The conventional costing method applies indirect costs to products on a predetermined

overhead rate. It uses volume-based cost drivers to allocate the manufacturing overhead costs
incurred. (Chan, 1993). Overhead costs are treated as a single pool of indirect costs. However, as
the proportion of non-unit related overhead costs to total overhead costs incurred in Voodoo is
large and the degree of product diversity is great, the application of conventional costing method
can distort product costs. This may lead to an overapplied or underapplied of overhead cost.
Therefore, activity-based costing (ABC) method is highly recommended as ABC method places
emphasis on the activities that causes the cost, unlike the conventional costing method which
focuses on costs incurred by Voodoo.
Activity-based costing (ABC)
ABC method is used to allocate overhead costs directly to cost objects. It involves the following
steps.
Identify resource costs and activities
Identify cost drivers associated with each activities
Assigning activity costs to products using activity drivers
Most of the food and beverages companies around the globe has adopted the ABC method. For
example, Nestle Food, one of the biggest food and beverage companies in the world, with a
market capitalisation of $233.52 billion US dollar is a firm adopter of the ABC method. (Forbes,
2013). The company had realised a cost savings of $325 US dollar through the usage of activity-
based costing in the implementation of Enterprise Resource Planning (ERP), a software used to
intergrate all the companys activities into a single system. (Kim, 2009).






Overhead Costs
Direct labour
hours
Iced tea drinks
Tea-flavoured
ice cream
Tea-flavoured
confectioneries
Cost Allocation Basis
Product Lines
Diagram 1: Conventional costing

























Iced tea drinks
Tea-flavoured
ice cream
Tea-flavoured
confectioneries
Product Lines
Activity based
cost pool
Cost Driver
Overhead Costs
Research &
Development
Sales
Processing
Extraction
Shipping and
distribution
Machine
depreciation
and
maintenance
Purchasing,
storage and
material
handling
Machine
Operation
Marketing
Other
manufacturing
overheads
Hours spent
in Research &
Development
department
Quantity of
raw material
No of batches
No of stages
Machine
hours
Machine
hours
No of sales
order
No of
deliveries
Direct labour
hours
No of sales
personnel
Diagram 2: ABC costing
Advantages of Activity-based costing
Supports the preparation of budgets and long-term plans.
Activity-based costing can be used to implement activity-based budgeting. As the full
costs of each activity involved in the production process has been identified, it will be
easier to calculate the cost per unit of activity driver for each activities. This enables the
management to identify the relationship between the activities which in turn helps in the
establishment of strategic goals for Voodoo. Furthermore, ABC improves the control of
overhead costs by linking such costs more directly to the activities which caused them.
ABC could be monitored over time to highlight where cost changes were occurring. As
each manufacturing plant of Voodoo is operating as a separate business unit, the cost
drives rates can provide a basis for detailed comparison between the manufacturing plants.
Hence, ABC can be used as a performance measure for the activities performed and as
cost reduction efforts as well as assist in the setting of budgets.

Eliminates cost distortions that are caused by conventional-based costing.
Cost distortion occurs because the conventional costing method combines all indirect
costs into a single cost pool. This pool is allocated on the basis of some resource common
to all of the companys products, typically direct labor. Cost distortion is prevented in
ABC by adopting multiple cost pools (activities) and cost drivers. Voodoo assigns costs
based on cost driving activity traceable to product. For instance, material handling was
previously allocated using direct labour hours but now can be allocated using quantity of
material. With more accurate product costs, Voodoos managers can make better
decisions relating to product retention, marketing strategy, and product profitability
(Ginoglou,n.d.). The management will also have better information to adjust their pricing
strategy to remain competitive in the global market.





Identifying value added and non-value added activities involved in production of
products.


Value-added activities


The data obtained from ABC can be used by Voodoos management to classify activities
as value-added and non-value-added. (Roztocki & Needy, 1999). Research and
development being a huge part of Voodoo is considered as value-added activities, as
value is added to the finished products. With a proven history of developing hot-selling
products, it can be seen that research and development played a pivotal role in
maintaining its posture against its competitors. Hence, RnD costs is influential in
determining the final costs of the products. On the other hand, rational decisions can be
made about whether to minimise or eliminate the activities that do not add value to the
finished products. This may lead to an increased in the products manufacturing
efficiency and reduced cost as fewer activity resources are being consumed. Each of the
manufacturing plant of Voodoo produces different products, namely iced tea drinks, tea-
flavoured ice cream and tea-flavoured confectioneries. However, the efficiency of the
activity resources consumed can be increased if each of the manufacturing plant produces
a specific product. This is because the processing of tea-based products requires
expensive equipment, systems, spaces and manpower. In addition, the transportation and
distribution process are also very costly. Thus, depending on the location of the sales
office in the state of Victoria, the finished products from each of the other two
manufacturing plants can be transferred first to one particular plant in order to reduce
transportation cost. For instance, if the sales office is in the hearts of Melbourne, the
products from Berwick and Ringwood manufacturing plant can be transferred first to the
Preston manufacturing plant. Then, all the products can be transported from the Preston
plant to the sales office.

Research
and
development
Production Marketing Distribution



Provides more reliable cost information for performance management and managements
decision making.
Due to a growing trend in the consumption of healthy foods, Voodoo faces fierce
competition from others in the industry. Therefore, if the top management is provided
with accurate cost information, they will be able to make important strategic decisions,
such as how to price products and whether to introduce a new product line for the
existing market or branch out into a new batch of customers. The distinction between
ABC and conventional costing method is ABC system takes into account all the cost
incurred for the activities of Voodoo across the entire chain of value as opposed to the
latter which only focusses on production overheads. As Voodoo sells its products through
its own sales force in all the eight states and territories in Australia, selling costs is
considered as one of the major forces in the costing decision. Hence, ABC system will
also include and allocates non-production overheads to products such as sales and
administration costs to give the true value of the products cost.



Limitations of Activity-based Costing
There is a low adoption of ABC system among companies because the setting up of the
system is costly and time consuming. Experienced consultants need to be hired and the
staffs involved need to be equipped with the necessary training and knowledge in the
operation of the system. Moreover, as the number of activities associated with the
manufacturing of each of the products increases, the cost of gathering information for the
ABC system becomes higher. For the production of tea drink, data concerning activities
such as coagulation, filtration, chlorination of water and extraction have to be collected.
This requires carefully designed interview and survey process to determine the activity
cost driver of the product. Besides, after the ABC model needs constant updating through
a new round of interviews and surveys. This reflects the continuous workpower needed to
maintain the model which ultimately increases overall labour cost. However, the benefits
enjoyed by Voodoo in the usage of ABC system will make its adoption all the
worthwhile. All in all, Voodoo needs to decide whether measurement costs involved is
justified with the expected benefits.