Overhead recovery and a special order at Marsa Precision Ltd
Marsa Precision Ltd makes two components, A and B. Budgeted production for 2025 is 400 units of A and 1,000 units of B. Budgeted manufacturing overhead is €480,000 and is absorbed on a single plant-wide direct labour hour rate; budgeted direct labour hours are 24,000 (3,000 for A and 21,000 for B).
Under this basis, A has a full cost of €450 per unit (direct cost €300 plus absorbed overhead €150) against a selling price of €430, so it appears to make a loss of €20 a unit. B shows a full cost of €840 against a price of €980, a margin of €140. The sales director wants to drop A and use the freed labour for B.
An activity analysis of the €480,000 overhead shows €300,000 is machine-related (6,000 budgeted machine hours, of which A uses 400 and B uses 5,600) and €180,000 is driven by set-ups (300 budgeted set-ups, of which A requires 20 and B requires 280). The remaining overhead is negligible.
A overseas distributor has offered €360 per unit for 150 units of A. The order would need 30 extra set-ups and 150 machine hours; there is spare capacity and existing sales would not be affected. Direct costs are variable.
1. Calculate the cost per unit of A and B under the existing plant-wide rate and under activity-based costing, and explain why the ranking of the two products reverses.
Read the worked answer
Plant-wide (labour hour) basis
OAR = €480,000 / 24,000 DLH = €20 per DLH.
A: direct cost €120,000 (400 × €300) + absorbed 3,000 × €20 = €60,000 → €180,000 → €450 per unit. Loss of €20 on a €430 price (−4.7%).
B: direct cost €420,000 (1,000 × €420) + absorbed 21,000 × €20 = €420,000 → €840,000 → €840 per unit. Profit €140 (14.3%).
Activity-based costing
Machine hour rate = €300,000 / 6,000 = €50 per machine hour. Set-up rate = €180,000 / 300 = €600 per set-up.
A: 400 × €50 = €20,000; 20 × €600 = €12,000 → €32,000 → €80 per unit → total cost €380, profit €50 per unit (11.6%).
B: 5,600 × €50 = €280,000; 280 × €600 = €168,000 → €448,000 → €448 per unit → total cost €868, profit €112 per unit (11.4%).
Why the ranking reverses
A consumes a lot of labour per unit (7.5 hours) but very few machine hours (1 per unit) and very few set-ups (0.05 per unit). B consumes 21 labour hours per unit but 5.6 machine hours and 0.28 set-ups per unit. A labour-hour rate treats every hour as equally costly, so it loads cost onto the labour-intensive product and under-loads the machine- and set-up-intensive one. A was cross-subsidising B, not losing money. The two products in fact earn almost identical margins, which changes the decision completely: dropping A would remove a contribution and leave B carrying the same overheads on half the volume.
2. Evaluate the distributor's offer of €360 per unit for 150 units of A. Show the relevant costs and state the minimum price at which the order could rationally be accepted.
Read the worked answer
The €380 ABC unit cost and the €450 full cost are both irrelevant for a one-off order with spare capacity: they include existing fixed overheads that will be incurred whether or not the order is taken. Relevant costs are those that change as a direct result of the decision.
Relevant cost build-up
| Item | Working | € |
|---|---|---|
| Direct cost | 150 × €300 | 45,000 |
| Extra set-ups | 30 × €600 | 18,000 |
| Machine hours | 150 × €50 | nil - spare capacity, no incremental cash outlay |
| Relevant cost | 63,000 |
Revenue = 150 × €360 = €54,000. Contribution = −€9,000, so on these assumptions the order should be rejected: it does not cover its own incremental cost. The shortfall is €60 per unit, so the minimum acceptable price is €63,000 / 150 = €420 per unit, which is well above the €380 average ABC cost - a striking illustration that unit cost and relevant cost answer different questions.
The judgement lies in the set-up assumption. Thirty set-ups for 150 units implies five units per set-up, which is far worse than the 20 units per set-up A normally achieves. If the order could be run in three set-up batches (150 units), set-up cost falls to 3 × €600 = €1,800, relevant cost becomes €46,800, and the order yields €7,200 contribution and should be accepted. Before rejecting, management should ask engineering whether the extra set-ups are genuinely unavoidable.
Qualitative factors to weigh: the risk of the export price leaking into the domestic market and undermining the €430 price; learning benefits; use of otherwise idle capacity; and whether the machine hours consumed could later be needed for profitable work (an opportunity cost that is currently zero).
3. The production manager proposes to cut the budgeted direct labour hours from 24,000 to 20,000 so that the absorption rate rises to €24 per hour and 'the margins look healthier'. Discuss the consequences and the ethical dimension.
Read the worked answer
Cutting the denominator does not change the €480,000 of overhead actually incurred; it only changes how much is charged to each unit. At €24 per hour, product A absorbs €180 of overhead instead of €150, and inventory and cost of sales rise accordingly. Reported profit therefore improves in the short term - but only by the amount of overhead left unabsorbed, and that over-absorption is credited back when the year's actual results are finalised. The 'improvement' is a timing and presentation artefact, not a real gain.
There are real harms. Product costs become misleading: A looks even less viable and might be dropped on false evidence, and pricing decisions built on inflated absorption rates will over-price and lose work. Inventory is carried at a cost that includes recovery of overheads never actually incurred at that level of activity, breaching the requirement that absorption be based on the normal level of activity. If the reduced hours were used to justify a year-end stock build, profit would be pulled forward from next year.
Ethically, this is deliberate manipulation of an accounting estimate to influence reported figures. Neutrality in the Conceptual Framework requires freedom from bias; choosing a denominator to flatter margins rather than to reflect normal capacity is misrepresentation, whatever the technical legitimacy of the arithmetic. If the manager genuinely expects activity to fall, the normal-capacity basis should be reassessed on evidence and disclosed, with the resulting unabsorbed overhead treated as a period cost. A candidate should state clearly that the proposal should be refused and the reason documented.