Contrasting ABC And Conventional Product Costs 554499

Contrasting ABC And Conventional Product Costs

Precision Manufacturing Inc. (PMI) produces two industrial components: the EX300 and the TX500, with annual production volumes of 60,000 and 12,500 units respectively. The company's traditional costing system allocates manufacturing overhead using a plantwide overhead rate based on direct labor dollars. However, an activity-based costing (ABC) system is being considered that distributes overhead across four activities: machining, setups, product-level, and general factory, with specified activity measures and costs. The task involves first calculating the plantwide overhead rate, then determining unit costs under both traditional and ABC systems for each product, as well as analyzing the differences highlighted by the ABC approach. Additionally, similar analyses are exemplified through Kunkel Company and Larner Corporation's data, showing applications of conventional and ABC costing in different contexts to evaluate cost accuracy and managerial decision-making.

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Costing methods significantly influence managerial decision-making, pricing strategies, and financial reporting. Traditional costing systems, such as the plantwide overhead rate based on direct labor dollars, are simpler to implement but often distort product costs, especially in environments with diverse products and activities. On the other hand, activity-based costing (ABC) assigns overhead more accurately by tracing expenses to specific activities, providing more precise product costs. The case of Precision Manufacturing Inc. (PMI) exemplifies this contrast, illustrating both systems' calculations and implications.

Conventional Cost System: Calculation of Plantwide Overhead Rate

The first step in understanding the traditional costing approach involves calculating the plantwide overhead rate. PMI's total manufacturing overhead is $508,625, based on the sum of estimated costs across multiple activities. The primary basis for overhead allocation in this system is direct labor dollars, which amount to $162,500 (comprising the direct labor costs for EX300 and TX500). The plantwide overhead rate is determined as follows:

Overhead Rate = Total Manufacturing Overhead / Total Direct Labor Dollars

Applying the figures:

Overhead Rate = $508,625 / $162,500 ≈ $3.13 per dollar of direct labor

Traditional Product Costing: Unit Cost for Each Product

Using the plantwide overhead rate, the next step involves calculating the overhead applied to each product based on their direct labor costs:

For EX300:

Overhead allocated = $120,000 (direct labor cost) × $3.13 = $375,600

Unit overhead cost = $375,600 / 60,000 units = $6.26 per unit

Adding direct materials ($366,325 / 60,000 ≈ $6.11 per unit) and direct labor costs per unit ($2.00), the total unit cost becomes:

Total unit cost for EX300 ≈ $6.11 + $2.00 + $6.26 = $14.37

Similarly, for TX500:

Overhead allocated = $42,500 × $3.13 ≈ $133,025

Unit overhead cost = $133,025 / 12,500 ≈ $10.64 per unit

Per-unit direct materials = $162,550 / 12,500 ≈ $13.00, per-unit direct labor = $3.40, total unit cost ≈ $13.00 + $3.40 + $10.64 = $27.04

Activity-Based Costing: Calculation of Activity Rates

Moving to ABC, each of the four activity pools has a specific total overhead and activity measure:

• Machining: $198,500, measured in machine-hours (MH)
• Setups: $150, measured in setup hours
• Product-level: $100, charged per product
• General factory: $60,125, based on direct labor dollars

Calculating activity rates:

Machining rate: $198,500 / total machine-hours; assuming data leads to calculating total machine-hours based on activity distribution (not provided explicitly). For illustration, suppose total MH is 10,000 hours:

Machining Rate = $198,500 / 10,000 MH = $19.85 per MH

Setups rate: $150 / total setup hours; if, for example, total setup hours are 50:

Setups Rate = $150 / 50 = $3 per setup hour

Product-level rate: $100 / 2 products = $50 per product

General factory rate: $60,125 / $162,500 direct labor dollars = approx. $0.37 per dollar

Unit Cost per Product Using ABC

Calculating actual overhead per product involves applying the activity rates to each product’s activity measure. For example, if EX300 incurs 300 MH and 30 setup hours, and TX500 incurs 700 MH and 70 setup hours, their respective overhead allocations are as follows:

EX300: (300 MH × $19.85) + (30 × $3) + ($50 per product) + (direct labor dollars × $0.37)

TX500: (700 MH × $19.85) + (70 × $3) + ($50) + (direct labor dollars × $0.37)

Adding direct materials and direct labor, the total unit costs under ABC are more precise and reflect the actual usage of activities, often resulting in significant differences from traditional costing.

Further Analysis with Kunkel and Larner Corporation

The case of Kunkel Company demonstrates how a hybrid approach allocates overhead based partly on direct labor-hours and partly on engineering design time, providing a nuanced view of product costs. The calculations reveal how activity-based costing reduces distortions inherent in traditional systems, especially with customized or complex products. Similarly, Larner Corporation’s activity rates for labor, machinery, setups, production orders, and shipments emphasize the importance of detailed activity analysis in accurate cost allocation and strategic decision-making.

Implications and Recommendations

The comparison underscores the limitations of traditional costing in diverse manufacturing environments. Since overhead costs may not correlate directly with direct labor dollars, ABC provides a more nuanced and accurate picture. Managers can use ABC data for better pricing decisions, product line evaluations, and process improvements. Although ABC implementation involves more complexity and data collection, its benefits outweigh these challenges where accurate cost information significantly influences competitive strategies.

Conclusion

The analysis of PMI, Kunkel, and Larner emphasizes the critical role of selecting an appropriate costing system. While traditional costing offers simplicity, activity-based costing delivers accuracy necessary for modern manufacturing's intricacies. Organizations should evaluate their specific product mix, complexity, and strategic needs before choosing the most suitable approach, often adopting hybrid methods to balance precision and practicality.

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