Marvin’s Motors Company (MMC) manufactures outboard motors for use on small to medium sized boats. MMC produces three models: the Standard, the Deluxe and the Performance. The company uses a normal job costing system with manufacturing overhead applied on the basis of direct labour hours. The system has been in place with little change for 25 years. Budgeted product costs and sales data are as follows:
Standard Deluxe Performance
Annual sales (units)
20,000 1,000 10,000
Product costs (per unit):
Raw materials $80 $ 120 $ 100
Direct labour 3hrs @ $20 = $60 2hrs @ $25 = $50 2hrs @ $25 = $50
Manufacturing overhead
??? ??? ???
Total product cost $ ??? $ ??? $ ???
Details of budgeted overhead costs are as follows:
Manufacturing overhead budget:
Depreciation, machinery 1,480,000
Maintenance, machinery 120,000
Depreciation, taxes and insurance for factory 300,000
Engineering (changes to product design) 350,000
Purchasing, receiving and shipping 250,000
Inspection and repair of defects 375,000
Material handling 400,000
Miscellaneous manufacturing overhead costs 295,000
Total $ 3,570,000
For the past 10 years, the company’s pricing formula has been to set each product’s budgeted price at 150% of its full product cost. Recently, however, the Standard motor has come under increasing price pressure from competitors. As a result of this pressure, the price on the Standard model has been lowered to $320. But even at this low price, sales have only increased marginally.
Alvie Singer, the company CEO, recently asked Anne Hall, the financial controller, 'Why can't we compete with these other companies on the standard model? They're selling motors just like our standard model for $310. That's not much more than our production cost. In my view, our production processes are as efficient as anyone’s. In fact, I’ve talked to colleagues in the industry, and as far as I can see we’re at, or at least very near to best practice. Our technology is state of the art.' Ironically, our Deluxe motor, which is the least efficient to produce, is selling very well (albeit in a niche market) at our full 50% mark-up. None of this is making sense to me.
Hall responded by saying, 'I think this is due to an outmoded product costing system. As you may remember, I raised a red flag about our system when I came on board last year, but the decision was made to keep the current system in place. I think this was the wrong call. You see, the current system was introduced when MMC had only the one product, but now we have three, quite different motors it seems to me our costing system is distorting our product costs. Let me run a few numbers to demonstrate what I mean.'
Singer looked interested, but a bit concerned. ‘I think I know what you mean, but I’m not sure that more change is what we need right now. The management team was dead against ABC when you first raised it, and the production staff have always been resistant to change. To be honest the business has changed so much over the past couple of years that even I’m starting to lose touch. All that new machinery we installed a couple of years back has made us more labour-efficient, but the automation has meant that I no longer have enough understanding of the production processes to make intuitive decisions like I used to.’
Hall countered by pointing out that the accounting department is more than ready for change. ‘We have a couple of ABC experts in the department, and our computer system is sophisticated enough to deal with the data and computational demands of an ABC system.’ In fact, we’re already collecting a lot of the data we will need, so the incremental cost of implementing ABC will be quite low.
While still not fully convinced, the CEO gave the go ahead for Hall to undertake an ABC trial, to see what difference such a system would make. She began by compiling some basic data needed to implement an activity based costing system. These data are displayed in the following table.
Expected Total Usage Per Month
Activity Cost Pool Activity Driver Standard Deluxe Performance
Machinery (depreciation on machinery; maintenance of machinery) Machine hours 2,800 1,500 5,000
Engineering (engineering; inspection & repair of defects) Engineering hours 750 250 850
Materials (purchasing, receiving and shipping; material handling) Number of material orders 200 450 1300
Factory (depreciation, taxes and insurance for factory; miscellaneous overhead) Direct Labour Hours Students to calculate
The financial controller notes from her knowledge of operations and from the above figures that many of the overhead costs are only partially related to the volume of production, and some not at all. Certainly there is little association between overhead costs and the amount of direct labour used. One concern she has, though, is that it is sometimes difficult to identify the best causal cost driver, and getting this right is the key to the accuracy of the system. For example, she is not sure whether machine hours is the best cost driver for Machinery as many of these costs are time-related. She chose machine hours partly because it is a very cost-effective measure to collect. She is also concerned about the Factory costs which, as far as she can see, are not related to any particular activity. She decided upon direct labour hours in the end because the data were already available and she couldn’t think of anything better.
Required:
Task 1: Calculations (Answer in spaces provided.) (6 marks)
Calculate the product cost and budgeted price of each of the firm’s three products:
i. Based on the firm’s existing costing system; and
ii. Based on an activity based costing approach, using the data compiled by the financial controller.
Present your answers in spaces provided in the Task 1a section of the template, and provide full calculations in Appendix 1. (Note that you will not receive any marks for Task 1 if you do not provide full calculations.)
Suggestion: You can perform all calculations in a spreadsheet (e.g., Excel) and then transfer them to the template document via a partial screen dump (eg, using Microsoft’s ‘Snipping’ tool). Please do not upload an excel spreadsheet. Your full assignment must be completed in one file, using the template provided.
Task 2: Advice on the results of the ABC trial (Maximum three pages.) (15 marks total)
Assuming the accuracy of the ABC costings, prepare a report to the CEO that interprets the results of the ABC trial. Specifically, your report is to:
a) Provide a very brief comparison of the costing results produced by the two systems. The purpose of this comparison is to highlight the key differences for the CEO, setting the scene for parts ii and iii below. (This part should be no greater than a half page.) (2 marks)
b) Identify and explain the reasons why the existing system is inaccurate, and how the ABC approach corrects these inaccuracies. (6 marks)
c) For each of the three product lines, advise the CEO on what actions he should consider taking on the basis of the ABC data, in relation to both price setting (that is, how, if at all, should the price change), and on product mix (whether or not the product line should be continued). Justify your advice by reference to your calculations in Task 1, any further calculations you perform on the data, and any relevant case facts. (7 marks)
Task 3: Advice on System Replacement (14 marks)
On the basis of the above data, the CEO is now strongly considering the replacement of the existing costing system with an activity based costing system. He has asked you to provide him with information to support this decision. Specifically, you are asked to produce a report containing the following information, each presented as a separate section on a new page:
a) Relevant characteristics of MMC: Identify and explain four (and only four) characteristics of MMC beyond “incorrect product costing” that would indicate that the firm is likely to benefit if ABC is introduced. In other words, what is it about the firm, its products, or its production process that indicates ABC would be of benefit to MMC? (In your research you would have discovered that the benefits of ABC will be greatest for firms that display certain characteristics. It is these characteristics that you are being asked to provide here.) For each characteristic, present evidence from the case that this characteristic exists in MMC, and briefly explain why this characteristic is evidence that the firm is likely to benefit from ABC. (Maximum two pages). (8 marks)
b) Potential Challenges: Describe two (and only two) potential challenges that MMC is likely to face because of the introduction of ABC. In relation to each of the challenges, suggest actions that management could take to manage them or minimise their impact. (Please note that this is not merely a “hypothetical” question requiring you to think about all the possible challenges of implementing ABC. You are required to include here only challenges that MMC are likely to face as indicated by the facts provided in the case data. ) Maximum one page. (6 marks)
Task 1: Calculations
To calculate the product cost and budgeted price of each of the firm's three products, we need to determine the total product costs per unit based on the existing costing system and the activity-based costing approach.
Existing Costing System:
The existing costing system applies manufacturing overhead on the basis of direct labor hours. The budgeted manufacturing overhead costs are given as $3,570,000.
To calculate the manufacturing overhead rate, we divide the total manufacturing overhead costs by the total direct labor hours:
Manufacturing overhead rate = Total manufacturing overhead costs / Total direct labor hours
Total direct labor hours can be calculated by multiplying the direct labor hours per unit by the expected annual sales for each product.
For Standard model:
Direct labor hours per unit: 3 hours
Expected annual sales: 20,000 units
Total direct labor hours: 3 hours * 20,000 units = 60,000 hours
For Deluxe model:
Direct labor hours per unit: 2 hours
Expected annual sales: 1,000 units
Total direct labor hours: 2 hours * 1,000 units = 2,000 hours
For Performance model:
Direct labor hours per unit: 2 hours
Expected annual sales: 10,000 units
Total direct labor hours: 2 hours * 10,000 units = 20,000 hours
Now we can calculate the manufacturing overhead costs for each product by multiplying the manufacturing overhead rate by the total direct labor hours for each product.
For Standard model:
Manufacturing overhead costs = Manufacturing overhead rate * Total direct labor hours
= Manufacturing overhead rate * 60,000 hours
For Deluxe model:
Manufacturing overhead costs = Manufacturing overhead rate * Total direct labor hours
= Manufacturing overhead rate * 2,000 hours
For Performance model:
Manufacturing overhead costs = Manufacturing overhead rate * Total direct labor hours
= Manufacturing overhead rate * 20,000 hours
The total product costs can be calculated by adding the raw materials costs, direct labor costs, and manufacturing overhead costs for each product.
For Standard model:
Total product cost = Raw materials cost + Direct labor cost + Manufacturing overhead cost
For Deluxe model:
Total product cost = Raw materials cost + Direct labor cost + Manufacturing overhead cost
For Performance model:
Total product cost = Raw materials cost + Direct labor cost + Manufacturing overhead cost
Budgeted Price:
The budgeted price for each product is set at 150% of its full product cost.
To calculate the budgeted price, we multiply the total product cost by 1.5 (150%).
Now, you can use the given budgeted product costs and sales data to calculate the product cost and budgeted price of each of the firm's three products based on both the existing costing system and the activity-based costing approach. Transfer the calculations to the provided template in the Task 1a section. Remember to show the full calculations in Appendix 1.