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ABC fall 2019 - Practice Questions of Activity-Based Costing
Managerial Accounting (MA103)
Institute of Business Administration
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Activity Based Costing (ABC)
Q1. Triple Limited makes three types of gold watch – the Diva (D), the Classic (C) and the Poser (P). A traditional product costing system is used at present; although an activity based costing (ABC) system is being considered. Details of the three products for a typical period are: Hours per unit Material Production Labour hours Machine hours Cost per unit ($) Units Product D ½ 1½ 20 1 , 750 Product C 1½ 1 12 1, Product P 1 3 25 7, Direct labour costs $6 per hour and production overheads are absorbed on a machine hour basis. The overhead absorption rate for the period is $28 per machine hour. Required: (a) Calculate the cost per unit for each product using traditional methods, absorbing overheads on the basis of machine hours. Total production overheads are $654,500 and further analysis shows that the total production overheads can be divided as follows: % Costs relating to set-ups 35 Costs relating to machinery 20 Costs relating to materials handling 15 Costs relating to inspection 30 Total production overhead 100 The following total activity volumes are associated with each product line for the period as a whole: Number of Number of movements Number of Set ups of materials inspections Product D 175 112 1, 150 Product C 115 121 1, 180 Product P 480 187 1, 670 670 120 1, Required: (a) Calculate activity based recovery rates (4 marks) (b) Calculate the cost per unit for each product using ABC principles (work to two decimal places). (c) Discuss why absorption costing gives better result as compared with traditional absorption costing in today’s manufacturing environment. (4 marks) (d) What will be impact on pricing and profitability if company switches to absorption costing?
(d) Pricing and Profitability Switching to ABC can, as in this case, substantially change the costs per unit calculations. Consequently if an organisation’s selling prices are determined by a version of cost-plus pricing then the selling prices would alter. In this case the selling price of D and C would rise significantly, and the selling price of P would fall. This, at first glance may be appealing however:
- Will the markets for D and C tolerate a price rise? There could be competition to consider. Will customers be willing to pay more for a product simply because Triple Ltd has changed its cost allocation methods?
- Product P is a high volume product. Reducing its selling price will have a dramatic effect on revenue and contribution. One would have to question whether such a reduction would be compensated for by increased volumes.
Alternatively, one could take the view that prices are determined by the market and therefore if Triple Ltd switches to ABC, it is not the price that would change but the profit or margin per unit that would change. This can change attitudes within the business. Previously high margin products (under a traditional overhead absorption system) would be shown as less profitable. Salesmen (possibly profit motivated) can begin to push the sales of different products seeking higher personal rewards. (Assuming commission based on profits per unit sold) It must always be remembered that if overheads are essentially fixed then they should be ignored in business decision making. Switching to ABC can change reported profits per unit but it is contribution per unit that is perhaps more important.
Q2. Linacre Co operates an activity-based costing system and has forecast the following information for next year. Cost Pool Cost Cost Driver No of Drivers Production set-ups £105,000 Set-ups 300 Product testing £300,000 Tests 1, Component supply and storage £25,000 Component orders 500 Customer orders and delivery £112,500 Customer orders 1 , General fixed overheads such as lighting and heating, which cannot be linked to any specific activity, are expected to be £900,000 and these overheads are absorbed on a direct labour hour basis. Total direct labour hours for next year are expected to be 300,000 hours. Linacre Co expects orders for Product ZT3 next year to be 100 orders of 60 units per order and 60 orders of 50 units per order. The company holds no stocks of Product ZT3 and will need to produce the order requirement in production runs of 900 units. One order for components is placed prior to each production run. Four tests are made during each production run to ensure that quality standards are maintained. The following additional cost and profit information relates to product ZT3: Component cost: £1·00 per unit Direct labour: 10 minutes per unit at £7·80 per hour Profit mark up: 40% of total unit cost Required: Calculate cost per unit of Product ZT3 by using ABC
Q3. Jola Publishing Co publishes two forms of book.
The company publishes a children’s book (CB), which is sold in large quantities to government controlled schools. The book is produced in only four large production runs but goes through frequent government inspections and quality assurance checks. The paper used is strong, designed to resist the damage that can be caused by the young children it is produced for.
The book has only a few words and relies on pictures to convey meaning.
The second book is a comprehensive technical journal (TJ). It is produced in monthly production runs, 12 times a year. The paper used is of relatively poor quality and is not subject to any governmental controls and consequently only a small number of inspections are carried out. The TJ uses far more machine hours than the CB in its production.
The directors are concerned about the performance of the two books and are wondering what the impact would be of a switch to an activity based costing (ABC) approach to accounting for overheads. They currently use absorption costing, based on machine hours for all overhead calculations. They have accurately produced an analysis for the accounting year just completed as follows: CB TJ $per unit $per unit $per unit $per unit Direct production costs Paper 0·75 0· Printing ink 1·45 4· Machine costs 1·15 1· 3·35 6· Overheads 2·30 3· Total cost 5·65 10· Selling price 9·05 13· Margin 3·40 3· The main overheads involved are: Overhead % of total overhead Activity driver Property costs 75·0% Machine hours Quality control 23·0% Number of inspections Production set up costs 2·0% Number of set ups If the overheads above were re-allocated under ABC principles then the results would be that the overhead allocation to CB would be $0·05 higher and the overhead allocated to TJ would be $0·30 lower than previously.
Required:
(a) Explain why the overhead allocations have changed in the way indicated above. (b) Briefly explain the implementation problems often experienced when ABC is first introduced.
Q5. Duff Co manufactures three products, X, Y and Z. Demand for products X and Y is relatively elastic whilst demand for product Z is relatively inelastic. Each product uses the same materials and the same type of direct labour but in different quantities. For many years, the company has been using full absorption costing and absorbing overheads on the basis of direct labour hours. Selling prices are then determined using cost plus pricing. This is common within this industry, with most competitors applying a standard mark-up. Budgeted production and sales volumes for X, Y and Z for the next year are 20,000 units, 16,000 units and 22,000 units respectively. The budgeted direct costs of the three products are shown below: Product X Y Z $ per unit $ per unit $ per unit Direct materials 25 28 22 Direct labour ($12 per hour) 30 36 24 In the next year, Duff Co also expects to incur indirect production costs of $1,377,400, which are analysed as follows: Cost pools $ Cost drivers Machine set up costs 280,000 Number of batches Material ordering costs 316,000 Number of purchase orders Machine running costs 420,000 Number of machine hours General facility costs 361,400 Number of machine hours –––––––––– 1,377, –––––––––– The following additional data relate to each product: Product X Y Z Batch size (units) 500 800 400 No of purchase orders per batch 4 5 4 Machine hours per unit 1·5 1·25 1· Duff Co wants to boost sales revenue in order to increase profits but its capacity to do this is limited because of its use of cost plus pricing and the application of the standard mark-up. The finance director has suggested using activity based costing (ABC) instead of full absorption costing, since this will alter the cost of the products and may therefore enable a different price to be charged. Required: (a) Calculate the budgeted full production cost per unit of each product using Duff Co’s current method of absorption costing. All workings should be to two decimal places. (3 marks) (b) Calculate the budgeted full production cost per unit of each product using activity based costing. All workings should be to two decimal places. (11 marks) (c) Discuss the impact on the selling prices and the sales volumes OF EACH PRODUCT which a change to activity based costing would be expected to bring about. (6 marks) (20 marks)
Q6. Naceur makes three products A, B and C. Budgeted cost and production information for the coming period is as follows: Product A B C Per thousand metres Costs Direct materials £120·00 £100·00 £60· Direct labour £42·00 £42·00 £28· Machine hours 6·00 hrs 6·00 hrs 4·00 hrs Labour hours 0·1 hrs 0·1 hrs 0·02 hrs Output in thousand metres 120 100 80 The three products are manufactured using the same production technology. They are usually produced in production runs of 10,000 metres and sold to wholesalers in batches of 5,000 metres. The company uses a cost plus pricing system and a gross margin of 20% on sales to calculate prices. Budgeted production overhead is absorbed using a machine hour rate and the budgeted overhead for the coming period has been analysed as follows: £ Rates, rent, supervision, power and depreciation 26, Set up costs 15, Goods inwards 9, Finished goods inspection 5, Dispatch 9, Total £65, Budgeted machine hours for the period are 1,640 hours.
Required: (a) Calculate the budgeted total cost per thousand metres for each product, showing clearly prime cost, overhead cost and total cost; (5 marks) (b) The sales manager of Naceur has complained that its main competitor is undercutting its prices for products A and B by several pounds. Naceur’s price for product C on the other hand is lower than that of the competitor. She believes these price differences are caused by their competitor using an activity-based costing (ABC) system to cost products, and a cost plus pricing system with a mark-up of 20% on total activity based cost to calculate prices. In an attempt to make Naceur’s costings more accurately reflect the usage of resources by products you have ascertained that the cost drivers for the overhead activities are as follows: Cost Pool Cost driver Budgeted driver activity for the period
Rates, rent supervision, power and depreciation machine hours 1, Set up costs number of production runs 30 Goods inwards costs Number of requisitions 120 Finished goods inspection costs number of production runs 30 Dispatch costs Number of sales orders 60 The number of requisitions raised by goods inwards was 40 for each product and the number of sales orders was 60 (one order per batch sold). Required: (i) Calculate the budgeted cost driver rate for each overhead activity; (5 marks) (ii) Calculate the budgeted total cost per thousand metres for each product using an activity-based costing approach; (10 marks) Answer : Overhead cost per thousand metre: 221·77 227·10 203·
Q7. Beckley Hill (BH) is a private hospital carrying out two types of procedures on patients. Each type of procedure incurs the following direct costs: Procedure A B $ $ Surgical time and materials 1,200 2, Anaesthesia time and materials 800 1, BH currently calculates the overhead cost per procedure by taking the total overhead cost and simply dividing it by the number of procedures, then rounding the cost to the nearest 2 decimal places. Using this method, the total cost is $2,475· for Procedure A and $4,735·85 for Procedure B. Recently, another local hospital has implemented activity-based costing (ABC). This has led the finance director at BH to consider whether this alternative costing technique would bring any benefits to BH. He has obtained an analysis of BH’s total overheads for the last year and some additional data, all of which is shown below: Cost Cost driver $ Administrative costs Administrative time per procedure 1,870, Nursing costs Length of patient stay 6,215, Catering costs Number of meals 966, General facility costs Length of patient stay 8,553, Total overhead costs 17,606,
Procedure A B No. of procedures 14,600 22, Administrative time per procedure (hours) 1 1· Length of patient stay per procedure (hours) 24 48 Average no. of meals required per patient 1 4 Required: (a) Calculate the full cost per procedure using activity-based costing. (6 marks) (b) Making reference to your findings in part (a), advise the finance director as to whether activity-based costing should be implemented at BH. (4 marks) (10 marks)
Q9. PQ is a building supplies retailer that operates a chain of shops throughout the country. The company has
grown rapidly but profits have started to fall. The company has an excellent Inventory Procurement and Management System but the accounting systems are very poor. A management accountant has recently been appointed to help improve decision making within the company. The company sells building supplies, ranging from bags of nails and screws to pre-packed kitchen units, to a wide range of customers including home owners and professional builders. The company offers a free delivery service on all orders totalling over $100. Within each shop there are specialist sections that have skilled staff to offer help and advice to customers. Examples include:
- The “Design Station” which offers free advice on kitchen and bathroom installation and design.
- The “Cutting Bay” which cuts timber to customers’ specific requirements. There is no charge for this service. Other areas of the shop are “help yourself” where customers select their requirements from racked displays of products and then pay at the check-out points. The recently appointed management accountant was shocked to discover that the company’s pricing policy is to add a 100% mark-up to the bought in cost of all products. The management accountant has suggested that the mark-up should not be the same for all products because certain products and certain types of customer will be more costly to sell and service respectively. The management accountant has suggested that an activity based costing system should be introduced to allow Direct Product Profitability and Customer Profitability Analyses to take place.
Required:
(a) Explain how the allocation and absorption of costs differs in activity based costing compared to
traditional absorption costing. (4 marks)
(b) Explain how activity based costing could help to increase the profits of PQ. (6 marks)
(Total for Question Three = 10 marks)
Q10. F Company supplies pharmaceutical drugs to drug stores. Although the company makes a satisfactory return, the
directors are concerned that some orders are profitable and others are not. The management has decided to investigate a new budgeting system using activitybased costing principles to ensure that all orders they accept are making a profit. Each customer order is charged as follows. Customers are charged the list price of the drugs ordered plus an additional charge
for overheads. A profit margin is also added, but that does not form part of this analysis and can therefore be ignored. Currently F Company uses a simple absorption rate to absorb these overheads. The rate is calculated based on the budgeted
annual overhead costs divided by the budgeted annual total list price of the drugs ordered. An analysis of customers has revealed that many customers place frequent small orders with each order requesting a variety of drugs. The management of F Company has examined more carefully the nature of its overhead costs, and the following
data have been prepared for the budget for next year: Total list price of drugs supplied $8m
Number of customer orders 8, Overhead costs $000 Cost driver Invoice processing 280 See Note 2 Packing 220 Size of package – see Note 3 Delivery 180 Number of deliveries – see Note 4 Other overheads 200 Number of orders Total overheads 880
Notes:
- Each order will be shipped in one package and will result in one delivery to the customer and one invoice (an order never results in more than one delivery).
- Each invoice has a different line for each drug ordered. There are 28,000 invoice lines each year. It is estimated that 25% of invoice processing costs are related to the number of invoices, and 75% are related to the number of invoice lines.
- Packing costs are $32 for a large package, and $25 for a small package.
- The delivery vehicles are always filled to capacity for each journey. The delivery vehicles can carry either 6 large packages or 12 small packages (or appropriate combinations of large and small packages). It is estimated that there will be 1,000 delivery journeys each year, and the total delivery mileage that is specific to particular customers is estimated at 350,000 miles each year. $40,000 of delivery costs are related to loading the delivery vehicles and the remainder of these costs are related to specific delivery distance to customers. The management has asked for two typical orders to be costed using next year’s budget data, using the current method, and the proposed activity-based costing approach. Details of two typical orders are shown below: Order A Order B Lines on invoice 2 8 Package size Small Large Specific delivery distance 8 miles 40 miles List price of drugs supplied $1,200 $
Required:
(a) Calculate the charge for overheads for Order A and Order B using: (i) the current system; and (3 marks) (ii) the activity-based costing approach. (12 marks) (b) Write a report to the management of F Company in which you assess the strengths and weaknesses of the proposed activity-based costing approach for F company; (5 marks)
ABC fall 2019 - Practice Questions of Activity-Based Costing
Course: Managerial Accounting (MA103)
University: Institute of Business Administration
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