Overcosting and Undercosting (Example 1 at the end of these notes)

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1 Chapter 5 Activity-Based Costing Overcosting and Undercosting (Example 1 at the end of these notes) Distortions from inaccurate costing Activities/Resources/Cost Drivers

2 Steps in ABC Identify resources and activities Assign costs to activities Assign costs to cost objects Types of cost-pools and drivers: Unit based (volume) Batch-level Product-sustaining level Facility-sustaining level Comparison of volume-based (POHR) allocation and ABC Example 2 (at the end of these notes) Activity analysis and value-added activities

3 ABC for a service firm ABC for customer profitability analysis Strategic cost management

4 Example 1 Orange networks makes network hubs. They have two types: C (complex) and S (simple). They are the industry leader and have been for years in making hubs like the S hub. But they find that they are not currently price competitive in making these anymore. Their strategy is to mark up their products 30% on full cost which is about as much as the market for this type of product will allow. Here is a summary of their unit manufacturing costs: C S Direct materials $ $90.00 Direct labor $20.00 Overhead Total $ $ Selling prices are, thus set at: $205 for S and $335 for C. The market price for C is $198 and for S is $375. Direct labor is $20 per hour and overhead is applied based upon the rate of $48.89 per DLH. After investigation, they noted that there were two cost pools. There was a volume-based cost pool that totaled $120,000 and a batch-based cost pool that totaled $100,000. There are 2 units of C or 10 units of S in a batch and DLH is still considered an appropriate driver for the volume based cost pool. Orange networks plans to produce 1,000 units of C and 2,500 units of S. What is the appropriate unit cost for each of these products and what is the appropriate selling price to obtain a 30% markup on full cost?

5 Example 2 College Supply Company (CSC) makes three types of drinking glasses: short, medium, and tall. It presently applies overhead using a predetermined overhead rate based on direct labor-hours. A group of company employees recommended that CSC switch to activitybased costing and identified the following activities, cost drivers, estimated costs and estimated cost driver units for Year 5 for each activity center. Activity pool Recommended Cost Driver Estimated Cost Estimated Cost Driver Units Setting up Number of $24, runs production production runs Processing Number of orders 40, orders orders Handling Pounds of materials 16,000 8,000 pounds materials Using machines Machine-hours 48,000 10,000 hours Quality control Number of 40, inspections inspections Packing and Units produced 32,000 20,000 units shipping $200,000 In addition, management estimated 2,000 direct labor-hours for year 5. Assume the following cost driver volumes occurred in February of Year 5: Short Medium Tall Number of units produced 1, Direct materials costs $4,000 $2,500 $2,000 Direct labor-hours Number of orders Number of production runs Pounds of material Machine-hours Number of inspections Units shipped 1, Direct labor costs were $20.00 per hour. 1. Compute the production cost per unit of each product using Direct Labor-Hours to allocate overhead (indirect costs) 2. Compute the production cost per unit of each product using Activity-Based Costing to allocate overhead (indirect costs). 3. Compute Cost of Goods Sold using each method.

6 Example 3 The controller for Wolfe Machining has established the following overhead cost pools and cost drivers: Overhead Cost Pool Budgeted Overhead Cost Cost Driver Budgeted Activity Machine setups $240,000 Number of setups 200 setups Material handling $90,000 Units of raw material 60,000 units Quality control inspections $48,000 Number of inspections 1,200 inspections Other overhead costs $160,000 Machine hours 20,000 machine hours Order no. 715 has the following production requirements: Machine 7 setups: Raw 11,200 material: Inspections: 16 Machine 850 hours: Required: A. Compute the total overhead that should be assigned to order no. 715 by using activitybased costing. B. Suppose that Wolfe were to use a single, predetermined overhead rate based on machine hours. Compute the rate per hour and the total overhead assigned to order no. 715.

5-54 Volume-based Costing Versus ABC

5-54 Volume-based Costing Versus ABC 1. Product A Product B Product C Materials $50.00 $114.40 $65.00 Labor 20.00 12.00 10.00 Overhead* 116.00 69.60 58.00 Total Cost $186.00 $ 196.00 $133.00 *overhead