This report entails a case study on Afreen Trading, a company situated in the UAE, which manufactures, exports, and supplies exquisite Ladies Hand Bags in three various colors, White, Brown, and Purple, all of which are made from the identical raw material, which includes pearl buffalo horn plates. The company allocated overheads to its products utilizing direct labor hours based on traditional full costing. To increase profitability, the company contemplated on using an activity-based costing (ABC) system. Based on the data provided, questions A-E were answered, and conclusion and recommendations were made for the three handbags. Firstly, the full cost per unit for each product under the traditional absorption method was calculated and compared to ABC system. Secondly, reasons for changes in cost per unit for changing from traditional absorption costing to ABC system are also discussed. Thirdly, the report incorporates the effects of pricing and products’ profitability for changing the costing system from the traditional absorption method to ABC system. Lastly, the steps and possible pitfalls for corporate managers to avoid when presenting an ABC system into such a business as Afreen Trading is formulated. As illustrated below, it is noted that if the information is gathered, but no action is taken, ABC costing is useless to Afreen Trading. The fact that this type of costing is actionable is the key to its worth. This study enables businesses to make product line selections, determine where to target sales efforts, and assess the genuine value delivered by capital equipment.
The Full Cost per Unit for Products White, Brown, and Purple Under Traditional Absorption Costing
The Full Cost per Unit of Each Product Using Activity-Based Costing
The Reasons for the Changes in Cost per Unit When the Costing System Is Changed
Calculating an accurate manufacturing cost for each product is a vital piece of information for a company’s decision-making. For example, knowing the cost of producing a unit of a product affects not only how business budgets to manufacture that product, but it is often the starting point in determining the sales price. An important component in determining the total production cost of a product or job is the proper allocation of overhead. For some companies, the often less-complicated traditional method does an excellent job of allocating overhead. However, for many products, the allocation of overhead is a more complex issue, and an ABC system is more appropriate.
Based on the ABC costing technique, it was discovered that the cost per unit of white beautiful ladies’ handbags is higher under the ABC system compared to the traditional absorption method. For instance, the computation shows that the cost per unit of white beautiful ladies’ handbags using ABC is $13.22 compared to $12.42 using the traditional absorption technique. Moreover, the cost per unit of brown beautiful ladies’ handbags under the ABC methodology is similarly higher, at $19.02 compared to $18.99. Despite the cost per unit of Purple beautiful Ladies Hand Bags under the two methods being almost the same, the discrepancy in both White and Brown beautiful Ladies Hand Bags is evident. These discrepancies are because; White beautiful Ladies Hand Bags employs a far smaller percentage of total direct labor hours spent, yet incurs higher amounts of shipping and machine setup costs. As such, this is the primary cause of the variations in cost per unit.
Furthermore, the traditional costing technique includes an average overhead rate in addition to the direct costs of the produced items. Such a rate is based on a single cost driver, such as the number of labor hours required to produce a white or brown beautiful ladies’ handbag. ABC, on the other hand, outlines all of the overhead processes required to make each product (Banerjee, 2021). The core tenet of the ABC system is that not all bags require the support of all overhead costs; hence, it is not necessary to apply the same overhead costs to all the types of products, in this case, handbags (Banerjee, 2021). As such, this belief is regarded as one of ABC’s most influential and effective elements. In this case, the overhead imposed on the goods, and therefore the overhead cost per unit of the product, will be considerably different from the cost per unit received from the absorption system.
The Potential Cost Management Implications of Switching to an ABC System
Activity-based costing is a more precise approach to costing products and services, resulting in more accurate price decisions. It improves managers’ awareness of overheads and cost drivers, and it makes pricey and non-value-added operations more apparent, allowing them to be reduced or eliminated. ABC’s cost management program demonstrates that this technique gives institutional managers with cost driver rates along with process volume statistics that can be used to manage costs. The cost drivers may be used to benefit the redesign of current commodities since they accurately reflect overhead costs that are often levied when pricing a product. ABC also employs many cost factors, the majority of which are transactional rather than product volume-based. This system is concerned with all actions outside and within the organization to trace additional overheads in connection to the manufactured items. As a result, the ABC method aids in the development of management decision-making processes by utilizing more standardized data linked to the product cost.
As a result, it can be stated that the ABC approach not only provides an excellent platform for calculating more accurate product costs, but also a cost-management measure. It is assumed that resource-consuming activities normally incur costs and that such items incur costs due to the operations demanded by them, such as production and design (Mc Laney and Atril, 2018). It becomes simpler to grasp and efficiently conduct management costs by identifying and commenting on significant functions in which a business engages. The primary goal is to regulate operations rather than costs. Costs can be efficiently managed in the end by regulating the causes that produce such actions.
The Effects on Pricing and Product Profitability from Switching from Traditional Absorption Costing to an ABC System
The tables below depict the profitability differences between the conventional absorption method and ABC systems:
Pricing and profitability study of the purple handbag: This product’s cost per unit under ABC is lower ($24.146) than under the traditional absorption method ($24.836). As a result, the company may achieve a greater profit level of roughly $15.854/unit under ABC as opposed to $15.164/unit under the traditional absorption technique. The lower number of manufacturing runs required to make this product contributes to its profitability. ,Consequently, this product has a cheaper machine setup cost than brown and white handbags.
However, brown handbag pricing and profitability analysis indicate a higher profitability ratio in both the traditional absorption technique and the ABC method compared to all other handbag colors. For instance, in comparison to other handbag colors, this product achieves a higher percentage of profitability of 45.75 and 45.66 for traditional and ABC techniques, respectively. The profitability is much higher as compared to 32.86% and 28.46 for white handbags and 37.91% and 39.64% for purple for traditional and ABC methods, respectively. However, the difference in percentage profitability in brown handbags is minor, so it is not necessary to modify its pricing because its profitability is consistent.
For white handbags, the pricing and profitability analysis and computation indicate that it is losing money. This product’s profit with ABC is $5.28, but the profit under the Traditional absorption technique is $6.08. One of the primary reasons for such a decrease in profit might be a greater number of deliveries than brown handbags and a bigger number of production runs. These highlighted ABC actions have resulted in the product incurring greater delivery and machine setup costs as compared to its comparable handbag colors. The increase in costs has resulted in a decrease in profit. Therefore, for white handbags, the Company should concentrate on lowering machine setup and delivery costs while boosting selling prices to achieve increased profitability.
However, the two costing techniques as indicated in Table 10 above suggest that absorption costing for purple handbags is losing $0.69. The underlying difference is that the number of manufacturing runs required to make purple handbags is relatively low in ABC in comparison to the volume of units produced. As a result, ABC is more beneficial in determining if purple handbags are, in fact, more lucrative than white handbags. In this case, the corporation may consider the effectiveness of purple handbags while considering adjustments to white handbags. If this is not practicable, the firm may consider eliminating white handbags and just selling more of purple handbags.
The Steps and Possible Pitfalls to Avoid When Introducing an ABC System into a Business
First, tasks must be selected and organized into activity pools. The supporting activities that are linked to a product line or service are referred to as “activity pools.” During the planning phase that involves activity identification, such an organization as Afreen Trading Company may encounter such issues as the failure of senior executives to form a specialized project team (Mc Laney and Atril, 2018). To avoid such pitfalls during the implementation process, a corporation should focus on organizing seminars and workshops for training and teaching staff how to utilize ABC costing techniques (Kim, 2017). Furthermore, the team leader should make selections based on their grasp of business information and ability to deal with employees from various functional areas of the firm.
ABC subsequently proceeds on to activity analysis, finding the processes that support a product while avoiding some of the inherent problems of traditional costing. ABC costing necessitates activity analysis, which is analogous to process modeling in lean manufacturing. This activity analysis reveals indirect cost links and enables the direct assignment of a portion of that function to a final product.
Assignment of Costs
Costs are given to an activity pool drawn from the findings of steps #1 and #2. Human resources costs, for example, might be classified as auxiliary administrative or ancillary management costs. Each of these pools will contribute to the cost of the item in some way. A company may encounter several difficulties while assigning costs and assessing activities. For instance, a firm may experience an insufficient emphasis on training to acquire internal knowledge amongst workers (Mc Laney and Atril, 2018). The activity variables and materials might as well be at an excessively detailed level. Furthermore, cost stability might not have been established. Certain ways might assist a company in dealing with these difficulties. Workers must be involved in the selection of cost drivers. Instead of specific details on individual tasks, managers must incorporate information and statistics on how the operations interrelate. The project manager should use practical competence to assign expenses to cost items.
Calculate Activity Rates
Direct labor hours or indirect support labor may be included in the first analysis. These tasks must be given a financial value in actual money. At this point, all ratios must be applied. For example, manufacturing labor hours should be calculated using a weighted labor rate that includes bonus costs.
Assign Costs to Cost Objects
After identifying and explicitly defining activity costs, pools, and rates, the subsequent step is to allocate them to cost objects. Objects are commonly characterized as the outcomes provided to a consumer. This product should have some resale value in both production and non-manufacturing situations when compared to the budgeted costs.
Prepare and Distribute Management Reports
Once the ABC costing assessment is completed, the cost data should be presented to cost objects and program owners succinctly and cohesively. This explanation of the costing analysis is crucial for justifying the cost of the assessment, as this is not always a negligible cost. While introducing the ABC system, the following problems should be avoided throughout the documentation of the outcomes from step 4 to step 6. For example, overall, company leaders might not respond appropriately to ABC information. Therefore, to counteract the challenge, corporate managers should be able to defend their actions and omissions based on ABC data.
Banerjee, B. (2021) Cost accounting: theory and practice. 14th edn. Delhi: India. PHI Learning Private Limited.
Kim, Y. (2017) Activity Based Costing for construction companies. 1st edn. Seattle, WA: John Wiley & Sons Ltd.
Mc Laney, E. and Atril, P. (2018) Accounting and Finance: An introduction. 9th edn. London: England. Pearson.