Assignment Description
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:
In the above question , there is a problem with the allocation of overheads , which is the main reason the Financial controller has suugested to change the sytem of costing to ABC i.e Activity based costing .
The raw material and labour costs remain the same under any method of costing. However the overheads form a major portion of costs and hence an accurate allocation is very much essential for deriving perfect costs . Therefore activity based costing is preferred over the traditional methods of job costing.
Under ABC , the specific cost drivers are identified and the proprotion of the driver for each activity or cost element is tracked down .On the proportionate basis , the costs of overhead will be allocated to the overhead instead of the quantity produced as under traditional systems.
1. The per unit costs and the target prices,under both the systems have been computed in the following tables :
| Calculation of Unit cost under Product Costing | ||||
| Sr No | Particulars | SM | DM | HDM |
| $ | $ | $ | ||
| 1 | Actual Sales price per unit | $ 210.00 | ||
| 2 | Annual sales (units) | 42,500 | 1,700 | 20,000 |
| Product costs: | ||||
| 3 | Raw material | $ 27.50 | $ 47.75 | $ 73.00 |
| 4 | Direct labour | $ 20.00 | $ 35.00 | $ 35.00 |
| 5 | Manufacturing overhead | $ 240.00 | $ 350.00 | $ 350.00 |
| 6 | Total cost per unit (3+4+5) | $ 288 | $ 433 | $ 458.00 |
| 7 | Target price = (6 ) x110% | $ 316.00 | $ 476 | $ 504 |
| Calculation of Unit cost under ABC System | ||||
| Sr No | Particulars | SM | DM | HDM |
| $ | $ | $ | ||
| 1 | Actual Sales price per unit | $ 210.00 | ||
| 2 | Annual sales (units) | 42,500 | 1,700 | 20,000 |
| Product costs: | ||||
| 3 | Raw material | $ 27.50 | $ 47.75 | $ 73.00 |
| 4 | Direct labour | $ 20.00 | $ 35.00 | $ 35.00 |
| 5 | Manufacturing overheads : ( Refer WN 1) | |||
| a | Depreciation, machinery | 1,070,000 | 347,750 | 1,257,250 |
| b | Maintenance, machinery | 70,000 | 22,750 | 82,250 |
| c | Engineering | 305,500 | 39,000 | 305,500 |
| d | Inspection and repair of defects | 223,344 | 28,512 | 223,344 |
| e | Purchasing, receiving and shipping Material handling | 418,112 | 71,168 | 400,320 |
| f | Depreciation, taxes and insurance for factory Miscellaneous manufacturing overhead | 563,850 | 201,375 | 577,275 |
| Total Manufacturing costs | 2,650,806 | 710,555 | 2,845,939 | |
| 6 | Per Unit Manufacturing overhead cost ( Total Overhead cost / Units ) | $ 62.37 | $ 417.97 | $ 142.30 |
| 7 | Total Per Unit cost (3+4+6) | $ 110 | $ 501 | $ 250 |
| 8 | Target price (7) x 110% | $ 121.00 | $ 551.00 | $ 275.00 |
WN 1