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Accounting
a) i) Using direct labour hours as the cost driver for the overhead costs, the following table presents the net profit calculation for each line of motorcycle:
Vroom plc
Total Profit
Driver:
Direct labour
Sunshine
Roadster
Fireball
Output
DL
P
Materials
Revenue
less DL
less Materials
Gross Profit
Less Overhead
Net Profit
Activity-based costing is designed to allocate overhead costs based on the resources that each activity consumes (The Economist, 2009). The key to activity-based costing is that the cost drivers are assigned differently, and in a manner that should better reflect actual resource usage than a cost driver that may be picked almost at random (Investopedia, 2013). Using ABC, the following are the net profit calculations for the three different products at Vroom.
Vroom plc
Total Profit
Driver:
ABC
Sunshine
Roadster
Fireball
Output
DL
100000
110000
40000
250000
P
Materials
Deliveries
Set-ups
Purchase orders
Revenue
7
8
2800000
less DL
1
1100000
400000
less Materials
400000
480000
180000
less Del
800000
640000
560000
less SU
2
2666667
1
less PO
1750000
1312500
437500
Net Profit
1050000
1800833
-110833
b) Activity-based costing is designed to give a more accurate representation of the costs for each product. The above charts are the net profit calculations using the current managerial accounting and using activity-based costing. These tables will be used to illustrate the value of activity-based costing.
The current system uses direct labour hours as the means by which overhead is allocated. This is not a particularly accurate reflection of how the overhead costs are actually incurred. It is, in fact, a shorthand assumption that bears little relationship to reality. Using direct labour hours as the means of allocating overhead expense tells us that each of our products is profitable, but activity-based costing gives us a different result.
Activity-based costing requires a higher standard of information gathering than does traditional costing. Instead of using an ad hoc allocation system that works on an unsubstantiated assumption that there is a link between direct labour hours and the overhead costs incurred for a given product, activity-based costing requires use to gather accurate data and use that data in our decision-making process.Thus, activity-based costing is superior in terms of its inputs, and it is not surprise then that ABC gives us a more useful output as well.
Overhead is divided into three general categories -- deliveries to retailers, set up costs for production, and the cost of processing purchase orders. Each of these things incurs different costs, and what activity-based costing does is that it allocates these different costs on the basis of how much each product incurs them. Some products require more work in terms of servicing accounts, and in terms of lost productivity due to set up time. Activity-based costing requires us to gather that information and then use it in our analysis.
What we see with the activity-based costing calculation is that the Fireball is a money-losing product for us. This product is actually expensive in terms of the cost of servicing it. In short, the Fireball costs more to service than would have been allocated under the direct labour hours system. This makes sense, because we have automated production for the Fireball and manual production for the other two products. Thus, the Fireball's allocation of fixed costs under the current system is skewed by the fact that it uses an automated production process. Activity-based costing removes that skewing and reveals the true costs associated with the Fireball.
The method by which activity-based costing is implemented is to gather accurate information about the cost links between the items in the overhead and the different products. We have this information. Then, to produce the income statement, we put these costs into the variable cost category. We have traditionally viewed them as fixed costs, but they do vary depending on the product and the volume of each product that we sell. So they are not true fixed costs -- the idea of….....