Full Costing and Activity Based Costing - Assignment Example

FULL COSTING AND ACTIVITY BASED COSTING Tutor: Institution: Date: Introduction Some companies appear more successful implementing activity based costing, (ABC) by helping managers in making critical decisions regarding product mixes, product designs, pricing, and process improvements than others (Cooper and Kaplan, 1992) However, closer analysis reveals characteristics such as cost structures, environment and product range as important ingredients contributing to such success. Other business organizations employ the traditional absorption costing or variable costing techniques in their processes. Task 1 Marginal Costing Technique Product Ouse Lendal Cliftton Selling price@ unit 300 400 500 Direct material cost @ unit 30 40 15 Direct labor cost @ unit 2 2 4 Total cost (32) (42) (19) Contribution @ unit 262 358 481 Full Costing Technique Product Ouse Lendal Cliftton Selling price @ unit 300 400 500 Direct material cost @ unit 30 40 15 Direct labor cost @ unit 2 2 4 Overheads @ unit 200 200 400 Total cost (232) (242) (419) Profit @ unit 68 158 81 Workings Total overheads= £3,000,000 Total number of direct hours=9000x2+3000x2+1500x4=30,000 (Based on the number of direct labor hours) Overhead absorption rate= (3,000,000/30,000)= £ 100 Overheads= Ouse= 100x2=£ 200 Lendal= 100x2=£ 200 Clifton=100x4=£ 400 ABC costing (Overhead Apportionment) Type of overhead Cost £ Cost driver Cumulative of cost drivers Ouse £ Lendal £ Cliftton £ Set up costs 350, 000 No. of production runs 100 105,000 70,000 175,000 Machine related costs 900,000 No. of machine hours 60000 540,000 135,000 225,000 Receiving costs 350,000 No. of receipts 700 25,000 35,000 290,000 Packing 650,000 No. of deliveries 50 234,000 91,000 325,000 Engineering 750,000 No. of production runs 100 225,000 150,000 375,000 Total Overheads 3,000,000 1129,000 481,000 1390,000 Workings Total machine hours= 9000x4+3000x3+1500x10= 60,000 hours. No. of receipts= 50+70+580= 700 No. of deliveries= 18+7+25= 50 Number of production runs= 30+20+50= 100 Ouse Lendal Clifton Set up overheads = 350000x30/100 350000x20/100 350000x50/100 =£105000 =£70000 =£175000 Packing costs= 18x650000/50 7x650000/50 25x650000/50 =£234000 =£91000 =£325000 Machine related costs=900000x9000x4/60000 900000x3000x3/60000 900000x1500x10/60000 =£540000 =£135000 =£225000 Engineering costs= 30x750000/100 20x750000/100 50x750000/1000 =£225000 = £150000 =£375000 Receiving costs= 50x350000/700 70x350000/700 580x350000/700 =£25000 = £35000 =£290000 ABC Costing (profit statement) Product Ouse Lendal Cliftton Direct material cost @ unit 30 40 15 Direct labor cost @ unit 2 2 4 Overhead costs 125.4 160.3 926.7 Total cost (157.4) (202.3) (945.7) Selling price @ unit 300 400 500 Profit @ unit 142.6 197.7 (445.7) Workings Overhead Apportionment as @ cumulative (above) 1129000/9000 125.4 481000/3000 160.3 1390000/1500 926.7 Task 2 Marginal costing In marginal costing method, only the relevant costs incurred in the production of products are considered in decision-making (Atrill and McLaney, 2007). These costs include direct material, direct labor hours, total variable costs, and direct expenses (Clinton, 2004). Therefore, the cost of production of the three products which are relevant in decision making based on the approach of marginal costing Ouse £32, Clifton £19 and Lendal £42. The costs have been determined by summing up all the direct labour and the direct material costs incurred by York Ltd in the production of the three products. The margin contributions of the three products have also been determined as Ouse £262, Clifton £481and Lendal £358. Based on the above-calculated figures, it is evident that Clifton (£481) is the most profitable of the three products based on the marginal contribution analysis method. Lendal with a contribution margin of £358 is the second most profitable and ultimately Ouse with a contribution margin of £262. Therefore, based on the contribution margins highlighted above, the management of the company should produce more of Clifton units, followed by Lendal and finally of less of Ouse units in order to maximize profits which in turn will lead to maximization of shareholders wealth. Therefore, for sound management decision making, the management should allocate more resources to Clifton, Lendal, and less to Ouse for profit maximization. ABC and Full Costing Where overheads form the main portion of costs incurred in production of products relative to prime costs of production like direct labor, variable overheads, direct expenses and direct materials correct apportionment of overheads to products is important for decision-making (White, 2004 p.17). In modern business organizations, service unit departments play a major function unlike in the past when manufacturing activities were undertaken mainly by the production departments of the organization. The overall costs incurred in the production of products and services consist mainly of material handling costs, customer service costs, search costs, procurement, machine maintenance costs, and quality controls (Weetman, 2006). Therefore, it is important to allocate these costs of production from the service departments, which form the major overheads of production to products, since they influence the costs of producing products and services largely than the prime costs. Thus, the ever-rising expenses incurred by service departments of the organization should be apportioned to the final products so that the correct pricing and product mixes can be determined for sound decision making by management (Seal, Garrison and Noreen, 2007). The use of ABC method in determining the profitability and costs of producing products excels the traditional full costing method, which apportions overheads to products using pre-determined charging rates (Pavlatos, 2008). York ltd uses an overhead absorption rate of £100 in allocating the total overhead costs of £3,000,000 using direct labor hours as a basis of absorption. This assumption of using direct labor hours as a basis of apportioning overheads is inappropriate since the three different products Clifton hours, Lendal 4 hours, and Ouse 2 hours, have different labor usage requirements per unit. Therefore, this can cause drastic cost variances that cannot be estimate correctly. Therefore, based on the overhead absorption rate of £100, the unit overhead costs determined for each of the three products, Clifton £400 , Lendal £200, and Ouse £200 using the full costing method is different from the ABC overhead cost per unit of Ouse £125.4, Lendal £160.3 and Clifton £926.7. This disparity would be attributed to the absorption rate of £100 used, which uses direct labor hours as a basis for overhead absorption. Thus, it is evident that absorption costing is an inefficient method of absorbing and distributing overheads to products, which ultimately influence the overall product profitability but does not result to reporting of serious cost distortions of products (Boer and Klammer, 1994, p.61). Offenbacker (2004) argued that, “product costs are much more accurate under ABC– although overhead costs will NEVER be accurate because they are INDIRECT costs since the overhead to be absorbed is exactly the same overhead but analyzed differently.” Therefore, overhead apportionment based on the ABC method, which uses cost drivers, helps do away with cost distortions created by traditional full costing by apportioning expenses to products by using overhead consumption rates based on cost drivers (Sharman, 2003). For example, the set up expenses for York Ltd Company, have been determined using the number of production runs made by machines for each of the products. Thus, using this cost driver, the set up costs have been appropriately distributed to the products; Clifton £175, Ouse £105, and Lendal £70 (hundreds of thousands, 000). A good relevant example is the case for the negative profit for Clifton of £ 945.7 under the Activity Based Costing method. Using the traditional costing or variable costing, the profit margin from Clifton was the highest with £481 and £81 under variable costing and full costing respectively. However, when using the Activity Based Costing method, the profit is negative. Therefore, from this illustration, it is evident; allocation of production overheads to product costs is very important in determining the final cost per unit of a product, which is pertinent in pricing decisions, and the overall profitability of the firm since products consume the firm’s resources in varying (Roztocki, et al., 2008 p. 284). According to Cheney (2005), the application of ABC, system in a firm has various implications. The distortion of product cost will be eliminated leading to improved accuracy. As such, there will be fairer or better pricing. Furthermore, this will result in more accurate evaluation of the products’’ relative profitability. Moreover, different product lines and products utilize overhead resources at significantly differing rates. A change in the product mix can result in significant cost changes, which cannot be accurately predicted by traditional cost systems. Gunther, (2005) argues that under traditional costing methods, arbitrary costs result in make/buy decisions, which are incorrect. Full costing and Variable costing Under Full costing method, a product is assessed and reported at its (product) final cost (Chea, 2011, pp. 3-10). Some costs, for example, fixed overheads are hard to trace with particular product units, and this does not imply that they are not expenses of their particular products. As such, these costs should be allocated to their particular products. Absorption costing displays some deficiencies in enhancing sound management decisions. Therefore, full costing method is not primarily the best indicator in deciding whether to discontinue a good or how to value it. Finance analysts and specialists give additional information using marginal costing method in order to accommodate the deficiencies incurred in full costing method (Kaplan and Anderson, 2003).in marginal costing method, variable manufacturing costs are allocated to goods and to the cost of inventory sold. Specifically, these costs are made up of variable manufacturing overhead direct labor and direct materials. Fixed overhead costs are often regarded as period costs together with SG&A (Khozein, Dankoob, and Barani, 2011, pp. 112-117). The question then becomes, how does it aid in the process of decision-making? The answer to this question is that, regardless of the quantity of products manufactured, fixed production overheads will be incurred. However, for a company to survive and maintain its profitability, it should recover those expenses. In reality although, the inclusion of production overheads especially, the fixed cost of production can lead management to making wrong decisions, which will compromise the long-run survival and profitability of the firm (Alabbadi and Areiqat, 2010). Assuming York Ltd company produces ten thousand units of its products with costs: Clifton £19, Ouse £32 and Lendal £42, under variable costing. When manufacturing overheads are included the costs changes to Clifton £419, Ouse £232, and Lendal £242 under traditional costing. Considering managerial decision: assuming York Ltd company management has been asked to produce one more unit for each of its products at Lendal £43, Clifton £20, and Ouse £33. The production of the extra units by the company will not result to increase in overheads. However, management may turn down this offer on grounds of increased costs of production if the company is using traditional costing system. This will result in wrong management decision since the extra unit appears to have a negative margin. However, variable costing suggests a positive profit margin from the offer. Thus, marginal costing will be appropriate for decision making in this case Conclusion Marginal costing methods provide better results for good decision-making. This is because it only takes into consideration costs, which are relevant for making decisions. For example, variable production overheads, direct materials, direct expenses and direct labor costs. Irrelevant overhead costs are ignored like fixed costs in marginal cost techniques. They are taken as period costs hence written off against the period’s contribution since they are basically incurred even if the goods are produced or not produced. Lastly, after comprehending the disadvantages of full costing method, I would advocate for the use of ABC or marginal costing method to analyze the profitability of various goods of York Ltd References ALABBADI, H. and AREIQAT, A. (2010). The Systematic Relationship between the Activity Based Management (ABM) and the Activity Based Costing (ABC). Interdisciplinary Journal of Contemporary Research in Business, 2(2), 239-264. [Online], Available: Business Source Complete [Accessed: 06 Dec 2013]. ATRILL, P. and MCLANEY, E. (2007). Management accounting for decision making. 5th edition: Harlow FT: Prentice Hall. BOER, E. and KLAMMER, G. (1994) Absorption vs. Variable Costing. [Online], Available: http://www.articlesbase.com/management-articles/absorption-costing-vs-variable-direct-costing-5353059.html [Accessed: 26 Dec 2013]. Chea, A. C. (2011). Activity-Based Costing System in the Service Sector: A Strategic Approach for Enhancing Managerial Decision Making and Competitiveness. 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