You have been employed as a consultant for Fitzgerald Ltd. Your brief is to review the current management accounting systems operating within Fitzgerald Limited, with particular reference to the treatment of production overheads and the profitability of their main products. Fitzgerald Ltd is a manufacturing company that produces three main products for sale in the UK market. The three products are the Tesla, the Volta and, the Alpha. Each product uses the same resources, but in different quantities. The production process requires that all three products are produced in batches, but again the batch sizes vary. Details of batch sizes and other relevant information are shown in the table of budgeted data for April 2018 below: Product Tesla Volta Alpha Budgeted production 1200 2000 4000 Direct labour hours per unit 2.5 4.5 3.5 Machine hours per unit 4 3 5 Materials cost per unit (£) 110 91 124 Batch size 30 50 250 Machine setups per batch 1 1 1 Purchase orders per batch 6 8 10 Material movements per batch 5 3 2 The direct labour rate is £12 per hour. Fitzgerald’s budgeted production overhead costs for April 2018 are £570,000 and current practice is to absorb these costs into product costs using an absorption cost rate based on direct labour hours. The selling prices for the machines are as follows: Model: Tesla £220.00 Volta £298.00 Alpha £315.00 The management of Fitzgerald Ltd is considering changing to an activity based method of attributing overhead costs to products and as a result they have identified the following cost drivers and related cost pools: Cost pool £ Cost driver Machine maintenance 200,000 machine hours Machine setups 80,000 machine setups Purchasing 170,000 purchase orders Material handling 120,000 material movements In your meeting with management the sales director states: “I really don’t see the point in all this. The overheads are what they are, and futile discussions as to how they should be apportioned between products are a waste of time. Surely it makes sense to write them off in the period incurred” In response to this the production director states: “Whilst I can see the point in apportioning overheads, I really can’t see the point in introducing an activity based approach. There is nothing wrong with using labour hours,but if we must change we can save time and money by sticking with a traditional approach but based on machine hours.” In response the accountant replies: “The traditional approach is based on the statutory external reporting requirements of the Companies Act and is compliant with International Financial Reporting Standard. It is reported to tend to be less accurate because it uses labour or machine hours to absorb overheads, where often no cause and effect relationship exists. My only concern is that Activity Based Costing recognises more cost centres which is more work for the accounts dept. and I am not sure of its benefits.” You are required to:
a) Determine the profit per unit of each product using the current overhead absorption system based on labour hours. (21 marks)
b) Determine the profit per unit of each product using an activity based costing approach. (30 marks)
c) In not more than 2,000 words prepare a report for the management of Fitzgerald Ltd which must include the following:
i. An analysis of the profitability of the different products using the two different methods of apportioning overheads, and the reasons for the differences in product profitability. You should refer in your answer to parts (a) and (b) of the question which should be included in the appendices to the report. (14 marks)
ii. Your comments on the views of the three directors, illustrating your points where ever possible by reference to parts (a) and (b). (30 marks) iii. Your recommendations to the management of Fitzgerald Ltd, as to whether or not you think Activity Based Costing is appropriate for Fitzgerald Ltd.