M4 Response (KE)
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
ACTIVITY BASED COSTING OF MERIT-O-CRACY PLC CASE STUDY
Amount allocated to both small and large campaigns of advertising through existing methods.
The use of overhead method ensures that resources are allocated based on the process of direct advertising expenses. The expenses are allocated to their respective areas through analytical procedures to ensure they are correctly matched to their causes.
The overhead costs which, are allocated to the small advertising campaigns are:
The overhead allocated to large advertising campaigns includes:
The company spends $600,000.00 in advertising in small campaigns than in the large campaigns. The higher expenditure in the small campaigns is a result of more customers who are in the middle class (Drury, 2013). The firm ensures the large population in the middle and lower class gets the information of the product to widen its market (Plank, 2013).
Application of the Activity-Based Costing method in calculation of the cost of each driver in the cost pools.
Rental and associated expense
Administrative and support staff
Total overhead expense
The production staff consumes the highest amount of money for the firm because of many experienced employees. The employees offer expertise in production that helps in producing higher volumes. The creative staff follows in the second level as they also spend a greater amount in paying their creativity. The rental of the premises used by the firm also follows and the administrative and support has the lowest expenditure because of the few personnel required to run the enterprise.
Activity cost pool
Administration and support
Distribution of the resources consume across the whole activity
Distribution of the resources consumed across the whole activity
Production Creative Admin and support Total
Wins bids services
Large campaigns 25.00 400.00 100.00 525.00
Small campaigns 325.00 400.00 300.00 1025.00
Total activity 350 wins 800 bids 400.00 –
Allocation of expenses to the respective cost pools
Distribution of the Resources Consumed Across each Activity
Admin & support services
The rental and other associated costs = $450,000.00/3
The rates of activity associated with cost pools
Activity Expense Pools
cost per cost driver
$2,571 per win
$812.50 per bid
Admin & support
$1,125 per service
Using the expenses in the cost driver to get the expenses of the activity based in both large and small campaigns
Admin & support services
The percentage that is added to the cost of direct advertising so as to recover all the costs in the activity based costing.
The large campaigns for advertising are estimated to be overvalued according to the approaches used (Drury, 2013).
The small campaigns the amount added are:
Plank, P. (2013). Introduction. In Price and Product-Mix Decisions Under Different Cost Systems (pp. 1-5). Springer Gabler, Wiesbaden.
DRURY, C. M. (2013). Management and cost accounting. Springer.
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