Question 3 Use of Absorption costing Dull company is a Mauritian company that was created in the year 1980. Since that time Dull company used labour intensive methods to produce three varieties of shirts namely Lux, Deluxe and Standard. The shirts are made only for the local market. Demand for products Lux and Deluxe is relatively elastic whilst demand for product Standard is relatively inelastic. Each product uses the same materials and the same type of direct labour but in different quantities. For many years, the company has been using full absorption costing and absorbing overheads on the basis of direct labour hours. Using traditional method of production, the company has relatively small amount for production overhead and absorption costing was an acceptable method to absorb overhead. Selling prices are determined using cost plus pricing. This is common within this industry, with most competitors applying a standard mark-up. K Change in production methods With increase in competition with local producers and imports, Dull company had to completely innovate the production process five years ago. Orders are no more for homogeneous shirts. Customers want customisation so more production runs are undertaken. Similarly, materials are bought on Just In Time basis to minimise cost. Yearly Activity level and direct cost per unitrespectively. Budgeted production and sales volumes for Lux, Deluxe and Standard for the next year are 20,000 units, 16,000 units and 22,000 units The budgeted direct costs of the three products are shown below: Product Lux Deluxe Standard Rs per unit Rs per unit Rs per unit Direct material 25 28 22 Direct labour (Rs 12 per hour) 30 36 24 Production Overhead In the next year, Dull company also expects to incur indirect production costs of Rs1,377,400, which are analysed as follows: Cost pools RS Cost drivers Machine set up costs 280 000Number of batches Material ordering costs 316 000Number of purchase orders Machine running costs 420 000Number of machine hours General facility costs 361 400Number of machine hours 1 377 400The following additional data relate to each product: Product Lux Deluxe Standard Batch size (units) 500 800 400 Number of purchase orders per batch 4 5 4 Machine hours per unit 1.5 1.25 1.4 Change to Activity Based Costing Dull company wants to boost sales revenue in order to increase profits but its capacity to do this is limited because of its use of cost plus pricing and the application of the standard mark-up. The finance director has suggested using activity based costing (ABC) instead of full absorption costing, since this will alter the cost of the products and may therefore enable a different price to be charged