Question

Air United, Inc. manufactures two products: missile range instruments and space pressure gauges. During April, 50 range instruments and 300 pressure gauges were produced, and overhead costs of $94,500 were estimated. An analysis of estimated overhead costs reveals the following activities.

Activities				Cost Drivers		Total Cost
1.		Materials handling		Number of requisitions		$40,000
2.		Machine setups		Number of setups		21,500
3.		Quality inspections		Number of inspections		33,000
						$94,500

The cost driver volume for each product was as follows.

Cost Drivers		Instruments		Gauges		Total
Number of requisitions		400		600		1,000
Number of setups		200		300		500
Number of inspections		200		400		600

(c)

Write a memorandum to the president of Air United explaining the benefits of activity-based costing.

Answer 1

Advantages of Activity Based Costing (ABC):

The following are the advantages of ABC:

1. Accurate Product Cost:

ABC brings accuracy and reliability in product cost determination by focusing on cause and effect relationship in the cost incurrence. It recognises that it is activities which cause costs, not products and it is product which consume activities. In advanced manufacturing environment and technology where support functions overheads constitute a large share of total costs, ABC provides more realistic product costs.

ABC produces reliable and correct product cost data in case of greater diversity among the products manufactured such as low-volume products, high-volume products. Traditional costing system is likely to bring errors and approximation in product cost determination due to using arbitrary apportionment and absorption methods.

2. Information about Cost Behaviour:

ABC identifies the real nature of cost behaviour and helps in reducing costs and identifying activities which do not add value to the product. With ABC, managers are able to control many fixed overhead costs by exercising more control over the activities which have caused these fixed overhead costs. This is possible since behaviour of many fixed overhead costs in relation to activities now become more visible and clear.

3. Tracing of Activities for the Cost Object:

ABC uses multiple cost drivers, many of which are transaction based rather than product volume. Further, ABC is concerned with all activities within and beyond the factory to trace more overheads to the products.

4. Tracing of Overhead Costs:

ABC traces costs to areas of managerial responsibility, processes, customers, departments besides the product costs.

5. Better Decision Making:

ABC improves greatly the manager’s decision making as they can use more reliable product cost data. ABC helps usefully in fixing selling prices of products as more correct data of product cost is now readily available.

6. Cost Management:

ABC provides cost driver rates and information on transaction volumes which are very useful to management for cost management and performance appraisal of responsibility centres. Cost driver rates can be used advantageously for the design of new products or existing products as they indicate overhead costs that are likely to be applied in costing the product.

7. Use of Excess Capacity and Cost Reduction:

ABC, through the processes of pooling of activity costs and the identification of cost drivers, can lead to a range of applications. These include the identification of spare capacity and the fostering of cost reduction by comparing the resources required under ABC with the resources that are currently provided. This provides a platform for the development of activity-based budgeting in which the resource relationships identified by ABC are used to project future resource requirements.

8. Benefit to Service Industry:

Service organizations, such as banks, hospitals and government departments, have very different characteristics than manufacturing firms. Service organizations have almost no direct costs, most of the costs are overheads and they do not hold stocks of service as the service is consumed when it is produced. Traditional costing has generally been considered inappropriate for these organizations, whereas ABC offers the potential of benefits from improved decision making and cost management.

The benefits of implementing ABC include:

o It helps you identify all the overheads caused by the same activities.

o One can easily identify the cost drivers for each activity thereby allowing you to control costs at their source.

o It can help you identify, for example, profitable products, services, processes, activities, customer segments, distribution channels, contracts and projects. This should help you when making pricing, product/service mix and design decisions.

o ABC allows for continuous improvement. By thoroughly measuring and looking at the costs and cost drivers of different processes and activities, improvements can be made. For example, by knowing the cost drivers, cost reduction can be achieved, either through outsourcing particular activities or moving to different areas in the industry value chain.

Managers are always looking for more effective ways to figure out the cost of their products. In the case of the Ultimate Planner, that we have been discussing during this module, getting all of the costs, from direct materials, direct labor and overhead, into the cost of the product will allow managers to appropriately price the product so the company can make a profit on each sale. If we miss allocating one of the indirect costs to our products, we are missing out on a cost, thus lowering our potential profit. So when we look at traditional costing versus activity based costing, how can we decide which one makes the most sense for our business?

Traditional costing will have one rate for allocation of overhead for the entire business operation, while activity-based absorption costing creates multiple cost pools. The ABC system can be extremely complicated and difficult to implement. Traditional costing is easy to implement and is the most common costing method used.