Question

2. The following comparative data is provided for the Laventura Boating Company. It is stated that the company has more accurate product cost information using activity based costing to allocate overhead.

a. Describe the differences in profitability resulting from the two costing approaches.        (4 marks)

b. Explain why the overhead cost is so different using activity-based costing. (2 marks)

c. List 2 possible decisions that management might take due to the significant change in relative profitability of the two types of boats resulting from the use of ABC. (2 marks)

d. Activity-based costing undoubtedly provides better cost information than most traditional costing methods, such as plant wide and department allocation methods. However, ABC has its limitations. What are the advantages and disadvantages of using activity-based costing? (6 marks)

                                                                Laventura Boating Company

                                                       (Direct labour hours as allocation base)

                                                                               FISHING BOAT                   LUXURY BOAT

                                                                                             $                                          $  

Direct materials                                                              32 000                                  41 600

Direct labour                                                                   19 200                                  24 000

Overhead*                                                                       40 960                                  51 200

Total product cost per unit (a)                                         92 160                                116 800

Sales price (b)                                                                102 400                                144 000

Profit= (b)-(a)                                                                   10 240                                 27 200

                                                                            Activity-Based Costing

                                                                     (several different allocation bases)

                                                                           FISHING BOAT                    LUXURY BOAT

                                                                                       $                                              $

Direct materials                                                        32 000                                      41 600

Direct labour                                                             19 200                                      24 000

Overhead*                                                                32 128                                      95 360

Total product cost per unit (a)                                   83 328                                    160 960

Sales price (b)                                                         102 400                                    144 000

Profit= (b)-(a)                                                            19 072                                    (16 960)

Answer 1

Answer is given below

a) Differences in profitability The difference in profitability is mainly due to the method of allocation of overheads Traditional method uses labor hour as allocation method. The labor hour method calculates predetermined overhead rate and allocates overhead based on the direct labor hours consumed whereas ABC method allocates overheads based on the actual consumption of activities ABC method of allocation identifies the cost pools and then calculates the activity cost driver Overheads are allocated based on the activities consumed multiplied by the activity cost driver rate b) Overhead cost is so different in ABC method mainly due to the activities consumed Overhead allocated to Luxury boat is more due to the more consumption of activities c) 2 possible decisions that management might take 1 Increase selling price of Luxury Boat to make it profitable 2 Reduce cost of Luxury boat by reviewing the activities consumed for its production d) Advantages and disadvantages of using activity-based costing Allocation of overhead as per traditional method does not correlate the cost with activities consumed ABC method should be used because it has advantages. Below are the listed advantages -It helps in accurate product costing and taking reliable decisions - It helps in decision making like Product level profitability, launch of new products, customer level cost analysis, etc - It helps in accurate Product pricing - It helps in better cost management through cost control and cost reduction Disadvantages of ABC Costing - ABC costing method is time consuming since it needs identification of activities and calculating activity cost driver rates - It needs specialized knowledge to apply the ABC costing method throughout the organisation - ABC method is not useful if cost is more than benefits involved in implementing it