ASSIGNMENT - ACTIVITY BASED COSTINGS

TANK-KIT CO.LTD.

Tank-Kit Co.Ltd (TKCL) is a large manufacturing company producing oil tanks and is located in the South of London. It was started as a company in 1970 and has enjoyed steady growth in both sales and profits.   Kristina Clayton, the founder's daughter, joined the company in 1998 after graduating from university with a degree in accounting and finance. One of her first tasks was to revise the accounting system as there was a demand for more accurate product cost information to support the firm's strategy of offering keen prices in a highly competitive market where a few firms dominated.

Kristina is surprised by the depth of opposition that she faces in trying to change the organisation. Some members of the firm appear to be happy to accept the shortcomings of the "old" system on the basis that there are comfortable with it and they understand its workings. However, with the support of her powerful and influential father, she wins the argument and now has the job of implementing her "new "system.

Kristina's father has now retired and she is conscious that she must prove herself to the organisational members and is aware that disruption due to the implementation of a new system can be upsetting. However, at the same time, profits are down below budget and the accountant is very critical of the current costing system saying that it is out of line with the updated manufacturing systems as well as way behind current theoretical ideas on product costing. According to the accountant, they are still absorbing overheads on labour hours and that they have an artificially high overhead absorption rate of £150 per labour hour. He claims that they are pricing themselves out of the market on their established product line. He suggests that product costs would be more meaningful if absorbed on the basis of machine hours.

Kristina decides that she should investigate this matter. Over the past five years, overhead costs had risen to £599,300 per month, a 46% increase, while direct labour hours have risen from £168200 to £170000, a small increase. The product processes are now largely mechanised with a high level of automation. Direct labour hours are 4000 compared with machine hours of 6500 (it is possible that some labour is still being classed as direct when in fact the change in technology and automation has altered the nature to indirect.

Kristina asks the manufacturing manager about the rise in overhead costs but this results in him getting very upset and saying-"How can I keep costs down when marketing ignore our standard specifications and insist on 23 different versions of every product? I need more specialist engineers to monitor the changes and they do not come cheap. Also there are completely new parts coming through from design with huge material costs; materials handling is an increasing headache. And the number of specials going through on small production runs continues to increase. I need many more set-ups per shift and it is skilled work, but you cannot pick up that sort of skilled labour easily, so overtime is going through the roof". Kristina then decides to talk to the marketing manager, who says-"We are facing fierce competition for our main high volume lines and we just can't match the low prices in the marketplace. However, we have successfully increased our sales of the more specialised tanks despite an increase in prices forced on us by manufacturing. So, we are meeting our overall sales targets and as we encourage this trend towards the high margin specialist product lines, our profits will rise. I don't see any problem at present but there will be many problems if manufacturing do not get control of their cost increases"

Kristina starts to pull together the information and gets frustrated at the inconsistencies" We are meeting our sales targets but production costs are rising because of the switch to specialist products. However, as these are sold at a higher price, we should be improving our profits. I really don't understand why our profits are falling"

As Kristina designed the costing system, she is reluctant to admit it is at fault and she remembers clearly the opposition she had when she last recommended changes. She no longer has her father to back her up so she decides to bring in a consultant (you, the student) to help identify the problem and to make recommendations as to future action. Kristina supplies you with the following information:

Budgeted overhead costs per month:

Machines:                                                                   £ 279,500

Set-up and engineering support:                                   £200,200

Materials handling:                                                       £119,600

Total overheads:                                                          £ 599,300

Direct labour:                                                              £170,000

Total manufacturing cost excluding direct materials:        £769,300

Further details:

Budgeted labour rate:                                                   * £42.50/ labour hour

Budgeted overhead burden:                                          * £149.825/ labour hour

Total cost per labour hour:                                            £192.325

* based on budgeted 4000 labour hours

Questions:

1. Analyse the problem and give advice as to the advantages of switching to machine hours as an overhead recovery base.

2. Show how an activity based system would change the analysis of the costs between the standard and specialist products.

3. Advise on the implementation of an ABC system. How can Kristina's fears be lessened?