## 2. Similarities and differences when compared to activity based costing (ABC)

Let us consider the following case scenario. Company ABC (a fictitious entity) produces and sells two different types of high-tech speakers: the Standard Model and the Luxury Model. Due to intense competition, speaker prices have fallen significantly. The company believes there are no other ways to reduce costs for the two speaker models. The Standard Model is profitable, but the Luxury Model can result in losses. The company considers whether it needs to discontinue the Luxury model.

Input data for analysis:

 Standard Model Luxury Model Direct material (per unit) \$30 \$40 Direct labour (per unit) \$10 \$20 Total direct costs \$40 \$60 Fixed production overhead: Machine cost \$500,000 0.25 hours 0.5 hour Set-up cost \$420,000 200 units per set-up 250 units per set-up Quality inspection cost \$100,000 50 units per inspection 100 units per inspection Total overhead \$ 1,020,000 Quantity, units 15,000 10,000 5,000

Firstly, the number of machine hours is calculated under both traditional costing and ABC methods:

Machine Hours = 10,000 × 0.25 hours + 5,000 × 0.5 hours = 5,000 hours

The Standard Model requires 2,500 hours and the Luxury model requires 2,500 hours.

Secondly, under the traditional costing model, the fixed production overhead absorption rate (FOAR) equals \$204 per machine hour (i.e., \$1,020,000 ÷ 5 000 hours).

Under the ABC method the number of activities is calculated as follows:

• To determine the number of set-ups: (10,000 ÷ 200) + (5,000 ÷ 250) = 50 (Standard Model) and 20 (Luxury Model) = 70 in total.
• To determine the number of quality inspections: (10,000 ÷ 50) + (5,000 ÷ 100) = 250 inspections (200 and 50 for Standard and Luxury Models, respectively).

Finally, overhead costs are allocated to the two models as follows:

Overhead Costs (Standard Model) = \$204 × 0.25 hours ×10,000 units = \$510,000

Overhead Costs (Luxury Model) = \$204 × 0.5 hours × 5,000 units = \$510,000

ABC Model

 Machine Cost (Standard Model) = \$500,000 x 2,500 = \$250,000 5,000

Machine cost for the Luxury Model would be the remaining amount: \$500,000 - \$250,000 = \$250,000.

 Set-up Cost (Standard Model) = \$420,000 x 50 = \$300,000 70

Set-up cost for the Luxury Model would be the remaining amount: \$420,000 - \$300,000 = \$120,000.

 Quality Cost (Standard Model) = \$100,000 x 200 = \$80,000 250

Quality cost for the Luxury Model would be the remaining amount: \$100,000 - \$80,000 = \$20,000.

The results under the two methods are compared in the operating statements below:

 Traditional Costing ABC Costing Standard Model Luxury Model Standard Model Luxury Model Direct costs \$ 40,000 30,000 Direct costs \$ 40,000 30,000 Fixed overheads 510,000 510,000 Machining costs 250,000 250,000 Set up costs 300,000 120,000 Quality inspections 80,000 20,000 Total cost 550,000 540,000 Total cost 670,000 420,000 Cost per unit 55 108 Cost per unit 67 84 Selling price (**) 80 100 Selling price (**) 80 100 Profit/(loss) per unit 25 (8) 13 16

(*) Total direct costs are calculated by multiplying the per-unit cost by the quantity produced: \$40 x 10,000 = \$40,000 and \$60 x 5,000 = \$30,000.

(**) Represents an assumed selling price for the purposes of this analysis.

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