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Sewing Easy Ltd has been in business for two years manufacturing sewing machines. It currently manufactures two models, the basic and advance. Last year, 2017 they made good profit and they were happy their business is running well. They are about to enter a new phase in their business, selling to an overseas buyer. However, they are a bit confused as to why the buyer is only interested to buy the advance model and not the basic or both. For product costing purposes the business uses the traditional costing system and machine hours to assign indirect cost to the sewing machines as they are fairly new in business and don’t want to spend too much money to implement a more refined costing system-they are making profit, why change things? 

However, the owner of the business, Sam Moroney is a bit concerned as to the reason why the overseas buyer is not interested in buying the basic model and has appointed you to get to the bottom of this. He had been advised by fellow business buddies to implement Activity Based costing from the beginning but ignored it. He is thinking maybe it’s time. 

The following information has been supplied to you regarding the business for the year 2017. 

Basic Model

Units produced and sold: 1600

Direct material cost per unit: $325

Direct Labour cost per unit: $150 

Advance Model

Units produced and sold: 1500

Direct material cost per unit: $560

Direct labour cost per unit: $260 

The total indirect/overhead costs and activities are as follows: 

Inspection: $20 000

Assembly: $90 000

Production Scheduling: $105 000

Machine set-up: $35 000 

The models use the activities in the following ways: 

Basic Model                                     Advance Model

Inspection                            200                                                     750    Inspections

Assembly                              4600                                                  3400  machine hours

Production scheduling      50                                                       500     Runs

Machine set-up                   100                                                     250     set up

Other operating expenses for the advance model are: selling and administration $140 600, interest expense $25 200 and office rent $35 900. 

Required: Calculations in two decimal places 

  • 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. 
  • 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.
  • 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?
Background Information

Solution 1:

The following table shows the calculation for cost per unit for both basic and advance model under traditional method of costing:

Statement of Cost- Traditional 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

         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 Allocated to Basic Model

         1,43,750

 - Overhead Allocated to Advance Model

         1,06,250

From the above table we can see that the cost per unit of basic model under traditional costing is $565 per unit and that of advance model is $891 per unit. In calculation of above cost per unit we have not included other indirect cost. 

Solution 2:

The following table shows the calculation for cost per unit for both basic and advance model under activity based costing:

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

From the above table we can see that the cost per unit of the basic model under activity based costing is $522 per unit and that of advance model is $936 per unit. In calculation of above cost per unit we have not included other indirect cost. 

Solution 3:

The following table calculation of selling price per unit under traditional costing method:

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

 The following is the statement of profit and loss for Sewing Ltd, if traditional costing method is used:

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

 The following table calculation of selling price per unit under Activity Based Costing:

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

 The following is the statement of profit and loss for Sewing Ltd, if Activity Based Costing is used:

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

From the above calculations we can see that under traditional method of cost allocation the overhead allocated towards the advance model is $106250, and that under activity based costing is $174494. The cost allocated towards basic model under traditional cost method is $143750 and that under activity based costing is $75506. Under traditional method of costing, only a single cost driver is used to allocate the cost. But under activity based costing, cost allocation is done based on actual consumption of activity. Cost is adequately and as per usage is allocated under activity based costing. (Atkinson, 2012)

In the given scenario we see that the overseas buyer is interested to purchase only the advance model and not the basic model. The reason behind this is irregular distribution of cost. The company uses traditional system of cost allocation, using only one cost driver to allocate cost. This has resulted in a part of cost which was actually incurred for advance model to be shifted to basic model. Since, the cost allocated is less towards the advance model; the selling price for the same is also reduced. The company is currently charging $ 1069 per unit for advance model from the overseas buyer. If the company would have used activity based costing the, price charged from the customer would have been $1124. The overseas buyer has observed this difference in price for $55 per unit. Since sewing ltd is charging $55 less per unit on the advance model, the overseas buyer is interested in buying only the advance model.

Calculation of Cost per Unit

For basic model, the company is charging $678 per unit under traditional costing method. If it uses activity based costing then the company would charge $627 per unit for the basic model. Since the company is using traditional costing method, it is charging $51 per unit more on the basic model. The overseas buyer can purchase the basic model from market at $627 per unit. This is why the overseas buyer is not interested in buying the basic model form Sewing Ltd.

Therefore, we see that method of cost allocation has a high effect on the product pricing. Using the correct method of cost allocation is very important, as it affects the buyer’s decision. (Berry, 2009) Wrong allocation of cost among products may lead to financial troubles for the company. 

Solution 4:

There are various methods of cost allocation that can be used. When the absorption costing method is used rate which is predetermined is taken into consideration in order to ascertain the price of the products. It is obvious that company will not just ask for the expenses it will also ask for a profit margin that will affect the change in cost and selling price of the product. There seems to exists huge variations in the amount which is charged from the customers and the actual amount that the firm incurs as expenses. (Bierman & Smidt, 2010)The differences between the expenses and actual selling price of the product make differences in the books and should be treated in the accounting system.

For example, if we take into consideration the concept of recovery of overheads, then you will be able to understand the fact. If a company decides to produce 20000 units of a product and it is also likely to incur $100000 as overhead expenses then it will be clear for the company that it needs to charge $5 per unit as the overhead expenses. The selling price with the customer is asked to pay contains the price of overhead expenses which in this case is $5. The method which has been used in order to evaluate overhead expenses is on estimated basis. The overhead expenses that were incurred by the company was $72000 and the units produced by 18000 which resulted in the net per unit overhead expenses to value at $4. The company was said to receive the dollar for $90000 of overhead expenses after selling the 18000 units which had produced. The over recovery amount in the given case around $18000 which is needed by the company to adjust in its book of accounts.

Comparison of Profit under Traditional and ABC Costing Methods

The only case when the actual overhead costs and the estimated overhead costs are same is the case when the company charges the exact overhead charges that have actually been incurred by the organization during the production of a certain product (Boyd, 2013). This is the case where no under or over-recovery that may exist. There are several methods that can be used by the organization in order to record the over and under expenses that have been incurred during the time of production: (Datar M. S., 2015)

The amount which is the difference between the actual and applied overhead is settled with the profit and loss statement. It is supposed to be one of the best and easiest methods in order to treat this kind of transactions (Datar S. , 2016). This method consists of charging the overhead expenses directly in the profit and loss account of the firm so that the expenses incurred by the organization can be adjusted in the accounts of that particular financial year.

The amount of the overhead expenses can also be transferred to the financial document of the next year. This method is mostly used by the manufacturers in order keep the accounts of the present financial year clean. (Holtzman, 2013)This method carries forwards the difference in the overhead expenses to the next year and the treatment of the overhead expenses will take place in the financial documents of the next year. In order to eliminate the difference of the value of the overhead expenses, the manufacturer claims to adjust it in the statements.

Another method that can be used to evaluate the difference of the overhead expenses is to charge them in the same financial year. This method is generally used when there have been any mistakes in the calculation of the overhead expenses at the starting of year. This method generally uses a predetermined overhead expense that is charged to the customers at the time of selling process. (Horngren, 2012)

Therefore it is clear that there are cases arising in relation to the under and over expenses that are charged to the customers and also there have been methods on how to treat these expenses in the books of accounts so as to keep them clean.

Solution 5:

The activity-based costing system uses the technique of allocation of the cost and expenses of the resources that have been incurred in the manufacturing of a certain product. This is a new type of Costing method which is used by the firm in order to allocate all the cost and expenses that have been incurred in the manufacturing of the product by the resources that have been used as raw materials and does help the company in ascertainment of appropriate decisions. (Menifield, 2014) It has been observed that these types of Costing methods are very reliable when the organization needs to construct the relationship between the costs and the actual price of the product. Also because of diverse nature of some of the expenses, it is very hard for them to allocate in the type of cost on the manufacturing process. It has also been clearly observed that this type of processes is mainly design for the use of manufacturing industries and not for retail companies because of their diverse nature. The main advantages of the use of the activity-based costing system are:

Conclusion

Analysis of the production cost - the main function which was observed about the activity-based costing method was to assign groups for different cost so that there may be a clear differentiation between the services actual and the real cost of the manufactured products and thus Clear View of the cost required in order to manufacture the product is ascertained. They are Organisation in which small overhead expenses group up in order to form a large expense and does affecting the cost of the product sold, hence making it necessary for the firm to allocate the cost in a specified manner so that the firm can be protected from the problems that may prevail upon it in the future during the analysis of the course related to the manufactured product. (Noreen, 2015)

Assistance in controlling costs - the activity-based costing system depends on the functionality that is present between the activities that are required in order to manufacture the product and the product itself thus making it easier for the managers to access the cost of the overhead expenses that are incurred in order to perform the activities. There are also many other available measures that can be used in order to control the costs. (Nwanji, 2016)

Discovering the activities - the ABC method of Costing includes the assessment of each activity in order to make proper analysis on the costs related to a product so as to make allocation of the activities that are related to the factory expenses thus ensuring that there are no expenses that have been left or excluded during the time of valuation of a specified product. (Piper, 2015)

Enhancement of the decision-making process - the information that is collected using the ABC method prove to be very helpful in ascertainment of decisions by the manager so that the activities performed may be in the best concern for the organization. This also helps to ascertain a realistic price of the product which is also affordable to the customer. (Seal, 2012)

Assistance in capacity realization - the main purpose of the ABC method is to allocate the expenses in different groups show that the price of the product can be ascertained. The process helps managers in order to ascertain the maximum utilization of expenses which can be controlled and also help them to control the cost of the product by including the capacity. (Seitz & Ellison, 2009)

The mentioned advantages of the ABC method one of the most important and reliable objectives that are needed to be fulfilled by the firm. There is some limitation along with the advantages they are as follows:

References

Expensive and torturing methods of application - all the data should be collected at a single place which makes it easier for the appropriate allocation of the overheads. This process of collecting data is very complex and hence is considered unsuitable for the application in the process of Costing. (Siciliano, 2015)

Unsuitability regarding the small Enterprises - in order to perform the activity based costing method it is important for the firm to collect all the data and work in a manual way so that complete and useful information is achieved. Thus the application of this process makes it a lot harder for the small firms because of the expenses required by the method in order to function. (Taillard, 2013)

Difficulty in measurement - this method of cost allocation a certain lot of expenses but it still lacks in a certain mint of the value of resources that are needed in order to manufacture the product. Because of the complexity of this task, this requires a lot of attention and any presence of incorrect data may lead to Bad effects on the form and also may lead to the organization incurring losses in future. (What is Management Accounting?)

And suitability towards service industry - after the study of the given data it is your dad appropriation of the expenses in order to manufacture the product is not an easy task and as the service industry doesn't have any type of divisions of cost and utilities, the ascertainment of the costs and their allocation is made difficult. (White, 2009)

Therefore after the clear analysis of the ABC method of costing we have come to the conclusion that it is very helpful in the allocation of the cost but also have certain drawbacks. Therefore it should be made necessary for the companies in order to analyze the environmental changes before ascertaining any of the costing techniques.

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

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

Bierman, H., & Smidt, S. (2010). The Capital Budgeting Decision. Boston: Routledge.

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.

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

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

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.

Nwanji, T. (2016). 

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

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

Seitz, N., & Ellison, M. (2009). Capital Budgeting and Long-Term Financing Decisions. New York: Thomson Learning.

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

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

What is Management Accounting? (n.d.).

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

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