Semester 1 Accounting & Finance: Activity Based Costing System

This essay discusses the application and usefulness of the Activity-Based Costing (ABC) system in management accounting for allocating costs to products, contrasting it with traditional methods. It highlights the increasing competition driving businesses to adopt efficient accounting systems for accurate cost information. The ABC system identifies activities as cost drivers and allocates overhead costs accordingly, providing a more precise product costing compared to conventional methods that often rely on machine hours, which can lead to inaccurate cost allocations, especially for products with varying activity requirements. A hypothetical example illustrates the ABC system's application, detailing the allocation of overhead costs per unit for two products. The essay also addresses the judgmental aspects and limitations of ABC, such as complexity and suitability for smaller firms, while emphasizing its utility in decision-making by providing accurate cost information for planning, control, and profitability optimization. Ultimately, the essay concludes that the ABC costing system is more effective than traditional methods for informed decision-making.

Accounting and Finance
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Introduction
The present essay is developed for providing an understanding of the recently used
management accounting systems by the accountants for allocating of costs to the products. In
this context, it discusses the usefulness of activity based costing system over the traditionally
used methods to allocate the costs to the products.
Use of Management Accounting Systems
Calculating the Cost of an Individual Project by Activity-Based Costing (ABC) system
The increasing competition is causing the businesses to adopt the use of efficient
management accounting systems for gathering accurate information about the costs of the
processes, products and services. The traditional method of costing is largely criticized by the
management accountants due to their inappropriateness to assign overhead costs on the basis of
products (Wnuk-Pel, 2010).
As such, the management accountants are largely incorporating the use of Activity-Based
Costing (ABC) system for calculating the cost of an individual project, service or activities
within a department. The system is providing to be highly useful in identifying the important
activities within a department and allocating accurately their overhead costs. The different
activities required for manufacturing a product is considered as a cost driver such as
consumption of power, quality inspections or machine setups. It then assigns the cost involved in
carrying out these activities to the products that requires these activities for completion. As such,
it helps in assigning accurately overhead costs to the activities and therefore highly useful in
determining the price of product (Fadzil and Rababah, 2012).
The benefits of using ABC costing system in comparison to the conventional system of
costing can be discussed in relation to the two products that are manufactured by the same
company, that are, Product A and Product B. Product A requires many type of activities such as
engineering, testing and machine set ups for completion and is produced in low volume. On the
other hand, Product B does not require any special activities for its completion but it’s
manufactured in high volume. As such, the use of conventional system of accounting will result
in allocating the overall overhead to the products on the basis of machine hours consumed. This
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will result in allocation of only small overhead costs to the Product A as the machine hours
consumed is less but it requires different type of special activities for completion. On the other
hand, Product B will be allocated high amount of overhead although it has consumed very less
overhead activity. Therefore, the use of traditional method of costing will result in inaccurate
calculation of costs of products and this drawback can be effectively overcome with the use of
ABC method of costing. ABC system will result in allocation of costs as per the resources
consumed by each of the products for their overall completion. The costs of the activities will be
allocated to the products on the basis of consumption and thus will result in accurate allocation
of overhead costs to the products (Aryanezhad, Makui and Rashidi Komijan, 2009).
Following is a hypothetical example to explain the use of activity based costing:
Information Given
Products ==> Product 1 Product 2
Output in units: 9000 15500
Selling price per unit
£
90.00
£
110.00
Cost per unit:
Direct material
£
38.00
£
48.00
Direct labour
£
27.00
£
25.00
Total machine hours 1000 3000
Number of production
runs 48 70
Order Executed 60 70
Number of Shipments 70 80
Basis for activity based costing
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Overhead
Annual
Budgeted
cost
Cost Driver
Machine department cost
£
270,000.00 Machine hr
Set-Up Cost
£
118,000.00 Production runs
Inspection/Quality control
£
59,000.00 Production runs
Material Handling
£
39,000.00
Number of order
executed
Delivery
£
30,000.00 Shipments
Total Overheads
£
516,000.00
Statement of cost pool
Overhead Cost Cost Driver Driver
units
Overhead
cost per
driver unit
Machine department cost
£
270,000.00 Machine hr 4000 £
67.50
Set-Up Cost
£
118,000.00 Production runs 118 £
1,000.00
Inspection/Quality control
£
59,000.00 Production runs 118 £
500.00
Material Handling
£
39,000.00
Number of order
executed 130 £
300.00
Delivery £ Shipments 150 £
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30,000.00 200.00
Statement of division of overhead cost to per unit of product
Overhead
Overhead
cost per
driver unit
Product 1
Units Product 1 Product
2Units Product 2
Machine department
cost
£
67.50 1000 £
67,500.00 3000 £
202,500.00
Set-Up Cost £
1,000.00 48 £
48,000.00 70 £
70,000.00
Inspection/Quality
control
£
500.00 48 £
24,000.00 70 £
35,000.00
Material Handling £
300.00 60 £
18,000.00 70 £
21,000.00
Delivery £
200.00 70 £
14,000.00 80 £
16,000.00
Total £
171,500.00
£
344,500.00
Statement of profit per unit of both the products
Particulars Product 1 Product 2
Selling Price per unit £
90.00
£
110.00
Less:
Cost per unit:
Direct material £
38.00
£
48.00
Direct labour £
27.00
£
25.00
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Overhead Cost per
unit
£
19.06
£
22.23
Profit per unit £
5.94
£
14.77
Areas Requiring Judgment and Limitations
The allocation of cost through use of activity based costing there is required to make
various judgments so that overhead costs can be allocated properly to each product. The
definition of the type of overhead cost and its cost driver it is very difficult to assign each
overhead cost. So, there is need to make judgments while estimating the overhead costs and
allocating the costs to each product as per cost driver.
The various limitations associated with the system of ABC can be stated as follows:
 Complexity: The method of ABC costing is often complex to be understood by the
accountant and requires larger amount of time for identifying the cost drivers and
allocation of costs on their basis. Thus, the increasing complexity can require larger costs
for the companies to determine the costs of the products.
 Non-useful for smaller firms: ABC method of costing may not be relevant for small-sized
organizations for determining the accurate product cost (Bradtke, 2007).
Usefulness of ABC system for decision-making purpose
ABC is designed for providing management the accurate information regarding the costs
of products that is useful in taking significant planning and control decisions. The association of
the costs on the basis of activity consumed helps in developing a clear relationship between their
sources and the related costs (Moisell, 2012). The costs consumed by different activities assist
the manager in developing effective strategies for its reduction and optimizing the profitability.
The calculation done through the use of ABC costing system can be effectively used for
decision-making as it would help in determining the product costs on the basis of actual
overhead activities consumed during their completion. As such, I would happily adopt the use of
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such system for cost determination as it would have a direct impact on maximizing the
profitability of the company (Infandoudas and Gurd, 2010).
Conclusion
It can be stated from the overall discussion held in the essay that ABC costing system is
more useful as compared with the use of traditional costing system. The traditionally used
accounting system methods are not proving to be useful for the management accountants to
allocate the products and enable the right decision-making.
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References
Aryanezhad, M. B., Makui, A. and Rashidi Komijan, A. 2009. A new euristic approach to solve
product mix problems in a multibottleneck system. International Journal of Industrial
Engineering 5 (9), pp. 46–57.
Bradtke, D. 2007. Activity-Based-Costing. GRIN Verlag.
Fadzil, F. and Rababah, A. 2012. Management Accounting Change: ABC Adoption and
Implementation. IBIMA Publishing Journal of Accounting and Auditing.
Heisinger, K. 2009. Essentials of Managerial Accounting. Cengage Learning.
Infandoudas, P. and Gurd, B. 2010. Costing for decision-making in a theory of constraints
environment. Journal of Applied Management Accounting Research 10 (1), pp. 43–58.
Moisell, A. 2012. Costing for Decision Making: Activity-based Costing vs. Theory of
Constraints. International Journal of Knowledge, Culture and Change Management 12(1), pp. 1-
13.
Wnuk-Pel, T. 2010. Changes in Company’s Management Accounting Systems: Case Study on
Activity- Based Costing Implementation and Operation in Medium-Sized Production Company.
Eurasian Journal of Business and Economics 3(6), pp.85-111.
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