Traditional costing system

1. Calculate cost per unit of the two models of sewing machines under the current traditional costing system.

2. Calculate cost per unit of the two models of sewing machines under Activity based Costing.

3. Sewing easy sells the advance model at a price of cost (under the current costing system) plus 20% and is willing to give the same selling price to the overseas buyer. The overseas buyer wants to purchase only the advance model. Prepare December 2017 Profit and Loss Statement for the advance model where (a) traditional costing is used to calculate the product cost (b) Activity Based Costing is used to calculate the product cost. Analyse why the overseas buyer is interested to buy only the advance model. In your discussion you should highlight the importance of accurate product costing.

4. Seldom will we see that the actual overhead and applied overhead is the same. Discuss why and state three ways to deal with under/over applied overhead costs.

5. What are the main benefits and limitations of ABC system?

Statement of Cost- Traditional Approach
Particulars	Basic Model	Advance Model
Units produced and sold	1,600	1,500
Direct Material cost per unit	325	560
Direct Labour cost per unit	150	260
Total Material Cost	5,20,000	8,40,000
Total Labour cost	2,40,000	3,90,000
Total Allocated Overhead cost	1,43,750	1,06,250
Cost related only to advance Model
Selling and Administration expenses	–	1,40,600
Interest Expense	–	25,200
Office Rent	–	35,900
Total Cost	9,03,750	15,37,950
Cost Price Per unit	565	1,025
Allocation of Overhead under Traditional approach
Particulars	Amount
Inspection	20,000
Assembly	90,000
Production Scheduling	1,05,000
Machine set-up	35,000
Total Overhead	2,50,000
Total Machine Hours consumed	8,000
Overhead per Machine Hour	31
Overhead Allocated to Basic Model	1,43,750
Overhead Allocated to Advance Model	1,06,250

Statement of Cost- ABC approach
Particulars	Basic Model	Advance Model
Units produced and sold	1,600	1,500
Direct Material cost per unit	325	560
Direct Labour cost per unit	150	260
Total Material Cost	5,20,000	8,40,000
Total Labour cost	2,40,000	3,90,000
Total Allocated Overhead cost	75,506	1,74,494
Cost related only to advance Model
Selling and Administration expenses	–	1,40,600
Interest Expense	–	25,200
Office Rent	–	35,900
Total Cost	8,35,506	16,06,194
Cost Price Per unit	522	1,071

Allocation of Overhead-ABC Approach
Particulars	Inspection	Assembly	Production Scheduling	Machine set-up	Total Cost
Cost	20,000	90,000	1,05,000	35,000	2,50,000
Consumption of resource – units	950	8,000	550	350
Cost per unit	21	11	191	100
Units for Basic Model	200	4,600	50	100
Units for Advance Model	750	3,400	500	250
Total Overhead for Basic Model	4,211	51,750	9,545	10,000	75,506
Total Overhead for Advance Model	15,789	38,250	95,455	25,000	1,74,494

Statement of Profit and Loss- Tradition Approach
Particulars	Basic Model	Advance Model
Sales	10,84,500	18,45,540
Less:
Total Material Cost	5,20,000	8,40,000
Total Labour cost	2,40,000	3,90,000
Total Allocated Overhead cost	1,43,750	1,06,250
Cost related only to advance Model
Selling and Administration expenses	–	1,40,600
Interest Expense	–	25,200
Office Rent	–	35,900
Profit	1,80,750	3,07,590
Calculation of Sales Price Per unit- Tradition Approach
Particulars	Basic Model	Advance Model
Cost per unit	565	1,025
Add: profit margin 20%	113	205
Sale Price Per unit	678	1,230
Statement of Profit and Loss- ABC Approach
Particulars	Basic Model	Advance Model
Sales	10,02,607	19,27,433
Less:
Total Material Cost	5,20,000	8,40,000
Total Labour cost	2,40,000	3,90,000
Total Allocated Overhead cost	75,506	1,74,494
Cost related only to advance Model
Selling and Administration expenses	–	1,40,600
Interest Expense	–	25,200
Office Rent	–	35,900
Profit	1,67,101	3,21,239
Calculation of Sales Price Per unit- ABC Approach
Particulars	Basic Model	Advance Model
Cost per unit	522	1,071
Add: profit margin 20%	104	214
Sale Price Per unit	627	1,285

The company has been using tradition costing system under which cost allocation is not done in a proper manner. The price of the advance model charged by the company is $1230, whereas if the company would have adopted ABC costing they would have charged $1285 per unit. The overseas buyer has noticed this lower price for the given company and is interested in advance model only. Since some portion of expense of advance model has been transferred to basic model, the price of that has increased from $627 to $678. This means that the basic model is overpriced and advance model is under price. This is reason because of which the overseas buyer is interested only in the advance model and not in the basic model or both.

In order to pre determine the unit cost for the manufacturing companies, the managers evaluate and budget the expenses which are likely to be expended in the production process. These expenses are then allocated over the units produced to determine the cost per unit. Based on this data the amount is recovered from the customers (Holtzman, 2013). When the production cycle starts and actual expenses start to incur, then it is found that there are variances between the budgeted and actual rates. Due to this difference the under and over recovery of overheads takes place. No treatment is required if the applied and actual overhead are same. This can be possible only when the budgeted expenses are equal to the actual expenses.

This under and over recovery are to be treated in the books of accounts. There are three common ways in which these are treated. They are as follows:

• Carrying forward the said amount: many companies follow the rule to carry forward the under or over recovered amount to the next financial year. The adjustments are made in the following year and then the balance is carried forward to the next year.
• Writing off in profit and loss account: the simplest ways to treat under or over recovery is to write off the amount in the profit and loss statement for that year.
• Adjustment in the current year with existing units: this is the least commonly used ways. Under this system the under or over recovered amount is adjusted over the remaining units unsold. This is unrealistic as it increases the price of the products.

Therefore, companies can treat under and over recovery of overheads in the manner which is most suitable to them.

Activity based cost, as the name suggest is the type of costing technique under which the cost are allocated based on the activities consumed by the product. This modern costing technique which helps is better allocation of cost, so that correct costing for a product can be done. This system has both advantages and disadvantages. The advantages are:

• Since the ABC costing requires the cost data to be collected at one place, it gives the mangers a pool of data to work and analyse on. They can process this data and make important decisions.
• Since this system helps allocate cost as per usage, this helps eradicate the system of over and under absorption of expenses. This helps in better recovery and accountability of cast data.
• Just as discussed above, some products are wrongly overpriced while using averages for cost apportionment. This approach helps remove this uneven distribution and helps in correct pricing of the product
• The data collected is too much in this approach, using this data the managers can implement policies which may help them in cost saving techniques. It may also help unnecessary costs.(Menifield, 2014)

These were the advantages. Following are the few disadvantages of activity based costing:

• In order to implement the ABC approach, too much data collection is required which requires extensive labour and time
• This approach may result to be expensive for small manufacturing companies.
• Since this system is most suited to manufacturing units, the service industry do not benefit from them.
• Since the activities are the cost drivers under this approach it is important for the managers to understand the organisational processes properly. This involved too much man power.
• It is very time consuming process.

Therefore we see that the activity based costing has both advantages and disadvantages. The companies should try to make of the system by overcoming the disadvantages. It is important that the enterprises apply the system only if it would help them simplify the processes and not the opposite.

Holtzman, M. (2013). Managerial Accounting For Dummies. Hoboken, NJ: Wiley.

Menifield, C. E. (2014). The Basics of Public Budgeting and Financial Management: A Handbook for Academics and Practitioners. Lanham, Md.: University Press of America.