Question

Your friend owns a bicycle shop that derives most of its revenues from repair and maintenance services. Her services range from simple tune-ups to complex rebuilding of racing and mountain bikes. She has four employees who work at the shop and she rents the building that the business operates out of.

Respond to the following questions:

1.) List two specific major costs of operations that would be considered to be direct costs, and explain your reasoning.

2.) The shop served 1,400 customers last year, and currently allocates overhead using the number of customers as the cost driver. The amount of overhead charged to each customer is the same regardless of the work performed, $22.50. With your knowledge of overhead allocation, suggest a single cost driver that may more accurately allocate overhead costs to customers. Explain why you believe the cost driver you suggest will be more accurate than using the number of customers.

Answer 1

Response to Question 1

Two specific major costs of operations that would be considered as direct costs are:

• Labour, i.e. Cost of manpower: Since the major revenues are derived from repair and maintenance services, manpower would be considered as a significant direct cost as without man power, the core business activity at the shop cannot be run. Therefore, manpower cost would be considered as one of the major direct costs
• Consumables and spare parts: Considering again, that the major revenue is derived from repairs and maintenance services, the cost of consumables and parts, especially in cases of rebuilding of racing and mountain bikes would be the next major direct costs, as they are directly related to the core business activity of the shop.

Response to Question 2

• Number of customers does not seem to be the right cost driver to allocate overhead costs here. Considering that the business activity of the shop is to provide repairs and maintenance services, the overhead would be better distributed in terms of time taken to attend each customer. For example, a simple tune up may use up the workshop space for only an hours, whereas building a racing or a mountain bike may easily take a couple of days. Considering both these scenarios as a single customer and allocating the same overheads based on the same surely is not correct. Therefore, time spent in such a business model would be a more appropriate cost driver for allocation of overhead costs.