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Traditional vs Activity Based Costing

 A. DDT Ltd. 

Statement Showing computation of Cost of Product X, Y, Z

(Based on the traditional approach of accounting overheads) 

Product X

Product Y

Product Z

Units

 5,000

 8,000

 7,500

Prime Cost (£)

 64,000

 64,000

 72,000

Overheads (£)

249,600

124,800

374,400

Refer to W.N.1

(32,000*7.8)

(16,000*7.8)

(48,000*7.8)

Total Cost of Products (£)

 313,600

 188,800

 446,400

Cost Per unit (£)

62.72

23.6

59.52

(£313,600/5000 units)

(£188,800/8000 units)

(£408,000/7500units)

 Working Notes: 

  1. Overhead Rate per Labour Hour 

=    Total Overhead

       Total Labour Hour 

=    748,800

       96,000 

=     £ 7.8 per labour hour 

  1. Statement showing computation of Cost of Product X, Y, Z (Using Activity Based Costing system)

Product X

Product Y

Product Z

Units

 5,000

 8,000

 7,500

Prime Cost (£)

 64,000

 64,000

 72,000

Material Inspection (£)

100,000

60,000

160,000

(400,000 kg * £ 0.25)

(240,000 kg * £ 0.25)

(640,000*£ 0.25)

Machine Maintenance (£)

158,400

52,800

105,600

(24,000 hrs*£ 6.6)

(8,000 hrs*£ 6.6)

(16,000 hrs*£ 6.6)

Production Scheduling (£)

18,816

54,656

38,528

(105*£ 179.2)

(305*£ 179.2)

(215* £ 179.2)

Total Cost of Products (£)

 341,216

 231,456

 376,128

Cost Per unit (£)

68.24

28.93

50.15

(£341,216/5000 units)

(£231,456/8000 units)

(£376,128/7500 units)

Working Notes:

  1. Calculation of Rate per Activity Cost Driver

Activity

Cost Driver

Cost Pool [a]

Cost Driver[b]

Cost/Unit of Cost Driver [(a)/(b)]

Material Inspections

Material Quantity

£ 320,000

1,280,000

£ 0.25 per Material Quantity

Machine Maintenance

Machine Hours

£ 316,800

48,000

£ 6.6 per Machine hour

Production Scheduling

Production Set Ups

£ 112,000

625

£ 179.2 per Set up

 3. Statement of Cost Driver 

Cost Driver

Product X

Product Y

Product Z

Total

Material Quantity (Kg)

400,000

240,000

640,000

1,280,000

Machine Hours

24,000

8,000

16,000

48,000

Production Set Ups

105

305

215

625

  1. Comparison

Particulars

Product X (£)

Product Y (£)

Product Z (£)

Under Traditional Costing System (a)

62.72

23.6

59.52

Under ABC System (b)

68.24

28.93

50.15

Differences (b)-(a)

5.52

5.33

-9.37

Costing can be done under two different bases i.e. under Traditional Costing System and Activity based Costing.

The traditional product cost system uses single recovery rate for allocating the overheads costs to the product like either direct labour hours or machine hours.

Suppose there is a company which produce more than one product and their process is affected by the activity like material inspection, production run, orders executed, number of set ups, purchase requisition, using the traditional methods of costing may give inaccurate cost of products. Hence in that case activity based costing method should be use for recovering overheads which gives most accurate cost to products.

DDT Ltd. is company having multiproduct (Product X, Product Y, Product Z) having overhead affected by activity like material inspection, number of set ups, etc. DDT Ltd. should use activity Based Costing for accurate product cost. In above comparison table between traditional costing system and Activity Based Costing of DDT Ltd, Product X and Product Y is under cost and Product Z is over cost under traditional costing system. Since in Activity Based Costing, Cost are allocated on the basis of activities, this cost is more realistic than the traditional costing method. DDT Co. can apply Activity Based Costing in following steps:

  1. Identify activity.
  2. Create activity cost pool.
  3. Find cost driver for above activities.
  4. Find rate for activity cost driver and allocating the cost to Cost Objects. (Product X, Product Y, Product Z)
  1. Budgeting means preparing a financial plan for the given period of time. Budget may be for a period – short period, mid-range and long-term periods. Different type of budget is prepared for different purpose. The different type of budget is Cash Budget, functional budget, fixed budget, flexible budget. Budget is effective tool of a company which guides the manager for business process and allocating resources.
  1. Planning ahead: Budgeting is the process of future planning in terms of financial expectation. At the beginning of period managers draws future plan, anticipates future problems and plan the solutions to tackle them. Managers act according to plan and responses to changed situations.
  2. Co-ordination among different division: While planning the budget, it kept in mind all the sections of company. It Outlines the Budget which is not only beneficial to a particular section of company, but to the company as a whole. It does it by co- ordinating with different division of company time to time. Budgeting takes different division of company into a common plan and resolve conflicts between the different division of company in most beneficial manner to the company as a whole. Examples- For the discount Purchasing manager want to buy inventory in bulk quantity but production Manager may not want that because large inventory may increase carrying cost which can be used in different opportunities.
  3. Communication with employees: For performing well as plan in the budget, managers should effectively communicate employees time to time. Further they should ensure all the employee had understood the plan properly. Thus, Budgets helps in improving communication and with the effective communication Company can achieve its objectives.
  4. Provides a Motivation: Budgets set the goal and the provide the road map to perform. The set goal provides the managers a motivation to work as per the standard provided and achieve the organisation objectives.
  5. Allocating the resources: Organisation has limited asset and resources. At the beginning itself, organisation assess the resources they have and the objectives they have to achieve. Thus, Budgeting helps in allocating the resources in efficient manner so that with that limited resources the organisation can obtain highest possible benefits.
  6. Control: At the beginning, financial plan is made. At the end, actual results (in terms of Income and expense) is available with the organisation. Now they can compare actual results with the budgeted one and find out the variances and reason of variances. These reasons of variances actually to be use as a control mechanism in future periods.
  7. Evaluation of performance: Budget set a standard goal and objectives. Every personnel in the organisation should work according to plan and achieve the targets. So, by comparing the actual results with budgeted, the performance of every personnel is evaluated, and provide guidance or appraisal as per the performance.
  1. The areas of differences between management accounting and financial accounting are as follows:
  2. Data and Record: Financial accounting keep record of the financial transaction of the organisation. Every data used by organisation is supported by the evidence.

Whereas Management accounting uses the data mostly of future orientation. Data uses by the management are not accurate because it is related to future, so data should be logical and based on relevant facts.

  1. Purpose: Financial accounting provides information to all its stakeholders like internal- employee and external- suppliers, customers, investors, government and helps them in their decision making.

Management accounting provides information only to internal management and helps them in taking business decisions.

  1. Time Period: Financial accounting records the transaction that has already occurred. It is generally prepared for one year.

Management accounting does not have any fixed period. It is generally prepared for present or future.

  1. Mandatory Requirement: Financial accounting is mandatory requirement to be prepared by law.

Whereas, Management accounting is not mandatory.

  1. Governing principles: Financial accounting is prepared on the basis of ‘generally acceptable accounting principles’ (GAAP).

Management accounting does not have any governing principles and prepared according to management requirement.

  1. Content: Financial accounting includes Balance Sheet, Profit and loss statement and Cash flow statement.

Management accounting contains report about product, business process.

  1. Information: Financial accounting provide only financial information.

Management accounting provides both financial and non- financial information.

  1. Audit: Financial accounting is audited by statutory auditors. Whereas management accounting is not required to be audited.
  2. Budgeting means preparing a financial plan for the given period of time. Different type of budget is prepared for different purpose. The different type of budget is Cash Budget, functional budget, fixed budget, flexible budget.

The differences between fixed budgeting and flexible budgeting.

Fixed Budget

Flexible budget

Fixed Budget is prepared for a single level of output and does not change according to change in level of output.

Flexible budget is prepared for the different level of activity.

It is Static.

It is dynamic.

Fixed Budget is prepared on the basis of assumption based on some relevant factor.

Flexible budget is prepared and adjusted as per actual output.

Fixed budget cannot be used for evaluating performance of managers.

Flexible budget is used for comparing actual results with budgeted and thus performance of managers is evaluated.

Fixed Budget is used for the planning purpose.

Flexible Budget is used for the controlling purpose.

Fixed Budget is fixed and cannot be altered.

Flexible Budget can be altered any time.

Fixed Budget is not suitable for the business like affected by weather.

Flexible Budget is suitable for any type of business.

Fixed Budget does not help managers in dealing with uncertainty.

Flexible Budget help managers in dealing with uncertainty that comes in future.

At the end of period, Ketia has actual revenues and costs. So, at the end, ketia is able to compare its actual results with budgeted values and find out differences between actual and budgeted. These differences or the deviation from budgeted is known as variances which is calculated by subtracting actual figure by budgeted figure (Budgeted- Actual). Different variances are as follows:

These variances can be divided into two categories

  • Favourable variances: If the actual result is better than budgeted one, it is favourable variances.
  • Unfavourable variances: It actual result is not better than budgeted one, it is unfavourable variances.

Variances analysis finds the sources and reason of differences between actual and budgeted. By the help of this formation, managers should take proper remedial action to correct the discrepancies. Example If Sales is less than budgeted then effective action should be taken to increased sales. If working hour is less than Budgeted, remedial action is taken for effectively allocating working hours.

References:

Borad, S. B., (2017). Differences between Financial Accounting and Management Accounting. [Online] Available from https://efinancemanagement.com/financial-accounting/difference-between-financial-and-management-accounting Accessed June 13, 2017.

Markgraf, B., (2017). What is Budget Variance Analysis. [Online] Available from https://smallbusiness.chron.com/budget-variance-analysis-60250.html Accessed June 13, 2017.

Marquis, A., (2017). Major Objectives of a Budget System. [online] Available from  https://smallbusiness.chron.com/major-objectives-budget-system-31094.html Accessed June 13, 2017.

MymindCoach. (2017). What is Budgeting? What is budget? (2017). [Online] Available from https://www.mymoneycoach.ca/budgeting/what-is-a-budget-planning-forecasting. Accessed June 13, 2017. 

Peavler, R.,(2016). Definition of Budgeting for Business. [Online] Available from https://www.thebalance.com/budgeting-for-business-393264 Accessed June 13, 2017. 

Surbhi, S., (2015). Differences between Fixed Budget and Flexible Budget. [Online] Available from https://keydifferences.com/difference-between-fixed-budget-and-flexible-budget.html Accessed June 13, 2017.

Walker, S., (2012). Budget and Various Analysis. [Online] Available from https://www.slideshare.net/toejamatic/budgeting-variance-analysis Accessed June 13, 2017.

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My Assignment Help. (2022). How To Use Activity Based Costing For Product Costing In An Essay?. Retrieved from https://myassignmenthelp.com/free-samples/ac50030e-managerial-finance/traditional-costing-system-file-A8E967.html.

"How To Use Activity Based Costing For Product Costing In An Essay?." My Assignment Help, 2022, https://myassignmenthelp.com/free-samples/ac50030e-managerial-finance/traditional-costing-system-file-A8E967.html.

My Assignment Help (2022) How To Use Activity Based Costing For Product Costing In An Essay? [Online]. Available from: https://myassignmenthelp.com/free-samples/ac50030e-managerial-finance/traditional-costing-system-file-A8E967.html
[Accessed 18 July 2024].

My Assignment Help. 'How To Use Activity Based Costing For Product Costing In An Essay?' (My Assignment Help, 2022) <https://myassignmenthelp.com/free-samples/ac50030e-managerial-finance/traditional-costing-system-file-A8E967.html> accessed 18 July 2024.

My Assignment Help. How To Use Activity Based Costing For Product Costing In An Essay? [Internet]. My Assignment Help. 2022 [cited 18 July 2024]. Available from: https://myassignmenthelp.com/free-samples/ac50030e-managerial-finance/traditional-costing-system-file-A8E967.html.

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