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
(Standard Model)

= $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
(Standard Model)

= $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
(Standard Model)

= $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
Model

Luxury
Model

 

Standard
Model

Luxury
Model

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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