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Chicago Co: Activity-Based Costing (ABC) vs Traditional

I need some help in addressing the following questions:

1. What are some differences between activity-based costing and the traditional costing systems?

2. What are some of the reasons that activity-based costing may be resisted by top management?

3. Why are activity rates important to management? In your opinion, why is the activity-based costing approach probably unacceptable for external financial reports?

The controller of Chicago Company is in charge of installing a new costing system that includes the allocation of indirect manufacturing costs to the producing departments. After studying the situation, he found there were three cost drivers that could be used to assign the indirect costs, each with its own merits. After computing the allocations for the departments on a sample month, he found that each cost driver favored (that is, assigned less costs to) a different department. Machine hours favored Department X, direct manufacturing labor hours favored Department Y, and number of processing steps performed favored Department Z.

4. What additional factors must the controller consider before deciding on an allocation base for the indirect manufacturing cost assignment to the departments?

Solution Preview

Here is the help you requested:

1. What are some differences between activity-based costing and the traditional costing systems?

Activity costing creates and ala carte pricing system for variable overhead items. This price-per-act system permits the comparison with outside sources for replacement choices. For instance, if baking the coffee beans costs $15 per hour, perhaps the vendor would pre-bake them for less. The predetermined overhead rate becomes a way to benchmark with external sources for variable overhead costs.
ABC permits better understanding of resource consumption. Traditional uses only one activity to assign costs and the remaining overhead is presumed to be used in about the same proportion as the single activity used as an allocation base. However, this is rarely true. In some cases, like with customized products, some products may use certain resources exclusively (100%). ABC permits jobs to be assigned costs based on individual resources they consumed, not just one "representational resource." This makes sure that some products are not "overcosted" or "undercosted," giving a signal that prices could go up or down in the market place while retaining profit targets. Over and under costing often lead to dominating for one ...

Solution Summary

Your tutorial is 583 words and discusses competitive, pricing and management reasons for activity-based costing as well as times when it would not be a good choice. The best practices for choosing cost drivers is mentioned.