Question

How does a company transform its breakeven or loss customers into profitable ones while using activity-based (menu-based) pricing? Provide a specific example!

Answer 1

solution

Activity Based Pricing / Activity Based Costing is an Modern method of allocating overheads to the products and deciding the pricing of the product . it gives importance to non volume measure for allocating overhead cost which is ignored in traditional methods like absorption costing

there are 4 important steps in activity based princing / activity based costing for assigning the overheads costs to products

1) Identify all the activities which are performed for manufacturing the products or for rendering the services

2) identify Cost for each activity (Identified in steps 1) (It is term as cost Pool)

3) Find Out a determinent (Cost Driver) based on which we can assign activity cost to the produsts/services

4) Assign Cost of activity based on the Demand of Activity by the Product manufacturing

In Traditional method Overheads are assigned based on some Volume e.g Machine Hours , Labours Hours , Unit Produced it ignores the other more important factors which are non valume factors viz Number of set up Required by the products, Number of Purchase Order to be made etc

in the following example we try to solve same example with traditional method and activity based pricing method and we cover as how loss is converted into profit in activity based pricing method

Example

ABC LTD PRODUCE 2 PRODUCTS L & H

Annual manufacturing details are as followed

Product	output	machine hours	labou hours	No of purchase order	No of set ups	Contribution per unit
L	1000	2000	4000	80	40	160
H	10000	20000	40000	160	60	35
TOTAL	11000	22000	44000	240	100

Total cost center cost is 440000 ( futher analysed below)

particulars	Amount
Volume - related	110000
Purchase -related	120000
Set-up related	210000
Total	440000

a) Contribution from Each Product (Sales revenue less variable cost)

Product L = Contribution per unit * No of Units Produced

= 80 *1000 =160000

Product h = Contribution per unit * No of Units Produced

= 35 *10000 = 350000

b) Traditional Method of assigning overhead Cost & Computation of profit & loss

Absorption of overheads Based on Machine Hours

Absorption rate = overheads cost/ total machine hours

= 440000/22000

= 20/machine hour

Overheads Assigned to Product L = Machine Hours * Absorption Rate

= 2000*20

=40000

Overheads Assigned to Product h = Machine Hours * Absorption Rate

= 20000*20

=400000

Computation of Profit / Loss

Product L	Product H	Total
Contribution	160000	350000	510000
Less: Overheads Cost	40000	400000	440000
Profit/Loss	120000	-50000	70000

Note

Product L = Contribution - Overheads

=160000-40000

=120000(profit)

Product H = Contribution - Overheads

=350000-400000

=50000(loss)

c) Activity Based Pricing / Acitivity Based Costing

Computation of cost driver rate

particulars	cost drivers	drivers volumes	cost pool	cost driver rate
Volume - related	Unit Produced	11000	110000	10/ output
Purchase -related	Purchased order	240	120000	500/purchase order
Set-up related	no of set ups	100	210000	2100/per set up

Assignment of Overhead cost

particulars	working product L	Product L	working product H	Product H
Volume - related	1000*10	10000	10000*10	10000
Purchase -related	80*500	40000	160*500	80000
Set-up related	40*2100	84000	60*2100	126000
Total		134000		306000

Computation of Profit / Loss

	Product L	Product H	Total
Contribution	160000	350000	510000
Less: Overheads Cost	134000	306000	440000
Profit/Loss	26000	44000	70000

Product L = Contribution - Overheads

=160000-134000

=26000(profit)

Product H = Contribution - Overheads

=350000-306000

=44000(profit)

Note

Overall profit of ABC ltd remains same i.e 70000

But Profit from individual product changes due to change of cost allocating method where we saw that how loss Showing  product H is converted into Profit showing Product because of change in method adopted in overhead allocation