Activity based costing

Unit 4 Assignment B

Submitted to: Nur-e-Alam Khan

Submitted by: Ibrahim Hossain [25270571]

This report aims to analyze the motivations behind Eaton Company's desire to exercise control, explore
different cost categories that the company will encounter, and propose methods to manage these costs
effectively. Additionally, an evaluation will be conducted using an activity-based costing model to
determine the profitability of Eaton's CNC (computer numerical control) - machined parts used in their
jet engine assemblies.

Importance of Cost Control:

Initially, the significance of cost control will be elucidated. Eaton Company must diligently regulate and
assess all cost aspects to ensure the organization's profitability. The revenue generated from product
sales should cover manufacturing costs along with a margin for profit. Additionally, the company must
consider the pricing strategies employed by rival firms for similar products and strive to maintain
competitiveness. Striking a balance between profitability and competitive pricing is crucial, underscoring
the importance of accurate product costing for Eaton.

Categories of Costs:

Eaton Company encounters various types of costs, which include:

Direct Costs: Expenses directly associated with manufacturing the company's products, such as raw
materials and direct labor costs.

Indirect Costs: Expenses indirectly linked to the manufacturing process, encompassing areas like energy,
insurance, and wages.

Fixed Costs: Unchanging expenses such as rent, machinery costs, depreciation, overheads, and
insurance.

Variable Costs: Expenses that can fluctuate over time, such as raw materials.

Semi-Variable Costs: Costs influenced by demand fluctuations, for instance, maintenance, commissions,
and overtime expenses.

Administration/General Costs: Costs related to administrative functions associated with product

manufacturing, including finance, information technology, and human resources.

In addition to identifying and managing these diverse cost components, Eaton Company needs to make
decisions pertaining to:

Investment: Evaluating whether to invest a significant amount in the development and manufacturing of
a product before realizing any profit. This decision entails an element of risk, requiring a careful
assessment of the potential return on investment and weighing it against the expenditure.

Withdrawal: When a product fails to generate profit, the company must determine if it is cost-effective
to withdraw it from the market. This action would reduce future manufacturing costs, allowing the
organization to redirect the saved resources toward potentially more profitable ventures.
Make or Buy: Occasionally, it may be more cost-efficient for the company to procure a product or its
components from external sources rather than manufacturing them in-house.

In summary, this report delves into Eaton Company's motivations for cost control, explores various cost
categories encountered by the company, and suggests strategies for cost management. Furthermore, an
evaluation using an activity-based costing model will assess the profitability of Eaton's CNC-machined
parts utilized in jet engine assemblies.

Activity Based Costing (ABC) is a method employed by Eaton Company, an engineering firm specializing
in aircraft and jet engine production for the aerospace industry. This approach allows for a
comprehensive analysis of the costs associated with the CNC-machined component of the jet engine
assembly, which is manufactured within computer numerical control (CNC) cells.

I’ll be referring to each engine part manufactured as a unit .

Numbers of units manufactured and sold 275 000

per annum

Price each unit is sold for £6.00

Therefore the total amount of money made by the company from sales of the products , without
considering any costs is :

Sales revenue = number of units sold x price per unit

=275 000 x £6.00 = £1,650,000

Direct Costs
Direct Material Costs £ 0.50

Direct Labour Costs £ 0.40

Direct material costs = number of units sold x material costs per unit

= 275 000 x £0.50 = £137 500

Direct labour costs = number of units sold x labour costs per unit = 275 000 x £0.40 = £ 110 000

Total direct costs = direct material costs + direct labour costs = 137 500 + 110 000 = £247 500

Indirect costs
Activity cost pool Activity driver Cost per Total Total

unit of activity per indirect

activity annum costing for

driver the activity

driver

Purchasing Number of £880 50 880 x 50 =

purchase £44 000

received

Setting up of CNC Number of cell £750 100 750 x 100 =

manufacturing cells set-ups £75 000

 required

Machine calibration Number of £100 1000 100 x 1000 =

and testing tests that need £100 000

to be carried

out

Machine maintenance Number of £650 200 650 x 200 =

batch runs to £130 000

take please

Total indirect costs

£ 349 000
Calculation of the annual profit from revenue and costs

Number of units 275 000

produced and sold

Total direct costs £247 500

Total indirect £349 000
costs
Revenue per unit £6.00

Direct costs per Total direct costs ÷ number of units = 247 500 ÷ 275 000 = £0.90
unit

Indirect cost per Total indirect costs ÷ number of units = 349 000 ÷ 275 000 =
unit £ 1.27

Gross profit per Revenue per unit – costs per unit = 6.00 – 0.90 – 1.27 = £3.83
unit

Gross profit Gross profit per unit ÷ revenue per unit = 3.83÷6.00 = 63.83%
margin
Based on the findings of this analysis, it can be inferred that Eaton Company
effectively manages costs and achieves profitability in the manufacturing of the
part. This conclusion is supported by a substantial gross profit margin of 63.83%.