MODULE 1 Solution 2 Abkaber plc (a) (i) Labour hours Total overhead cost = $12,000,000 Total labour hours

= 500,000 hours Overhead per labour hour = $12,000,000/500,000 = $24

COSTING METHODS

(ii)

Activity Based Costing Deliveries to retailers $2,400,000/250 = $9,600 Set-ups $6,000,000/100 = $60,000 Deliveries inwards $3,600,000/800 = $4,500

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MODULE 1 (b) REPORT ABKABER PLC To: From: Subject: Date: (i) Direct costs Directors of Abkaber plc Management Accountant The Introduction of Activity Based Costing December 2002

COSTING METHODS

The direct costs of labour and materials are unaffected by the use of ABC as they are directly attributable to units of output. Notwithstanding the fact that labour is a relatively minor cost, however, the use of labour hours to allocate overheads magnifies its importance. The labour hours allocation basis As labour appears to be paid at a constant rate an allocation using labour cost or labour hours gives the same result. The central concern is, however, whether there is a cause and effect relationship between overheads and labour hours. Moreover for this allocation base to be correct overheads would need to be linearly variable with labour hours. This seems unlikely on the basis of the information available. ABC and labour hours cost allocation ABC attempts to allocate overheads using a number of cost drivers rather than just one as with labour hours. It thus attempts to identify a series of cause and effect relationships. Moreover, those in favour of ABC argue that it is activities that generate costs, not labour hours. While costs are likely to be caused by multiple factors, the accuracy of any ABC system will depend on both the number of factors selected and the appropriateness of each of these activities as a driver for costs. Each cost driver should be appropriate to the pool of overheads to which it relates. As noted already there should ideally be a direct cause and effect relationship between the cost driver and the relevant overhead cost pool, but this should also be a linear relationship (i.e. costs increase proportionately with the number of activities operated). The contrast between the labour hours costing system and ABC can be seen in requirement (a). These differences can be brought out by reviewing the comments of the directors. (ii) The Finance Director Using the labour hours method of allocation the Fireball makes an overall profit of $520,000 but using ABC it makes a loss of $182,000. There is thus a significant difference in the levels of cost allocated and in profitability between the two methods, to the extent it affects the conclusions on the Fireballs viability. The major reason for the difference appears to be that while labour hours are not all that significant for Fireball production, the low volumes of Fireball sales cause a relatively high amount of set-ups, deliveries and purchase processes, and this is recognised by ABC. If the Fireball model is to continue, a review of the assembly and distribution systems may be needed in order to reduce costs. There may, however, be other non-financial reasons to maintain the Fireball, e.g. maintaining a wide product range and raising the reputation of the motorcycles, which may increase sales of other models. The Marketing Director The marketing director suggests that ABC may have a number of problems and its conclusions should not be believed unquestioningly. These problems include:

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(1) For decisions such as the closure of Fireball production or the pricing of the new motorbike rental contract, what is really needed is the incremental cost to determine a break-even position. While ABC may be closer to this concept than a labour hours allocation basis, its accuracy depends upon identifying appropriate cost drivers. (2) The use of ABC for one-off decisions can be distinguished from its use in normal, ongoing costing procedures. It is perfectly possible that while labour hours may have been used for normal costing, an incremental costing analysis would be undertaken for important one-off decisions such as the closure of Fireball production or the pricing of the new motorbike rental contract. In these circumstances the introduction of ABC in normal costing procedures may have restricted benefits. (3) There may be interdependencies between both costs and revenues that ABC is unlikely to capture. Where costs are truly common to more than one product then this may be difficult to capture by any given single activity. (4) As with labour hours allocations it is the future that matters. Any relationship between costs and activities based upon historic experience and observation may be unreliable as a guide to the future. The Managing Director (1) ABC normally assumes that the cost per activity is constant as the number of times the activity is repeated increases. In practice there may be a learning curve, such that costs per activity are non linear. As a result, the marginal cost of increasing the number of activities is not the same as the average. (2) Also, in this case, fixed costs are included which would also mean that the marginal cost does not equal the average cost. (3) The MD is correct in stating that some costs do not vary with either labour hours or any cost driver, and thus do not fall easily under ABC as a method of cost attribution as there is no cause and effect relationship. Depreciation on the factory building might be one example. The Chairman From a narrow perspective of reporting profit it is true that the two methods give the same overall profit as is illustrated in requirement (a) at $4,180,000. There are, however, a number of qualifications to this statement: (1) If the company carried stock then the method of cost allocation would, in the short term at least, affect stock values and thus would influence profit. (2) If the ABC information can be relied upon, notwithstanding the above qualifications, then a decision could be taken to cease Fireball production as it generates a negative contribution of $182,000. This was not apparent from the use of labour hours; thus by the introduction of ABC and the subsequent closure decision profits would, all other things being equal, improve by $182,000. Further Issues The following should also be considered in evaluating ABC: The need to develop new data capture systems, and the relevant costs of doing so. Increased and on-going analysis work Continued evaluation of cause and effect relationships between cost drivers and cost pools.

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