Question

Question 4: Activity Based Costing (20 marks in total)

Black and Hollis perform consulting services related to e-commerce and information systems, in Adelaide. The firm, which bills $187.50 per hour for services performed, is in a very tight labour market and is having difficulty finding quality staff. The labour cost per hour paid by Black and Hollis for professional staff time is $67.50. Selected information follows:

• Billable hours for clients for the year totalled 5,000, consisting of information systems services, 3,100 and e-commerce, 1900.
• Administrative costs of $513,000 was (and continues to be) allocated to both consulting services based on billable hours. These costs consist of staff support, $270,000; in house computing, $204,600, and miscellaneous office charges, $38,400.

A recent analysis of staff support costs found a correlation with the number of clients served. In-house computing and miscellaneous office charges varied directly with the number of computer hours logged and the number of client transactions respectively. The following table shows the number of clients, computer hours and client transactions for the e-commerce and information system consulting services.

	e-commerce consulting	Information systems consulting	Total
Number of clients	50	200	250
Number of computer hours	1800	2600	4400
Number of client transactions	600	400	1000

Required:

1. Assume that the firm uses traditional costing procedures allocating total costs based on billable hours. Determine the profitability of the firm’s e-commerce and information systems consulting services expressing your answer in both dollars and as a percentage of activity revenue.
2. Repeat requirement 2 using activity-based costing.
3. You have been asked by William Black to prepare a short report to Sam Spade, one of the firm’s partners, explaining how activity based costing can improve costing accuracy when compared with traditional costing procedures. In the report provide a response to Sam's approach, he doesn’t care where his professionals spend their time because as he notes, ‘Many clients come to expect both services and we need both to stay in business. Also, information systems and e-commerce professionals are paid the same hourly rate’. Include in the report an evaluation as to whether an aggressive expansion of either consulting service is desirable. (350 words)

Answer 1

Answer 1:

Profitability of the firm’s e-commerce and information systems consulting services under traditional costing:

Administrative costs = $513,000

Administrative costs are based on billable hours.

Administrative cost allocated per billable hour = $513,000 /5000 = $102.60

e-commerce Information systems services Total Service Revenue (@$187.50 Per hour Labor cost (@$67.50 per hour) Administrative cost (applied @102.60 per hour) Profit Profit as % Total (1900 hours) $356,250 $128,250 $194,940 $33,060 9.28% Total 3100 hours $581,250 $209,250 $318,060 S53,940 9.28% $937,500 $337,500 $513,000 $87,000 9.28%

Answer 2:

Profitability of the firm’s e-commerce and information systems consulting services using activity-based costing:

Cost driver rate calculation and allocation to service lines based on activity based costing:

Allocated to Cost Driver Staff support cost In house computin Miscellaneous office charges$38,400 Number of client transactions Total administrative costs $513,000 Cost driver quantity Cost driver rate e-commerce Information systems $216,000 $120,900 $15,360 $352,260 $1,080.00 $46.50 $38.40 $54,000 $83,700 $23,040 $160,740 $270,000 Number of clients $204,600 Number of computer hours 250 4400 1000

Profitability using ABC:

e-commerceInformation systems services Total Service Revenue (@$187.50 Per hour Labor cost (@$67.50 per hour) Administrative cost (applied @102.60 per hour) Amount $356,250 $128,250 Amount $581,250 $209,250 $937,500 $337,500 $54,000 $83,700 $23,040 $288,990 $67,260 18.88% $216,000 $120,900 $15,360 $561,510 $19,740 3.40% $270,000 $204,600 $38,400 $850,500 $87,000 9.28% Staff support cost In house computin Miscellaneous office charges Total costs Profit Profit as %

Answer 3:

Report to Sam Spade, one of the firm’s partners, explaining how activity based costing can improve costing accuracy when compared with traditional costing procedures

Mr Sam Spade,

Partner,

Sub: Improving accuracy of reporting using activity based costing when compared with traditional costing procedures

Dear Mr Sam,

I refer to attached analysis of costing and profitability of the two service lines e-commerce system consulting and Information system consulting.

Our total expenses are $850,500 out of which $513,000 (almost 60%) are overheads. Under traditional costing system 60% of total costs are allocated based on billable hours which is not correct basis. If we allocate based on billable hours , we observe that both our service lines results in same profitability of 9.28%. This however does not reflect the actual costs incurred as cause and effect have not been factored while allocating administrative expenses.

In contrast, when analyze the activities involved in administrative expenses, identify cost drivers and allocate costs based at the cost driver rates, we find e-commerce services has better profitability at 18.88% as compared to Information system services' profitability at 3.40%. Activity based costing system allocates cost based on cause and effect and gives more precise costing of our service lines. This helps us in analyzing and evaluating our services and their profitability.This will also help better control of expense and pricing of our services.

We do not do such analysis and continue using traditional costing we run the risk of inaccurate costing, pricing and quotations and hence making erroneous decisions. This has the potential of taking business which are not profitable and losing business which are profitable.

In service industry where overheads are of higher proportion of total cost it is essential to allocate costs on rational basis by using methodologies such as Activity based costing.

It is also essential to evaluate desirability of aggressive expansion of either consulting services. We must evaluate the financials analysis and sustainability of service lines with quality work in view of a very tight labor market and difficulties we are facing in finding quality staff.