Question

                                   

SHORT CASE STUDY                                                         

Oriental Motor Assembly Pte Ltd assembles three types of motorcycle at the same factory in Singapore: the 100cc Discover; the 250cc Pulsar and the 1000cc Punch. It sells the motorcycles throughout the world. In response to market pressures Oriental Motors 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). Oriental Motors accountant has produced the following analysis.

	Annual Output (Units)	Annual Direct labour hours	Selling price ($ per unit)	Raw material cost ($ per unit)
Discover	2000	200,000	4,000	400
Pulsar	1600	220,000	6,000	600
Punch	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.

The annual cost driver volumes relating to each activity and for each type of motorcycle are as follows:

	Number of deliveries to retailers	Number of set-ups	Number of purchase orders
Discover	100	35	400
Pulsar	80	40	300
Punch	70	25	100

The annual overhead costs relating to these activities are as follows:

Particulars	Amount ($)
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 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 Punch 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 motorcycle rental company for Discover 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:

1. Calculate the total profit on each of Oriental Motors three types of product using each of the following methods to attribute overheads:

1. The existing methods based upon labour hours.           
2. Activity-based costing.                                                                

Answer 1

I. Overhead rate = Total overhead costs/Total direct labor hours

Total overhead costs = $2400000 + 6000000 + 3600000 = $12000000

Total direct labor hours = 200000 + 220000 + 80000 = 500000

Overhead rate = $12000000/500000 = $24 per direct labor hour

	Discover	Pulsar	Punch
Sales	8000000	9600000	3200000
Less: Costs
Raw material cost	800000	960000	360000
Direct labor cost	1000000	1100000	400000
Overheads cost	4800000	5280000	1920000
Total cost	6600000	7340000	2680000
Total profit	1400000	2260000	520000

Working:

	Discover	Pulsar	Punch
Sales	=2000*4000	=1600*6000	=400*8000
Less: Costs
Raw material cost	=2000*400	=1600*600	=400*900
Direct labor cost	=200000*5	=220000*5	=80000*5
Overheads cost	=200000*24	=220000*24	=80000*24

II.

				Discover		Pulsar		Punch
Activity	Activity Cost $	Cost Driver Volumes	Activity Rate $	Cost Driver Usage	Allocated Cost	Cost Driver Usage	Allocated Cost	Cost Driver Usage	Allocated Cost
Deliveries to retailers	2400000	250	9600	100	960000	80	768000	70	672000
Set-up costs	6000000	100	60000	35	2100000	40	2400000	25	1500000
Purchase orders	3600000	800	4500	400	1800000	300	1350000	100	450000
Total	12000000				4860000		4518000		2622000

	Discover	Pulsar	Punch
Sales	8000000	9600000	3200000
Less: Costs
Raw material cost	800000	960000	360000
Direct labor cost	1000000	1100000	400000
Overheads cost	4860000	4518000	2622000
Total cost	6660000	6578000	3382000
Total profit	1340000	3022000	-182000