Question

Assume another product line is also being considered – bookshelves. Only use this information for the questions listed directly below.  Higher skilled workers would be required which will result in paying them $15 per hour.  Additional MOH costs for the year will be $150,000.    These costs will be in addition to the costs already being incurred. These costs are due to the additional product line and also related to the current product lines for additional production abilities. The two lines will share all MOH costs.

1. Should the company consider using ABC? Discuss why or why not? Areas to include in the discussion but not limited to the following: impact on product cost, implications of not using the right allocation and its impact on price if any, etc….

2. How specifically would ABC help allocate MOH costs?  

Answer 1

1. The Company should consider Activity Based Costing. Though the highly skilled labor cost can be directly allocated to the product via labor hours but for allocation of additional overhead, ABC must be considered. The additional overhead costs that are incurred will be shared between two products (new product – bookshelves and existing product).

Why should the Company consider ABC:

a. ABC will be required for allocation of overheads.

If the product range was narrow or if the overheads cost were relatively small, then any inappropriate overhead allocation would not be significant. In the case above, $150,000 will need to be properly allocated so that accurate costs of the new product line can be determined.

b. It will also be required for pricing and better decision making

If ABC is properly implemented, it can give more accurate and reliable costing of products and a better understanding of overheads. If traditional allocation is done on the basis of direct labor hours or so, the pricing of the product could be incorrect as the overheads would not be properly allocated and the cost determined may not be realistic as to what the markets offers for the product and the product line profitability may also not be realistic.

Hence, accurate information on product costs enables better decisions on the marketing, product design and product mix.

c. Integrates well with continuous improvement programs (such as Total Quality Management).

It complements the various improvement programs as it will be able to provide quantitative data that is required for implementation of such programs, which will help the Company to gain a competitive advantage and a culture of continuous improvement which is beneficial in the long term. If ABC is not implemented, then continuous improvement programs will take longer and more expensive to implement as the data required will not be readily available.

d. Use of Excess Capacity and Cost Reduction

While identifying the various activities required for the manufacturing of the bookshelves, we will also be able to distinguish between value added and non value added activities, which will help in cost reduction which will further help in increasing the demand of the new product. Since ABC helps in identification of activity costs and activity drivers, it also identifies spare capacity which could be used if resources are properly allocated.

1. ABC is basically a methodology where costs are assigned to activities rather than the product or service, so the overheads costs are accurately allocated to products or services that use those activities. In order to correctly associate costs with products and services, there will be an identification of the activities that take place in the organization. The costs related to that specific activity will be determined along with the relevant cost drivers. A activity cost driver is a variable, which determines the work volume or work load of a particular activity. The rates of the activities will be determined which can be calculated by Total Cost Activity/Activity Driver and then there will be a assignment of the activities to the products. So in the case of the new product, the activities that make the Bookshelves will be identified and their rates will be determined and it will be assigned to bookshelves depending on how much bookshelves consumes/used the activity.