Activity Based Costing System for Cost Computation and Profitability Analysis

This article discusses the use of Activity Based Costing (ABC) system for cost computation and profitability analysis. It includes traditional cost based computations, ABC costing system, P&L statements, and benefits and limitations of ABC costing.

ACCOUNTING
STUDENT ID:
[Pick the date]

Question 1
Traditional cost based computations for the two models are summarised below.
Question 2
The activity drivers cost computation is indicated below.

Costing of the two models as per ABC costing system is carried out below.

Question 3
As the mark up needed to arrive at selling price is 20%, hence unit advance system selling
price is (1+ (20/100))*890.93 = $1,069.12
P&L statement assuming traditional costing price
P&L statement assuming ABC costing price
The comparison of the profitability of operations in the above two cases provides the answer
to the strange behaviour of the foreign buyer. Considering that at the current selling price for
the advance system , the company is actually making a loss, it is clear that the foreign buyer
would not get more competitive quote since assuming similar costs, the selling price offered
by other players would be higher. Also, in this case, overheads have been underapplied to
advance model leading to higher costs estimates for the basic model making its price
uncompetitive in the market (Damodaran, 2015).

Question 4
One of the issues leading to mismatch between the actual and applied overhead is the choice
regarding the cost method which may be inappropriate as in the current case. Another issue is
the limited accuracy of the ABC method as it would be difficult to expect 100% accuracy
from this method as breaking down of activities into smaller activities and finding cost
drivers is limited to practical levels (Northington, 2015).
The measures for dealing with the issue at hand are outlined as follows (Parrino and Kidwell,
2014).
 The firms should make a transition to ABC based costing system from the traditional
costing as the latter leads to incorrect allocation of overheads.
 The product price must be linked to accurate costing and also the prices offered by
competitors. The linking of prices to competitors can enable the company to make up
for any under-costing or over-costing.
 The deviation of the product pricing of the company from competitors price must be
analysed as this could be the result of inaccurate allocation and hence once identified,
it can be rectified.
Question 5
Main benefits of ABC costing are enumerated as follows (Petty et. al., 2015).
 The pricing decisions are improved since the underlying costing of the products
undergoes an improvement.
 The decision making by the management improves especially when decisions pertain
to the most profitable product lines, decisions regarding production outsourcing or
special order acceptance in case of spare capacity.
 As a result, ABC is not just a costing system but a strategic system which enables that
the firm remains competitive in the market.
There are certain key limitations of activity based costing as enumerated below (Brealey,
Myers and Allen, 2014).

 This costing system has higher complexity and hence difficult to implement. There is
requirement of consultants and trained manpower for the implementation of this
system in a firm along with resource requirement. This makes it difficult for small
firms to make the switch to ABC system.
 The implementation of ABC system in itself may not improve decision making at the
firm level. This is because managers face difficulties with usage of the information
under this costing and hence have to be trained in this regards. Further, issues are still
possible thus limiting the positive impacts.

References
Brealey, R. A., Myers, S. C. and Allen, F. (2014) Principles of corporate finance, 2nd ed.
New York: McGraw-Hill Inc.
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York:
Wiley, John & Sons.
Northington, S. (2015) Finance, 4th ed. New York: Ferguson
Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London:
Wiley Publications
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M. and Nguyen, H. (2015).
Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education, French
Forest Australia.
.