Question

1) Select the type of manufacturing company that would most benefit from activity based costing:

	Overhead costs compared to Total Product Costs	Product Diversity
(A)	Low	Little
(B)	Low	Considerable
(C)	High	Little
(D)	High	Considerable

		(A)
		(B)
		(C)
		(D)

Answer 1

Answer – option (D)

Overhead Costs compared to total product costs – HIGH

Product Diversity – Considerable

Considerable product diversity indicates greater likelihood for cost distortion when using traditional costing methods. ABC system provides a basis for cost allocation by identifying the activities for each product. Total activity costs are allocated to products based on their usage.

Manufacturing companies where overhead costs form a considerable portion of product cost require a more realistic allocation basis to products so as to provide a reasonable cost estimate.

Unlike traditional costing methods, ABC aims to assign overhead cost to products based on the proportion of their actual usage by the products. The approach ensures that products are assigned costs in proportion to their usage of that particular cost pool. Using a single plantwide overhead rate does not consider the product usage of a specific activity pool but allocates overhead based on the common allocation basis such as direct labor hours.

Manufacturing companies with high overhead cost and considerable product diversity would benefit from ABC method in identifying the activity pools and activity pool usage by products. This enables assignment of costs based on their actual usage of resource. So, if a particular product does not use a resource, its cost is not allocated to the product. The approach provides a more realistic basis for cost estimation and profitability calculation.