Question Tag: Profit Analysis

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  • 25 Marks

MA – Nov 2017 – L2 – Q3 – Activity-based costing

Calculate the prime cost, profit per unit using both absorption and activity-based costing, and comment on the differences and limitations.

Bonti Ltd produces three different products using two production departments. The company currently uses Absorption Costing to establish product costs and profitability. The Directors have recently attended a conference on Activity Based Costing (ABC) and are examining whether ABC might provide a better system for Bonti Ltd.

The following budgeted information for the period ended 31 December 2017 has been collated for each of the three products:

Product Taya Maya Paya
Production and Sales (units) 8,750 4,000 6,000
Unit sales price (GH¢) 56 106 84
Direct materials 1.5kg 6kg 7kg
Direct labour:
– Machine Department (hours per unit) 1 hour 8 hours 6 hours
– Assembly Department (hours per unit) 4 hours 3 hours 1 hour
Direct expenses (GH¢ per unit) 2 6 3
Machine Department (machine hours per unit) 2 hours 5 hours 4 hours

Raw material costs GH¢4 per kilo, and the hourly rate for all labour is GH¢5. The direct expenses relate entirely to specialized packaging, which is uniquely designed for each of the products and is therefore directly attributable to that product alone.

The current costing system absorbs overheads to the Machine and Assembly Departments on the basis of a recovery rate of GH¢3.50 per machine hour and GH¢1 per labour hour respectively.

The following is an analysis of the overheads by department:

Department Overheads (GH¢)
Purchasing Department 22,400
Production Set-up & Design Dept 34,500
Customer Service Department 32,600
Machine Department 123,000
Assembly Department 26,500

The Departmental Managers have provided the following additional information about operations in their departments:

Activity Taya Maya Paya Total
Number of set-ups 10 10 30 50
Number of customer orders 80 86 160 326
Number of purchase orders 30 32 50 112

The Machine Department is capital intensive, and the Assembly Department is labour intensive.

Required:

a) Calculate the prime cost for each product.
b) Calculate the profit per unit for each product if overheads are absorbed on the Current Costing basis.
c) Calculate the profit per unit for each product if overheads are absorbed using an Activity Based Costing approach. Clearly identify any cost drivers you assign.
d) Comment on why there is a difference between the profit/loss shown on an Absorption Costing basis and that shown using Activity Based Costing.
e) Identify THREE limitations of Activity Based Costing.

a) Prime cost for each product:

Taya Maya Paya
Direct materials @ GH¢4 per kg 6 24 28
Direct labour @ GH¢5 per hour
– Machine Dept 5 40 30
– Assembly Dept 20 15 5
Direct expenses 2 6 3
Prime cost 33 85 66

(3 marks)

b) Profit per unit calculation using current absorption basis:

Taya Maya Paya
Prime Cost 33.00 85.00 66.00
Overhead absorption:
– Machine Dept @ GH¢3.50 per machine hour 7.00 17.50 14.00
– Assembly Dept @ GH¢1.00 per labour hour 4.00 3.00 1.00
Total Product Cost 44.00 105.50 81.00
Selling Price 56.00 106.00 84.00
Profit Per Unit 12.00 0.50 3.00

(5 marks)

c) Per unit profit calculation using Activity Based Costing basis:

Taya Maya Paya
Overhead Allocation:
– Purchasing Dept (W1) 6,000 6,400 10,000
– Production Set-up & Dept (W2) 6,900 6,900 20,700
– Customer Service Dept (W3) 8,600 8,600 16,000
– Machine Dept (W4) 35,000 40,000 48,000
– Assembly Dept (W5) 17,500 6,000 3,000
Total Product overheads 73,400 67,900 97,700
Units Produced 8,750 4,000 6,000
Overhead per Unit 8.39 16.98 16.28
Prime Cost 33.00 85.00 66.00
Total Product Cost 41.39 101.98 82.28
Selling Price 56.00 106.00 84.00
Profit per Unit 14.61 4.02 1.72

WORKINGS

Cost Drivers and Rates per unit of Cost Driver:

  • W1: ABC cost per unit of driver for purchasing department:
    GH¢ 22,400 / 112 = GH¢ 200 per purchase department
  • W2: ABC cost per unit of driver for set up & design department:
    GH¢ 34,500 / 50 = GH¢ 690 per set up
  • W3: ABC cost per unit of driver for customer service department:
    GH¢ 32,600 / 326 = GH¢ 100 per customer order
  • W4: ABC cost per unit of driver for machine department:
    GH¢ 123,000 / 61,500 = GH¢ 2 per machine hour
  • W5: ABC cost per unit of driver for Assembly Department:
    GH¢ 26,500 / 53,000 = GH¢ 0.50 per assembly labour hour
  • Machine Hours (Machine Dept):
    Taya (8,750 x 2 hrs) = 17,500 hours
    Maya (4,000 x 5 hrs) = 20,000 hours
    Paya (6,000 x 4 hrs) = 24,000 hours
    Total: 61,500 hours
  • Labour Hours (Assembly Dept):
    Taya (8,750 x 4 hrs) = 35,000 hours
    Maya (4,000 x 3 hrs) = 12,000 hours
    Paya (6,000 x 1 hr) = 6,000 hours
    Total: 53,000 hours

(11 marks evenly spread)

d) Comment on the difference between Absorption Costing and Activity Based Costing:

  • Under the traditional absorption costing system, overheads are absorbed based on volume-driven cost drivers such as machine hours and labour hours. However, Activity-Based Costing (ABC) allocates overheads using more specific cost drivers, such as the number of setups, customer orders, and purchase orders. This results in more accurate product costing under ABC.
  • In this case, Maya shows a higher profit under ABC due to its lower demand on overhead activities compared to its production volume. Paya, on the other hand, receives a higher allocation of overheads under ABC, leading to a lower profit per unit.

(3 marks)

e) Limitations of Activity Based Costing:

  1. High Implementation Costs: Implementing ABC systems is resource-intensive, requiring significant time and financial investments.
  2. Complexity: The complexity
  • 20 Marks

MA – Nov 2020 – L2 – Q1 – Budgetary Control

Prepare a financial analysis statement showing the current annual forecast of costs, revenues, and profits for the years 2019-2021 for a motor car manufacturer.

A motor car manufacturer has been specializing in the production and sale of Bedford model cars. The model is somewhat outmoded, and the current sales forecast indicates that the current (2018) sales level of 150,000 will be the same as in 2019 but will decline to 130,000 cars in 2020 and 110,000 cars in 2021. The company supplies according to orders received, and no stocks are held. Carbon monoxide emission regulations will prevent the model from being manufactured and sold after December 2021.

The company’s current estimates of the selling price and costs in 2019 are as follows:

Per car (GH¢) Amount (GH¢)
Selling Price 11,200
Production costs:
– Material and Labour (vary with production volume) 3,600
– Assembly 4,000
– Delivery 2,500
  • 75% and 40% of the assembly and delivery costs respectively are fixed, and the remainder vary with production volume.
  • In addition, the company estimates that it will incur the following non-production costs:
    • Marketing costs of GH¢60 million would be amortized on a straight-line basis over three years.
    • The Administration costs of GH¢10 million are fixed per annum.
    • The selling price, variable costs per car, and total fixed costs are expected to remain constant throughout the period from 2019 to 2021.

The company’s Managing Director is unhappy with the current annual profit forecasts for 2019–2021 based on the information above and believes that the company has the potential to increase the profit to a desired level of GH¢245 million in each of the years 2019 to 2021. The Managing Director has undertaken a strategic review and developed the following strategies to eliminate the gap:

Strategy 1: A marketing proposal will enable the company to enter a new overseas market with the result that the total (including the overseas market) sales level will be stabilized at 160,000 cars per annum from 2019 to 2021. The market entry costs will be GH¢30 million for each of the three years.

Strategy 2: A re-design of the car will enhance its sales appeal and will permit the company to increase its selling price to GH¢12,000. The re-design costs are GH¢30 million and are to be amortized over three years on a straight-line basis.

Strategy 3: A radical cost reduction program will improve efficiency and lower all variable costs by 20%. This will add GH¢70 million to the annual fixed overheads each year from 2019 to 2021.

Required:

a) Prepare a financial analysis statement showing the current annual forecast of costs, revenues, and profits for each of the years 2019 to 2021 and briefly comment on the figures. (Ignore the time value of money)

b) Calculate the profit gap for 2019, 2020, and 2021.

c) Estimate the profit in 2019 if:

i) Strategy 1 was implemented;
ii) Strategy 2 was implemented;
iii) Strategy 3 was implemented.

d) Evaluate which strategy to implement

 

Year 2019 2020 2021
Sales Units 150,000 130,000 110,000
Revenue (GH¢’million) 1680 1456 1232
Materials & Labour 540 468 396
Assembly 150 130 110
Delivery 225 195 165
Total Variable Cost 915 793 671
Contribution 765 663 561
Less: Fixed Costs 630 630 630
Profit 135 33 (69)

Comments:

  • The profit decreases significantly over the years, turning negative by 2021 due to declining sales volumes while fixed costs remain constant.
  • The company will need to consider implementing one or more of the proposed strategies to close the profit gap and achieve its desired profit levels.

b)

Year Desired Profit (GH¢’million) Actual Profit (GH¢’million) Profit Gap (GH¢’million)
2019 245 135 (110)
2020 245 33 (212)
2021 245 (69) (314)

 

c)

ategy Sales Units Revenue (GH¢’million) Materials & Labour (GH¢’million) Assembly (GH¢’million) Delivery (GH¢’million) Total Variable Cost (GH¢’million) Contribution (GH¢’million) Fixed Costs (GH¢’million) Profit (GH¢’million)
Original 150,000 1680 540 150 225 915 765 630 135
Strategy 1 160,000 1792 576 160 240 976 816 660 156
Strategy 2 150,000 1800 540 150 225 915 885 640 245
Strategy 3 150,000 1680 432 120 180 732 948 700 248

 

d)

Strategy 3 should be selected as it not only results in the highest profit compared to the original scenario and the other strategies, but it also closes the profit gap effectively.

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