Student ID Number: 230025622

Task-Business Report on Case Study

ABC Vs. Traditional Costing Method

MBA in health care management

Module Code MBB7008M

Module Title Accounting and Finance for Decision making

Module Tutor Dr. Fawas

Student Name Mazen Hani Abu-Hudeib

Student ID ID Number: 230025622

Assignment Title Task-Business Report on Case Study

Final report submission 24/12/2022

Word counts:

 Executive summary – 98 words.

 Introduction and main body- 1589 words.

Page | 1
Student ID Number: 230025622

Declaration

I, Mazen Hani Abu-Hudeib, declare that, unless otherwise mentioned, I am the only author

of this assignment and that all research was done by myself. I correctly cited every source.

Page | 2
Student ID Number: 230025622

Executive summary of the given report:

This report provides a clear, practical illustration of how two different costing

methodologies differ, the widely adopted activity-based costing (ABC) methodology and the

traditional costing methodology. In addition to outlining both approaches in this study, we also

provide a practical illustration of a computation that employs each approach. We also

acknowledge the causes of the numerical shift that occurred because of utilizing both

approaches. We demonstrate how this shift impacted all created items' revenue and selling price.

At the end of this report, we will discuss the pitfalls to avoid when introducing an ABC system

into a business.

Page | 3
Student ID Number: 230025622

Table of Contents:

Content Page

Declaration 2

Executive Summary 3

Introduction 4

Calculations 5

Reasons for change in costs per unit when the costing system was changed 8

Potential cost management implications of switching to an ABC system 9

Effects on pricing and product profitability from switching 9

Possible Pitfalls to avoid when introducing an ABC system into the business 10

Page | 4
Student ID Number: 230025622

Afreen Trading

Afreen Trading is a business situated in the United Arab Emirates that produces, exports,

and supplies stunning ladies' handbags in the colors white, brown, and purple. These handbags

are all made from the same raw material, including pearl buffalo horn plates. The corporation

employed direct labor hours to allocate overhead costs to its product using traditional full

costing. The Company is currently considering an activity-based costing system to increase its

profitability. This abrupt adjustment is being made to determine the exact cost of each product

and its profit per unit. The following information is provided for the three handbags:

White Brown Purple

Production Volume (Units) 30,000 24,000 36,000

Raw materials per unit (kg) 1.5 2.4 3.0

Direct materials cost per unit ($) 3.6 5.76 7.2

Direct Labour hours per unit (hrs) 0.2 0.3 0.4

Direct labor cost per unit ($) 5.92 8.88 11.84

Other operational Data

Machine hours per unit (hrs) 0.5 0.7 0.9

Production runs 32 24 16

Number of Purchases 48 56 84

Number of Deliveries 96 60 124

Selling price per unit ($) 18.5 35 40

The price for raw materials per kilogram is $2.40 and the direct labor cost per hour is

$29.60. The annual overhead costs, along with the relevant cost drivers, have been analyzed

below:

Page | 5
Student ID Number: 230025622

Overhead Cost Centre Cost Driver $

Machine setup costs ($) Production Runs 74,000

Machine Running costs ($) Machine hours 120,000

Purchasing Costs ($) Number of Purchases 94,000

Delivery Costs ($) Number of Deliveries 112,000

Total 400,000

(a) i. Cost per unit under complete absorption

Total yearly overhead expenses: $

cost of machine setup 74,000

Machine maintenance fees of 120,000

Purchase expenses 94,000

Costs of delivery 112,000

400,000

Rate of overhead absorption:

White Brown Purple Total

quantities produced 30,000 24,000 36,000 90,000

hours of labor per unit 0.2 0.3 0.4

Total hours worked 6,000 7,200 14,400

27,600

Page | 6
Student ID Number: 230025622

Consequently, the overhead absorption rate is $400,000 divided by $27,600, or $14.49 per

hour.

Pricing per unit:

White Brown Purple

$ $ $

Raw materials ($2.40 x 1.5/2.4/3.0) 3.60 5.76 7.20

Direct labor ($29.60 x 0.2/0.3/0.4 hrs) 5.92 8.88 11.84

Overhead ($14.49 x 0.2/0.3/0.4 hrs) 2.98 4.47 5.96

Total cost per unit 12.50 19.11 25.00

ii. Price per unit using the ABC method

Cost factors:

Cost pools $ Price driver

cost of machine setup 74, 000 72 production runs (32 + 24 + 16)

Machine maintenance fees 120,000 64,200 machine hours (15,000 + 16,800

+ 32,400)

Purchase costs 94,000 188 purchase order (48 + 56 + 84)

Delivery costs 112,000 280 deliveries (96 + 60 + 124)

400,000

Cost per machine set up $74,000/72 = $1,057.14

Cost per machine hour $120,000/62,400 = $1.9230

Charges per order $94,000/188 = $500

each delivery fee of $112,000/280 = $400

Allocation of overheads to each product:

Page | 7
Student ID Number: 230025622

White Brown Purple Total

$ $ $ $

Machine set up costs 32,889 24,667 16,444 74,000

Machine running costs 28,037 31,402 60,561

120,000

Purchase costs 24,000 28,000 42,000 94,000

Delivery costs 38,400 24,000 49,600

112,000

123,326 108,069 168,605

400,000

Numbers of units produced 30,000 24,000 36,000

$ $ $

Cost of overhead per unit 4.11 4.50 4.68

Total cost per unit White Brown Purple

$ $ $

Materials 3.60 5.76 7.20

Labor 5.92 8.88 11.84

Overheads 4.11 4.50 4.68

13.63 19.14 23.72

(b) The reason for the changes in cost per unit was when the costing system was changed

from traditional absorption to ABC.

Page | 8
Student ID Number: 230025622

Below is a summary of the overhead expenses broken down by production volume.

Product White Brown Purple

Volume 30,000 24,000 36,000

Traditional overheads $2.98 $4.47 $5.96

ABC overheads $4.11 $4.50 $4.68

It is clear how the move to activity-based costing has affected things: Purple's overhead has

dropped, whereas that of White and Brown has increased. This alteration was done better to

comprehend their production costs and profits per unit. To do this, the Company examined its

handbag manufacturing volumes, handbag costs, and drivers of pertinent overhead expenditures.

Adjustments in cost per unit were necessary to transition from complete absorption costing to

ABC; these changes will be covered in more detail in the following paragraphs.

This agrees with those who think ABC provides more egalitarian unit costs that fairly reflect

the labor involved in producing different products. The purple purse is an example of this, as it

may take longer to make than the white or brown goods but is simpler to handle once it has

started. The lengthy production lines may be the cause of this. The demand for White and Brown

handbags isn't very high. Even so, while they only require a small amount of "trouble," the

administrative staff must devote a significant amount of time to them.

(c) The potential cost management implications of switching to an ABC system

Costs incurred due to work being done are referred to as marginal costs. They would include

the labor and the materials in this scenario. Total absorption costs is the term used when

overheads are taken into consideration. For many firms, overheads are fixed by nature and

remain the same regardless of changes in the workforce. Any attempt to allocate expenses to

items (by, say, work hours) would traditionally be arbitrary and offer little real value to the

Page | 9
Student ID Number: 230025622

outcome. The overhead absorption rate is virtually useless because it is just the average of these

costs (over labor hours). By switching to marginal costing, the issue of budget volume

unpredictability would also be resolved. To determine the fixed cost absorption rate, budget

volume is required.

A shift away from total absorption cost could be advantageous because managers and

customers can better comprehend the marginal cost. If overheads are omitted from the cost

allocations, the costs would still need to include a more significant margin to cover them. In the

end, revenues must meet all expenses to generate a profit. More costs can be directly attributed to

products if the activities that generate costs are identified, eliminating the requirement for the

arbitrary allocation of numerous overhead costs.

Any firm must perform the duties of cost identification, measurement, and management. Cost

drivers and cost-cutting methods allow organizations to improve efficiency by giving them

information about how their business is run. Businesses can manage costs and remove waste by

precisely identifying cost drivers. Organizations can make decisions that optimize operations and

boost profits by thoroughly analyzing the cost drivers. The most crucial and expensive tasks in a

company can be determined by identifying the cost drivers. Organizations can identify the most

profitable activities and areas for possible savings by precisely assessing the expenses.

(d) The effects on pricing and product profitability from switching traditional absorption

costing to an ABC System.

Switching to ABC could drastically change cost-per-unit calculations, as it did in this case.

As a result, if a business sets its selling prices using cost-plus pricing, those prices fluctuate. The

Company must correctly price its products to maintain its position in the marketplace and hit its

desired revenue and profitability goals. To maintain fair and competitive rates, the Company

Page | 10
Student ID Number: 230025622

must be able to compute the cost of its products and services with greater accuracy. Additionally,

it enables clients to decide intelligently regarding the expenses related to buying goods and

services from the Company. The Company gains for itself and its consumers by appropriately

pricing its items. Always remember that overhead costs should not be considered when making

company decisions if they are virtually set. While switching to ABC can change reported

earnings per unit, contribution per unit should be more weight.

It might be difficult to transition from classic absorption costing to an activity-based costing

(ABC) system without analyzing the organization's data and procedures. Determining how to

distribute expenses to products entails looking at procedures, production, and overhead costs.

Switching to ABC could depending on the product, dramatically affect cost-per-unit estimates,

necessitating a corresponding adjustment to prices. Potential dangers include erroneous cost

allocations or under- or overinvesting in certain activities. Additionally, existing cost-plus

pricing techniques that a corporation may have may need to be modified to reflect the

modifications made by the new system.

(e) Possible pitfalls to avoid when introducing an ABC system into a business

Page | 11
Student ID Number: 230025622

A thorough review of the organization's data and operations is necessary before

implementing an activity-based costing (ABC) system. Understanding how to distribute expenses

to certain items, such as production and administrative expenditures, is necessary. Changing to

ABC could dramatically change cost-per-unit estimates and necessitate revising prices, depending

on the product. Additionally, to reflect the changes the new system will bring about, cost-plus

pricing techniques may need to be modified.

Pitfalls:

- A requirement for understanding. Many managers need help to fully accept ABC as a cost-

control technique since they need to understand it fully.

- Difficulty in identifying elements that affect costs. It can take time to identify the proper drivers

in a real-world situation. For instance, it may take work to pinpoint a single factor for the high real

estate prices.

Page | 12
Student ID Number: 230025622

- the requirement for precise accounting records. Change is discouraged since ABC needs a new

set of accounting records but this is often not possible right now. It takes some time to establish

new cost pools.

ABC systems entail detecting and assessing numerous costs, activities, and cost drivers to

cut costs. This study is carried out by creating a system or diagram to represent the cost-activity

relationship. The diagram or system provides a visual representation of the numerous activities and

their relationships to the cost of production. Direct material, direct labor, and overhead costs are

the three categories of cost drivers, and both internal and external factors can affect them.

Page | 13
Student ID Number: 230025622

References

Ness, J. C. T., 1995. Harvard Business Review. Online at: https://hbr.org/1995/07/tapping-the-

full-potential-of-abc [Accessed 15 Dec. 2022]

Sherman, F. 2019. Bizfluent. Online at: https://bizfluent.com/12811167/absorption-costing-vs-

activity-based-costing-for-decision-making [Accessed 15 Dec. 2022]

Wilkinson, J. 2013. The strategic CFO. Online at: https://strategiccfo.com/activity-based-

costing-abc-vs-traditional-costing/ [Accessed 15 Dec. 2022

Page | 14