Assignment for Quantitative Analysis for Managers moudel

The manufacturing cost of Kopi Lua reduces from £ 6.00 per kg to £ 4.83 per kg which is 19.5% lower and since the price mark-up is 30%, the actual margin is much higher. For the Costa Rica blend, however, the cost goes up from £ 5.00 per kg to £ 7.15 per kg causing a loss of £ 0.65 per kg since the selling price is 5 x 1.3 = £ 6.50 per kg.
The present method of overhead allocation based on direct labour hours results in an equal allocation of £ 1.50 per kg to each of the two blends of coffee when it is clear that the efforts in purchasing, materials handling and quality control have to be higher for processing the Costa Rica coffee in small batches of 500 kg each compared to processing Kopi Lua in batches of 10,000 kg each. Such cost anomalies could be present in each of the 40 blends that the company makes.
Another significant reason to change the overhead allocation method is that the product cost would change each time the product mix made in the plant changes. This has the impact of causing variations in profitability.
Activity based overhead allocation has another important advantage over the labour hour based allocation. Each element of the overhead cost can be scrutinized to see if any reduction is possible. For example, purchasing costs could reduce if the Costa Rica coffee was bought in, say, 2 batches a year in place of 4. It is not clear why the number of setups should be three per batch when the batch sizes are so different. Reducing the number of setups for Costa Rica would reduce the allocated materials handling costs.
The concept of Activity Based Costing (ABC) was first defined by Robert Kaplan and William Burns in the late 1980s. Initially ABC focused on the manufacturing industry where technological developments and productivity improvements had reduced the proportion of direct labour and direct materials costs but increased the proportion of indirect or