Activity Based Costing in an Organization-Free-Sample for Student

Questions: 1.Critically evaluate the consulting groups recommendation of switching the overhead assignment to an activity-based approach. 2.Verify the overhead cost per unit reported by the consulting group using direct labor hours to assign overhead. Compute the per-unit gross margin for each product. Show all workings. 3.Recompute the unit cost of each product using activity-based costing. Compute the per-unit gross margin for each product. Show all workings. 4.With reference to your analysis in (3), what recommendations that addressed the issues in the case would you suggest for South Pacific Chemicals Ltd. management team to consider, while competing in a competitive environment? Answers: 1.The consulting group recommended the firm to use Activity Based Costing (ABC) instead of the traditional costing. The reason that has been cited is that ABC leads to more accurate allocation of the overheads cost which is indeed accurate. In the current costing system, the overhead cost is allocated on the basis of the plantwide rate which is linked to direct labour hours consumed. Clearly, this process undermines the underlying difficulty that is involved in the production of S-17 chemical due to which the overhead cost of this product may be significantly higher. Additionally, the fact that the competitors are able to sell X-14 at lower than the cost of the company further strengthens the rationale to shift to ABC as it might be possible that the overhead costs may be over-allocated to X-14 while under-allocated to S-17. As a result, the customers are willing to buy the same quantity of S-17 even if a 25% hike in prices is put in place by the company. Further, literature review also provides support in favour of ABC as compared to traditional costing systems such as absorption costing. This is because the ABC system involves breaking down the overhead tasks into smaller activities and identifying the respective cost drivers of each of these sub-activities. Further, the activity levels associated with different products is computed so that the allocation of the overheads cost can be carried out accurately (Northington, 2012). This ensures not only better costing of the individual products but also more competitive pricing. Considering the relative performance of the two products for the company, conducting the ABC analysis is indeed a prudent suggestion by the consulting group. A potential downside of the recommendation is the incremental cost associated but considering that the management is looking to shut down production of a product, this is required in order to make a prudent decision (Petty et. al., 2015). 2.Plantwide Overhead Rate Computation The following information has been provided. Total overhead costs incurred in the production of the two chemicals = $ 6,990,000 Total direct labour hours = 250,000 + 22,500 = 272,500 Hence, plantwide overhead rate = 6990000/272500 = $ 25.65 per direct labour hour Direct labour hour per unit computation Production quantity of X-14 = 1,000,000 Production quantity of S-17 = 200,000 Direct labour hours required for X-14 = 250,000 Direct labour hours required for S-17= 22,500 Hence, direct labour hours per unit of X-14 = (250000/1000000) =0.25 hours Also, direct labour hours per unit of S-17 = (22500/200000) = 0.1125 hours Overhead cost per unit computation Overhead cost per unit for X-14 = 0.25*25.65 = $6.41 Overhead cost per unit for S-17 = 0.1125*25.65 = $2.89 Unit Gross Margin Computation Unit selling price of X-14 = $15.93 Unit total cost for X-14 = 6.41 + 4.27 = $10.68 Hence, gross margin per unit for X-14 = 15.93 10.68 = $ 5.25 Unit selling price of S-17 = $12 Unit total cost for S-17 = 2.89 + 3.13 = $6.02 Hence, gross margin per unit for S-17 = 12 6.02 = $ 5.98 3.The respective overhead activities along with their respective cost drivers are identified below. Based on the above cost drivers, the unit cost for each activity has been computed as shown below. Now based on the individual activity level of the two chemicals, the overhead cost would be allocated to the two products. This has been achieved as indicated below (Parrino and Kidwell, 2011). From the table above, it is apparent that total overhead costs allocated to the production of X-14 and S-17 are $3,498,919 and $ 3,491,081 respectively. The total production level of X-14 and S-17 are 1,000,000 kg and 200,000 kg respectively. Hence, per unit overhead cost for X-14 = 3498919/1000000 = $ 3.50 per kg Also, per unit overhead cost for X-14 = 3491081/200000 = $ 17.46 per kg Therefore per unit total cost for X-14 = 3.5 + 4.27 = $7.77 per kg Also, per unit total cost for S-17 = 17.46 + 3.13 = $20.59 per kg Unit Gross Margin for X-14 = 15.93 7.77 = $8.16 Unit Gross Margin for S-17 = 12 20.59 = -$ 8.59 4.Based on the gross margins obtained from ABC system, it is apparent that X-14 is the profit making chemical while S-17 is loss making at the current prices. This aberration is primarily because under the existing system of absorption costing, there is over-allocation of overhead costs to X-14 and under-allocation of the same to S-17. As a result, X-14 is being priced much higher than it should be while S-17 is underpriced. This clearly explains how the competitors are able to provide X-14 at $ 10 per kg. Taking the ABC system into consideration, the South Pacific Chemicals could also match and potentially beat the competitors price thereby making up for the lost ground in terms of market share lost. Further, with regards to S-17, considering the underpricing, it is not surprising that even with a 25% hike, the customers would continue buying. It is recommended that in order to improve the competitive position, the company should reduce the price of X-17 to less than $ 10 per kg whi le enhance the price of S-17 to about $ 25 per kg. References Northington, S. (2011) Finance, 4th ed. New York: Ferguson Parrino, R. and Kidwell, D. (2011) Fundamentals of Corporate Finance, 3rd ed. London: Wiley Publications Petty, JW, Titman, S, Keown, AJ, Martin, P, Martin JD and Burrow, M. (2015), Financial Management: Principles and Applications, 6th ed. Sydney: Pearson Australia,