The purpose is to describe the use of activity based costing and its benefits. For this purpose, the R&D cost of Ideal Manufacturing Company has been used. The comparison of activity based costing with conventional method has been done. Finally, the benefit of use of activity based costing has been described. Activity Based Costing The cost of a product comprises of direct material, direct labor and overheads. It is easy to trace direct material and direct labor to a particular product.
But it is not easy to trace directly all overheads to a particular product to determine its product cost. For example, if company pays $200000 as rent of factory, it can not be said that for which product it has been paid. It is absorbed to the product cost, on some arbitrary basis or assumption. If company decides to produce 10000 units, then the factory rant will be dividend by 10000 units to arrive at $20 per product for rent or if company decides to produce 20000 units the rent to be charged $10 for each product.
The method is conventional and very easy to use. But it is not necessary that the overhead rate determined is the true representative of the resources used by the product. The activity based costing helps in allocating cost to the product according to the resources used by each activity. The Ideal Manufacturing Company total overheads of R&D department is $8. 4 million, if company uses the conventional method of overhead, the rate on the basis of number of hours is 8400000/15000 = $560 per hour.
Under this method, the R&D cost to in house department is 1800*560 = $1008000 and to outsider it is 800*560 = $448000. As the company is deciding to use activity based costing, and there are four activities therefore the rate of each activity is determined and it is as follows: Market Analysis $ 70 per hour Product Design $ 940 per design Product Development $ 40,000 per product Prototype Testing $ 2,800 per test The above rate is the true representative of the cost related to its driver.
Now the each activity rate is used to determine the R&D cost being charged to in house department and it is as follows: Market analysis $ 126,000 Product design $ 263,200 Product development $ 400,000 Prototype testing $ 257,600 Total cost charged in house $ 1,046,800 It is quite clear that the traditional method based on hours is showing R&D cost of $1008000, which is short by 1046800-1008000 = $38800. It means that the cost for the activity used in house was more than it is charged using traditional method.
Under activity based costing, the R&D cost to outsider is as follows: Market analysis $ 56,000 Product design $ 167,320 Product development $ 120,000 Prototype testing $ 196,000 Total cost charged to outsider $ 539,320 The traditional method is showing cost being charged is $448000, instead of $539320 under activity based costing. The different of cost is 539320-448000 = $91320. Benefit of Applying ABC If company uses selling price strategy of cost plus mark up of 20%, then the selling price of in house product under traditional approach is 1008000*1. 2 = $1209600 and under activity based costing it is 1046800*1. 2 = $1256160. The use of activity based costing will show the true selling price of the product, thus the loss of 1256160 -1209600 = $46560 may be saved. If ABC is not used, the customer may be charged low selling price for a product which should be charged high selling price and another product may be charged with high selling price instead of low selling price. Thus, it will help the competitor to take undue advantage for selecting incorrect selling price for each product.
If the company charges 20% above R&D cost, the selling price under conventional approach to outsider is 448000*1. 2 = $537600, instead of selling price of $539320*1. 2 = 647184, a loss of 647184-537600 = $109584, under conventional method as compared to activity based costing method. From above discussion it is concluded that activity based costing helps in allocating correct cost to each product according to the resources being used. It also helps in setting accurate selling price and makes the product competitive in the market. Reference: