Assignment 1: Discussion—ABC Or Activity-Based Costing
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. Tasks: 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:
- Creative: 800 advertising campaigns the agency bids for, 400 of which are bids for large campaigns and 400 for small campaigns.
- Production: 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.
Paper For Above instruction
Activity-Based Costing (ABC) is a sophisticated costing methodology that allocates overhead costs based on the actual activities that drive costs within an organization. Unlike traditional costing methods, which often allocate costs uniformly across products or services, ABC seeks to enhance accuracy by identifying cost pools and their respective cost drivers. This approach is particularly valuable in service industries like advertising agencies, where overhead costs can be complex and difficult to allocate precisely.
In the context of Merit-o-cracy PLC, understanding the distinctions between traditional (existing) methods and ABC is crucial for accurate cost allocation and effective pricing strategies. Traditionally, Merit-o-cracy applies a markup of 100% over direct advertising costs, which assumes overhead costs are proportional to these direct costs. This simple method results in a uniform overhead allocation of $4,000 to small campaigns and $28,000 to large campaigns, corresponding directly to the direct costs of the campaigns. While straightforward, this method overlooks the actual activities that consume resources, potentially leading to mispricing, especially for larger campaigns that may require disproportionately more resources.
Applying ABC enables a more detailed analysis by identifying key cost pools: creative staff, production staff, administrative and support staff, and rental costs. Each cost pool has specific cost drivers: the number of bids for campaigns, the number of campaigns won, and the number of customers served. Through this detailed analysis, Merit-o-cracy can allocate overhead with greater precision, informing better pricing decisions and profitability analysis.
Calculation of Overhead Allocation under Existing Methods
Currently, Merit-o-cracy allocates overhead directly based on the direct advertising costs of campaigns. For small campaigns, each incurs $4,000 of overhead, while large campaigns incur $28,000. Given 325 small campaigns and 25 large campaigns, the total overhead allocated under this method is:
- Small campaigns: 325 x $4,000 = $1,300,000
- Large campaigns: 25 x $28,000 = $700,000
Total overhead allocated = $1,300,000 + $700,000 = $2,000,000
This total aligns with the organization's annual overhead budget, demonstrating the current method's simplicity.
Applying Activity-Based Costing to Merit-o-cracy
In ABC, costs are assigned based on activity levels and their respective cost drivers, which include:
- Creative Staff Costs: linked to the number of bids for campaigns
- Production Staff Costs: related to campaigns won
- Administrative & Support Staff Costs: connected to the number of customers
- Rental and Associated Costs: shared equally among departments
Calculating the activity-based cost per driver involves dividing each cost pool by its activity level:
Creative Staff Cost per Bid
Total creative staff costs = $500,000
Number of bids = 800
Cost per bid = $500,000 / 800 = $625
Production Staff Cost per Campaign Won
Total production staff costs = $750,000
Campaigns won = 350
Cost per campaign won = $750,000 / 350 ≈ $2,143
Administrative & Support Staff Cost per Customer
Total admin & support costs = $300,000
Number of customers = 400
Cost per customer = $300,000 / 400 = $750
Rental and Associated Costs
Total rental costs = $450,000
Shared equally among three departments, so each department's share = $150,000
Cost per department, per activity, is thus apportioned equally, but since rental costs are people-based, they are divided by staff numbers. Given equal staffing, each department incurs $150,000 in rental costs.
Calculating Overhead for Small and Large Campaigns Using ABC
Using the above costs per driver, we calculate the overhead applied to individual campaigns:
Small Campaigns
- Bids for small campaigns = 400; cost per bid = $625
- Campaigns won = 325; cost per win = $2,143
- Customers served = 300; cost per customer = $750
- Overhead from activity-based costing (ABC):
- From bids: 400 bids x $625 = $250,000
- From campaigns won: 325 x $2,143 ≈ $696,475
- From customers: 300 x $750 = $225,000
Large Campaigns
- Bids for large campaigns = 400; cost per bid = $625
- Campaigns won = 25; cost per win = $2,143
- Customers served = 100; cost per customer = $750
- Overhead from activity-based costing:
- From bids: 400 x $625 = $250,000
- From campaigns won: 25 x $2,143 ≈ $53,575
- From customers: 100 x $750 = $75,000
Determining Overhead Percentage to Add to Direct Costs
Summing the overheads:
- Small campaigns: $250,000 + $696,475 + $225,000 ≈ $1,171,475
- Large campaigns: $250,000 + $53,575 + $75,000 ≈ $378,575
Divide by total direct advertising costs for each campaign type:
Small campaigns:
Total direct costs = 325 x $4,000 = $1,300,000
Overhead percentage = ($1,171,475 / $1,300,000) x 100 ≈ 90.1%
Large campaigns:
Total direct costs = 25 x $28,000 = $700,000
Overhead percentage = ($378,575 / $700,000) x 100 ≈ 54.1%
Conclusion
The analysis reveals that under traditional methods, all campaigns are allocated a flat 100% markup, yielding an overhead of $4,000 and $28,000 for small and large campaigns respectively. Conversely, ABC demonstrates that larger campaigns, although costly, have a lower percentage overhead (about 54%) relative to their direct costs, while smaller campaigns incur a higher percentage overhead (around 90%). This discrepancy suggests that Merit-o-cracy’s current pricing may not accurately reflect resource use, particularly disadvantaging larger campaigns. Adoption of ABC would enable more precise pricing strategies, potentially improving competitiveness and profitability.
References
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