ANSWER 1: Over the 20 years, the product mix of the company has changed substantially. The company was producing and selling only three products, pies, finger buns and lamingtons before 20 years. These products were produced in very large volume by simple machines and lot of labour. However, over the 20 years, the company has changed its product mix completely. Now it produces wide range of low volume items like Danish pastries, donuts and vanilla slices besides Pies and Lamingtons. The low volume items require lot of extra time for machinery setup and material handling. Moreover, the company has introduced computer controlled mixing machines and oven to replace direct labour operation.
These changes in the product mix and production system has increased indirect production overhead like machine cost, setup cost and material handling cost very significantly. This has resulted in need for an accurate costing system.
Traditional costing system is not very useful in these types of industries. Traditional costing system does not allocate cost according to resources utilized by product. This may have caused some costing of some products to be overstated and costing of some products to be understated.
The company, Craving for the cakes private limited, is using traditional costing system for costing of its products. Under the traditional costing system, total cost of production is allocated to products based on the quantity of production of different products. It does not take in to account resources utilised by different products in different proportions.
Effect of traditional costing system on product costing is as under:
(a) Lamington: The existing product costing system overstates the cost of Lamington as it apportions cost based on number of quantity produced. Lamington is produced in large volumes. Therefore, higher cost is apportioned to it under the traditional costing system. Traditional costing system does not taken into account saving in machine setup and material handling cost because of high volume of production. Thus, overall costing of Lamington is overstated under the traditional costing system.
(b) Danish pastry: The existing product costing system understates the cost of Danish pastry as it apportions cost based on number of quantity produced. Danish pastry is produced in low volumes. Therefore, low cost is apportioned to it under the traditional costing system. Traditional costing system does not taken into account extra machine setup and material handling cost involved because of low volume of production. Thus, overall costing of Danish pastry is understated under the traditional costing system.
Activity based costing can overcome the limitations inherent in the existing costing system as it is more scientific method of costing.
Activity based Costing is an accounting method that identifies the activities that a firm performs, and then assigns indirect costs to products. An activity based costing (ABC) system recognizes the relationship between costs, activities and products, and through this relationship assigns indirect costs to products less arbitrarily than traditional methods.
Activity based costing can overcome inherent differences in the existing costing system by assigning indirect cost to different products as per the activity of the firm. More overheads costs like machine setup and material handling will be assigned to low volume products as compared to high volume products as low volume products require more machine setups and material handling time. Thus, activity based costing can overcome differences in the existing costing system by assigning cost according to activity of the product.
U.B. Bright should consider following factors when…