Choosing Between Two Costing Systems
A job-order manufacturer, Precision Engineering, produces bespoke machine parts. It currently absorbs overhead on a single plant-wide rate based on direct labour hours: budgeted overhead Tk 4,800,000 over 96,000 labour hours = Tk 50 per hour. Two product lines exist. Line A is labour-intensive (8 labour hours, 2 machine hours per unit) and Line B is machine-intensive (1 labour hour, 10 machine hours per unit). Annual volumes are 6,000 units of A and 4,000 of B. The operations manager complains that Line B 'looks cheap but eats machine time and setup resources', and that Line A is being overcharged. A consultant proposes activity-based costing with three pools: machine-related Tk 2,400,000 (driven by 52,000 machine hours), setup Tk 1,440,000 (driven by 1,200 setups), and labour-related Tk 960,000 (driven by 96,000 labour hours).
1. Compare the overhead cost per unit of each product under the current plant-wide rate versus the proposed ABC system.
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Current system (Tk 50/labour hour):
- Line A: 8 hrs × 50 = Tk 400/unit
- Line B: 1 hr × 50 = Tk 50/unit
ABC rates:
- Machine: 2,400,000 / 52,000 = Tk 46.15/machine hour
- Setup: 1,440,000 / 1,200 = Tk 1,200/setup
- Labour: 960,000 / 96,000 = Tk 10/labour hour
Line A per unit: machine 2 × 46.15 = 92.30; labour 8 × 10 = 80; setup (assume 400 setups ÷ 6,000 units = 0.0667 × 1,200 = 80). Total ≈ Tk 252/unit.
Line B per unit: machine 10 × 46.15 = 461.50; labour 1 × 10 = 10; setup (800 setups ÷ 4,000 = 0.20 × 1,200 = 240). Total ≈ Tk 711/unit.
(Setup split assumed 400/800; if the exam gives a different split, substitute it. The direction of the result is what matters.)
Conclusion: the plant-wide rate overcharges Line A (400 vs ~252) and massively undercharges Line B (50 vs ~711) - exactly the operations manager's complaint.
2. What decision risk does the current system create, and what should management do?
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Risk under the current system: Line B appears to cost Tk 50/unit when it really consumes ~Tk 711 of overhead. If pricing is cost-plus, Line B is being sold below true cost - a classic cross-subsidy where high-volume labour-intensive Line A subsidises machine-intensive Line B. Management may win more Line B orders thinking they are profitable, and lose Line A orders that are priced too high.
Actions:
- Adopt ABC (or at least a machine-hour driver for the machine pool) so pricing reflects resource consumption.
- Re-price Line B upward and review Line A pricing downward to win volume.
- Validate the setup-cost split and driver data before switching - ABC is only as good as its drivers.
- Weigh ABC's implementation cost against the benefit; a two-pool hybrid may suffice.