Overhead Absorption and a Loss-Making Product Line
A furniture manufacturer produces three lines: chairs, tables and cabinets. It absorbs production overhead on a single direct-labour-hour rate. Budgeted overhead is BDT 9,600,000 and budgeted direct labour hours are 240,000, giving a rate of BDT 40 per hour. The following actual results are reported for the year: chairs sold 20,000 units at BDT 900 each with direct cost BDT 500 per unit and 3 labour hours per unit; tables sold 8,000 units at BDT 2,400 each with direct cost BDT 1,500 per unit and 6 labour hours per unit; cabinets sold 3,000 units at BDT 4,000 each with direct cost BDT 2,900 per unit and 8 labour hours per unit. The sales director wants to drop cabinets because they show the lowest margin. A consultant notes that cabinets consume 45 minutes of machine time per unit against 10 minutes for chairs, and machine-related overhead is BDT 6,000,000 of the total. Fixed costs are unavoidable in the short term.
1. Compute the profit per line under the existing absorption method and identify the apparent problem.
Read the worked answer
Labour hours used: chairs 20,000 x 3 = 60,000; tables 8,000 x 6 = 48,000; cabinets 3,000 x 8 = 24,000; total 132,000 hours. Overhead absorbed at BDT 40 = BDT 5,280,000, leaving BDT 4,320,000 under-absorbed (9,600,000 - 5,280,000).
Contribution before overhead:
- Chairs: 20,000 x (900 - 500) = BDT 8,000,000
- Tables: 8,000 x (2,400 - 1,500) = BDT 7,200,000
- Cabinets: 3,000 x (4,000 - 2,900) = BDT 3,300,000 Total contribution BDT 18,500,000.
Absorbed overhead by line: chairs 60,000 x 40 = 2,400,000; tables 48,000 x 40 = 1,920,000; cabinets 24,000 x 40 = 960,000. Line profits: chairs 5,600,000; tables 5,280,000; cabinets 2,340,000. Cabinets are profitable but the weakest. The apparent problem is that the single labour-hour rate loads overhead onto labour-intensive lines and ignores that cabinets are machine-intensive, so the reported margin misrepresents their true consumption of resources.
2. Recompute using activity-based costing with machine-related overhead of BDT 6,000,000 and the balance driven by labour hours, and advise on dropping cabinets.
Read the worked answer
Machine hours: chairs 20,000 x 10/60 = 3,333; tables 8,000 x 30/60 = 4,000; cabinets 3,000 x 45/60 = 2,250; total 9,583 hours. Machine overhead rate = 6,000,000 / 9,583 = BDT 626 per machine hour (rounded).
Machine overhead allocated: chairs 3,333 x 626 = 2,086,000; tables 4,000 x 626 = 2,504,000; cabinets 2,250 x 626 = 1,409,000.
Remaining overhead BDT 3,600,000 absorbed on labour hours at 3,600,000 / 240,000 = BDT 15 per hour: chairs 900,000; tables 720,000; cabinets 360,000.
Total overhead: chairs 2,986,000; tables 3,224,000; cabinets 1,769,000. Line profit: chairs 8,000,000 - 2,986,000 = 5,014,000; tables 7,200,000 - 3,224,000 = 3,976,000; cabinets 3,300,000 - 1,769,000 = 1,531,000.
Cabinets remain profitable on a contribution basis (BDT 3.3 million), and fixed costs are unavoidable. Dropping them would lose that contribution and leave the remaining lines to absorb the overhead. The advice is to retain cabinets and investigate pricing, machine utilisation or automation, not to eliminate the line on an absorption-cost margin.
3. Explain why a loss-making line may still be retained and what qualitative factors matter.
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A line is retained in the short term when its contribution covers its avoidable costs and any positive contribution helps absorb unavoidable fixed costs. If overhead absorption allocates a share of common fixed costs to the line, the line can show an accounting loss while still contributing cash. Dropping it would reduce total profit by the lost contribution unless the freed capacity is redeployed to a more profitable use.
Qualitative factors include: whether the freed machine time can produce more tables or a new product; customer relationships where cabinets are sold as part of a package; loss of supplier discounts on volume; employee skills and redundancy costs; brand positioning; and strategic entry into a segment. The examiner rewards a clear statement of the relevant-versus-irrelevant cost distinction, the avoidable/unavoidable split, and recognition that absorption profit is not the same as incremental cash effect.