1. Introduction 3
2. Traditional costing system and its limitations 3
3. Activity-Based Costing 4
4. Case Question 4
5. Analysis of the different result between traditional costing system and ABC system 5
6. Limitations of ABC system 6
7. Conclusions and Recommendations 6
8. References 7
Eastside Medical Testing performs five different tests T1 to T5 to detect drug use. Nuclear Systems, Inc., is one of the few companies that required T1. It accounts for almost half of the 3500 T1 tests conducted in the prior year. Recently, Ro Worth, vice president of operations at Nuclear Systems, questioned that the relatively high price being charged for T1. The price for a T1 test is $35, which is higher than the next most expensive test by 40%. Worth thinks that his company is being taken advantage of because they are one of the few companies requiring that T1 test and Eastside Medical Testing. Emmet Wilson is the founder and owner of the company. Before he responding to Worth’s letter, he reviewed the revenue and costs related to the tests. T1 produces a profit of $6.5 per test, which is much higher than the profit of any other test. But he has wondered whether the profitability of T1 is distorted by the company’s simple approach to allocating overhead. The company is using traditional costing system and the overhead allocation is based on direct labor cost. Direct labor is only 10% of the total overhead. And he began to analyze the overhead costs and calculate the ABC cost of the five tests. This article is going to compare the traditional costing system and ABC system. And analyze the benefits and limitations related to both systems.
2. Traditional costing system and its limitations
Traditional based costing is an accounting method that uses a single cost driver to allocate indirect manufacturing costs. Sometimes referred to as the conventional method, traditional costing assigns a single cost driver such as machine hours, direct labor hours or unit volume to several products. (Akers) There several steps in the traditional costing process. First, managers should identify indirect costs and estimate for a certain period. After that, cost-driver with a causal link to the cost is determined. And the certain amount of cost –driver for the certain period is estimated. In this case, direct labor cost are being used as the cost driver, total overhead costs would be divided by the total cost of direct labor. This figure is referred to as the predetermined overhead rate, which is then multiplied by the product's per-unit overhead cost. Using the cost driver of direct labor hours, per-unit overhead cost is determined by dividing the estimated total direct labor costs per product by the individual production volume.
The traditional method of apply manufacturing overhead fails to help managers with decisions making. Since traditional costing system does not identify specific cost drivers or an accurate per-unit cost. Management can gain little useful information to make judgments about production activity, product enhancement or discontinuation. Traditional based costing is too overall as it does not take into unique product features. So it is common to overestimate the cost of high-volume, simple product or low-volume, complex products under traditional costing system. And it fails to identify the costing part of indirect activities and in hence managers will not be able to control the cost with a single cost driver.
3. Activity-Based Costing...