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.                        (6 MARKS)
2. Activity-based costing.                                                                 (6 MARKS)

2. Write a report to the directors of Oriental Motors as its cost accountant. The report should:

1. Evaluate the labour hours and the activity-based costing methods in the circumstances of Oriental Motors.                                      (4 MARKS)
2. Examine the implications of activity-based costing for Oriental Motors, and in so doing evaluate the issues raised by each of the directors.      (4 MARKS)

In drafting the report to directors, refer your calculations in requirement (a) above where appropriate.

   ([6 + 6] + [4 + 4]) = 20 mark

Answer 1

A) Total Profit as per existing method based on labour hours:

(figurs in $)

PARTICULARS	DISCOVER	PULSAR	PUNCH
Sales	8,000,000 (2,000*4,000)	9,600,000 (1,600*6,000)	3,200,000 (400*8,000)
(-)Raw Material Cost	800,000 (2,000*400)	960,000 (1,600*600)	360,000 (400*900)
(-) Direct Labour Cost	1,000,000 (200,000*5)	1,100,000 (220,000*5)	400,000 (80,000*5)
(-) Overheads Cost	4,800,000 (12,000,000*2/5)	5,280,000 (12,000,000*2.2/5)	1,920,000 (12,000,000*0.8/5)
Profit	1,400,000	2,260,000	520,000

Total Profit = 1,400,000 + 2,260,000 + 520,000 = $4,180,000

B) Total profit as per activity based costing:

Allocation of Overheads as per cost drivers

Overheads (OH)	Total OH Costs	Cost Drivers	Cost Driver Quantity	Overhead Rate per cost driver quantity ($)
Deliveries to Retailers	2,400,000	No. of deliveries	250	9,600 (2,400,000 / 250)
Set-up Costs	6,000,000	No. of set-ups	100	60,000 (6,000,000 / 100)
Purchase Orders	3,600,000	No. of purchase rders	800	4,500 (3,600,000 / 800)

Total Profit as per Activity Based Costing:

(figures in $)

PARTICULARS	DISCOVER	PULSAR	PUNCH
Sales	8,000,000 (2,000*4,000)	9,600,000 (1,600*6,000)	3,200,000 (400*8,000)
(-)Raw Material Cost	800,000 (2,000*400)	960,000 (1,600*600)	360,000 (400*900)
(-) Direct Labour Cost	1,000,000 (200,000*5)	1,100,000 (220,000*5)	400,000 (80,000*5)
(-) Overhead Cost
Delivery Cost	960,000 (9,600*100)	768,000 (9,600*80)	672,000 (9,600*70)
Set-up Cost	2,100,000 (60,000*35)	2,400,000 (60,000*40)	1,500,000 (60,000*25)
Purchase Orders	1,800,000 (4,500*400)	1,350,000 (4,500*300)	450,000 (4,500*100)
Profit / Loss	1,340,000	3,022,000	- 182,000

Total Profit = 1,340,000 + 3,022,000 + (182,000) = $4,180,000

C)To

The Directors

Oriental Motor Assembly Pte. Ltd.

Subject:  Evaluation of profit as per existing method and as per activity based costing:

We are currently operating three motor cycle model namely "Discover", "Pulsar" and " Punch".For the motor cycle model "Punch" , the existing method (i.e allocation on the basis of direct labour hours) leads to a profit whereas activity based costing leads to loss. This is so because this model( i.e Punch) has less number of direct labour hours as compared to other motor cycle models due to its less output units as compared to others. But when we use activity based costing and allocate the overheads as per cost driver quantities then there is not much difference between cost driver quantities af all the models. Therefore, the overhead allocation from activity based costing leads to loss in model "Punch".

D)

(i)Allocation of overhead cost on the basis of cost drivers is much better way than allocation on the basis of direct labour hours. This method shows the actual picture and profitability of each product.

(ii) Though overall profits are unaffected whether we use any of the method, but activity based costing helps us to analyse the position of each product in a better way and accordingly we can increase our profits by reducing costs in specified areas.

(iii) Activity based costing does not merely averages costs for our entire production, rather it shows the true allocation of our overheads in every particular area.