The objective of doing this Cost Accounting Assignment is to understand how to do a proper calculation of traditional costing method and the Activity-based Costing. It is important to have this basic practice to help us in the experience of doing this calculation while we are studying other topic. Through the process of calculation of both methods, I have done by given the history of both method, the definition of both method, and the explanation of both methods. Other than that, I also have given the differences of the traditional costing method and activity-based costing. I also have given the advantages and disadvantages of both methods. This calculation is for understand total profit of ScooterDriver’s product. And discuss the implication of activity-based costing for the director.
TABLE OF CONTENT
PAGE NO.
1.
EXECUTIVE SUMMARY
1
2.
QUESTION 1
Calculation total profit
Absorption costing
Activity-based costing
Report
Evaluate absorption costing and activity-based costing
Implication of activity-based costing
3-4
4-5
6-12
12-14
3.
QUESTION 2
15-24
4.
REFERENCES
25-26
QUESTION 1
Calculate the total profit on each ScooterDriver’s three types of product using each of the following methods to attribute overheads
Absorption costing
OAR = Budgeted production overhead
Budgeted activity level
OAR = RM2,400 000+RM6,000 000+RM3,600 000
200 000 + 220 000 + 80 000(direct labour hours)
= RM12, 000 000
500 000(direct labour hours)
= RM 24 per direct labour hours
Product cost per unit
RisingStar(RM) RoadRider(RM) FireRoll(RM)
Direct material 400 600 900
Direct labour (RM5Ã-100hrs) 500 (RM5Ã-137.5hrs) 687.50 (RM5Ã-200hrs)1000
Prime cost 900 1287.50 1900
(+)Production (RM24Ã-100) 2400 (RM24Ã-137.5hrs)3300 (RM24Ã-200hrs) 4800
Overhead
Production cost per unit 3300 4587.50 6700
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Profit
RisingStar(RM) RoadRider(RM) FireRoll(RM) Total(RM)
Selling Price per unit 4000 6000 8000
(-) Production costs (3300) (4587.50) (6700)
Profit per unit 700 1412.50 1300
(Ã-)Output Unit 2000 1600 400
Profit 1,400 000 2,260 000 520 000 4,180 000
Activity based costing
OAR = Budgeted production overhead
Budgeted activity level
Deliveries to retailer = RM2,400 000
250 (100+80+70)
= RM 9600 per deliveries to retailers
Set- up costs = RM 6,000 000
100(35+40+25)
= RM60000 per set up
Purchase orders = RM 3, 600 000
800(400+300+100)
= RM 4500 per purchase order
Product cost per unit
RisingStar(RM) RoadRider(RM) FireRoll(RM)
Direct material 400 600 900
Direct labour (RM5Ã-100hrs) 500 (RM5Ã-137.5hrs) 687.50 (RM5Ã-200hrs) 1000
Prime cost 900 1287.50 1900
Production overhead
[
Deliveries to retailers 480 480 1680
[ [
Set up costs 1050 1500 3750
[ [ [
Purchase order 900 843.75 1125
Production cost per unit 3330 4111.25 8455
Profit
RisingStar(RM) RoadRider(RM) FireRoll(RM) Total(RM)
Selling Price per unit 4000 6000 8000
(-) Production costs (3330) (4111.25) (8455)
Profit per unit 670 1888.75 (455)
(Ã-)Output Unit 2000 1600 400
Profit 1,340 000 3,022 000 (182 000) 4,180 000
To : ScooterDriver’s director
From : Management Accountant
Evaluate the labour hour and the activity-based costing methods in the circumstances of ScooterDriver.
ABSORPTION COSTING METHOD
During the most of the 1900s, almost all companies used traditional costing systems that those do not accumulate or report costs of activities or processes (Anderson, 1995). Traditional absorption costing methods attribute production overheads to units of output without attempting to allocate administration, selling or distribution overheads and many activities are not directly related to production volume(e.g. ordering, delivery, transportation, equipment set-up, machining and administration) (Miller and Vollman, 1985).
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These require non-volume based cost drivers if costs are to be appropriately traced and provide the motivation for the development of activity based costing (ABC) systems(Hilton, 1994). Direct material and direct labour costs can be easily be traced to jobs and processes, but manufacturing overhead may bear no obvious relationship to individual units of product and assignment of overhead made through a volume-based activity base (or cost driver), attempt to ensure that products which cause large amounts of overheads costs correspond with those which require large amounts of the cost driver (Sizer, 1989).
The allocation of manufacturing overhead (indirect manufacturing costs) to products on the basis of a volume metric such as direct labour hours or production machine hours(Sizer, 1989). As manufacturing becomes more sophisticated the manufacturing overhead costs usually increase while the direct labour hours or production machine hours decrease therefore, the direct labour or machine hours are unlikely to be the root cause of the manufacturing overhead(Hilton, 1994).
ABC (ACTIVITY-BASED COSTING)
ABC (Activity-Based Costing) arise in the 1980s from the increasing lack of relevance of traditional cost accounting methods (Weetman,2006). The traditional cost accounting methods were designed around 1870 – 1920 and in those days industry was labor intensive, there was no automation, the product variety was small and the overhead costs in companies were generally very low compared to today, from the 1960s – particularly 1980s – this changed rapidly (Whitehead and Upson, 1982). For these reasons, and more, traditional cost accounting has been called everything from ‘number 1 enemy of production’ and questions whether it is ‘an asset or a liability’ have been raised (Innes and Mitchell, 1998).
ABC has been promoted by Johnson(1988), Kaplan(1988) and Cooper (1988), among others, as a means of improving the quality of management accounting information when traditional methods of allocation overhead costs might be misleading to the users of product cost information (Smith, 1995). Harvard Business School Professor Robert S. Kaplan was an early advocate of the ABC system, while mainly used for private businesses, ABC has recently been used in public forums, such as those that measure government efficiency (Cooper, 1990). ABC recognizes that many significant overheads are related to activities which are independent of volume and identifies those cost drivers which consume resources to determine process and product costs (Innes and Mitchell, 1998).
ABC is an alternative to traditional accounting where business overhead (indirect costs such as lighting, heating, and marketing) provided in the percentage of direct costs of the activities but this is not satisfactory because the two activities that absorb the costs are directly can use very different amounts of overhead (Izhar, 1990). An industrial robot is a large scale, for example, can use the same amount of labour and materials as a robot. But the specific robot uses far more time (overhead) engineers from a mass production company (Johnson and Kaplan, 1987).
ABC is an accounting method that allows businesses to gather data about their operating costs and they are assigned to specific activities such as planning, engineering, or manufacturing and then the activities are associated with different products or services (Jones and Dugdale, 2002). In this way, the ABC method enables a business to decide which products, services, and resources are increasing their profitability, and which are contributing to losses (Johnson and Kaplan, 1987). Managers are then able to generate data to create a better budget and gain a greater overall understanding of the expenses that are required to keep the company running smoothly (Izhar, 1990). Generally, activity-based costing is most effective when used over a long period of time, as opposed to shorter-term solutions such as the theory of constraints (Smith, 1995).
ABC is a method of allocating costs to products and services (Izhar, 1990). It is generally used as a tool for planning and control and it was developed as an approach to address problems associated with traditional cost management systems that tend to have the inability to accurately determine actual production and service costs, or provide useful information for operating decisions (Hopper, Northcott and Scapens, 2007). With these defiencies managers can be exposed to making decisions based on inaccurate data. The higher exposure is for companies with multiple products or services (Innes and Mitchell, 1998).
DIFFERENCES BETWEEN TRADITIONAL AND ABC SYSTEMS
There is a basic philosophical difference between the traditional and the ABC approaches. Traditionally sees overheads as rending a service to cost units, the cost of which must be charged to those units (Atrill and Laney, 2007). ABC sees overheads as being caused by activities, and so it is the cost units that cause the activities that must be charged with the cost cause (Drury, 2005).
It is not always easy to see how and why some overheads costs have arisen (Atrill and Laney, 2007). This has traditionally made them more difficult to control that direct labour and materials costs, if, however an analysis of overheads can identify the cost drivers, question can be asked about whether the activity driving certain costs is necessary at all, and whether the cost justifies the benefit (Warren, Reeve and Fess, 2005).
Adopting ABC requires that most overheads can be analysed and the cost drivers identified (Drury, 2005). This means that it might be possible to gain much cleaner insights about the overheads costs that are caused, activity by activity, so that fairer and more accurate product costs can be identified, and costs can be controlled more effectively (Warren, Reeve and Fess, 2005).
Under ABC, an overheads cost pool is established for each cost driver in which all of the costs caused by that driver are placed (Atrill and Laney, 2007). All costs associated with this activity would be allocated to that cost pool and the total costs in that pool would then be allocated to output, using the cost driver identified, according to the extent to which each unit of output ‘drove’ those costs (Warren, Reeve and Fess, 2005).
Allocating overheads costs to cost pools, as is necessary with ABC, contrasts with the traditional approach, where the overheads are normally allocated to production departments (cost centers) (Atrill and Laney, 2007). In both cases, however, the overheads are then charged to cost units (goods or service) (Drury, 2005).
With the traditional approach, overheads are apportioned to product departments (cost centers) (Dyson, 2007). Each department would then derive an overhead recovery rate, typically overheads per direct labour hour (Weetman, 2006). Overheads would then be applied to units of output according to how many direct labour hours were worked on them (Abraham, Glynn, Murphy and Wilkinson, 2008).
With ABC, the overheads are analysed into cost pools, with one cost pool for each cost driver (Drury, 2005). The overheads are then charged to units of output, through activity cost driver rates, and these rates are an attempt to represent the extent to which each particular cost unit is believed to cause the particular part of the overheads (Abraham, Glynn, Murphy and Wilkinson, 2008).
ADVANTAGES AND DISADVANTAGES OF ABSORPTION COSTING AND ABC
ABSORPTION COSTING
ADVANTAGES
DISADVANTAGES
It assumes all the costs that contribute to the final product in some way(Atrill and Laney, 2007). This includes both direct costs and indirect costs(Atrill and Laney, 2007). Direct costs refer to the costs that can be detected directly to the product itself, such as direct materials or direct labor(Atrill and Laney, 2007). Indirect costs refer to costs which cannot be detected directly to the products and allocated to products, such as property taxes or factory manager wage(Atrill and Laney, 2007).
A disadvantage of absorption costing involves pricing decisions(Drury, 2005). When a company has excess capacity and it considers various business opportunities, it may deny business that would generate profits for the company(Drury, 2005). The company evaluates each business opportunity using absorption costing as its base cost(Drury, 2005). The company accepts business opportunities that provide revenue above the absorption cost and rejects business opportunities that provide revenue below the absorption cost(Drury, 2005). Some of the business that the company rejects may contribute additional profits to the company when it has excess capacity (Drury,2005).
Generally accepted accounting principles (GAAP) represents the standard that most corporations pursue for financial reporting(Johnson and Kaplan, 1987). Generally accepted accounting principles need corporations to use absorption costing for external reporting(Johnson and Kaplan, 1987). Companies that use different forms of product costing for internal analysis is still necessary to maintain a system of absorption costing to GAAP(Johnson and Kaplan, 1987). Companies that use absorption costing for all the valuable products have the advantage that the cost of the same can be used for all purposes(Johnson and Kaplan, 1987).
Another disadvantage of absorption costing involves skewing the results of decisions made to discontinue business segments(Izhar, 1990). When the company uses absorption costing in the decision, the analysis includes fixed costs that will remain whether the company eliminates the segment or not(Izhar, 1990).
Absorption costing identify fixed costs in the cost of the product(Izhar, 1990). Because it is suitable to determine the price of the product(Izhar, 1990). Pricing based on absorption costing ensure that all costs are covered. (Izhar, 1990)
Absorption costing does not help in cost control and planning and control functions(Johnson and Kaplan, 1987). It is not useful in determining the responsibility for the occurrence of cost(Johnson and Kaplan, 1987). It is not practical to hold the manager responsible for the cost of which he / she does not control(Johnson and Kaplan, 1987).
Absorption costing will show the proper calculation of the profit of variable costing in situations where production is carried out to have a sale in the future (e.g., seasonal production and seasonal sales) (Izhar, 1990).
Some costs can be removed from the product during the income statement for the inventory issue(Johnson and Kaplan, 1987). Therefore, managers evaluated on operating income can temporarily increase profit by increasing production(Johnson and Kaplan, 1987).
.
ACTIVITY-BASED COSTING
ADVANTAGES
DISADVANTAGES
The advantage of activity-based costing is the accuracy in the process of costing with regards to the product line, the end-users of the product, the stock-keeping units employed by the management and the channel and category which streamline the flow of the product from the producer to the end user(Dyson, 2007).
The process of data collection for this system is very time consuming(Smith, 1995).
This system helps in the process of better understanding the concept of resource allocation overhead costs business as common as they used by specific product line and their relationship to specific cost drivers(Dyson, 2007).
The system is so transparent that some managers will not approve because they want to keep a few things from the viewpoint of owners(Smith,1995).
This process is for cost of unitary, or the marginal cost calculations based on the contrast with the traditional method of cost accounting that uses the total cost(Dyson, 2007).
Capital expenditure on systems based on the following activities and running costs can be a road block for the firm(Smith, 1995).
The system is easy to understand and interpret it can be accessed, use and functional implemented throughout all forms of business set-up(Dyson, 2007).
The system helps in the process of benchmarking which is part of the quality control system(Dyson, 2007).
The system works very well will increase the quality and up gradation program(Dyson, 2007).
The implication of activity based costing
The finance director argued that “I very much doubt whether selling FireRoll is viable but I am not convinced that activity-based costing would tell us any more than the use of labour hours in assessing the viability of each produt.”
From my opinion, I not agree with what finance director told because in activity-based costing use cost driver. Cost driver is a factor that can cause a change in the cost of an activity. An activity can have more than one cost driver attached to it. For example, a production activity may have the following associated cost-drivers such as a machine, machine operators, floor space occupied, power consumed, and the quantity of waste and/or rejected output. In ScooterDriver they used three type of cost driver such as deliveries to retailers, set-up costs and purchase orders. So we can see how much each cost driver cost for the product and choose the product fairer and more accurate product costs can be identified, and costs can be controlled more effectively. Other than that, activity-based costing not only using labour hours for assessing the viability of each product, it also use machine hours.
The marketing director argued that “I am in the process of negotiating a major new contract with a motorcycle rental company for the RisingStar model. For such a big order, they will not pay our normal prices but we need to at least cover our incremental costs. I am not convinced that activity-based costing would achieve this as it merely averages costs for our entire production.”
From my opinion, I not agree with what marketing director told because activity-based costing shows average cost better than absorption costing. Absorption costing is more simplistic and less accurate than activity-based costing, and typically assigns overhead costs to products based on an arbitrary average rate. Activity-based costing is more complex and more accurate than absorption costing. This method first assigns indirect costs to activities and then assigns the costs to products based on the products’ usage of the activities.
The managing director argued that “I believed that activity-based costing would be an improvement but it still has its problems. For instance, if we carry out an activity many times surely we get better at it, and costs fall rather than remain constant. Similarly, some costs are fixed and do not vary either with labour hours or any other cost driver.”
From my opinion, I not agree with what managing director told because the definition of fixed cost in activity-based costing is a cost element of an activity that does not vary with changes in the volume of cost drivers or activity drivers. For example “The deprecation of machine” may be direct to a particular activity, but it is fixed with respect to changes in the number of units of the activity driver. Same goes to ScooterDriver’s product the cost is fixed over a given time not all time or period. And the designation of fixed cost can also vary depending on the extent which the volume of production , activity drivers or cost drivers may change.
The chairman argued that “I cannot see the problem. The overall profit for the company is the same no matter which method of allocating overheads we use. It seems to make no differences to me.”
For my opinion, I agree with what chairman argued that both method gave same profit but from my point of view, I think that activity-based costing more benefit than the absorption costing. The profit of ScooterDriver company is RM4180000. For what I said that activity-based costing more benefit because absorption costing mostly utilizes volume related allocation bases while activity-based costing. uses drivers at various levels. Activity-based costing is a method that allocates a cost to various activities which then enable an organization to make informed decisions regarding products and/or services. Once the costs have been determined, they can be input into computer applications designed to analyze the costs. Management can then modify the budget and help the company become more profitable by decreasing inefficient activities. So activity-based costing is more advantage to a company to make profit.
Question 2
Explain how the business environment that businesses face has changed over the past decades and discuss how this has had impact on management accounting.
INFORMATION TECHNOLOGY (IT)
The so called “new media boom” of the 1980s failed to live up to expectations because the underlying technologies never became widespread(Drury, 2004). In contrast, technological advances on two fronts which are digitization and networking have become indispensable components of today’s society(Drury, 2004). Digitization is enabling the fusion of different media based on technologies for processing and transmitting huge volumes of data(Drury, 2004). Networking is creating virtual communities on networks (cyberspace) centered on the Internet(Drury, 2004).
With the advance of technology, electronic networks are revolutionizing structures and processes in the business world(Hilton, 1994). To improve processes, businesses are introducing e-mail and intranets. But of even greater impact is the revolution in business contacts not only with other companies but with consumers. The infrastructure has grown as more consumers use personal computers and participate in networks, and technological advances are making communication more efficient. Whereas information technology in the past mainly focused on changing work processes inside companies, today’s revolution in information and communications technology could potentially alter the model of communication between businesses and consumers.
In the old economy information communication, and transactions are all physical things(Hilton, 1994). They include cash, stamps, invoices, stock certificates, reports, face to face meetings, analog telephones, radio and television broadcasts, receipts, blueprints, maps, photographs, books, newspapers, magazines, and direct mail advertising. In the new economy, all types of information transactions, and personal communication will increasingly be digitized-that is, compressed into bits, stored in computers and transmitted through networks at the speed of light. The quality of information will be much better than with analog transmission.”
Today our approach to daily life is centered on physical things(Hilton, 1994). For example, the act of shopping involves a process of going to a store, obtaining information on the desired product, making a purchasing decision, paying money, and receiving the product. With the emergence of mail order shopping, transactions could be carried out simply by exchanging information on a product or service, and credit cards and mail delivery eliminated the need to visit a store and talk to a sales clerk(Hilton, 1994).
In other words, information on products and services could be dissociated from and distributed separately from the physical product or service, eliminating time and space restrictions of conventional physical communication. This implies a shift in management resources from land, labor and capital, to information. In the information network society, the conventional conditions for corporate success such as large cities, large markets, and large companies will no longer apply. Companies can operate from anywhere if they are connected to a network, and can plunge right into the global market rather than grow in the local market. Since the most important factor is the value of the information a company possesses, we predict that market entry and competition will intensify as size of capital becomes irrelevant to market entry.
Application of IT in management accounting has major impact on the organization’s profits. It is wrong to conclude that implementation of new technology in management accounting will improve company’s profits. Implementation of new technologies may reduce company’s income, as the implementation is costly depending on the technology adopted. There is a risk to the companies that if inappropriate technology is chosen, then the company is forced to incur unnecessary costs which lead to waste of resources. However, if the management and the accountants study the feasibility and the functionality of the systems before the implementation of IT in management accounting, then the above risk can be avoided. The skill and knowledge of accountants should be repositioned to support the application of IT in management accounting. The companies have to send their staff to IT related training to acquire and update their IT skills to use the system efficiently. The users of the system must be trained well in order to take advantage of the technology within the system. Selecting user friendly system is essential, as it require less IT skilled personnel to handle the system. Most of the systems available now are user-friendly and easy to use. Technology is changing fast and it is very difficult to keep track with the technology changes. The company’s challenge is to adopt a technology that can be used for a long period which may not be achievable now. The new technology today will be obsolete within couple of months and will be replaced by more sophisticated technology. So the company has to select the technology that is upgradeable to meet the future technology requirement.
GLOBALIZATION
Globalization’ means ‘the reduction of the difference between one economy and another’ so that trade within and between different countries is increasingly similar all over the world. Globalization has become a big buzz word in the last 10/15 years, but it has been going on for centuries, and especially since 1945.
In the 17th Century new ship design allowed Europeans to start trading with the rest of the world in a much bigger way, although trade was still a tiny part of the economy compared to agriculture.
Later developments in transport, steam ships, the railways and now aircraft, have all contributed to the development of trade. Aircraft also move people around quickly, so the sense of the size and distances of the world ‘shrinks’ making us feel that far-away places are no longer so strange. The internet now allows international communication in a way that was not possible before; your favourite site could just as easily be in New Zealand as in London.
The following main factors have fuelled the pace of globalization which are first is technological change, especially in communications technology. For example, UK businesses and data by satellite to India (taking advantage of the difference in time zones) where skilled but cheaper data handlers input the data and return it by satellite for the start of the UK working day.
Second is transport is much cheaper and faster. This is not just aircraft, but also ships. The development of containerization in the 1950s was a major breakthrough in goods handling, and there have been continuing improvements to shipping technology since then.
Third is removal of capital exchange controls. The movement of money from one country to another was also controlled, and these controls were lifted over the same period. This allowed businesses to move money from one country to another in a search for better business returns; if investment in one’s own country looked unattractive, a business could buy businesses in another country. During the 1990s huge sums of money, mainly from the US, have come into the UK economy.
There are three impact of globalization on management accounting. First, management accounting deals with both financial and non-financial data to support a wide range of managerial decisions in contrast to financial accounting’s focus solely on financial data to support investors’ and creditors’ capital allocation decisions. “For many companies,” notes CareerBank.com CFO Douglas Banister, “the real value-add is the integration of financial reporting with operational information.”
Second, management accounting looks forward as well as backward, whereas financial accounting is oriented solely towards history. Management accounting involves anticipating what will, could, or should happen, as well as figuring out what did happen. Forecasting, planning, and budgeting are typical management accounting activities.
Third, management accounting looks outward as well as inward, whereas financial accounting is focused solely on what happens internally within an enterprise. Management accounting involves proactively seeking and identifying opportunities and threats that an enterprise faces from customers, competitors, suppliers, regulatory agencies, and other external parties. In short, management accounting is focused on enhancing business performance in a competitive environment, not simply on ensuring compliance with standards and regulations.
MANUFACTURING ENVIRONMENT
New manufacturing strategy commonly involves the use of new technologies, and changes in organizational structure and management practices, such as Just-in-Time (JIT) and Total Quality Management (TQM) that possible lead to a radical change in the way business is conducted. AMT applications include applications such as computer integrated manufacturing (CIM), computer-aided design (CAD), computer-aided engineering (CAE), flexible man
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