Weaknesses of traditional costing
2. Similarities and differences when compared to activity based costing (ABC)
Let us consider the following case scenario. Company ABC (a fictitious entity) produces and sells two different types of high-tech speakers: the Standard Model and the Luxury Model. Due to intense competition, speaker prices have fallen significantly. The company believes there are no other ways to reduce costs for the two speaker models. The Standard Model is profitable, but the Luxury Model can result in losses. The company considers whether it needs to discontinue the Luxury model.
Input data for analysis:
Standard Model |
Luxury Model |
||
Direct material (per unit) |
$30 |
$40 |
|
Direct labour (per unit) |
$10 |
$20 |
|
Total direct costs |
$40 |
$60 |
|
Fixed production overhead: |
|||
Machine cost |
$500,000 |
0.25 hours |
0.5 hour |
Set-up cost |
$420,000 |
200 units per set-up |
250 units per set-up |
Quality inspection cost |
$100,000 |
50 units per inspection |
100 units per inspection |
Total overhead |
$ 1,020,000 |
||
Quantity, units |
15,000 |
10,000 |
5,000 |
Firstly, the number of machine hours is calculated under both traditional costing and ABC methods:
Machine Hours = 10,000 × 0.25 hours + 5,000 × 0.5 hours = 5,000 hours
The Standard Model requires 2,500 hours and the Luxury model requires 2,500 hours.
Secondly, under the traditional costing model, the fixed production overhead absorption rate (FOAR) equals $204 per machine hour (i.e., $1,020,000 ÷ 5 000 hours).
Under the ABC method the number of activities is calculated as follows:
- To determine the number of set-ups: (10,000 ÷ 200) + (5,000 ÷ 250) = 50 (Standard Model) and 20 (Luxury Model) = 70 in total.
- To determine the number of quality inspections: (10,000 ÷ 50) + (5,000 ÷ 100) = 250 inspections (200 and 50 for Standard and Luxury Models, respectively).
Finally, overhead costs are allocated to the two models as follows:
Traditional Costing Model
Overhead Costs (Standard Model) = $204 × 0.25 hours ×10,000 units = $510,000
Overhead Costs (Luxury Model) = $204 × 0.5 hours × 5,000 units = $510,000
ABC Model
Machine Cost |
= $500,000 x |
2,500 |
= $250,000 |
5,000 |
Machine cost for the Luxury Model would be the remaining amount: $500,000 - $250,000 = $250,000.
Set-up Cost |
= $420,000 x |
50 |
= $300,000 |
70 |
Set-up cost for the Luxury Model would be the remaining amount: $420,000 - $300,000 = $120,000.
Quality Cost |
= $100,000 x |
200 |
= $80,000 |
250 |
Quality cost for the Luxury Model would be the remaining amount: $100,000 - $80,000 = $20,000.
The results under the two methods are compared in the operating statements below:
Traditional Costing |
ABC Costing |
||||
Standard |
Luxury |
Standard |
Luxury |
||
Direct costs |
$ 40,000 |
30,000 |
Direct costs |
$ 40,000 |
30,000 |
Fixed overheads |
510,000 |
510,000 |
Machining costs |
250,000 |
250,000 |
Set up costs |
300,000 |
120,000 |
|||
Quality inspections |
80,000 |
20,000 |
|||
Total cost |
550,000 |
540,000 |
Total cost |
670,000 |
420,000 |
Cost per unit |
55 |
108 |
Cost per unit |
67 |
84 |
Selling price (**) |
80 |
100 |
Selling price (**) |
80 |
100 |
Profit/(loss) per unit |
25 |
(8) |
13 |
16 |
|
(*) Total direct costs are calculated by multiplying the per-unit cost by the quantity produced: $40 x 10,000 = $40,000 and $60 x 5,000 = $30,000.
(**) Represents an assumed selling price for the purposes of this analysis.
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