Question

The Gadget Co produces three products, A, B and C, all made from the same material. Until now, it has used traditional absorption costing to allocate overheads to its products. The company is now considering an activity-based costing system in the hope that it will improve profitability. Information for the three products for the last year is as follows:
A B C
Production and sales volumes (units) 15,000 12,000 18,000
Selling price per unit $7.50 $12 $13
Raw material usage (kg) per unit 2 3 4
Direct labour hours per unit 0.1 0.15 0.2
Machine hours per unit 0.5 0.7 0.9
Number of production runs per annum 16 12 8
Number of purchase orders per annum 24 28 42
Number of deliveries to retailers per annum 48 30 62
The price for raw materials remained constant throughout the year at $1.20 per kg. Similarly, the direct labour cost for the whole workforce was $14.80 per hour. The annual overhead costs were as follows:
$
Machine set up costs 26,550
Machine running costs 66,400
Procurement costs 48,000
Delivery costs 54,320

Required:
(a) Calculate the full cost per unit for products A, B and C under traditional absorption
costing, using direct labour hours as the basis for apportionment. (15 marks)

(b) Calculate the full cost per unit of each product using activity-based costing. (20 marks)
  
(c) Using your calculation from (a) and (b) above, explain how activity-based costing may help The Gadget Co improve the profitability of each product. (15 marks)

Answer 1

Calculation of overhead costs to be allocated to each product under traditional method based on direct labor hours
	Product A	Product B	Product C	Total
Units produced	15000	12000	18000
Direct Labor hours per unit	0.1	0.15	0.2
Total direct labor hours required	1500	1800	3600	6900
Total overhead costs = (26550+66400+48000+54320)	$195,270
Calculation of overhead rate = (195,270/6,900)	$28.30	per hour
Calculation of full cost per unit under traditional costing
	Product A	Product B	Product C	Total
Raw materials	$2.40	$3.60	$4.80
	(1.20*2)	(1.20*3)	(1.20*4)
Direct Labor	$1.48	$2.22	$2.96
	(14.80*0.10)	(14.80*0.15)	(14.80*0.20)
Overhead	$2.83	$4.25	$5.66
	(28.30*0.10)	(28.30*0.15)	(28.30*0.20)
Full cost per unit	$6.71	$10.07	$13.42
Calculation of activity rate
Activity	Overhead	Cost driver	Volume of cost driver		Activity rate
Machine set up costs	$26,550	Production runs	36	(16+12+8)	$737.50
Machine running costs	$66,400	Machine runs	32100	(0.50*15000)+(0.70*12000)+(0.9*18000)	$2.07
Procurement costs	$48,000	Purchase orders	94	24+28+42	$510.64
Delivery costs	$54,320	Deliveries to retailers	140	48+30+62	$388.00
Calculation of overhead cost for each product
	Product A	Product B	Product C
Machine set up costs	$11,800	$8,850	$5,900
Machine running costs	$15,514	$17,376	$33,510
Procurement costs	$12,255	$14,298	$21,447
Delivery costs	$18,624	$11,640	$24,056
Total overhead costs	$58,193	$52,164	$84,913
Production volume	15000	12000	18000
Overhead cost per unit	$3.88	$4.35	$4.72
Calculation of full cost under ABC costing
	Product A	Product B	Product C	Total
Raw materials	$2.40	$3.60	$4.80
Direct Labor	$1.48	$2.22	$2.96
Overhead	$3.88	$4.35	$4.72
Full cost per unit	$7.76	$10.17	$12.48
c
From ABC costing we can see that the product C is providing highest profit to the company as compared to product B where the profit is lower and profit A where there is loss
Therefore the company should increase the volume of production and sale for product C to improve its profitability.
Also company should analyse the increase in cost for product A, some of the reason is higher number of deliveries for the product.
The company should analyze whether it would be beneficial for the company to continue the product A production and sale.
Thus ABC costing helps to calculate the correct cost of each of the product by allocating overhead based on activity and volume of activity.