Originally Posted by Taejeah
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Explain why costs per unit calculated under ABC are often very different to costs per unit calculated undermore traditional methods.
Discuss the implications of a switch to ABC on pricing and profitability.
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The traditional method is referred to as absorption costing. ABC is the modern method that replaces absorption costing.
ABC involves the identification of cost drivers ie, the cost of an organisation,s major activities. Overheads are charged to productson the basis of their usage of the factors causing the overheads.
ON the other hand, absorption costing deals with overheads in three stages allocation apportionment and absorption. It is a method of product costing which aims to include in the total cost of a product an appropriate share of the organisation's total overhead. This is an amount which reflects the amount of time and effort that has gonr into producing the product.
Cost per unit
This refers to the cost of a product ie, one/single unit of a product and is calculated as follows:-
direct materials
add direct labour
add direct expenses
equals prime cost
add production overhead
equals production cost
add non-production overhead
equals total/full cost
Any calculation requiring cost per unit whether it be using any costing method will achieve the same figure for prime cost. This is because direct cost remains the same in all calculation. Overheads are indirect cost and are incurred when making a product but cannot be traced directly and in ull to the product. Therefore, it is the overhead cost that each method is working towards achieving differently.
Reason for the differences in the cost per unit (CPU):
Absorption - due to the traditional environment ie significant machine hours, labour hours (most common bases) overheads are charged to products using what is considered a fair basis. This fair share of overhead will include a portion of all production overhead expenditure and possibly including admin and marketing for example. This is so as it is deemed that each unit of the product receives some benefit from these costs. This is done by arriving at an overhead absorptin rate (OAR) which is calculated using budgeted figures being budgeted overhead divided by the budgeted activity level. The rate calculated is charged to production overhead based on the actual units produced.
ABC - overheads are assigned to the units of output based on the different activities undertaken during production. ABC uses many cost drivers as its absorbtion bases and thus facilitates a good understanding of what drives overhead costs.
The main idea associated with ABC is that:
Activities causes cost to be incurred
Units produced creates a demand for cost
Overheads are assigned to output units based on its consumption of the activities
To conclude, due to the different treatment of overheads under the various methods, cost per unit is bound to differ as the methods are calculating overheads in a different way.
Implication of a switch to ABC:-
Switching to ABC can change the cost per unit calculations substantially. It has implications on both price and profitability.
Prices based on cost plus pricing for example, would require greater costing information, this would be very useful and prices will change based on each costing method used. There are organisations that prices their products based on what the market will bare, thus, if prices are recalculated its the profit margin for a product will change and not the price.
With high profit margins products are now seen as less profitable. For example an organisation can decide to reduce the selling price but if its a high volume product, the number of units sold might not increase sufficiently to compensate for the loss in total revenue.
Study group - Costing
Linear Mode
