Activity based costing is considered a better method of allocating manufacturing

Question

Activity based costing is considered a better method of allocating manufacturing overhead than the more simplified "plant-wide" overhead allocation method.

a. Activity based costing does require more work than a plant-wide allocation. Under what circumstances is it worth the extra effort?

b. What is the typically result when activity based costing is adopted, in terms of cost allocation between different products?

c. Name three advantages of activity based costing over plant-wide allocation.

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Explanation / Answer

a. ABC method is more useful whenthe overheads are not centred around a partiicular base like machine hour or labor cost . When overheads are varied like purchasing , material handling , R&D , design , maintenance , utilities and all of the overheads have significant value and different prodcuts consume different amount of overhead resources. In this case allocationg overhead on machine hour or labor cost will be inaccurate and ABC method is preferable.

b. When ABC costing is adopted , the true cost of overhead recources consumed by individual products are revealed and it removes the earlier bias of overhead cost allocations created by old method of overhead allocation on a sigle basis. ABC costing also improves the cost effeiciency as we get to know the areas where we can improve the costing by eliminating unnecessary consumeption of resources. It also focus on the need to eliminate non value adding activities to reduce the overhead.

c. Advantages of ABC over plant wide allocation;

1. The truce overhead cost consumed and true profitability of each product can be ascertained.

2. The cost of resources provided to service departments are identified. Possible opportunities to reduce service department costs acn be explored.

3. As the resources consumed by each product can be identified , there is more stress on eliminating non value added activities to reduce unnecessary overhead.

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