Activity Based Costing (ABC)

Exercise 1
Reliable Machining Products (RMP) is a discrete automotive component supplier. RMP has been
approached by Chrysler with a proposal to significantly increase production of Part T151A to a
total annual quantity of 100000 units. Chrysler believes that by increasing the volume of
production of Part T151A, RMP should realize the benefits of economies of scale and hence
should accept a lower price than the current $6.00 per unit. Currently, RMP’s gross margin on
100000 units of Part T151A is 3.3% computed as follows:

Particulars Total Per Unit

Direct Material $150,00 $1.50
0
Direct Labour $86,000 $0.86
Indirect Manufacturing (400% of direct labour) $344,00 $3.44
0
Total Cost $580,00 $5.80
0
Sales Price $6.00
Gross Margin $0.20
Gross margin percentage 3.3%

Part T151A seems to be a marginal profit product. If additional volume of production of Part
151A is to be added, RMP management believes that the sales price must be increased not
reduced as requested by Chrysler. The management of RMP sees this quoting situation as an
excellent opportunity to examine the effectiveness of their traditional costing system versus an
activity based –costing system. Data have been collected by a team consisting of accounting and
engineering analysts and as follows.
Activity Centre Cost Drivers Annual Cost- Annual Total Cost-Driver
Driver Overhead Consumption
Quantity Costs (Part 151A)
Quality Number of Pieces 10,000 $800,000 1,000
Scrapped
Production Number of Setups 500 $50,000 12
Scheduling
Materials Number of Setups 500 $600,000 12
handling
Shipping Number of Containers 60,000 $300,000 500
Shipped
Shipping Number of Shipments 1,000 $50,000 100
Administration
 Production Number of Machine 10,000 $1,500,000 500
Hours
a. Prepare a schedule calculating the unit cost and gross margin of Part T151A using
activity based costing approach.
b. Based on the ABC results what course of action would you recommend regarding the
proposal by Chrysler.

Exercise 2
William Brothers Ltd. produces three types of calculators; C 1, C2 and C3. The company has been
using direct labour hours as the basis for allocating overheads costs. Currently, company is
planning to implement Activity Based Costing (ABC) in order to ascertain cost per unit more
systematically. Its accountants and engineers have identified the following activities, related cost
drivers and monthly costs for all indirect costs.

Activity Cost Driver Indirect cost of

manufacturing
(monthly)
Materials Procurement Number of orders Rs 24000
Materials handling Number of movements Rs 33000
Set-up Number of set-ups Rs 60000
Engineering Engineering change notices Rs 200000
Power Kilowatt hours Rs 180000
Maintenance Maintenance hours Rs 90000
Quality control Number of inspection Rs 70000

Direct costs and cost-driver activity for each product for recent month are as follows:

C1 C2 C3
Units produced 2500 5000 10000
Total direct materials cost 250000 500000 900000
Total direct labour hours 4000 1000 3000
Direct labour hour rate 30 40 20
Kilowatt-hours 5000 10000 15000
Engineering change notices 13 5 2
Number of movements 77 132 154
Number of orders 78 104 130
Number of set-ups 96 120 144
Maintenance hours 36 54 72
Number of inspection 12 24 48

Help the company in order to ascertain unit cost by using ABC and compare with the present
costing system of the company. In your opinion which costing method is better? Why?
Exercise 3

Sun Chemicals and Drugs Pvt. Ltd. manufactures four syrups (100 ml bottles) for acidity and
gastric problems. The company uses traditional costing method and charges overhead costs as
350% of direct labor costs for each type of syrups. As per the recent monthly data, the chief cost
accountant was surprised to find that, one of the top selling syrups- Gestone- is making a loss
and he wanted to do an analysis of the cost structure of the product. The direct ingredients cost
and direct labor costs per bottle are Rs 20 and Rs 8 respectively. The selling price per bottle is Rs
55 and total bottles sold last month were 200000. Other monthly overhead details for the four
syrups are given below;
Activity Cost driver Cost of Total cost Cost driver
activity driver consumption by
consumption Gestone
Ingredients procurement Purchase order 2500000 500 80
Production scheduling Number of setups 4900000 700 140
Quality control Batches 2000000 400 60
Packaging and labeling Batches 5000000 400 100
Shipping Number of shipments 3600000 120 30
You are required to suggest a better method to Sun Chemicals, with the help of proper
calculation, for ascertaining the cost and profit per bottle in a more scientific way.