Traditional Costing System

Write about the Importance of Accurate Product Costing for ABC System.

With the increase in selection of products offered to the consumers based on variance in size and designs along with colour, all business organisations have to deal with enormous products. This has resulted in the evolution of product costing. Product costing is the accounting technique of ascertaining the various business expenses related to the development of business products (Cinquini et al. 2015). The current report would discuss product cost under the traditional costing system and activity-based costing (ABC) system. The second portion would focus on highlighting the benefits of the ABC system from the perspective of a manufacturing organisation. In addition, the report describes the ways through which the cost drivers could be chosen in the ABC system. Finally, the report would shed light on depicting the reasons behind the occurrence of over or under allocation of overhead and the ways through which such occurrence could be dealt. 

Traditional costing system is the system of distributing factory overhead to the products depending on the volume of production. In this method, the application of overhead is made depending on either direct labour hours or usage of machine hours. In this context, Annan et al. (2016)        cited that cause and effect techniques are used in this method and it considers direct costs as well indirect costs and other business expenses. Under direct costs, certain matters are included, which are the material costs used in the process of production and the labour cost of creating products. The indirect costs consider those expenses, which could not be estimated easily. These consist of matters like overhead costs and unpredictable costs of direct labour. By taking all these costs together, it is possible for a business organisation to project the overall cost needed to manufacture a product. After the estimation of total cost, the organisation would be able to ascertain the amount of expected profit. This is conducted in this system by dividing the overall product costs by the costs of direct labour needed to manufacture the finished product (Cooper 2017).

However, a small variation in resource volume could cause significant variation in the applied overhead amount. The issue is inherent greatly in extremely automated production environments, in which there is huge factory overhead and there is nearly non-existence of direct labour. For instance, traditional costing computation might find that it is necessary to distribute factory overhead to products at $300 per direct labour hour. Hence, if a slight modification is made in the manufacturing process raising direct labour by a single hour, it would result in increase in product cost by $300 of overhead. This huge variation in applied overhead is not realistic, as there is not presence of direct relationship between factory overhead and production volume all the time (Eldenburg et al. 2016).

Activity-Based Costing System

This is a system that initially allocates costs to activities, which are the real cause of overhead and after this, the activity costs are assigned to the products making actual demand of the activities. Firstly, this system identifies each activity engaged in the manufacturing process and then the activities are categorised based on cost hierarchy. The cost hierarchy could be batch level, unit level, facility level and product level (Andersch et al. 2014). The third step involves identifying and gathering the overall costs associated with each activity. The next step is to select the suitable cost drivers for the activities and accordingly, the overall units of the cost drivers pertinent to the activities are computed. The next step is to compute the activity rate, which is the activity cost per unit of the pertinent cost driver. Finally, this system applies the activity cost to products depending on the usage of activity by the product.

For instance, an organisation manufactures two products, which are Product A and Product B. Product A is an item of low volume needing various activities like additional testing, special engineering and machine setups, since small quantities are ordered. Product B is similar to Product A; however, it is an item of high volume, which is running constantly and thus, it does not need special activities and special production. If the organisation uses traditional costing system, the overhead might be assigned to products depending on machine hours (Cardes, S. and Gooneratne 2016). As a result, a small portion of overhead cost might be assigned to Product A due to the absence of machine hours in it. However, the organisation might need to deploy additional testing, engineering and setup activities. In opposition, Product B would be assigned huge overhead because of such machine hours; however, little overhead activity is required. Hence, the actual cost of manufacturing overhead of each product might be computed incorrectly and thus, ABC system would mitigate this deficiency by allocating overhead on above one activity.

In ABC system, the organisation would compute the resource cost utilised in the activities. After thus, the activity cost would be apportioned to the products demanding activities. Considering the above example, Product A would be allocated a portion of the special testing, special engineering and machine setup costs. The other products utilising any of such activities would be allocated a part of their costs. There would not be allocation of any special cost on Product B; instead, a small portion of machine setup is allocated. 

Benefits of ABC System in Manufacturing Organizations

There are certain benefits that ABC system could provide to a manufacturing company and they are demonstrated briefly as follows:

In advanced manufacturing environments where the overheads of support functions include vast amount of total costs, realistic product costs could be obtained with the help of ABC system. This could be applied in case of greater diversity among the produced goods such as high-volume as well as low-volume products (Fisher and Krumwiede 2015). Thus, it eliminates the errors as well as approximation in ascertainment of product cost because of absorption methods and arbitrary allocation.

This system helps in identifying the actual nature of cost behaviour along with minimising costs and detecting activities not adding value to the product. Thus, the managers of the manufacturing firms could control fixed overhead costs, as they could control over activities resulting in fixed overhead costs due to the visibility and clarity of activities (Hoozée and Hansen 2017).

Multiple cost drivers are used by the ABC system and most of them are based on transactions, instead of product volume. In addition, ABC is related to all activities within the internal and external premises of the factory for identifying additional overheads to the products.

With the help of ABC system, the managers of the manufacturing organisations could make better decisions, as reliable data of product cost could be used. This paves the path to fix product selling price due to the availability of accurate product cost data (Klemstine and Maher 2014).

With the help of ABC system, it is possible to obtain rates of cost drivers and transaction volume information crucial for the manufacturing organisations in relation to cost management and performance assessment of their responsibility centres. These rates could be used beneficially so that new products could be designed or the current products could be modified. This is because indication is towards the overhead costs, which are probable to be applied in product costing.

ABC system, with the help of activity pool cost and cost driver identification, could result in numerous applications in the manufacturing organisations. These take into account detecting the spare capacity and promotion of cost minimisation by contrasting the resources needed under this system with those that are available currently (Langfield-Smith et al. 2017). As a result, platform is created for activity-based budgeting where the resource relationships detected by the ABC system are utilised for estimating future resource needs.

The ABC system undertakes the following series of steps to select cost drivers: 

Cost Drivers Selection Process in ABC System

 As the manufacturing organisations deal with material handling tasks regularly, it becomes difficult to assign material handling cost to various working units. In this case, the cost object is the material handling cost (Lueg and Morratz 2017). By setting the cost object, the firms could ascertain cost driver for allocating material handling cost to different departments.

By considering the above example, the departments might track work in relation to the number of material boxes manage or overall weight of the materials managed. The movement of the material boxes in terms of numbers and the material weight managed are two techniques to quantify material handling activities and the management might think of them as alternate cost drivers (Munzarova et al. 2015). The ascertainment of a cost driver among potential alternative relies on the way the cost drivers might correlate with cost object along with contribution to management control and measurement of cost.

In case, the handled materials are homogeneous in nature and packaging is made in identical box size, each unit would incur identical handling cost for each box of material handled. On the other hand, if there are differences in material content and packaging, unit managing big heavy material box would incur additional handling cost like additional labour. Thus, the material weight in the form of cost driver has close connection with material handling cost (Novák and Popesko 2014). 

In case, there is under allocation of overhead, it implies that additional overhead costs have been incurred than the estimated costs and the charge of difference is made to expense as incurred (Sakao and Lindahl 2015). On the other hand, if there is over allocation of overhead, this implies that lower overhead costs are spent than anticipated in order to apply additional cost to cost objects. Several reasons are inherent for under or over allocation of overhead and they constitute of the following:

• The expected amount does not match with the amount of overhead incurred.
• The basis on which the application of overhead is made in an amount not identical to the expected amount. For instance, if $100,000 of standard overhead needs to be applied and 2,000 direct labour hours are estimated to be included in the period, the rate of overhead application is made at $50 per hour. However, the actual total labour hours are 1,900. In that case, the overhead amount of $5,000 related to the missing 100 hours is not possible to be applied (Settanni et al. 2014).
• Seasonal variations could be observed in actual overhead or on application basis against a standard rate depending on broader-term average.
• The allocation basis might not be accurate, which might be because of computation error or data entry.

In order to deal with under or over allocation of overhead, the following ways could be used:

• The difference could be charged to the cost of revenue at once
• The difference could be applied to the pertinent cost objects

Even though the first approach could be achieved easily, less precision is involved in it. On the other hand, a write-off is restricted generally to lower variance, while the second method could be utilised for bigger variances.

The overhead absorption issue could be minimised by utilising Just-in-Time system for minimising the inventory on hand at the end of the reporting year (Vosough, Groh and Schulz 2017). By carrying out the same, there could be formation of case, in which the overhead costs could be charged to expense when incurred.

Reasons Behind Over or Under Allocation of Overhead

Conclusion:

Based on the above discussion, it could be stated that ABC system possesses various features in contrast to the traditional costing system due to which it is widely used by the manufacturing organisations operating in the global markets. This is because with the help of ABC system, these organisations could obtain relevant cost information based on which they could allocate costs to products. Moreover, this system selects the appropriate cost driver from a wide range of drivers available through adequate assessment. Finally, it has been found that under or over allocation of overhead could be mitigated with the help of Just-in-Time systems. 

References:

Andersch, A., Buehlmann, U., Palmer, J., Wiedenbeck, J.K. and Lawser, S., 2014. Product costing guide for wood dimension and component manufacturers. Gen. Tech. Rep. NRS-140. Newtown Square, PA: US Department of Agriculture, Forest Service, Northern Research Station. 31 p., 140, pp.1-31.

Annan, E.M., Doe, M., Anyamadu, R. and Ahiale, F.K.A., 2016. A survey of costing practices of SMEs in the informal sector: Koforidua, Ghana. International Journal of Innovative Research and Development, 5(9).

Cardes, S. and Gooneratne, T.N., 2016. Institutionalization of Activity Based Costing in a Sri Lankan Manufacturing Firm: A Case Study. Colombo Business Journal, 7(01), pp.37-51.

Cinquini, L., Collini, P., Marelli, A. and Tenucci, A., 2015. Change in the relevance of cost information and costing systems: evidence from two Italian surveys. Journal of Management & Governance, 19(3), pp.557-587.

Cooper, R., 2017. Target costing and value engineering. Routledge.

Eldenburg, L.G., Wolcott, S.K., Chen, L.H. and Cook, G., 2016. Cost management: Measuring, monitoring, and motivating performance. Wiley Global Education.

Fisher, J.G. and Krumwiede, K., 2015. Product costing systems: finding the right approach. Journal of Corporate Accounting & Finance, 26(4), pp.13-21.

Hoozée, S. and Hansen, S., 2017. A comparison of activity-based costing and time-driven activity-based costing. Journal of Management Accounting Research.

Klemstine, C.F. and Maher, M., 2014. Management Accounting Research (RLE Accounting): A Review and Annotated Bibliography. Routledge.

Langfield-Smith, K., Smith, D., Andon, P., Hilton, R. and Thorne, H., 2017. Management accounting: Information for creating and managing value. McGraw-Hill Education Australia.

Lueg, R. and Morratz, H., 2017. Understanding the error-structure of Time-driven Activity-based Costing: A pilot implementation at a European manufacturing company. European Journal of Management, 17(1), pp.49-56.

Munzarova, S., Vavra, J., Bednarikova, M., Vlckova, V. and Ritschelova, A., 2015. COST MANAGEMENT AND PRODUCT COSTING, EVIDENCE FROM THE PRACTICE OF MEDIUM-SIZED BREWERY IN THE CZECH REPUBLIC.

Novák, P. and Popesko, B., 2014. Cost variability and cost behaviour in manufacturing enterprises. Economics and Sociology.

Sakao, T. and Lindahl, M., 2015. A method to improve integrated product service offerings based on life cycle costing. CIRP annals, 64(1), pp.33-36.

Settanni, E., Newnes, L.B., Thenent, N.E., Parry, G. and Goh, Y.M., 2014. A through-life costing methodology for use in product–service-systems. International Journal of Production Economics, 153, pp.161-177.

Vosough, Z., Groh, R. and Schulz, H.J., 2017. On Establishing Visualization Requirements: A Case Study in Product Costing. In Eurographics Conference on Visualization (EuroVis): Short Papers.