Question

With reference to SCB accountant’s recommendation, critically discuss how Activity Based Costing (ABC) can address the distortions of product costing linked to traditional costing system. You should support your discussion with relevant academic literature.

Answer 1

Ans:

In the field of accounting, activity-based costing and traditional costing are two different methods for allocating indirect (overhead) costs to products.

Both methods estimate overhead costs related to production and then assign these costs to products based on a cost-driver rate. The differences are in the accuracy and complexity of the two methods. Traditional costing is more simplistic and less accurate than ABC, and typically assigns overhead costs to products based on an arbitrary average rate. ABC is more complex and more accurate than traditional costing. This method first assigns indirect costs to activities and then assigns the costs to products based on the products’ usage of the activities.

Traditional Costing Method

Traditional costing systems apply indirect costs to products based on a predetermined overhead rate. Unlike ABC, traditional costing systems treat overhead costs as a single pool of indirect costs. Traditional costing is optimal when indirect costs are low compared to direct costs. There are several steps in the traditional costing process, including the following:

1. Identify indirect costs.

2. Estimate indirect costs for the appropriate period (month, quarter, year).

3. Choose a cost-driver with a causal link to the cost (labor hours, machine hours).

4. Estimate an amount for the cost-driver for the appropriate period (labor hours per quarter, etc.).

5. Compute the predetermined overhead rate (see below).

6. Apply overhead to products using the predetermined overhead rate.

Predetermined Overhead Rate Calculation

Use the following formula to calculate predetermined overhead rate:

Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Cost-Driver Amount

Activity-Based Costing Benefits

Activity based costing systems are more accurate than traditional costing systems. This is because they provide a more precise breakdown of indirect costs. However, ABC systems are more complex and more costly to implement. The leap from traditional costing to activity based costing is difficult.

Traditional Costing Advantages and Disadvantages

Traditional costing systems are simpler and easier to implement than ABC systems. However, traditional costing systems are not as accurate as ABC systems. Traditional costing systems can also result in significant under-costing and over-costing.

Cost Distortions

The Cooper Pen Company example on pages 160-170 illustrates how production volume differences create product cost distortions (See Exhibit 5-1). In their example, the traditional cost system allocates overhead costs using a plant wide rate of 300% of direct labor costs. This causes the high volume products (blue and black pens) to be charged with too much overhead and the low volume products (red and purple pens) to be charged with too little overhead. The reason for these distortions is revealed by the faulty assumption underlying the traditional cost allocation system, i.e., that all overhead costs are driven by production volume, or that the link between cause (driver) and effect (cost) cannot be established. Traditional cost systems treat all overhead costs as unit level costs. However, as ABKY explain, production volume is only one of many cost drivers. A factory producing a large variety of products will have a much greater need for support (e.g., purchasing, scheduling, setup, order tracking and quality control) than a factory that produces a few products.

Cooper Pen Company Traditional Cost Allocations Based on Direct Labor Costs $2000001111 11111 150000111 100000 + 500001 OKTT DM DL Frg Hnd Set Sup Run Total Blue Red Black Purple

Cooper PenCompany Cost Assignments Based on ABC $ 20000011 15000011 100000+1 30.000 DM DL Frg Hrd Set Sup Run Total Blue Red Black Purple

Cooper Pen Company Traditional Cost Allocations Versus ABC Traditional ABC $200000 150000 100000 50000 * Amount Overcosted 2T ARO 04 SS 'm& Distortion Amount Undercosted Mål ovh Total Blue Red ovh Total Black Purple