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April 3, 2016 | Author: | Posted in accounting, mathematics and economics





Accounting and finance

In this we are going to prepare the income statement on traditional based costing and activity based costing . After that the report tells about the differences in the product line profitability The report will reveal the contrasting views on the tow approaches of allocating with respect to E Lab and also discuss the benefits that will come up using activity based costing

Traditional costing

The traditional absorption costing used in typically manufacturing company is still allocated overhead into products using [banner_entry_middle]

direct labor or machine hour as the driver . They are often allocated largest overhead cost based on smallest direct labor

( HYPERLINK “http /www .theacagroup .com /activitybasedcosting .htm www .theacagroup .com /activitybasedcosting .htm

Income Statement

Traditional Costing

Adchlor Badchlor Cifchlor Revenue 0

Direct Costs :Materials 3276000

Quality control 8400000 8400000 2520000

Labor 4680000

Utilities , power 2400000 2520000 684000 5604000Overhead AdminSetup and testing 875543 .5 875543 .5 262663 .0 2013750

Loading materials 190878 .3 190878 .3 57263 .5 439020

Test runs 1081513 .0 1081513 .0 324453 .9 2487480

Detailing 4383260 .9 4383260 .9 1314978 .3

Laboratory 664782 .6 664782 .6 199434 .8 1529000

Facilities .9 .9 4229478 .3

Research development 8400434 .8 8400434 .8 2520130 .4

Selling administrative 6400000 .0 6400000 .0 1920000 .0 Income (loss ) 2494673 .9 5905326 .1 2911597 .8 6322250 Activity Based Costing

ABC is a system of accounting that focuses on activities as the fundamental cost objects and uses the costs of these activities as building blocks for compiling the costs of other cost objects (Such as product or department .ABC seeks not only to allocate over heads to product costs on more realistic basis , than simply production volume but also attempts to show relationship between overheads costs and activities that cause them It is also called activity-bases costing or activity accounting (Charles T . Horngren p150

E Lab only produced a few types and high quantities of products before traditional costing method which focused on direct costs were much more important than the production overheads , traditional costing would be accurate before While the production structure has changed , the times demand that flexibility and love of change replaced absorption costing method in E Lab

The calculation step of ABC

E-Labs , Inc . is a pharmaceutical manufacturer in San Juan . The company has a highly automated processing system that is used to manufacture three patented pharmaceuticals : Adchlor , Badchlor and Cifchlor

Cost drivers are the real factors that decide the cost incurred and the resource consumed . Unlike the traditional method plagued by inaccuracy in manufacturing overheads allocation . ABC need not adopt two-stage cost allocation process to figure out the each target cost , in to achieve cost information accuracy . Therefore , ABC adopts multi activities to distribute costs . It demonstrates that choosing proper cost drivers is the most important and key step

In practice the ABC system uses many drivers as allocation bases in the second stage of the cost allocation system whereas the traditional cost systems tend to use , at the most , two second-stage allocation bases (Colin Drury , 2002 , p298

ABC process : Activity-based costing has the following five steps

Identify the different activities performed by the business

Calculate the pool

Identify a cost driver (i .e . a causation factor ) for each activity

Calculate the cost driver rate (i .e . the average cost of one occurrence of the cost driver

Assign part of the cost each activity to different products based to the extent to which each product has caused the activity to occur (i .e apply the cost driver rate (Proctor R . 2000 , p67

For example in E LAB , first of all , overheads expensed can be allocated into eight activities , including setting up and testing , loading , test run , detailing , laboratory , facilities , research and development and selling and distribution . Secondly , we can work out the each activity according to the cost pool we just allocated into Thirdly , identifying cost drivers for eight activities , they are number of batches for setting up , number lots for loading and test runs , and revenue base After getting the figures of activity costs and cost drivers , we can work out the cost driver rate , and at last , we assign the cost rate to the part which has caused the activity to occur

Income Statement

Activity Based Costing

Adchlor Badchlor Cifchlor Revenue 0

Direct Costs :Materials 3276000

Quality control 8400000 8400000 2520000

Labor 4680000

Utilities , power 2400000 2520000 684000 5604000Overhead AdminSetup and testing 537000 1074000 402750 2013750

Loading materials 114000 239520 85500 439020

Test runs 622080 1524480 340920 2487480

Detailing 3546500 3358000 3177000

Laboratory 537000 642000 350000 1529000

Facilities 4463280

Research development 8010364 8651194 2659441

Selling administrative 6102819 6591044 2026135 Income (loss ) 686622 5400658 234974 6322254 A comparative analysis of traditional costing method with ABC costing method

Measurement of cost by traditional costing method and ABC costing method are greatly different . ABC allocates the activity costs into products by cost drivers , while traditional costing method uses quantity drivers (direct labor cost ) to allocate costs . Since the use of the traditional costing method was not avoided of products loss , we may as well say then that its continual use would be a wrong economic decision

It is impossible to get correct activity information of each activity and the activity channeled towards production by using traditional costing method , while this can be achieved easily and accurately by ABC method . With the use of ABC , E Lab could now analyze which activity is tends towards loss of products , in to discuss the possibility of reduction of such activities

The product loss , measured by traditional costing method , was not encountered by ABC method since ABC could accurately allocate cost information

Through the calculation of ABC , we are able to know the production of which good consumes activity most , which cost of activity is highest helping us knows how to decrease cost and enhance efficiency . For example in E Lab ‘s plant , the unit activity cost is the highest no of batches , its cost is maintaining activity . It is necessary we look for alternative ways of carrying out these activities such as decreasing electricity consumption per hour , in to decrease the activity cost per hour of operating machine activity

In that case , ABC method brought a great advantage for E Lab . If it used absorption costing systems normally calculate their product costs to on direct labor cost which is not according to the activities . This gives the impression of a high degree of accuracy but it is really an example of mathematical precision . Because of the arbitrary correlations used by this traditional approach , it is quite possible that the two products have the same over head , i .e . Badchlor and Adchlor . If this is so , the calculation shows that it is a waste of resources , giving a misleading answer

A traditional absorption costing system may be cheaper to operate than an activity-based costing system but the cost of the errors resulting from its inaccuracies can be far greater . One important factor affecting the cost effectiveness of ABC systems is the continuous fall in the price of information technology . The rapid revolution in information systems is greatly reducing their operating costs whilst , at the same time , greatly increasing their effectiveness (Proctor R . 2000 p72 . ABC overcomes all these disadvantages which absorption costing system has , as we can see , the reason of adopting ABC method is not only for costing calculation purpose , but also focus on customer service management decision etc , everything in a company will be considered into costing , activities will be the core for costing calculation , these will make ABC system more accurate for the modern style manufacturing definitely

After the above discussion now we are going to analyze that why the product cost and the profitability is different in two approaches . As we have discussed that the traditional costing is based on direct labor costs i .e . for Adchlor for Badchlor and 4680000 dollars and if we allocate the over head costs but the above base the first two products have the same cost but in actually the two products are manufactured in different batches and the number of batches for the two products is different so this problem is resolved by using activity based costing

In the traditional costing income statement the product Adchlor has a loss because of the wrong base for allocation of overheads . Actually the costs associated with the product Cifchlor is allocated to the Adchlor which will raise the product cost and thus results in the loss for those products . This point is very important to the company as the management has cash flows problem so they have to make decision that which product is loss generating products so to reduce or ends up the production fir that product . But that problem is solved by using the activity based costing and this reveals the product Adchlor is generating good profits

By using the traditional costing income statement the overheads allocated to the three products line costs are 2147934 , 2147934 , and 644379 for Adchlor , Badchlor and Cifchlor respectively and using activity based costing the product line costs are 1917459 , 2838000 and 829170 which shows that the product costs are allocated arbitrary and have the huge differences in the overheads costs . The overheads are allocated to the production on the basis of labor costs in traditional costing and in ABC method the base is used is the no . of batches and the lots in which the products are produced

The ABC method completely change the picture of the profitability of the three products as initially the Adchlor is in loss but actually that product is generating profit


The above discussion reveals the fact that the traditional based costing is not so realistic than activity based costing . E Lab can make decisions about the pricing and how to reduce the costs associated with the product line and run with the current market situation . The profitability of the company can be increased by producing greater no of batches and lots . The ABC method opens the new doors for the profitability for the E Lab Inc . as the method is very significant for the pharmaceutical companies because the pharmaceutical products are made according to the no . batches or lots so the overhead is allocated to the products on more realistic bases and the pricing mechanism will work effectively


Mats and Usry . Costing : Activity Based Costing . 2004



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