Practice 16.

Knickknack Inc. manufactures two products: odds and ends. The firm uses a
single, plantwide overhead rate based on direct-labor hours. Production and
product-costing data are as follows:

Odds Ends
Production quantity 1,000 units 5,000 units
Direct material $40 $60
Direct labor (not including setup 30 (2 hr. at $15) 45 (3 hr. at $15)
time)
Manufacturing overhead* 96 (2 hr. at $48) 144 (3 hr. at $48)
Total cost per unit $166 $249

*Calculation of predetermined overhead rate:

Manufacturing overhead budget:

Machine-

Plant-
$816,000

Predetermined overhead rate:

Budgeted manufacturing overhead = $816,000 = $48 per direct-labor hour

Budgeted direct-labor hours (1,000)(2)+(5,000)(3)

Knickknack, Inc. prices its products at 120 percent of cost, which yields target
prices of $199.20 for odds and $298.80 for ends. Recently, however, Knickknack
has been challenged in the market for ends by a European competitor, Bricabrac
Corporation. A new entrant in this market, Bricabrac, has been selling ends for
$220 each.

Knickknack´s president is puzzled by Bricabrac´s ability to sell ends at such a low

cost. She has asked you (the controller) to look into the matter. You have decided
that Knickknack´s traditional, volume-based product-costing system may be
causing cost distortion between the firm´s two products. Ends are a high-volume,
relatively simple product. Odds, on the other hand, are quite complex and exhibit a
much lower volume. As a result, you have begun work on an activity-based costing
system.
Required:

1. Let each of the overhead categories in the budget represent an activity cost
pool. Categorize each in terms of the type of activity (e.g. unit-level activity).

2. The following cost drivers have been identified for the four activity cost pools.

Activity Cost Pool Cost Driver Budgeted Level of Cost

Driver
Machine-related costs Machine hours 9,000 hr.
Setup and inspection Number of production 40 runs
runs
Engineering Engineering change 100 change orders
orders
Plant-related costs Square footage of space 1,920 sq. ft.

You have gathered the following additional information:

Each odd requires 4 machine hours, whereas each end requires 1 machine
hour.
Odds are manufactured in production runs of 50 units each. Ends are
manufactured in 250 unit batches.
Three-quarters of the engineering activity, as measured in terms of change
orders, is related to odds.
The plant has 1,920 square feet of space, 80 percent of which is used in the
production of odds.

For each activity cost pool, compute a pool rate.

3. Determine the unit cost, for each activity cost pool, for odds and ends.

4. Compute the new product cost per unit for odds and ends, using the ABC
system.

5. Using the same pricing policy as in the past, compute prices for odds and ends.
Use the product costs determined by the ABC system.

6. Show that the ABC system fully assigns the total budgeted manufacturing
overhead costs of $816,000.

7. Show how Knickknack´s traditional, volume-based costing system distorted its

product costs.