Premier Components: ABC, Drop Decision and a Special Order
Premier Components (PC) makes two industrial parts, X and Y, in a single Sialkot plant. Annual overhead is PKR 30 million, currently absorbed on direct labour hours (DLH). Total DLH are 300,000: X uses 210,000 and Y uses 90,000. Output is 70,000 units of X and 30,000 of Y. Direct material and labour are PKR 400 and PKR 150 per unit for X, and PKR 250 and PKR 100 per unit for Y. Selling prices are PKR 900 for X and PKR 700 for Y. An activity-based study identifies three overhead pools: setup PKR 12 million driven by 600 setups (120 for X, 480 for Y); inspection PKR 9 million driven by 1,200 inspections (300 for X, 900 for Y); machining PKR 9 million driven by 90,000 machine hours (45,000 each). PC has idle capacity for 5,000 additional Y units; a new customer offers PKR 620 per unit, requiring 20 extra setups, 50 extra inspections, and 1,500 idle machine hours.
1. Calculate product costs and margins under the traditional and ABC systems, and explain the cause of any distortion.
Read the worked answer
Traditional rate = 30m / 300,000 DLH = PKR 100 per DLH. X overhead per unit = 210,000 × 100 / 70,000 = PKR 300; Y = 90,000 × 100 / 30,000 = PKR 300. X total cost = 400 + 150 + 300 = PKR 850, margin PKR 50 (5.6%). Y total cost = 250 + 100 + 300 = PKR 650, margin PKR 50 (7.1%).
ABC rates: setup 12m / 600 = PKR 20,000 per setup; inspection 9m / 1,200 = PKR 7,500 per inspection; machining 9m / 90,000 = PKR 100 per machine hour.
X overhead: (120 × 20,000) + (300 × 7,500) + (45,000 × 100) = 2.4m + 2.25m + 4.5m = PKR 9.15m, or PKR 130.71 per unit. X total cost = 400 + 150 + 130.71 = PKR 680.71, margin PKR 219.29 (24.4%).
Y overhead: (480 × 20,000) + (900 × 7,500) + (45,000 × 100) = 9.6m + 6.75m + 4.5m = PKR 20.85m, or PKR 695 per unit. Y total cost = 250 + 100 + 695 = PKR 1,045, margin −PKR 345 (−49.3%).
Traditional costing averages overhead by labour hours, but Y consumes 480 of 600 setups and 900 of 1,200 inspections. X is high-volume and simple; Y is low-volume and complex. Traditional costing therefore cross-subsidises Y and overcosts X.
2. Advise whether PC should discontinue Y if 40% of setup and inspection costs and 20% of machining costs are avoidable, and released capacity has no alternative use.
Read the worked answer
Lost revenue if Y is dropped = 30,000 × 700 = PKR 21.0m. Saved direct costs = 30,000 × (250 + 100) = PKR 10.5m. Avoidable overhead = 40% × (9.6m + 6.75m) + 20% × 4.5m = 6.54m + 0.9m = PKR 7.44m. Total avoidable cost = 10.5 + 7.44 = PKR 17.94m. Net loss from dropping Y = 21.0 − 17.94 = PKR 3.06m.
Y still contributes PKR 3.06m toward unavoidable overhead and common costs. Do not drop Y solely because its ABC full cost exceeds its price. First try repricing toward full cost, reducing complexity (fewer setups and inspections), or redeploying capacity. Drop Y only if the released capacity can generate more than PKR 3.06m of contribution, or if the longer-term price cannot cover avoidable and attributable costs.
3. Evaluate the special order for 5,000 Y units at PKR 620 using relevant costing.
Read the worked answer
Revenue = 5,000 × 620 = PKR 3.10m. Relevant costs: direct material 5,000 × 250 = PKR 1.25m; direct labour 5,000 × 100 = PKR 0.50m; extra setups 20 × 20,000 = PKR 0.40m; extra inspections 50 × 7,500 = PKR 0.375m; machining uses idle hours, so no incremental machining cost unless it displaces existing work. Total relevant cost = 1.25 + 0.50 + 0.40 + 0.375 = PKR 2.525m. Contribution = 3.10 − 2.525 = PKR 0.575m.
Accept the order if capacity is genuinely idle, there is no cannibalisation of existing sales, no extra fixed costs arise, and there is no better use of the capacity. Rejecting it because the full ABC cost is PKR 1,045 would be wrong for a short-term incremental decision. If the order becomes recurring, revisit the price because it may not cover long-run attributable costs.