Question

Let’s consider costing for a service organization. Assume you are a consultant for a law firm. The firm currently has no traditional cost accounting system in place. A partner has taken a course in management accounting and wants to understand traditional and activity based costing. Explain to the partner how a traditional overhead rate is determined and what would be a good denominator activity to use as the base. Also explain what is meant by activity-based costing and how it would might lead to better decisions for the firm.

Answer 1

Under traditional costing the overhead allocated using one single predetermined rate for all the activities. Predetermined overhead is the rate which is used to apply overhead to services and is usually completed and calculated at the beginning of the year by dividing the overhead cost with the allocation based. In manufacturing industries there are a number of overhead and overhead base which can be use to predetermine the overhead rate like direct materials, direct labour and other manufacturing overhead and they would have multiple predetermined rate available for each activity. In service industry, the allocation is mostly on the manual hours that is inputted based on which we can calculate the overhead rate for the industry. Therefore, a good denominator activity to use as the base to determined overhead rate is total employee hours.

Activity based costing is the new method to determine the overhead rate and allocate overhead costs. It is the overhead cost allocation system which allocates overhead to multiple acitivity cost pools and assigns this activity cost pools to services by means of a cost drivers that represent the activities used. Activity is the event or transaction that causes a cost to be incurred in providing a service. Activity cost pool is the overhead cost which is attributed to different type of activity. Cost drivers are any activity that has a direct relationship with the resources consumed. The activity based costing segregates the overhead rate into various cost pools to provide more accurate cost information. It enhances control over the overhead cost. It is uses more cost pools to assign overhead rate which would help in making effective management decision.