Wallen manufacturing uses the traditional volume-based product costing approach which uses only a single item (cost determinant) to come up with the rate to be used in apportioning or assigning the overheads to our three products. As such, we accumulate all overheads resulting in total overheads. It is out of the total overheads that we determine what cost is to be associated with each product using the single cost determinant deemed to be most closely related to causing the overheads (For Wallen, we use direct labor). Shortcomings Using a single cost driver to allocate overheads may result in inaccurate product costs the assumption that products consume overheads at the same rate is wrong.
For instance, we can’ t use labor cost in apportioning engineering and material handling costs since engineering cost is determined by the number of change orders that may differ among the products while material handling is determined by raw material costs for each product and not labor cost. Hence, the two cost determinants or drivers should be used in order to allocate costs accurately. Using the volume-based costing approach, therefore, results in over costing the products produced in large quantities e. g.
Jaza and Nance while under costing products like Meliss which are produced in low quantities. As such, volume-based costing results in assigning the wrong selling prices to products. Explanation of the activity-based approach to costing Activity-based costing traces the overhead activities to the products which use the activities. The method, therefore, considers the cause and effect relationship between the overhead activity and the product/ cost driver. Using ABC, an overhead cost is only assigned to the caused/ used the activity e. g. the engineering costs will only be assigned to the products that benefited from the test orders. Therefore, the method is more reasonable and accurate in allocating overheads to products. The advantages of ABC costing include; With ABC, it is possible to estimate the costs of individual products more precisely. The method enables equitable and scientific pricing by reducing prices of products that use less activity while increasing the price of products that use more of the overhead activities. The method enables the elimination of the cost of producing nonprofitable products and allocation of more funds to profitable products thus increasing l profitability. The method aids in exposing wastes and inefficiencies hence boosting productivity. The method will provide quantifiable figures for future planning and budgeting. How ABC will help us eliminate the problems identified with volume-based approach; The volume-based approach has been giving us inaccurate product costs since it uses a single rate in cost assignment.
However, activity-based costing will enable us to get accurate product costs since overheads costs will be realistically assigned to products using the relevant cost determinants/drivers. Furthermore, products produced in higher quantities will no longer be over costed since the extent to which an activity driver is consumed by a product will be considered in allocating overheads.
For instance, if Jaza used 20% of raw material, only 20% of the material handling cost will be assigned to it. Thus if we have accurate product costs, our products will be sold at their right prices. Production of nonprofitable products will be stopped and more volumes of the more profitable products produced. Hence, no product will be sold at a loss. The profitability of products under Volume-based approach Profitability = actual selling price-production cost. Therefore profitability will be as shown below; product a) product cost b)Actual selling price c)=(b-a) Profitability under actual selling price Jaza $573.00 $639.00 $66 Nance $508.50 $762.75 $254.25 Meliss $286.50 $600.00 $313.50
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