REVIEW PROBLEM: ACTIVITY-BASED COSTING

Aerodec, Inc., manufactures and sells two types of wooden deck chairs: Deluxe and Tourist. Annual sales in units,
direct labor-hours (DLHs) per unit, and total direct labor-hours per year are provided below:

Costs for direct materials and direct labor for one unit of each product are given below:

Manufacturing overhead costs total $800,000 each year. The breakdown of these costs among the company's six
activity cost pools is given below. The activity measures are shown in parentheses.

Required:
1. Classify each of Aerodec's activities as either a unit-level, batch-level, product-level, or facility-level activity.
2. Assume that the company applies overhead cost to products on the basis of direct labor-hours.
a. Compute the predetermined overhead rate.
b. Determine the unit product cost of each product, using the predetermined overhead rate computed
in (2)(a) above.
3. Assume that the company uses activity-based costing to compute overhead rates.
a. Compute the activity rate for each of the six activities listed above.
b. Using the rates developed in (3)(a) above, determine the amount of overhead cost that would be
assigned to a unit of each product.
c. Determine the unit product cost of each product and compare this cost to the cost computed in (2)
(b) above.

Solution to Review Problem

1.

2. a.
   b.

3. a.

b.

c.
Under activity-based costing, the unit product cost of the Deluxe deck chair is much greater than the cost computed
in 2(b), and the unit product cost of the Tourist deck chair is much less. Using volume (direct labor-hours) in 2(b) to
apply overhead cost to products results in too little overhead cost being applied to the Deluxe deck chair (the low-
volume product) and too much overhead cost being applied to the Tourist deck chair (the high-volume product).

THE FOUNDATIONAL 15
Hickory Company manufactures two products—14,000 units of Product Y and 6,000 units of Product Z. The company
uses a plantwide overhead rate based on direct labor-hours. It is considering implementing an activity-based costing
(ABC) system that allocates all of its manufacturing overhead to four cost pools. The following additional information
is available for the company as a whole and for Products Y and Z:

1. What is the company's plantwide overhead rate?

First calculate the total estimated OH: (200000+100000+84000+300000) = 684000
Then divide by the allocation base which is DLH 12000
POHR: $57 per DLH

2. Using the plantwide overhead rate, how much manufacturing overhead cost is allocated to Product Y? How
much is allocated to Product Z?
Product Y: 8000 DLH * $57 = $456000 Product Z: 4000 * $57 = $228000

3. What is the activity rate for the Machining activity cost pool?
Estimated OH Divided by Expected activity: $200000/10000= $20 per MH
4. What is the activity rate for the Machine Setups activity cost pool?
Estimated OH Divided by Expected activity: $100000/200 = $500 per set-up

5. What is the activity rate for the Product Design activity cost pool?
Estimated OH Divided by Expected activity:$84000/2 = $42000 per product

6. What is the activity rate for the General Factory activity cost pool?
Estimated OH Divided by Expected activity: $400000/12000= $25 per DLH

7. Which of the four activities is a batch-level activity? Why?

Set-ups not influenced by the number of units

8. Which of the four activities is a product-level activity? Why?

Product design not influenced by the number of units or batches.

9. Using the ABC system, how much total manufacturing overhead cost would be assigned to Product Y?
Take each activity rate and multiply by each activity measure of Product Y
($20 * 7000) + ($500 * 50) +$42000 + ($25 * 8000) = $407000

10. Using the ABC system, how much total manufacturing overhead cost would be assigned to Product Z?
 Take each activity rate and multiply by each activity measure of Product Z
($20 * 3000) + ($500 * 150) +$42000 + ($25 * 4000) = $277000

11. Using the plantwide overhead rate, what percentage of the total overhead cost is allocated to Product Y?
What percentage is allocated to Product Z? 456000/684000 = 67% for Y, 33% for Z refer to 2,

12. Using the ABC system, what percentage of the Machining cost is assigned to Product Y? What percentage
is assigned to Product Z? Are these percentages similar to those obtained in question 11? Why?
Y: 7000/10000= 70% and Z 3000/10000=30%
Similar because machining is distributed on machine hours which is unit level activity.

13. Using the ABC system, what percentage of Machine Setups cost is assigned to Product Y? What
percentage is assigned to Product Z? Are these percentages similar to those obtained in question 11? Why?
Y: 50/200 = 25%, Z 150/200 = 75% No the basis is allocating set-ups to Z rather than to Y.
Although Product Y is the high-volume product (14,000 units) and Product Z is the low-volume
product (6,000 units), Product Y only consumes 25% of the total machine setups and Product Z
consumes 75% of the total machine setups. The conventional system is allocating too much of
the machine setup costs to Product Y and too little of these costs to Product Z.
14. Using the ABC system, what percentage of the Product Design cost is assigned to Product Y? What
percentage is assigned to Product Z? Are these percentages similar to those obtained in question 11? Why?
Y: 50%, Z: 50%. These percentages are different because Product Design is a product-level cost pool.
Although Product Y is the high volume product (14,000 units) and Product Z is the low-volume product
(6,000 units), both products consume 50% of the product design resources. The conventional system is
allocating too much of the product design costs to Product Y and too little of these costs to Product Z.

15. Using the ABC system, what percentage of the General Factory cost is assigned to Product Y? What
percentage is assigned to Product Z? Are these percentages similar to those obtained in question 11? Why?
Under the ABC system, the General Factory allocation percentages are the same as the
plantwide allocation percentages because the General Factory cost pool is allocated to products
using the same unit-level activity measure (direct labor-hours) as the plantwide approach.
EXERCISE 3–10 Contrasting ABC and Conventional Product Costs [LO2, LO3, LO4]
Rocky Mountain Corporation makes two types of hiking boots—Xactive and Pathbreaker. Data concerning these two
product lines appear below:

The company has a conventional costing system in which manufacturing overhead is applied to units based on direct
labor-hours. Data concerning manufacturing overhead and direct labor-hours for the upcoming year appear below:

Required:

1. Compute the predetermined overhead rate based on direct labor-hours. Using this rate and other data from
the problem, determine the unit product cost of each product.

Estimated Overhead $2200000/110,000 /DLHs = $20 POHR

Xactive: DM 64.80 + DL 18.2 + MOH (1.4*20) = $111

Pathbreaker: 51 + 13+ (1 * 20) = $84

2. The company is considering replacing its conventional costing system with an activity-based costing system
that would assign its manufacturing overhead to the following four activity cost pools:

Determine the activity rate for each of the four activity cost pools.

Supporting direct labor 797000/110000 = 7.25 DLH

Batch setups 680000/400=1.7 set-up

Product sustaining 650000/2 = 325000 product

General factory 72500/10= 7.25 MH

 3. Using the activity rates and other data from the problem, determine the unit product cost of each product.

Xactive Pathbreaker
Direct materials $1,620,000 $3,825,000
64.8*25000;51*75000..................
Direct labor 455,000 975,000
18.2*25000;13.*75000.....................
Supporting direct labor
7.25*35000;75000........................ 253,750 543,750
Batch setups 1.7*250;150................ 425,000 255,000
Product sustaining ........................... 325,000 325,000
General factory 7.25*2500;7500     18,125     54,375
Total cost (a)..................................... $3,096,875 $5,978,125
Number of units (b)........................... 25,000 75,000
Unit product cost (a) ÷ (b)................ $123.88 $79.71

4. Explain why the conventional and activity-based cost assignments differ.

Conventional uses unit-level DLH as allocation base therefore X collects 32% of MOH
whereas P collects 68%
X(1.4*25000)/110000=32%
On the other hand ABC uses batch level of 31% of MOH distributed 62.5% for X and 37,5
for P and Product level for another 30% of MOH distributed 50-50 between products.

PROBLEM 3–12A Contrasting ABC and Conventional Product Costs [LO2, LO3, LO4]

Precision Manufacturing Inc. (PMI) makes two types of industrial component parts—the EX300 and the TX500. It
annually produces 60,000 units of EX300 and 12,500 units of TX500. The company's conventional cost system
allocates manufacturing overhead to products using a plantwide overhead rate and direct labor dollars as the
allocation base. Additional information relating to the company's two product lines is shown below:

The company is considering implementing an activity-based costing system that distributes all of its manufacturing
overhead to four activities as shown below:

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Required:
1. Compute the plantwide overhead rate that would be used in the company's conventional cost system.
Using the plantwide rate, compute the unit product cost for each product.

Predetermined = Estimated total manufacturing overhead cost

overhead rate Estimated total direct labor dollars

$508,625
= = $3.13 per DL$
$162,500

EX300 TX500
Direct materials................................ $366,325 $162,550
Direct labor....................................... 120,000 42,500
Manufacturing overhead applied
@ $3.13 per direct labor-dollar...... 375,600 133,025
Total manufacturing cost (a)............ $861,925 $338,075
Number of units (b).......................... 60,000 12,500
Unit product cost (a) ÷ (b)............... $14.37 $27.05

2. Compute the activity rate for each activity cost pool. Using the activity rates, compute the unit product cost
for each product.

The activity rates are computed as follows:

(a) (b) (a) ÷ (b)

Activity Cost Pools Total Cost Total Activity Activity Rate
Machining....................... $198,250 152,500 MHR $1.30 per MHR
Setups............................. $150,000 375 setup hrs. $400 per setup hr.
Product-level.................. $100,250 2 products $50,125 per product
General factory............... $60,125 162,500 DL$ $0.37 per DL$

Under the activity-based costing system, the unit product costs would be
computed as follows:
EX300 TX500
Direct materials................................. 366,325 162,550
Direct labor........................................ 120,000 42,500
Machining.......................................... 117,000 81,250
Setups................................................ 30,000 120,000
Product sustaining............................ 50,125    50,125
General factory..................................      44,400    15,725
Total cost (a).....................................    727,850  472,150
 Number of units (b)........................... 60,000 12,500
Unit product cost (a) ÷ (b)............. $12.13 $37.77

3. Why do the conventional and activity-based cost assignments differ from one another?

ROBLEM 3–17A Contrast Activity-Based Costing and Conventional Product Costs

Puget World, Inc., manufactures two models of television sets, the N 800 XL model and the N 500 model. Data
regarding the two products follow:

Additional information about the company follows:

a. Model N 800 XL requires $75 in direct materials per unit, and Model N 500 requires $25.
b. The direct labor wage rate is $18 per hour.
c. The company has always used direct labor-hours as the base for applying manufacturing overhead cost to
products.
d. Model N 800 XL is more complex to manufacture than Model N 500 and requires the use of special
equipment. Consequently, the company is considering the use of activity-based costing to assign
manufacturing overhead cost to products. Three activity cost pools have been identified as follows:

Required:
1. Assume that the company continues to use direct labor-hours as the base for applying overhead cost to
products.
a. Compute the predetermined overhead rate.
Estimated OH divided by allocation base which is DLH: $1785000/21000 = $85 per DLH
a. Compute the unit product cost of each model.
N800 XL: DM + DL + (POHR * DLH) 75+54+ ($85*3)=$384
N500: DM + DL + (POHR * DLH) 25+18+85*1 = $128
2. Assume that the company decides to use activity-based costing to assign manufacturing overhead cost to
products.
a. Compute the activity rate for each activity cost pool and determine the amount of overhead cost
that would be assigned to each model using the activity-based costing system.
N800 XL N500
Machine setups 360000/300 = $1200 per setup *100= $120000 *200 = $240000
Special processing 165000/16500= $10 per SP *16500= $165000 - = -
General factory 1260000/21000= $60 per DLH * 9000= $540000 *12000= $720000
Total $825000 $960000
a. Compute the unit product cost of each model.
Number of units 3000 12000
OH per unit $275 $ 80
Direct material 75 25
Direct labor 54 18
Unit product cost $404 $123
3. Explain why manufacturing overhead cost shifts from Model N 500 to Model N 800 XL under activity-based
costing.
Under conventional costing 43% of DLH are assigned to product N800XL whereas N500 is assigned 57%
which is a unit-level allocation. It is important to note that, even under activity-based costing, 71% of the
company’s overhead costs continue to be assigned to products on the basis of direct labor-hours:

Machine setups (number of setups)............................ $  360,000 20 %

Special processing (machine-hours)............................ 165,000 9
General factory (direct labor-hours)............................  1,260,000  71
Total......................................................................... $1,785,000 100 %
First, where possible, overhead costs have been traced to the products rather than being lumped
together and spread uniformly over all units. Therefore, special processing costs, which are all
due to processing Model N 800 XL, have been assigned to Model N 800 XL and none to Model N
500 under the activity-based costing approach.
Second, the costs associated with the batch-level activity (machine setups) have been assigned on
the basis of setups rather than direct labor-hours. Each setup, regardless of the batch size, is
assigned the same amount of machine setup cost. Some products are produced in large batches
and some are produced in small batches. The smaller the batch, the higher unit cost. In this
example, the data can be analyzed as follows:

Model N 800 XL:

Machine setup cost from ABC system (a).......................... $1,200 per setup
Average number of units per setup
3,000 units ÷ 100 setups (b)....................................... 30 units per setup
Average setup cost per unit (a) ÷ (b)............................... $40.00 per unit

Model N 500:
Machine setup cost from ABC system (a).......................... $1,200 per setup
Average number of units per setup
12,000 units ÷ 200 setups (b)...................................... 60 units per setup
Average setup cost per unit (a) ÷ (b)............................... $20.00 per unit
Thus, the average setup cost per unit is 2.0 times as great for Model N 800 XL as for Model N
500. Such differences in cost are obscured when direct labor-hours (or any similar measure of
volume) is used as the basis for applying overhead costs to products.