Finance/Accounts order 3000 words

Part A.

 

 

  1. Calculation of Variable and Fixed Factory Overhead Cost per Direct Labour Hour (DLH).

 

(a) The variable factory overhead cost per direct labour hour can be calculated by dividing the budgeted amount of variable overhead cost by the budgeted number of direct labour hours (DLHs). (Drury, 2007). That is:

 

= $4/DLH.

 

(b) The fixed factory overhead cost per direct labour hour can also be calculated by dividing the budgeted amount of fixed factory overhead cost by the budgeted number of direct labour hours. (Drury, 2004, 2007). That is:

 

= $4.75/DLH

 

  1. Calculation of Total Cost per Case

 

  1. Total Cost per case of Hinkels

 

Cost Item   Amount($)
Direct Materials Cost5.00
Direct Labour Cost3.60a
Variable Overhead Cost2.40b
Fixed Overhead Cost2.85c
Total Cost$13.85

 

Notes on calculations.

 

a Direct Labour cost is calculated by multiplying the direct labour rate per hour by the number of direct labour hours per case. For Hinkels, this is given by

 

Direct Labour Cost = 0.6 hrs X $6/hr = $3.60.

 

b Variable overhead cost is calculated by multiplying the variable factory overhead cost per direct labour hours by the total number of direct labour hours.

 

Variable Factory Overhead cost per case of Hinkels = 0.6DLH x $4/DLH = $2.40 per case.

 

cFixed Factory Overhead Cost is calculated by multiplying the fixed factory overhead cost per direct labour hour by the number of direct labour hours required to produce one case of Hinkels. This is calculated as follows:

 

Fixed factory overhead cost per case of Hinkels = 0.6DLH x$4.75/DLH = $2.85.

 

  1. Total Cost per case of Quirts

 

Cost ItemAmount ($)
Direct Materials Cost10.00
Direct Labour Cost6.40e
Variable Overhead Cost3.20f
Fixed Overhead Cost3.80g
Total Cost per Case$23.40

 

Notes on Calculations

 

e Direct Labour cost is calculated by multiplying the direct labour rate per hour by the number of direct labour hours per case. For Quirts, this is given by

 

Direct Labour Cost = 0.8 hrs X $6/hr = $6.40

 

f Variable overhead cost is calculated by multiplying the variable factory overhead cost per direct labour hours by the total number of direct labour hours.

 

Variable Factory Overhead cost per case of Quirts= 0.8DLH x $4/DLH = $3.20 per case.

 

gFixed Factory Overhead Cost is calculated by multiplying the fixed factory overhead cost per direct labour hour by the number of direct labour hours required to produce one case of Quirts. This is calculated as follows:

 

Fixed factory overhead cost per case of Quirts= 0.8DLH x$4.75/DLH = $3.80

 

  1. Calculation of Target Quantity

 

The company desires a pre-tax profit of $300,000. We need a quantity for each case that can provide this target profit. Assuming that each product contributes $150,000, we can set up an equation where the unknown quantity can be determined. Let the quantity be Q. Therefore

 

Selling Price x Q – Cost Price x Q – Non Factory Fixed cost = Target profit.

 

To arrive at the pre-tax profit, we must also deduct the non factory fixed costs from the selling price. The fixed costs are apportioned to the two products based on direct labour hours.

 

For Hinkels, fixed cost is given by

 

(2,000,000/320,000) x 0.6 x 400,000 = $1,500,000

 

For Quirts, fixed non factory fixed cost is given by

 

(2,000,000/320,000) x 0.8 x 100,000 = $500,000

 

For Hinkels, the quantity can be calculated as follows

 

21Q – 13.85Q – 1,500,000 = 150,000

Simplifying the left hand side we get:

 

7.15Q = 1,650,000

Therefore Q = 230,769 Cases.

 

For Quirts, the quantity is determined as follows:

 

30Q – 23.4Q – 500,000 = 150,000

 

Simplifying the left hand side we get:

 

6.6Q = 650,000

Therefore Q = 98,485 Cases.

 

Therefore, the company must produce and sell 230,769 and 98,485 cases of Hinkels and Quirts, respectively to be able to make a pre-tax profit of $300,000. This is based on the assumption that each product contributes $150,000. However, altering the pre-tax profit required from each product will also alter the quantities.

 

 

 

 

Part B. Activity Based Costing.

 

An activity rate for each cost driver is calculated by dividing the total cost of the activity by the number of activities. (Blocher et al., 2005). This is shown in the table below.

 

 

Calculation of Activity Rates
Activity Consumption cost driverCost ($) (1)Activity Consumption (2)Activity rate [(1)÷(2)] ($)
Purchases440,0002000002.20
Materials movement615,0001500004.10
Machine hours265,0001000002.65
Direct Labour Hours960,0003200003.00
Direct Labour Hoursa520,0003200001.63

 

Notes.

aDirect labour hours appears twice because it carters for the fixed overhead cost of $520,000 that cannot be traced to any cost driver. So the cost driver in this case is the number of direct labour hours.

 

1)     Apportionment of Overheads to Products

 

One the activity rates have been calculated, the costs can now be apportioned to the products based on their demand for activities. (Drury, 2004, 2007; Blocher et al., 2007).

 

 

  1. a) Hinkels

 

 

Activity Consumption Cost DriverActivities (1)Activity

Rate ($) (2)

Total O/H ($) [(1) x (2)] (3)O/H per case

[(3)÷400,000] ($)

Purchas orders150,0002.203300000.83
Material movement110,0004.104510001.13
Machine hours60,0002.651590000.40
Direct labour hours240,0003.007200001.80
Direct labour hours240,0001.633900000.98
Total Overhead Cost per Case400,000$5.13

The total cost for each activity is calculated by multiplying the activity rate by the number of activities. To get the unit cost, the total overhead cost is divided by the number of cases produced. In the case of Hinkels, 400,000 cases are produced.

 

 

  1. b) Quirts

 

 

Activity Consumption Cost DriverActivities (1)Activity

Rate ($) (2)

Total O/H ($) [(1) x (2)] (3)O/H per case

[(3)÷100,000] ($)

Purchas orders50,0002.201100001.10
Material movement40,0004.101640001.64
Machine hours40,0002.651060001.06
Direct labor hours80,0003.002400002.40
Direct labour hours80,0001.631300001.30
Total Cost Overhead Cost400,000$7.50

 

2)     Total costs

  1. a) Total Cost of Hinkels = Direct Labour cost + direct labour Cost + Factory overhead cost

 

= $5.00 + $3.60 + $5.13 = $13.73

 

  1. b) Total Cost of Quirts

= $10.00 + $6.40 + $7.50 = $23.90.

 

3)     Calculation of Volume.

 

We also assume here that each product must contribute $150,000 to the anticipated pre-tax profit of $300,000.

 

Therefore for Hinkels, we have

 

21Q – 13.73Q = 150,000

Simplifying and solving for Q we get

 

Q = 20,632 Cases.

 

For Quirts we have

 

30Q – 23.90Q = 150,000.

Simplifying and solving for Q we get

 

Q = 24,590Cases.

 

 

Part C. Discussion

 

The difference in the two figures is as a result of the differences in the allocation of overheads under the two approaches – traditional costing and activity based costing. (ABC). Under traditional costing, more of the costs tend to be allocated to the product that is produced in a high volume. For example, Hinkels demanded 240,000 direct labour hours to produce 400,000 cases while Quirts demanded 80,000 hours to produce 100,000 cases. As a result, Hinkels was charged a higher amount of overhead cost under traditional costing than under activity based costing. On the contrary, Quirts was charged more overhead cost under ABC than under traditional costing. It can be observed here that the difference was not much because only two products were produced and the process was to some extent labour intensive. Moreover, Hinkels was produced in a higher quantity and demanded more activities while Quirts was produced in a lower quantity and demanded less activities. Thus, there was really no difference in the application of either costing approaches. However, in situations where there are many products produced using highly automated production systems and where a low volume product tends to demand more activities, it becomes important to use activity based costing. (Drury, 2004, 2007; Blocher et al., 2005).  This paper recommends ABC because the company may subsequently expand its product lines, as well as increase the automation of its manufacturing processes.

 

Volumes under ABC are lower than volumes under traditional costing because in the case of traditional costing, non factory fixed costs of $2,000,000 had to be deducted to arrive at pre-tax profit. Thus more cases had to be produced for each product to cover the non factory fixed costs. However, under activity-based costing, there was not non factory fixed costs.

 

Activity-based costing is a costing technique that allocates overheads cost to products or cost objects based on the products’ demand for activities. The assumption underlying activity based costing is that products or cost objects consume activities while activities in turn consume resources. (Gupta and Galloway, 2001; Drury, 2004). Activity based cost systems allocate costs to activities based on their consumption of resources, and then activity costs are allocated to products or cost objects based on their individual demand for activities. (Gupta and Galloway, 2001; Drury, 2004).  On the other hand, traditional absorption costing methods assign overhead or indirect costs to products using a two stage approach. (Goebel et al., 1998; Blocher et al., 2005). Firstly, overheads are allocated to cost centres (or cost pools) and secondly, overheads are allocated from cost pools or cost centres to products (or cost objects). (Goebel et al., 1998; Blocher et al., 2005).  As earlier mentioned, this method of allocating costs to products or cost objects has a number of shortcomings. In making the first allocation to cost pools, many different methods may be used but the second allocation to cost objects or products is almost always based on labour hours. (Goebel et al., 1998) This leads to the following definition of a traditional costing system by Goebel et al (1998: 499):

“ a traditional cost system is one that uses a volume basis for overhead expense assignment”.

 

 

 

Activity-based costing was developed by Kaplan and Norton both professors of Harvard Business school and it has received a lot of praises. The main differences between activity based costing approaches and traditional based costing approaches. The main difference is that while traditional costing systems are based on volume-related cost drivers, activity based costing extends the allocation basis to include non-volume cost drivers as well. (Lamminmaki and Drury, 2001). This is due to the fact that increased product variety and the development of technologies have resulted in a growth in overhead costs that are unrelated to volume and has in turn increased the probability that traditional costing methods will generate cost information that is misleading. (Lamminmaki and Drury, 2001).

According to Blocher et al (2005) firms with either increasing expenses, numerous products services, customers processes, or a combination of the aforementioned processes can be greatly impacted by an activity based costing system. These include plants that produce standard and custom products, high-volume and low-volume products, or mature and new products. In addition, firms that accept small and large orders alike, offer standard and customised deliveries, or satisfy all customers including those who demand frequent changes either before or after delivery and those who hardly ever demand warranties can benefit substantially from activity based costing. (Blocher et al., 2005: p 138)

According to Innes and Mitchel (1995), ABC makes costs more visible since it details the organization’s activities and their respective costs. Instead of simply recording costs by the type of input, which they represent it, categorizes them by the way in which they are consumed. From the foregoing, three possibilities of cost reduction have arisen which include:

 

Value added analysis: Activities are screened to identify non-value added activities which result in no customer benefits through the enhancement of final product or service and should therefore be targeted for elimination. (Innes and Mitchel, 1995; Blocher et al., 2005),

Core I support:  In this tripartite classifica­tion of activities priority is given to the freeing of resource from the latter two categories either to augment the former or to simply eliminate cost. (Innes and Mitchel, 1995; Blocher et al., 2005).

Activity mapping: Activities are recorded on a two dimensional map showing the flow of work by location; and in terms of its duration. The identification of complexity and duplication is facilitated and a basis for process re-engineering is provided. (Innes and Mitchel, 1995),

Another advantage of activity based costing is that organisations that adopt it have the possibility of automatically adopting activity based budgeting (ABB) developed from the basic framework of activity based costing because it becomes possible for the company to match activity budgets to relevant individuals, and therefore support the operation of practical responsibility accounting. (Innes and Mitchel, 1995). Activity based budgeting also enables the company to make use of available cost driver statistics, which assist in assessing future resource needs by giving an indication of existing and planned work throughout. (Innes and Mitchel, 1995). It is also possible for the company to make use of variance feedback available in the Activity based budgeting system which includes detailed information about all individual cost pools. (Innes and Mitchel, 1995). This in turn facilitates budget flexing which is dependent on cost drivers. it is also provides information on capacity utilisation.

Activity-based cost information can be used as a means of re-pricing products to customers so that revenues can exceed costs used in producing products for individual customers (Cooper and Kaplan, 1992). In addition, Activity based costing can help a company to identify unprofitable customers as well as unprofitable products. (Cooper and Kaplan, 1992). As such, prices can be lowered to customers ordering standard products in high volumes and increased to customers ordering highly customised products in low volumes. (Cooper and Kaplan, 1992). Activity based costing therefore enables a company to separate profitable products from unprofitable products as well as unprofitable customers from profitable ones. By so doing a company can better understand how to better serve each customer segment.

 

Conclusions

 

This paper has analysed the criticisms tabled against traditional cost accounting methods. In addition, the paper has analysed the proposed alternative activity based costing and the evidence tabled for its superiority over traditional volume based costing. Based on the evidence, one can conclude that traditional absorption costing is not suitable in today’s modern manufacturing environment given the increased complexity in products and manufacturing techniques as well as increasing globalisation and competition. Consequently, activity based costing is superior over traditional absorption costing since it produces more reliable cost information. Many organisations have adopted activity based costing and find it very useful in generating superior information. For example, Granof et al. (2000) show that ABC can be applied to a single department of a major institution of higher education in order to provide more management-oriented information than the systems currently employed. Granof et al (2000) also suggest that the primary benefit of ABC is not only that it is an improvement of an existing system but that it provides the structure for the establishment, for the first time, of a true management-oriented system.

Despite its merits, ABC has been subject to criticisms. For example there is evidence which suggest that the benefits of ABC for price-setting do not necessarily extend to more competitive markets. Rather, the competitive setting itself offers more valuable information. (Cardinaels et al., 2004).  In addition, Briers et al (1999) cited in Cardinaels et al. (2004) provides evidence that participants with biased cost data perform better when they receive highly informative market feedback. McGowan et al. (2006) in an analysis of ABC implementation and hospital performance argue that society does not benefit from the implementation of ABC in a government/non-governmental organisation. However, despite these slight shortcomings of ABC, this paper concludes that the shortcomings of the traditional cost accounting are more than those of ABC and thus, ABC is superior over traditional absorption costing.

 

 

References.

 

Blocher, E., Chen, K., Cokins, G., Lin, T. (2005). Cost Management. A Strategic Emphasis.(3rd International Edition). McGraw-Hill

 

Cardinaels, E., Roodhooft, F., Warlop, L. (2004). The value of Activity-Based Costing in Competitive Pricing Decisions. Journal of Management Accounting Research, vol. 16, pp. 133-148.

 

Cooper, Robin; Kaplan, Robert S. (1992). Activity-Based Systems: Measuring the Costs of Resource Usage. Accounting Horizons; Vol. 6(3); pp 1-12.

 

Drury, C. (2004) Management and cost accounting (6th edition), Thomson Learning, London

 

Drury, C. (2007). Management and Cost Accounting, Cengage Learning EMEA.

 

Gupta, M., Galloway, K. (2003). Activity-Based costing/management and its implications for operations management. Technovation, vol. 23, pp. 131-138.

 

Innes, J., Mitchel, F. (1995). A survey of activity-based costing in the U.K.’s largest companies. Management Accounting Research., Vol. 6, pp 137-153

 

Lamminmaki,  D., Drury, C. (2001). A comparison of New Zealand and British product-costing practices. The International Journal of Accounting, vol. 36, pp. 329-347.

 

McGowan, A. S., Holmes, S. A., Martin, M. (2006). The Association Between Activity-Based Costing System Adoption and Hospital Performance. AAA 2007 Management Accounting Section (MAS) Meeting. Available at SSRN: http://ssrn.com/abstract=921471