Activity-based costing and product profitability
Meridian Products makes two products, A and B, in the same factory. Annual data: Product A output 8,000 units, direct cost £22 per unit, selling price £40, 2 machine hours per unit, 100 production setups, 200 quality inspections. Product B output 2,000 units, direct cost £45 per unit, selling price £95, 4 machine hours per unit, 300 setups, 600 inspections. Total overhead is £240,000, analysed into machine-related £100,000, setup £80,000 and inspection £60,000. The existing system absorbs all overhead on machine hours. The sales manager uses full cost plus a 10% mark-up for pricing and argues that A is loss-making and should be dropped. The production manager says B is the problem because it causes most setups and inspections. There is no spare capacity, and dropping either product would release machine hours but not fixed overhead in the short term. The management accountant is considering activity-based costing.
1. Calculate the full cost per unit and profit per unit under the existing machine-hour absorption system.
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Total machine hours:
- Product A: 8,000 × 2 = 16,000 hours
- Product B: 2,000 × 4 = 8,000 hours
- Total = 24,000 hours
Overhead absorption rate = £240,000 / 24,000 = £10 per machine hour.
Product A:
- Overhead per unit = 2 × £10 = £20
- Full cost = £22 + £20 = £42
- Selling price = £40
- Loss = £2 per unit; total loss = 8,000 × £2 = £16,000
Product B:
- Overhead per unit = 4 × £10 = £40
- Full cost = £45 + £40 = £85
- Selling price = £95
- Profit = £10 per unit; total profit = 2,000 × £10 = £20,000
Total profit = £20,000 − £16,000 = £4,000.
Under the existing system, A looks loss-making and B looks profitable. That supports the sales manager's view that A should be dropped. However, the system assumes all overhead is driven by machine hours, which may not reflect the real causes of setup and inspection costs.
2. Recalculate using ABC and advise which product is more profitable.
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Activity rates:
- Machine-related: £100,000 / 24,000 machine hours = £4.1667 per machine hour
- Setup: £80,000 / (100 + 300) = £80,000 / 400 = £200 per setup
- Inspection: £60,000 / (200 + 600) = £60,000 / 800 = £75 per inspection
Product A:
- Machine: 16,000 × £4.1667 = £66,667
- Setup: 100 × £200 = £20,000
- Inspection: 200 × £75 = £15,000
- Total overhead = £101,667
- Overhead per unit = £101,667 / 8,000 = £12.71
- Full cost = £22 + £12.71 = £34.71
- Profit per unit = £40 − £34.71 = £5.29; total profit ≈ £42,320
Product B:
- Machine: 8,000 × £4.1667 = £33,333
- Setup: 300 × £200 = £60,000
- Inspection: 600 × £75 = £45,000
- Total overhead = £138,333
- Overhead per unit = £138,333 / 2,000 = £69.17
- Full cost = £45 + £69.17 = £114.17
- Loss per unit = £95 − £114.17 = £19.17; total loss ≈ £38,340
ABC reverses the conclusion: A is profitable and B is loss-making. B consumes most setup and inspection resources despite its low volume. The sales manager's plan to drop A is not supported by ABC. However, total profit is unchanged at about £4,000 because ABC only reallocates the same overhead. Before dropping B, the company must consider contribution and avoidable costs: B earns contribution of £95 − £45 = £50 per unit, or £100,000 in total, and £12.50 per machine hour, compared with A's £18 per unit and £9 per machine hour. In the short term, dropping B would lose that contribution and may not save the allocated overhead. The better actions are to reprice B, reduce its setups and inspections, or redesign it, rather than drop it immediately.
3. Discuss the limitations of ABC here and what additional information you need before changing prices or dropping a product.
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The ABC calculation is more informative than machine-hour absorption, but it is not a complete decision tool. Limitations include:
- The activity pools and drivers are chosen by the management accountant; setup and inspection costs may not be truly driven by the number of setups or inspections.
- The rates use annual budgeted data and may include unused capacity, so product costs can change if volume changes.
- ABC ignores market demand and competition; a full-cost loss does not necessarily mean a product should be dropped.
- It does not show which overheads are avoidable. Dropping B may save setup and inspection costs only if the company can reduce those activities; many allocated costs will remain.
- Implementation and data collection are costly, and the data may be approximate.
Before changing prices or dropping a product, I would want:
- Contribution per unit and per limiting factor, not just full cost.
- Evidence on price sensitivity and customer demand for A and B.
- A breakdown of avoidable versus unavoidable overhead if either product is dropped.
- The possibility of reducing B's complexity, such as fewer setups through larger batch sizes or fewer inspections through supplier quality improvement.
- Whether machine hours are genuinely the binding constraint and whether released hours can be used profitably.
The correct decision is not 'drop the loss-making product' but 'use ABC to understand complexity, then compare avoidable costs and lost contribution under each alternative'.