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ACC200 Introduction to Management Accounting

Published : 14-Sep,2021  |  Views : 10

Question:

Jackson Ltd manufactures two products  FRED and MARTHA  .The firm uses a single plantwide overhead rate based on direct labour hours .Product costing data is as follows:
                                                                                                     FRED                         MARTHA
Production Quantity                                                                1000 units               5000 units  
Direct material                                                                           $40                          $60                                           
Direct labour                                                                               30(2 hours)             45 ( 3 hours)
Manufacturing overhead                                                          96( 2 hours)          144 ( 3 hours)
Total cost per unit                                                                    $166                        $249
Manufacturing overhead is currently  calculated by using a conventional volume based approach using a predetermined overhead rate based on the number of direct labour hours used to produce the product.The manufacturing overhead budget consists of the following overhead costs:
     Machine related  costs                                                   $450,000
     Setup and inspection                                                         180,000
     Engineering                                                                            90,000
     Plant related costs                                                                96,000
    Total                                                                                     $816,000                 

Currently Jackson prices its products at 120% of total manufacturing cost .It has noticed that a competitor is producing MARTHA and has been pricing its products at $230 each and that sales of MARTHA have been declining over the last year.Because of this the accountant at Jackson has suggested that Activity Based costing should be considered .He suggested the following details
  Activity Cost Pool                    Cost driver                                   Budgeted level
 Machine related costs            Machine hours                             9000 hours
 Setup and inspection              Number of production runs      40 runs
 Engineering                               Engineering change orders       100 change orders
 Plant related costs                   Square footage of space            1,920  sq ft.

You have gathered some further information about the two products :
Each FRED requires 4 machine hours, whereas each MARTHA requires 1 machine hour
The FRED is manufactured in production runs of 50 units each .Each MARTHA is manufactured in
  250 unit batch
Three quarter of the engineering activity ,in terms of change orders ,is related to FREDs
The plant has 1,920 square feet of space, 80 per cent of which is used in the production of FREDs

Required:
(a) Calculate the cost per unit for FREDs and MARTHAs using the conventional approach when calculating overhead
(b) Calculate the cost per activity for each activity cost pool
(c) Calculate the product cost per unit for FREDs and MARTHAs using Activity Based Costing.

(d) Using the same pricing approach as above(120% of total manufacturing cost) calculate the price
      that would be charged for FREDs and MARTHAs using Activity Based costing.
(e ) Based on your calculations using Activity Based costing explain how the conventional volume based approach to allocating overhead has lead to mispricing the products.
(f) What are the benefits that would come from  introducing Activity Based costing(ABC).
(g) Are there any disadvantages from using ABC.                

Answer:

  1. Calculation of predetermined overhead rate:

Total Budgeted Manufacturing Overhead

 =

$816,000

Allocation basis

 =

Direct Labour Hours

Predetermined Overhead Rate

 =

Budgeted Manufacturing Overhead/Direct Labour Hours

Predetermined Overhead Rate (per hour)

 =

$816,000/17,000         

Predetermined Overhead Rate (per hour)

 =

$48         

  1. Calculation of Direct Labour Hours

FRED = (1000*2) = 2,000 hours

MARTHA = (5000*3) = 15,000 hours

Total hours = 17,000 hours

  • Calculation of cost per activity using Activity Based Costing

Overheads

Cost driver

Budgeted Level

Overhead Amount

Cost per activity

Machine related costs

Machine hours

9,000

450,000

50

Setup and inspection

Number of production runs

40

180,000

4,500

Engineering

Engineering change order

100

90,000

900

Plant related costs

Square footage of space

1,920

96,000

50

  • Calculation of cost per unit of products using the Activity Based Costing

Particulars

 Fred

 Martha

 Units

Rate per unit

Total

 Units

Rate per unit

Total

Direct Material

1,000

40

40,000

5,000

60

300,000

Direct Labour

1,000

30

30,000

5,000

45

225,000

Machine related costs

4,000

50

200,000

5,000

50

250,000

Setup and inspection

20

4,500

90,000

20

4,500

90,000

Engineering

75

900

67,500

25

900

22,500

Plant related costs

1,536

50

76,800

384

50

19,200

WN-1: Calculation of activity required by products

Overheads

Cost driver

 Budgeted Level

 Overhead Amount

 Cost per activity

Activity Required

 FRED

 MARTHA

Machine related costs

Machine hours

9,000

450,000

50

4,000

5,000

Setup and inspection

Number of production runs

40

180,000

4,500

20

20

Engineering

Engineering change order

100

90,000

900

75

25

Plant related costs

Square footage of space

1,920

96,000

50

1,536

384

Calculation of Selling Price under Activity Based Costing

Particulars

FRED

MARTHA

Cost per unit

500

180

Add: Profit Margin (20% of manufacturing costs)

100

36

Selling Price

600

216

  • The prices of the products under conventional method are $ 166 for FRED and $249 for MARTHA whereas the prices of products under activity based costing are $500 for FRED and $180 for MARTHA. Thus, we can see that under conventional approach the FRED was under costed by $334 per unit and MARTHA was over costed $69. This is because, the conventional approach has allocated the manufacturing overhead using direct labours hours and not considering whether the product has actually consumed the resources or not. Since product MARTHA uses 3 direct labour hours and product FRED uses 2 direct labour hours, the burden of manufacturing overhead is more on product MARTHA rather than on product FRED and hence, the cost per unit of product MARTHA is higher than product FRED.

On the other hand, the activity based costing has allocated the manufacturing overhead on the basis of actual resources consumed. In this method, the different costs are identified and then the relevant cost drivers are allocated to the costs. Then these costs are allocated on the basis of actual level of activities consumed by both the products. For example, the plant related costs is allocated on the basis of Square foot of space. The product FRED has used 1536 sq. ft of space whereas the product MARTHA has used only 384 sq. ft. of space. Hence, the cost of 96,000 has been allocated in the ratio of 1536:384.

From the above, it is clear that the conventional method is not a realistic method and hence allocates the overhead on a wrong basis, which in turns gives the wrong cost and hence, gives the wrong selling price.

  • The following are the benefits of using activity based costing:
  1. Activity based costing provides the accurate results i.e. cost pf products as it is based on actual consumption of resources rather than allocating the costs on a blanket rate.
  1. Activity based costing is based upon deep analysis of different costs and their behaviors. Hence, one should know about the non value added activities and can eliminate them to reduce the costs.
  1. As it involves the analysis of data, thus it helps in finding out the long or wasteful processes and thus reduces the costs.
  2. Activity based costing by pooling the various costs with their cost drivers helps in identifying the wasteful activities and then it allocates the costs according to consumption by products. Thus, the management can plan the utilization of resources appropriately after knowing these activities.
  3. Reduction in costs make the product prices competitive and thus the management can make appropriate pricing strategies.
  • The following are the disadvantages of using activity based costing:
  1. Activity based costing is an expensive costing method which involves high implementation costs.
  1. The input data required for implementation of this method, is of very high importance. Thus, accuracy of input data is of greater priority and importance.
  1. It involves collecting, verifying and examining the input data, hence it is a time consuming and a lengthy process.
  1. Due to higher implementation and collection costs, this method is not useful for smaller enterprises.
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