QUESTION 1

Company A has the following information applicable to its products:

Total Overheads = 100,000

Total machine Hours = 50,000

Product A B
Units of Production 2,500 5,000
Material Cost p/unit 30 50
Labour Cost per unit 20 16
Machine Hrs P/unit 10 5

% Overheads
Set up Costs 35
Inspections 45
Materials Handling 20

A B Total
Set ups 300 50 350
Inspections 500 250 750
Goods Movements 300 700 1000

Required:
What is the Cost per unit of A and B
(1) Under Traditional Absorption Costing.
(2) Under ABC.
Solution
Absorption Rate Calculation
Absorption Rate = Total Overheads/ Machine Hours
100,000/ 50,000= The absorption rate to absorb overheads is $2 per machine hour.

Cost Per Unit under Absorption Costing

Item Working A B
Allocated Overhead (Hrs p/unit x $2) 20 10
Material Cost Per Unit 30 50
Labour Cost Per Unit 20 16
Total Cost Per Unit 70 76

Cost Per Driver

Category Cost Pool No. Drivers Cost Per Driver
Set up Costs 35,000 350 100
Inspections 45,000 750 60
Materials Handling 20,000 1,000 20
Total Overheads 100,000

Cost Per Unit of each Product

Driver Working Product A Working Product B

Set up Costs 300 x 100 30,000 50 x 100 5,000
Inspections 500 x 60 30,000 250 x 60 15,000
Movements 300 x 20 6,000 700 x 20 14,000
Total Overheads 66,000 34,000
Total Production 2,500 5,000

Cost Per Unit under ABC

Overheads Per Unit 26.4 6.8
Materials Cost Per Unit 30 50
Labour Cost Per Unit 20 16
76.4 72.8

QUESTION 2
Assume High Challenge Company makes two products, touring bicycles and mountain bicycles. The touring
bicycles product line is a high-volume line, while the mountain bicycle is a low-volume, specialized product.

High Challenge Company allocated manufacturing overhead costs to the two products for the month of
January.  Overhead of $2,000,000 was estimated and used 20,000 machine hours. 

In using activity-based costing, the company identified four activities that were important cost drivers and a
cost driver used to allocate overhead. These activities were (1) purchasing materials, (2) setting up machines
when a new product was started, (3) inspecting products, and (4) operating machines.
Accountants estimated the overhead and the volume of events for each activity. For example, management
estimated the company would purchase

Purchasing 100,000 pieces of materials TZS200,000

Machine Setups 400 setups TZS800,000
Inspections 4,000 inspections TZS400,000
Running machines 20,000 machine hours TZS600,000 .

These estimates were made last year and will be used during all of the current year. In practice, companies
most frequently set rates for the entire year, although some set rates for shorter periods, such as a quarter.

High Challenge would like to compare traditional and ABC on absorbing overheads:-

Option 1: on Traditional method

It had used 1,500 machine hours for the Touring bicycle product line and 500 machine hours for the Mountain
bicycle product line

Option 2: ABC method

The following information about the actual number of cost driver units for each of the two products:

Touring Mountain
Purchasing Materials 6,000 pieces 4,000 pieces
Machine Setups 10 setups 30 setups
Inspections 200 hours 200 hours
Running Machine 1,500 hours 1,500 hours

Required:
What is the Cost per unit of Touring and Mountain
(1) Under Traditional Absorption Costing.
(2) Under ABC.

SOLUTION

The activity cost rates (predetermined overhead rates) are calculated as follows:

 Activity Cost Driver (activity) Overhead Cost TZS Estimated Units Rate TZS
Purchasing Materials Pieces of materials 200,000 100,000 pieces 2 per piece
Machine Setups Machine setups 800,000 400 setups 2,000 per setup
4,000 inspect.
Inspections Inspection hours 400,000 100 per inspect. hour
hours
20,000 mach.
Running Machine Machine hours 600,000 30 per machine hour
Hours
Total Overhead TZS 2,000,000

Multiplying the actual activity events for each product times the predetermined rates computed earlier
resulted in the overhead allocated to the two products:

Touring  Mountain 
(6,000 pieces x TZS2 (4,000 pieces x TZS2
Purchasing Materials TZS 12,000 TZS 8,000
per piece) per piece)
(10 setups x TZS2,000 (30 setups x TZS2,000
Machine Setups 20,000 60,000
per setup) per setup)
(200 hours x TZS100 (200 hours x TZS100
Inspections 20,000 20,000
per hour) per hour)
 (1,500 hours x TZS30 (500 hours x TZS30
Running Machine 45,000 15,000
per hour) per hour)
Total Overhead TZS 97,000 TZS 103,000

Now we can compare the overhead allocated to the two product lines using the traditional method and
activity-based costing, as follows:

  Touring bicycles Mountain bicycles

Traditional method TZS 150,000 TZS 50,000

Activity-based costing TZS 97,000 TZS 103,000

Notice how the total overhead for the month of January is the same at TZS200,000 but the amount allocated
to each product is different.
Analysis More overhead is allocated to the lower volume mountain bicycles using activity-based costing. The
mountain bicycles are allocated more overhead per unit primarily because activity-based costing recognizes
the need for more setups for mountain bicycles and for as many inspection hours for the more specialized
mountain bicycles as for the higher volume touring bicycles. By failing to assign costs to all of the activities,
touring bicycles were subsidizing mountain bicycles. Many companies have found themselves in similar
situations. Activity-based costing has revealed that low-volume, specialized products have been the cause of
greater costs than managers had realized.
 
TUTORIAL Question
Roche has recently set up a small business, which manufactures three different types of chair to customer
order. Each type is produced in a single batch per week and dispatched as individual items. The size of the
batch is determined by the weekly customer orders. The three different types of chair are known as the Type
A, the Type B and the Type C. The Type A is a fully leather-upholstered chair and is the most expensive of
the range. The Type B is the middle-of-the-range chair, and has a comfortable leather seat. The cheapest of
the range, the Type C, is purely a wooden chair, but Roche feels it has great potential and hopes it will
provide at least 50% of the sales revenue.
Roche has employed Mr F, an experienced but unqualified accountant, to act as the organization’s
accountant. Mr F has produced figures for the past month, July 2010, which is considered, a normal month in
terms of costs:
Profit statement for July 2010:
Roche hopes to use these figures as the basis for budgets for the next three months. The managers are
pleased to see that the organizational made its first monthly profit, however small it might be. On the other
hand, they are unhappy with Mr F's advice about the loss-making Type C, which is, either to reduce its
production or to increase its price. Roche's managers are concerned because this advice goes against its
marketing strategy. After much discussion Mr F says that he has heard of a newer type of costing system,
known as activity-based costing (ABC), and that he will recalculate the position on this basis. In order to do
this, Mr F has extracted the following information:

The overheads included in July’s profit statement comprised:

Required:
(a) Use the ABC technique to prepare a revised product cost statement for July 2010 such as Mr F might
produce.
(b) Drawing upon the information form Roche to illustrate your answer, explain why the use of ABC provides
an adequate basis for Roche's managers to make decisions on the future production volume and price of the
Type C.