CASE STUDY USING TRADITIONAL COSTING METHOD Cuecraft is an SME which manufactures high quality snooker and pool

cues. For a number of years the accountant has dealt with the recovery of overhead in a traditional manner following the procedure outlined earlier. The business has three major producing cost centres; Machining, Finishing and Packing.

The process of allocation and apportionment for period end March 2000 had been complete and the predetermined figures we Cost centre Overhead Machine hours Direct labor hours Overhead recovery rates per machine hour or labor hour Machining Finishing 70,000.00 27,500.00 13000 6250 5.38 4.40

A new product 'Davis' is estimated to take the following standard hours to produce per unit: Machining Finishing Packing 3.00 1.50 0.25 4.75 standard hours

The accounting technician and the production manager agree the following predetermined standard costs per unit: Direct Material Direct Labor: (all direct production operatives are paid 7/hr) 16.00

33.25

Thus the production cost of one unit based on traditional method would be: Machining Finishing Packing 3.00 1.50 0.25 4.75 @ 7 per hour 16.00 33.25 49.25

Direct material Direct labor Prime cost Production Overhead: Machining: (3 machine hr x 5.38) Finishing: (1.50 machine hr x 4.40) Packing: (0.25 labor hr x 4.62)

16.14 6.6 1.16

23.90 Production cost 73.15

USING ABC METHOD Budget plan quarter end March 2000 Activity Process set up Material procurement Maintenance Material handling Quality Control Ordering processing Cost Pool 37,500.00 9,000.00 10,000.00 22,500.00 20,500.00 13,000.00 112,500.00 Cost Driver Volume 100 set ups 50 purchase orders 10 standard maintenance plans 2000 material movements 250 inspection 300 customer Cost pool driver rates 375.00 180.00 1,000.00 11.25 82.00 43.33 per set up per purchase order per planned maintenane cyle per movement per inspection per customer

The business has a number of products, one of which is the new product 'Davis'. In the budget period ended March 2000 it plans to produce 800 'Davis' cues. The achieve this level of output it will require the following activity demand: 4 set ups 4 purchase orders 2 standard maintenance plans 100 material movements 70 inspections 8 sales customers

USING ABC TECHNIQUE WE FIND: Process set up Material procurement Maintenance Material handling Quality Control Ordering processing 375 x 4 180 x 4 1,000 x 2 11.25 x 100 82 x 70 43.33 x 8 1,500.00 720.00 2,000.00 1,125.00 5,740.00 347.00 11,432.00

THUS, OVERHEAD COST PER UNIT = 11,432.00/800 = 14.29

Here we can see that when associated with cost pools and identified to the activities which drive cost, shows an overhead unit cost of 14.29. Prime cost: Direct Material

16.00

Direct Labor Production Overhead Production cost

33.25 14.29 63.54

years the accountant

d the predetermined figures were: Packing 15,000.00 3250 4.62

dard costs per unit:

per purchase order per planned maintenane cyle per movement per inspection per customer

period ended March 2000 activity demand:

e cost, shows an overhead

XYZ Company The following information provides details of the costs, volume and transaction cost drivers for the period in respect of XYZ Ltd.: Products B 30,000 7 40 3 3 30 10 7 70 25

Sales and production (units) Raw Materials usage (units) Direct materials cost (php) Direct labor hours Machine hours Direct labor cost (php) Number of production runs Number of deliveries Number of receipts Number of production orders Overhead costs Set up Machines Receiving Packing Engineering Total Requirement: a) b) c) Amount 75,000 1,000,000 900,000 650,000 750,000 3,375,000

A 90,000 10 30 2.5 5 20 5 18 50 45

C 15,000 14 15 1.5 7.5 10 50 50 700 60

Total 135,000 1,320,000 4,125,000 337,500 652,500 2,850,000 65 75 820 130

Calculate the total costs for each product if all overhead costs are absorbed on a labor hour basis; Calculate the total costs for each product, using activity based costing; Calculate and list the unit product costs from your figures in (a) and (b) above to show the differences between them and to comment briefly on any conclusions which may be drawn which could have pricing and profit implications.

TRADITIONAL DIRECT LABOR HOURS BASIS The direct labor hour rate is P10, calculated by dividing the total overheads by the total number of direct labor hours: Total overheads Total number of direct labor hours = 3,375,000 337,500 = 10 per dlh

Since we are using direct labor hour rate method for the absorption of all overheads, the product costs per unit must be: A Direct materials Direct labor Overheads Total product cost 30 20 25 75 B 40 30 30 100 C 15 10 15 40

The overheads recovered are: Direct labor hour rate x number of direct labor hours per product For product A, for example, the calculation is: P10 per dlh x 2.5 dlh = P25

ABC METHOD As we said above, to apply the ABC method, we need to identify cost drivers for two stages: 1 cost drivers tracing the costs of inputs into cost pools; and 2 cost drivers tracing the costs into product costs The workings that follow illustrate clearly how such cost drivers work through the ABC system in these two stages: an initial overhead rate or amount of being further subdivided according the needs of the situation. workings: The calculations for each of the rates to be used are: The machine hour rate is the only rate that is what we might call a traditional rate. All of the other rates we are about to use involve a two stage process. We will see the elements of these two stages as we get to them. machine hour overhead rate 1,000,000 652,500 machine hours This rate is used as normal. = 1.5326

For the set up costs, we first devise a rate to tell us the cost per set up: total set up overheads divided by the number of set up in this case, this is 75,000 65 production runs = 1,153.85

We will return to this rate shortly. All of the other rates are calculated similarly. Hence they will be presented now without further comment. Receiving rate 900,000.00 820 receipts 650,000.00 75 deliveries 750,000.00 130 prod'n orders = 1,097.56

Packing rate

8,666.67

Engineering rate

5,769.23

All of this information can now be put together into a cost per unit statement as follows.

The final stage in the whole ABC procedure, as far as product cost determination is concerned is to find out the costs per unit. The cost per unit statement follows, and then we will work through the calculation. Unit costs Direct materials Direct labor Machine overheads Set up costs Receiving costs Packing costs Engineering costs Total costs Overheads workings: Machine overheads are found by multiplying the machine hour rate by the number of machine hours per product per unit: machine hour rate machine hours equals 1.5326 x 5 7.66 3 4.60 7.5 11.49 A 30.00 20.00 7.66 0.0641 0.6098 1.7333 2.8846 62.9546 12.95 B 40.00 30.00 4.60 0.3846 2.5610 2.0222 4.8077 84.3732 14.37 C 15.00 10.00 11.49 3.8462 51.2195 28.8889 23.0769 143.5257 118.53

The set up costs rate we have already is the rate per machine set up, the cost per unit is calculated by multiplying the rate per set up by the number of set up per product and then dividing the results by the total number of units per product: Set up cost per set up Number of set ups equals 1,153.85 x 5 5,769.23 10 50 11,538.46 57,692.31

these values are then divided by the number of units per product to give us the cost per unit: 0.0641 0.3846 3.8462

The receiving, packaging and engineering costs are all calculated in the same way as the set up costs. There is no need to re these calculations, but check that they are understood. Summarising each of these methods now we can see the impact of the different methods on product costs. Assuming that the ABC method is really more effective than the traditional approach, product A shows a cost difference of P42.1085 per unit.

Summary 1: Total cost per unit using each of the two methods: A B C

DLH ABC Difference

75.0000 62.9546 12.05

100.0000 84.3732 15.63

40.0000 143.5257 (103.53)

Summary 2: Overheads per unit using each of the two methods A 25.0000 12.9546 12.05 B 30.0000 14.3732 15.63 C 15.0000 118.5257 (103.53)

DLH ABC Difference

direct labor hours:

osts per unit must be:

ese two stages:

rates we are about to use

ded by the number of set ups:

o find out the costs per unit.

rs per product per unit:

d by multiplying the rate units per product:

osts. There is no need to repeat

uct costs. Assuming that the ce of P42.1085 per unit.

Friends Company, a manufacturer of valves, produces and sells two types of valves: Gas Safety Valves (GSV) and MSC Valves (MSC). Friends Company has the following data for the two products: GSV MSC 10,000 5,000 78 130 21 35 30 20 3 4 600000 50000

Production volume Selling price (php) Unit prime cost (php) Direct labor-hours Direct labor-hours per unit Budgeted factory overhead (php) Budgeted direct labor-hours

USING VOLUME BASED COSTING SYSTEM IN AN EXAMPLE Let's calculate the unit product cost using volume-based costing. Under traditional costing, the factory overhead cost is assigned based on direct labor-hours (DLH). The factory overhead rate is determined as follows:

Factory Overhead Rate per DLH

Total Factory Overhead Total DLH

In this case, the factory overhead rate per DLH = P600,000 / 50,000 = P12 per DLH (i.e. plant wide rate). Using this information, we can determine the total amount of factory overhead assigned to each product and the factory overhead cost per unit both products: GSV MSC P12.00 per DLH 30,000 20,000 360,000 240,000 10,000 5,000 36.00 48.00

Factory overhead cost per DLH Direct labor hours Factory overhead assigned (php) Production volume (in units) Factory overhead cost per unit (php)

Note: P360,000 = P12.00 x 30,000 amd P20,000 = P12.00 x 20,000 Now we can calculate the unit margin profit for each product and determine how profitable the production are: GSV Unit selling price Less: Unit prime cost Less: Unit overhead cost Unit margin Unit margin percentage A B C D=A-B-C E=D/A x 100% 78 MSC 130

Safety Valves (GSV)

s determined as follows:

ant wide rate). each product and

the production are: