Quantitative Analysis for Managers - Coursework Example

Module STX 4114 – Quantitative Analysis for Managers Case Study: Coffee Blend Limited Question Use of labour hours as base for assigning manufacturing overhead to products. a) The predetermined overhead rate to be used during the year is shown below. (in £ )     Total direct labour costs 600,000 Labour hours   50,000 Hourly labour cost   12.00 Total Overhead Costs   3,000,000 Overhead cost per labour hour 60.00 b) The unit product costs for the two blends of coffee are shown below. ( in £ )   Kopi Lua Costa Rica Direct Materials   4.20 3.20 Direct Labour cost @ 0.025 hrs/ bag 0.30 0.30 Assigned overhead for 0.025 hours 1.50 1.50 Product cost per kilo bag of coffee 6.00 5.00 Question 2 – Using activity based costing for assigning manufacturing overhead to products. a) The total overhead cost for the year for each blend of coffee is shown below. Activity based overhead cost for each product         ( in £ ) Total cost Activity Unit Cost Kopi Lua Costa Rica Purchasing 513,000 1,710 300     Assigned cost 5/yr and 4/yr 1,500 1,200 Material Handling 720,000 1,800 400     Assigned cost 30/yr and 12/yr 12,000 4,800 Quality Control 144,000 600 240     Assigned cost 10/yr and 4/yr 2,400 960 Roasting 961,000 96,100 10.00     Assigned cost 1,000 x 1 hr/yr and 20 x 1 hr/yr 10,000 200 Blending 402,000 33,500 12.00     Assigned cost 1,000 x 0.5 hr/yr and 20 x 0.5 hr/yr 6,000 120 Packaging 260,000 26,000 10.00     Assigned cost 1,000 x 0.1 hr/yr and 20 x 0.1 hr/yr 1,000 20 Total overhead cost/yr 3,000,000         Total overhead assigned to each blend     32,900 7,300 b) The overhead cost per kilo for each blend of coffee is shown below ( in £ )       Kopi Lua Costa Rica Total assigned overhead cost       32,900 7,300 Total Production per year (kg)       100,000 2,000 Overhead Cost per kg of coffee       0.33 3.65 c) The product cost per kilo of each blend of coffee is shown below. ( in £ )       Kopi Lua Costa Rica Direct materials cost per kg       4.20 3.20 Direct Labour cost per kg       0.30 0.30 Overhead Cost per kg of coffee       0.33 3.65 Product cost per kg of coffee       4.83 7.15 Question 3 - The findings from the overhead cost allocation exercise Coffee Blend sets the price of various blends of coffee at a 30% mark-up over the cost and therefore it is important to establish the product cost with accuracy. The product cost is made up of three elements, direct materials, direct labour and allocated overheads. Direct materials and direct labour used for each blend of coffee are accurately identified. The manufacturing overheads per year are significant at £ 3,000,000 and the method of allocation can cause significant variations in the calculation of product cost. This impact of the method of overhead allocation on product costs is illustrated in the in the above calculations. The manufacturing cost of Kopi Lua reduces from £ 6.00 per kg to £ 4.83 per kg which is 19.5% lower and since the price mark-up is 30%, the actual margin is much higher. For the Costa Rica blend, however, the cost goes up from £ 5.00 per kg to £ 7.15 per kg causing a loss of £ 0.65 per kg since the selling price is 5 x 1.3 = £ 6.50 per kg. The present method of overhead allocation based on direct labour hours results in an equal allocation of £ 1.50 per kg to each of the two blends of coffee when it is clear that the efforts in purchasing, materials handling and quality control have to be higher for processing the Costa Rica coffee in small batches of 500 kg each compared to processing Kopi Lua in batches of 10,000 kg each. Such cost anomalies could be present in each of the 40 blends that the company makes. Another significant reason to change the overhead allocation method is that the product cost would change each time the product mix made in the plant changes. This has the impact of causing variations in profitability. Activity based overhead allocation has another important advantage over the labour hour based allocation. Each element of the overhead cost can be scrutinized to see if any reduction is possible. For example, purchasing costs could reduce if the Costa Rica coffee was bought in, say, 2 batches a year in place of 4. It is not clear why the number of setups should be three per batch when the batch sizes are so different. Reducing the number of setups for Costa Rica would reduce the allocated materials handling costs. For a multi-product manufacturing facility such as CBL, the activity based allocation of overheads is clearly better than overhead allocation based on direct labour hours. Question 4 - The advantages of using Activity Based Costing system of overhead allocation over the traditional method The concept of Activity Based Costing (ABC) was first defined by Robert Kaplan and William Burns in the late 1980s. Initially ABC focused on the manufacturing industry where technological developments and productivity improvements had reduced the proportion of direct labour and direct materials costs but increased the proportion of indirect or overhead costs (Edwards, 2008). A 2001 paper by the Chartered Institute of management Accountants (CIMA) points out that “Activity Based Costing (ABC) is not a method of costing but a technique for managing the organization better. It measures the cost and performance of activities, resources and the objects which consume them in order to generate more accurate and meaningful information for decision making”. Any business consists of a series of activities the ABC system provides relevant cost information about each activity. This information also helps identify non-value-added activities which are waste activities that need to be eliminated to improve business performance. The major benefit of the ABC system is the identification of ‘cost drivers’ for each activity and helps management identify improvement measures to reduce the impact of the cost drivers (CIMA, 2001). The advantages of the ABC method of cost allocation over the traditional method are evident from the Coffee Blends case study discussed above. Instead of looking at the manufacturing overhead costs as a lump sum for the one year period, looking at the elements of the cost such as the support functions of purchasing, materials handling, quality control and the manufacturing operations such as roasting, blending and packaging helps identify the cost drivers for each of these activities and helps frame the questions the managers can ask themselves to reduce costs and improve operational efficiency. The major problem with implementing the ABC is the difficulty in identifying the activities involved in the manufacture of each product and collecting the cost data for each activity. Special efforts are often needed to collect this data and it is often easier to follow the financial accounting data than to monitor and create the ABC data. Even with the best efforts, some elements of cost remain difficult to assign to specific products or customers and these need to be assigned arbitrarily. This leads to questions on the need for the cost and effort needed to collect ABC data (Edwards, 2008). The traditional methods of overhead allocation align with financial accounting requirements and that data is also independently audited. There is very little doubt that a cost allocation process where the true costs of a product or activity are known provides better information for management control than a system where costs are allocated arbitrarily based on labour hours or machine hours. There is cost and effort involved in collecting this information but the benefits in terms of the ability of management to control the manufacturing process outweigh these costs (Joyce, 2010). * * * * References: 1. CIMA, (2001). “Activity based Management – An Overview”, The Chartered Institute of Management Accountants, April 2001. (Accessed on 16 March 2013 at www.cimaglobal.com) 2. Edwards, S., (2008). “Activity Based Costing”, CIMA Topic Gateway Series N0.1. November 2008. (Accessed on 16 March 2013 at www.cimaglobal.com) 3. Joyce, J., (2010). “Management Accounting – Performance Analysis”, CIMA, 2010. (Accessed on 16 March 2013 at www.cimaglobal.com) Read More