Introduction
Determination of full costs and selling prices is one of the most important methods of costing in any enterprise that is aimed at improving on profitability as well as making decisions. Most of the organisations face challenges in trying to figure which method to use to both full cost and selling price. The greater challenge is in the apportionment of overheads which has led to two different approaches in allocating them. These methods are original costing method and activity based costing method. The analysis below answers the question on overheads allocation using the two methods and also comparing their effectiveness in the allocation of overheads.
Full cost and selling Price
Original costing method
- Full cost= direct labour + overheads (charged on direct labour)
Total overheads = 4,410,000
Overheads recovery rate 4410000/ 21000 =210 per hour
Table1. Full cost per unit.
Table 2. Selling price.
Activity based costing method
Table 3. Full cost.
Table 4. A continuation of table 3.
Table 5. Full costs are as follows.
Table 6. Therefore selling prices of the products are the following.
Appendices
- Table 1
Overhead costs = overhead recovery rate x hours
LO- 210x ½ = 105
MID – (1×210) =210
HI – (1×210) = 210
- Table 2
20% is the profit margin above the total cost (direct costs +overhead costs)
Selling price = full cost + profit margin
LO = 134 + (134×20%) = 160.8
MID = 280.5 + (280.5×20%) = 336.6
HI = 323 + (323×20%) =387.6
Note table 6 the same procedure
- Table 3: Overhead Cost Pool
- Table 4: Overhead Cost per Unit
Discussion
Implications and price differences of the above costing methods
Original costing method and activity based method are vital to firms in the calculation of cost allocations to the products. Both original costing method and activity based methods have different implications to the price determined. The subsequent difference in price comes about due to the different allocation of the resources. For instance, the overhead charged to LO using activity based costing method is 91.33 pounds while through the use of original costing method LO is charged 105 pounds. The overhead of LO while using activity based costing method is more accurate. That’s why it is advisable to use it when making decisions concerning product pricing (Atrill and McLaney 13).
Secondly, the overhead charged on MID through original costing method is 280.5 pounds while the overhead charged using activity based costing is 629.6 pounds. In this case the overhead obtained from activity based costing method is higher than the one obtained from original costing method. This implies that MID is affected by either many activities or some activities are expensive at its provision. Again, the overhead cost of HI calculated using is original costing method are 323 pounds while overheads cost of the same product using activity based costing method is 194.43 pounds. In this case activity based costing method is giving a value lower than original costing method. This implies that product HI has been allocated a higher overheads cost than it deserves.
Analysis of the two costing methods with recommendations
In original costing method, allocation of cost is done using direct labour. Therefore the use of direct labour makes labour intensive products cost higher compared to the other products. Original costing method fails to give a more accurate cost because it relies on one parameter in the determination of the cost of the products. Besides, the allocation of costs to the activities is done randomly on the basis of labour and machine hours. Through the use of activity based costing approach, allocation of costs is more accurate especially in the circumstances where there are no similar rates of direct labour-hours. Activity based costing method allocates cost using all the activities that are involved in the production for example, machine setups, salaries, orders among others (Weiner 17). Finally, basing on original costing method, it implies that errors are likely to occur leading to inaccurate pricing which may have devastating effects on the revenues of the business or its market share.
In original costing method labour is the main factor of production. In this case overheads are charged against the cost of materials and direct labour. Original costing approach overheads are charged against the products departments or cost centres. While in the activity based accounting costs are apportioned to cost pools. Costs are given to services and products alike by the use of drivers of cost. This is done to each of the aforementioned pools. This method does not provide linkage between products and the actual effort used. The method does not trace where costs occurred and why they were incurred (Leslie 81). This method usually gives analysis that is inaccurate, not flexible and also not timely. Activity based accounting approach is more recommendable because it captures all the costs at the activity centres thus it gives a fair cost to each product. Additionally, activity based costing approach enables decision makers figure out on how they can improve their productivity and also on how to maximize shareholder value (Lightcap 1).
On the Activity Based Costing (ABC) method, allocation of overhead costs are based on the real performance and expenditures sourced from the firm’s information records and also knowledge from staff that are connected directly with the delivery of those products. ABC is also instrumental in improving organizational performance. Activity based costing method is required in the firms whose overheads are high and there is presence of different kinds of products.
Analysis of the business/strategic options
As evidenced in the above discussion, the fact that cost reduction opportunities are available in activity based costing makes it preferable than original costing. This is complemented by the maintenance of quality in applying the aforementioned cost reduction opportunities. On the analysis of business/ strategic options in the presence of new information, the organisation should focus on several concerns. First, the business should focus on the competitors in the market, what they are offering and for how much are they selling for. This will enable the business to ensure that it is not competed out. Secondly, the organisation should focus on how to penetrate to the markets dominates by competitors. Thirdly, the firm should try as much as possible to keep prices at a rate that can not invite competitors to the market.
Conclusion
It is clear that both activities based costing method and original costing methods are important in the determination of both full costs and selling price. Original costing method, however, has many shortcomings due to the generalisation of overheads. This reason makes it unreliable and inflexible causing some inaccuracies in computation of full costs. Activity based costing method gives better results despite being very tedious in computation. It incorporates all cost drivers thus ensuring that every cost is captured. Therefore firms are supposed to rely on activity based costing method in determining the actual prices and costs. From the above information the firm is supposed to rely on activity based costing method in determining the actual prices because of the advantages it has over the original costing method.
Works Cited
Atrill, P. & McLaney, E. Management accounting for decision makers. U.K. McMillan Publishing, 2006. Print.
Leslie, Chadwick. Management Accounting. Britain. Bell & Bain, 1999. Print.
Lightcap, Victoria. “Development of activity based costing”. 2008. Web.
Weiner, Jerry. Activity based costing for financial institutions. Journal of Bank Cost & Management Accounting, 1995.