Memo to Adam and Brian

Questions: 1). Prepare a memo for Adam detailing the advantages and disadvantages of activity based costing compared to traditional costing. 2). Prepare a memo for Brian including a quantitative analysis of Tracy Sharps business to determine if it truly reflects the results of the operations for the past 3 years. Ensure that you address his concerns regarding the decrease in sales combined with an increase in profit as well as the increasing inventory amounts for the years. Answers: (1). To : Adam Farmer From : Employee, SXS Dune Adventures Date : 04th of June 2016 Subject : Merits and Demerits of ABC as Compare to Traditional Costing Activity based costing has been referred to as the method to allocate the costs to the product by identifying and monitoring the activities. It includes calculating the estimates of consumption of activities, identifying the drivers which help to allocate the cost to the activities on the basis of estimates of consumption. CIMA, Official Terminology, 2005, p.3 ABC has thus been defined as the collection and calculation of financial and operational information relating the significant activities of the company to cost of the product. The main objectives of the activity based costing is to improve the product costs accuracy by changing the factors considered to allocate the cost and to improve product mix and decision relating to pricing of the product. Following are the advantages of Activity Based Costing over the Traditional Costing Fixed verses Variable Cost Split Under the traditional costing, the splitting of fixed and variable cost becomes complex as the business grows whereas in activity based costing incorporates the concept of long run variable cost which further helps in making the strategic business decision in an effective manner. Provides Information at each stage Activity Based costing provides the information about the cost of product at each and every stage of its production whereas the traditional costing provides the information after the product gets manufactured. More Accurate Activity Based costing provides more accurate and realistic product cost. It recognizes the behavior of cost, identifies the value added and remove the non value added activities whereas traditional based costing does not provides accurate the figure of cost. Quien and Ben, 2008 has written the following as ABC is regarded as the best accurate cost estimation method. They have further added that ABC helps managers to identify cost drivers of all activities and remove non value added activities. (p.32) Cut across the Traditional method of allocation - Activity based costing has facilitated the allocation of costs on the basis of consumption of activities with suitable cost drivers whereas under traditional costing method cost is allocated on the basis of recovery rate which is considered as inappropriate for decision making purpose. Following are the disadvantages of Activity Based Costing over the Traditional Costing Increase in Frequency of Errors Under activity based costing, the frequency of occurring of errors in the cost estimation is high due to increase in the number of cost pools which affects the decision making power of the management. Datar(1994) has written that the there is high frequency of errors in the measurement of cost due to availability of multiple activities and cost drivers. Expensive to Implement and Time Consuming Activity based costing approach is expensive in terms of cost as well as in terms of times to implement and incorporate then the traditional method of costing. Complex System Activity based costing is complex system as it consists of various cost drivers and cost pools. Therefore, they are appropriate only for large organizations whereas traditional costing is simple and is appropriate for small organizations. Noreen (1991) has mentioned that the ABC provides the better results for the management only in certain conditions and not in all conditions. (p.3) Difficult to ascertain the activities Under Activity Based Costing, it sometimes become difficult to identify the activities as some costs supports many activities and it is impossible to allocate the same cost to different activities and thus provides inappropriate results to the management. Assumption Activity based costing is developed on the assumption that there is direct linear relationship between the utilization of activities and the application of the relevant cost drivers which otherwise is not applicable in the current scenario. Best, Employee (2). Memo to Brian Beech To: Brian Beech From: Employee, SXS Dune Adventures Date: 04th of June 2016 Subject: Analysis of Tracy Sharps Business Sharp Look Flags business has welcomed an increase in net income from (-) $1,000 in the year 2013 to $ 1,500 in the year 2015 with corresponding decrease in the Sales from $ 20,000 in the year 2013 to $ 17,500 in the year 2015. The Comparative statement of Income has been prepared on the basis of Absorption costing under which Inventory has been valued at Total Cost (Variable Cost plus Fixed Cost) due to which the inventory is valued at higher price. Seiler, 1959, has written that the Absorption costing is regarded as the full cost method as it includes all the manufacturing costs and allocates them to the product whether it is variable or fixed. (p.50). The same fact has reported by Paperman in 1976 and Lal in 2008. Also if production exceeds the sales then the profit under absorption costing is higher. It is because the fixed overhead is absorbed over more number of units produced and carried to next accounting period with the closing inventory. Profit is lower when the sales exceeds the production as the fixed overhead is recovered in valuation of closing stock and thus cost of production is higher. As per the below financial information the profit is lower in the first year and higher in the third year. S. No. Particulars 2013 2014 2015 1 Sales (in $) 20000 18750 17500 2 Sales (in Units) 800 750 700 3 Production (in Units) 600 800 1000 4 Net Income / (Net Loss) (in $) -1000 250 1500 5 Under (Over Applied Overheads) (in $) 1400 0 -1400 6 Net Income before Absorption of Overheads(in $) 400 250 100 From the above table, it is inferred that: The profit is lower in the year 2013 because of less production and excess sales in units. The profit is higher in the year 2015 because of more production and less sales in units. It is implied that the net income before absorption of overheads has given true picture of the working of the company as the net income has been decreased from $400 in the year 2013 to $ 100 in the year 2015 with the corresponding decrease in the sale from $20,000 to $17,500 in year 2013 to 2015 respectively. Thus, the company should not purchase Sharps business. Best, Employee. References CIMA, Activity Based Costing, November 2008. Rasiah D, (2011), Why Activity Based Costing is still tagging behind the traditional costing in Malaysia? published in Journal of Applied Finance and Banking, Melaka :International scientific press. Haddai M and Seyednezhad, 2015, Comparative Study of Traditional and Activity-Based Costing in Forging Companies of Iran Tractor. Lucey, T(2009), Costing, South Western Cengage, Chapter 19.