Question

Egerton Manufacturing Ltd produces a range of products at seven separate sites. The directors have decided to introduce Activity Based Costing (ABC) and have asked each site manager to obtain and analyse the relevant data for their site. Product costs are currently calculated using absorption costing, with overheads being absorbed on a machine hour basis. As part of the process of introducing ABC, the directors wish to assess the profitability of individual products, with the possibility that the product range may be reduced. You are the Manager of the Brumley site and you have obtained the following data:

Product	A	B	C
	$	$	$
Selling price per unit	300	530	435
Direct material per unit	55	67	98
Direct labour per unit	41	54	57
Overheads per unit	117.20	293	117.20
Total cost per unit	213.20	414	272.20
Budgeted production volume	600 units	400 units	200 units
Machine hours per unit	0.6	1.5	0.6
Production runs in period	32	40	25
Number of sale orders	19	5	15
Number of deliveries of material	8	2	16

The budgeted overheads of the site for the period are:

Machine running costs	$78,560
Set up costs	$82,900
Material handling costs	$49,500

Machine hours are limited to 1,140 hours per period.

Required:

a) Calculate the cost of each product using ABC. Choose appropriate cost drivers for each activity

b) Draft a memo to the Managing Director which:

            (i) Using the ABC information, indicates which product(s) should no longer be manufactured and justify your recommendation;   

            (ii) Discuss any other factors which should be considered before a final decision is made.

                                                                                        

Answer 1

Solution :

Part A : Cost per unit under ABC

Step 1 : Computation of OH Recovery rate
S.No	Activity	Cost Pool	Cost Driver	Quantity of Cost Driver	ABC Rate (Cost Pool ÷ Cost driver)
1)	Machine running costs	$                   78,560	Machine Hours	1140	$                   68.91
2)	Set up costs	$                   82,900	Production Runs	= 32+40+25 = 97	$                854.64
3)	Material handling costs	$                   49,500	Number of deliveries of material	= 8 + 2 + 16 = 26	$             1,903.85

Step 2 : Overhead cost under ABC
S.No	Particulars	A	B	C
1)	Production volume (units)	600	400	200
2)	Machine hours p.u	0.60	1.50	0.60
3)	Machine hours for budgeted units (1 x 2)	360	600	120
4)	ABC rate of Machine running costs	$                      68.91	$                               68.91	$                        68.91
5)	Machine running costs (3 x 4)	$ 24,808.42	$ 41,347.37	$ 8,269.47
6)	Production Runs	32	40	25
7)	ABC rate of Set up	$ 854.64	$                            854.64	$                     854.64
8)	Set up costs (6 x 7)	$ 27,348.45	$ 34,185.57	$ 21,365.98
9)	Number of deliveries of material	8	12	26
10)	ABC rate of Material handling costs	$ 1,903.85	$                        1,903.85	$                  1,903.85
11)	Material handling costs (9 x 10)	$ 15,230.77	$ 22,846.15	$ 49,500.00
12)	Total Overhead cost ( 5+8+11)	$ 67,387.64	$                      98,379.09	$                79,135.45
13)	Overhead cost p.u ( 12 ÷ 1)	$                     112.31	$                            245.95	$                     395.68

Step 3 : Product Cost p.u under ABC
S.No	Particulars	A	B	C
1)	Direct material p.u	$                     55.00	$                              67.00	$                       98.00
2)	Direct labor p.u	$                      41.00	$                              54.00	$                        57.00
3)	Overhead cost p.u (as per Step 2)	$                     112.31	$                            245.95	$                     395.68
4)	Total cost per unit (1+2+3)	$ 208.31	$ 366.95	$ 550.68

Part B (i) : Memo

To :  The Managing Director,Egerton Manufacturing Ltd

Please find the analysis of the per unit profits and losses of the products A,B&C as per the ABC costing

S.No	Particulars	A	B	C
1)	Selling price p.u	$                  300	$                   530.00	$              435.00
2)	Direct material p.u	$                     55.00	$                              67.00	$                       98.00
3)	Direct labor p.u	$                      41.00	$                              54.00	$                        57.00
4)	Overhead cost p.u (as per Step 2)	$                     112.31	$                            245.95	$                     395.68
5)	Total cost per unit (2+3+4)	$ 208.31	$ 366.95	$ 550.68
6)	Profit/(Loss p.u) (1-6)	$ 91.687	$ 163.052	$ (115.677)

Based on the above analysis, it can be concluded that Product C, should not be manufactured as it results in a loss.

Part B (ii) : Other factors to consider
1) Evaluate whether the cost drivers selected are accurate and make the required changes to any new cost and cost drivers identified.

2) Identify the Value added and non-value added activities of Product C, and check whether any cost savings or savings in machine hours is possible.

3) The market demand for the product should be analyzed and evaluate if there are any alternative options to ensure the supply of Product C to the market. Options like sub-contracting, direct purchase from the market or implementing any change in the production process should be considered and evaluated.

4) The life cycle stage of the products should be considered.