Question

The annual overhead costs relating to these activities are as follows: ????????Particulars Deliveries to retailers Amount ($) ????????2,400,000 ????????Set-up costs 6,000,000 ????????Purchase orders 3,600,000 ????? All direct labour is paid at $20 per hour. The company holds no stocks. 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 Unwind model 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 caravan rental company for the Getaway model. For such a big order they will not pay our normal prices so we will need to ensure very competitive pricing, and therefore accurate costing. 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”.

(b) You, as the consultant management accountant, are required to write a report to the directors of Wayco Leisure. The report should: (I) Evaluate the labour hours and the activity-based costing methods in the circumstances of Wayco Leisure. (II) Examine the implications of activity-based costing for Wayco Leisure, and in so doing evaluate the issues raised by each of the directors.

Answer 1

To,

The Directors,

Wayco Leisure

Dear All,

   I would like to address your concerns regarding the use of activity based costing for allocation of OH instead of labor hours. Labor hour based allocation is a very broad and unrefined way of allocation. A percentage of labor hours is allocated as OH, however no information about the composition of overheads is given. Further, the overhead rate is predetermined. The actual overhead might differ and this may result in under or over application of OH. While quoting prices to the customers, accurate costing is of utmost importance as if the an incorrect price is quoted, the company may suffer financially.

As far as the concern of getting better at an activity with time, I would like to point out that the aim of activity based costing is to identify non value adding activities. Once the cost of each activity is known, cost saving ideas can be worked upon which will greatly help in achieving the target of competitive pricing.

The overall profit of the company may not remain the same, since more accurate costing and pricing may result in higher profits for the company.

You are requested to take into account the benefits related to activity based costing and then take an informed decision.

Regards,

XYZ