Meridian Components: ABC versus labour-based costing and the special-order decision
Meridian Components makes two lines in one plant. Product A: 40,000 units, price 360, direct material 110, direct labour 90 (the same 90 for product B), variable overhead 40. Product B: 6,000 units, price 480, direct material 120, direct labour 90, variable overhead 60. Fixed production overhead is 4,140,000 and total direct labour cost is also 4,140,000, so Meridian has always allocated overhead at 100% of direct labour cost. An activity analysis shows three fixed pools: setup 1,035,000 driven by 345 setups (A 45, B 300); machine 2,070,000 driven by 103,500 machine hours (A 34,500, B 69,000); inspection 1,035,000 driven by 1,725 inspections (A 345, B 1,380). Plant capacity is 110,000 machine hours. A distributor has offered to buy 4,000 units of A at 270 for a one-off export order. The order needs one additional setup and one-off tooling of 90,000. Separately, sales believes that discontinuing B would free resources to sell 3,000 more units of A. 40% of B's allocated fixed overhead would be avoided if B were dropped.
1. Compute the unit cost of A and B under the existing labour-based method and under activity-based costing, and explain what drives the difference.
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Labour-based (rate = 4,140,000 / 4,140,000 = 100% of direct labour cost).
- A: 110 + 90 + 90 = 290; margin against 360 = 70 per unit (19.4%).
- B: 120 + 90 + 90 = 300; margin against 480 = 180 per unit (37.5%).
Activity-based rates.
- Setup: 1,035,000 / 345 = 3,000 per setup. A: 45 x 3,000 = 135,000 (3.38 per unit). B: 300 x 3,000 = 900,000 (150 per unit).
- Machine: 2,070,000 / 103,500 = 20 per machine hour. A: 34,500 x 20 = 690,000 (17.25 per unit). B: 69,000 x 20 = 1,380,000 (230 per unit).
- Inspection: 1,035,000 / 1,725 = 600 per inspection. A: 345 x 600 = 207,000 (5.18 per unit). B: 1,380 x 600 = 828,000 (138 per unit).
Unit cost. A: 110 + 90 + 25.80 = 225.80, margin 134.20. B: 120 + 90 + 518 = 728, a loss of 248 per unit (51.7% of price).
Why the flip happens. The labour base spreads overhead almost equally per unit because A and B each carry 90 of direct labour. But B is a low-volume, high-complexity product: it consumes 11.5 machine hours per unit against 0.86 for A, absorbs 300 of 345 setups and 1,380 of 1,725 inspections. Labour content is simply uncorrelated with the consumption of setup, machine and inspection resources, so the traditional rate systematically under-costs B and over-costs A. B has been subsidised by A, and any pricing or product-mix decision taken on the labour-based number is unreliable.
2. Should Meridian accept the 4,000-unit export order at 270? Support the answer with relevant-costing arithmetic, including any opportunity cost.
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Incremental analysis.
- Contribution per unit = 270 - (110 + 90 + 40) = 30. Total contribution = 30 x 4,000 = 120,000.
- One-off tooling = (90,000).
- One additional setup at 3,000 = (3,000).
- Net relevant benefit = 27,000.
Capacity check (the opportunity cost test). Each unit of A uses 0.8625 machine hours (34,500 / 40,000). The order needs 4,000 x 0.8625 = 3,450 machine hours. Current usage is 103,500 of 110,000 hours, leaving 6,500 hours idle. The order consumes only 3,450 hours, so nothing is displaced and the opportunity cost is nil. Had the order required more than 6,500 hours, the contribution foregone on displaced A units (60 per unit, or about 69.6 per machine hour) would have to be deducted and the order would probably fail.
Conclusion. Accept on the numbers, since 27,000 is positive and no better use of the idle hours exists. But the margin is thin and qualitative factors decide it. Confirm the order is genuinely one-off and will not be used as a reference price by domestic customers, confirm the export price does not trigger any undertaking given to existing distributors, and confirm the tooling cost is truly one-off and not the first slice of an ongoing commitment. If any of those fails, the 27,000 evaporates. Get the export destination and pricing restrictions checked before acceptance rather than after.
3. Evaluate the proposal to discontinue product B, taking account of the claimed 3,000 extra units of A.
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Contribution lost if B is dropped. B's variable cost is 120 + 90 + 60 = 270, so contribution = 480 - 270 = 210 per unit x 6,000 = 1,260,000.
Fixed costs avoided. ABC overhead per unit of B is 518, so allocated fixed overhead is 518 x 6,000 = 3,108,000. Only 40% is avoidable: 1,243,200. The remaining 1,864,800 is common cost that will be reallocated to A.
Net effect before any alternative use. 1,260,000 - 1,243,200 = 16,800 worse off. On fixed-cost arithmetic alone, dropping B is very slightly negative, i.e. essentially break-even.
The 3,000 units of A. Contribution per unit of A = 360 - 240 = 120. If 3,000 additional units can genuinely be sold at 360, that adds 360,000, producing a net gain of about 343,200 and reversing the conclusion. Test the assumption: the freed capacity is 69,000 machine hours, while 3,000 units of A need only 2,588 hours, so capacity is not the constraint - market demand is. The whole case rests on an uncontracted sales forecast, and pushing 7.5% more A into the market may require price concessions that reduce the 120 contribution.
Recommendation. Do not discontinue on this evidence. The 16,800 figure says B is roughly self-funding at the contribution level, and the gain depends on an unproven demand assumption. The better route is to attack B's complexity cost: cutting setups from 300 to 75 through campaign scheduling saves 675,000 of setup cost and turns B into a contributor without losing its 1,260,000 contribution.