Mellow Case

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CASE STUDY ON ACTIVITY BASED COSTING

MELLOW LTD.

Mellow Ltd manufactures and sells a wide range of machine tools. In the past few years the company has been performing reasonably well, but its market share has been declining as a result of severe competition.

The company uses absorption costing for both external reporting as well as for providing individual product information for decision-making. In 20x5, although the company performed well overall, senior management was concerned with the profit performance of some specific product lines. The production manager was surprised when the accountant showed him that some difficult and time consuming products produced in small batches had made very attractive profit margins, while some of his favourites which sold very well and were produced in large quantities showed rather poor or negative margins.

On the advice of the company's financial consultants, management decided to trial a system of activity based costing (ABC) for 20x6, while still retaining the traditional costing system. The consultants stated that an ABC system would provide more accurate product cost and margin information to guide the company's strategic production and marketing effort as well as highlight value adding and non-value adding activities performed by the company.

At the end of the first quarter of 20x6, the following information was available:

Income Statement For The Quarter Using Absorption Costing

$'000$'000$'000
Sales40,000
LessCost of goods sold
Materials8,000
Labour7,500
Production overheads10,000
Total25,500
Gross margin14,500
LessMarketing expenses
Delivery expenses400
Sales commissions2,000
After sales service500
Advertising and promotions2,000
Sales administration 1,0005,900
Administration expenses 3,000
Total 8,900
Net income before tax 5,600

Other Information:

Production overhead application rate per direct labour hour for absorption costing used for all products manufactured: $20.00

Activity cost pools, cost drivers identified, costs and driver units used for the ABC system:

Production Expenses
Activity Cost PoolsCost
$
Purchasing
Materials handling and storage
Machine set-up
Quality control
Labour and other overhead
Packaging1,200,000
1,000,000
1,350,000
800,000
10,650,000
2,500,000

Marketing Expenses
Activity Cost PoolsCost
$
Delivery expenses
Sales commission
After sales service400,000
2,000,000
500,000

Driver Units
Activity Cost PoolsDriver Units
No. of purchase orders
No. of components used
No. of set-ups
No. of batches
No. of machine hours
No. of units
No. of sales orders
Sales dollars
No. of service calls3,000
5,000,000
9,000
3,200
500,000
625,000
4,000
$40,000,000
10,000

Note: For the purpose of the ABC system the company has classified production wages as an overhead expense. It was also decided not to allocate administration (general) expenses, advertising and promotions, and sales administration expenses to products under the ABC system.  

Data regarding TWO of the MANY products produced by the company:

Products“The Tim”“The Allen”

Per Unit Data:
Price____________$80.00___________$400.00
Direct materials cost____________$20.00___________$120.00
Direct wages____________$15.00___________$60.00
Labour hours____________1___________4

Other data:
No. of purchase orders____________200___________200
No. of components used____________450,000___________100,000
No. of set-ups____________50___________1,000
No. of batches____________50___________200
No. of machine hours____________30,000___________8,000
No. of units produced & sold____________30,000___________2,000
No. of sales orders____________300___________400
Sales dollars____________$2,400,000___________$800,000
No....
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