Zamindar Foods: Overhead Cross-Subsidy and the Tender Decision
Zamindar Foods produces three lines. Total manufacturing overhead is PKR 180 million, currently absorbed on direct labour hours. Budget data:
| Line | Units | DL hours | Setups | Inspections | Purchase orders |
|---|---|---|---|---|---|
| A (standard) | 200,000 | 400,000 | 200 | 100 | 1,000 |
| B (mid-range) | 80,000 | 300,000 | 400 | 250 | 1,200 |
| C (custom) | 20,000 | 300,000 | 600 | 450 | 1,800 |
| Total | 300,000 | 1,000,000 | 1,200 | 800 | 4,000 |
Overhead pools are: setup PKR 72m, inspection PKR 48m, purchasing PKR 60m. The sales team is paid a bonus on reported gross margin. A hospital group has invited a tender for 5,000 units of Line C at PKR 1,900 per unit; direct material and labour for Line C are PKR 1,050 per unit.
1. Calculate the overhead per unit under the current absorption method and under activity-based costing, and interpret the result.
Read the worked answer
Current absorption rate PKR 180,000,000 ÷ 1,000,000 DL hours = PKR 180 per DL hour.
| Line | Overhead absorbed | Per unit |
|---|---|---|
| A | 400,000 × 180 = PKR 72.0m | PKR 360 |
| B | 300,000 × 180 = PKR 54.0m | PKR 675 |
| C | 300,000 × 180 = PKR 54.0m | PKR 2,700 |
Activity-based rates
- Setup: 72m ÷ 1,200 = PKR 60,000 per setup
- Inspection: 48m ÷ 800 = PKR 60,000 per inspection
- Purchasing: 60m ÷ 4,000 = PKR 15,000 per order
| Line | Setup | Inspection | Purchasing | Total | Per unit |
|---|---|---|---|---|---|
| A | 12.0m | 6.0m | 15.0m | 33.0m | PKR 165 |
| B | 24.0m | 15.0m | 18.0m | 57.0m | PKR 712.50 |
| C | 36.0m | 27.0m | 27.0m | 90.0m | PKR 4,500 |
Interpretation. Line A is over-absorbed by PKR 39m (PKR 195 per unit); Line C is under-absorbed by PKR 36m (PKR 1,800 per unit). C consumes six times A's setups per unit and far more inspection and purchasing effort. Labour-hour absorption treats C as cheap because it is labour-light, which is precisely wrong. A is subsidising C, so C's reported margin - and the sales bonus - are flattered.
2. Using your ABC figures, advise whether Zamindar should bid for the hospital tender at PKR 1,900, and explain what else must be considered.
Read the worked answer
Full ABC cost per unit of C: direct cost PKR 1,050 + overhead PKR 4,500 = PKR 5,550. A price of PKR 1,900 is far below full cost, so on a full-cost basis the tender must be rejected.
But full cost is not the decision cost. The tender is for 5,000 units - 25% of C's volume, incremental. Relevant-cost logic:
- Direct material and labour: 5,000 × 1,050 = PKR 5.25m.
- Incremental setups/inspections/orders: if the tender adds, say, 150 setups, 110 inspections and 450 orders, incremental overhead = (150 × 60,000) + (110 × 60,000) + (450 × 15,000) = 9.0m + 6.6m + 6.75m = PKR 22.35m.
- Incremental cost ≈ PKR 27.6m, i.e. PKR 5,520 per unit - still far above PKR 1,900. Even on marginal cost the bid destroys value unless the batch is large enough to absorb setup effort.
Other considerations
- Capacity: is there idle capacity? If so, the floor is incremental cash cost, not full cost; but at PKR 1,900 even cash cost (PKR 1,050 plus any incremental overhead) may not be covered once batch costs are included.
- Strategic: a hospital reference could open a new channel; but loss-leading into a structurally loss-making line is not a strategy.
- Price precedent: a PKR 1,900 public price will be cited by existing customers and may trigger renegotiation across C.
- Root cause: C's design and ordering discipline, not its price, is the problem. Reduce setups and order frequency before bidding.
Recommendation: decline at PKR 1,900 and counter with a specification-standardised, larger-batch offer. If management wants the reference account, treat any discount as a separately approved marketing spend with a cap, not as a hidden cost subsidy.
3. The sales team's bonus is based on reported gross margin. What behavioural consequences follow, and how should the performance system change?
Read the worked answer
Current behaviour. Under labour-hour absorption, C shows a high reported margin because it is charged only PKR 2,700 overhead against PKR 4,500 of actual resource consumption. Salespeople are therefore incentivised to chase custom, low-volume, high-complexity orders - the very work that erodes profitability. A will look marginal and be under-sold, even though it is the most efficient line. The bonus rewards reported margin, not cash contribution.
Consequences if ABC is simply imposed on the existing bonus
- C's margin collapses; sales staff may abandon a legitimate product line overnight.
- Staff may dispute the cost driver rates, especially allocations they cannot control (purchasing orders raised by production planning).
- Gaming: orders batched at period-end to reduce apparent setups, or inspections deferred.
Redesign
- Measure contribution after controllable ABC costs: setups and orders influenced by sales and planning, not factory-wide inspection.
- Add non-financial measures - order size, number of changeovers per order, on-time delivery - so complexity is managed, not merely charged.
- Use ABC for pricing and product-mix decisions, and a simpler controllable-margin measure for bonuses.
- Publish rates and driver volumes so the link between behaviour and cost is visible.
- Review C's product design and customer ordering patterns jointly with sales before any target is set.
The principle: cost systems inform decisions; performance systems drive behaviour. Using the same number for both without care creates the cross-subsidy problem in a new form.