Activity-Based Costing or ABC 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.

Case study:

Merit-o 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 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 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-os 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 these 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

Tasks:

Examine the case above 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.