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Profitability Under Traditional Accounting Systems

Table 1 below summarizes profits and rate of return before tax for the flagship envelope and cup product lines when total production overhead is applied pro-rata according to share of gross revenue.

Table 1

Revised Profitability Estimates Under Activity-Based Costing

Re-assessing the situation using activity-based costing, we first reallocate total production overhead according to what is already known about the three main cost drivers that comprise total production overhead:

  • Pool 1 = $1,260,000 using machine hours as the cost driver
  • Pool 2 = $2,257,500 using direct labor hours as the cost driver
  • Pool 3 = $1,500,000 using the number of quality inspections as the cost driver

The intermediate step is to do cost driver analysis (Table 2), followed by analysis of activity by product (Table 3 below):

Table 2

Table 3

Table 4

Recommendation

Considering the above, we discern three crucial advantages to activity-based costing. First of all, it appears that traditional accounting overestimates the production overhead carry that is imputed for both product lines. Second, the more stringent ABC approach reveals that the overhead allocation ratio between the two product lines is closer to 5:1 than the 21:1 that traditional accounting would have us presume. This suggests, thirdly, that there is scope for adjusting envelope pricing upward to at least match the ROI we currently realize for cups.

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