Question

You are a Controller at a manufacturing company. You have been going over the numbers for manufacturing overhead and you don't think the company is using the best method to assign it. Recently you heard about activity based costing and have done research into it. You believe that it would be in the company's best interest to switch from its traditional method for assigning manufacturing overhead to activity based costing. Write a memo to the CEO explaining the benefits the company will see from this switch.

When you reply: You are the CEO and you don't think activity based costing is as good as its made out to be. Write a memo back to the Controller with the issues you believe the company would have if they made the switch.

Answer 1

MEMORANDUM

DATE : 24/02/2020

TO: The CEO

FROM : The Cost Controller

SUBJECT : Requesting for switch from traditional method for assigning manufacturing overhead to activity based costing.

This is in reference to the above mentioned issue that it is for the benefit of the company to shift from traditional method to Activity based costing for allocation of manufacturing cost as there are some of the problem with traditional method which, ABC costing seems to provide solution in my view

Problems with traditional method

• Costs are related to cost centers and hence not realistic of cost behavior
• As absorption costing emphasized on total cost namely both variable and fixed, it is not so useful for management to use to make decision, planning and control.
• The emphasis is on total cost thus  the cost volume profit relationship is ignored.This results in making decisions on the basis of intuition

Advantages of A B C Costing  

• More accurate costing of products/services, customers, SKUs, distribution channels.
• Better understanding overhead.
• Easier to understand for everyone.
• Utilizes unit cost rather than just total cost.
• Integrates well with Six Sigma and other continuous improvement programs.
• Makes visible waste and non-value added activities.
• Supports performance management and scorecards
• Enables costing of processes, supply chains, and value streams
• Facilitates benchmarking

Thus in the end I would like to conclude that Absorption costing is the traditional cost accounting method that focuses on the product or service when fixing costs. It works under the simple approach of assigning resources to products or services directly while Activity based costing is a modern cost accounting approach that focuses on activities as the fundamental cost. ABC presumes that products or services consume activities, and activities consume resources. It thus, works to convert indirect costs into direct costs.

Absorption costing helps ascertain the overall profitability or efficiency of the manufacturing system but fails to provide the real cost of individual product units.

Activity based costing mirrors the functioning of the enterprise and contributes to strategic decision-making processes. ABC provides the real cost of individual product units and, thereby, helps identify inefficient or non-profitable products that eat into the profitability of other highly profitable products. ABC also helps price products equitably, allowing breaking down of product or service into sub-components or offering "top ups" based on customer needs.

Comparing absorption costing and activity based costing, activity based costing improves the quality of management accounting information, especially in large and multi-product operations where conventional overhead allocation methods such as absorption costing may produce misleading results.

Hope you will permit for the switch in method