Management Accounting: Executive Summary on Costing Methods Analysis

This report provides a critical analysis of traditional and modern costing methods. It begins by outlining the traditional approach, emphasizing its historical context and limitations in today's business environment. The report then explores the modern costing methods, specifically Activity-Based Costing (ABC), and highlights its advantages in accurately allocating costs and determining product profitability. A comparative analysis is presented, contrasting the two methods and illustrating their impact on cost allocation through a practical example. The report also discusses the limitations of ABC and concludes that modern costing systems offer improved accuracy in cost allocation and aid in better decision-making compared to traditional methods. The report uses examples of traditional and modern costing systems to help demonstrate the key differences between the two methods and also discusses the types of costing methods used in manufacturing entities.

ACCOUNTING AND FINANCE- Management Accounting
Executive Summary
The report seeks to critically analyse the traditional methods of costing of products and services. The
importance and relevance of those method in today’s costing environment. The report goes on to
further detail that the cost allocation under traditional method do not hold much significance in
today’s business environment. The report also tries to align traditional and modern should be used
together as traditional method is short term oriented while modern costing is long term oriented.
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Table of Contents
Contents
Executive Summary...............................................................................................................................1
Table of Contents..................................................................................................................................2
Introduction...........................................................................................................................................3
Analysis..................................................................................................................................................3
Cost Allocation under Traditional Costing System.............................................................................3
Cost Allocation under Modern Costing System.................................................................................4
Traditional Cost System.....................................................................................................................4
Limitations.............................................................................................................................................6
References.............................................................................................................................................7
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Introduction
Costing System shall mean to define a system through which cost are allocated to cost objects. Thus,
cost assignment is the main objective of costing. Further, there are two methods of costing i.e..
Traditional Method and Modern Method.
Traditional Costing method has its origination in the mid of twenty century on account of
automatization of manufacturing. The primary concern under traditional method of costing was on
cost of manufacture of production and methods of allocating indirect cost of production to services
and products. However, there has been noted change in business environment in the end of twenty
Century and beginning of 21st Century which enabled and led to the development of modern tools of
accounting. The main purpose of modern accounting is to provide management with information that
helps in judging the profitability and true cost of services, projects, products, activities, consumers
etc.
The fact that led to the development of Modern accounting has been technological development,
change in Consumer’s Preference, global Competition and survival issues, true costing of a particular
product instead of random allocation.
Brief Facts
Traditional Method no longer hold importance in the costing field as they don’t provide information
on potential areas where cost can be saved as the same is the niche area in today’s cut throat
competition market. As in current times, prices of products are less amenable while cost can be
controlled, thus a requirement for better costing tool led to obsolescence of the traditional method.
There are generally three types of costing used in a manufacturing entity. They are usually (a) Job
Order Costing, (b) Process Costing and (c) Activity Based Costing.
The first two costing system fall under traditional method while the third one is a modern system of
costing. The first two methods depends on process of manufacturing while ABC can be used
irrespective of manufacturing process.
Traditional Costing System
The basic distinction between job costing and process costing system lies in the fact that how cost
object is determined under both these systems. Under job costing, cost object is a job while under
process costing cost object is process. Thus, job costing is applicable for manufacturing process
initiated by customer while process costing is applicable on continuous process and not initiated from
customer end.
Under the method the direct cost like raw material, labour etc are traced to products and services and
indirect cost allocation is a major cause of concern which limits the usefulness of traditional method
of costing. Under this method, they are allocated on the basis of the following cost bases like Direct
Labour Hour, Machine time Hours etc
The method of indirect cost allocation has an impact on the profitability of the product, service, job
etc. Thus, it presents a wrong picture by improper allocating of indirect cost impacting the
profitability. (Dutta, 2004)
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Dutta, M (2004) Cost Accounting: Principles and Practice. Pearson, India
Advantage: The chief advantage of this method is it is not complex and very easy as indirect cost are
allocated based on a single parameter. Further, the method is in alignment with reporting requirement
of various countries. In addition, it is best suited for small businesses. (Mathur, 2001)
Disadvantage: The disadvantage are greater than advantage as method is outdated as it does not
report true cost of production and profitability. Further, indirect cost is driven by various factors
rather than single. (Jain, 2000)
Cost Allocation under Modern Costing System
Activity based Costing was developed within an intention to rectify the shortcomings of traditional
costing system. The primary aim of Activity based Costing is to present a true and fair allocation of
cost over products and therefore impacting the product profitability. The system focuses on product
cost and special attention is paid to indirect costs of manufacturing. The main assumption under ABC
costing system is “Products consume activities and activities consume resources:. Under, the current
method cost is allocated based on various drivers of activity rather than department or jobs (like in
traditional systems). In short, indirect manufacturing cost are first allocated to activity tools. It is thus
important for the purpose of determination of relation between the indirect manufacturing activity and
the activity identified. In the second step, indirect manufacturing costs are allocated to products using
cost drivers. Thus, the use of multiple allocation base shall help in providing a more objective and
accurate product profitability evaluation.
Advantage: The method helps in allocating indirect cost based on various parameters, thus allocating
cost in a more rational manner and helps in determining the true profitability of the product. Modern
costing helps to eliminate the deficiency of traditional costing and aids decision making.
Disadvantage: ABC costing is complex and not suitable for smaller business.
The example of computation of traditional costing system and modern costing system has been
provided here-in-below:
Traditional Cost System Vs Modern Costing
Sl No Products Compared Product A Product B Total
1 Unit Produced and Sold 900000 2100000
300000
0
2 Selling Price per Unit 3 2
3 Direct Labour Cost/unit 0.5 0.5
4 Direct Materials Cost/ Unit 0.75 0.75
5 Sales Revenue(=1*2) 2700000 4200000
690000
0
Direct Cost
6 Direct Labour Cost(=1*3) 450000 1050000
150000
0
7 Direct Materials Cost (=1*4) 675000 1050000
172500
0
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8 Total Direct Costs (=6+7) 1125000 2100000
322500
0
Traditional Costing : Finding Indirect or Overheads Cost
Sl.
No Indirect Components Prod A & B indirect % of Total Indirect
1 Materials Purchasing 180500 12.7%
2 Machine Setups 375000 26.4%
3 Product Packaging 280000 19.7%
4 Machine testing and calibration 300000 21.1%
5 Machine Maintenance and Cleaning 287000 20.2%
Total indirect 1422500 100.0%
Allocation of Cost on the basis of Direct Labour Costs
Sl No Particulars Brief
1 Total Indirect Cost 1422500
2 Total Labour Cost Rate 1500000
3 OAR 94.83%
4 Product A- Direct Labor Cost 450000
5 Proportion of indirect Cost 426750
6 Product B- Direct Labor Cost 1050000
7 Proportion of indirect Cost 995750
Sl No Products Compared Product A Product B Total
9 Unit Produces and Sold 900000 2100000
300000
0
10 Total Direct Cost 1125000 2100000
322500
0
11 Total indirect Cost 426750 995750
142250
0
12 Revenue per Unit 3 2
13 Direct Cost (=10./9) 1.25 1
14 Indirect Cost (=11/9) 0.47 0.47
15 Gross Profit 1.28 0.53
16 Gross Profit Margin (=15/12) 42.53% 26.29%
ABC Costing
Sl No Products Compared Product A Product B Total
1 Unit Produced and Sold 900000 2100000 3000000
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ABC Costing
2 Selling Price per Unit 3 2
3 Direct Labour Cost/unit 0.5 0.5
4 Direct Materials Cost/ Unit 0.75 0.75
5 Sales Revenue(=1*2) 2700000 4200000 6900000
Direct Cost
6 Direct Labour Cost(=1*3) 450000 1050000 1500000
7 Direct Materials Cost (=1*4) 675000 1050000 1725000
8 Total Direct Costs (=6+7) 1125000 2100000 3225000
Sl
No Activity Pool Cost Driver (CD)
Activity Units
CD Unit
Cost
Total
Actvit
y
Prod
uct A
Total
indir
ect
Cost
A
Total
Actvit
y
Prod
uct B
Total
indir
ect
Cost
B
1 Purchase Orders No of Purchase Orders 1800 75
1350
00 25
4500
0
2 Machine Setups No of Set ups 1500 150
2250
00 100
1500
00
3 Product Packaging
No of product
packages packed 0.2
9000
00
1800
00
5000
00
1000
00
4
Machine Test and
Calibration No of tests 100 1000
1000
00 2000
2000
00
5
Maintenance and
Cleaning No of Batch runs 1150 200
2300
00 50
5750
0
Total
8700
00
5525
00
Sl. No Products Compared Product A Product B Total
9 Unit Produces and Sold 900000 2100000
300000
0
10 Total Direct Cost 1125000 2100000
322500
0
11 Total indirect Cost 870000 552500
142250
0
12 Revenue per Unit 3 2
13 Direct Cost (=10./9) 1.25 1
14 Indirect Cost (=11/9) 0.97 0.26
15 Gross Profit 0.78 0.74
16 Gross Profit Margin (=15/12) 26.11% 36.85%
On perusal of the above, it can be seen that the Product B in truth is more profitable than Product A.
Limitations
The shortcomings of the ABC method is enumerated here-in-under:
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(a) Deriving the activities that influence indirect cost and the drivers of cost is a time consuming and
costly process;
(b) The drivers identified and the activity chosen may not be a true representative of indirect cost
incurred;
(c) The results obtained may not hold good if different drivers are used;
(d) If the process involved identification of many drivers and activity, the same shall increase the
complexity of the assignment of cost; (Drury, 2006)
(e) The system is costly and difficult to maintain;
(f) The results derived under the method can be misinterpreted.
Conclusion
The conclusion that can be derived is that modern costing system helps in better allocation of indirect
cost as witnessed from example above. Further, the method helps in ascertaining the true profitability
of product and aids in decision making. It can also be seem that the method weeds out the deficiencies
of traditional costing system.
References:
Drury, C., 2006. Cost and Management Accounting:. 6th Edition ed. China.: EMEA,.
Dutta, M., 2004. Cost Accounting: Principles and Practice. India: Pearson, India..
Jain, P., 2000. Cost Accounting. India: McGraw-Hill.
Mathur, S., 2001. Accounting for Management.. India: McGill-Hill,.
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