 221700 816000
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QUESTION C
FRED: $664.3
MARTHA: $150.42
Calculation of per unit overhead cost under ABC
Per unit overhead cost for FRED (Amount in $)
Overhead cost assigned to Fred / No. of total units
594300/1000
594.3
Per unit overhead cost for Martha (Amount in $)
Overhead cost assigned to Martha/ No. of total units
227100/5000
45.42
Calculation of product cost per unit on the basis of FRED and MARTHAs using Activity
Based Costing
Table 5: Calculation of total cost as per ABC method
Particular FRED MARTHA
(Amount in $) (Amount in $)
Direct Material 40 60
Direct Labour 30 45
Manufacturing Overhead 594.3 45.42
Total cost per unit 664.3 150.42
QUESTION D
Selling price per product
FRED: $797.16
MARTHA: $180.50
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Calculation of price that would be charged for FRED and MARTHA
Table 6: Calculation of selling price after allocating overhead as per ABC method
Particular FRED MARTHA
(Amount in $) (Amount in $)
Total cost per unit 664.3 150.42
Price Charged 120% above total cost per unit
120% above total cost
per unit
Manufacturing Overhead 797.16 180.504
Selling price per unit 797.16 180.504
QUESTION E
Comparison of Total Cost
Particular FRED MARTHA
Cost as per Conventional Method 166 249
Cost as per ABC Method 664.3 150.42
Comparison of Selling Price
Particular FRED MARTHA
Charging price as per Conventional Method (Note) 199.2 298.2
Charging price as per ABC Method 797.16 180.50
Note:
Calculation of selling price as per conventional method:
FRED:
Total cost +20%
166+ (166*.20)
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$199.2
MARTHA
Total cost +20%
249+ (249*.20)
=$298.8
From above comparison, it can be analyzed that a major cost was apportioned to
product FRED, but the same was not apportioned to it. Due to same reason the appropriate
cost of the product was not ascertainable; as it was allocated on the traditional method. As per
traditional method of allotting business expenses, mostly management expenditure costs are
allocated in terms of such factors which are machine and labour working hours. Expressing it,
in other words, traditional is involved of there is a sole driver of the overheads of the factory,
that is machine and labour working hours or any other volume been produced an indicator. In
fact, there is the existence of many drivers of the factory outlay; setup of machinery,
exceptional inspections, handling, special warehousing and so on. Diversified portfolio or
high demands, the higher there will be cost allocation if these different activities through just
one activity, like the machine hours of productivity (Stapleton et al., 2004).
According to the traditional method, performing cost of the overall diversified
activities will be inclusive in just one cost section, and further, it will be divided by the
production machine hour’s number. The result will be considered as the average rates that
will be applicable to each and every product irrespective of the number and complexity of the
activities, as many diversified cost activities doesn’t relate at all along with the production
machine hour’s number, the consequence of this allocation is thus misleading (Mitra, 2009).
The same issues existed in case of product MARTHA, i.e. the expenses were allocated more
than the amount which was relating to it. Due to it over price was charged to customers and
as its competitors were able to sell the product at a lower price because they applied ABC
method for allocating the expenses. Hence, they were able to allocate the expenses in more
appropriate manner and ascertain appropriate selling price too (Arora, 2012). It can be said as
one of the reasons that its competitors had higher sales in comparison to Jackson Ltd.
ABC is aimed to cover up the traditional method’s weakness and threats via
containing different costing pools and further allocating all the costing pools based on its root
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cause. Thus, now Jackson Ltd will be able to improve its sales as well as provide products at
appropriate selling price (Drury, 2013).
QUESTION F
Advantages of ABC
Kaplan and Bruns firstly defined ABC costing in the late 1980s. It is normally seen as
a contemporary alternative to absorption costing, enabling managers to understand the
product and net profitability better. This furnishes the company with enhanced information to
enable value-based and hence more efficient decisions (Abdel, 2011).
This method is focused on cost drivers, the activities which result in an increase in
cost. Traditional absorption costing is focused on volume-based drivers like labour hours, on
the other hand, ABC employs transaction-related drivers like the total amount of order
received etc. Resultantly, long-run variable overheads, which are customarily considered as a
fixed cost, could be traced to the product (Rajasekaran, 2010).
Activity-based costing (ABC) offers more of accuracy for the products regarding its
costing, decision-making or leading. It boosts understanding of expenses and drivers of costs,
and highlights highly expensive and non-value activities in the business, enabling managers
to eliminate them from management (Kostakis, Boskou and Palisidis, 2011). ABC also
effectual challenges to operating costs in such a way that it can find better ways of
eliminating overheads. It also allows developed products and analysis of customer
profitability. It promotes position and performance of business tools and techniques like
scorecards and rapid improvements. Determination of products by using ABC method is
more reliable yet accurate; it is because it aims at the impacts of activities and costs regarding
the manufacturing goods (Debarshi, 2011). The complex of the selling price for multiple
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products as per the ABC is accurate and fair, due to the allocation of outlays in terms of
related cost drivers.
Controlling overhead containing fixed/variable make it more possible in monitoring
activities. The relation between activities and costs are purely visible and are determined in
ABC. This, it drives opportunities to manipulate overhead costs. Adequate details and
information can be acquired in order to make better decisions in regards to profitability of
various lines of product. Ascertainment of cost under ABC costing can be said more accurate
and reliable as it is based on cause and effect linkage of cost relating to producing goods
(Mhamdia and Ghadhab, 2012). Thus, due to same reason, appropriate allocation of overhead
is possible. As fixation of the selling price for various products in case ABC costing method
is done in a more appropriate manner as it is allocated on the basis of relevant cost drivers.
Moreover, other information can also be obtained by this method which assists in making
decisions relating to the profitability of different products (Wagener, 2013).
QUESTION G
Disadvantages of ABC
Business entities that adopt ABC method drives the threat of spending more than
earning, giving much time and efforts on collecting data. Too much focus and data can
frustrate the managers who are engaged in the method of ABC. However, insufficient details
can result in lack of data. One other general factor that has a hand in the collapse of ABC is
the failure to perform on the consequence that the data has provided. This basically occurs in
business which is unwilling to put ABC in their priority. Another disadvantage is that is not
easy to choose the most appropriate cost drivers, and it is also hard to measure cost based on
the activities, that are not appropriate for concerns of small manufacturing companies. It is
also difficult to determine entire activities which can impact costs (Goektuerk, 2007).
Implementation of ABC method is a big project which demands considerable
resources. Once it is incorporated, an ABC system demands high maintenance and is thus
expensive. Data related to several activity measures need to gathered, examined and fed into
the system. This method furnishes numbers like product margins, which are odds with the
figures furnished by conventional costing techniques. However, managers are habitual of
using the traditional methods to keep their operations running, and this system is mostly
employed in performance appraisal (Zeuner, 2012). The data from ABC method has high
chances of being misinterpreted and should be dealt with care when making decisions. Cost
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designated to items, customers and other objects have just potential relevancy. Prior to
making any important decision using ABC data, managers should determine which costs are
actually crucial for decisions to be taken. Reports produced by the Activity Based Costing
System are not in conformation with the generally accepted accounting principles.
Resultantly, a business involved in this costing method must keep two cost systems – one to
prepare its external reports and one for internal usage (Kim, 2017).
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REFERENCES
Abdel, M., 2011. Review of Management Accounting Research. Palgrave Macmillan.
Arora, M., 2012. A Textbook of Cost and Management Accounting. Vikas Publishing House.
Debarshi. B., 2011. Management Accounting. Pearson Education.
Drury, C., 2013. Management and Cost Accounting. Springer.
Goektuerk, H., 2007. Activity-Based Costing (ABC) - Advantages and Disadvantages. GRIN
Verlag.
Kim, Y., 2017. Activity Based Costing for Construction Companies. John Wiley & Sons.
Kostakis, H., Boskou, G. and Palisidis, G., 2011. Modelling activity‐based costing in
restaurants. Journal of Modelling in Management, 6(3), pp.243-257.
Kostakis, H., Sarigiannidis, C., Boutsinas, B., Varvakis, K. and Tampakas, V., 2008.
Integrating activity‐based costing with simulation and data mining. International Journal of
Accounting & Information Management, 16(1), pp.25-35.
Mhamdia, A. and Ghadhab, B., 2012. Value management and activity based costing model in
the Tunisian restaurant. International Journal of Contemporary Hospitality Management,
24(2), pp.269-288.
Mitra, J., 2009. Advanced Cost Accounting. New Age International.
Rajasekaran, V., 2010. Cost Accounting. Pearson Education.
Stapleton, D., Pati, S., Beach, E. and Julmanichoti, P., 2004. Activity‐based costing for
logistics and marketing. Business Process Management Journal, 10(5), pp.584-597.
Wagener, D., 2013. Activity-Based Costing and Its Later Development Into Activity Based
Budgeting and Management. GRIN Verlag.
Zeuner, P., 2012. Activity-Based Costing. GRIN Verlag.
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