Question

Please answer all parts

2. Hearts plc currently uses an absorption costing model to allocate overheads to its three products X, Y and Z. It is currently considering whether an activity-based costing model might provide more accurate cost information and, as a result, allow the company to regain its previous market position. The production overheads for the year ended 31 March 2017 were as follows: Machine set up costs £26,550 Machine running costs £66,400 Procurement costs 4 Delivery costs £48,000 £54,320 The following information for each product is available: Production and sales volume Selling price per unit Material content per unit Labour input per unit Machine hours per unit Total number of production runs Total number of purchase orders Total number of deliveries 15,000 £7.50 0.1hr 0.5hr 16 24 48 12,000 £12 3kg 0.15hr 0.7hr 12 28 18,000 £13 4kg 0.2hr 0.9hr 8 42 62 The average cost of materials used during the year was £1.20 per kg, while the average labour cost was £14.80 per hour Required (a) Calculate, showing all workings, the total cost of one unit of each product according to an absorption costing model, using direct labour hours as the basis for allocating (b) Calculate, showing all workings, the total cost of one unit of each product according to an activity-based costing model and comment on your findings. (10) (c) Advise the directors of Hearts pic about the implications for management of moving from an absorption costing to an activity-based costing system

Answer 1

a) Cost per unit under absorption costing model

Total Annual Overhead Costs: $

Machine set up Costs   26,550

Machine running Costs 66,400

Procurement Costs 48,000

Delivery Costs 54,320

   195,270

Overhead absorption rate:

A B C Total

Production Volumes 15,000 12,000 18,000

Labour hours per unit 0.1 0.15 0.2

Total Labour hours 1,500    1,800 3,600 6,900

Therefore,overhead absorption rate =$195,270/6,900= $28.30 per hour

Cost per unit :

	A	B	C
	$	$	$
Raw materials ($1.20*2/3/4 kg)	2.40	3.60	4.80
Direct Labour ($14.80*0.1/0.15/0.2hrs)	1.48	2.22	2.96
Overhead ($28.30*0.1/0.15/0.2hrs)	2.83	4.25	5.66
Total Cost per unit	6.71	10.07	13.42

b) Cost per unit using ABC Costing

Cost Driver:

Cost pool Cost Driver

   Machine set up Costs   26,550 (36 production runs 16+12+8)

Machine running Costs 66,400 (32,100 machine hours 7,500+8,400+16,200)

Procurement Costs 48,000 (94 purchase orders 24+28+42)

Delivery Costs 54,320 (140 Deliveries 48+30+62)

   195,270

Cost per machine set up $26,550/36=$737.50

Cost per machine hours $66,400/32,100= $2.0685

Cost per order $48,000/94 =$510.6383

Cost per delivery $54,320/140 =$388

Allocation of overheads to each product:

	A	B	C	Total
	$	$	$	$
Machine set up costs	11,800	8,850	5,900	26,550
Machine-running costs	15,514	17,375	33,510	66,400
Procurement costs	12,255	14,298	21,447	48,000
Delivery costs	18,624	11,640	24,056	54,320
Total	58,193	52,163	84,913	195,270
Number of Units produced	15,000	12,000	18,000
Overhead Cost per unit	3.88	4.35	4.72

Total Cost per unit:

	A	B	C
	$	$	$
Raw materials	2.40	3.60	4.80
Direct Labour	1.48	2.22	2.96
Overhead	3.88	4.35	4.72
Total Cost per unit	7.76	10.17	12.48

c) Using activity -based costing

The following things can be observed -

Product A

The cost per unit of Product A is under ABC is $7.76 and under absorption costing is $6.71 and is 16% higher under ABC. So the company should do something to either reduce its cost or increase the selling price . Machine set up cost is also high for product A in comparison to other products and this could be reduced. Delivery cost are also high and this could be reduced through more efficiency.

Product B

The difference between the two approach is just $0.07 and the selling price is also $12 so it does not whichever method of costing is applied and product B is profitable

Product C

The unit cost for C is 7% lower under ABC when compared to absorption costing. Under absorption costing it is incurring a loss of $0.42 per unit as $13 is the cost. The reason could be that the number of production runs and product tests carried on C is relatively low. This leads to lower apportionment of machine set up cost to C.

ABC is therefore very useful in identifying that product C is more profitable than A.