General Electrical Corporation manufactures electric motors for commercial use. The company produces three models called standard, deluxe and heavy-duty. The company uses a job costing system with manufacturing overhead applied on the basis of direct labour hours. The system has been in place with little change for 25 years. Product costs and annual sales data are as follows:
|Standard model||Deluxe model||Heavy-duty model|
|Annual sales (units)||30000||1500||15000|
For the past 10 years, the company’s pricing formula has been to set each product’s budgeted price at 110 per cent of its full product cost. Recently, however, the standard model motor has come under increasing price pressure from offshore competitors. As a result the price on the standard model has been lowered to $110.
The company CEO recently asked the financial controller, ‘Why can’t we compete with these other companies? They’re selling motors just like our standard model for $160. That’s only $2.50 more than our production cost. Are we really that inefficient?’
The financial controller responded by saying, ‘I think this is due to an outmoded product costing system. As you may remember, I raised a red flag about our system when I came on board last year. But the decision was to keep our current system in place. In my opinion, our product costing system is distorting our product costs. Let me run a few numbers to demonstrate what I mean’.
Getting the CEO’s go-ahead, the financial controller compiled the basic data needed to implement an Activity Based Costing system. These data are displayed in the following tables. The percentages are the proportion of each activity driver consumed by each product line.
|Activity||Activity driver||Standard model||Deluxe model||Heavyduty model|
|Depreciation, machinery||Machine time||40%||13%||47%|
|Maintenance, machinery||Machine time||40%||13%||47%|
|Inspection and repair of defects||Engineering hours||47%||6%||47%|
|Purchasing, receiving and shipping Material handling||Number of material orders||47%||8%||45%|
|Depreciation, taxes and insurance for factory Miscellaneous manufacturing overhead||Factory space usage||42%||15%||43%|
|Inspection and repair of defects||$562,500|
|Purchasing, receiving and shipping||$375,000|
|Depreciation, taxes and insurance for factory||$450,000|
|Miscellaneous manufacturing overhead||$442,500|
Read the above scenario and write a report to the managing director discussing the following key areas:
- How General Electrical’s traditional product costing system distorts the product costs of the standard, deluxe and heavy-duty models and prices. Note: You are required to calculate per unit cost and target price.
- Discuss general problems associated with General Electrical Corporation traditional costing system and highlight any indicators that the current costing system is outdated and flawed.
- Calculate per unit cost and target price for each product line using Activity-Based Costing (ABC) system. (Note: calculate the rate per activity driver to be used in the desired activity-based costing system. Round up to the nearest two decimal points)
- Discuss costs and benefits of adopting Activity Based Costing for General Electrical Corporation.
- Analyse and explain the differences in the product costs and target prices for each product line between the two alternative costing systems. Discuss likely reasons for the identified differences.