Advantages and Disadvantages of Traditional Costing vs Activity Based Costing

In the traditional costing method, there is a pre determined rate that is calculated based on a particular factor such as machine hours or labour hours. This rate is charged among all the products that are produced by the company (Boyd, 2013). However, if there is existence of any kind of joint costs then such costs is allocated to all the products so that unit cost of each product is determined.

As the name suggests, this method is considered to be old and obsolete because this method ignores the actual consumption of the resources. This costing method is preferred by the companies that produce a single product and also when there are not many activities involved in the production process (Easton, 2010). In the recent times, a company usually has a modern production process that involves production of multiple products that involve many activities. It is a complex process and therefore, traditional costing method is not used for such companies.

It has been observed that when this accounting method is followed the burden of overhead costs shifts from one product to another (Datar, 2015) . The overhead costs are not distributed in an equal proportion because the amount of resource that is utilised is not the same. If the costs are distributed evenly then it will lead to wrong pricing of the product. Some products may be over price whereas some products may be underpriced.

In order to overcome the drawback of traditional costing method, many companies has started using Activity Based Costing which also taken into consideration the amount of resources used (Holtzman, 2013).

The modern way of allocating cost among various products is also known as Activity Based Costing. This method has been introduced in order to overcome the disadvantages of the traditional costing system (Datar, 2016). In order to allocation costs based on this method, the company need to collect and analyse the cost data available. The number of units that are consumed and the amount that has been spent on such units are recorded. Cost per unit is calculated with the help of this information. On the basis of the rate per activity, the total costs is distributed among various products (Datar, 2016).

This system of costing is considered to be more appropriate because it allocates costs only to the product if it has utilised that specific function and only to the extent the consumption has been done (Horngren, 2012). So, this costing method is considered to be more accurate and reliable. The management is able to price the product correctly using the Activity Based Costing.

Case Study: The Impact of Traditional Costing on Pricing Decisions

In order to take correct decisions, the management of the company must choose the cost allocation method wisely. In order to understand this statement better let us taken into consideration the scenario provided to us. In the given situation, the management is thinking of phasing out the production of one model of printer which is called Lexon because it is generating low operating income (McLaney & Adril, 2016). But if we use correct cost allocation method and evaluate the data properly then the results obtained will be completely opposite.

It is very important for the management of the company to choose a cost allocation method which is appropriate. The product pricing decisions taken by the management is reliable on the method that is adopted (Menifield, 2014). If the information on the basis of which the decision is made is incorrect then the decision taken up by the management may also prove to be wrong. Any wrong decisions taken up by the company may hurt its financial viability.

The following table shows the income statement of the company:

Beztec Limited
Income statement for the financial year ended 31December 2017
	Lexon	Protox	Total
Revenues	$23 760 000	$7524 000	$31 284 000
Cost of goods sold	15 048 000	5 266 800	20 314 800
Gross margin	8 712 000	2 257 200	10 969 200
Selling and administrative expense	6 996 000	1 613 700	8 609 700
Operating income	$1 716 000	$643 500	$2 359 500
Units produced and sold	24 000	6 000
Operating income per unit sold	$71.50	$107.25

The operating income for Lexon and Protox is $71.50 per unit and $107.25 per unit respectively. On the basis of this information, the company decided to shut down production of Lexon printers.

In order to check whether the decision taken up by the management was correct or not, operating income using Activity based costing should be calculated. The activity rate per unit consumed and information about various activity consumed should be used to evaluate the decision (Noreen, 2015).

The total cost activities on the basis of these rate per activity which are consumed are as follows:

Activity-cost-driver quantities
Activity-cost driver (driver quantity)	Lexon	Protox	Total
Soldering (number of solder points)	13,33,125	4,33,125	17,66,250
Shipments (number of shipments)	18,225	4,275	22,500
Quality control (number of inspections)	63,225	23,963	87,188
Purchase orders (number of orders)	90,113	1,23,727	2,13,840
Machine power (machine-hours)	1,98,000	18,000	2,16,000
Machine set-ups (number of set-ups)	18,000	15,750	33,750
Calculation of activity rate
Activity-cost driver	Total activity costs	Total Number of Activities	Rate per unit
Soldering	11,65,725	17,66,250	0.66
Shipments	10,64,250	22,500	47.30
Quality control	15,34,500	87,188	17.60
Purchase orders	11,76,120	2,13,840	5.50
Machine power	71,280	2,16,000	0.33
Machine set-ups	9,28,125	33,750	27.50

Using this cost allocation rate we have recalculated the operating income per unit from both the products:

Allocation of Activity Cost
Activity-cost driver	Lexon- Activity	Lexon – Amount	Protox-Activity	Protox-Amount
Soldering	13,33,125	8,79,862.50	4,33,125	2,85,862.50
Shipments	18,225	8,62,042.50	4,275	2,02,207.50
Quality control	63,225	11,12,753.62	23,963	4,21,746.38
Purchase orders	90,113	4,95,621.50	1,23,727	6,80,498.50
Machine power	1,98,000	65,340.00	18,000	5,940.00
Machine set-ups	18,000	4,95,000.00	15,750	4,33,125.00
Total		39,10,620.12		20,29,379.88

The actual amount of costs that are consumed by each product can be observed. The overhead cost that was allocated based on the traditional system made the product overpriced because the overhead allocated was more than what was actually consumed. The reason for the low operating income of Lexon and high operating income of Protox was wrong costing method of cost allocation (Piper, 2015).

The new cost allocation rate has been used to recalculate the operating income of each of the product:

Beztec Limited
Income statement for the financial year ended 31December 2017
	Lexon	Protox	Total
Revenues	237,60,000	75,24,000	312,84,000
Cost of goods sold	136,78,620	66,36,180	203,14,800
Gross margin	100,81,380	8,87,820	109,69,200
Selling and administrative expense	69,96,000	16,13,700	86,09,700
Operating income	30,85,380	-7,25,880	23,59,500
Units produced and sold	24,000	6,000
Operating income per unit sold	129	-121

After the calculation under Activity based costing, we can observe that the operating income form per unit of Lexon was $ 129 per unit and the operating loss from Protox was $ 121 per unit. The operating income under traditional system for Lexon and Protox was $71.50 and $107.25 respectively.

The Role of Accountants in Maintaining Financial Stability and Integrity

The management would have taken a wrong step by stopping the production of Lexon printers as it would result in operating losses.

Beztec limited has an accountant whose name is Sue Smith. As we know, it is the responsibility of an accountant to make sure that the financial statements that are prepared by the company for the interest of the stakeholders must reflect a true and fair view about the company. It should be prepared in such a manner that the users of the financial statement gets clear picture of the company’s financial performance and position (Seal, 2012).

Smith is a knowledgeable person as he has specialised skills in the field of accounts and finance. According to him, the company must adopt activity based costing and made decisions based on that results as it will help the management to take correct decisions (Siciliano, 2015). The CEO of the company wanted smith to adopt traditional costing because there was some personal interest.

It is the duty of the accountant to fulfil her responsibilities with professionalism and integrity. The accountant must look for the benefits of the company and act accordingly. It is her duty to look after the financial health of the company and maintain financial stability. She was forced to not carry out his work independently because there was a personal interest of the CEO of the company. The bonus that the CEO receives is dependent on the revenues of the different departments so he does not want that production of any product stops.

Smith is one of the employees of the company and should act for the best interest of the company. It will be unethical on his part to attain financial benefits or provide financial benefit to any other employee at the cost of the company. Based on the principles that are laid down by the authorities the accountant must work with honesty.

Therefore, sue must calculate the cost based on both the cost allocation method and then explain his view to the management of the company based on the results obtained (Taillard, 2013).

The gross profit margin for both the models of printers is calculated using Traditional costing system and Activity Based Costing. The calculation is as follows:

Gross Profit analysis
Gross profit margin under traditional costing	36.67	30.00
Gross profit margin under Activity Based costing	42.43	11.80

From the above table, we can observe that the GP margin for Lexon under activity based costing resulted to 42.43% whereas it was 36.67% under traditional costing. However, it was seen that GP margin for Protox under activity based costing was 11.8% but under traditional costing method it was 30%. Therefore, we can conclude that the choice of costing method can have a great impact on the decision making process of the management (White, 2009).

As we know, traditional cost allocation method ignores the utilisation of resources and only focuses on the distribution of the pre determined rate. It is not necessary that the pre determined rate that is charged is correct and therefore, there might arise a difference in the actual overhead per unit and the overhead recovered per unit from the customers.

When the overhead recovered from the customers is more than the actual overhead, and then it is a situation of over recovery. Similarly, when the actual overhead is more than the amount of overhead recovered it is known as under recovery. Such under or over recovery has to be treated in the books of accounts.

The treatment of under/over recovery is explained below:

• Adjustment in the profit and loss account- The over / under recovered amount of overhead can be adjusted in the profit and loss account of the same year. The company can arrive at a correct profit and loss only after making such adjustments. These adjustments are to be made in the same year. This method is most commonly adopted by any companies as it is very easy to implement.
• Adjustments made in the remaining number of units- The adjustment for amount of under/ over recovery has to be made in the number of units that are not yet sold and lying in the stock of the company. This system is not considered to be good because the cost per unit might vary from year to year. This might lead to pricing the same product differently in the same year. This method is the least likely adopted by companies.
• Carried forward to the next year- In this treatment the amount of over or under recovery is carried forward to the next year which affects the cost per unit of the next year. This leads to improper costing of the product. The expense should be accounted in the same year in which it is incurred to make a proper adjustment.

Conclusion and Recommendation

It is clear from the above discussion that the company must adopt correct costing methods in order to avoid mispricing of a product. If the decisions made by the management are based on any incorrect data or information then the company might suffer. It is the duty of the management to take into consideration all the alternatives, evaluate them deeply and then take a final decision. The decisions should be taken for the benefit of the company.

We conclude that the company must adopt activity based costing and should also stop the production of Protox printers so that there are no operating losses that the company has to suffer.

Atkinson, A. A. (2012). Management accounting. Upper Saddle River, N.J.: Paerson.

Berry, L. E. (2009). Management accounting demystified. New York: McGraw-Hill.

Boyd, W. K. (2013). Cost Accounting For Dummies. Hoboken: Wiley.

Datar, M. S. (2015). Cost accounting. Boston: Pearson.

Datar, S. (2016). Horngren’s Cost Accounting: A Managerial Emphasis. Hoboken: Wiley.

Easton, P. (2010). Financial statement analysis & valuation. Cambridge, UK: Cambridge Business Publishers.

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

Horngren, C. (2012). Cost accounting. Upper Saddle River, N.J.: Pearson/Prentice Hall.

McLaney, E., & Adril, D. P. (2016). Accounting and Finance: An Introduction. United Kingdom: Pearson.

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

Noreen, E. (2015). The theory of constraints and its implications for management accounting. Great Barrington, MA: North River Press.

Piper, M. (2015). Accounting made simple. United States: CreateSpace Pub.

Seal, W. (2012). Management accounting. Maidenhead: McGraw-Hill Higher Education.

Siciliano, G. (2015). Finance for Nonfinancial Managers. New York: McGraw-Hill.

Taillard, M. (2013). Corporate finance for dummies. Hoboken, N.J.: Wiley.

White, T. S. (2009). The 60 minute ABC book. Bedford: Consortium for Advanced Manufacturing International.