Meridian Instruments: Activity-Based Costing and the Custom Systems Line
Meridian Instruments builds two products in one plant: a standard laboratory balance (40,000 units a year) and configured analytical systems (600 units a year). Manufacturing overhead of $4.20 million is currently allocated on direct labour hours - 0.5 hours per balance and 6 hours per system, 23,600 hours in total. The CFO's activity-based pilot produced four pools: set-ups $1.10 million across 2,200 set-ups (400 standard, 1,800 custom); engineering change orders $0.90 million across 1,500 orders (150 standard, 1,350 custom); machine-related costs $1.60 million across 104,000 machine hours (80,000 standard, 24,000 custom); and $0.60 million of facility costs allocated on labour hours. Practical capacity is 2,600 set-ups. Each configured system sells for $4,900 and uses $1,100 of materials and six labour hours at $45. The sales director argues the line's 50% mark-up on traditional cost must be defended; the plant manager wants the line exited.
1. Calculate the unit product cost of each product under the existing labour-hour rate and under the activity-based pools, treating the 400 unused set-ups correctly. Show the rates and the allocation to each product.
Read the worked answer
Traditional rate: $4,200,000 ÷ 23,600 DLH = $177.97 per DLH.
- Balance: 0.5 × 177.97 = $88.98
- System: 6 × 177.97 = $1,067.80
Activity rates (capacity-based for set-ups):
- Set-ups: $1,100,000 ÷ 2,600 practical capacity = $423.08. Charged to products only for the 2,200 set-ups used; the 400 idle set-ups ($169,231) stay as a period cost, not a product cost.
- Change orders: $900,000 ÷ 1,500 = $600.00
- Machine-related: $1,600,000 ÷ 104,000 = $15.3846 per machine hour
- Facility: $600,000 ÷ 23,600 = $25.4237 per DLH
Allocation:
| Pool | Balance | System |
|---|---|---|
| Set-ups (400 / 1,800) | $169,231 | $761,538 |
| Change orders (150 / 1,350) | $90,000 | $810,000 |
| Machine (80,000 / 24,000) | $1,230,769 | $369,231 |
| Facility (20,000 / 3,600) | $508,475 | $91,525 |
| Total overhead | $1,998,475 | $2,032,294 |
| Units | 40,000 | 600 |
| Overhead per unit | $49.96 | $3,387.16 |
Full unit cost:
- Balance: material and labour plus $49.96 overhead.
- System: $1,100 + $270 + $3,387 = $4,757, a margin of $143 on the $4,900 price, or 2.9%.
Under traditional costing the system showed a cost of $2,438 and a 50.5% margin. The entire difference is driven by the custom line's consumption of set-ups (1,800 of 2,200) and engineering orders (1,350 of 1,500) - batch- and product-sustaining activities that labour hours simply do not capture.
2. The plant manager wants to exit the custom line on the basis of the activity-based loss. Advise the board, distinguishing activity-based cost from avoidable cost.
Read the worked answer
An activity-based cost is a full cost; it is not automatically an avoidable cost. Test the line by what actually disappears if it stops:
- Revenue: 600 × $4,900 = $2,940,000
- Materials: 600 × $1,100 = $660,000
- Direct labour: 600 × $270 = $162,000
- Engineering change orders: $810,000 - avoidable only if the engineers can be released or genuinely redeployed elsewhere
- Set-up resource: $761,538 - avoidable only if set-up crew and consumables vary with the work
- Machine-related: $369,231 - avoidable only if machine time is variable or the capacity has an alternative use
- Facility costs ($91,525) and the unused-capacity charge ($169,231) remain regardless
If the first five items are avoidable, the line contributes $177,231 a year to overhead - exiting destroys that sum and the customer relationships, without releasing the plant.
If engineering is a fixed team that would simply be reallocated, the line's avoidable contribution turns negative (about −$633,000), and exit is justified provided the standard line can absorb the people and the building.
The correct judgement is therefore conditional, and the decision hinges on cost-behaviour evidence the board does not yet have. Practically: the line is marginally profitable at an activity-based full cost, and a 6.8% price increase (to about $5,233) or a redesign that halves change orders restores a normal return. Recommend a 90-day review that (a) confirms which batch and product-sustaining resources are truly avoidable, and (b) negotiates price or specification with the custom customers, before any exit decision. Exiting on an allocated loss figure alone would be the classic error this analysis is designed to expose.