Question

Wheels assembles three types of motorcycle at the same factory: the 50cc Sun; the 250cc Shine
and the 1000cc Star. It sells the motorcycles throughout the world. In response to market
pressures Wheels has invested heavily in new manufacturing technology in recent years and, as
a result, has significantly reduced the size of its workforce.
Historically, the company has allocated all overhead costs using total direct labour hours, but is
now considering introducing Activity Based Costing (ABC). Wheels's accountant has produced
the following analysis.
Annual Annual direct Raw
output labour Selling material
(units) Hours price cost
($ per unit) ($ per unit)
Sun 2,000 200,000 4,000 400
Shine 1,600 220,000 6,000 600
Star 400 80,000 8,000 900
The three cost drivers that generate overheads are: Deliveries to retailers – the number of
deliveries of motorcycles to retail showrooms Set-ups – the number of times the assembly line
process is re-set to accommodate a production run of a different type of motorcycle Purchase
orders – the number of purchase orders.
Strategic Management Accounting (June 2020) Page 2 of 3 MAA
The annual cost driver volumes relating to each activity and for each type of motorcycle are as follows:
Number of Number of
deliveries Number of purchase
to retailers set-ups orders
Sun 100 35 400
Shine 80 40 300
Star 70 25 100
The annual overhead costs relating to these activities are as follows:
$
Deliveries to retailers 2,400,000
Set-up costs 6,000,000
Purchase orders 3,600,000
All direct labour is paid at $5 per hour. The company holds no inventories.
At a board meeting there was some concern over the introduction of activity based costing.
The finance director argued: 'I very much doubt whether selling the Star is viable but I am not convinced that activity based costing would tell us any more than the use of labour hours in assessing the viability of each product.'
The marketing director argued: 'I am in the process of negotiating a major new contract with a motorcycle rental company for the Sun model. For such a big order they will not pay our normal prices but we need to at least cover our incremental costs. I am not convinced that activity based costing would achieve this as it merely averages costs for our entire production'.
The managing director argued: 'I believe that activity based costing would be an improvement but it still has its problems. For instance, if we carry out an activity many times surely, we get better at it and costs fall rather than remain constant. Similarly, some costs are fixed and do not vary either with labour hours or any other cost driver.'
The chairman argued: 'I cannot see the problem. The overall profit for the company is the same no matter which method of allocating overheads we use. It seems to make no difference to me.'
Required:

b) Write a report to the directors of Wheels, as its management accountant. The report should:
(i) evaluate the labour hours and the activity based costing methods in the circumstances of Wheels; and
(ii) examine the implications of activity based costing for Wheels, and in so doing evaluate the issues raised by each of the directors.
Refer to your calculations in requirement (a) above where appropriate.

Answer 1

Solution

Wheels Assembles

a. Calculation of the total profit on each three types of product using –

(i) The existing method based on labor hours

Predetermined overhead rate = total estimated overhead cost/total direct labor hours

Total estimated overhead cost = $2,400,000 + 6,000,000 + 3,600,000 = $12,000,000

Total direct labor hours = 200,000 + 220,000 + 80,000 = 500,000

Predetermined overhead rate = $12,000,000/500,000 = $24 per DLH

Overhead assigned to Sun = $24 x 200,000 hours = $4,800,000

Overhead assigned to Shine = $24 x 220,000 = $5,280,000

Overhead assigned to Star = $24 x 80,000 = $1,920,000

Costs and profit for each type –

Sun
Sales	$8,000,000	($4,000 x 2,000 units)
Expenses -
direct materials	$800,000	($400 x 2,000)
Direct labor	$1,000,000	($5 x 200,000 DLH)
Overhead assigned	$4,800,000
Total expenses	$6,600,000
Profit	$1,400,000

Shine
Sales	$9,600,000	($6,000 x 1,600 units)
Expenses -
direct materials	$960,000	($600 x 1,600)
Direct labor	$1,100,000	($5 x 220,000 DLH)
Overhead assigned	$5,280,000
Total expenses	$7,340,000
Profit	$2,260,000

Star
Sales	$3,200,000	($8,000 x 400 units)
Expenses -
direct materials	$360,000	($900 x 400)
Direct labor	$400,000	($5 x 80,000 DLH)
Overhead assigned	$1,920,000
Total expenses	$6,600,000
Profit	$520,000

(ii) Activity based costing –

Step1 – calculation of activity rates:

Activity Rates
Activity	Estimated Cost	Total activity usage	Activity Rate
Deliveries to retailers	$2,400,000	250 deliveries to retailers	$9,600 per delivery
Set-up Cost	$6,000,000	100 setups	$60,000 per setup
Purchase order costs	$3,600,000	800 purchase orders	$4,500 per order

Step 2 – assignment of overhead costs to products –

Sun
Activity	Estimated Usage	Activity Rate	Overhead Assigned
Deliveries to retailers	100 deliveries	$9,600	$960,000
Setup Costs	35 setups	$60,000 per setup	$2,100,000
Purchase orders	400 orders	$4,500 per order	$1,800,000
Total cost			$4,860,000

Shine
Activity	Estimated Usage	Activity Rate	Overhead Assigned
Deliveries to retailers	80 deliveries	$9,600 per delivery	$768,000
Setup Costs	40 setups	$60,000 per setup	$2,400,000
Purchase orders	300 orders	$4,500 per order	$1,350,000
Total cost			$4,518,000

Star
Activity	Estimated Usage	Activity Rate	Overhead Assigned
Deliveries to retailers	70 deliveries	$9,600	$672,000
Setup Costs	25 setups	$60,000 per setup	$1,500,000
Purchase orders	100 orders	$4,500 per order	$450,000
Total cost			$2,622,000

Step 3 –

Costs and profit for each type –

Sun
Sales	$8,000,000	($4,000 x 2,000 units)
Expenses -
direct materials	$800,000	($400 x 2,000)
Direct labor	$1,000,000	($5 x 200,000 DLH)
Overhead assigned	$4,860,000
Total expenses	$6,660,000
Profit	$1,340,000

Shine
Sales	$9,600,000	($6,000 x 1,600 units)
Expenses -
direct materials	$960,000	($600 x 1,600)
Direct labor	$1,100,000	($5 x 220,000 DLH)
Overhead assigned	$4,518,000
Total expenses	$6,578,000
Profit	$3,022,000

Star
Sales	$3,200,000	($8,000 x 400 units)
Expenses -
direct materials	$360,000	($900 x 400)
Direct labor	$400,000	($5 x 80,000 DLH)
Overhead assigned	$2,622,000
Total expenses	$3,382,000
Profit	-$182,000