Understanding Manufacturing Overheads, Conventional And Activity-Based Costing Is Essay.

Manufacturing Overheads

(a)  It is important to have a brief description of manufacturing overheads first. Also known as production cost, factory overhead & factory burden, manufacturing overheads are incurred in a factory’s manufacturing processes. The cost incurred in the factory for the production purpose other than direct Labour and direct materials cost  is termed as manufacturing overhead cost. This is why, it is often referred to as an indirect cost. According to accounting principles, valuation of inventory &  cost of goods sold should be made on the basis of direct material cost, direct Labour cost and manufacturing overheads (Berman, Knight and Case, n.d.) . However, it is to be stated that the expenses occurring outside the factory in relation to the said product such as selling & administrative costs, general expenses, etc doesn't form a part of product cost and are not inventorial. Such expenses are charged in the income statement in the respective accounting year in which it occurred. Examples of such costs are depreciation on the factory equipment, plant related expenses, inspection costs, etc (Shim and Siegel, 2008).

Because manufacturing overheads are considered to be an indirect cost, accountants face the task of assigning or allocating overheads cost to each of the product units if there are more than one product. There can establish no direct relationship (Bruner, Eades and Schill, 2017). For example, the depreciation of the  machine is based on the value of the machine and not the units actually manufactured (Saltelli, Chan and Scott, 2008).

Thus, there are numerous methods of allocating overheads and businesses adopt the method based on their operations & the market forces. Two most common approaches are conventional or traditional costing and activity - based costing (Taylor, 2008)..

Coming to conventional approach, it refers to the allocation of manufacturing overheads to products on the basis of volume metric such as direct labour hours or production machine hours or certain percentage of prime costs etc (Clarke and Clarke, 1990).. With a decrease in labour hours or machine hours, the overhead cost increases. As per this approach, accountants derive one cost for all the activities of the manufacturing excluding direct labour costs  and materials costs and multiples such unit cost with the respective cost driver be it direct labour hours or machine hours. Such overhead rate is also referred to as 'overhead absorption rate' or 'single blanket rate' (Fairhurst, 2015).

As per the given question, we are required to compute the cost of product unit of Fred and Martha on the basis of single overhead rate (Galbraith, Downey and Kates, 2002).. The single overhead rate is calculated by dividing budgeted costs by total hours required as shown in the notes. The overhead rate comes out as $48/product unit and also, manufacturing overhead costs are to be valued on the basis of direct labour hours (Saunders and Cornett, 2017). So one unit of Fred costs $96 ($48*2 hours for one unit) and one unit of Martha costs $144 ($48*3 hours for one unit).

Conventional Costing

(b) As per the question asked, we are required to compute the cost of each of the cost activity on the basis of their respective cost drivers (TULSIAN, 2016).. Thus, it is better to first state the meaning of all the terms used. Cost activities, also referred to as cost pools, refers to the different types of activities undertaken for the manufacturing processes. Such costs are indirect in nature but forms the part of cost of the  product. Examples of such activities includes equipment related expenses, machine related expenses, inspection costs, setup costs, etc. 'Cost Driver' refers to the different factors on which the cost of an activity depends. It triggers a change in the activity's costs (Galbraith, Downey and Kates, 2002).. It is used basically in activity based costing to allocate the specific overhead costs to the product. Usually, such concept is adopted when the business operations are vast in nature and correct costing of their products is mandatory or when the activities undertaken for manufacturing ae large in number. Business operations that look for minimum accounting requirements or doesn't involve too many activities go for a single blanket rate for calculating overheads absorbed.

Each cost pool has its own cost driver on the basis of which the rate is being calculated. For example, production runs, machine hours, time taken for inspection, etc. Let us consider some cost pools &  their drivers : quality assurance cost depends on the number of visits for quality check, depreciation depends on the value of machine, electricity depends on the light points, machine insertion costs depends on the number of parts inserted, etc (Holland and Torregrosa, 2008)..

The given table shows the rate of each of the activity as per the cost driver. For example, the first one, machine related expenses $450000 is divided by the budgeted cost driver 9000 hours and therefore, the rate of absorption for machine related expenses comes out as $50/machine hour. In a similar way, the rate of absorption has been calculated for each of the activity based on their respective cost drivers (Khan and Jain, 2014).

(c) Activity Based costing is an opposite method of the conventional approach (Phillips, 2014). It is an approach for allocation of overheads in a more precise manner to those items that are actually being used (Reilly and Brown, 2012). This methodology is mostly used in complex environments, where there are a good number of machines & equipments and a number of related & non-related processes and a single rate would lead to wrong costing of the product. This approach identifies the relationship between products and the activities undertaken & the associated costs and this is how indirect costs are assigned to products which is less arbitrarily than tradition approcahes.

Activity-Based Costing

Usually, activity costing is used in manufacturing sectors as it enhances the reliability of the cost data and hence, thereby, produce the true costs and leadsto better classification of costs.

As per the five question, we are asked to calculate the product cost of each unit using ABC approach and using the data given in part (b), the overhead costs have been calculated for the purpose of product cost (Palepu, Healy and Peek, 2016)..

(d) Initially, the firm priced its product @120% of manufacturing costs that made them to price one unit of Fred @ $199.20 and one unit of Martha @ $298.80. Using the same pricing method of valuing at 120% of manufacturing costs, let us calculate the price to be charged for per unit of each of the product when the cost is being calculated on activity based costing.

Price of one unit of Fred : 120% of $504.30 = $605.16/unit.

Price of one unit of Martha : 120% of $181.34 = $217.608/unit.

Thus, where previously the profit from one unit of Fred was $33.20, ABC approach gives a profit of $100.86. Similarly, where profit from one unit of Martha was $49.80, ABC analysis gives a profit of $36.268.

(e) Allocation of overheads on the basis of conventional approach is often based on the volume such as the number of direct labour hours, or production units. However, there are certain costs that are not always based on volume of production. For example, a few of manufacturer's low volume products requires significant amounts of engineering costs, setup costs, inspection costs, etc. Allocation of such costs on the basis of production hours instead of on the basis of their root causes will result in the inaccurate & misleading costing valuation of products.

Conventional approach is usable if the business operations aren't very complex and the activities engaged aren't so much in number. In such a case, a single overhead absorption rate would work for valuation. However, in case of a number of business activities, it is better to develop a rate for every cost driver so as to do a proper valuation of products. Inaccurate results leads to taking of wrong decisions by the top management be it the case of control purposes, of pricing of the product or sending quotations. Also, conventional approach doesn't reflect the true cost of the resources consumed by the end products. Conventional approach includes splitting of cost into fixed & variable costs which is often unrealistic because if business grows, the splitting of costs gives inaccurate product cost.

Conventional approach is not suitable for manufacturing sector as manufacturing sectors includes the valuation on the basis of degree of completion of work with accurate indirect costs incurred.

(f)  The fundamental benefit of adopting ABC analysis is to determine the overhead rate more precisely. This costing also serves a number of other benefits as stated below :

• Activity costs : ABC's job is to identify the activities and track its costing individually so as to see whether such costs are in line with industry standards. If not, then ABC analysis shows a clear picture of ongoing costs and provides the management an opportunity of focusing on cost reduction.
• Customer Profitability : Usually, the costs incurred for individual customers are simply product costs, there are certain other unusual overhead costs such as product return handling, high customer service costs, etc. ABC analysis can sort such costs and provixesan assurance whether the customers are paying reasonable profit.
• Make or Buy : Abc analysis provides a detailed allocation of costs associated with the in-house manufacturing of a product, so that a firmcan judge on that basis to eliminate those items if the outsourcing of such an item would be more reasonable.
• Margins : With ABC analysis, margins can be determined of various products, product lines and entire subsidiaries. This is useful in a sense to determine the position of the company resources to earn the largest margins.
• Production facilities : It is usually better to segregate overhead costs at the plant wide level so as to compare the costs of production between different facilities.

(g) With the above explanations, it is clearly visible that the ABC approach provides a better costing process than conventional approach and helps in an accurate allocation of indirect costs. However, thereare alot of problems associated with ABC analysis :

• Cost Pool Volume : While its an advantage that such an analysis provides high quality of information, it is also disadvantageous in a sense that it comes with the cost of using a large number of cost pools and with involvement of large number of cost pools, the cost of managing such cost pools is higher.
• Installation time : ABC systems are difficult to install with multi year installations being the norm that the company wants to install it across all product lines & facilities. It becames difficult to maintain the budgetary support & management support as months goes by but installation remains incomplete. Thus, success rates are higher than smaller & more targeted ABC installations.
• Multi-deparmental data sources : ABC system requires data from multiple departments and each of this department may have high priorities. Thus, the larger number of departments are involved, the greater is the risk that the input data will fail.
• Project basis : Many ABC projects are based on a project basis, so that the collection of information takes place only once and such information is useful only for the current year's operational situation. However, the usefulness of such information declines as the operational structure changes. So, ABC tends to be done and discarded
• Reporting of unused time : When a company asks its employees to report about the time spent on each activity, the employees have a very strong urge that the reported time equals to 100%of their time. However, it is not possible to entirely devote 100% time by the employees as there are good number of idle time in anyone's work say lunch hours, breaks, administrative meetings, playing games, Internet usage, gossips with other members, etc. In such a case, employees mask their idle time on one activity by apportioning it to the other activity. This leads to misallocation of costs under ABC analysis and sometimes, by large amounts.

Thus, an adoption of system involvs both advantages and disadvantages. It all depends on the nature & size of the business as well as how much important it is for them to comply with the accounting principles & standards. Looking into such matters relating to business operations, the approach of costing is adopted thereon as the ultimate goal of every business is to show a true reflection of its costs and to charge a reasonable price from its customers.

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