Activity Based Costing and Its Main Advantages

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Table of Contents

Traditional Costing Approach
Activity Based Costing Approach
Discussion and Analysis of Details
Reference List

Traditional Costing Approach

Using the traditional costing method, the total cost of each product will be as shown in the schedule below. The total cost column represents a summation of the variable and fixed costs.

Number of Units	Variable Cost	Fixed Cost	Total Cost
0	0	3,000	3,000
1	1,100	3,000	4,100
2	1,200	3,000	4,200
3	1,300	3,000	4,300
4	1,400	3,000	4,400
5	1,500	3,000	4,500
6	1,600	3,000	4,600
7	1,700	3,000	4,700
8	1,800	3,000	4,800
9	1,900	3,000	4,900
10	2,000	3,000	5,000

Because the relationship between price and output is such that a selling price of 3,000 yields zero sales and a reduction by 100 on this selling price increases the sales units by one; the selling price and the associated profits/(loss) for each unit will be as represented in the schedule below:

Unit Selling Price	Total Unit Cost	Associated Unit Profits
0	3,000	(3000)
1,100	4,100	(3000)
1,200	4,200	(3000)
1,300	4,300	(3000)
1,400	4,400	(3000)
1,500	4,500	(3000)
1,600	4,600	(3000)
1,700	4,700	(3000)
1,800	4,800	(3000)
1,900	4,900	(3000)
2,000	5,000	(3000)

Activity Based Costing Approach

Using Activity Based Costing, the fixed cost is assigned to each particular product thus whereas the selling price shall remain as established, the associated profits will change significantly as a result of the apportionment as shown below:

Number of Units	Variable Cost	Fixed Cost	Total Cost
1	1,100	3,000	4,100
2	1,200	1,500	2,700
3	1,300	1,000	2,300
4	1,400	750	2,150
5	1,500	600	2,100
6	1,600	500	2,100
7	1,700	429	2,129
8	1,800	375	2,175
9	1,900	333	2,233
10	2,000	300	2,300

Discussion and Analysis of Details

This model of determining cost is involved with the identification of all necessary activities of the entire production process and allocating the associated cost of each activity to the entire products produced. This allocation is based on the actual uptake or consumption of each activity onto a product.

The main advantage of activity based costing model is that it helps to identify and pinpoint the products, processes or activities which are not operating efficiently. This will be done through comparing their output and consumption. Activity based costing will also be useful in helping to pinpoint the unnecessary costs in the entire production process which the entity can do without.

This model of estimating costs is also key in the allocation of resources in the production process, using the model, more resources can be assigned to the more efficient products, activities or processes while fewer resources can be assigned to the inefficient activities.

The model can also find application in the cost control strategy adopted by the entity because it will provide the necessary information to management on the departments or individual products that are operating below the acceptable (ideal) standards. This method may also be of importance in helping to fix the selling prices of the output. Based on the estimated cost of the product and the level of profits that are expected by the firm, the entity is able to know the price at which sales will be most.

The main limitation of this model however is that it might be extremely difficult to determine and accurately apportion certain costs in the entity to each particular product, for instance the salary of the chief executive officer may be difficult to be accurately assigned to products because the chief executive’s input is not easily and directly traceable on the particular product.

The CEO’s efforts are evenly balanced on the general well being of the firm and are hard to establish a particular criterion that will accurately apportion these efforts. It has also been argued that the ABC model of cost estimation is increasingly expensive and complicated to be used in the management and control of costs (Horngren, Datar & Foster 2006, p. 214).

The traditional costing approach has largely been considered as more convenient and fairly easy to apply. The traditional system is useful to management in providing solutions to among other management problems; make or buy decisions, subcontract or produce internally, proceed or cut down the entire production process.

Within the context of pricing, the organization may adopt a strategy that ensures that its products are not priced extremely high in comparison to the industry average. The prices of its products should be pegged on the prevailing market prices and the prices of goods offered by competitors.

If possible, the firm may adopt a collusion strategy with competitors in order to harmonize the prices of products in the entire market. This will make it impossible for a single firm to undercut the rest of the market players by selling at lower prices (Atrill & McLaney, 2007, p. 124).

Reference List

Atrill, P. & McLaney, E. 2007. Management Accounting for Decision Makers. Financial times management prentice hall. New Jersey.

Horngren, C., Datar, S. & Foster, G. 2006. Cost accounting: a managerial emphasis. Pearson Prentice Hall. NJ.

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Activity Based Costing and Its Main Advantages

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