Kestrel Precision: Absorption Costing Versus Activity-Based Costing for a Customer Quote
Kestrel Precision Ltd machines components for aerospace customers. It has two production departments. Budgeted overheads are £480,000 in machining and £210,000 in finishing. Machining overhead is absorbed on budgeted machine hours of 24,000; finishing overhead on budgeted labour hours of 14,000. A new customer has requested a quotation for 1,500 units of component XR7. Estimated prime cost is £18.40 per unit. Each XR7 requires 0.12 machining hours and 0.08 finishing labour hours. The sales director proposes a 20% mark-up on total absorption cost.
The production manager argues that the quote will be misleading. She says XR7 is a low-volume, complex part that will need 60 machine setups, while the machining overhead pool includes £120,000 of setup cost driven by 800 budgeted setups. The rest of machining overhead varies with machine hours. Finishing overhead remains labour-hour driven. The period is also expected to end with £36,000 of under-absorbed overhead because machine hours will be below budget.
1. Calculate the machining and finishing overhead absorption rates, the full absorption cost per unit of XR7 and the quoted price at a 20% mark-up. Show your workings.
Read the worked answer
Machining OAR = £480,000 / 24,000 machine hours = £20.00 per machine hour. Finishing OAR = £210,000 / 14,000 labour hours = £15.00 per labour hour. Overhead per XR7 = (0.12 × £20) + (0.08 × £15) = £2.40 + £1.20 = £3.60. Prime cost £18.40 + overhead £3.60 = full absorption cost £22.00. Mark-up = 20% × £22.00 = £4.40; quoted price = £26.40 per unit. For 1,500 units the quote is £39,600.
2. Recalculate the cost of XR7 using activity-based costing for setup costs, with the remaining machining overhead absorbed on machine hours. Quantify the change in quoted price and explain why the two methods differ.
Read the worked answer
Setup driver rate = £120,000 / 800 setups = £150 per setup. Setup cost for XR7 = 60 setups × £150 = £9,000; per unit = £9,000 / 1,500 = £6.00. Remaining machining overhead = £480,000 − £120,000 = £360,000. Remaining machining OAR = £360,000 / 24,000 = £15.00 per machine hour; XR7 = 0.12 × £15 = £1.80. Finishing overhead = 0.08 × £15 = £1.20. ABC overhead per unit = £6.00 + £1.80 + £1.20 = £9.00. Full ABC cost = £18.40 + £9.00 = £27.40; 20% mark-up = £5.48; price = £32.88. The difference is £32.88 − £26.40 = £6.48 per unit, or £9,720 on 1,500 units. Why: XR7 consumes 60/800 = 7.5% of setup resource but only 180/24,000 = 0.75% of machine hours. Traditional absorption spreads setup cost on machine hours and therefore undercosts complex, low-volume work.
3. Advise Kestrel's management on which cost basis to use for this quotation and on the treatment of the £36,000 under-absorbed overhead. Include relevant costing and behavioural considerations.
Read the worked answer
For a quotation, ABC gives a better estimate of the resources the order will consume, so £32.88 is a more defensible full cost price. However, the minimum price in the short term is the relevant cost, not full absorption cost. If Kestrel has spare capacity and no incremental fixed costs, the relevant cost is prime cost plus any incremental variable overhead and opportunity cost; the £36,000 under-absorbed overhead is a period cost caused by below-budget machine hours, not by XR7, so it should not be loaded into the quote. Loading it would overstate the relevant cost and could lose profitable work. If under-recovery is structural, management should revise the overhead budget or capacity, not recover the shortfall through one customer.
Behaviourally, sales may resist a price of £32.88 if competitors quote near £26. A sensible approach is to use ABC for cost insight, set a floor price from relevant costing, and negotiate between the floor and the ABC full cost. The treatment of under-absorbed overhead should be consistent with accounting policy: write it off to cost of sales in the period, or apportion it if it relates to abnormal circumstances.