Prudence Auto Insurance Co incurred both direct and indirect costs. Direct costs were incurred at branches as they performed sales and operating activities, while indirect costs were incurred at headquarters as it supported branches through the activities of the information technology, operating support, investment, marketing and general administrative teams. Indirect costs accounted for a significant part (50 per cent) of the total costs incurred. However, they could be neither directly traceable nor logically related to specific sales activities. Prudence Auto Insurance currently allocated indirect costs incurred by headquarters to branches based on sales revenue. Using the amount of sales revenue as an allocation base for overhead was not regarded as a reasonable method by the Plaine Wilhems branch manager. Branch managers had complained that the current allocation base was not related to the level of actual benefits they received from the headquarters. They argued that the allocation process distorted the operating performances of branches as reflected in the books. The manager of the Kansas branch suggested that the ABC (activity-based cost) method be applied to solve the problems related to the current overhead allocation process.

(a) Comment on the points raised by the branch manager and discuss on limitations of the present allocation base.

(b) Justify the shift to an Activity Based Costing based on the information provided in the case study and from your understanding of the conditions that should prevail to recommend a shift to the ABC system