Question

For companies that manufacture several products that use different proportions of manufacturing overhead resources, why does the use of activity based costing provide more reliable product cost information for management decision-making than would traditional costing system that uses a single cost driver to allocate all manufacturing overhead activities/resources?

Answer 1

Use of activity based costing helps in assigning overheads to different products based on the level of activities used in the manufacturing of those products. Some products are high value to the organization and may require use of more activities in production, while other activities may be of less importance to the organization and therefore may require use of less activities. Allocation of overheads using traditional costing can result in undervaluation or overvaluation of more or less costly product, since overheads are allocated using a single predetermined overhead rate based on a particular criteria such as labor hours, machine hours etc.

With the use of activity based costing, management can easily identify products requiring more overheads and can price them accordingly.