Activity-Based Costing and Bookkeeping Services at T&K Solutions

This report analyzes the financial implications of T&K Solutions' bookkeeping services. It evaluates whether to continue these services by examining profit and loss statements, considering both fixed and variable costs. The analysis highlights the impact of dropping bookkeeping services, which would reduce the overall profit due to fixed expenses. The report also discusses activity-based costing (ABC) as a superior method for allocating overhead costs, particularly in service firms, contrasting it with traditional costing methods. It argues against the view that ABC is only relevant for manufacturing, emphasizing its benefits in analyzing overheads and making informed business decisions. The analysis reveals that ABC provides a more accurate allocation of costs compared to traditional methods, leading to better decision-making regarding service profitability and pricing. Incorrect overhead allocation impacts profitability and can lead to poor decisions, making the ABC system a valuable tool for service industries.

TASK-A
Part-(b)
Email
To Terry and Kerry,
T&K Solutions
Subject: Advise on whether to operate or drop book keeping services
Dear Sirs,
This in reference to your query regarding whether to operate or drop book keeping services, after
analyzing the profit and loss statement, we noticed that the current total profit of the business is
$432,800 which is getting reduced to $374,400 if the book keeping services are dropped. This is because
most of the expenses are fixed in nature and will be incurred irrespective of the fact whether the
bookkeeping services will be continued or not. Only the variable costs of book keeping services will be
eliminated if the book keeping services are dropped. The fixed expenses which will remain irrespective
of whether the boom keeping services are operated or dropped are:
(a) Partner Salary of $75,000
(b) Office staff of $45,000
(c) Rent & utilities cost of $16,000 and $8,000
(d) Depreciation of $5000
Further, the Advertising expense is in the nature of mixed expense which will be reduced by only 10% of
total advertising cost i.e. is reduced by $2400 only.
Hence, if the book keeping services are dropped, then there will be no revenue and total expense of
book keeping services will be $154,600 resulting in the net loss of $154,600. So, the loss of book keeping
services will be increased from $96,200 to $154,600 resulting in a net decrease in total profit of the firm
by $58,400.
Thus, it is advised to not to drop the book keeping services.

TASK-C
ABC or Activity based costing is a costing method to allocate overhead costs to the products. It is a
practical and more reliable method as compared to traditional costing system. It allocates the cost on
the basis of resources consumed by particular activities. It starts with identifying the activities and their
associated cost and then move towards identifying the cost drivers of the identified activities. Then the
cost drivers consumed by respective service or products is identified and lastly the cost is allocated to
the services or products on the basis of consumption of respective cost drivers (Staff, 2018).
We did not agree with the view of Kerry that ABC is only relevant for manufacturing companies and has
no benefit to service firms. This is because, the activity based costing is useful for all the companies
having overheads from more than one activities as it helps in systematic allocation of overheads.
However, we can say that the ABC is not useful for companies with smaller turnover or structure as it is
a costlier system to adopt and use. But for the big service firms like ours, the ABC system is perfect and a
must use costing system as it helps in analyzing the overheads and also helps in deciding whether a
particular business segment is useful or not (Martin, 2018).
Considering the ABC and traditional costing system in our firm, from the above calculations, we can see
that overhead costs are overcharged to “Tax” and “Bookkeeping” services by $ 28,936 and $ 8,449
respectively and is under charged to “Advisory services” by $37,385 under the traditional costing system
as compared to activity based costing system. We are saying this because the ABC system is a practical
method which allocates the costs on the reasonable basis whereas the traditional costing system
allocates the cost on a blanket rate basis without considering the fact that how much resources or
overheads has actually been consumed by that service sector. So, the cost computed or allocated by the
ABC system is accurate and more reliable as compared to traditional costing system.
Implications of Incorrect overhead allocation to products and services
The incorrect allocation of overhead costs, impact the overall profitability of the service sector and
portray the wrong picture of profitability. Due to this incorrect picture of profitability, it is possible that
the management takes the wrong decisions in regard to whether a particular service should be
continued or not and such other important costing decisions. Further, the correct allocation of costs
helps in setting the correct selling prices of the product. If a product price is wrongly set, then there are
chances that the product is either over-priced or underpriced as compared to market prices. And this
will badly impact the potential market of the product, as the consumer will not buy the product which is
over-priced and selling the product at low price will impact the profitability of the firm.
Hence, to conclude, the activity based costing system is much useful for service industries as it is for
manufacturing companies and we should use the ABC system in our firm also.

References:
Martin, J. (2018). Activity-Based Costing in the Service Sector. [online] Maaw.info. Available at:
http://maaw.info/ArticleSummaries/ArtSumRuhlHartman98.htm [Accessed 11 May 2018].
Referenceforbusiness.com. (2018). Activity-Based Costing - type, benefits, How activity-based costing
works. [online] Available at: http://www.referenceforbusiness.com/small/A-Bo/Activity-Based-
Costing.html [Accessed 11 May 2018].
Staff, I. (2018). Activity-Based Costing - ABC. [online] Investopedia. Available at:
https://www.investopedia.com/terms/a/abc.asp [Accessed 11 May 2018].