Question

Madina Electrical Corporation manufactures electric motors for commercial use. The company produces three models called SM, DM and HDM. The company uses a job costing system with manufacturing overhead applied on the basis of direct labour hours. The system has been in place with little change for 30 years. Product costs and annual sales data are as follows:

	SM	DM	HDM
Annual sales (units)	42500	1700	20000
Product costs:
Raw material	$27.50	$47.75	$73.00
Direct labour	$20.00	$35.00	$35.00
Manufacturing overhead	$240.00	$350.00	$350.00

For the past 13 years, the company’s pricing formula has been to set each product’s budgeted price at 110 per cent of its full product cost. Recently, however, the SM motor has come under increasing price pressure from offshore competitors. As a result, the price on the SM has been lowered to $210.

The company CEO recently asked the financial controller, ‘Why can’t we compete with these other companies? They’re selling motors just like our SM for $290. That’s only $2.50 more than our production cost. Are we really that inefficient?’

The financial controller responded by saying, ‘I think this is due to an outmoded product costing system. As you may remember, I raised a red flag about our system when I came on board last year. But the decision was to keep our current system in place. In my opinion, our product costing system is distorting our product costs. Let me run a few numbers to demonstrate what I mean’.

Getting the CEO’s go-ahead, the financial controller compiled the basic data needed to implement an Activity-Based Costing system. These data are displayed in the following tables. The percentages are the proportion of each activity driver consumed by each product line.

	Product lines
Activity	Activity driver	SM	DM	HDM
Depreciation, machinery	Machine time	40%	13%	47%
Maintenance, machinery	Machine time	40%	13%	47%
Engineering	Engineering hours	47%	6%	47%
Inspection and repair of defects	Engineering hours	47%	6%	47%
Purchasing, receiving and shipping Material handling	Number of material orders	47%	8%	45%
Depreciation, taxes and insurance for factory Miscellaneous manufacturing overhead	Factory space usage	42%	15%	43%

Activity Costs

Activity	Estimated costs ($)
Depreciation, machinery	2675000
Maintenance, machinery	175000
Engineering	650000
Inspection and repair of defects	475200
Purchasing, receiving and shipping	389600
Material handling	500000
Depreciation, taxes and insurance for factory	600000
Miscellaneous manufacturing overhead	742500

Required

Read the above scenario and write a report to the managing director discussing the following key areas:

1. How Madina Electrical’s traditional product costing system distorts the product costs of the SM, DM and HDMs and prices. Note: You are required to calculate per unit cost and target price.
2. Discuss general problems associated with Madina Electrical Corporation traditional costing system and highlight any indicators that the current costing system is outdated and flawed.
3. Calculate per unit cost and target price for each product line using Activity-Based Costing (ABC) system. (Note: calculate the rate per activity driver to be used in the desired activity-based costing system. Round up to the nearest two decimal points)
4. Discuss costs and benefits of adopting Activity Based Costing for Madina Electrical Corporation.
5. Analyse and explain the differences in the product costs and target prices for each product line between the two alternative costing systems. Discuss likely reasons for the identified differences.

Report should incorporate the following sections:

1. Cover page
2. Executive summary
3. Table of contents
4. Introduction
5. Body
6. Conclusion
7. Reference list (8-10 references must be cited)

To achieve this task, you are required to:

• review journal articles to discuss traditional product costing systems and articles to discuss the appropriateness of the contemporary approaches to cost allocations (e.g. ABC approach) to resolve the issues of costing.

Answer 1

Cover page : Evaluation of costing system for the company.

Executive summary: Evaluation of benefits of activity based costing system over the company's traditional costing system.

Table of contents:

1)Allocation of overheads

2)Calculation of overhead rate per unit

3)Calculation of unit cost and target price.

Introduction: This report consists of evaluation of abc costing system over the traditional costing system.

Body: as below

1)Allocation of overheads based on activity based costing

Activity	Associated cost	SM	DM	HDM	SM	DM	HDM
Depreciation, Machinery	2675000	40%	13%	47%	1070000	347750	1257250
Maintenance, Machinery	175000	40%	13%	47%	70000	22750	82250
Engineering	650000	47%	6%	47%	305500	39000	305500
Inspection and repair of defects	475200	47%	6%	47%	223344	28512	223344
Purchasing, receiving and shipping	389600	47%	8%	45%	183112	31168	175320
Material handling	500000	47%	8%	45%	235000	40000	225000
Depreciation Taxes and insurance of factory	600000	42%	15%	43%	252000	90000	258000
Miscellaneous Manufacturing Overhead	742500	42%	15%	43%	311850	111375	319275
Allocated Total overheads					2650806	710555	2845939

2)Calculation of overhead rate as per Activity based costing system

Particulars	SM	DM	HDM
Allocated overheads	2650806	710555	2845939
Units	42500	1700	20000
Overhead rate per unit	62.3719	417.9735	142.2969

3 )Calculation of unit cost and selling price as per Activity based costing

Particulars	SM	DM	HDM
RAW MATERIAL	27.5	47.75	73
DIRECT LABOUR	20	35	35
Overheads	62.3719	417.9735	142.2969
Total cost per unit	109.8719	500.7235	250.2969
Desired profit	10.98719	50.07235	25.02969
Target Price to be fixed (110% of total cost)	120.8590	550.79585	275.32659

Conclusion : As the Management was using allocation of overheads using direct labour hours the product SM became over priced as compared to the cost as per Activity based costing.

In activity based costing Activities are traced and recorded and then the overheads are allocated based on those activities so this system gives more accurate valuation of costs.

Also it was said that competitors were charging 290 for production SM so it highly profitable due to its low cost.

Therefore the company has to introduce activity based costing system for allocation of overheads.