Computation of cost per unit for sewing machine under Traditional method

Traditional costing approach is the system of allocation of the factory overhead over the products on the basis of production volume for the resources consumed. As per this method the overhead is generally applied on the basis of direct labour value for hours consumed or use of machine hours. Major problem associated with traditional costing approach is that factory overhead may be higher as compared to allocation basis, so that small change in volume of the resources consumed will results into big changes in the overhead application (Dong, Liu and Lin 2014). On the other hand, activity based costing (ABC) is the accounting approach that recognizes and allocates the costs to activities of overheads and assigns the costs to products. ABC approach identifies the relationship among manufactured products, overhead activities and based on the relationship the direct costs are allocated to products. Fantori Ltd that is engaged in selling 2 types of models basis and advance is that is planning for implementing the Activity Based Costing approach against the existing traditional approach (Lakmal 2014). The report will focus on computation of cost per unit for 2 models based on traditional approach as well as ABC approach.  Based on overhead allocation the report will focus on the profitability of advance model under both the approaches.

Computation of cost per unit for sewing machine under traditional method

Using the traditional method the company allocates the overheads based on the direct labour cost spend per unit for each model. However, it is unlikely that each model will consume the overhead at the same rate for which the labour cost is consumed. For instance, the inspection cost is $ 30,000 and inspection for basic model is 210 and for advance model it is 760. Hence, it is justified to allocate the inspection cost based on the labour expenses.

From the above table, it can be identified that the direct cost per unit for basic model is $ 525 whereas the same for advance model is $ 860 per unit. Overhead cost per unit for basic model is $ 63.35 and for advance model is $ 347.38. The significant difference in overhead cost is due to the fact that selling and distribution expenses, office rent and interest expenses are incurred for the advance model only (Plank 2018). Total cost per unit for basic model as per traditional approach is $ 588.35 whereas the same for advance model is $ 1207.38 per unit.

Computation of cost per unit for sewing machine under Activity Based Costing

Computation of cost per unit for sewing machine under activity based costing

Activity based costing allocates the overhead to products in more logical approach as compared to the traditional method of allocating the overhead on the basis of the labour hour. Under ABC approach the costs are allocated to the costs related to the activities those are real cause of the overheads. For instance, the inspection cost is $ 30,000 and inspection for basic model is 210 and for advance model it is 760. Hence, the inspection cost will be allocated on the basis of number of inspection carried out for each model.

From the above table, it can be identified that as per ABC method the direct cost per unit for basic model is $ 525 whereas the same for advance model is $ 860 per unit. Overhead cost per unit for basic model is $ 51.59 and for advance model is $ 359.88. The significant difference in overhead cost is due to the fact that selling and distribution expenses, office rent and interest expenses are incurred for the advance model only (Keiser, Garner and Vandermar 2017). Total cost per unit for basic model as per ABC model is $ 576.59 whereas the same for advance model is $ 1219.88 per unit.

Profit and loss statement for advance model

From the above table, it can be identified that as per traditional method as well as ABC method the direct cost per unit for advance model is $ 860 per unit. However, the total cost per unit as per traditional method is $ 1207.38 and as per ABC method is $ 1219.88. The company sells the advance model at cost under the existing method that is traditional method plus 30% that makes the selling cost to $ 1,569.59. Same selling price is used by the company for selling the advance model to overseas buyer. This makes profit per unit as per traditional model $ 362.21 and as per ABC method at $ 349.72 per unit (Osadchy and Akhmetshin 2015).

While considering the finance aspect accurate costing of the product is important for the purpose of preparing the financial statement as well as filing of tax. Each component of the financial statement and reporting has an impact on the overall financial aspect of the business. Incorrect computation of product costing will have great impact on the sales revenue of the company which in turn will have great impact on the profitability of the company (Akhavan, Ward and Bozic 2016). Accurate product costing is important for the below mentioned reasons –

• Impact on budget – process of budget depends on the accurate calculation of revenues and expenses so that more accurate forecast can be made. If the product costs are miscalculated, there will be significant errors in the process of budget.
• Income statement – the income statement depends on the accurate computation of COGS or the product cost. Cost for each product that is sold is subtracted from the sales value to arrive at profit. If the calculation of product cost is wrong it will lead to lower or higher profit as compared to actual (Costabile et al. 2017).
• Assets and inventory – calculation of inventory are based upon the accurate reporting of product’s direct cost. If the product cost is not computed correctly the value of inventory will not be accurate. Based on amount of error in the calculation it may lead to material misstatement of asset reporting. Assets of the company are important aspect for determining the business with for the potential investors or when the business seeks borrowing for financing.  
• Decision making purpose – while computing the product cost, approaches varies for the manufactured products and the product bought from the wholesaler. If the product is purchased product cost is simply the price paid for buying the product. On the contrary when the product is manufactured all the related costs with manufacturing are considered. Hence, accurate product costing is required for making a decision regarding purchase or manufacturing the product.

Profit and loss statement for Advance model

Various reasons are there for which the overseas buyer is interested in purchasing the only advance model. Normally for allocating overhead to products ABC approach is considered as more suitable against the traditional method of allocating the overheads. From the above it can be identified that per unit cost per unit for basic model as per traditional model is $ 588.35 whereas the same under ABC approach is $ 576.59. However, the cost per unit for advance model as per traditional model is $ 1207.38 whereas the same under ABC approach is $ 1219.88 (Boukherroub et al. 2015). Hence, using the traditional approach the company is determining higher cost for basic model and lower cost advance model as compared to the ABC approach. Further, the company will use the same price that is price under traditional method plus 30% for selling the advance model to overseas buyer. It will further lower the selling price of advance model as compared to the price if the 30% is added to cost under ABC model. Therefore the overseas buyer will be able to buy the advance model at lower cost and will make profit on it. On the other hand, they will be at the losing end if they purchase the basic model (Javid et al. 2016). Hence, the overseas buyer is interested in purchasing the advance model only.

Overhead cannot be recognised directly to the jobs. Most of the companies use the predetermined rate of overhead instead of the actual overhead due to various reasons. The reasons are –

• Usually the overhead is not incurred at uniform rate throughout the year. However, allocating more overhead in winter as compared to summer will not serve the purpose.
• Some of the overhead costs are fixed and it does not change with the changes in the units of production. In other words, the pre-determined rate remain constant for each month

If the above presented calculation is taken as an example, it can be identified that the actual overhead for Basic model as per ABC approach is $ 51.59 and for advance model it is $ 359.88 per unit. On the other hand, the applied overhead as per traditional approach for basic model is $ 63.35 per unit and for advance model it is $ 347.38 per unit. In traditional approach the overhead is allocated on the basis of machine hour rate or labour hour rate whereas under ABC approach cost activities are used as the basis for allocating overhead (Mitra 2016). Hence, owing to change in the method of allocating overheads the applied overhead varies with the actual overhead.  

In the given scenario, for basic model over applied overhead cost per unit is ($ 63.35 – $ 51.59) = $ 11.76. On the contrary, under applied overhead cost per unit for advance model is ($ 359.88 – $ 347.38) = $ 12.50. Dealing with the under / over application of overhead cost can be made though the following –

• Charging directly to COGS – under this method over applied or under applied overhead is closed and thereafter it is charged to cost of goods sold account. This is done by the cost accountant at the closing of each accounting period or at the end of each month. In case where the amount is transferred at the closing of the accounting period the amount of over or under application is carried forwarded to next year and it is accounted as income for over application and as deferred charges for under application (Weygandt, Kimmel and Kieso 2015)
• Writing off to costing profit and loss account – if the amount involved with under application or over application is negligible, it can be written off by transferring to the costing profit and loss account. If the over or under absorption is accounted for using this approach the closing stock valuation will be over-reported or under-reported (Novak et al. 2017).
• Carry forward to subsequent year – under this approach the applied or under applied overhead can be carry forwarded to subsequent year or next period of accounting. This amount then can be shifted to the overhead reserve account. The overhead reserve account is reported under balance sheet.  

Importance of Accurate Product Costing

Actual overhead = $ 300,000

Applied overhead = $ 210,000

Under applied overhead = $ (300,000 – 210,000) = $ 90,000.

If the amount for over applied or under applied of inventory is significant, the amount shall be allocated among accounts including the applied overhead that is – work – in – process inventory, finished goods inventory and cost of goods sold. Significant amount here means the balances of these accounts will be different if the actual overhead costs are allocated to them (Dale and Plunkett 2017). Allocation will restate the balances of these accounts as follows –

Account	Closing balance	Proration of under-applied overhead	Account balance after proration
Work in progress	$               60,500.00	$                 2,721.82	$          63,221.82
Finished goods	$               90,000.00	$                 4,048.99	$          94,048.99
Cost of goods sold	$          1,850,000.00	$               83,229.19	$     1,933,229.19
Total	$          2,000,500.00	$               90,000.00	$     2,090,500.00

Conclusion 

Based on the above computation and discussion it can be concluded that the ABC approach helps to compute more accurate cost for any product against the traditional approach. The reason behind this is that under ABC method cost activities or cost centres are used for allocating the overheads whereas under traditional approach overheads are allocated based on the machine hour rate or labour hour rate that may misstate the cost of the product. Hence, Fantori Ltd shall use ABC method for computing per unit cost of their product. 

Reference 

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Osadchy, E.A. and Akhmetshin, E.M., 2015. Accounting and control of indirect costs of organization as a condition of optimizing its financial and economic activities. International Business Management, 9(7), pp.1705-1709.

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