Question

You have just taken a job at a manufacturing company and have discovered that they use one predetermined overhead rate to apply manufacturing overhead costs. You would like to introduce them to activity based costing and explain to them why this costing method can be used and why it is helpful.

Compose a short email - 2 to 3 short paragraphs because the president it too busy to read anything longer than that - proposing an activity based costing system and what that might mean for product costs and management decisions. You could give a brief example if you feel that is necessary for your explanation to the president.

Answer 1

President,

Subject: introduction of Activity-based costing

Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services.

1. The ABC system is based on activities, which are considered any event, unit of work, or task with a specific goal.

2. An activity is a cost driver, Eg: purchase orders or machine setups.

3.The cost driver rate, which is the cost pool total divided by cost driver, is used to calculate the amount of overhead and indirect costs related to a particular activity.

Major Advantage: This costing system is used in target costing, product costing, product line profitability analysis, customer profitability analysis, and service pricing. Activity-based costing is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy.

EXAMPLE:

Cost under Traditional costing

Direct materials	25,000
Purchased components	35,000
Labor cost	15,600
Manufacturing overheads ($270 × 250)	67,500
Total cost under traditional product costing system	143,100

XYZ bills Platinum at cost plus 25%, so the amount of sales to be booked would amount to $178,875 (= $143,100 × 1.25).

Cost under ABC:

	(A)	(B)	(A × B)
Activity	Activity Rate	Activity Usage	Activity Cost Assigned
Production of components	93	320	29,760
Assembly of components	62	250	15,500
Packaging	43	150	6,450
Shipping	46	150	6,900
Setup costs	143	15	2,145
Designing	123	70	8,610
Product testing	48	22	1,056
Rent	75%	15,600	11,700
			82,121

Total cost of the order is hence:

	US$
Direct materials	25,000
Purchased components	35,000
Labor cost	15,600
Manufacturing overheads	82,121
Total cost under activity-based costing	157,721

Based on the more accurate estimation of the order cost, the invoice should be raised at $197,150 (=$157,721 × 1.25) instead of $178,875 calculated under traditional product costing system.