Mellow Case
CASE STUDY ON ACTIVITY BASED COSTING
MELLOW LTD.
Mellow Ltd manufactures and sells a wide range of machine tools. In the past few years the company has been performing reasonably well, but its market share has been declining as a result of severe competition.
The company uses absorption costing for both external reporting as well as for providing individual product information for decision-making. In 20x5, although the company performed well overall, senior management was concerned with the profit performance of some specific product lines. The production manager was surprised when the accountant showed him that some difficult and time consuming products produced in small batches had made very attractive profit margins, while some of his favourites which sold very well and were produced in large quantities showed rather poor or negative margins.
On the advice of the company's financial consultants, management decided to trial a system of activity based costing (ABC) for 20x6, while still retaining the traditional costing system. The consultants stated that an ABC system would provide more accurate product cost and margin information to guide the company's strategic production and marketing effort as well as highlight value adding and non-value adding activities performed by the company.
At the end of the first quarter of 20x6, the following information was available:
Income Statement For The Quarter Using Absorption Costing
$'000 $'000 $'000 Sales 40,000 Less Cost of goods sold Materials 8,000 Labour 7,500 Production overheads 10,000 Total 25,500 Gross margin 14,500 Less Marketing expenses Delivery expenses 400 Sales commissions 2,000 After sales service 500 Advertising and promotions 2,000 Sales administration 1,000 5,900 Administration expenses 3,000 Total 8,900 Net income before tax 5,600
Other Information:
• Production overhead application rate
MELLOW LTD.
Mellow Ltd manufactures and sells a wide range of machine tools. In the past few years the company has been performing reasonably well, but its market share has been declining as a result of severe competition.
The company uses absorption costing for both external reporting as well as for providing individual product information for decision-making. In 20x5, although the company performed well overall, senior management was concerned with the profit performance of some specific product lines. The production manager was surprised when the accountant showed him that some difficult and time consuming products produced in small batches had made very attractive profit margins, while some of his favourites which sold very well and were produced in large quantities showed rather poor or negative margins.
On the advice of the company's financial consultants, management decided to trial a system of activity based costing (ABC) for 20x6, while still retaining the traditional costing system. The consultants stated that an ABC system would provide more accurate product cost and margin information to guide the company's strategic production and marketing effort as well as highlight value adding and non-value adding activities performed by the company.
At the end of the first quarter of 20x6, the following information was available:
Income Statement For The Quarter Using Absorption Costing
$'000 $'000 $'000 Sales 40,000 Less Cost of goods sold Materials 8,000 Labour 7,500 Production overheads 10,000 Total 25,500 Gross margin 14,500 Less Marketing expenses Delivery expenses 400 Sales commissions 2,000 After sales service 500 Advertising and promotions 2,000 Sales administration 1,000 5,900 Administration expenses 3,000 Total 8,900 Net income before tax 5,600
Other Information:
• Production overhead application rate