Question

Johnson Associates is a catering firm in Tucson, Arizona, with revenue of $4 million. The business began ten years ago as a one-owner bakery, but has dramatically changed in size and function during the past five years. The four partners foresee the business doubling in sales revenue within two years, and expect the firm to expand into other services including flowers, furnishings, decorations, and music. Johnson Associates employs six full-time and ten part-time employees. The four partners also work full-time, each partner managing a separate business function. The firm currently uses a volume-based costing system installed seven years ago and modified three years later.

Required: (a) With just the above information, comment on Johnson Associates changing and future costing system needs. (b) Is Johnson Associates a probable candidate for an activity-based costing system (ABC)? Why or why not?

Answer 1

Volume based cost accounting system :

Traditional product costing system is also referred to as functional-based cost accounting system or volume-based costing system. Under taditional product costing system, it determines product cost by way of allocating, direct costs to the products and then subsequently adding a proportion of overheads deemed to be related to the units produced.

Remarkable changes have taken place in production methods, organisational structure, cost behaviour and magnitudes. Overheads now-a- days constitute a very high proportion of total costs as compared to direct labour. Support func­tions and their costs have shown increasing trends continually. Thus, at present, overheads are less affected by production volume (as in conventional costing), but more by range and complexity of products manufactured.

The following are the limitations of volume-based costing system:

- It creates a bias toward direct labor reduction as a cost reduction technique

- Different products utilize different amount of resources which is not recognised by volume based system

- Overheads now constitutes larger part of Cost of a product, which is not appropriately considered in Volume based system

Company is in the business of catering services and now they have diversified in to decoration, furnishing, flowers and music which are all supportive products and services along with its main service catering. Volume based system will not provide proper justification for costing of company as now newly and different services and products are added in company's basket which requires proper costing.

Activity based costing is an modern method of cost recognising and reducing which aims to provide proper accounting of overheads on appropriate basis. It assigns overheads based on pre determined factors which are alloted to all products or services of company. As company has added new services and products ABC will best fit its costing system as it will help to derive true and correct cost for each of its services.

There can be constraints like deciding an parameter for allotment of Overhead cost to various products and calculating the amount of overheads costs and variety of products to which it belong. Broad Groups or segment wise Services or product classification can be used to provide with proper costing and achieve accurate cost of products.