ACC200: Evaluating Traditional Costing vs. Activity Based Costing

This report analyzes two primary costing methods: traditional costing and activity-based costing (ABC). It begins with an executive summary highlighting the core differences in overhead cost allocation, followed by an introduction that explains the context of the analysis using a case study of Sewing Easy Limited. The report then delves into the calculation of cost per unit using both traditional and ABC methods, including detailed workings and calculations of predetermined overhead rates and overhead allocation. The report also presents profit and loss statements for a specific product model under both costing systems, followed by an analysis of why overseas buyers are interested in a particular model based on pricing differences. It concludes with a discussion on actual versus applied overheads and a review of the benefits and limitations of the ABC system, offering a comprehensive understanding of the two costing methods and their implications.

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ACC200: ASSIGNMENT TERM 1 2018

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Executive Summary
There are mainly two methods of costing that are used to allocate the direct as well as
indirect cost to the cost system. The two main costing methods are traditional costing and
activity based costing. The main difference in traditional costing method and activity based
costing method is that way of allocating the overhead costs to different products. In this report a
given case problem has been solved using both traditional costing method and activity based
costing model. In this assignment advantages and limitations of the activity based costing has
been discussed in detail to have an overview on how activity based costing helps cost manager to
allocate various types of cost to the cost system. The give case problem is solved to find out the
cost per unit under traditional costing system and activity based costing system. It has been
found that Activity base costing model has used more sensible approach to allocate all the
indirect to given products: Basic Model and Advance Model. Activity based costing has applied
cost driver for each cost and on the basis of that overhead rate for each activity is determined to
allocate these overhead costs to each of product line. In this way overhead cost has been
proportioned to products on the basis of resources used by each product in each activity.

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Introduction
In the field of management accounting the two main costing methods used to allocate the
indirect (Overhead) costs are activity based costing and traditional method. In both these
methods cost overhead rate of the production are calculated are assign to the total cost of product
using the cost driver rate. Traditional costing system uses only one cost driver rate while activity
based costing uses many cost driver rate to allocate the overhead cost to the total production cost.
In this report a typical case scenario has been given to calculate the cost per unit of
products using both traditional costing and activity based costing system. The given case
scenario is of Sewing Easy Limited that manufactures two models of sewing machines and these
models are basic model and advance model. In the given case problem management at Sewing
Easy Limited is concerned why oversea buyers are interested only in advance model not in the
basic model. Company currently is using the traditional method for allocating the cost and wants
to move to activity based costing system. In order to find out the reason why oversea buyer are
interested in advance model not in basic model, calculation has been made to find out cost per
unit using both traditional costing method and activity based budgeting method.
Solution-1: Calculation of cost per unit under the traditional costing system
The traditional method of cost accounting is used for allocation of manufacturing
overhead costs as per the manufactured products. The method is used for allocation of indirect
costs as per the volume of products manufactured. The method is highly useful for the business
managers to gain an overview of the overall indirect costs involved in the manufacturing process
of the company. The indirect costs are allocated on the basis of number of units produced or on
the basis of direct labor or the machine hours. The method involves identifying the indirect cost
related to the manufacturing process of the company on a regular basis (Tulsian, 2006).
The most significant advantage of the method is that it is relatively simple to be applied
as it is easy for the business managers to identify the indirect costs as per the products produced
or labor and machine hours consumed. The method also has a significant drawback that the
method is less reliable to be sued in the firms involved in manufacturing of large volume of few
products. This is because the increase in the amount of overhead expenses can increase the
chances of error occurrence in allocating the overhead costs to different products (Drury, 2008).

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The cost per unit of the models is as below:
Particulars Basic Advance
Direct material cost 325.00 560.00
Direct Labor cost 150.00 260.00
Allocated indirect overheads 89.84 70.83
Other costs* (201,700/1,500) 134.47
Total cost per unit 564.84 1,025.30
The cost per unit for Basic Model is $564.84 and for Advance Model is $1,025.30.
*Other costs include the following:
Selling & Admin expense 140,600
Interest expense 25,200
Office rent 35,900
Total expense 201,700
WN-1 – Calculation of predetermined overhead rate
Predetermined Overhead Rate = Total Indirect Overhead/ Total Machine hours
= 250,000/8000
= $31.25
WN-2 – Calculation of allocation of indirect overheads
Particulars Basic Advance
Total machine hours 4,600 3,400
Units produced and sold 1,600 1,500
Machine hour per unit (total machine 2.88 2.27

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hours/ unit produced and sold)
Overhead per unit 89.84 70.83
Solution-2: Calculation of cost per unit under activity based costing system
The business manager at present adopts the use of activity based costing in comparison to
traditional costing method to overcome from the significant disadvantages of the traditional
costing method. The activity based costing method is developed for gaining an in-depth analysis
of the relation between overhead costs and cost drivers (Crosson and Needles, 2010). The
method involved identification of all the activities in the manufacturing process and then
attributing the costs as per the activities identified. The method of costing proves to be highly
efficient in controlling the overheads as it is highly flexible for identifying the overhead cost on
the basis of fluctuation of the customers. The cost of each activity involved in the manufacturing
process is used in compiling the overall cost of the manufacturing process (Bradtke, 2007). The
method is regarded as the most accurate method of identification of overhead costs and
identification of the wasteful activities that lead to the occurrence of operational inefficiencies.
Thus, it enables the operational managers for developing an effective method of improving the
manufacturing cycle-time. The product cost is determined on the basis of cost incurred in
development of each activity and thus accurately measures the resources consumption in each
activity. This facilitates the managers in providing sufficient information relating to the nature of
resources consumed by various activities involved in the manufacturing process (Maingi, 2013).
The cost per unit of both the products is as below:
Particulars Basic Advance
Direct material cost 325.00 560.00
Direct Labor cost 150.00 260.00
Allocated indirect overheads 47.19 116.33
Other costs* (201,700/1,500) 134.47
Total cost per unit 522.19 1,070.80
The cost per unit for Basic Model is $522.19 and for Advance Model is $1,070.80.

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WN-3 – Calculation of allocation of indirect overheads
Particulars
Indirect
Overhead
s
Activities Consumed Overhead
allocation
Basic
Model
Advanc
e Model Total Cost
Driver
Cost
per
activit
y
Basic
Model
Advanc
e Model
Inspection 20,000 200 750 950
Inspection
s 21.05 4,211 15,789
Assembly 90,000 4,600 3,400 8,000
machine
hours 11.25 51,750 38,250
Production
scheduling 105,000 50 500 550 Runs 190.91 9,545 95,455
Machine set-up 35,000 100 250 350 set up 100.00 10,000 25,000
Total Costs 250,000 75,506 174,494
No. of units 1,600 1,500
Cost per unit $ 47.19 $116.33

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Solution-3 (a): Profit and Loss Statement for the advance model using traditional costing
As on December, 2017
Particulars Units Per unit Amount ($)
Sales (WN-4) 1,500 1,230 1,845,000
Less: Direct material cost 1,500 560 840,000
Less: Direct Labor cost 1,500 260 390,000
Less: Overhead cost 1,500 70.83 106,245
Less: Other expenses
Selling & Admin expense 140,600
Interest expense 25,200
Office rent 35,900
Net Profit 307,055
WN-4 – Calculation of selling price under traditional costing
The selling price per unit is 20% plus cost.
Selling price per unit = 1025.30*120%
= $1,230
Solution-3 (b): Profit and Loss Statement for the advance model using ABC
As on December, 2017
Particulars Units Per unit Amount ($)
Sales (WN-5) 1,500 1,285 1,927,433
Less: Direct material cost 1,500 560 840,000
Less: Direct Labor cost 1,500 260 390,000
Less: Overhead cost 1,500 116.33 174,494
Less: Other expenses
Selling & Admin expense 140,600

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Interest expense 25,200
Office rent 35,900
Net Profit 321,239
WN-5 – Calculation of selling price under traditional costing
The selling price per unit is 20% plus cost.
Selling price per unit = 1070.80*120%
= $1,285
Analysis on why the overseas buyer is interested only in Advance Model
The overseas buyer is interested in the Advance Model only since it is underpriced as
compared to market. The Advance Model is underpriced by $45 ($1025-$1071) and the Basic
Model is overpriced by $43 ($565-$522).
This is because the company has been allocating the costs using the traditional costing
method which is not the correct method to allocate costs, since it allocates the cost using blanket
rate. On the other hand, the ABC costing is an appropriate method and produces accurate
allocation of costs as it allocates the cost on the basis of activities consumed by the products.
Hence, as the advance model is underpriced, so the overseas buyer are interested in
purchasing the advance model and since the Basic Model is overpriced that’s why the overseas
buyer is not interested in basic model.
Hence, it is very much necessary for the company to allocate the costs properly so that
the products are priced accurately.
Solution-4: Discussion on actual overhead and applied overhead
The actual overheads and applied overheads will be same when the actual overheads and
actual resources (i.e. labor hours or machine hours) are same as budgeted. But this situation

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happens very rarely as there is always difference between the budgeted and actual overheads and
budgeted and actual resources consumed.
The three ways to deal with over or under applied overheads are:
 One way is to calculate a supplementary rate of the difference between actual and applied
overheads. Then this difference is charged to the products.
 Second way is to write off the difference of applied and actual overheads in the profit and
loss account.
 The last way is to carry forward the difference of actual and applied overheads in the next
year.
Solution-5: Benefits and Limitations of Activity based costing system
Activity based costing method is a popular and most used methods for the cost allocation.
It has the following advantages (Your Article Library, 2018):
(a) The ABC method allocates the costs on a systematic basis and hence the product costs
are generally accurate and error free.
(b) Since, the allocation of costs is correct and error free, the product cost or selling price
assigned to the products is also correct.
(c) ABC is best for the organizations having multiple products and various indirect
overheads. As it involves systematicallocation of overheads by allocating the costs to the
activities and mapping those activities with the cost drivers.
(d) It helps the management in managing the costs. As it gives the clear picture of costs and
there related activities, the management can easily identify the performing activities or
divisions and non-performing activities and division. On the basis of this information, the
management can take various decisions.
The disadvantages of ABC are as below (Money Matters | All Management Articles, 2018):
(a) The ABC method is very costly system for its implementation as it involves through
understanding of the process and identifying the related costs and cost drivers.
(b) Since, it is a costly system, it is not advisable for smaller firms.

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(c) It is a complicated system to understand, and only the professionals or high level people
can understand this. Hence, specialized knowledge or professionals are required for
implementation and use of ABC.
Conclusion
It has been found on the basis of overall analysis that traditional costing system does not
accurate cost allocation and also leads to wrong decision making. Under traditional costing
system one can face issue of over pricing or under pricing of products as overheads is divided
using single recovery rate without giving effect of actual resources (activity consumption) by
each product. This create many issues while making the decision of profitability provided by
each product as traditional costing does not give any actual profit provided by each product. On
the contrast activity based costing method uses actual consumption of resources used by each
product to allocate the overhead costs. Activity based costing helps to ascertain overhead rate of
each activity in order to allocate each overhead cost to each product on the basis of actual
consumption of activity in production of each product.

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References
Bradtke, D. 2007. Activity-Based-Costing. GRIN Verlag.
Crosson, S. and Needles, B. 2010. Managerial Accounting. Cengage Learning.
Drury, C. 2008. Management and Cost Accounting. Cengage Learning EMEA.
Maingi, J. 2013. Advantages & Disadvantages of activity based costing with reference to
economic value addition. GRIN Verlag.
Money Matters: All Management Articles. 2018. Advantages and Disadvantages of Activity
Based Costing. [Online] Available at: https://accountlearning.com/advantages-and-
disadvantages-of-activity-based-costing/ [Accessed on: 9 May 2018].
Referenceforbusiness.com. 2018. Activity-Based Costing - type, benefits, How activity-based
costing works. [Online] Available at: http://www.referenceforbusiness.com/small/A-Bo/Activity-
Based-Costing.html [Accessed on: 11 May 2018].
Tulsian. 2006. Cost Accounting. Tata McGraw-Hill Education.
Your Article Library. 2018. Advantages and Demerits of Activity Based Costing (ABC).
[Online] Available at: http://www.yourarticlelibrary.com/accounting/costing/advantages-and-
demerits-of-activity-based-costing-abc/52617 [Accessed on: 9 May 2018].