Question

Rock Fitness Inc. is a high-end athletic gear supplier. The production of gear involves many complex and specialized activities that before now have lacked organization or procedural direction. The production manager has mentioned recently about changing and applying a simple yet effective costing system to improve on efficiency of production and wants your advice about activity-based costing (ABC). While your advice has been solicited, the production manager has also stated that interrupting the existing costing system would be a detriment to the factory. Instead, the production manager has asked you to prepare a memo to the executive board explaining how implementing an ABC system is far too complicated and does not provide an overall benefit to the company. In contrast, as the entry level accountant, you have knowledge and have verified that an ABC system would in fact assist the company more effectively in identifying the basis of costs and how to actually regulate the costs.

Questions: Discuss the issues and ramifications of fulfilling the production manager’s request and how it effects the company. How would you handle this situation and what action would you take to ensure that the cost benefit constraint of selecting a valuable costing system is not ignored?

Answer 1

Advantages of Activity-Based Costing

• Provides realistic costs of manufacturing for specific products
• Allocates manufacturing overhead more accurately to products and processes that use the activity
• Identifies inefficient processes and target for improvements
• Determines product profit margins more precisely
• Discovers which processes have unnecessary and wasted costs
• Offers better understanding and justification of costs in manufacturing overhead

Disadvantages of Activity-Based Costing

• Collection and preparation of data is time-consuming
• Costs more to accumulate and analyze information
• Source data isn't always readily available from normal accounting reports
• Reports from ABC don't always conform to generally accepted accounting principles and can't be used for external reporting
• Data produced by ABC may conflict with managerial performance standards previously established from traditional costing methods
• May not be as useful for companies where overhead is small in proportion to total operating costs

ABC produces more accurate costing of products by essentially converting broad indirect costs into direct costs of production. It determines the costs of the various sources of indirect costs and allocates these expenses to the specific activities that use them.

Issue of following managers advice leads to improper allocation , So will try to explain advantages as mentioned above to manager.