Activity-Based Costing vs Traditional Accounting: A Comparative Study Essay

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Table of Contents

Profitability Under Traditional Accounting Systems
Revised Profitability Estimates Under Activity-Based Costing
Recommendation

Profitability Under Traditional Accounting Systems

Table 1 below summarizes profits and rate of return before tax for the flagship envelope and cup product lines when total production overhead is applied pro-rata according to share of gross revenue.

Table 1

Income Statement

Revenue	Envelopes	Cups	TOTAL
Revenue	Amount	Amount	Amount
Gross sales	$15,000,000	$16,800,000	$31,800,000
Less sales returns and allowances
Net sales	$15,000,000	$16,800,000	$31,800,000
Cost of Sales
Cost of Sales	Amount	Amount	Amount
Total cost of goods sold	$8,250,000	$8,750,000	$17,000,000
Gross profit (loss)	$6,750,000	$8,050,000	$14,800,000
Operating Expenses
Operating Expenses	Amount	Amount	Amount
General/Administrative
Total General/Administrative expenses	2,366,745	2,650,755	5,017,500
Net income before taxes	$4,383,255	$5,399,245	$9,782,500

Rate of Return
Rate of Return	41.3%	47.4%	44.4%

Revised Profitability Estimates Under Activity-Based Costing

Re-assessing the situation using activity-based costing, we first reallocate total production overhead according to what is already known about the three main cost drivers that comprise total production overhead:

Pool 1 = $1,260,000 using machine hours as the cost driver
Pool 2 = $2,257,500 using direct labor hours as the cost driver
Pool 3 = $1,500,000 using the number of quality inspections as the cost driver

The intermediate step is to do cost driver analysis (Table 2), followed by analysis of activity by product (Table 3 below):

Table 2

ACTIVITY	COST DRIVER	Total Units for Cost Driver	Total Cost	Unit Cost
Pool 1	Machine hours	1,850,000	$1,260,000	$0.68
Pool 2	Direct labor hours	1,850,000	2,257,500	1.22
Pool 3	Number of quality inspections	1,850,000	1,500,000	0.81

Table 3

ACTIVITY BY PRODUCT ANALYSIS
			EXPECTED USE		ABC COST ASSIGNED
ACTIVITY	COST DRIVER	UNIT COST	Envelopes	Cups	Envelopes	Cups
Pool 1	Machine hours	$0.68	200,000	50,000	$136,216.22	$34,054.05
Pool 2	Direct labor hours	1.22	34,500	153,625	42,099	187,464
Pool 3	Number of quality inspections	0.81	1,000	6,500	811	5,270
				TOTALS	$179,126.35	$226,788.34

Table 4

ABC COST ALLOCATION OF PER-UNIT OVERHEAD

Overhead costs assigned to envelopes	=	$179,126.35	=	$0.12
Number of envelopes		1,500,000

Overhead costs assigned to cups	=	$226,788.34	=	$0.65
Number of cups		350,000

TRADITIONAL COST ALLOCATION
A. Calculate overhead per direct labor dollar

Total overhead costs	=	$5,017,500.00	=	$2.22
Total direct labor dollars		2,257,500

Envelopes
$2.22 X $ 0.276 =	$0.613	Overhead per unit

Cups
$2.22 X $ 5.267=	$11.693	Overhead per unit

Comparison of Eastvaco overhead per unit
ABC vs. Traditional Methods

	ABC	Traditional
Envelopes	$0.12	$0.61
Cups	0.65	11.69

Recommendation

Considering the above, we discern three crucial advantages to activity-based costing. First of all, it appears that traditional accounting overestimates the production overhead carry that is imputed for both product lines. Second, the more stringent ABC approach reveals that the overhead allocation ratio between the two product lines is closer to 5:1 than the 21:1 that traditional accounting would have us presume. This suggests, thirdly, that there is scope for adjusting envelope pricing upward to at least match the ROI we currently realize for cups.

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