Product profitability under ABC and a special order
Halden Furniture Ltd produces two lines: Standard and Custom. Annual overhead is CU 600,000. Under its current plant-wide system, overhead is absorbed on direct labour hours: Standard uses 40,000 hours and Custom 10,000 hours. Direct costs and output are: Standard - materials CU 300,000, labour CU 400,000, 20,000 units, selling price CU 65; Custom - materials CU 150,000, labour CU 100,000, 5,000 units, selling price CU 90. The sales director wants to drop Custom because a competitor has cut prices. An activity analysis shows: setup costs CU 150,000 (Standard 100 setups; Custom 500 setups), material handling CU 200,000 (Standard 200 moves; Custom 600 moves), and inspection CU 250,000 (Standard 1,000 inspections; Custom 4,000 inspections). Custom uses specialised labour and has no alternative use for its equipment. A one-off export order for 1,000 Custom units at CU 70 has been received; existing Custom sales would not be affected, but the order would require CU 8,000 of extra setup cost and would use idle capacity.
1. Calculate the product cost per unit under the traditional plant-wide method and under activity-based costing. Interpret the difference.
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Traditional method: overhead rate = CU 600,000 ÷ 50,000 direct labour hours = CU 12 per hour. Standard overhead = 40,000 × CU 12 = CU 480,000; total cost CU 300,000 + CU 400,000 + CU 480,000 = CU 1,180,000; unit cost CU 59. Custom overhead = 10,000 × CU 12 = CU 120,000; total cost CU 150,000 + CU 100,000 + CU 120,000 = CU 370,000; unit cost CU 74. Under traditional costing, Standard earns CU 6 per unit and Custom earns CU 16 per unit. ABC: setup rate = CU 150,000 ÷ 600 = CU 250 per setup; handling rate = CU 200,000 ÷ 800 = CU 250 per move; inspection rate = CU 250,000 ÷ 5,000 = CU 50 per inspection. Standard overhead = (100 × CU 250) + (200 × CU 250) + (1,000 × CU 50) = CU 25,000 + CU 50,000 + CU 50,000 = CU 125,000; total cost CU 825,000; unit cost CU 41.25. Custom overhead = (500 × CU 250) + (600 × CU 250) + (4,000 × CU 50) = CU 125,000 + CU 150,000 + CU 200,000 = CU 475,000; total cost CU 725,000; unit cost CU 145. ABC shows Custom consumes far more setup, handling and inspection resource per unit. The plant-wide rate overcosts Standard and undercosts Custom because it assumes overhead is driven only by labour hours.
2. Should Halden discontinue Custom on the basis of the ABC loss? Show the relevant analysis and identify the additional information needed.
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The ABC loss is not by itself a discontinuation decision. Custom's contribution before allocated overhead is revenue CU 450,000 less direct materials CU 150,000 and direct labour CU 100,000 = CU 200,000. If Custom is dropped, that contribution is lost. The decision depends on avoidable fixed costs. The ABC overhead of CU 475,000 includes setup, handling and inspection costs; some may disappear if Custom is dropped, but many may be committed. If avoidable overhead is less than CU 200,000, dropping Custom reduces profit. If avoidable overhead exceeds CU 200,000, dropping may be financially justified. Halden also needs to know whether the equipment has an alternative use or sale value, whether Standard demand can use released capacity, whether Custom is needed to support the product range, and whether complexity can be reduced by re-pricing, reducing setups, or outsourcing. The better immediate response is to re-price or redesign Custom, not to drop it solely because ABC shows a fully absorbed loss.
3. Evaluate the one-off export order for 1,000 Custom units at CU 70, including the CU 8,000 extra setup cost.
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Use relevant costing because idle capacity exists. Relevant revenue = 1,000 × CU 70 = CU 70,000. Relevant materials = 1,000 × (CU 150,000 ÷ 5,000) = CU 30,000. Relevant direct labour = 1,000 × (CU 100,000 ÷ 5,000) = CU 20,000, assuming the specialised labour is genuinely variable or can be used without additional cost; if it is fixed and no extra labour is needed, this cost is not relevant. Extra setup cost = CU 8,000. Total relevant cost = CU 58,000, giving an incremental contribution of CU 12,000. On the stated assumptions, accept the order because it improves profit and uses idle capacity. Before accepting, confirm that existing sales will not be cannibalised, that no better use of capacity exists, that the labour cost is truly incremental, and that the CU 70 price will not set an unsustainable precedent with other customers.