Overhead Absorption Rate Distortion in a Multi-Product Job Shop
Karim Engineering Works produces three product lines in one factory. It currently absorbs all production overhead on direct labour hours. Budgeted overhead is BDT 9,600,000 and budgeted direct labour hours are 48,000, giving a rate of BDT 200 per hour. Product A uses 2 labour hours and 6 machine hours per unit; Product B uses 5 labour hours and 1 machine hour; Product C uses 1 labour hour and 8 machine hours. Machine-intensive Product C is winning large orders, while labour-intensive Product B is losing tenders to competitors. The production manager suspects the costing system is misallocating overhead. An activity analysis shows BDT 5,760,000 of overhead is machine-related (driven by 96,000 budgeted machine hours) and BDT 3,840,000 is labour-related. The managing director wants to know whether the pricing problem lies in the costing method.
1. Calculate the overhead cost per unit for each product under the current labour-hour method and under an activity-based approach, and identify which products are over- or under-costed.
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Current method. Absorption rate = BDT 9,600,000 ÷ 48,000 hours = BDT 200 per labour hour.
- Product A: 2 hours × BDT 200 = BDT 400
- Product B: 5 hours × BDT 200 = BDT 1,000
- Product C: 1 hour × BDT 200 = BDT 200
Activity-based method.
- Machine-related rate = BDT 5,760,000 ÷ 96,000 machine hours = BDT 60 per machine hour.
- Labour-related rate = BDT 3,840,000 ÷ 48,000 labour hours = BDT 80 per labour hour.
- Product A: (6 × 60) + (2 × 80) = 360 + 160 = BDT 520
- Product B: (1 × 60) + (5 × 80) = 60 + 400 = BDT 460
- Product C: (8 × 60) + (1 × 80) = 480 + 80 = BDT 560
Comparison.
- Product A is under-costed by BDT 120 per unit (400 vs 520).
- Product B is over-costed by BDT 540 per unit (1,000 vs 460).
- Product C is under-costed by BDT 360 per unit (200 vs 560).
The labour-hour method subsidises machine-intensive products and penalises labour-intensive ones, because it treats labour hours as the sole driver of a cost pool that is 60% machine-driven.
2. Explain how the distortion explains the observed commercial symptoms, and advise on whether the company should switch to activity-based costing in full.
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Explaining the symptoms. Product C consumes eight machine hours per unit but only one labour hour, so under labour-hour absorption it carries only BDT 200 of overhead when its true consumption is BDT 560. Its reported cost is therefore understated by BDT 360, so tenders priced on reported cost look profitable and the company wins volume it should not want at those prices. Product B consumes five labour hours but only one machine hour; it absorbs BDT 1,000 when it truly consumes BDT 460, so its quoted prices are inflated by BDT 540 and it loses tenders to competitors who cost more accurately. The pattern of winning C orders and losing B orders is exactly what a misallocated overhead system predicts, so the costing method is a credible cause of the pricing problem.
Advice on full adoption. Full activity-based costing is not automatically the answer. Considerations:
- The two-pool model here is a simplification; a full system may need many cost pools and drivers, raising data collection and administration cost.
- Benefits are greatest where overhead is large relative to direct cost, product diversity is high and competition is price-sensitive, all of which appear true here.
- A staged approach is prudent: introduce the machine-hour and labour-hour split first, validate it against actual costs, then refine further pools only where the cost of measurement is justified.
- Pricing decisions should not rely on cost alone; market conditions, capacity utilisation and strategic value still matter.
Recommendation. Adopt at least the two-driver model immediately, because it corrects a demonstrable BDT 540 and BDT 360 per-unit error, and review whether finer pools are warranted once the simpler model is embedded.