Question

1. Identify and discuss the advantages and disadvantages of activity based costing:
2. Does a company's costing method have any effect on its pricing decisions? Explain.

please briefly detailed answer not less than 500 words with References please.

Answer 1

SOLUTION :

(1)

Advantages of activity based costing :

# It helps to identify the costs incurred for specific products and services

# Aids in determining the pricing of various products and services

# Overhead allocation becomes more logical

# Helps to identify non value adding activities thus leading to cost reduction

Disadvantages of activity based costing :

# Comparitively expensive to traditional methods of costing

# It is difficult to be applied for a small organisation or an organisation with limited number of products

(2)

A company's costing methods have huge impact on its pricing decisions.

Accounting information is often an important input to pricing decisions. Most firms need to make
decision about setting or accepting selling prices for their products or services. In some firms
selling price is derived directly from cost information by estimating future product’s cost & adding a
suitable profit margin.

In many businesses, the common method of price determining is to estimate the cost of product &
fix a margin of profit. The term ‘cost’ here means Full Cost at current output and wages level since
these are regarded as most relevant in price determination.

If a firm wants to survive and stay in business, it has to maintain its fixed capital intact so that its fixed assets may be replaced at the end of their useful working life out of the funds generated from profits retained in the business.  

In a period of relatively stable price levels, depreciation based on historical cost of fixed assets would
perhaps be adequate for achieving this object. In periods when the price level is continuously
changing, the firm may not be left with adequate funds generated out of accumulated depreciation
at the end of the life of the plant to replace the plant at a higher price. Hence depreciation should
be properly included as a part of cost so as to leave sufficient profits for asset replacement.
Pricing based on total costs is subjected to two limitations. They are:

▪ The allocation of inter-departmental overheads is based on an arbitrary basis; and
▪ The allocation overheads will require estimation of normal output which often cannot be done
precisely.

In order to avoid these complications, Variable Costs which are considered as relevant costs are
used for pricing, by adding a markup (to include fixed costs allocation also).