Product Costing And Overhead Allocation In Traditional And Activity Based Costing

Calculation of Cost per Unit under Traditional and ABC Methods

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

2. 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.

3. 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.
What are the main benefits and limitations of ABC system?

Statement of Cost- Traditional Approach
Particulars Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper	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
Total Cost	9,03,750	13,36,250
Cost Price Per unit	565	891

Allocation of Overhead-Traditional approach
Particulars	Amount
Inspection	20,000
Assembly	90,000
Production Scheduling	1,05,000
Machine set-up	35,000
Total Overhead to be allocated	2,50,000
Total Machine Hours consumed	8,000
Overhead per Machine Hour	31
– Overhead Allocted to Basic Model	1,43,750
– Overhead Allocted 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
Total Cost	8,35,506	14,04,494
Cost Price Per unit	522	936

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
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	16,03,500
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
Other Operating Expenses for Advance model
– Selling and Administration expenses	–	1,40,600
– Interest Expense	–	25,200
– Office Rent	–	35,900
Profit	1,80,750	65,550

Calculation of Sales Price Per unit- Tradition Approach
Particulars	Basic Model	Advance Model
Cost per unit	565	891
Add: profit margin 20%	113	178
Sale Price Per unit	678	1,069

Statement of Profit and Loss- ABC Approach
Particulars	Basic Model	Advance Model
Sales	10,02,607	16,85,393
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
Other Operating Expenses for Advance model
– Selling and Administration expenses	–	1,40,600
– Interest Expense	–	25,200
– Office Rent	–	35,900
Profit	1,67,101	79,199

Calculation of Sales Price Per unit- ABC Approach
Particulars	Basic Model	Advance Model
Cost per unit	522	936
Add: profit margin 20%	104	187
Sale Price Per unit	627	1,124

It has been observed that in the provided case the overseas buyers have shown their interest only towards the advance model and not the basic model of the sewing machines. It is also seen that the company is operating under the traditional costing methods. The price that was offered by the company to the overseas buyer was $1069 per unit. As stated above, the company follows the traditional method and therefore the overheads are allocated on the basis of consumption of machine hours. (Paul, 2014) This is not considered to be a practical approach of costing because the actual usage is never taken into consideration in doing the apportionment.  In case the company has adopted ABC model then the price would have been $1124. It is known by the overseas buyer that the cost is wrongly charged to the basic model instead of the advance model. Since, the buyer knows that there is a fault in the costing system therefore, it wants to buy sewing machine under the advance model and not the basic model (Atkinson, 2012).

The cost that is not directly related to the manufacturing of the product is known as overhead expenses. These cost are not directly related to a particular product and therefore, there are different ways of allocating these overhead. (Berry, 2009)

There are two most common methods of allocation of overhead known as traditional approach and Activity based costing.

Preparation of Profit and Loss Statement for the Advance Model

In the traditional approach, all the overhead cost are added together and then distributed based on a single attribute among all the different products that were produced. It is important for the company to ascertain the cost per unit as it helps in the determination of the selling price of each unit. (Boyd, 2013) However, the company is not aware of the actual expenses and so the pre-determined rate is used that is calculated using the budgets.

The budget is used by the company to ascertain the cost and forecasts the profit and sales in the future. The management plays a key role in the preparation of a budget because it estimates the level of output along with the expenses. The expenses that are estimated also include the overhead expense (Dash, 2016). The cost per unit is calculated by dividing the total estimated cost divided by the total estimated units of production. This budgeted cost per unit helps to determine the selling price of the product. There may be a variance present between the actual figures and the estimated figures.  However, the overhead that is recovered from the customers are based on the budgeted figures and not the actual figures. (Datar M. S., 2015)

Let us understand this concept, with the help of an example:

Particulars	Budgeted	Expenses p.u.
No of units produced	2,000
Direct Material	5,000	2.50
Direct Labour	2,500	1.25
Direct Expenses	2,500	1.25
Overhead Expenses	3,000	1.50

Particulars	Actual	Expenses p.u
No of units produced	1,900
Direct Material	5,200	2.74
Direct Labour	2,600	1.37
Direct Expenses	2,500	1.32
Overhead Expenses	3,200	1.68

We can see that the overhead that has been recovered from the customer is $1.50 whereas the actual overhead that has incurred is $1.68 which shows that there is an under absorption of overhead. (Datar S. , 2016)

There might be an under or over absorption in a company most of the time. This is because of the difference in budgeted overhead and actual overhead (Datar M. S., 2015)The treatments of over absorption and under absorption are as follows:

1. The most commonly used treatment is debiting the difference to the profit and loss account in the same year.
2. The under/ over absorption may be carried to the next year.
3. The third is the most complex treatment which is adjusting the under/ over absorption to the existing units.(Paul, 2014)

In the Activity Based Costing, the costs are distributed and allocated on the basis of the resources actually used in the product. This method helps in proper allocation of costs as it is a modern costing approach. This approach is usually adopted by the manufacturing companies. (Donanldson, 2012)

1. Decision making – The data that is obtained through this approach is reliable and therefore, the management can take decisions based on it. Such as setting the selling price for a product. So, we can say that it helps in the process of decision making(Seal, 2012)
2. Controlling costs – It gives a clear picture of the activity and the product. Therefore, the fixed overhead is easily traceable which helps the management to control cost.
3. Helps in capacity utilisation- This approach gives a detailed knowledge of the cost involved which gives the company an idea of making optimum utilisation of the resources.(Girard, 2014)
4. Accurate product cost- The costs are properly allocated which helps the company to know the accurate and correct cost of the product.
5. Tracing activities- the consumption of each activity is traced so that proper allocation can be made. It also helps in ensuring that all the related costs are included in the product. (Holtzman, 2013)

• This approach is considered to be complex and expensive because all the data of cost have to be maintained for the proper allocation. Therefore, the application of this approach is tiring and difficult.(Horngren, 2012)
• This approach involves a lot of manual work as well as time which is not suitable for small enterprises as it becomes costly for them to adopt ABC.(Taillard, 2013)
• We know that the costs are measured on the basis of usage of resources and it is not easy to know how much resources have been consumed. Therefore, this makes the work too tedious. However, the data might not be correct which may lead to wrong results.(Hubig, 2013)
• This approach is not suited for the service industry because there is no production of units that can be measured. Therefore, this approach is mainly adopted by the manufacturing concerns only.(Menifield, 2014)

The ABC costing approach has various advantages and is useful to the manufacturing entities. However, it also has some limitations. The technique of costing should be adopted by the companies after looking at its own suitability.

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