ABC Practice Question 2

Game Stores sells a range of electrical, clothing and homeware products through a chain of
department stores. The main administration functions are provided from the company’s head
office. Each department store has its own warehouse which receives goods that are delivered
from a central distribution centre.

The company currently measures profitability by product group for each store using an
absorption costing system. All overhead costs are charged to product groups based on sales
revenue. Overhead costs account for approximately one-third of total costs and the directors
are concerned about the arbitrary nature of the current method used to charge these costs to
product groups.

A consultant has been appointed to analyse the activities that are undertaken in the
department stores and to establish an activity-based costing system.

The consultant has identified the following data for the latest period for each of the product
groups for the Rundu Town store:

PROD
UCT GROUP
Clothing Electrical Homeware
Sales N$4 400 000 N$3 300 000 N$1 100 000
Cost of sales N$2 800 000 N$2 300 000 N$600 000
Number of deliveries 104 52 26
Number of pallets per delivery 50 20 10
Number of inventory items 20 000 14 000 6 000
Number of customers 2 100 000 1 050 000 350 000
Number of requisitions 522 243 135

The consultant has also obtained the following information about the support activities:

Activity Cost driver Overheads

N$000
Customer service Number of customers 1 100
Warehouse receiving Number of pallets delivered 700
Warehouse Issuing Number of requisitions 300
In- store merchandising Number of inventory items 400
Central administration Sales revenue 316

Required:

(a) Calculate the total profit for each of the product groups using:

(i) the current absorption costing system; (4 marks)

(ii) the proposed activity based costing system. (13 marks)

(b) Explain how the information obtained from the activity-based costing system might be
used by the management of the company. (4 marks)

(c)Explain the circumstances under which an activity-based costing system would produce
similar product costs to those produced using a traditional absorption costing system.
(4 marks)

Solution

Suggested Approach

In part (a) (i) candidates should identify the gross profit for each product group and then calculate the
overhead absorption rate. This rate can then be applied to each product group and the total profit
calculated. In part (a) (ii) candidates need to calculate a cost driver rate for each of the activities and
then apply this cost driver rate to calculate the overhead cost for each activity per product group. The
total profit for each product group can then be recalculated. In part (b) candidates need to clearly
explain how the activity based costing information could be used by management. In part (c) the
circumstances under which an activity based costing system would produce similar product costs to a
traditional absorption costing system should be clearly explained

(a)(i)
Clothing Electrical Homeware
N$000 N$000 N$000
Revenue 4 400 3 300 1 100
Cost of sales 2 800 2 300 600
Gross profit 1 600 1 000 500
Overhead cost 1 408 (1 mark) 1 056 (1 mark) 352 (1 mark)
Total profit 192 (56) 148

For student to gain these marks they must present their answer in a formal profit statement as above

Overhead cost workings:(1 mark)

Clothing Electrical Homeware Total

N$000 N$000 N$000 N$000
Sales revenue 4 400 3 300 1 100 8 800
% of total 50% 37.5% 12.5% 100%
sales revenue
Overheads 2 816 x 50% 2 816 x 37.5% 2 816 x 12.5% 2 816
cost 1 408 1 056 352

OR:

Total Overhead = 2,816,000 = 0.32 = 0.32*4,400 = 1,408

Total Sales 8,800,000

 a) (ii) Workings

Activity Cost Driver Overhead Cost driver rate

N$000
Customer Number of customers 1 100 1,100 000/3 500 000
service = N$0.314 per customer
Warehouse receiving Number of pallets delivered 700 700 000/6 500
=N$107.69 per pallet
Warehouse issuing Number of requisitions 300 300 000/900
=N$333.33 per requisition
In-store merchandising Number of inventory items 400 400 000/40 000
=N$10 per inventory item
Central administration Sales revenue 316 316 000/8 800 000
=$0.0359 per $ of sales revenue
(1/2 mark each cost driver rate
calculated)

Activity Overhead allocation

Clothing Electrical Homeware

Customer 2 100 000 x $0.314 1 050 000 x $0.314 350 000 x

service $660 000 $330 000 $0.314
$110 000
Warehouse 5 200 x $107.69 1 040 x $107.69 260 x $107.69
receiving $560 000 $112 000 $28 000
Warehouse issuing 522 x $333.33 243 x $333.33 135 x $333.33
$174 000 $81 000 $45 000
In-store 20 000 x $10 14 000 x $10 6 000 x $10
merchandising $200 000 $140 000 $60 000
Central 4 400 000 x $0.0359 3 300 000 x $0.0359 1 100 000 x
administration $158 000 $118 500 $0.0359
$39 500
Total overheads $1 752 000 $781 500 $282 500

(1/2 mark for each overhead allocated per department no mark for totals thus total = 7, 5 marks)

Allow for rounding off differences

Profit statement

Clothing Electrical Homeware

N$000 N$000 N$000
Revenue 4 400 3 300 1 100
Cost of sales 2 800 2 300 600
Gross profit 1 600 1 000 500
Overhead cost 1 752 781.5 282.5
Total Profit (152) (1 mark) 218.5 (1 mark) 217.5 (1 mark)
Award marks for wrong profit figures that have been calculated with wrong overhead allocation.
However addition and subtraction errors that makes the profit statement meaningless should be
penalised

(b)

Using an activity-based costing (ABC) system the cost drivers that cause a change to the cost of
activities are identified. These cost drivers provide information to management to enable them to take
actions to improve the overall profitability of the company. Cost driver analysis will provide
information to management about how costs can be controlled and managed. Variance analysis will
also be more useful as it is based on more accurate costs. The establishment of more accurate product
costs should also help managers to assess product profitability and make better decisions concerning
pricing and product mix.

In this example the use of an ABC system has resulted in different levels of profit for each of the
product groups. It is apparent that the Clothing product group is less profitable than thought and that
both Electrical and Homeware are more profitable using the ABC system than using the absorption
costing system. This information will enable management to make important decisions regarding
pricing of the product groups. The prices in both the Electrical and Homeware product groups could
potentially be reduced to make them more competitive and increase volumes. The prices in the
Clothing product group could be increased to make the product group more profitable. Before making
any decisions however managers would need to review market prices and consider the effect of any
adjustment on the company’s market position. If market conditions would not allow an increase in
price they could look at ways to reduce costs of clothing in particular. ABC gives more detailed
information about how costs are incurred and the potential for cost reduction by reducing activity
levels. The company may also consider the possibility of discontinuing the clothing product group as
it is loss-making or allocating less store space to that product group.(4 marks for any two advantages
of ABC related to the question)

(c)

Using an activity based costing (ABC) system the various support activities that are involved in
making products or providing services are identified. ABC recognises that there are many different
drivers of cost, not just production or sales volume. The cost drivers are identified in order to
recognise a causal link between activities and costs. They are then used as the basis to attach activity
costs to a particular product or service. However in some circumstances an activity based costing
system will produce similar product costs to those produced using a traditional absorption costing
system as follows:

• When consumption of overheads is primarily driven by volume.

• When overhead costs are low relative to direct costs.

• Where there is little diversity in the product range resulting in similar overhead resource input to all
products.
• Where products are not complex or where products are mass produced. (4 marks for any four
similaries between ABC and traditional cost method)