Grady and Associates performs a variety of activities related to information systems and ecommerce consulting in Toronto, Canada. The firm, which bills $125 per hour for services performed, is in a very tight local market and is having difficulty finding quality help for its overworked professional tight local labor market and is having difficulty finding quality help for its overworked professional staff. The cost per hour for professional staff time is $45. Selected information follows Billable hours to clients for the year totaled 5,000, consisting of information systems services, 3,100; e-commerce consulting, 1,900 Admin cost of $342,000 was (and continues to be) allocated to both services based on billable hours. These costs consist of staff support, $180,000; in house computing, $136,400 and miscellaneous office charges, $25,600 A recent analysis of staff support costs found a correlation with the number of clients served. In house computing and miscellaneous office charges varied directly with the number of computer hours logged and number of client transactions, respectively. Tabulation revealed the following data:
Info Systems Service Ecommerce Total # of clients 200 50 250 #of comp hours 2600 1800 4400
# of client trans 400 600 1000
1Activity based costing (ABC) is said to result in improved costing accuracy when compared with traditional costing procedures. Briefly explain how this improved accuracy is attained
Activity based costing apply overheads to the products on the basis of activities while the traditional approach of absorption costing applies overheads on volume based cost drivers such as machine hours or labor hours. But with advancement in technology and modern manufacturing environment requires a system of costing in which overhead needs to be applied on activity based cost drivers this means that overheads are applied to the products on the basis of the usage of support activities by each product.
This could be made clearer with the help of this example
Product A Bc
Material cost 256
Direct labor 544
Overhead per 555
Total cost 121415
Total overheads 15
Labor hours 3
Each product require 1 hour to product
In absorption costing
Overhead absorption rate = 15/3 = 5 per hour
Overheads applied to each product 5 dollars per unit
Continue the same example for activity based costing
Setup cost 6
Number of setups 4
Machine cost 10
Machine hours 3
Product A require 2 setups and the other products requires 1 setup each
Over head recovery rate = overheads /activity
Setup cost =6/4=1.25
Machine cost = 10/3 = 3.33 per hour
Product A Bc
Material cost 256
Direct labor 544
Setup cost31.251.25
Machine cost3.333.333.33
Total cost 13.3313.5814.58
Now we can see that product A’s total cost in ABC costing is 13.33 because it require 2 setups.
It clearly represent that activity based costing provide a correct application of overheads to units according their usage of support activities.
Bidding can be improved by using ABC costing rather than conventional method of costing. Look at the example given in this link
That company can bid competitive price if it would have used Activity Based Costing. It can be further explained. For example the $800000 production overhead includes the following items:
Indirect Material$400000
Indirect labor$200000
Other production overhead$200000
In the example the production overhead applied per direct labor hour is $20, when the total direct labor hour is to be worked equal to 40000. Now if the company uses this conventional approach all products will be charged $20 per direct labor hour. The company is bidding for a project with the following detail:
Direct material500000
Direct labor300000
Production overhead400000 (20 *20000 direct labor hours used by the project)
Add gross profit240000 (20% of total cost)
Total Selling price1440000
Company is not considering what the quantity of each item has been used. If ABC costing would have been used and the detail would be as follows:
Indirect Material$400000(cost driver 80000 units of material)
Indirect labor$200000(cost driver 40000 direct labor hours)
Other production overhead$200000(cost driver 40000 direct labor hours)
Now if the project would have used ABC with following resources usage
20000 of indirect material and 20000 direct labor hours. Now the bid price would be as follows:
Direct material500000
Direct labor300000
Indirect material100000
Indirect labor100000
Other production overhead100000
Add gross profit220000 (20% of total cost)
Total Selling price1320000
ABC costing is widely used in manufacturing area but it may also be used in service industry as law firm or accounting firm. Look at the following link
The use of ABC involves two issues, one is the determination pools and categories of indirect cost and the second one is the selection of appropriate cost driver which is related to that particular indirect cost.
With the help of ABC the accounting firm will be in a position to determine the cost of each assignment such as audit, filing of tax return more accurately.
2. Assume that the firm uses traditional costing procedures, allocating total costs on the basis of billable hours. Determine the profitability of the firm’s information systems and ecommerce activities, expressing your answer both in dollars and as a percentage of activity revenue.
IT / E CommerceRevenues / 387500 / 237500
less
Staff hours cost / 139500 / 85500
admin cost
342000/5000 =68.40 / 212040 / 129960
Net profit / 35960 / 22040
Net prifit margin. / 9.28% / 9.28%
3. Repeat requirement (2), using activity based costing
IT / E CommerceRevenues / 387500 / 237500
less
Staff hours cost / 139500 / 85500
staff support
180000/250 =720 / 144000 / 36000
Inhouse computing
136400/4400 =31 / 80600 / 55800
Misc
25600/1000= 25.6 / 10240 / 15360
Net profit / 13160 / 44840
Net prifit margin. / 3.40% / 18.88%
4. Jeffery Grady, one of the firm’s partners doesn’t care where his professionals spend their time because as he notes “many clients have come to expect both services and we need both to stay in business. Also information systems and ecommerce professionals are paid the same hourly rate.” Should Grady’s attitude change? Explain.
No, as far as the professional staff charges are concerned they should be charged at the same rate of 545 per hour, but the other admin cost should be distributed on the basis of proportion of related resources consumed by IT and E commerce. It is quite apparent that it changes the profit margin of each sources of revenue
5. Is an aggressive expansion of either service currently desirable? Briefly discuss.
As the net profit margin of E commerce is higher than IT related services therefore the E commerce activity should be given more attention and it should be expanded.
Detail Required: LOW; Urgency: HIGH