Sewing Easy Ltd: Traditional Vs Activity Based Costing

Traditional Costing vs Activity Based Costing

Question 1

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The costing of the two models as per the traditional costing is exhibited below.Question 2

The costing of the two models as per the ABC costing is exhibited below.

Question 3

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The company has a policy of determining price by applying a 20% mark-up on the cost.

Estimated selling price for one unit of advance system = (1+ (20/100))*890.93 = \$1,069.12

Considering the cost price of the advance system equivalent to the cost under traditional costing, the P&L statement for 2017 is referred to as highlighted below (Drury, 2016).Apparently, the current costing indicates that the company is incurring profits by selling the advance model to the tune of \$ 65,585.

Considering the cost price of the advance system equivalent to the cost under ABC costing, the P&L statement for 2017 is referred to as highlighted below

Unlike the estimates by the company, it becomes evident from the computation above that at current pricing, there is a loss for the company for the sale of advance model. This clearly explains why the foreign company has shown interest in procurement of this model as it finds this price very competitive owing to the company selling at a loss. Also, the above computation would indicate that the pricing of basic model is done at very high price since the overheads are underapplied for the advance model.  Clearly, this costing anomaly needs to be eliminated by migrating to ABC base costing (Damodaran, 2015).

Question 4

It is quite common to witness that there tends to be a deviation between overheads that ar actually incurred and those that are applied. Two possible reasons in this regards are outlined below (Northington, 2015).

• The allocation of overheads cost on the basis of the traditional costing method leads to issue of over-allocation and under-allocation.
• While this issue can be addressed through ABC based costing, but considering the practical constraints to sub-divide the activities to smaller units, the process is not 100% accurate but provides reasonable or working accuracy.

Considering that the above is a common phenomenon, hence measures or ways tom deal with the above situation are required as highlighted below (Parrino and Kidwell, 2014).

• A shift should be made by companies towards ABC costing owing to more accurate cost allocation. This is especially true for firms have multiple products and are in manufacturing business.
• Besides, the underlying costing of the product, while pricing the product the company must also consider the prevalent prices in market which provide an estimated of likely cost over estimation or under estimation.
• The sales team must have regular updates with regards to prevailing market price of the product and any significant deviation of the company’s price from the same needs to be analysed further particularly with regards to costing of product.

Question 5

The use of ABC based costing system tends to lead to a plethora of benefits for the firm which are outlined below (Petty et. al., 2015).

• The overhead or indirect costs incurred by the firm are appropriately allocated to the respective products and their cost is accurately determined. This sets the way for accurate pricing which is pivotal for the success of the product along with company’s reputation.
• The availability of accurate information on costing improves the management decision making related to production, outsourcing and dealing with special orders. This is not possible if accurate cost information is not available.

Despite the advantages, the deployment of ABC based costing system also has some potential issues mentioned below (Brealey, Myers  and Allen, 2014).

• In comparison to traditional costing system, ABC based costing is much complex and thereby in order to make the switch from traditional to ABC costing, specialised manpower, time and financial resources are required.
• Even the implementation of ABC system may not bring about improvement in decision making as the managers tend to find hard to interpret and use the information available through ABC costing system for making successful decisions.
• Owing to the above, incremental training costs would have to borne making ABC costing system an expensive affair with significant upfront costs.

References

Brealey, R. A., Myers, S. C. and Allen, F. (2014) Principles of corporate finance, 2nd ed. New York: McGraw-Hill Inc.

Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.

Northington, S. (2015) Finance, 4th ed. New York: Ferguson

Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley Publications

Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M. and Nguyen, H. (2015). Financial Management, Principles and Applications, 6th ed..  NSW: Pearson Education, French Forest Australia.