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NN42 Accounting and Management

Published : 10-Sep,2021  |  Views : 10

Question:

1. An overhead analysis table, which clearly states the basis you have used to allocate the overhead costs 
 
2. Recommended overhead absorption rates for departments 1 and 2, stating the reasons for your choice 
 
3. The product cost of one unit of X3  

The MD is concerned a recession may be on the way following the UK’s decision to exit the European Union. He believes the competitors are likely to reduce their prices and has asked you to look at the alternative costing technique of activity based costing (ABC) to see if it may help their position. He has asked you to;

4. Describe the advantages and disadvantages of ABC 
 
5. Assesses whether ABC could be suitable for the company

Answer:

1. Depicting the overhead analysis table that could be used to allocate the overhead costs:

Overhead Analysis Sheet

Particulars

Basis of apportionment

Dept 1

Dept 2

Stores

Maintenance

Total

Indirect materials– X3 model

Allocation

 

 £             63,000

 

 

 £        63,000

Heating and lighting

Floor space (square metres)

 £            183,556

 £           137,667

 £            68,833

 £          22,944

 £      413,000

Rent

Floor space (square metres)

 £            264,444

 £           198,333

 £            99,167

 £          33,056

 £      595,000

Depreciation of machinery

Value of machinery (£)

 £              28,866

 £             96,220

 £                    -   

 £            6,415

 £      131,500

Maintenance wages

Maintenance calls

 £              34,167

 £             47,833

 £                    -   

 £                 -   

 £        82,000

Machine insurance

Value of machinery (£)

 £              80,122

 £           267,073

 £                    -   

 £          17,805

 £      365,000

Factory supervisors salary

Number of Inspections

 £              36,364

 £             43,636

 £                    -   

 £                 -   

 £        80,000

Quality control

Volume (cubic metres)

 £            191,538

 £           111,731

 £            79,808

 £          31,923

 £      415,000

Total

 

 £            819,057

 £           965,493

 £          247,808

 £        112,143

 

Reallocate Store cost

Requisitions from stores

 £            119,631

 £           128,176

-£          247,808

 £                 -   

 £                -   

Reallocate Maintenance

Machine hours

            96,674.65

           15,467.94

                       -   

    (112,142.59)

 £                -   

Actual Overhead costs

 

 £         1,035,363

 £        1,109,137

 £                    -   

 £                  -   

 £                -   

2. Recommending the overhead absorption rates for departments 1 and 2:

Absorption overhead rates

Dept 1

Dept 2

Actual Overhead costs

 £                     1,035,362.51

 £    1,109,137.49

Machine hours

 £                        250,000.00

 £         40,000.00

Labour hours (A grade)

 £                        140,000.00

 £         60,000.00

Labour hours (B grade)

 £                          20,000.00

 £         30,000.00

Absorption rates

 

 

Per machine hour

 £                                   4.14

 

Per labour hour

 

 £                12.32

The per machine hour rate is mainly chosen as the absorption rate for department 1. The machine rate is actually chosen due to the high machinery usage conducted by department 1 in comparison with labour usage. In addition, per labour hour rate is mainly chosen as the absorption rate for department 2. Moreover, in department 2 relatively labour usage is high in comparison with machine hour usage, thus labour hour rate is used for absorption costing. Dung and Aoki (2014) stated that use of absorption costing allows companies to depict the minimum costs incurred for producing a relative product.

3. Depicting the product cost of one unit of X3:

Particulars

Amount

Amount

Direct Material Costs

 £                     1,770,000.00

 

Direct Labour Costs (A grade)

 £                          82,500.00

 

Direct Labour Costs (B grade)

 £                        255,000.00

 

Prime Cost

 

 £    2,107,500.00

Production Overhead

 

 

Labour Costs

 £                     1,109,137.49

 £    1,109,137.49

Total Production Cost

 

 £    3,216,637.49

Total units produced

 

          300,000.00

Per Unit cost

 

 £                10.72

4. Depicting advantages and disadvantages of ABC:

Activity based costing mainly allows companies to effectively manage its overhead cost and take adequate decisions. In addition, it also allows companies to take adequate decision regarding continuity of different operations. Ruiz-de-Arbulo-Lopez, Fortuny-Santos and Cuatrecasas-Arbos (2013) stated that activity based costing is mainly used by companies with low overhead costs, as it helped in reducing excess expenditure and increase profitability. However, there are some advantage and disadvantages of ABC method, which are depicted as follows.

Advantages if Activity Based Costing:

  • ABC method mainly helps in portraying the accurate costs of products by including all the relative expenditure conducted by the company
  • ABC has a better understanding of overhead costs
  • It helps in utilising unit cost rather that total cost
  • Allow the company to identify wasteful activities, which does not contribute to profitability
  • Allow management to take better decision with precise knowledge about relatively costs incurred in the organisation.
  • It allows management o identify costs related to supply chain and value streams

Disadvantages if Activity Based Costing:

  • The major limitation of ABC method is the substantial amount of resources, which is needed in the method for evaluating costs.
  • Due to the complexity of the ABC method, it is not effectively used by businesses, which in turn decreases its demand among managers.
  • ABC method increases the chance of misinterpretation by adding each costs incurred by the company. Production costs, marketing costs and object costs are all included in the ABC method.
  • In addition, GAAP does not accommodate the ABC method and thus, business has to use both ABC and traditional costing method. This mainly increase the expenses of the company for maintaining two cost system

5. Depicting whether ABC could be suitable for the company:

After the overall evaluation of merits and demotes of ABC method, it is seen that use of new costing method could only increase expenses of the company. In addition, there is a relative chance of a recession, which will in turn increase expenditure and reduce profitability of the company. However, the current absorption system has effectively depicted the relative costs of each product. Nevertheless, the use of ABC method could only helps in decreasing the cost of X1 and X2 products, while increment in costs of X3 products could be seen. In this context, Kaplan and Anderson (2013) stated that activity based costing helps organisation to shut the production process, which does not provide adequate return from investment. On the contrary, Marx (2016) argued that the high inclusion of costs identified by ABC method mainly decrease motivation level of management in time of recession.

Seeing the advantages it could be possible, for Eriksen Ltd to use Activity based costing in their costing valuation. In addition, this could mainly help in depicting the accurate costs of each product, which could in turn help the company make adequate adjustment to selling price of X1, X2 and X3 product. Frazier (2014) mentioned that activity based costing allows management to identify wasteful products, which is hamper profitability of the company. On the other hand, Balakrishnan, Labro and Soderstrom (2014) criticises that activity based costing needs high-end costs, which could raise the current expenses and hamper profitability of the company. Thus, use of Activity based costing in Eriksen Ltd could effectively help the company improve their position if UK is being hit by a recession.

Reference:

Balakrishnan, R., Labro, E. and Soderstrom, N.S., 2014. Cost structure and sticky costs. Journal of management accounting research, 26(2), pp.91-116.

Dung, N.T.P. and Aoki, M., 2014. The Evolution of Management Accounting Practices in Vietnam-a Survey research on Vietnamese food and beverage enterprises.

Frazier, W.E., 2014. Metal additive manufacturing: a review. Journal of Materials Engineering and Performance, 23(6), pp.1917-1928.

Kaplan, R. and Anderson, S.R., 2013. Time-driven activity-based costing: a simpler and more powerful path to higher profits. Harvard business press.

Marx, C., 2016. An activity-based costing approach to fall of ground accidents in a South African gold mine.

Ruiz-de-Arbulo-Lopez, P., Fortuny-Santos, J. and Cuatrecasas-Arbós, L., 2013. Lean manufacturing: costing the value stream. Industrial Management & Data Systems, 113(5), pp.647-668.

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