Company ABC has 5 departments that are in a sequential production

relationship. That is, the WIP of Dept 1 becomes one of the inputs of Dept 2
(i.e. Dept 2's transferred-in cost); the WIP of Dept 2 becomes one of the inputs
of Dept 3 and so on.
The accountant for Company ABC wants to evaluate the performance of each
department by producing department based Profit and Loss statements. The
manager of each dept. will be held responsible for his/her dept's profit or loss.
The accountant wants to minimise the cost of setting up this control system
by using the absorption costs figures generated for the financial accounting
system to produce these Profit and Loss statements.
The System would be used for control purposes i.e. to manage
management/departmental performance

1. Explain how you could improve the accountant's proposed system.

Explain how your system would function.
Critically evaluate the strengths and weaknesses of your suggested
improvement.

(1) The following are the steps that could be used to improve the accountants
proposed system:
(a) Create cost pools and determine standard set of accounts that should be
included in those cost pools.
(b) Determine the amount of usage of for each activity and is used to assign
overhead costs, such as machine hours or direct labor hours used.
(c) Divide the usage measure into the total costs in the cost pools to arrive at the
allocation rate per unit of activity, and assign overhead costs to produced
goods based on this usage rate.

(2) Functioning of the system:

Under the proposed control system a product would absorb a broad range of fixed
and variable costs. These costs would not be recognized as expenses in the month
when they are paid. Until the inventory is sold, the inventory would remain as asset.
When the inventory is sold, they are charged to the cost of goods sold.
Proper control measures for the system for each department would be established to
control the absorption of cost.

(3) Strengths and weaknesses of suggested improvement:

The following are the strengths and weaknesses of the suggested improvement:
Strengths:
(a) The system would recognize the fixed expenses in product cost. This system
is suitable to determine the full cost of the product. Hence, it a best pricing
model.
(b) In product having seasonal production and seasonal sales, this system
provides accurate profit over variable costing.
(c) The system is consistent with accrual and matching accounting concepts that
match costs with revenue for a particular accounting period.
(d) The external reports prepared for stock valuation are highly reliable and
acceptable.
(e) The system avoids bifurcation of costs into fixed and variable.
(f) The managers of cost centres would be altered in advance with the allocation
of apportionment of fixed factory overheads.

Weaknesses:
(a) Generally absorption costing is not preferable for decision making, as the
fixed manufacturing overheads would be considered in product cost.
(b) The fixing of price would be a barrier as it considers as the product cost.
(c) Absorption costing is not helpful in control of cost and planning and control
functions.
(d) Managers who are evaluated on the basis of operating income can
temporarily improve profitability by increasing production.