Calculation And Allocation Of Overhead Costs: Traditional Vs Activity Based Costing

Calculation per unit using Traditional costing method

In the field of accounting, there are mainly 2 methods of calculating the costs, the traditional costing method being the first and the activity based costing method being the second. These are the methods of the allocation of the indirect costs.

Both of these methods are used for the purposes of estimation of the overhead costs which are related with production and then these are the costs that are assigned to the products using some rate of the cost driver. The difference between these 2 methods is the accuracy and the complexity which is employed when employing these methods. The traditional method of costing is the method which is way simpler and is also considered to be less accurate when compared with the activity based costing method. This is the method which assigns in these costs of the overheads to the products and is based upon the arbitrary average rate. The method of ABC is more complex and is also more accurate when compared with the traditional method of costing. The first method is the one which assigns all of the indirect costs to the various different activities and then goes on to assign in the costs to the products which is based upon the usage of the various different activities of each one of the product.

The traditional costing method is the system wherein all of the indirect costs are applied to the products which is based upon a pre-determined overhead rate. The method of ABC and the traditional costing system helps in treating the overhead costs in one single pool of indirect costs. The traditional costing method acts accurately when the indirect costs are much low when compared with the direct costs. The following are the steps that are applied when it comes to the allocation of the costs under the traditional costing method:

1. Identification of all of the indirect costs
2. Estimation of all of the indirect costs suing some appropriate period, usually a year, quarter or a month
3. Selecting the cost driver with one casual link to the cost such as the labour or the machine hours
4. Estimation of the different amounts of the cost drivers for an appropriate period using the labour hours for each quarter
5. Computation of the overhead rate
6. Application of these overheads to the products using a predetermined overhead rate.

The activity based costing system is much more accurate when compared with the traditional costing system. This is due to the fact that this method provides a more precise breakdown of all of the indirect costs. The activity based costing system is also complex and more costly when it comes to implementation. The change from the traditional costing method to the activity based costing method is very difficult (Wilkinson, 2019).

The following table shows the calculation of cost per unit using the Traditional costing method:

Particulars	Basic	Advanced
Units	1,700.00	1,600.00
Direct material	350.00	580.00
Direct labour	175.00	280.00
Total overhead costs:
Inspection			30,000.00
Assembly			1,00,000.00
Production scheduling			1,10,000.00
Machine set up			40,000.00
Total overheads			2,80,000.00
Division of overheads on the basis on machine hours	1,60,487.80	1,19,512.20
1.98
Divided by the number of units produced	1,700.00	1,600.00
Overhead per unit	94.40	74.70
Total cost per unit	619.40	934.70

The following table shows the calculation of cost per unit using the Traditional costing method:

Particulars	Basic	Advanced
Units	1,700.00	1,600.00
Direct material	350.00	580.00
Direct labour	175.00	280.00
Total overhead costs:
Inspection in 210:760	6,494.85	23,505.15	30,000.00
Assembly in 47:35	57,317.07	42,682.93	1,00,000.00
Production scheduling in 60:510	11,578.95	98,421.05	1,10,000.00
Machine set up in 120:270	12,307.69	27,692.31	40,000.00
Total overheads	87,698.56	1,92,301.44	2,80,000.00
Divided by the number of units produced	1,700.00	1,600.00
Overhead per unit	51.59	120.19
Total cost per unit	576.59	980.19

As could be seen from the above tables, the prices calculated under the ABC method is much more accurate and are also less. This is mainly due to the following reasons:

1. This method helps in the reduction of the costs and this is done by the way of providing a meaningful information on the various different opportunities that are available for the purposes of reducing the costs.
2. This method helps on the activities. Therefore, the management is capable of taking quality decisions by the way of knowing the nature of each and very activity
3. The method helps in the classification of the activities such as the value adding and the non-value adding activities. This method helps the management in concentrating on the forces of the value added activities along with elimination of the non-value added activities.
4. There are some of the costs which are the non-manufacturing costs which comprise of a major component of the total cost of each product.
5. When the costing of the product is done accurately, then it leads to a proper adoption of the pricing policy.
6. The statement of profit and loss is compared on the basis of each activity and it helps in the comparing of the costs of each activity with one another.
7. When the costing information has been predicted with accuracy, then it helps the management in the adoption of the productivity improvement approaches such as the total quality management etc.
8. By using this costing technique, the management is able to take the decisions of make or buy.
9. In case, the resources which are available are not capable of being used, then the same can be used even after the sub-contracting of the manufacture of the products and then the management can decide to manufacture the product within the company.
10. If any product is transferred from one department to another, then the transfer price of the same can be fixed (Account learning, 2019)

Particulars	Basic	Advanced
Traditional	934.70	980.19
ABC	619.40	576.59

The following table shows the relevant calculations:

Profit and Loss statement:
	Traditional method	ABC method
Direct material	580.00	580.00
Direct labour	280.00	280.00
Overheads per unit	74.70	120.19
Total cost per unit	934.70	980.19
Add: profit margin @ 30%	280.41	294.06
Selling price	1,215.10	1,274.24
Sales revenue	19,44,165.85	20,38,791.87
Less: costs	14,95,512.20	15,68,301.44
Profit	4,48,653.66	4,70,490.43

Profit and Loss statement:
	Traditional method	ABC method
Direct material	350.00	350
Direct labour	175.00	175
Overheads per unit	94.40	51.59
Total cost per unit	619.40	576.59
Add: profit margin @ 30%	185.8213773	172.9762162
Selling price	805.23	749.56
Sales revenue	12,88,361.55	11,99,301.77
Less: costs	10,52,987.80	9,80,198.56
Profit	2,35,373.74	2,19,103.21

The reason as to why the oversees buyer may want to buy only the advanced model may be due to the accurate product costing. Or may be due to the fact that he may find the advanced model much more appealing or better in terms of use.

1. When the price of the product has been predicted accurately, then the company would be able to estimate the revenue and the expenses for the next period with utmost accuracy. There would be no chances of any miscalculations or significant errors.
2. If the costing of each unit has been calculated accurately, then the cost of the goods sold or the product cost can be calculated easily. The cost of the product can be subtracted from the selling price of the product which would help in the accurate prediction of the profit margin or the loss. In case, if these calculations are not correct, then the revenue figure may be higher or may be lower than reported.
3. In case, if the calculations of the inventory are not accurate, then the product would be reported at their wrong or incorrect amounts in inventory in the balance sheet. This would result in an inaccurate valuation of the inventory. It creates a material error when it comes to the reporting of an assets.
4. When the cost of the product is calculated, then the approach adopted varies and depends upon the product which is purchased from outside. If the product is purchased from outside, then the price paid for the purchase of the same is important and when the product is manufactured in house, then the product shall be made in house and if the costs are not determined accurately, then that would create issues and wrong decision making would be done (Small business chron, 2019).

The concept of overhead refers to the manufacturing costs that are considered to be indirect in nature. These are termed as indirect costs since these do not form the part of the prime costs.

Calculation per unit using ABC costing method

The overheads are calculated on the basis of some pre-determined overhead rate which is calculated using the total amounts of the manufacturing overheads divided by the number of the machine hours or the actual direct labour hours.

The future is not certain and so are the future overhead costs and the number of machine hours that would be consumed when the product would be manufactured. There is always a difference between the overheads that have been applied and the overheads that were estimated or that were anticipated. These are the differences that generally at the end of the year (Accounting coach, 2019).

The difference between the manufacturing overhead applied and the manufacturing overhead that was estimated is termed as the over or under applied manufacturing overhead.

In case, the manufacturing overhead which has been applied is more than the manufacturing overhead that was incurred, then the applied manufacturing overhead less the actual incurred manufacturing overhead would be termed as the over applied-manufacturing overhead.

In case, the manufacturing overhead which has been applied is less than the manufacturing overhead that was incurred, then the applied manufacturing overhead less the actual incurred manufacturing overhead would be termed as the under applied-manufacturing overhead.

The existence of either under applied or over applied manufacturing overhead is common since it all depends upon the pre-determined overhead rate. This is the arte which is calculated as at the beginning of the period and is calculated using some estimated information gathered during the previous period (Accounting for management, 2019).

The following are the ways of treating the over and the under application of the overheads:

• It can be transferred to the next year
• It can be charged to the costing profit and loss account
• It can be charged to the production account which is the supplementary rate which has been worked out and has been applied (Tutors on net, 2019).

Actual overhead	3,00,000.00
Applied overhead	2,10,000.00
Under applied overhead	90,000.00
Work in progress	2,721.82	60,500.00
Finished goods	4,048.99	90,000.00
Cost of goods sold	83,229.19	18,50,000.00
	90,000.00	20,00,500.00

Conclusion:

The above report has been written on the traditional costing method and the activity based costing method. It can be seen that the ABC method is much more superior and accurate when compared with the traditional method of calculation of costs.

The costs calculated under the ABC method is much less when compared with the costs calculated under the traditional costing method. This can be seen from the following table:

Particulars	Basic	Advanced
Traditional	934.70	980.19
ABC	619.40	576.59

Also, an accurate costing of the product is very much important since it helps the management in making the key decisions and in the absence of the same, the company could also go into losses.

3 ways of treating the over and the under applied overheads include the charge to the next year or charge to the costing profit and loss account or charge to the production, work in progress or the cost of goods sold. The technique adopted depends upon the case and the facts in each case.

References:

Accounting for Management. (2019). Over or under-applied manufacturing overhead – explanation, journal entries and example | Accounting for Management. [online] Available at: https://www.accountingformanagement.org/over-or-under-applied-manufacturing-overhead/ [Accessed 19 Jan. 2019].

AccountingCoach.com. (2019). What is the difference between actual overhead and applied overhead? | AccountingCoach. [online] Available at: https://www.accountingcoach.com/blog/dfifference-actual-overhead-applied-overhead [Accessed 19 Jan. 2019].

Money Matters | All Management Articles. (2019). Advantages and Disadvantages of Activity Based Costing. [online] Available at: https://accountlearning.com/advantages-and-disadvantages-of-activity-based-costing/ [Accessed 19 Jan. 2019].

Smallbusiness.chron.com. (2019). Importance of Accurate Calculating in Product Cost. [online] Available at: https://smallbusiness.chron.com/importance-accurate-calculating-product-cost-36698.html [Accessed 19 Jan. 2019].

Tutorsonnet.com. (2019). Treatment Of Over Or Under Absortion Of Overhead | TutorsOnNet. [online] Available at: https://www.tutorsonnet.com/over-or-under-absorption-of-overhead-homework-help.php [Accessed 19 Jan. 2019].

Wilkinson, J. (2019). Activity Based Costing vs Traditional Costing • The Strategic CFO. [online] The Strategic CFO. Available at: https://strategiccfo.com/activity-based-costing-abc-vs-traditional-costing/ [Accessed 19 Jan. 2019].