Question

Answer all questions. 1. Describe how the direct, step-down and reciprocal cost allocation methods differ in the way they recognise reciprocal services among support departments. (6 marks) 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 Direct labour Overhead* Total product cost per unit (a) Sales price (b) Profit= (b)-(a) 32 000 19 200 40 960 92 160 102 400 10 240 41 600 24 000 51 200 116 800 144 000 27 200 Activity-Based Costing (several different allocation bases) FISHING BOAT LUXURY BOAT Direct materials Direct labour Overhead* Total product cost per unit (a) Sales price (b) Profit= (b)-(a) 32 000 19 200 32 128 83 328 102 400 19 072 41 600 24 000 95 360 160 960 144 000 (16 960)

Answer 1

1)

Direct method - It is based on allocation of support cost to only Operating departments. There is no Interaction between Support Departments prior to allocation.

Step Down method - In this method , support cost is distributed to other support departments and to operating departments that partially recognizes the mutual services provided among all support departments . There is One-Way Interaction between Support Departments prior to allocation

Reciprocal method - Allocates support department costs to operating departments by fully recognizing the mutual services provided among all support departments . There is Full Two Way Interaction between Support Departments prior to allocation.

2)

a)

Differences in profitability:- Fishing boat has turned to more profitable segment than Luxury boat. Traditional method of allocation can give poor decision making outcome as it relies on only one basis for allocation of total overhead cost. ABC mainly focus to get closer to the true cost and true profitability of individual products and services and to understand better the true costs and return on investment from projects, programs, or other initiatives.

In the given question , as per more realistic basis , Luxury boat segment is incurring losses and should be discontinued.

b)

Overhead cost is different in ABC as ABC determines cost primarily by making direct costs out of many of the expenses that traditional cost accounting treats as indirect cost.

c)

2 decisions :-

Firstly, the company should either discontinue the product luxury boat or increase the sales price to make it profitable.

Secondly, There should be increase in production of fishing boat as it is more profitable.

d)

Advantages :- Better product cost.

better decision making

tracing of overhead cost

tracing of activites for cost budget

more information about cost behaviour.

Disadvantages :- Expensive

Complex

difficult selection of cost drivers

time consuming

not effective for smaller firms