Question

For companies that manufacture several products that use different proportions of manufacturing overhead resources, why does the use of activity based costing provide more reliable product cost information for management decision-making than would traditional costing system that uses a single cost driver to allocate all manufacturing overhead activities/resources? Write your response in a professional manner as if you were responding to the president of your company.

Answer 1

The company needs to know the price incurred to produce single unit of any of the products. It helps in establishing the base price and at the same time helps in determining profitability. If a company is incurring multiple overhead costs and each has its own way of allocation then company needs to undertake Activity based costing. Multiple cost pools allows the company to group costs being that are being affected or influenced by similar cost drivers and to consider cost drivers beyond the usually used cost drivers like machine hours or labour hours. This results in a better and much more accurate distribution of overhead.
while the traditional method basically pools all the indirect costs of production and applies those costs equally across departments using one single and appropriate cost driver such as machine hours.
Activity based costing is often used when accuracy is essential and when there are large number of similar items being produced.