Reference no: EM131101741

Question:

Advance Limited assembles three types of bicycle: Model A, Model B and Model C. its sells the bicycles throughout the world. In response to market pressures, Advance Limited has invested heavily in new manufacturing technology in recent years and, as a result, has significantly reduced the size of its workforce.

Historically, the company has allocated all overhead costs using total direct labour hours, but is now considering introducing Activity Based Costing (ABC). Advance Limited's accountant has produced the following analysis.

	Annual Output (units)	Annual Direct Labour Hours	Selling price (€ per unit)	Raw material cost (€ per unit)
Model A	2,000	200,000	4,000	400
Model B	1,600	220,000	6,000	600
Model C	400	80,000	8,000	900

The three cost drivers that generate overheads are:

Deliveries to retailers: The number of deliveries of bicycles to retail showrooms

Set-ups: The number of times the assembly line process is re-set to accommodate a production run of a different type of bicycles

Purchase orders: The number of purchase orders

The annual cost driver volumes relating to each activity and for each type of bicycle are as follows:

	Number of deliveries to retailers	Number of set-ups	Number of purchase orders
Model A	100	35	400
Model B	80	40	300
Model C	70	25	100

The annual overhead costs relating to these activities are as follows:

	€
Deliveries to retailers	2,400,000
Set-up costs	6,000,000
Purchase orders	3,600,000

All direct labour is paid at €5 per hour. The company holds no stocks. At a board meeting there was some concern over the introduction of activity based costing.

The finance director argues: ‘I very much doubt whether selling the Model C is viable but I am not convinced that activity based costing would tell us any more than the use of labour hours in assessing the viability of each product.'

The marketing director argued: ‘I am in the process of negotiating a major new contract with a bicycle rental company for Model A. For such a big order they will not pay our normal prices but we need at least cover our incremental costs. I am not convinced that activity based costing would achieve this as it merely averages costs for our entire production.'

The managing director argued: ‘I believe that activity based costing would be an improvement but it still has its problems. For instance, if we carry out an activity many times surely we get better at it and costs fall rather than remain constant. Similarly, some costs are fixed and do not vary either with labour hours or any other cost driver.'

The chairman argues: ‘I cannot see the problem. The overall profit for the company is the same no matter which method of allocating overheads we use. It seems to make no difference to me.'

Required:

(a) Calculate the total profit on each of Advance Limited's three types of product using the existing method based upon labour hours to attribute overheads. Show your calculations.

(b) Calculate the total profit on each of Advance Limited's three types of product using activity based costing to attribute overheads. Show your calculations.

(c) Evaluate the labour hours and the activity based costing methods to the circumstances of Advance Limited.

(d) Evaluate the issues raised by each of the directors. Refer to your calculations above where appropriate.