Question

Cintra is the Management Accountant of Fine pens Ltd. The company manufactures various types of pens ranging from cheap disposable units to expensive units which are intended to be reusable. Both ball point pens and fountain pens are produced. The current cost allocation system in use is Absorption costing.and Cintra is very comfortable with the use and application of this costing method.

Ram has recently joined the company in a senior capacity. Both Cintra and Ram were recently discussing the current costing method and another method, namely Activity based costing. Ram suggested a switch to Activity based costing as the method of cost allocation .

Required:

a) Briefly state why Ram may have suggested such a switch . Relate to the scenario described above.                                                                      

b) List and briefly describe 3 advantages of Activity based costing over Absorption costing.                                                                                        ( 3 marks)

Answer 1

a) Activity based costing

Activity based costing system identify the company's activities and analyse the indirect cost based on these activities and then assign the cost to the individual unit of production based on the activity usage. For example, inspection and testing cost will be assigned to each unit based on direct labour hour, machine setup cost is assigned based on number of setup. etc.

Absorption costing

Absorption costing system assign the total manufacturing cost to all the units produced by the company. Under absorption costing, the unit cost include direct material, direct labor and variable and fixed manufacturing overheads.

Ram might have suggest such a switch as under absorption costing manufacturing overhead allocated to cheap disposable units and expensive units which are reusable are same. Whereas under ABC system, first the activity will be determined, then the cost driver and after cost is assigned based on cost driver. It is possible that manufacturing overheads are more for the expensive units then the cheap disposable unit, which can be determined under ABC system.

b) Advantages of activity based costing over Absorption costing

1. It provide more accurate cost of the individual unit - As the cost is assigned based on specific activity pool and cost driver, cost of the unit is more accurate then absorption costing where even if the activity usage is less for some specific units cost assigned will be same as other units.

2. It identify the nature of the cost: ABC identify the activity and based on that assign the cost. It also determines that whether an activity is value added activity or non-value added. It helps the manager to avoid non value added activities, thus reducing the cost which are unnecessary. It help the management to identify the activity which cause more fixed overhead cost, management control over these activities can reduce the fixed overhead cost

3. Better decision making: As the cost data is more reliable and accurate under ABC system, it help the management to fix selling price accordingly and earn better returns.