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Why there are Differences in Costing arise when an ABC system replaces a Traditional Cost System?

When an ABC system replaces a traditional cost system, high volume products generally end up costing less and low volume products end up costing more than under the traditional system. The reasons for this are as follows: Under traditional costing, all overhead costs are assigned at the per unit level (e.g. per DLH). Therefore, any product that has more units of the base used for allocating overhead (e.g., DLHs), will get assigned more cost. This is also true of batch level costs like machine set-up cost, and any other costs which are not driven by the number of DLHs but by some other activity units. However, the problem is particularly a problem for batch type costs like machine setup costs. Under traditional costing, these costs are usually assigned to products on a unit level basis as one component of the single plant-wide overhead rate (based on estimates done at the beginning of the year). If batch sizes are the same for all products, this is not an issue. However, if batch sizes are smaller for low volume products and bigger for high-volume products, then this is a problem. This has the effect of assigning set-up costs to all products regardless of the size of a batch or the number of batches actually run for a given product. All that matters is the number of units produced in terms of the allocation base (like DLHs) for a given product. As a result, higher volume products end up having higher assigned set up costs in total than low volume products simply because the cost is applied per unit there are more units to charge for high volume products. This is the exact opposite of what should happen in fact (because high volume products often run larger sized batches). A fixed set-up cost should be the same in total for all batches and cheaper per unit for high volume/large batch size products because you can spread the fixed setup cost over more units. Under an ABC system, this problem is remedied because costs are assigned in two stages: In the first stage, batch costs are assigned to the total product cost based on the number of batches used to make all the units of a given product. Once this amount is determined, then you can divide it by the number of units produced to convert it to a per unit cost basis (second stage). That is, batch level costs are first assigned to a batch-based activity (e.g. #of batches). Once this is done in total for a given product, then you can divide buy the number of unit produced to convert it to a cost per unit. Most setup costs are essentially fixed with respect to the size of the batch. Large sized batches would result in fewer batches being run. When divided by the number of units produced, the per unit cost for setups for high volume products would actually be lower. But, for products with small batch sizes, more batches would have to be run resulting in a higher total cost for setups. When divided by the number of units produced, this would result in a higher cost per unit for the smaller volume product. In summary, under ABC, batch costs like machine setups reflect the true cost per unit, unlike the traditional method where batch costs penalize the product with the most units regardless of batch size or number of batches run.

This two-stage assignment of costs (first to the batch level activity, then to the units of product) has the effect assigning a higher unit cost to low volume products with small batch sizes and a lower unit cost to higher volume products with large batch sizes. The same effect also occurs with product level costs. This two stage assignment of cost typically results in high-volume products being cheaper and low volume products more expensive under ABC. Also, under traditional costing, costs are assigned to products even though the product may not have used any of the resources that gave rise to the cost. e.g. product design costs are assigned to all products even though not all products used product design resources. Under ABC, costs are assigned only if the cost object used the resource or activity that caused the cost. In the case of product design costs, you would first assign the design costs to the products that used this activity, and then you would divide by the number of units of each product. Example of How Traditional Job Costing Penalizes High Volume Products When the Overhead Cost is a Batch level Cost # of units produced: Average size of a batch: Product A = 40,000 units A 2,000 units Product B = 10,000 units B 500 units 50,000 units Cost of setup per batch = $1,000 Total setup cost for the year = 40 batches x $1,000 = $40,000 Assignment of Set-up Costs, Traditional Job Costing (one stage costing) Total set-up costs for the year = $40,000 Set up costs/unit for all units produced = $40,000/50,000 units = $0.80/unit Total set up cost assigned to Product A = 40,000 units x $0.80/unit = $32,000 (as part of overhead applied) Total set-up cost assigned to Product B = applied) 10,000 units x $0.80 /unit = $8,000 (as part of overhead

Assignment of Set-up Costs When Set-up is treated as a separate Batch-level Activity (two stage costing) Product A Set-up cost per batch $1,000 # of units produced 40,000 Average size per batch 2,000 units # of batches 40,000/2,000 = 20 batches Product B $1,000 10.000 500 units 10,000/500 = 20 batches

Product Total setup cost # of units prod. Cost/unit for setup costs

Product A 20 x $1,000 = $20,000 40,000 $20,000/40,000 = $0.50/unit

Product B 20 x $1,000 = $20,000 10,000 $20,000/10,000 = $2.00/unit

Note: under traditional costing, the lower volume product, Product B, is assigned a cost of $8,000 whereas under ABC, Product B is assigned a cost of $20,000 . Likewise, the higher volume product, Product A is assigned a cost $32,000 under the traditional method but only $20,000 under ABC. The ABC method reflects the cost of the setups actually used by each product and takes into account the smaller batch sizes for product B. This is not done under the traditional system. Batch costs like Setup costs are simply allocated on the basis of total number of units produced regardless of the number of setups actually used.