Question

A Dance Studio sells all types of items for dancing.

Some items are inexpensive ribbons, while some are expensive, made-to-order dresses. Some items are sold to individuals while others are bought in large quantities by dance companies. The manager does not understand why many of those long-term customers are finding other suppliers.

The company uses a conventional costing system and maintains only a single overhead allocation basis for all types of customers and all products are assumed to share same amount of time and effort.

Required:
Explain why so many long-time customers are finding other suppliers and what changes to the costing system might be useful to avoid losing further customers.

Answer 1

The long-time customers are most likely finding other suppliers because they are getting better value from them, i.e, they are getting better prices.

Dance Studio sells expensive made to order dresses as well as inexpensive ribbons. While some items are sold to individuals in small quantities, others are sold in bulk to dance companies. Therefore, there is both product and volume diversity, which indicates that the items sold in bulk and those sold in small quantities have different demands on resources and activities.

The problem is that the company uses a conventional cost accounting system for allocation of overhead costs, using a single overhead cost pool and a single cost driver. This results in overcosting for some items and undercosting for others. This in turn leads to overpricing for some of the items, and the long term customers have successfully found other suppliers selling the same or similar products cheaper.

Therefore, in order to avoid over or undercosting of products, the company should adopt activity based costing, a system in which overhead costs are allocated to cost objects on the basis of volume of activities consumed. Activity based costing is based on the premise that the cost object consumes activities, and the activities consume resources. Therefore an attempt should be made to identify the activities consumed by each product line, and the cost driver for these activities. There would be as many overhead cost pools as there are activities. An activity rate would be computed for each cost pool on the basis of the volume of cost drivers consumed by each product line, and accordingly, overhead costs are assigned to the product. This removes any element of arbitrariness in the allocation of overheads. Overcosting and overpricing can be avoided as costs are assigned more accurately than in the conventional method.