CASES ON ACTIVITY BASED COSTING SYSTEM

1) Mentland Limited manufactures three types of products, Alpha, Beta and Delta. Presently the
company allocates all overheads on the basis of machine hours. At a recent management
meeting, the finance director, Sadia suggested that the present overhead allocation system of
using one blanket allocation basis distorts product costs, thus making it difficult to manage
overhead costs. The finance director proposed a change over to an Activity-Based Costing
(ABC) system. Relevant information relating to the three products is provided below:

Product Labour Machine hours Direct Direct Units Total

hours per per unit(a) labour cost Material produce machine
unit per hour cost per unit d (b) hours
a*b
Alpha 1 3 12 40 1,500 4500
Beta 3 2 12 24 2,500 5000
Delta 2 6 12 50 14000 84000

A total budgeted overhead for the period is 1,309,000 and a total budgeted machine hour is
93,500 hours.

The above total budgeted overheads can be divided into the following:

%
Material handling 30
Inspection 20
Set-ups 40
Machinery running 10

You further ascertain that materials were moved as follows for each product, Alpha 54 times, Beta
72 times and Delta 204 times. Numbers of inspections are Alpha 360, Beta 420 and Delta 1,420.
Numbers of set-ups are Alpha 110, Beta 170 and Delta 820.
REQUIRED:

A. Calculate the cost of each product under the conventional product costing system.
B. Calculate the cost of each product using Activity-Based Costing (ABC).
C. Briefly explain how the use of the ABC system offer a better understanding of the costs
allocated to each product.

QUESTION 4
Telford Limited produces a special type of soft drink which it distributes throughout the Telford
area. For many years, the company has concentrated on the residential market where it had a
comparative advantage. At the end of 20X4, management unanimously agreed to expand
production and distribute to companies and schools. The company therefore created two operating
divisions- Residential Sales and Commercial Sales. The residential sales division will be
responsible entirely for the distribution of the soft drinks to households.
The commercial sales division will be responsible entirely for the distribution of the soft drinks to
companies and schools. The soft drinks for the commercial market will require a slight
modification in its contents. It will also need special packaging and labelling.

Since the creation of the two operating divisions, there has been constant disagreement between
the residential sales manager and the accounting department over the way costs are assigned to the
products. The residential sales manager notes that, we all know the commercial soft drinks
consume much resources and efforts than the residential drinks.
I wonder why they all have the same per unit overhead cost.

During the year, 20X7, 90,000 boxes of residential and 10,000 boxes of commercial soft drinks
were produced and sold. The costing department provided a total cost for the year as follows:

Direct Materials Residential Soft Drink 180,000

 Commercial Soft 30,000
Drink

Direct Labour Residential Soft Drink 90,000

CommercialSoft Drink 20,000

Production Support (Overheads) 1,966,00

0

In January 20X8, Telford Limited submitted a bid to supply soft drinks to the refectory at the
University of Wolverhampton. It is managements policy that all company products should be
priced at full cost plus at least a 10% mark-up. As a result, the manager of the commercial sales
department added a 10% profit margin to its full production cost (based on the production cost for
20X7). Before the bid was submitted, the residential sales manager wrote a letter to the chief
executive objecting to the price being quoted on the basis that the residential sales division was
cross-subsidising the activities of the commercial sales division. He continued by noting that the
profit of his division has been declining because part of the costs assigned to the residential soft
drink relate to the production of the commercial soft drink. The chief executive then asked the
management accountant to review the companys production cost structure. The following results
were obtained from the review.

1. The existing cost system allocates all overheads to products on the basis of units produced
(boxes).

2. On further investigation of costs for ABC, it was found that 376,000 of the production support
cost could be traced directly to the different products in the form of direct labour. 360,000 of
this is traceable to residential operations and the balance to commercial operations.

The company then undertook a detailed activity analysis. Three main activity areas were identified
as follows:
 Total Residential Commercial
Set-up 1,987,500 1,391,250 596,250
Mixing 1,019,230 815,384 203,846
Bottling 265,000 238,500 26,500

The balance of the production support cost after deducting the traceable direct labour cost has been
analysed as follows:

30% Set up
50% Mixing
20% Bottling

REQUIRED:
(A) Calculate the cost per box of both residential and commercial soft drinks using
the traditional overhead allocation system. Determine the bid price submitted to the University
of Wolverhampton for a box of commercial soft drink.
(B) Calculate the cost per box of both residential and commercial soft drinks using
activity based costing. Determine the bid price that would have been submitted
to the University of Wolverhampton for a box of commercial soft drink if the
company had used activity based costing.

SOLUTION

QUESTION ONE

Conventional Product Costing

Alpha Beta Delta

Direct material 40 24 50
Direct labour 12 36 24
Variable overheads 42 28 84
 Total cost 94 88 158

Activity-Based Costing

Workings:
Material handling 30% x 1,309,000 = 392,700/330 = 1,190 per material handling
Inspection 20% x 1,309,000 = 261,800/2,200 = 119 per inspection
Set-up 40% x 1,309,000 = 523,600/1,100 = 476 per set-up
Machine running 10% x 1,309,000 =130,000/93,500 = 1.4 per machine hour
1,309,000
4 marks for workings

Cost per unit:

Workings Alpha Beta Delta

Material handling (1,190*54) 64,260 85,680 242,760
Inspection (119*360) 42,840 49,980 168,980
Set-up (476*110) 52,360 80,920 390,320
Machine running (1.4*4,500) 6,300 7,000 117,600
Total overhead cost 165,760 223,580 919,660
Units 1,500 2,500 14,000
Overhead cost per unit 165,760/1500 110.506 89.432 65.69
Direct material 40 24 50
Direct labour 12 36 24
1) Unit cost 162.506 149.432 139.69

QUESTION TWO

Traditional System

Residential Commercial

Direct Materials 180,000 30,000

Direct Labour 90,000 20,000
Total Direct Cost 270,000 50,000
Production 90,000 10,000
Unit variable cost 3 5
Overheads 19.66 19.66
Unit Cost 22.66 24.66
Profit (10%) 2.466
Bid Price 27.126

(A) ABC
Workings Residential Commercial

Direct Materials Per question 180,000 30,000

Direct Labour Adjustment 450,000 36,000
Set-Up 1,391,250*0.24 333,900 143,100
Mixing 815,384*0.78 636,000 159,000
Bottling 238,500*1.20 286,200 31,800
Total cost 1,886,100 399,900
Production 90,000 10,000
Unit cost 20.96 39.99
Profit (10%) 3.999
Bid Price 43.989

Workings

Adjustment to labour costs---- it was identified that the production overheads included 376,000 of labour costs
which had not been included in direct labour costs. Thus, an adjustment is necessary.

Residential () Commercial ()
Original direct labour cost 90,000 20,000
Adjustment--- 376,000 360,000 16,000
New direct labour cost 450,000 36,000

This means that the new production support overhead = 1,966,000 - 376,000 = 1,590,000

Set up cost driver rate = 1,590,000 *30% /1,987,500 = 0.24/set up

Mixing cost driver rate = 1,590,000 *50% /1,019,230 = 0.78/mixing
Bottling cost driver rate = 1,590,000 *20% /265,000 = 1.2/bottles