Management Accounting

Group Project

Understanding ABC

Submitted by- Group 3, Section D, Batch (2021-2023)

Name Enrolment number

Abhisake Mishra 21A3HP610

Injimamul Islam 21A3HP633
Naveen Satish 21A3HP622
Shone Padinjakara 21A3HP627
Kavita Kiran Shah 21A3HP624

Submitted to-
Dr. Amith Vikram
Q1.
Explain the difference between traditional costing and ABC costing and discuss the
significance of ABC costing through an example.
• In traditional costing, manufacturing overhead is allocated to products depending on the volume
of production resources required. Costs are accumulated into facility- or department-specific cost
pools in a traditional costing system. Each cost pool's costs are heterogeneous; they are costs from
a variety of major processes and are rarely produced by a single element. Traditional costing
systems allocate expenses to items based on volume: units, direct labour input, machine hours,
income, and so on. Traditional costing is concerned with estimating the cost of a single cost object,
such as a product or service unit. Traditional costing is appropriate for labor-intensive businesses
with low overhead.
• ABC (Activity-Based Costing) is a costing system that focuses on the activities that are conducted
in the production of products. ABC costing is a method of costing in which costs are traced first
to activities, then to products. Costs are accumulated in activity cost pools using the ABC scheme.
These are made to match to significant company activities or processes. Costs in each cost pool
are generally caused by a single factor—the cost driver—by design. The ABC system allocates
costs from activity cost pools to products, services, and other cost items using allocation bases that
correspond to the cost drivers of activity costs. ABC focuses on estimating the costs of a variety
of cost objects: units, batches, product lines, business processes, consumers, and suppliers, to name
a few. Capital-intensive, product-diverse, widely diversified collection of operating activities,
variable in number of production runs, and high-overhead enterprises can benefit from ABC
system.
Consider Company ABC, which has a $50,000 annual electricity expenditure as an example of
activity-based costing. The electric expense is directly proportional to the amount of labour hours
worked. There were 2,500 labour hours worked throughout the course of the year, which is the
cost driver in this case. The cost driver rate is calculated by multiplying the $50,000 annual electric
expense by 2,500 hours, which yields a cost driver rate of $20. The corporation utilizes electricity
for 10 hours for Product XYZ. The product's overhead expenses are $200, or $20 multiplied by
ten.
Q2.
List out the benefits and limitations of ABC costing.
Advantages of Activity Based Costing (ABC)
 Accurate Product Cost - By concentrating on the cause-and-effect connection in the cost
incurrence, ABC improves the accuracy and reliability of product cost estimation. It
recognises that activities, not things, produce costs, and that products consume activities.
 Information about Cost Behaviour - ABC identifies the true nature of cost behaviour and
assists in cost reduction and the identification of activities that add no value to the product.
Managers may control numerous fixed overhead expenses using ABC by exerting more
control over the activities that result in these fixed overhead costs.
 Tracing of Activities for the Cost Object - ABC employs a variety of cost drivers, the
majority of which are transactional rather than volume-based. ABC is also concerned with
all operations within and outside the production in order to track down additional overheads
to the products.
 Tracing of Overhead Costs - Aside from product costs, ABC tracks expenses to areas of
management responsibility, processes, consumers, and departments.

Demerits of Activity Based Costing (ABC)

 Expensive and Complex - ABC is more difficult than typical product costing systems since
it contains various cost pools and many cost drivers. Managing the ABC system may be
costly.
 Selection of Drivers - Selection of cost drivers, assignment of common costs, fluctuating
cost driver rates, and other issues arise throughout the implementation of the ABC system.
 Disadvantages to Smaller Firms - ABC is valuable in different ways for different
organisations. For example, a major manufacturing firm can use it more effectively than a
small one. ABC is also expected to benefit enterprises that use cost-plus pricing since it
provides realistic product costs. Firms that adopt market-based pricing, on the other hand,
may not favour ABC.
 Measurement Difficulties - The measurements required to establish an ABC system are the
system's principal expenses and restrictions. Management must estimate the costs of
activity pools and identify and analyse cost drivers to serve as cost allocation bases in ABC
systems. Even the most basic ABC systems need several computations to estimate product
and service pricing. These measures are too expensive. Activity cost rates must also be
adjusted on a regular basis.
Q3.
What is relevant and not relevant cost? Explain with example.
Relevant cost is a word used in management accounting to indicate avoidable expenditures that
occur only when business actions are made. The idea of relevant cost is utilized to minimize
extraneous facts that might stymie decision-making. Relevant cost, for example, is used to decide
whether a business unit should be sold or kept. If a decision can affect the cash flow, then the
matter is relevant, and the costs of that decision are worth considering.
For example, Naveen Books is considering purchasing a printing press for its medieval book
division. If Naveen Books buys the press, it will eliminate 10 scribes who have been copying
the books by hand. The wages of these scribes are relevant costs since they will be eliminated
in the future if management buys the printing press.
Irrelevant cost are costs that would not be changed by a management choice, whether they are
favorable or negative. When that choice is taken, irrelevant costs such as fixed overhead and
sunk costs are ignored. However, to potentially preserve the company, a management must
be able to differentiate an irrelevant expenditure.
Example - Legal expenses are borne by the Company, which hardly gives any revenue generation.

Q4.
A company is considering a make a new product, in this context explain the relevance of cost
of materials.
If a company decides to keep an asset for use in the manufacture of a new product rather than
selling it, then its cash flow is affected by the decision to keep the asset, as it will now not benefit
from the sale of the asset. This effect is known as an opportunity cost, which is the value of a
benefit foregone when one course of action is chosen in preference to another. In this case, the
company has given up its opportunity to have a cash inflow from the asset sale. Now the company
must decide which costs are relevant to decision-making.
While considering making a new product, there are various types of cost like cost of material, cost
of labour, cost of machinery etc. All these types will be having different cost which may or may
not be relevant.
Suppose the company try to analyze which all cost of raw material is relevant.
Relevant Cost of Raw Material

Units Units Additional information

in inventory required

Material Nil 40 Current purchase price is $7/unit.

A

Material B 100 purchased 150 Current purchase price is $14/unit. The material has
for $10/unit no use in the company other than for the project
under consideration. Units in inventory can be sold
for $12/unit.

Material C 50 purchased for 120 Current purchase price is $22/unit. The material is
$20/unit regularly used in current manufacturing operations.

Analysis
 Material A – As there is no inventory, all 40 units required will have to be bought in at $7
per unit. This is a clear cash outflow caused by the decision to make the new product.
Therefore, the relevant cost of Material A for the new product is (40 units x $7) = $280

 Material B - The 100 units of the material already in inventory has no other use in the
company, so if it is not used on the new product, then the assumption is that it would be
sold for $12/unit. If the new product is made, this sale won’t happen, and the cash flow is
affected. The original purchase price of $10 is a sunk cost and so is not relevant. In addition,
another 50 units are needed for the new product, and these will need to be bought in at a
price of $14/unit.

 Material C – This material is regularly used in the company, so if the 50 units in inventory
are diverted to the new product, then this will mean that inventory will need to be
replenished. To do this, Material C purchases for existing products will be accelerated by
50 units. The current purchase price of $22 will be used to determine the relevant cost of
Material C as this will be the value of each unit purchased. The original purchase price of
$20 is a sunk cost and so is not relevant. Therefore, the relevant cost of Material C for the
new product is (120 units x $22) = $2,640.
Q5.
What are the assumptions of relevant costing and explain the principles of CVP analysis?

Assumptions of Relevant Costing

 The behavior of both costs and revenues are linear throughout the relevant range of activity.
(This assumption precludes the concept of volume discounts on either purchased materials
or sales.)
 Costs can be classified accurately as either fixed or variable.
 Changes in activity are the only factors that affect costs.
 All units produced are sold (there is no ending finished goods inventory).
 When a company sells more than one type of product, the product mix (the ratio of each
product to total sales) will remain constant.

CVP Analysis

CVP analysis involves the analysis of how total costs, total revenues and total profits are related
to sales volume, and is therefore concerned with predicting the effects of changes in costs and sales
volume on profit. It is also known as 'breakeven analysis'. This technique is useful in scenarios
like budget planning, pricing and sales volume decisions, sales mix decisions, cost structure and
production capacity decisions.

Principles of CVP Analysis

CVP analysis assumes of a linear total cost function (constant unit variable cost and constant fixed
costs) and so is an application of marginal costing principles.

 Period fixed costs are a constant amount, therefore if one extra unit of product is made and
sold, total costs will only rise by the variable cost (the marginal cost) of production and
sales for that unit.
 Also, total costs will fall by the variable cost per unit for each reduction by one unit in the
level of activity.
 The additional profit earned by making and selling one extra unit is the extra revenue from
its sales minus its variable costs, i.e., the contribution per unit.
 As the volume of activity increases, there will be an increase in total profits (or a reduction
in losses) equal to the total revenue minus the total extra variable costs. This is the extra
contribution from the extra output and sales.
 The total profit in a period is the total revenue minus the total variable cost of goods sold,
minus the fixed costs of the period.