Graham Hale, Controller of Brighton Rock Manufacturing Company (BRMC), a local machining shop with several computer controlled machine tools, was contemplating the pricing for a new order that had just arrived. The customer requested that BRMC submit a bid for the fabrication of 100 units of a complex product that the company had never built before (although it is well within their capabilities and compatible with current products). BRMC's engineers would have to spend time developing the process routines to machine the components required for the product. Hale wondered whether the usual markup of 35% over manufacturing cost would really be adequate for this order.
BRMC's current product costing system:
Materials for the order would cost $12.40 per unit of finished product. The product would require 0.6 direct labor hours and 0.8 machine hours per unit manufactured. The company's direct labor rate is $20 per direct labor hour. Overhead is currently applied to products using two rates: 200% of direct labor dollars (cost), and $70 per machine hour.
Thus the cost per unit of this order would be calculated as follows:
Direct materials $ 12.40
Direct labor 0.6 * $20 12.00
DL based overhead 200% * $12.00 24.00
MH based overhead 0.8 * $70 56.00
Total cost per unit produced $104.40
The total cost of the order would therefore be 100 * $104.40, or $10,440. Adding the 35% markup, BRMC would bid $10,440 * 1.35, or $14,094 for the job. Hale's concern is concerned that this bid would not pay for all the engineering effort, and also the selling and administrative expenses, and still leave any actual profit.
What about a different costing system: ABC?
Hale recalls that several months ago a summer intern from performed a simple activity-based study of BRMC's operations as part of a work-study project. Hale searched his files and found the report the student had prepared. He saw that the student had developed the following list of activities, cost drivers, and activity rates.
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ACTIVITY
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COST DRIVER
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ACTIVITY RATE
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Process customer orders
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Number of customer orders
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$100 / order
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Provide engineering design and support
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Engineering hours
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$75 / engineering hour
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Purchase and receive components
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Number of purchase orders
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$150 / purchase order
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Schedule production and perform first-item inspections
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Number of production runs
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$200 / production run
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Set up machines
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Number of set up hours
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$80 / set up hour
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Machine processing
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Machine hours
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$60 / machine hour
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Direct labor assembly
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Direct labor hours
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$50 / DLH
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Hale went on to estimate the quantity of each activity cost driver this new order would require.
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Activity cost driver
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Quantity for 100 units
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Number of purchase orders
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10
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Number of production runs*
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6
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Setup time per production run
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3 hours
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Number of customer orders
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1
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Engineering design and process time
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20 hours
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* A separate production run would be required to custom machine some of the components before assembly into the final product.
REQUIRED:
Hale speaks of "administrative" expenses that the bid (using traditional costing) might not be able to cover. What might some of these expenses be? Is their quantity likely to be affected by this order? Explain.
We listed the steps in developing an ABC system as being:
Define activities.
- Identify the cost of each activity.
- Define a cost driver for each activity.
- Calculate an activity (overhead) rate for each activity.
- Use the activity rates to assign activity costs to the product.
- The table does not show the total cost of each activity. Be certain you understand where the result of steps (a), (c) and (d) are reflected in the table.
- Identify each activity in the table as Unit, Batch, or Product level.
- Calculate the total cost of the order using activity based overhead application. Don't forget the materials and labor costs. What would the bid to the customer be if BRMC continues to use the 35% mark up?
- Explain why the number you obtain is so different from the one Hale obtained using the company's current overhead application rates. Is it better, or just different? Give at least two factors that suggest the company should use activity based costing for its specialty products.