(a) Traditional cost per unit

D                      C                    P

Material                            20                     12                   25

Labour ($6/hour)                     3                      9                    6

Direct costs                         23                     21                   31

Production overhead

($28/machine hour)                  42                     28                   84

Total production cost /unit             65                     49                   115

(b) ABC cost per unit

(i) Total overheads

  These were given at $654,500

(ii) Total machine hours (needed as the driver for machining overhead)

Product Hours/unit             Production units                      Total hours

D                  1½ 1,                         750 2                              1,125

C                  1                             1,250 2                            1,250

P                  3                             7,000                             21,000

Total machine hours                                                                  23,375

(iii) Analysis of total overheads and cost per unit of activity

(iv) Total overheads by product and per unit

Cost per unit

D                    C                      P

Direct costs (from (a))              23.00                 21.00                  31.00

Overheads (from (iv))              94.95                 79.07                  69.21

117.95                100.07                 100.21

c) The result of the change to Activity Based Costing is clear, the overhead cost of D and C have risen whilst that of P has fallen. This is in line with the comments of many who feel that ABC provides a fairer unit cost better reflecting the effort required to make different products. This is illustrated here with product P which may take longer to make than D or C, but once production has started the process is simple to administer. This may be due to having much longer production lines.

Products D and C are relatively minor volume products but still require a fair amount of administrative time by the production department; ie they involve a fair amount of `hassle`.

–  Product P has fewer set-ups, material movements and inspections per 1,000 units than or C

–  As a consequence product P’s overhead cost per unit for these three elements has fallen

–  The machining overhead cost per unit for P is still two or three times greater than for products D or C, but because this overhead only accounts for 20% of the total overhead this has a small effect on total cost.

–  The overall result is P’s fall in production overhead cost per unit and the rise in those figures for D and C

(d) Pricing and Profitability

Switching to ABC can, as in this case, substantially change the costs per unit calculations. Consequently if an organization’s selling prices are determined by a version of cost-plus pricing then the selling prices would alter.

In this case the selling price of D and C would rise significantly, and the selling price of P would fall. This, at first glance may be appealing however:

–  Will the markets for D and C tolerate a price rise? There could be competition to consider. Will customers be willing to pay more for a product simply because Triple Ltd has changed its cost allocation methods?

–  Product P is a high volume product. Reducing its selling price will have a dramatic effect on revenue and contribution.

One would have to question whether such a reduction would be compensated for by increased volumes.

Alternatively, one could take the view that prices are determined by the market and therefore if Triple Ltd switches to ABC, it is not the price that would change but the profit or margin per unit that would change.

This can change attitudes within the business. Previously high margin products (under a traditional overhead absorption system) would be shown as less profitable. Salesmen (possibly profit motivated) can begin to push the sales of different products seeking higher personal rewards. (Assuming commission based on profits per unit sold)

It must always be remembered that if overheads are essentially fixed then they should be ignored in business decision making.

Switching to ABC can change reported profits per unit but it is contribution per unit that is perhaps more important