Question

Saddleback Farms Inc. is a small agriculture-based company located on Nevis, one of the twin islands of the St. Kitts Nevis Federation. It utilizes ten (10) acres of land for growing coconuts, mangoes, avocados, various cash crops, and bushes for the manufacture of various teas for the local and regional markets. The owner/manager, Mr. Sylvester Livingstone and ten employees operate the farm. Mr. Livingstone believes that the pricing of products is flawed and engaged your firm to advise on any improvements he should make. Your firm assigned you to the task and after touring the Farm and holding discussions with key personnel, you discovered that the company uses a single rate based on direct labor hours to allocate overhead to product instead of activity-based costing.

Required: Write a letter to Mr. Livingstone discussing the pros and cons of single rate and activity-based costing to allocate overhead. Be sure to define terms and distinguish between the two approaches and then discuss the pros and cons for each. Conclude with making a recommendation on which approach the company should adopt.

Answer 1

Dear Sir,

Saddleback Farms Inc. is currently using traditional costing to allocate overhead to product based on direct labour hours.In this method, an average rate based on the total labour hours is used to allocate overhead to different products.

In actvity based costing, activity rates are calculated based on activity drivers and cost is allocated to each product based on the quantity of activity drivers per product.

The pros and cons of activity based costing vs traditional costing are mentioned below:

- Traditional costs applies the overhead to all products. However, not all products require the support of all overhead costs, thus allocating oveheads to all products is unreasonable.

- Activity based costing gives more accurate results than traditional costinga as the latter used a blanket rate to allocate overheads.

- Traditional method of costing is becoming increasingly obsolete as compared to activity based costing.

- Traditional costing is easy to implement whereas activity based costing is complex.

I would recommend that you use activity based costing by identifying cost drivers as this would result in accurate costing for your products even if more efforts are required.

Regards,

XYZ