To: Joe Morgan, Controller From: Me, Accounting Analyst I have analyzed the relative merits and demerits of ABC costing against job order costing as follows: Job Order Costing: In this system of costing, direct and indirect costs are allocated to batches or jobs rather than time periods. All the direct costs are recorded on job order cost sheets. Indirect factory overheads (both labor and material) are allocated as per predetermined rates estimated in advance. ABC (Activity Based Costing) system: A more efficient concept of allocating costs incurred during a given period, by correlating activities undertaken to the end product / service rendered. ADVANTAGES AND DISADVANTAGES Job Order Costing: This system is simple to use so is understood by all It is good when executing continuous uniform batches or large orders The cost of inventory and finished goods is known instantly. Disadvantages: As the overheads are allocated at rates determined in advance, it usually results in under or over allocation which is quantified only at the end of the given period. In case if the difference in the actual overheads and allocated overheads is very high, its absorption becomes very difficult. Cost of each unit in a batch cannot be segregated. ABC: Advantages: It is more accurate method of costing products or services as actual time spent is factored into cost of the output. Unit cost of in each batch is identifiable. It is very easy to pinpoint wastage and take remedial action. Disadvantages: Collection of data can be a daunting and time consuming task. Implementing this new system can prove costly for small enterprises As costs become transparent, wasteful activity managers can become hostile Cost Drivers can be chosen on the basis of the following three criteria: Cause of the cost can be the cost driver e. g., machine or labor hours incurred in conducting the activity.
For Pharmafin labor hours incurred in receipt of modules, their production, storage, movement to shop floor, assembly, quality assurance, shifting to loading dock for shipment, would be multiplied with the respective hourly labor rate to see the cost incurred on these activities. Benefit derived can be another cost driver where cause and effect relation cannot be established. Cost of customer sustaining activities of Pharmafin can be determined as per number of customers handled by the sales man. The cost of other activities like facility / entity-sustaining activities of Pharmafin can be allocated based on a reasonable estimate e. g., a proportion of new product sold. Thus all the three drivers would be used to determine the unit cost of the new line of equipment. The Plant Manager of Pharmafin assumes that the new line would entail only minimal changes in tool settings, so no loss of time would occur while rotating jobs.
This assumption can be very easily verified by implementing ABC system. It would be impossible to know about lost time in job order costing.
Similarly any additional time spent on selling the new line of equipment or handling customer complaints can be easily tracked with ABC system for each unit produced. As job order costing does not capture time value, management would not be able to track the actual unit cost incurred for the new line of equipment and compare it with its price and profitability. The performance of the new line as compared to other older equipment and budgeted target can only be determined on an ongoing basis with ABC system. I hope this memo would help us to take the right decision. Me Accounting Analyst Pharmafin