Activity Based Costing system
Describe the changes in cost structure that are likely to have occurred at Santa Cakes Pty Ltd over the last twenty years and explain their causes.
Refer to this case which the company is named Santa Cakes Pty Ltd manufactures a wide range of delicious cakes and pastries. Previously, they just have three product lines and using very simple machinery and a lot of hard work. As time goes by, the customer demands are changing, some specific products become more and more popular. But these products can not be produced in large volume. In order to produce a wide range of low volume lines as well as make and sell a lot of pies and lamingtons, they want to develop their production lines, which involve a lot of extra machinery set ups and material handling. These changes would directly lead to the changes in cost structure of the company.
In the past, the cost structure of company seems very simple; absorption costing system is easy applied to this structure. It is an inventory valuation and costing model that includes all manufacturing costs. For example, one is the direct material, those materials that become an integral part of a finished product and can be conveniently traced into it. Another is direct labor, those company labor costs that can be easily traced to individual units of product which are all kinds of cakes. The other is both variable and fixed manufacturing overheads, something like rent, insurance, power and utilities of the Santa Cakes Pty Ltd.
Currently, the company’s new cost structure is more complex than before, the traditional costing system is no longer suitable for current complicated conditions. So it is the time to adopt new costing system which is the Activity Based Costing system. This method computes the overall product cost taking into account the cost involved in the intermediate activities leading to delivery of the final product. ABC refines costing systems by focusing on individual activities as the fundamental cost object. It assigns costs to cost objects based on the activities undertaken to produce each product or service. This entails classifying the costs into one of four categories. These categories are unit level, batch level, product level, and product sustaining. Under this costing system, the company’s cost structure is more reliable.
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Do you think the existing cost system understates or overstates the cost of a lamington and a Danish pastry? Explain.
The existing cost system used by Santa Cakes Pty Ltd is absorption costing system. If Santa Cakes Pty Ltd only manufactures some similar products like pies, finger buns, and lamingtons, absorption costing system is suitable because absorption costing tries to share overhead costs between products as fairly as possible, and these products can be produced in large volumes, using very simple machinery and a lot of hard work. Because these products can cause similar amount of production overheads, we just use the total productions overheads divided by a total base like direct material or labor hours, we can simply get equal amount of product overheads for every product. There may be some small inaccurateness to the production cost of different products, but it is acceptable. Since this costing system is very easy to calculate the cost of each product. And it is very easy to understand by everyone.
Now, the company begins to develop their product lines. They adopt some computer controlled machines and replace a lot of direct labor operations. They also start to produce some specific new products, such as Danish pastries, donuts and vanilla slices. These changes bring some troubles in cost calculation. That is because the new products are very complex to produce; they can not be produce in large volume. In production process, a lot of activities are required to produce the new products, and these activities will definitely cause some costs in the process. These costs would directly lead to high production overheads. Under the existing costing system of the company, the high production overheads brought by new products would be distributed to every product equally. So the cost of old products like lamington would be calculated higher than the actual cost, and oppositely, the cost of new products like Danish pastry would be calculated lower than the actual cost. We can use a simple example to explain that.
Suppose each lamington contains following costs: direct material $1, direct labor $2.
The total production overheads are $2000. Under the existing costing system, based on direct material, producing 1000 lamingtons, the overhead cost per lamington should be calculated as follow:
OAR = Total overhead cost / Total direct material = $2000/1000 = $2
So the total cost of each lamington is 1+2+2=$5
If the company produces 1000 Danish pastries, each Danish pastry contains following costs: direct material $1, direct labor $2, the production overheads is $4000 based on direct material. So the total cost of each Danish pastry should be 1+2+4000\1000=$7
If the company produces 1000 Danish pastries and 1000 lamingtons at the same time, the production overheads is $5500 also based on direct material. The cost per unit would be like following:
Danish pastries 1+2+5000\2000=$5.5
The numbers calculated this time is much different from the above two. The costs of the two different products have been distorted because of the absorption costing system. It overstates the cost of a lamington, at the same time it understates the cost of a Danish pastry.
Explain how activity based costing could overcome the deficiencies inherent in the existing costing system.
Generally, Activity based costing is better than existing costing system which is the Absorption costing. There are some reasons as following:
Firstly, Absorption costing tries to share overhead costs between products as fairly as possible, but it does not show how much overhead cost each product “causes”. Therefore, the management accountant of Santa Cakes Pty Ltd may forget to ignore some costs. It is also difficult to control overhead costs because absorption costing makes no clear connection between overhead costs and what it is that causes them to increase. Moreover, it is hard to plan or budget for overhead costs if we do not know how changes in output will affect them.
Secondly, Activity based costing was developed as an alternative costing methodology. There is a cost to all activities carried out within an organization, and activity costs are distributed to products in relation to their use. As that can gives more financial information about the products costs, therefore, it can help managers to control the products costs which concentrates on each cost driver consumed and overhead costs which highlights the cost per unit of each cost driver, that makes all costs to be more distinct, as Activity Based costing cover every activity, it is more scientific and explains in details the cost of every activity, where there are large volumes.
Then, as sum up, ABC doesn’t eliminate or change costs, it provides data about how costs are actually consumed. In this example, if Santa Cakes Pty Ltd wanted to reduce costs using traditional data that would have to decrease salaries, or decrease costs of supplies. They don’t know enough to change the equipment or overhead costs. Using ABC data you can see that it costs the same to paint and inspect the door.
Absorption costing system is inaccurate in the way that they allocate costs. Large batch or high volume products and services typically incur 50-200% LESS overhead than they are assigned. Small batch or low volume products and services typically incur 200-1000% MORE overhead than they are assigned. This means that products and services that are considered highly profitable may in fact be profit eaters. This inaccuracy is becoming more and more critical as companies move toward customer-defined products and services (which often mean a batch size of one).
Thereby, in order to correctly associate costs with products and services, ABC assigns cost to activities based on their use of resources. It then assigns cost to cost objects, such as products or customers, based on their use of activities. This information assists company in making decisions about pricing, outsourcing, capital expenditures and operational efficiency. Therefore it could overcome the deficiencies inherent in the existing costing system.