GADGET CO.

Gadget Company produces products A, B and C which are made from the same raw material.
It uses a traditional full costing (sometimes called absorption costing) to allocate overhead to
its products. The company is considering an ABC system in the hope that this will improve
profitability. Information concerning the three products for last year is shown below.

A B C

Product & sales (units) 15 000 12 000 18 000

Sales price per unit 7,50 12 13

Raw materials kg / unit 2 3 4

Direct labor hours / unit 0,1 0,15 0,2

Machine hours per unit 0,5 0,7 0,9

Production runs per year 16 12 8

Purchase orders per year 24 28 42

Customer Deliveries per year 48 30 62

Raw materials prices were constant during the year at € 1,20 per kg. Direct labor costs for the
whole workforce were € 14,80 per hour. Annual overhead costs were as follows :

Machine set up costs : € 26 550

Machine Running costs € 66 400

Procurement costs € 48 000

Delivery costs € 54 320

Questions

i) Calculate the full cost per unit for products A, B and C under tradition full costing
system, using direct labour hours as the allocation base.

To complete this exercice, make the sum of all the overhead expenses, identify the total
labour hours and make the division to give an allocation of overhead in €s per hour of direct
labour. Then follow through the normal cost calculation for each product. Note that you will
have to calculate the total number of direct labour hours for each product : you have the
information concerning the labour hours per unit and the total units produced.

ii) Calculate the full cost per unit of each product using the ABC system.
The information above has given a clear breakdown of overhead by activity : setting up the
machine, running the machine, procurement and delivery. These are our four activities. What
are the cost drivers (les inducteurs de coûts) for these activities ?

 For machine set up costs : the number of production runs

iii) Calculate the analytical net profit per unit product by product using both systems

iv) Using the conclusions from your analysis, write a brief remark on how activity
based costing might help Gadget Co. to improve the profitability of each product.

FULL COSTING OR ABSORPTION COSTING : SOLUTION

i) calculate the total overhead that has to be allocated : make the sum of the overhead

Machine set up costs : € 26 550

Machine Running costs € 66 400

Procurement costs € 48 000

Delivery costs € 54 320

TOTAL OVERHEAD € 195 270

ii) Calculate the total direct labour hours : note that this number is the ‘number of
allocation base units’ which we have always found in the allocation table.

A B C

Product volume (units) 15 000 12 000 18 000

Labour hours per unit 0,1 0,15 0,2

Total labour hours 1 500 1 800 3 600

Total labor hours for the three products : 1500 + 1800 + 3600 = 6 900 hours

iii) Allocation per unit

As always: divide the total overhead to be allocated by the total number of allocation base
units : € 195 270 / 6 900 hours direct labor = € 28,30 per hour. Every time we use an hour of
labor for A, B or C : we will add an addition € 28,30 to cover overheads.
 iv) Calculate the full cost per unit : build the cost structure product by product

Product A Quantity Unit Cost Total

Raw materials per unit 2 kgs € 1,2 / kg € 2,40 / unit

Direct Labor per unit 0,1 hrs / unit € 14,8 / hr € 1,48 / unit

Overhead allocated to labor 0,1 hrs / unit € 28,3 / hr € 2,83 / unit

Total € 6,71 / unit

We cannot sum the quantity or unit cost columns :, the total cost / unit column on the right
hand side can be summed up : all the entries are in one single format : €s / unit.

Product B Quantity Unit Cost Total

Raw materials per unit 3 kgs € 1,2 / kg € 3,60 / unit

Direct Labor per unit 0,15 hrs / unit € 14,8 / hr € 2,22 / unit

Overhead allocated to labor 0,15 hrs / unit € 28,3 / hr € 4,25 / unit

Total € 10,07 / unit

Product C Quantity Unit Cost Total

Raw materials per unit 4 kgs € 1,2 / kg € 4,80 / unit

Direct Labor per unit 0,2 hrs / unit € 14,8 / hr € 2,96 / unit

Overhead allocated to labor 0,2 hrs / unit € 28,3 / hr € 5,66 / unit

Total € 13,42 / unit

v) Calculate the analytical net profit for each product

(in €s- A B C

Sales price per unit 7,50 12,00 13,00

Full cost per unit 6,71 10,07 13,42

Analytical profit per unit + 0,79 + 1,93 - 0,42

Product B looks great : product A looks ok : product C looks like a loss maker. Since C uses
lot of labor and we ysed direct labor hours as the allocation base product C pays a very large
charge per product in terms of overhead allocation to labor.
ACTIVITY BASED COSTING SYSTEM : SOLUTION

i) Prepare the matrix showing overhead cost per activity and cost driver units

ACTIVITY OVERHEAD COST DRIVER Total Driv. Unit COST / DRIVER

Set up € 26 550 Production runs 36 runs € 737.50 / run

Running € 66 400 Machine Hrs 32 100 hrs € 2.0685 / hr

Procurement € 48 000 Purchase orders 94 orders € 510.6383 / order

Delivery € 54 320 Deliveries 140 deliveries € 388 / delivery

TOTAL € 195 270

ii) Allocate Overhead to each product according to their activities

ACTVITY Drivers A Drivers B Drivers C Cost A Costs B Costs C

Set up 16 runs 12 runs 8 runs € 11 800 € 8 850 € 5 950

Running 7 500 hrs 8 400 hrs 16 200 hrs € 15 514 € 17 375 € 33 510

Procure 24 orders 28 orders 42 orders € 12 255 € 14 298 € 21 447

Deliveries 48 30 62 € 18 624 € 11 640 € 24 056

TOTAL € 58 193 € 52 163 € 84 913

Units 15 000 12 000 18 000

Overhead / € 3.88 / € 4.35 / € 4.72 /

Conclusion gives the allocation of overhead according to activity in the form of € / unit

iii) Calculate the full cost per product according the different activities

Include the allocation of overhead per unit in the cost structure to get the full cost per unit
using the ABC costing system. Direct materials and direct labor are the same – but the
allocation of overhead between the different products is radically different.

Product A Quantity Unit Cost Total

Raw materials per unit 2 kgs € 1,2 / kg € 2,40 / unit

Direct Labor per unit 0,1 hrs / unit € 14,8 / hr € 1,48 / unit

Overhead € 3,88 / unit

Total € 7,76 / unit

Raw materials per unit 3 kgs € 1,2 / kg € 3,60 / unit

Direct Labor per unit 0,15 hrs / unit € 14,8 / hr € 2,22 / unit

Overhead € 4,35 / unit

Total € 10,17 / unit

Product C Quantity Unit Cost Total

Raw materials per unit 4 kgs € 1,2 / kg € 4,80 / unit

Direct Labor per unit 0,2 hrs / unit € 14,8 / hr € 2,96 / unit

Overhead € 4,72 / unit

Total € 12,48 / unit

iv) Calculate the analytical net profit for each product

(in €s- A B C

Sales price per unit 7,50 12,00 13,00

Full cost per unit 7,76 10,17 12,48

Analytical profit per unit - 0,26 + 1,83 0,52