TABLE 1 Plastim’s Product Costs Using Traditional Based Costing Model
(Horngren, 2009, p167)
According to the information above, if Plastim wants to retain the Giovanni business for S3 lenses and make profit, it must reduce the price and cost of S3 lenses. Plastim now faces two main uncertainties: whether or not it can improve the technology and process for the S3 lenses to compete with Bandix and whether or not the S3 lens’ cost is overcosted. When the management asks a team of its design and process engineers to analyze and evaluate the design, manufacturing, and distribution operations for the S3 lens, the team is very confident that the technology and process of the S3 lens are lower than Bandix and other companies. However, the profit margin percentage is low for the S3 lens, where the company has a strong capability, but high on the newest, CL5 lens. So management starts to believe that there are perhaps problems with their costing system. Maybe the S3 lens is overcosted and CL5 lens is undercosted.
After reviewing the miscasting of the product cost, Plastim decides to use an ABC system. Direct costs are easy to combine with the product, so the ABC system focuses on the assignment of indirect costs to department, processes, products or other cost objects. The company identifies seven activities: design, setup molding machines, machine operations, shipment setup, distribution, and administration. Now, the ABC system is used to recalculate the total cost(see Table 2). (Horngren, 2009,)
TABLE 2 Plastim’s Product Costs Using Activity-Based Costing Model
(Horngren, 2009, p177)
Table 3 compares the traditional based costing model Plastim had been using and the ABC model. Note three points in Table 3, firstly, the ABC system combines more costs as direct costs. In the direct-cost categories, the traditional based costing model combines two costs and the activity-based costing model combines three costs; Secondly, the ABC system creates the same cost pools linked to different activities. In the indirect-cost pools, the traditional based costing model links to single activity, but the activity-based costing model links to six activities. Thirdly, the ABC system is based on the relationship between cause and effect for costs in each activity-cost pool.
TABLE 3 Comparing Alternative Costing System
(Horngren.C, 2009, p179)
The lower half of Exhibit 3 shows that the cost per unit of S3 lens ($58.75) in the traditional based costing model by the direct manufactory labor hours overcosts by $8.77 per unit comparing with the cost of S3 lens ($49.98) in the activity-based costing model and undercosts the cost of CL5 by $35.07. The CL5 uses a larger amount of output unit-level, batch-level, and maintenance products cost than is represented by the direct manufacturing labor-hour cost allocation basis. The S3 lens uses a smaller amount of these costs. “The ABC system, by its use of multiple indirect cost pools and activity-specific drivers at various levels of the cost hierarchy….” (Horngren.C, 2009, p178) is able to better recognize the resources used by the S3 and CL5 lens.
Plastim can offer Giovanni a price of $52 for the S3 lens. As the ABC model shows how to improve efficiency and further reduce the cost of the S3 lens. Without the information from the ABC model, Plastim will have an operating loss on the S3 lens at a price of $53. This incorrect information would have probably caused Plastim to reduce its business in S3 lens and focus on CL5 lens under the traditional based costing model. The ABC model claims that the cost of the complex lens is much higher ($132.07) than the cost under the traditional based costing model ($97). That will cause that CL5 lens has no advantage of competitive. At a price of $137 per lens for CL5, the profit margin is very small ($137.00 - $132.07=$4.93). As Plastim should reduce its prices on simple lenses, it would need to negotiate a higher price for complex lenses.
The ABC model is more accuracy than the traditional based costing model by the case study. However, the ABC model also has its limitations. Firstly, the process of calculation is complex. (Turney,1996) As the ABC model requires management to estimate cost of activity pool and identify cost drivers, it requires many calculations to determine costs of products. Secondly, the ABC model needs a heavy workload. (Kaplan, 1998) Under the ABC model, management has to choose many different cost drivers and they have to search a great number of data to calculate, so there are many jobs need to do.
To conclude, overheads in product costs are increasing in the proportion of enterprises, if it still use the traditional labor-hour basis for the overhead allocation, it cannot be satisfied by the develop of the enterprises. This report compares the impact of the traditional based costing model and the activity-based costing model on overhead allocation by case study. We can see that the ABC model on overhead allocation provides more real breakdown of product costs. It can allow managers to recognize the influence of quality control and product quality improvement cost. It is able to provide the manager with accurate measurements so that they can make decisions correctly. As when the enterprise uses the ABC model to allocate overhead, many activities are very detailed, it can also provide management for the companies specify budgeted costs for activities and use budgeted cost rates to cost products. However, when the enterprises decide to use the ABC model, the management should take into more consideration of its framework.
Reference
Atkinson, A (1995). Management accounting. 2nd ed. NY, Prentice Hall.
Atrill, P (2007). Management accounting for decision makers. 5th ed. London, Financial Times Prentice Hall.
Horngren, C (2009). Cost accounting: a managerial emphasis. 13th ed. London, Pearson.
Kaplan, R(1998). Cost and effect: usting integrated cost systems to drive profitability and performance. Boston, Harvard Business School Press.
Turney, B (1996). Activity based costing: the performance breakthrough. London, Kogan Page.
