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Overview of Traditional Costing Method

Essendon Electronics, a division of Elgin Ltd, manufactures a diverse range of electrical products.  Its range includes two LCD screen television models: the Monarch, which has been produced since 20XX and sells for $900, and the Regal, a newer model introduced in early 20X0, that sells for $1140. Based on the following income statement for the year ended 30 November 20X1, senior management at Elgin Ltd have decided to concentrate Essendon Electronics’ marketing resources on the Regal model and to begin to phase out the Monarch model.

Essendon Electronics
Income Statement for the financial year ended 30 November 20X1

Monarch

Regal

Total

Revenues

$19 800 000

$4 560 000

$24 360 000

Cost of goods sold

1 2540 000

3 192 000

15 732 000

Gross margin

7 260 000

1 368 000

8 628 000

Selling and administrative expense

5 830 000

978 000

6 808 000

Operating profit

$1 430 000

$390 000

$1 820 000

Units produced and sold

22 000

4 000

Net income per unit sold

$65.00

$97.50

 


Unit costs for Monarch and Regal are as follows:

 

Monarch

Regal

Direct materials

$208

$584

Direct manufacturing labour
Monarch (1.5 hours x $12)
Regal (3.5 hours x $12)

18

48

Machine costs*
Monarch (8 hours x $18)
Regal (4 hours x $18)

144

72

Manufacturing overhead other than machine costs**

200

100

Total cost

$570

$798

*Machine costs include lease cost of the machine, repairs and maintenance.
**Manufacturing overhead was allocated to products based on machine-hours at the rate of $25 per hour.



You have just joined Essendon Electronics as a graduate trainee accountant.  You have reviewed the company’s existing costing system. You have found that: dramatic changes had occurred within the business environment and the company’s manufacturing process over the past 20 years. However, the company’s costing system had remained the same since its inception 20 years ago. You believe Activity-based costing (ABC) and activity-based management could help in overcoming the deficiencies in the existing costing system. You have conducted detailed activity analysis, and one-on-one staff interviews.  You have noticed that many employees are not happy with the idea of implementing ABC. 

You have gathered the following information about the company's manufacturing overhead costs for the year ended 30 November 20X1.

 

Units of the cost-allocation base

Activity centre (cost-allocation base)

Total activity costs

Monarch

Regal

Total

Soldering (number of solder points)

$942 000

1 185 000

385 000

1 570 000

Shipments (number of shipments: batches)

860 000

16 200

3 800

20 000

Quality control (number of inspections)

1 240 000

56 200

21 300

77 500

Purchase orders (number of orders: batches)

950 400

80 100

109 980

190 080

Machine power (machine hours)

57 600

176 000

16 000

192 000

Machine set-ups (number of set-ups: batches)

750 000

16 000

14 000

30 000

Total manufacturing overhead

$4 800 000

 


You have discussed your analysis and shown the results to Tom Lockett, Essendon Electronics’ divisional manager.  Mr Lockett does not seem to be pleased. His comments are: “If you show headquarters this analysis, they are going to ask us to phase out the Regal line, which we have just introduced. This whole costing stuff has been a major problem for us. First Monarch was not profitable and now Regal.

‘Looking at the ABC analysis, I see two problems. First, we do many more activities than the ones you have listed. If you had included all activities, maybe your conclusions would be different. Second, you used number of set-ups and number of inspections as cost-allocation bases. The numbers would be different, had you used set-up hours and inspection-hours instead. I know that measurement problems precluded you from using these other cost-allocation bases, but I believe you ought to make some adjustments to our current numbers to compensate for these issues. I know you can do better. We can’t afford to phase out either product. ”

You are aware that a sizable portion of the divisional manager’s bonus is based on division revenues. Phasing out either product would adversely affect his bonus. After discussing the issue with Mr Lockett, you feel some pressure to do something about the results.

Required:

Prepare a report for the senior management accountant at Essendon Electronics.

Your report should include:

1.Calculation of the profitability of the Regal and Monarch models, using ABC.


2.A brief explanation regarding why these numbers differ from the profitability of the Regal and Monarch models calculated using Essendon Electronics’ existing costing system.

3.Your response to Mr Lockett’s comments and your recommendations on using ABC at Essendon Electronics.

4.The benefits, costs and limitations of adopting ABC.

Overview of Traditional Costing Method

Activity-based costing is a method of cost computation in which cost is determined by allocating overhead expenses on the basis of consumption of cost drivers. In this method, Cost behaviour pattern is time-related, volume related, scope related and transaction-related (Dale & Plunkett, 2017). Further, in the present era where the production process is comprised of several activities, this method helps the company to formulate the best price of the product by providing effective information regarding the price of the product. The present study is based on comparing traditional cost computation of Essendon Electronics for their products Monarch and Regal by applying activity-based costing to assist the company in better analysis and evaluation.

Table 1: Statement showing the profitability of products by making use of activity-based costing

Particulars

Monarch

Regal

Total

Sales

 $19,800,000.00

 $4,560,000.00

 $ 24,360,000.00

Less: Cost of Goods Sold

 $11,300,100.00

 $4,455,900.00

 $15,756,000.00

Gross profit

 $8,499,900.00

 $104,100.00

 $8,604,000.00

Less: Selling and Administrative Expenses

 $5,830,000.00

 $978,000.00

 $6,808,000.00

Net profit

 $2,669,900.00

 $(873,900.00)

 $1,796,000.00

Units Produced and Sold

22000.00

4000.00

26000.00

Net profit per unit

 $121.36

 $(218.48)

 $(97.12)

Working note 1

Table 2: Statement showing the cost of goods sold for Monarch and Regal

Particulars

Monarch

Regal

Output in units

22,000.00

4,000.00

Add: Direct Materials

$4,576,000.00

$2,336,000.00

Add:Direct Manufacturing Labour

$396,000.00

$192,000.00

Add:Machine Cost

$3,168,000.00

$288,000.00

Add:Manufacturing Overhead (Working Note 2)

$3,160,100.00

$1,639,900.00

Cost of Goods Sold

$11,300,100.00

$4,455,900.00

Working note

Table 3: Statement showing the computation of manufacturing overhead

Particulars

Cost Centre

Monarch

Regal

Total

Soldering

Solder points

$711,000.00

$231,000.00

$942,000.00

Shipments

Shipments

$696,600.00

$163,400.00

$860,000.00

Quality Control

Inspection

$899,200.00

$340,800.00

$1,240,000.00

Purchase Order

Orders numbers

$400,500.00

$549,900.00

$950,400.00

Machine Power

Machine Hours

$52,800.00

$4,800.00

$57,600.00

Machine set-ups

Set-upsnumbers

$400,000.00

$350,000.00

$750,000.00

Total cost

$3,160,100.00

$1,639,900.00

$4,800,000.00

Table 4: Statement showing a comparison of profits as per traditional and activity-based costing

Profit as per traditional costing

Monarch

Regal

Total

Operating profit

$1,430,000

$390,000

$1,820,000

Units produced and sold

22,000

4,000.00

26,000.00

Net income per unit sold

$65.00

$97.50

$162.5

Profit as per activity-based costing

Net profit

 $2,669,900.00

 $(873,900.00)

 $1,796,000.00

Units Produced and Sold

22000.00

4000.00

26000.00

Net profit per unit

 $121.36

 $(218.48)

 $(97.12)


By considering the above statement, it can be noticed that there is a significant difference in profits computed from both the methods. The major reason for the difference is that in the method of ABC costing, management has identified key activities in a functional area, and then assign the overhead cost on the basis of their activity. Thus it is a two-stage procedure for computing cost, by this Essendon Electronics can control the cost at a functional level. Further, the traditional method allocates overhead costs on the basis of blanket rates which in the present study is considered as machine hours. By comparing the outcome of both the methods it can be noticed that traditional states that Regal product is earning high profits, but ABC methods show that they are generating loss(Christopher, 2016). Analysis of ABC costing is more accurate because; this is a perfect method for computing the cost of the product as in this method company identifies its activities and allocate the cost of activities on the basis of their actual consumption instead of allocating all overhead expenses on single rate. Traditional costing avoids actual consumption thus computing cost by this method is not viable. Further, ABC costing helps in analysing the cost and profitability of the product which depends on the production process of the company. Thus it is a performance measurement tool for the company.By applying this method, a company can reduce its overhead cost (Weygandt, Kimmel and Kieso, 2015). It is the best technique which helps the company to achieve its goals that are minimizing the cost of the product and maximize the profit of the company. Further, by implementing ABC costing company can continue the evaluation of the cost of the product by which it can eliminate unnecessarily or non-value added cost of the product. In addition to this, by applying this method company can get to know that the total resources consumed by product, services or the customer by which Essendon Electronics can allocate its resources on a product which gives more profit (Cooper, 2017).

Overview of Activity-Based Costing Method

The comment made by Mr Lockett was in its own interest and the manager was more interested in its own profit rather than the organization as a whole, and forced the accountant trainee to not to implement Activity-based costing (ABC) on the basis of two problems namely; use of multiple activities that can led to different conclusions and using the number of inspections and set-ups as a base for cost-allocation. However, the main reason behind the pressurizing comments of managers was that the part of the manager’s bonus is dependent on the division profits, and given that the product will increase the bonuses dramatically.

The belief of the manager and the comments based on the same were absolutely wrong, as the implementation of ABC allots the manufacturing overhead costs to the products in a set and logical way as compared to the traditional one. Thus, it can be said that overlooking the comment of the manager; the business should rely on the ABC system that is more strategic, in order to remain profitable in every aspect (Banker & Byzalov, 2014).  From all the available tools and considering the scenario of business, it can be recommended that business accountants and managers should make use of the ABC method to improvise the profitability with being more cost, resources and time effective. The main objective of using the ABC method is to increase profitability and performance, plus this method accurately identifies the overhead costs and its drivers resulting in more streamlined business procedures (Nagle and Müller, 2017). All the direct, as well as indirect costs, will be assigned to the product, and the business will be able to have a better insight on whether it is performing well or not, and can remove the areas which are not effective. It can be said that the ABC method will be the suitable method for Essendon Electronics will be able to manage the manufacturing performance successfully and can improvise the product quality; thereby increasing the profits with the help of justifiable product pricing that can enable them to provide competitive pricing with return maximization (Settanni, Newnes, Thenent Parry &  Goh, 2014).. Therefore, it is significant that the business manager maintain the operations in an effective way, implementing these new accounting methods can result in cost and time to consume, but if used effectively they can bring the business on track or even higher.

It can be cited that the perceptions of managers are not viable and the same would affect the business; it is because the manager is not considering the situation of the business. Instead, they are tensed about own bonus. Regardless of the above methods aspects, it has been noticed that the accountant under pressure can conduct something else and can change the mindset, but technically the accountant has considered the best way to allocate the overhead costs that can help the business in maintaining its profits. According to the ethical codes as well, accountant’s responsibility is to consider public consider all of above, and it is essential to keep the interests safe with proper safety measures in place (Payne, Corey & Raiborn, 2018).

Analysis of Essendon Electronics' Monarch and Regal TV Models Using Traditional and ABC Costing Methods

Activity-based costing can be defined as an accounting tool that determines and allocate the cost of the product to overhead activities. Activity-based costing is an advanced method for allocating the cost of a product (Wilkinson, 2013). By applying ABC costing methodology management assign all direct cost like raw material, direct labour and indirect cost like machinery cost of the product in relation to their activity, thus this method identify the relationship between the cost of the product and use of the resources by the product.

Cost of activity-based costing

For allocating the overhead cost of the product, the proper cost driver should be identified by the company. A cost driver is based on the resources which are utilized by product. Therefore, this method shows the relationship among the resources, activities and allocating overhead cost. By understanding, the cost behaviour pattern of a product company can identify the proper cost driver, which helps in perfect allocation of the cost of the product.For the implementation of ABC costing method person should possess knowledge of cost accounting (Kumar and Reinartz, 2018).  It also requires experience in related industry or understanding of production process. It is not simple to apply ABC costing method.

As concerned with the case, it can be cited that the of implementing ABC can attract high costs and it can be time-consuming, as doing things from scratch needs time and patience, along with the higher amount of resources, costs and contributions. However, the adoption of new accounting system can result in meaningful analysis, as given in the case the organization performance is not satisfactory, so by implementing this method the costs can be reduced and also on the other hand business will be required to compromise its costs, measures and profits sometimes (Christ & Burritt, (2015).

Benefits of activity-based costing

In this method, the cost is allocated on the basis of their activity, which leads to the correct allocation of the cost of the product. Therefore, this method helps in finding out the more accurate and reliable price to be charged for the product.ABC costing helps in identify true cost behaviour pattern of the product, which helps management to alleviate the non-value added activities. Moreover, Management is also able to control the cost of the product. The company can also attain a competitive edge in the market by identifying the cost structure of the product (Freedman, 2018). As the ABC method also helps in reducing the cost of the product. With the help of the ABC method, management is able to make buying decisions about a product or subcontract from another person by considering the impact of the same on the cost of the product. Since ABC costing gives accurate information regarding the cost of the product, therefore, management can use this technique in the application of total quality management process, just in time process, business process re-engineering process (Chisambara, 2012). In addition to this, by applying ABC costing, the company can solve the product mix problem in a better way as loss-making products can be eliminated or improvised. Further, productions of products providing high profits can be increased.  

Comparison of Traditional and ABC Costing Methods and Their Applicability to Essendon Electronics' Monarch and Regal TV Models

Relating it to the case, it can be said that the company is using a traditional approach which shows that Regal is more profitable than a Monarch.  However, by considering actual consumption in the activity regal is generating a loss. Therefore, if decisions are taken on the basis of traditional approach regarding product mix then there will be a significant loss to the company this factor shows that approach of ABC is more analytical and accurate for companies having multiple products (Chenhall & Moers, 2015). As provided in the case scenario, the company position is not stable and needs to allow its multiple products effectively, and make its decisions better; with the help of ABC, the business will achieve all these aspects if implemented as accurately as possible.

Limitations of activity-based costing

ABC costing is not useful for small enterprises and also where the overhead cost of the product is very less as compared to operating cost. In addition to this, if the company is producing only one or a few products, then ABC costing does not come up with reliable results. It is because; ABC costing is a very time-consuming process as it is computed by collecting and preparing various data. Moreover, the original data is also not readily available in all the companies (Woodruff, 2018). In ABC costing activity rates are required to be updated on a regular basis. Generally, the ABC system requires so many calculations for computing the cost of the product.  Thus it is very costly to apply ABC costing method in the company. Further, in this method of costing, costs are allocated on the basis of cost driver of activity, but practically it is very difficult to select appropriate cost driver and assignment of the cost.

Since there are various activities involved in the case and allocation and identification and all can result in forming complexity and can lead to many complications and confusions, which can further make the application of this accounting system tougher (Maas, Schaltegger & Crutzen, 2016). 

ABC has the demerit regarding the complexity due to excessive use of costs pools and numerous cost drivers and thereby it is more difficult than traditional product costing systems. It can be evidenced; it is expensive to maintain the ABC system; some complexities take place while adoption of ABC, for example, cost driver selection and allotment of costs.

Conclusion

In accordance with the present study, the conclusion can be drawn that the ABC method is an improved technique of cost allocation. Management applies this method for analyzing the cost and profit of the product.  This technique is also used in target costing, product costing, service pricing, and customer profitability analysis. Thus ABC costing is a more authentic method for allocating the cost incurred by the company for manufacturing a product in comparison to traditional costing. The study also shows that if earlier, a company sets a performance standard by applying traditional costing method, then data produced by ABC may lead to conflict with the established standards. However, analysis of ABC is more accurate and viable for the decision-making process.

References

Banker, R.D. & Byzalov, D., (2014). Asymmetric cost behavior. Journal of Management Accounting Research, 26(2), pp.43-79.

Chenhall, R. H., & Moers, F. (2015). The role of innovation in the evolution of management accounting and its integration into management control. Accounting, Organizations and Society, 47, 1-13.

Christ, K. L., & Burritt, R. L. (2015). Material flow cost accounting: a review and agenda for future research. Journal of Cleaner Production, 108, 1378-1389.

Christopher, M., (2016). Logistics & supply chain management. Pearson UK.

Cooper, R., (2017). Target costing and value engineering. Routledge.

Dale, B. G., & Plunkett, J. J. (2017). Quality costing. Routledge.

Kumar, V. & Reinartz, W., (2018). Customer relationship management: Concept, strategy, and tools. Springer.

Maas, K., Schaltegger, S., & Crutzen, N. (2016). Integrating corporate sustainability assessment, management accounting, control, and reporting. Journal of Cleaner Production, 136, 237-248.

Nagle, T.T. & Müller, G., (2017). The strategy and tactics of pricing: A guide to growing more profitably. Routledge.

Payne, D. M., Corey, C. M., & Raiborn, C. (2018). A MODEL CODE OF ETHICS FOR DECISION MAKING IN ACCOUNT

Settanni, E., Newnes, L.B., Thenent, N.E., Parry, G. &  Goh, Y.M., (2014). A through-life is costing methodology for use in the product–service-systems. International Journal of Production Economics, 153, pp.161-177.

Weygandt, J.J., Kimmel, P.D. & Kieso, D.E., (2015). Financial & managerial accounting. John Wiley & Sons.

Online

Chisambara, P., (2012). 4 Benefits of Using Activity-Based Costing to Manage Costs. Retrieved from <https://erpminsights.com/the-benefits-of-using-activity-based-costing-to-manage-costs/>.

Freedman, J., (2018). Advantages & Disadvantages of Activity Based Costing. Retrieved from < https://yourbusiness.azcentral.com/advantages-disadvantages-activity-based-costing-11280.html>.

Wilkinson J., (2013). Implementing Activity-Based Costing. Retrieved from < https://strategiccfo.com/implementing-activity-based-costing-2/>.

Woodruff; J., (2018). The Disadvantages & Advantages of Activity-Based Costing. Retrieved from <https://smallbusiness.chron.com/disadvantages-advantages-activitybased-costing-45096.html

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