(Using Teejay's International based in Houston, Texas)
Introduction
One of the key challenges that management accountant have faced is allocating overheads costs to the products. In overcoming an attempt to address this challenge, various ways have been devised. One of the most instrumental developments in the allocation of overhead is the development of ABC accounting. ABC costing is an improvement to the traditional accounting approach that has always been in use. The method appreciates that there are numerous costs drivers hence identities these cost drivers and uses them to pool costs in order to allocate them to the products (Bendrey, Hussey & West, 2003).
Cost Allocation Process
Benefit Teejay's International Derives from ABC Approach
The first benefit in adopting the activity based accounting is an improvement in cost allocation. The use of differentiated cost drivers that best explain the relationship between the cost objects and the homogeneous pool of overhead facilitates accurate allocation of overheads to these objects. Second, ABC assists the organization in minimizing wastes. Since the cost uses homogeneous pools, it is possible to understand the wastage point in the production process thus addressing the issue. As a result, ABC process will assist in identifying the elements that are stressing to the organization production process. Consequently, this will positively impact on the firm production process which will enable the firm to pass the benefits to the consumers. The passed benefits will increase the firm's profitability through increased sales. Third, the method has been observed to play an adequate supportive role in supporting quality management initiatives such as the application of six sigma concept. The benefit is founded on the ABC process ability to improve business processes, especially production (Bendrey, Hussey & West, 2003).
The key limitation to this method is time consumption. The approach uses homogeneous pools as opposed to the overall heterogeneous data pool. As such, additional time will be required to correctly allocate the overhead cost to the right homogeneous pool (Bendrey, Hussey & West, 2003).
Application of the ABC to Teejay's International
Teejay's International has two departments namely receiving and processing and dispatch and distribution department. In the two departments, there are various machines that are used such as trollies, factory conveyor belts and sewing machines among others. The receiving and processing department is tasked with the responsibility of receiving the input materials from the supplies and transferring the received materials to the storage room where they are later transferred to the processing room. The dispatch and distribution department is where the finished products are delivered and packaged to be sent to various warehouses. The overhead costs relating to the two departments are summarized below.
Under the traditional accounting approach, it is expected that all the costs associated with the machines will be pooled together with other costs such as administrative expense. The firm uses direct labor hours as the allocation basis for its overhead. Further, the firm produces two products namely product Zed and product Exe. In addition, the two products are made from two inputs namely fabric One and fabric Two. The data relating to production, material consumption, and direct labor hours consumption are summarized in the table below.
The firm business model defines that the firm will distribute the finished products to its warehouse. Therefore, for the convenience of storage, each carton can only contain only one product.
Since this is a traditional approach, overhead costs that have been pooled together with other overheads are used to determine the allocation rate using direct labor as base as detailed in the table below.
Since this is the traditional approach, the overall rate is used to determine the cost allocation of the overhead per unit. For this case, the analysis narrows down to costs that are relevant to machine overheads to make the necessary illustration which will enable the demonstration of the difference between the traditional method and the ABC method.
Application of ABC Method
The application of ABC will take two stages. In the first stage, the methods first allocate the overhead on the usage of machines in each of the departments. According to a survey on the usage of machines, it was determined that the dispatch end distribution department used 40% of machinery while the rest is in the receiving and processing department. Assuming that these findings are still applicable to date, the overheads relating to the machines will allocate as follows.
In the second stage, the following methodology is applied to allocate costs. The second stage is the final stage where the cost to be charged to each unit will be determined. As such, it means distributing the total cost per department to one unit of each product.
In this case, for receiving and processing department, the most relevant allocating factor is the number of units received and processed. In relation to dispatch and distribution, the most suitable allocating factor is the number of cartons. Therefore, each product is allocated overhead costs based on the number of cartons that contain a specific product in the dispatch and distribution department. On the other hand, the number of material used to manufacture the product in the receiving and processing is used to allocate the overhead costs in receiving and processing department. The two costs per product are then summed and divided by the number of units to obtain the cost allocated per unit of each product. The output shows that the values are significantly different from the values that were generated by the traditional accounting method
The use of more than one overhead allocating factor eliminates the inefficiency of using labor hours. Through this elimination, it is clear that product Exe was charged higher charges primarily because it required high labor hours compared to product Zed. It follows that the adoption of the ABC costing has identified this weakness which could be amended thus facilitating ABC Company to review its prices hence restructuring the pricing regime to take advantage of this new cost allocation outcome. Also, from the computation, it is evident that cost hierarchy is observed since ABC starts from the lowest cost in the hierarchy to the highest. From traditional accounting, it is observed that this methodology ignores the existence of any cost hierarchy (Heisinger, 2010). The hierarchy level starts with unit level costs, batch-level costs, product level costs and facility-level cost which have been considered in arriving at the final ABC machine overhead cost allocation per unit. However, in this case, the computed example only goes up to the product level costs since the allocation only singled out the machine overheads, not the entire facility overheads.
Conclusion
References
Bendrey, M., Hussey, R., & West, C. (2003). Essentials of management accounting in business. London: Continuum.
Heisinger, K. (2010). Essentials of managerial accounting. Mason, OH: Southern-Western Cengage Learning.
