Acc 561 Managerial Analysis Paper

Absorption Based Costing – Managerial Analysis
Liliana Evans
ACC 561
11 May 2014
Professor Jill Datema

Absorption Based Costing – Managerial Analysis

Absorption based costing method (ABC) is used by companies to identify activities that it performs and then assigns direct and indirect costs to the product’s overall pricing. This method helps businesses determine the cost drivers that influence the product’s sales price by increase or decrease. ABC uses cost drivers, such as, direct labor, direct material along with transaction-based drivers. In this way, long-term variables overheads, traditionally considered fixed costs, can be traced to products (AICPA, 2014). The process used when applying the ABC method
is as follows:

Advantages of Absorption Based Costing ABC is a great method to accurately assign product/service costing to assist in pricing decisions.
Pricing accuracy is due to the utilization of unit cost rather than just total costs. Absorption based costing mirrors how production is done which can help facilitate benchmarking. The ABC method can help Ideal Manufacturing’s management better understand the overhead incurred due to production. “ABC helps management manage overhead and understand profitability of products and customers and, therefore, it is a powerful tool for decision making” (AICPA, 2014). Absorption costing matches costs with revenues to a particular time period. If Ideal Manufacturing is looking to manufacture products to sell at a later time, absorption costing is a method to use for in-house overhead allocation. Through absorption costing, the expense incurred from the production of inventory is not expensed until the inventory has been sold. Therefore, Ideal Manufacturing would have an opportunity to improve profits by periods. Let’s take a look at how costs would be allocate if Ideal Manufacturing used activity based costing for in-house and outside services.
Activity Based Costing Overhead Costs for In-/Out- house
Services Ideal Manufacturing has the following annual costs for each activity cost pool along with cost drivers and estimated drivers:

Activities
Cost Driver
Total Estimated Driver
Annual Costs
Marketing Analysis
Hours of Analysis
15,000 hours
$1,050,000
Product Design
# of Designs
2,500 Designs
$2,350,000
Product Development
# of Products
90 Products
$3,600,000
Prototype Testing
# of Tests
500 Tests
$1,400,000

First, Ideal Manufacturing must calculate what its in-house costs would be to manufacture its product before taking any outside orders. In order to calculate the total manufacturing overhead costs, the overhead rate for each activity must be computed by Total Annual Costs / Cost Driver per activity = Overhead rate.
Activity
Calculation
Overhead Rate
Marketing
1,050,000 / 15,000
$70
Product Design
2,350,000 / 2,500
$940
Product Development
3,600,000 / 90
$40,000
Product Testing
1,400,000 / 500
$2,800
TOTAL
Overhead Costs
$43,810

Now, that each activities’ overhead rate has been calculated, Ideal Manufacturing can compute the expense incurred per activity. Once having its in-bound overhead costs, Ideal Manufacturing will know the base amount needed to recover in-house expenses.
Activity
Calculation
Overhead Rate
Marketing
1,800 * $70
$126,000
Product Design
280 * $940
$263,200
Product Development
10 * $40,000
$400,000
Product Testing
92 * 2,800
$257,600
TOTAL
Overhead Cost
$1,046,800

What follows next, is the calculation of out-housing overhead costs. The total of overhead costs with the addition of the in-house overhead costs will give Ideal Manufacturing an accurate calculation of the expenses incurred to produce 10 products. Calculating overhead cost per activity allows Ideal Manufacturing to see if outside services is worth the trouble and will provide enough profits. By using absorption costing to calculate the overhead costs of outside services, Ideal Manufacturing will have an accurate base expense to apply to the products overall price.
Activity
Calculation
Overhead Rate
Marketing
800 * $70
$56,000
Product Design
178 * $940
$167,320
Product Development
3 * $40,000
$120,000
Product Testing
70 * 2,800
$196,000
TOTAL
Overhead Cost
$539,320

Conclusion Whether Ideal Manufacturing uses the variable costing method or the absorption costing method, the company will be following the requirements under the Generally Accepted Accounting Principles (GAAP). However, depending on the method chosen, profitability and profit reporting will be affect. By using absorption costing, Ideal Manufacturing can accurately allocate expenses and incur the needed revenue to begin recovering loss from R&D and turn the department into a profitable in-/outside servicing department.

References

AICPA, (2014). Absorption Based Costing (ABC). Chartered Global Management Accountant. Retreived on 9 May 2014. http://www.cgma.org/Resources /Tools/essential-tools/Pages/activity-based-costing.aspx