Applying the three rates calculated above to the time spent by the products in production gives the following results:
Comparing the figures arrived at using a Plantwide rate with those arrived at using a departmental rate, Job X costs have decreased and Job Y costs have increased. This is because Job X spends a large part of its production time in the low cost Department A (5,000 labour hours in A compared to 500 machine hours in B). In contrast, Job Y spend most of the production time in the high cost Department B (3,000 machine hours in B compared to 400 labour hours in A).
This illustrates the greater accuracy achieves using departmental rates.
If Activity-based Costing is used, the rates are no longer based on departments, but on activities. Each activity is regarded as having a cost driver, which “drives” the overhead cost of that activity. The cost of each product is then found by applying the cost per cost driver to the amount of cost drivers used by each product or job. A difficulty here is that the only information available for each Job is labour hours, machine hours, and the number of batches, therefore the cost drivers must be chosen from these measurements.
There is no obvious cost driver for General Factory overheads – they are facility-sustaining costs and cannot be traced to products using cost drivers, which have a cause-and-effect relationship. According to Drury, “the ABC literature advocates that these costs should not be assigned to products since they are unavoidable”. It would be best to include them in the percentage mark-up. However, if they are to be traced to products, the “cost driver” must be either labour hours or machine hours. As there are more labour hours than machine hours, labour hours will be used.
The calculations are detailed in Appendix 4, and give the following results:
Given the limited amount of information available, these figures may not be accurate, and if Activity-based costing is to be used, further information would need to be obtained.
Comments on the customers’ reaction to bids for Jobs X and Y
Using the Plantwide rate, the bid price of Job X was £18.75, which was turned down in favour of another bid which was £15.75.
If the more accurate departmental rates (Step method) had been used to find the cost of Job X, the bid price would have been only £14.63, and as it was less than the competitors’ bid, would have been the winning bid.
This confirms the Marketing Manager’s suspicion that the costing system is not accurate, and confirms the Production Manager’s confidence that they should be able to price their products competitively.. In the case of Job X, they lost business by over-pricing.
Using the Plantwide rate, the bid price of Job Y was £60, which was accepted by the customer because the next lowest bid was £103.
If the more accurate departmental rates (Step method) had been used to find the cost of Job Y, the bid price would have been £101.5. This was still slightly less than the next lowest bid, so the customer would probably have accepted the bid. The company therefore lost potential profit by under-bidding.
An explanation of the superiority of activity-based costing compared to traditional methods, for future costing
The use of labour rate are not accurate, as there is no longer a “cause-and-effect” relationship between labour hours and overhead cost, due to automation and the increase in costs outside the production area.
Even where machine hour rates are used, costs are still not accurate, as service department costs are not incurred in proportion to machine hours.
Use of hourly rates per production department therefore give rise to inaccurate costs, which distort prices and lead to loss of business or loss of profits.
Activity-based costing has moved away from absorbing overheads using an hourly rate, recognising that it is not necessarily the number of hours, which cause overheads costs.
Activities cause costs, and costs should be identified with activities, not departments. Each activity has a cost driver, which is the factor, which causes the costs to increase (cause-and-effect)
By using ABC, a rate per cost driver can be found for each activity, including those carried out by Service departments, so the costs of Service departments do not have to be shared between the Production departments.
This costing method is superior to the traditional departmental rates because:
- Costs of service departments can be traced directly to products using ABC, giving more accurate, and more detailed, costs
- It recognises that overheads depend on complexity not just volume
∙ It traces resource consumption for each activity so gives much more information
Conclusion (indicative comments)
The company should change their costing system to a departmental rate immediately, but should consider whether it is worth obtaining further information in order to introduce Activity-based costing, which should give even more accurate costs.
Appendix 1
Plantwide overhead rate
Plantwide overhead rate = Total overheads
Total direct labour hours
= (500,000 + 225,000 + 150,000 +625,000 +200,000 +800,000)
(200,000 + 50,000)
= £10 per labour hour
Costs and prices of Job X and Job Y using Plantwide rate (current method)
Table 1
Table 2
*Either format acceptable
Appendix 2
Departmental rates using the Direct method of service department allocation
Table 3
Department A Department B
Direct overhead £200,000 £800,000
Maintenance:
(1,000/8,000 x (500,000) 62,500
(7,000/8,000 £500,000) 437,500
Power:
(10,000/60,000 x £225,000) 37,500
(50,000/60,000 x £225,000) 187,500
Setups:
(40/200 x £150,000) 30,000
(160/200 x £150,000) 120,000
General Factory:
(35,360/130,000 x £625,000) 170,000
(94,460/135,000 x £625,000) 455,000
Total £500,000 £ 2,000,000
Dept. A overhead rate: £500,000/200,000 = £2.50 per Direct labour hour
Dept. B overhead rate: £2,000,000/120,000 = £16.67 per Machine hour
Costs and prices of Job X and Job Y using Direct method rates
Table 4
*either format acceptable
Appendix 3
Departmental rates using the Step method of service department allocation
Allocation order: General Factory, Maintenance, Power, Setups
Table 5
Dept. A overhead rate: (£480,276/200,000) = £2.40 per Direct labour hour
Dept. B overhead rate: (£2,019,724/120,000) = £16.83 per Machine hour
Costs of Job X and Job Y using Step method rates
Table 6
*Either format acceptable – there may be slight rounding differences
Unit costs using Activity-based costing Appendix 4
*cost driver measurements must be available for Job X and Y (so could not use maintenance hours for Maintenance or Kilowatt-hours for Power – the only possible cost drivers are labour hours, machine hours or number of batches)
Costs of Job X and Job Y using ABC rates
