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Management Accounting : Activity-Based Costing

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Describe about the Management Accounting for Activity-Based Costing.




The economic structure of the world works on the functioning of all the organizations producing variety of products according to the demand in the economic market. The firms operating in the market have their prime intension to maximize their profit by reducing their cost of production and increasing their sales in the market. The organizations take drastic steps through proper evaluation of the production process to reduce their production costs. The cost of production can be reduced by calculating the costs through various cost accounting formulas and creating cost models to improve the business conditions.

This report analyses cost calculation functions of Island Wheels Ltd, a producer of bicycles. They produce three different varieties of bicycles, namely Road, Trek and BMX. This organization is a small manufacturing company and thus is not of the same standard with the big brands in the market. They produce quality products, which are mostly hand-made and thus has a good established customer base.

The enterprise is in the opinion of expanding and thus requires predicting their future overhead costs to ascertain an increase in production. The firm also wants to find out their production cost if they increase their labor hours and machine times.  Island Wheels Ltd are in the opinion of applying ABC ( Activity-based costing) to their business and understand and reduce the cost of production. 

The report will evaluate and analyze the different aspects, which are in concern to Island Wheel Ltd to expand and reduce their product cost and cost of production.


The purpose of a cost formula and the components of the cost formula

Island Wheels Ltd, a manufacturer of bicycles is in the opinion of expanding and thus requires the need for cost accounting. Cost accounting refers to a process of recording, collecting and evaluating the costs involved in production. It is helpful in ascertaining the best course of action through cost efficiency. This process is helpful to the management in controlling the present operations of the firm and plans a better production structure for future. The elements, which are necessary for the calculation of the cost accounting, are raw materials, labor and fixed and variable overheads.  

Incase of Island Wheels Ltd , cost estimation methods are essential to determine the best cost formula method to calculate their proceedings. The organization has mixed costs in the information provided by John and is comprised of variable and fixed costs. The management needs to segregate the mixed cost into fixed and variable to predict and plan for the future according to the cost behavior. Cost estimation is done through various cost formulas, which are essential to determine the present and future cost trends of the organization[1]. The management of Island Wheels takes help from these formulas to take drastic decisions for the improvement of the firm.

The different types of cost formulas are as follows:

Account Analysis

Scatter graph

High-low method

Linear regression

The above four are the most generally used cost formulas by any organization and in case of  Island Wheels a proper analysis of all these four methods will be taken to find out the best cost formulating techniques for the organization.  Island Wheels Ltd does not have any differentiated fixed and variable costs and thus these formulas are necessary for Island Wheels Ltd. The ultimate purpose of cost estimation is to find out the fixed and variable costs, which is helpful to create a cost formula in accordance with Island Wheels Ltd to estimate their future costs.  The different modes of cost estimation formulas are as follows:

Determination of Cost formulas

Account analysis method

This method of analysis of fixed and variable costs is done to identify the cost behavior in the managerial accounting. This process requires just looking at the cost, which is incurred and predict its closest cost behavior.  The method requires the accountants have a subjective judgment and insight about the different costs.  The accountants need to have a good knowledge about the nature of the costs. This method is an approach to predict the costs only when information about one period is known.

Incase of Island Wheels Ltd, the  analysis examines each costs individually and then based on the insight, differentiates into fixed and variable costs. The variable costs are all added and the variable per unit cost is calculated by dividing the total variable cost by the total number goods produced and sold. The variable cost per unit is put in to the cost formula as the variable costs and the total costs are added to find out the total fixed cost component of the equation[2]. The cost equation created from these operations is used to determine the future costs of an organization. Island Wheels being a small manufacturing unit will not try to undertake this process as it involves the use of a predictive mechanism to try and realize their fixed and variable costs of production. The process can bring out errors and good knowledge of the accountant is required and so for this organization, to calculate the actual costs this method need not be used.

Scatter Graph method

This process involves the creation of a scatter graph after which a predicted fixed and variable costs are determined. This method provides a visual image of the total costs at different activity levels of Island Wheels Ltd. The only problem with this method is that it is very hard to visualize the cost equation line from the information points and especially when the information is variable from time to time.  The different steps in this process involves drawing of a graph with the y-axis consisting of the total costs and the x-axis of the units. The total costs of Island Wheels are pointed on the graph. The points, which are plotted on the graph are connected to form a straight line. Then the variable cost per unit is identified by looking at the slope by calculating the difference between the total costs and the difference between the units[3]. The point at which the line crosses the y-axis is the total fixed cost. Thus the formula of cost is:

     Y= VC+TFC

Island Wheels has its information about calculating the costs from this method and but as this process is complex and requires a lot of time, the organization will not apply it as the owner Mr. John has asked the report to be submitted by Monday.

High-Low Method

This is one of the major formula used to calculate the fixed and variable costs. This method uses the highest and the lowest levels of activities from the information set of Island Wheels to find out the parts, which are fixed and variable out of the total mixed costs. The method might not prove to be trustworthy if the information set is not in accordance with the normal level of activities. But in this case, Island Wheels has a proper data set and so this method can be applied. The method applies the costs shown at the highest and the lowest points from the information of Island Wheels and calculates the fixed and variable costs which is useful to determine the cost of product. The variable costs per unit is calculated by the mathematical slope formula, which segregates the cost change by the activity change. The variable cost per unit determined from the data set of Island Wheels is inserted in place of the variable cost

The total fixed cost is then calculated by inserting the total cost into the dependent variable and highest activity point for the independent variable.  The solutions are then plugged into the cost formula to ascertain the answer for Island Wheels. This process is the simplest method to calculate the desired requirements for Island Wheels and this process will bring out the best result for them according to their information set.   


Linear Regression Method

This is a statistical method used to determine the average amount of change in the dependent variable along with a single unit change in one or more independent variables.  This method uses all the observations available for Island Wheels Ltd  and then analyses them. The method involves the use of mathematical formulas to find out the regression line that reduces the total of the squared errors.  The method is a complex process as it involves the need to calculate the coefficients and the standard errors[4]. As this process requires mathematical formulas, it becomes difficult for many accountants to follow. Island Wheels does not have the required set of data available to calculate from this method and thus this method is not acceptable for this organization.

John Cruise the owner of Island Wheels Ltd unaware of which cost formula to be used for the improvement of the organization. All the above cost formulas are appropriate for analysis for any organization. According to the information available from Island Wheels Ltd, it is found that two scatter graphs representing the regression statistics for output of labor and the regression statistics for the output of machines are given.  An appendix containing the labor hours, machine hours and the overhead costs of the organization for a year is provided. These are the only information available from Island Wheels Ltd. All the formulas can be put into use but account analysis involves evaluation through insight and knowledge about the accountant to segregate the costs into fixed and variable, which can bring out wrong results if the knowledge about the activities are not sufficient. The regression analysis uses all the observations available in the set and by using of mathematical formulas, the actual costs are determined. The process is a complex one and thus is not widely used by the accountants. The scatter graph is provided by the organization in this case but calculation of slope from the graph and then inserting the relevant data in the formula requires a lengthy process. Thus incase of Island Wheels Ltd the best possible technique which can be implemented is the high low method because this process is a simple one taking only the highest and the lowest points from the data set. This process is user friendly and takes less time thus giving an accurate result. The information provided by John Cruise is true and just according to the actual activities and so the calculation from this method  is true and fair. Thus high low method will be taken for evaluating the information of Island Wheels Ltd and thus the information given about the labor hours, machine hours and the overhead costs will be taken into account to find out the fixed and variable costs.

Evaluation of Costs for Island Wheels Ltd

The organization provides the labor hour rate and machine rate along with the overhead costs to determine the costs of the organization. The computation of fixed and variable costs for the machine hours and labor hours for this organization is given below:

 Labor Hours

Slope Coefficient (Variable Cost) = Y2-Y1/X2-X1

                               = 82,150-53,000/7500-2500

                               = $ 5.83

Constant (Fixed Cost) =   82,150- ( $5.83*7,500)

                = $ 38, 425

Labor Hour estimating equation (Total Cost) = $ 38,425+ $ 5.83

                                                                              = $ 38,430.83

Machine Hours

Slope Coefficient (Variable Cost) = Y2-Y1/X2-X1

= 82,150-53,000/ 1750-680

Variable Cost = $ 27.24

Constant (Fixed Cost) = 82,150 – ( $27.24 * 1750)

Fixed Cost = $ 34,480

Machine hour estimation (Total Cost) = $ 34,480 + $ 27.24

Total Cost = $ 34,507.24

From the above, Y2= highest overhead cost

Y1= lowest overhead cost

X2= highest activity unit

X1= lowest activity unit

Thus it is observed that the total cost, fixed and variable costs of labor and machine is calculated giving the organization and John Cruise a proper report to analyze the cost of production. It is observed that the prediction through high low method has validity and can be used to calculate the costs for Island Wheels Ltd[5].


Product Cost Evaluation of Road, Trek and BMX

Island Wheels Ltd also needs to know the future costs of their products if their sales increase over the next month. The calculation of predicted costs in accordance with the high-low method is as follows:

Cost for Road Bicycles

Formula: Direct Materials per gram*Cost of materials+ Direct Labor*Wage Rate+ Estimated Labor Overhead+ Estimated Machine Overhead/ Sales Number intended for the next month

= 750* $160+ $80 * 2.5+ $ 37,000 + $ 43,000/ 1500

= $ 133.46

Cost for Trek Cycles

Formula: Direct Materials per gram*Cost of materials+ Direct Labor*Wage Rate+ Estimated Labor Overhead+ Estimated Machine Overhead/ Sales Number intended for the next month

Product cost = 1400* $160 + $80 * 3 + 37,000+43,000/1000

= $ 304.24

Cost for BMX

Formula: Direct Materials per gram*Cost of materials+ Direct Labor*Wage Rate+ Estimated Labor Overhead+ Estimated Machine Overhead/ Sales Number intended for the next month

Product cost= 850 * $160 + 1.5 * $ 80 + 37,000 + 43,000

= $ 432.24

Road Product Cost= $133.46

Trek Product Cost= $304.24

BMX  Product Cost= $ 432.24

It is observed that BMX range of cycles have the highest product cost and Road cycles has the lowest with respect to the information available from ISLAND Wheels Ltd.

Concept of Activity Based Costing

The organization Island Wheels Ltd  is also in the opinion that they would like to apply Activity based costing in their organization. The ABC (activity based costing) is also a type of costing which is useful for decision making for an organization. ABC method finds out the activities and functions of an enterprise and designates the cost of all the functions of the business according to the raw materials of the products and services and real consumption made by the activities. Island Wheels Ltd having its own set of data comprising of direct and indirect costs is can be implemented in this method and the method changes its indirect costs into direct costs This method can be useful to Island Wheels Ltd  to improve the costing efficiency and realizing  the real costs and the products and services, which are profitable[6]. ABC method mostly deals with the true costs and transforms many indirect costs of traditional method into direct methods. The method actually reflects the true usage of resource in every item.  The process is helpful in determining the actual activity of cost information of Island Wheels Ltd to concentrate on the operational areas, which needs improvement. This method though points out the cost information of each activity and raw materials used in the finished product for Island Wheels by assessing the labor hours, machine hours and the estimated product cost of their products , but the process is vey lengthy, expensive and complex, which lead to a number of errors while evaluating[7]. This process is useful in the long- run where the product costing can be determined but is not useful in day –to- day decision making.  Island Wheels though are in opinion on adopting this process but this process will not be suitable for the firm as it is a small firm having its office and manufacturing unit at the same location. The information available from Island Wheels Ltd regarding their cost of raw materials and other factors of production need to be analyzed in detail converting the indirect costs into direct costs and then evaluating according to the needs and requirements asked by Mr. John[8]. The organization has limited goals for future and if Activity based costing, method is implemented then it will lead to extension in the work process of the organization, as it requires a tedious and lengthy work process. The process is complex and can lead to errors, which are not required by the organization.

Benefits of Activity based costing

The method identifies the cost of a product or service more efficiently and the information is reliable as it concentrates more on the related series events between cost and activities while manufacturing a product or service.
There exists a fair and true fixed selling price of the goods as the overheads are derived based on a proper driver of costs.
The fixed and variable overheads can be properly controlled by proper supervision over the activities. As there exists a transparency between the linkage between the cost and activities, the overhead costs can be easily controlled.
Through this process, a considerable amount of information is available which is essential for decision making about the profitability of different goods.
Proper allocation of overheads utilizes a large part in the total costs.

Limitations of Activity based costing

It is complex to find out the total activities, which influence cost.
The most appropriate cost driven forces are not easy to identify.
The determination of cost on the basis of activities are difficult to obtain.
The process is not suitable for small manufacturing firms.

It can be seen that ABC method has many benefits, which can be useful for Island Wheels Ltd for long-term process. However, this benefit does not hold true for this organization because limitations of ABC method state that this process is not ideal for a small firm[9]. Island Wheels is a small manufacturing company and so it is of consideration that this method should not be implemented within the organization. The traditional costing method is ideal for Island Wheels Ltd and the information available for this organization can be used to evaluate the fixed and variable costs along with future estimated product cost by High Low method of cost formula.

Recommendation on introduction of ABC

From the above analysis of ABC method, it is observed that this process is a complex and tedious technique, which is very expensive and this method has a tendency to generate errors. It is known that Island Wheels Ltd is a small manufacturing organization , which produces quality hand- made bicycles and does not compete with the branded companies competing in the market. Being a small concern it is not advisable to implement activity based costing in their business process as this would increase the overall costs and will  affect the production function[10]. The traditional method of costing is thus advisable for this organization.



The above report shows that the organization Island Wheels Ltd being a small manufacturing unit uses the best cost formula technique. In this case High Low Method is the best technique to evaluate the total fixed and variable costs for the enterprise. High Low method is a simple technique and the information available from the organization can be best used to calculate the estimated cost of the product. This formula is essential for Island Wheels Ltd because being a small concern it can easily identify its cost of production and will also be helpful to determine the process which can be implemented to expand in the near future through increase in sales and reducing product costs.  The estimated product costs of their goods namely the Road, Trek and BMX are also calculated according to the estimated sales for the next month. The merits and demerits of activity based costing are also analyzed and it is found that it is not profitable to undertake this method of costing for this enterprise as it involves a complex method of evaluation and the infrastructure available to the firm is not adequate to undertake this costing method.


Reference List

Becker, Sebastian D., Andreas Wald, Christian Gessner, and Ronald Gleich. "The role of perceived attributes for the diffusion of innovations in cost accounting: The case of Activity-Based Costing." COMPTABILITE CONTROLE AUDIT 21, no. 1 (2015): 105-137.

Chuk, Elizabeth, Dawn Matsumoto, and Gregory S. Miller. "Assessing methods of identifying management forecasts: CIG vs. researcher collected." Journal of Accounting and Economics 55, no. 1 (2013): 23-42.

Crosson, Susan V., and Belverd E. Needles. Managerial accounting. Cengage Learning, 2013.

Degeorge, François, Yuan Ding, Thomas Jeanjean, and Hervé Stolowy. "Analyst coverage, earnings management and financial development: An international study." Journal of Accounting and Public Policy 32, no. 1 (2013): 1-25.

Demski, Joel. Managerial uses of accounting information. Springer Science & Business Media, 2013.

DRURY, COLIN M. Management and cost accounting. Springer, 2013.

Elhamma, Azzouz, and Y. I. Zhang. "The relationship between activity based costing, business strategy and performance in moroccan enterprises." Accounting and Management Information Systems 12, no. 1 (2013): 22.

Goetsch, David L., and Stanley B. Davis. Quality management for organizational excellence. pearson, 2014.

Huang, Xuan, Siew Hong Teoh, and Yinglei Zhang. "Tone management."The Accounting Review 89, no. 3 (2013): 1083-1113.

Hopper, Trevor, and Binh Bui. "Has management accounting research been critical?." Management Accounting Research 31 (2016): 10-30.

Kaplan, Robert S., and Anthony A. Atkinson. Advanced management accounting. PHI Learning, 2015.

Kaplan, Robert, and Steven R. Anderson. Time-driven activity-based costing: a simpler and more powerful path to higher profits. Harvard business press, 2013.

Kim, Yongtae, Siqi Li, Carrie Pan, and Luo Zuo. "The role of accounting conservatism in the equity market: Evidence from seasoned equity offerings." The Accounting Review 88, no. 4 (2013): 1327-1356.

Monroy, Carlos Rodriguez, Azadeh Nasiri, and Miguel Ángel Peláez. "Activity Based Costing, Time-Driven Activity Based Costing and Lean Accounting: Differences among three accounting systems’ approach to manufacturing." In Annals of Industrial Engineering 2012, pp. 11-17. Springer London, 2014.

Needles, Belverd E., Marian Powers, and Susan V. Crosson. Financial and managerial accounting. Nelson Education, 2013.

Suomala, Petri, Jouni Lyly-Yrjänäinen, and Kari Lukka. "Battlefield around interventions: A reflective analysis of conducting interventionist research in management accounting." Management Accounting Research 25, no. 4 (2014): 304-314..

Smith, Malcolm. Research methods in accounting. Sage, 2014.

Ward, Keith. Strategic management accounting. Routledge, 2012.

Waters, Peter M. "Value in Pediatric Orthopaedic Surgery Health Care: the Role of Time-driven Activity-based Cost Accounting (TDABC) and Standardized Clinical Assessment and Management Plans (SCAMPs)."Journal of Pediatric Orthopaedics 35 (2015): S45-S47.

Weygandt, Jerry J., Paul D. Kimmel, and Donald E. Kieso. Financial & Managerial Accounting. John Wiley & Sons, 2015.

.Whitecotton, Stacey, Robert Libby, and Fred Phillips. Managerial accounting. McGraw-Hill Higher Education, 2013.


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