Purpose of a Cost Formula and the Components

Discuss about the Costing Case Analysis for Activity Based Costing.

This project covers various aspects of costing analysis. The costing analysis will help to eliminate ambiguity in calculation of the product cost based on the formulas. The assessment of the product cost can be either based on conventional costing method or based on ABC or Activity Based Costing. The activity based costing or ABC costing is more precise in ascertaining the cost of the product. Here in below would look into different aspects of costing and analysis of costs of products (Study 2016).

Does anyone actually know the cost to operate their own car? If they actually know the figures they can easily calculate whether they can afford that car or not. People do often underestimate the cost of operating a vehicle or buying any product. The assessment of cost of products is of huge relevance to the business. This not only helps to maintain the product cost and to bring it down further to stay competitive. The cost formulas are important for the assessment of the cost to an organization. The cost assessment is based on some formulas. The formulas are primarily used to ascertain the costs of various components. The cost component includes fixed cost and variable cost (Smith 2016).

The cost formulas are used to determine the cost of a product after considering all the costs incurred or to be incurred in producing something or introducing a new activity. In case of a manufacturing company which manufactures ‘n’ number of items, a cost formula helps to calculate the total cost after considering all the fixed costs and variable cost of each product. The components of the cost formula are as follows:

Fixed costs –

These costs are fixed cost and does not increase or decrease with the number of products. The fixed cost are like rent of a factory, salary of staff, insurance cost etc. These costs can be incurred monthly/quarterly/yearly. At certain level of production the fixed costs remains the same. In case of increase of production beyond certain capacity might influence the fixed cost otherwise it remains fixed irrespective of number of units produced or manufactured.

Variable costs –

The costs are incurred in proportion to the number of products. The decrease in number of unit manufacture or the increase would have proportionate impact on the total variable cost of the product. So if the number of products increases or decrease, the variable cost may automatically increase or decrease. These costs are not constant like materials, labour wages, and cost of another product required producing the main product.

Determination of Cost Formula

There are some others costs which are also integral part of the production are duel in nature. Those costs are either partially fixed or partially variable. These costs are termed as  Semi-Fixed cost or Semi-Variable cost (Economics 2016).

The cost formula is mainly based on the allocation of cost and of the overhead. The material cost is based on the actual quantity of material used for production of one unit of goods. The allocation of material cost would be based on the number of units produced multiplied by the actual quantity of material used for production of each unit. This is a significant part of the production. The goods are to be produced according to the allocation of materials. The cost of materials is to be multiplied by the total material used. This would reflect in assessment of total material costs used for the production of the unit. John gathered data for last two years and created the estimation of the cost of goods produced by his company. According to him prediction model of overheads allocation would help ramp up production. The assessment of the prediction model is important aspect for the business. They have decided that if the labour hours and the machine hours are increased substantially, would it help to achieve better production and reduce the cost per unit. In this connection the assessment of the overhead based on the increased labour hour and machine hours become important.

The labour hour cost is $80 per hour and they are planning to increase our labour hours to 8,500 and machine time to 2,300 hours. This would significantly increase the production and also increase the cost of the products produced. The cost formula is determined on the basis of the allocation of cost and the cost functions. This approach of cost allocation would give proper indication of the actual cost of each bicycle produced. Once the apportionment and the calculation of the cost on the basis of labour hour and machine hour is complete, it would reveal the actual cost of the product. This kind of allocation and the calculation of cost are considered as ABC costing where activity based apportionment of the goods takes place (Johnson 2016).

The actual factors that are considered during ascertaining of the costs are as following:

• The identification of the activities of production and apportionment of the cost accordingly.
• The classification of each activity based on the method of apportionment like number of unit machine hour, labour hour.
• The identification and the calculation of accumulated cost of each unit and the total cost.
• The choice of most appropriate cost drivers
• The calculation of total units of the cost driver and the activity rate of each unit produced
• Application of the cost of each activity on the basis of the apportionment method.

If the number of labour hours and the machine hours are increased significantly, then the cost of each unit produced will be different. Total labour hours consumed is 7500 hours and if it is increased to 8500 hours. The labour cost will increase by $80,000. If the machine time is increased to 2300 hours, the extra machine hours would be $51000. This would ultimately increase the overhead cost but also increase the production at the same time.

Determination of the Costs as Requested by Jon Cruise

The estimated cost of the cycles will not match with the actual cost. The cost drivers will determine the cost of overhead significantly higher. Therefore the apportionment of the cost in the basis of machine hours and labour hours would be inappropriate. It should be linked to number of bicycles produced (Accountingcoach 2016).

ABC termed as Activity-based costing is a system followed in calculating a cost of product by taking into consideration the different resources, activities relating to processing the final product, all direct and indirect cost to be incurred for processing the product. ABC is a modern approach to determine the exact cost of a product. With the help of this method, the company can be able to calculate the cost of each product, services and activities. ABC is a activity based management for apportionment of overhead cost and other direct costs for identifying strength and weaknesses of production and other departments in a manufacturing industry. The allocation of the cost is entirely dependent on the use of the effective cost drivers where management has responsibility to allocate the cost based on the basis of activities of the production department (Way 2016).

The production department and the managers has the primary role to locate the loopholes in is the management and the production department which is causing drainage of resources. The ABC can allocate costs and provide much needed inputs to find out the activities responsible for loss or declined profit. The manufacturing industries have to follow various procurement process and the allocation of the raw material and other resources to production. The major process of manufacturing involves allocation of raw materials labours and other things of manufacturing are to run machine for production. The cost in production of each unit of product will be apportioned on the basis of cost drivers and that will allow better opportunity for the business to grow and cut cost (Lister 2016). 

This is an enormous task to be managed by ABC. The right direction and the process of allocation would yield better results for the organisation.  The organisation has the chances of increasing the cost of production. ABC costing for production and apportionment of the cost effusively analyses procurement and other policies and for the production at different level manages. The professional has to do the duty according to the proposed code of conduct for apportionment of raw materials of best grade with rest of job is on the application department.

Calculate the Product Cost

Advantages of Activity-Based Costing (ABC)

1. Helps to find out the product and service which is not generating enough profits for the company.
2. Helps to find out production or service activities which are out dated and more cost burden for the company thereby increasing the cost of the product.
3. The cost calculated under this method is more accurate and realistic.
4. Two or more products undergoing same activity can be allocated a cost which is reliable as all overheads are considered.
5. The required information from each processing department can be obtained to make allocate profits of different products and services.
6. It is a measurement tool to understand a product and its cost to a customer and profits to a company.
7. Useful in large manufacturing firms.
8. Better tool for management to allocate resources properly.

Limitations of Activity-Based Costing (ABC)

1. It is a costly method as compared to traditional method.
2. Difficult to select the most appropriate cost drive.
3. Difficult to calculate cost on the basis of activities.
4. Mid-sized firms, small manufacturing firms cannot afford the cost of ABC method.
5. Time consuming as staff from each department may be not co-operative to share information.

The main factor of ABC costing is nothing but apportionment of the cost on the basis of cost drivers. The conception would be better applied in an manufacturing organization which has multiple cost heads included in the production or manufacturing process. There are several other reasons for using ABM and the ABC techniques in cost of unit calculation, the cost calculated is separately analysed which equip every organization related to understanding of cost cutting.  The ABC techniques are applied in major industries like General Electric. The Chief Executive Jeffery Immelt once told President Obama regarding application of ABC techniques in these organizations which helped him to evaluate the cost structure of GE in America and other parts of the world in terms of labour cost. A wall street journal also reported that Wal-Mart is opening store all over the world and hiring most of the employees who are not US citizens (Matthews 2012).

This is to be acknowledged that main objective of the ABC costing can only when successful costing with aide of ABC can squeeze the cost out of the system. The better allocation of labour and the material can save cost and time and make manufacturing more efficient. The application of ABC would be successful in larger organisation. Island Wheels Ltd is comparatively small organisation to be able to control the factors of costing with aide of ABC costing. The important factor of ABC costing is review of the previous year performance to achieve next year’s goal (Efinancemanagement 2016).

The forecasting of profit in an organisation is dependent on many factors and ABC is one of such factors. Profit estimation and cost allocation would be more effective in large organisation where the efficiency is measured on the basis of performance. ABC is used as a tool for effective management system for sustained growth and profitability (Business 2016).

Conclusion: 

The understanding of ABC costing is bright from the point of view of the management. It can be best utilised for understanding of cost allocation. The growth factor of the business is to ensure smooth operation and cost control. If the costs are not controlled in the proper manner it would not help in building the organisation goals. The assessment of ABC is entirely dependent on te management and the efficiency of the management to create value for its goods. The important factor of ABC is understood in this report but the application carries a lot of risks including risk of cost escalation unless the cost factors and the cost drivers are allocated properly. The efficiency of the worker will not be judged by ABC if it is applied in a small industry. The ABC costing would be effective better in larger organisation with different departments where efficiency is only being judged with cost drivers.

References:

Accountingcoach. “What is a cost driver? accessed 09 13, 2016” www.accountingcoach.com. www.accountingcoach.com. 2016. https://www.accountingcoach.com/blog/what-is-a-cost-driver.

Business. “Activity Based Costing ABC, and ABC Management Explained.” accessed 09 13, 2016 www.business-case-analysis.com. www.business-case-analysis.com. 2016. https://www.business-case-analysis.com/activity-based-costing.html.

Economics. “Variable Costs and Fixed Costs.” economics.fundamentalfinance.com. economics.fundamentalfinance.com. 2016. accessed 09 13, 2016 https://economics.fundamentalfinance.com/micro_costs.php.

Efinancemanagement. “Cost Drivers.” accessed 09 13, 2016 www.efinancemanagement.com. www.efinancemanagement.com. 2016. https://www.efinancemanagement.com/costing-terms/cost-drivers.

Johnson, Rose. Traditional Costing Vs. Activity-Based Costing. 2016. accessed 04 10, 2016 https://smallbusiness.chron.com/traditional-costing-vs-activitybased-costing-33724.html.

Lister, onathan. “Product Costing vs. Cost Accounting.” smallbusiness.chron.com. smallbusiness.chron.com. 2016. accessed 09 16, 2016  https://smallbusiness.chron.com/product-costing-vs-cost-accounting-37642.html.

Matthews, Merrill. “Companies ‘Outsource’ Because That’s Where The Sales Are.” www.forbes.com. www.forbes.com. 2012. accessed 09 16, 2016 https://www.forbes.com/sites/merrillmatthews/2012/07/20/companies-outsource-because-thats-where-the-sales-are/2/.

Smith, Charmayne. “How to Calculate Predetermined Overhead Rate Machine Hours.” smallbusiness.chron.com. smallbusiness.chron.com. 2016. https://smallbusiness.chron.com/calculate-predetermined-overhead-rate-machine-hours-38399.html.

Study. “Total Cost in Economics: Definition & Formula.” study.com. study.com. 2016. https://study.com/academy/lesson/total-cost-in-economics-definition-formula.html.

Way, Jay. “How to Determine Cost Drivers.” smallbusiness.chron.com. smallbusiness.chron.com. 2016. accessed 09 13, 2016  https://smallbusiness.chron.com/determine-cost-drivers-40992.html.

www.accountingcoach.com. What is process costing? 2016. https://www.accountingcoach.com/blog/what-is-process-costing.