Accounting A) I) Using Direct Labour Hours

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 activity-based costing is that there are no true fixed costs, but that all activities have a cost and should be attributed directly to the product with which they are associated. On the income statement, the distinction between gross profit and net profit is eliminated. This makes the net profit more accurate, because all costs have been measured and ascribed to their relevant product, instead of only doing that with the direct costs. By treating direct and indirect costs the same, we get a much better sense of which costs go with which product, and that in turn allows us to produce a more accurate analysis of the net income associated with each of our different products. The results are interesting, because we can see that the Fireball is actually losing money for us -- the costs associated with bringing that product to market, now that we know them, are actually higher than the revenue that the Fireball generates for us.

As a result, we find that we are actually spending about £490,000 more per year on the Fireball than we thought we were. The product is actually losing money for us, because of the high costs we incur, in particular with set-ups and deliveries. To illustrate what this means to us, consider that right now we have a corporate-wide income statement as follows:

Total / Fireball

Revenue

17800000

less DL

2500000

less Materials

1060000

Gross Profit

14240000

Less Overhead

11500000

Net Profit

2740000

If we remove Fireball, the firm's income statement would look as follows:

Total w/o Fireball

Revenue

15

less DL

2100000

less Materials

880000

less Del

1440000

less SU

4666667

less PO

3062500

2850833

The difference is the £110,833 that we are presently losing on the Fireball.

This information does not mean that we would cancel the Fireball product. What it means is that with activity-based costing we have a much better sense of what the true costs of our products are. Part of the benefit is that we are forced to use better inputs, so there is an element of garbage in, garbage out here. When you use better data, you will get better results. But ABC is more than that -- the technique itself contributes to our understand of the product's costs because all of the cost elements are directly attributed to the individual product instead of allocated based on an ad hoc percentage.

You can see right away that this information is valuable. We know that the Fireball is actually a drag on our profits right now. We can now use this information to improve our profitability. We can make the Fireball more efficient, for example. We know which areas of cost are out of line for the Fireball -- the set-ups and the number of deliveries. So we can consolidate deliveries and reduce the number of production runs as a means to get this product back to profitability. We could also increase the price of the Fireball to better reflect the costs associated with it. The point is that activity-based costing gives us a more accurate reflection of what each product costs, and we can use that information to improve the performance of each individual product, and therefore the firm as a whole.