Question

In your readings this module, you were introduced to Activity-Based Costing or ABC. It is a method used to determine a reliable predetermined benchmark for the allocation of overhead costs to the products produced based on their activity levels. In this discussion, we will work a case study on ABC together. For your initial response, attempt to answer the questions yourself and post all the required items into the Discussion Area. You may want to post some elements during different days so the class can work this problem together. Then in your response postings, help each other with misunderstandings or miscalculations.

Tasks: Examine the case below and then…

Calculate the amount of overhead allocated to small and large advertising campaigns under existing methods.

Apply activity-based costing to calculate the cost per cost driver for each of the cost pools.

Use the costs per cost driver to calculate the activity-based overhead applicable to small and large campaigns.

Calculate the percentage to be added to direct advertising costs to recover overhead costs under activity-based costing.

Merit-o-cracy PLC is a specialist advertising agency. It has been long-established but is experiencing difficulties in winning new business. The Chief Executive believes that its pricing methods are leading to the loss of large customer advertising campaigns while it is consistently winning smaller business.

Merit-o-cracy costs work for pricing purposes on the basis of direct advertising costs (i.e. space or time purchased from newspapers, radio and TV) plus 100%. The 100% is intended to cover all the overheads of the business, which run at $2 million per year. It does not include any profit margin. This budget cost comprises:

Creative staff $500,000

Production staff $750,000

Administrative & support staff $300,000

Rental and associated costs $450,000

Merit-o-cracy classifies its advertising campaigns as either small or large. Of the 350 campaigns the agency wins, about 325 are classified as small. A typical small advertising campaign incurs direct advertising costs of $4,000 each (and therefore is allocated $4,000 of overheads under current methods). The other 25 advertising campaigns are large and incur direct advertising costs of $28,000 each.

Merit-o-cracy’s accountant has heard of activity-based costing. After speaking to the management team, she has gathered information on the most common causes of costs. She believes that creative staff costs are linked to the number of advertising campaigns the agency competes for. Production staff costs are related to the number of advertising campaigns the agency wins. Administrative and support staff costs are related to the number of customers the agency has. Rental and associated costs are people-based and as a similar number of staff is employed in each of the three departments, the costs should be equally shared. The accountant has also collected data on the activity levels in each of the three departments over the budget period. These are:

Creative

800 advertising campaigns the agency bids for

400 of these are bids for large campaigns and 400 for small campaigns

Production

350 advertising campaigns the agency wins

325 of these are small campaigns and 25 large campaigns

Admin & support

400 customers the agency services

300 of these are customers with small campaigns and 100 have large campaigns

Answer 1

Under current pricing methodology 100% of direct cost is taken as overhead cost and allocated to each job. Hence for a small advertising project $4,000 will be allocated as overhead and for a large advertising project $28,000 will be charges.

In case we use Activity based costing technique then the following table shows the various cost pools

Particulars	Creative staff	Production staff	Admin and support
Total cost	$500,000	$750,000	$300,000
Total no of units of the relevant cost driver	800	350	400
Cost per unit of cost driver (calculated by dividing the above two)	$625	$2,142.86	$750

For the rental cost the total cost will be simply divided equally among the two category of products.

Now the total overhead cost allocated to both type of advertising can be calculated as follows

Particulars	large advertising	small advertising
Creative staff cost	400*625 = $250,000	400*625 = $250,000
Production staff cost	25*2142.86 = $53,571	325*2142.86 = $696,429
Admin and support cost	100*750 = $75,000	300*750 = $225,000
Rental cost	$225,000	$225,000
Total overhead cost	$603,571	$1,396,429
Overhead cost per unit	603571/25 = $24,142.84	1396429/325 = $4,296.70

Hence the percentage to be added to direct cost is as follows

For large advertising = 24142.84/28000*100 = 86.22%

For small advertising = 4296.70/4000 = 107.42%