Please use the following information to answer the following question... - Discu
ID: 2578924 • Letter: P
Question
Please use the following information to answer the following question...
- Discuss the best way to allocate costs in this example and include approximate difference in profits between Corporate and Individual clients. What are the potential advantages and disadvantages of the activity-based system?
Duwe Chetam and Howe:
The law firm of Duwe, Cheatam and Howe provides legal services for clients. During the year corporate clients required 5,000 hours of legal services, while individuals required 3,000 hours. The firm has traditionally used direct labor hours to assign overheads. However, Ms. Duwe believes services to business clients cost more than services to individuals and is considering an activity-based costing system. The firm's revenues and costs for the year are show below:
Corporate
Individual
Total
Revenue
$150,000
$150,000
$300,000
Expenses:
Lawyers' salaries
$100,000
$ 50,000
$150,000
Overhead:
Filing
$ 10,000
Quality control
$ 5,000
Data entry
$ 25,000
Total Overhead
$ 40,000
Mr. Cheatam has kept records of the following data for use in the activity-based costing system:
Activity Level
Overhead Cost
Cost Driver
Corporate
Individual
Filing
Number of clients
5
5
Quality control
Number of hours spent
75
25
Data entry
Number of pages entered
1,000
1,500
Corporate
Individual
Total
Revenue
$150,000
$150,000
$300,000
Expenses:
Lawyers' salaries
$100,000
$ 50,000
$150,000
Overhead:
Filing
$ 10,000
Quality control
$ 5,000
Data entry
$ 25,000
Total Overhead
$ 40,000
Explanation / Answer
The best way to allocate costs of the given law firm is the activity-based costing system which is shown as follows:
Table showing bases of allocation
Cost Driver
Number of hours spent (75:25)
Table showing Revenue and cost of the law firm:
The potential advantages of activity based costing are as follows:
a) Improves Business Processes
An ABC system allocates indirect costs based on a product’s cost driver, or the factor that creates the cost. As costs are allocated per product, a picture starts to emerge of which business processes are performing well and which ones need to be improved. ABC can be used to identify non-valued added activities and can help to better allocate resources to efficient and profitable activities. The use of ABC can also add value to the continuous improvement of business processes.
b) Identifies Wasteful Products
The ABC method accounts for costs similar to the way production work is performed, allowing your business to better understand where overhead costs are going. The data can identify wasteful products and unnecessary costs, so that resources can be used productively. The method also helps to fix the price of products or services that are excessive or incorrect. Overall product and service quality can improve as ABC’s data details production and cost issues that need to be resolved.
The potential disadvantages of activity based costing are as follows:
a) Expensive Implementation
Setting up an ABC system can be expensive and time-consuming. As business activities are analyzed, they must be broken down into each activity’s individual components. The entire process can use up valuable resources as data are collected, measured and entered into the new system. Businesses may also need the assistance of a consultant who specializes in the setup of an ABC system and can provide training on its use. Using software can add an additional expense to the implementation but it can be used to automate many of the manual aspects involved in using ABC.
b) Misinterpretation of Data
Reports produced by an ABC system contain information, such as product margins, that vary from the information reported for a traditional cost method. It’s also possible that some activity-based costs may be irrelevant in certain decision-making scenarios; for example, ABC does not conform to accounting standards and should not be used for external reporting. Since traditional cost figures tend to be the norm, interpreting ABC data along with regular accounting information can be confusing and lead to bad decision-making. The use of software can streamline the process of maintaining an ABC system and simplify its integration with regular cost accounting information.
Overhead CostCost Driver
Total Cost Corporate Individual Filing Number of clients (5:5) $10,000 $5,000 $5,000 Quality controlNumber of hours spent (75:25)
$5,000 $3,750 $1,250 Data entry Number of pages entered (10:15) $25,000 $10,000 $15,000 Totals $40,000 $18,750 $21,250