Assignment 1: Discussion—ABC or Activity-Based Costing
In your readings this module, you were introduced to Activity-Based Costing or ABC. It is a method used to determine a reliable predetermined benchmark for the allocation of overhead costs to the products produced based on their activity levels. In this discussion, we will work a case study on ABC together. For your initial response, attempt to answer the questions yourself and post all the required items into the Discussion Area. You may want to post some elements during different days so the class can work this problem together. Then in your response postings, help each other with misunderstandings or miscalculations.
- Examine the case below and then…
- Calculate the amount of overhead allocated to small and large advertising campaigns under existing methods.
- Apply activity-based costing to calculate the cost per cost driver for each of the cost pools.
- Use the costs per cost driver to calculate the activity-based overhead applicable to small and large campaigns.
- Calculate the percentage to be added to direct advertising costs to recover overhead costs under activity-based costing.
Merit-o-cracy PLC is a specialist advertising agency. It has been long-established but is experiencing difficulties in winning new business. The Chief Executive believes that its pricing methods are leading to the loss of large customer advertising campaigns while it is consistently winning smaller business.
Merit-o-cracy costs work for pricing purposes on the basis of direct advertising costs (i.e. space or time purchased from newspapers, radio and TV) plus 100%. The 100% is intended to cover all the overheads of the business, which run at $2 million per year. It does not include any profit margin. This budget cost comprises:
Creative staff $500,000
Production staff $750,000
Administrative & support staff $300,000
Rental and associated costs $450,000
Merit-o-cracy classifies its advertising campaigns as either small or large. Of the 350 campaigns the agency wins, about 325 are classified as small. A typical small advertising campaign incurs direct advertising costs of $4,000 each (and therefore is allocated $4,000 of overheads under current methods). The other 25 advertising campaigns are large and incur direct advertising costs of $28,000 each.
Merit-o-cracy’s accountant has heard of activity-based costing. After speaking to the management team, she has gathered information on the most common causes of costs. She believes that creative staff costs are linked to the number of advertising campaigns the agency competes for. Production staff costs are related to the number of advertising campaigns the agency wins. Administrative and support staff costs are related to the number of customers the agency has. Rental and associated costs are people-based and as a similar number of staff is employed in each of the three departments, the costs should be equally shared.
The accountant has also collected data on the activity levels in each of the three departments over the budget period. These are:
- 800 advertising campaigns the agency bids for
- 400 of these are bids for large campaigns and 400 for small campaigns
- 350 advertising campaigns the agency wins
- 325 of these are small campaigns and 25 large campaigns
Admin & support
- 400 customers the agency services
- 300 of these are customers with small campaigns and 100 have large campaigns
By the due date assigned, post your initial response to the Discussion Area below. Through the end of the module, review and comment on at least two peers’ responses on two different days. Your response should be thorough and address all components of the posted question in detail, include citations of all sources, where needed, according to APA style, and demonstrate accurate spelling, grammar, and punctuation
The production activities in a company are both associated with the costs incurred as well as the profits to be made. Thus, it becomes very important for a firm to understand all the costs it incurs and how to, therefore, price her services or products according to the way that has been established that it will be profitable. There are many traditional methods used to account for coasts as well as modern methods. The modern methods have proven to be more efficient and straightforward whereas the traditional methods have proved to be inconsistent with their cost assignments and estimations.
The modern methods include the activity based costing method and are the one that I will largely talk about in this assignments while comparing it to the normal way and see the difference in the values obtained.
The case study
Merit-o-cracy PLC, which is a specialist-advertising agency, has been one example that will show the transition from the traditional costing methods to the modern ways. The case study spells out the various accounts of costs which are making the company to just win the smaller advertising projects that he big advisement campaigns.
Thus, what could just be the difference in the approach used? For this, I will have to find the allocation of costs to the small size advertising as well as the big or large size advertisements campaigns. From the case study, the amount of overhead allocated to small and large advertising campaigns under the existing methods will be calculated as follows:
Total pricing = space or time purchase + 100%
This means that for the 350 advertising campaign spaces, the total cost will be
This hence means that the rules as stated in the case study are still obeyed that on the direct costs of advertisements, there is 100% additional cost to cater for the overhead costs and the total amount of costs has just confirmed it.
Application of the activity based costing on every cost per cost driver
For activity-based costing, there is the allocation of the overhead to the items that actually use it. Thus if the company wants to target a reduction of its overhead costs then it has to spread its costs to only what it was working with that is the campaigns that were going to earn for the company or simply cost it but not on campaigns that will not mature.
Hence, the cost pools are as listed below
The advertisements spaces that will be bought for the large and small campaigns, creative staff, production staff, administration, support, and the rentals and associated costs. The cost has to be proportional in all aspects of the creative department, the production and the administration as well as the associated costs. Hence, I will look at the cost of 350 campaigns, which have been spread as 325 small campaigns and 25 large campaigns.
Looking at the ratio of the respective costs, 1 small campaign costs $4000 and 1 large campaign costs $28000. Thus for two both large and small campaigns will cost a total of $32000. Their respective proportions of the cost are, the small campaign’s proportion is 0.125 and the large campaign’s is 0.875.
Therefore, each departmental breakdown is going to be as follows;
800 (400 small +400 large) advertisements =$500000
Meaning that, for small advertisement= 0.125 X $500000=$62500
For large advertisement = 0.875 X $500000 = $437500
The large advertisement that were successful, =25/400 X $437500 = $27343.75
The small advertisement that were successful, = 325/400 X $62500 = $50781.25
Total creative staff overhead = ($27343.75+ $50781.25) = $78125
Production staff = $750000
Administrative & support staff =$300,000
Rental and associated costs = $450,000
The advertising costs =$2000000
The total activity-based overhead applicable to small and large campaigns
Total will be the sum of the new cost per pool drivers
Total = ($78125+$750000 + $300,000 + $450,000 + $2000000) =$3578125
The percentage to be added to direct advertising costs to recover overhead costs under activity-based costing
The percentage is the difference between the original amount and the new value worked on as a percentage;
Whereby we shall have
The above percentage also indicates how more expensive the traditional costing inflates the actual cost or how cheaper it looks when the activity-based costing will indicate costs of advertising.
Hence, therefore so that the company may actually identify the best way to control the costs that the company incurs while in its lines of operations.
Cokins, G. (2001). Activity-based cost management: An executive’s guide. New York: Wiley.
Hicks, D. T. (2002). Activity-based costing: Making it work for small and mid-sized companies.
This week we will learn about a new way of establishing overhead rates to allocate indirect costs. This is called ABC or Activity Based Costing. Attached please find a template that may help you work out the numbers for the case this week. Our discussion need to be around what is used in the calculations and why. Why do companies use ABC rather than just direct labor hours to allocate overhead?
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