By Jackie,
Researcher
Topic:
Education
Area of
discussion: Cost & Management Accounting
The
objectives of this research are to find out which method is considered the best
method to allocate indirect costs (i.e to generate relevant cost information
for decision making purposes), the correct ways on how to calculate it (steps
by steps guide is given below plus an additional real question taken from LCCI
as an extra revision purposes), to explain what are the differences between
activity-based costing and traditional absorption costing system and how to use
a “quick check” method of which I designed myself (to check whether the
computed answers are correct or not?).
Introduction
Generally,
both methods are used to calculate the cost of production. There are no
differences between these two methods in finding material costs and labour
costs. Their major concern is how to allocate the overhead costs to the cost of
production. Ideally, using Activity-Based Costing is better than Traditional
Absorption Costing as it is more accurate, reasonable and appropriate. This is
because Activity Based Costing system uses both volume-based and
non-volume-based cost drivers, while Traditional Absorption Costing system uses
only volume-based cost drivers. Examples of volume-based cost drivers include:
units of output, direct labour hours and machine hours while examples of
non-volume-based cost drivers include:
numbers of production inspection, number of machine set-up, number of
stock requisition and etc.
Let’s take a look
at this example:
Based on the question above,
single-stage traditional absorption costing system applies, whereby we need to
total up all the overheads cost and then divide it by the total level of
activity. For this question the level of
activity will be the total number of machine hours. After dividing it, we will
get the overheads cost per one unit of activity (i.e. production overhead absorption
rate). Then, the final step is to allocate this rate to the products by multiplying
it with the number of machine hours used by a particular product. See below.
For Activity-Based Costing, since the separate cost
activities are already given, then we only need to divide the cost of each
activity with their respective cost drivers in order to find the activity rates.
Cost driver is the factor that causes a change in an activity cost. For
example: number of inspections and number of set ups. See below.
Then, the final step is to allocate those rates to products
by multiplying them with the amount of cost drivers which will be used by them.
For example, if product Alpha requires 20 inspections, then, 20 inspections x £800/inspection
= £
16,000 will be allocated to product Alpha. In order to find the product
inspection overhead per unit, we have to further divide the amount by the Alpha’s
total production output (units) which is 500 units. Then, £32
will be allocated to each unit of Alpha. Same method of calculation applies for the
rest. See below.
A “quick check” method:
Although the cost of production per unit for each product is
different in Traditional Absorption Costing and Activity-Based Costing, both
methods will have the same total cost of production and because of this we can
use this “quick check” method to check the answers.
References, additional readings and
related links:
Gain an
understanding of the basic concept of activity based costing
The basic concept of activity based costing
Activity
Based Costing versus Traditional Costing
Activity Based Costing with worked example to
compare with Traditional Costing
