Traditional costing method limitations

The main objective of the report is to suggest other cost models as against the traditional costing methods as the traditional method uses the labour hour rate or machine hour rate for allocating the overheads. Therefore, the traditional costing method is regarded as outdated systems and is receiving various criticisms in recent times. The report will focus on other cost allocation system that is more systematic and use systematic approach to allocate the costs. Other costing systems that can be used against the traditional method of costing are absorption costing and activity based costing to calculate cost of individual product, activity or service (Ruiz-de-Arbulo-Lopez, Fortuny-Santos and Cuatrecasas-Arbós 2013. Pp. 647-668).

Under the traditional costing method, the manufacturing overheads are allocated on the basis of cost driver volume that is requirement of direct labour hours for producing the product. Cost diver is the factor that causes incurring of the costs like direct material, direct labour and machine hours. However the traditional accounting fails to assign the non-manufacturing costs associated with the product like the administrative costs (Subramaniam and Watson 2016. Pp. 275-305). Traditional costing method is outdated systems and receiving various criticisms in recent times. The reason behind this is that this system does not assign the cost appropriately as direct labour hour is not the best and most appropriate method. Further, it does not take into consideration other cost drivers associated with the product. Therefore, it can lead to inefficient management decision as it fails to take into consideration various non-manufacturing costs.

The absorption costing or full product costing is the method of calculating the cost of a product or service by taking into consideration all the indirect expenses and direct expenses. It considers all the costs incurred by business for manufacturing the product (Fullerton, Kennedy and Widener 2013. Pp 50-71). The accountant gathers all the costs like overhead, labour and materials costs throughout the company. Under absorption costing the overhead must be allocated to each product that is being manufactured (Salah and Zaki 2013).  

XYZ Plc manufactures product “P”. Following are other information associated with the production of “P” –

Selling price – £ 50.00 per unit

Direct materials – £ 8.00 per unit

Direct labour – £ 5.00 per unit

Variable production overheads – £ 3.00 per unit

Production for the month of January – 500 units

Sales for the month of January – 300 units

Fixed production overheads – £ 4,000 per month and absorbed on the basis of units. Normal production level is 400 units

Absorption costing and its application

Other costs are as follows –

Fixed selling cost – £ 4,000 per month

Fixed administrative cost – £ 2,000 per month

Variable sales commission – 5% of revenue from sales

No opening inventory was there. (Hoare 2018).

Solution –

Computation of full production cost

Direct material	£ 8.00
Direct labour	£ 5.00
Variable manufacturing overhead	£ 3.00
Fixed manufacturing overhead (£ 4000 / 400 units)	£ 10.00
Full production cost	£ 26.00

Computation of production and inventory value

Opening inventory	Production	Closing inventory
Nil	500 units * £ 26 = £ 13,000	200 units * £ 26 = £ 5,200

Over / under absorption of cost

Actual fixed manufacturing overhead	£ 4,000
Fixed manufacturing overhead absorbed (500 units * £ 10)	£ 5,000
Over absorption	£ 1,000

Computation of profit

Sales (300 units *£ 50)		£ 15,000
Less: cost of sales
Opening inventory	Nil
Production	£ 13,000
Closing inventory	£ (5200)	£ 7,800
Over absorption of fixed manufacturing overhead		£ 1,000
Gross profit		£ 8,200
Less: Expenses
Variable sales commission	£ 750
Fixed administration expenses	£ 2,000
Fixed selling expenses	£ 4000	£ 6,750
Net profit		£ 1,450

Therefore, it can be observed from the above example that the product manufacturing costs were fully absorbed by the produced units. It includes both the fixed variable costs and variable overhead costs. It is the accurate way for accounting the true cost of production.

• Apportionment of the overhead cost – the validity for determining the absorption costing is depended upon appropriateness of the allocation of overheads in correct manner. However, some overhead costs are allocated on arbitrary method. Therefore, the resulting costs are doubtful that can lead to unreliable and inaccurate product cost (Ahmed and Duellman 2013. Pp. 1-30)
• Fixed costs are periodic – as per the views of many accountants, the fixed administration, selling and manufacturing costs are periodic that is not beneficial for the future and hence, shall not be included in the inventory and product cost (Parthiban, Zubar and Katakar 2013. 1535-1548)

Absorption costing is not useful for decision making purpose of the management. Various problems related to this are selection of the production volume, utilization of optimum capacity, selection of the product mix, performance evaluation and choice of various alternatives that can only be solved with the assistance of variable cost analysis (Estampe et al. 2013. Pp. 247-258). Further, it leads to mispricing of product if product mixes are not selected properly. 

ABC costing technique identifies all the activities required for manufacturing the product and then allocates the indirect costs to the product. It further recognizes the relationship among products, costs and activities and based on that allocates indirect costs systematically and less arbitrarily as compared to absorption costing and traditional costing (Monroy, Nasiri and Peláez 2014. Pp 11-17).

XYZ Plc manufactures product “P”. Following are other information associated with the production of “P” –

Administration and selling overhead	£ 300,000
Manufacturing overhead	£ 500,000
Total overhead expenses	£ 800,000
Activity cost pool	Activity cost drivers
Processing orders	No. of orders
Assembling units	No. of units
Customer supports	No. of customers

Allocation of overhead expenses (Accounting for Overheads – Activity Based Costing (ABC), 2016)

	Assembling	Order processing	Customers supporting	Total
Manufacturing	50%	35%	15%	100%
Administration and selling	30%	45%	25%	100%
Total activity	1000 units	250 orders	100 customers

Solution –

Cost allocation –

	Assembling	Order processing	Customers supporting	Total
Manufacturing	£ 250,000	£ 175,000	£ 75,000	£ 500,000
Administration and selling	£ 90,000	£ 135,000	£ 75,000	£ 300,000
Total activity	£ 340,000	£ 310,000	£ 150,000	£ 800,000

Activity rate for activity driver –

Cost drivers	Total cost	Total activity	Activity rate
Assembling	£ 340,000	1000 units	£ 340 per unit
Order processing	£ 310,000	250 orders	£ 1,240 per unit
Customer supporting	£ 150,000	100 customers	£ 1,500 per customer

Computation of profit

Sales (100 units * £ 1000)	£ 100,000
Less: costs
Direct material (£ 100 * 100 units)	£ 10,000
Direct labour (£ 20 per hour * 4 hr * 100 units)	£ 8,000
Assembling cost (£ 340 * 100 units)	£ 34,000
Order processing (£ 1240 * 10)	£ 12,400
Customer supporting (£ 1500 * 10)	£ 15,000
Total cost	£ 79,400
Total profit (Sales – Total cost)	£ 20,600
Profit per unit	£ 20.60

It has been observed from the above example that the overheads have been allocated based on the cost drivers like assembling, customer supporting and order processing. Therefore, it is focussed on nature of the cost behaviour and it attempts providing meaningful costs for the product.

• It is a costly method to implement
• Adaptability of this system is not appropriate for all organizations as small companies have too many activities with very less transactions (Monroy, Nasiri and Peláez 2014. Pp. 11-17).
• It does not comply with the GAAP and the management has to prepare the reports through using the traditional as well as AVC both systems for external and internal purpose (Öker and Ad?güzel 2016. Pp. 39-56).
• Data produced from this system can easily be misinterpreted that can lead to mispricing of product (Monroy, Nasiri and Peláez 2014. Pp. 11-17)

ABC system can be used by the management as decision making tool as it delivers structured data for financial support that is different from the accounting data delivered by the general ledger (Govindan, Khodaverdi and Jafarian 2013. Pp. 345-354) Further, through association of costs to activities the clear relationship can be formed among the activity cost driver to related activity. Further, it is beneficial for the management to determine where the costs are incurred and where it can be minimized with appropriate efforts (Estampe, Lamouri, Paris and Brahim-Djelloul 2013. Pp. 247-248).  

Example of full production cost calculation

Conclusion 

It is concluded from the above discussion that the absorption costing are used for reporting the product costs under the financial records. The product costs are recorded under closing balance of inventory in balance sheet and are COGS in income statement.  The creditors, government agencies and investors use financial statement of the company for taking various decisions. Further, the investors take decisions for purchasing the stocks from the company and the creditors take decisions for extending the credit to the company. Further, the government agencies take decision for analysing whether the company comply the government programs. On the other hand, the ABC costing takes into consideration the associated costs with different activities. It is used for analysing the internal process costs that are involved with the production process. These 2 methods differ with respect to the cost data and the application of cost. While the absorption costing is focussed on the requirement of the outside users of financial statement, the ABC costing is focussed on the inside users of the financial statement. Further, the absorption costing bases all the manufacturing costs for production and ABC costing takes into consideration the cost associated with the product process. 

Reference 

Accounting for Overheads – Activity Based Costing (ABC). (2016). [ebook] Cenit Online, pp.5-6. Available at: https://studyonline.ie/wp-content/uploads/2016/08/ABC.pdf [Accessed 23 Feb. 2018].

Ahmed, A.S. and Duellman, S., 2013. Managerial overconfidence and accounting conservatism. Journal of Accounting Research, 51(1), pp.1-30.

Estampe, D., Lamouri, S., Paris, J.L. and Brahim-Djelloul, S., 2013. A framework for analysing supply chain performance evaluation models. International Journal of Production Economics, 142(2), pp.247-258.

Fullerton, R.R., Kennedy, F.A. and Widener, S.K., 2013. Management accounting and control practices in a lean manufacturing environment. Accounting, Organizations and Society, 38(1), pp.50-71.

Govindan, K., Khodaverdi, R. and Jafarian, A., 2013. A fuzzy multi criteria approach for measuring sustainability performance of a supplier based on triple bottom line approach. Journal of Cleaner Production, 47, pp.345-354.

Hoare, R. (2018). Absorption Costing V’s Marginal Costing. [ebook] Certified Public Accountants, pp.1-2. Available at: https://www.cpaireland.ie/docs/default-source/Students/F2-Mgmt-Accounting/absorption-costing-v-marginal-costing.pdf?sfvrsn=0 [Accessed 23 Feb. 2018].

Monroy, C.R., Nasiri, A. and Peláez, M.Á., 2014. Activity Based Costing, Time-Driven Activity Based Costing and Lean Accounting: Differences among three accounting systems’ approach to manufacturing. In Annals of Industrial Engineering 2012 (pp. 11-17). Springer, London.

Öker, F. and Ad?güzel, H., 2016. Time?driven activity?based costing: An implementation in a manufacturing company. Journal of Corporate Accounting & Finance, 27(3), pp.39-56.

Parthiban, P., Zubar, H.A. and Katakar, P., 2013. Vendor selection problem: a multi-criteria approach based on strategic decisions. International Journal of Production Research, 51(5), pp.1535-1548.

Ruiz-de-Arbulo-Lopez, P., Fortuny-Santos, J. and Cuatrecasas-Arbós, L., 2013. Lean manufacturing: costing the value stream. Industrial Management & Data Systems, 113(5), pp.647-668.

Salah, W. and Zaki, H., 2013. Product Costing in Lean Manufacturing Organization. Research Journal of Finance and Accounting, 4(6), pp.86-98.

Subramaniam, C. and Watson, M.W., 2016. Additional evidence on the sticky behavior of costs. In Advances in Management Accounting (pp. 275-305). Emerald Group Publishing Limited.