Activity Based Costing Case

Accounting Information for Decision Makers Ch 5 p 68

For the current year a company has budgeted to produce and sell 50,000 Product A and
200,000 Product B. Both products require two direct labor hours to complete. Therefore,
the company plans to work 500,000 direct labor-hours [(50,000 Product As produced x 2
hours = 100,000) plus (200,000 Product Bs produced x 2 hours = 400,000) equals
500,000]. The company has total manufacturing costs (total overhead costs) of
$10,000,000 to allocate to the two products.
Direct costs are:
Direct materials per unit
Direct labor @ $10/hour per unit

A units
$90.00
20.00

B units
$50.00
20.00

Under standard costing the firm would allocate their $10,000,000 in manufacturing
overhead costs using an estimate of 500,000 labor hours with the pay rate of $10.00 per
labor hour. So each product would be allocated $40.00 in overhead. This $40 per product
is calculated by dividing the total manufacturing overhead cost by the total labor hours to
get the application base rate ($10,000,000 total overhead costs / 500,000 total labor hours
= $20) and then multiplying the pay rate of $10.00 per labor hour by the application base
rate $20.
Product A requires two direct labor hours. Using the application base rate of $20 per
hour, product A would be assigned $40 overhead costs ($20 x 2 direct labor hours) and
product B would be assigned $40 in overhead costs ($20 x 2 direct labor hours).
Direct materials per unit
Direct labor @ $10/hour per unit
Manufacturing overhead @$20.00 per hour
Total Costs

A units
$90.00
20.00
40.00
$ 150.00

B units
$50.00
20.00
40.00
$ 110.00

This indicates that, according to the standard costing method, Product A is more
expensive to manufacture than product B. The organization was suspicious of these
results and decided to use the ABC costing method to provide more relevant information
and to see if this was accurate.
The ABC costing method provided the following information. The departmental
information accumulated by the organization was recatergorized into the following table
using cost drivers it felt best applied to the manufacturing overhead of the two products.
See the following table.

Table 1
Activity Cost Pools (drivers)
Labor related (labor hours)
Machine related (machine hours)
Machine setups (# of setups)
Production orders (# orders)
Material receipts (# of receipts)
Parts admin ( part types)
Product testing (# of tests)
General overhead (machine
hours)
Total

Costs

Expected activity
Total

Cost Driver
Product A

Cost Drivers
Product B

$800,000
$2,100,000
$1,600,000
$450,000
$1,000,000
$350,000
$1,700,000

500,000
1,000,000
4,000
1,200
5,000
700
20,000

100,000
300,000
3,000
400
1,800
400
16,000

400,000
700,000
1,000
800
3,200
300
4,000

$2,000,000

1,000,000

300,000

700,000

$10,000,000

Table 2 Overhead Rate Per Cost

Driver per activity

Estimated
Overhead
Costs

Total
Expected
Activity diver
units

Overhead
Rate per
driver

Activity
Labor related
Machine related
Machine setups
Production orders
Material receipts
Parts administration
Product testing
General Factory

$800,000
$2,100,000
$1,600,000
$450,000
$1,000,000
$350,000
$1,700,000
$2,000,000

Table 3 Total $ Activity overhead

allocation to Product

Product A

Product B

$160,000
$630,000
$1,200,000
$150,000
$360,000
$200,000
$1,360,000
$600,000

$640,000
$1,470,000
$400,000
$300,000
$640,000
$150,000
$340,000
$1,400,000

$4,660,000

$5,340,000

Units of Product produced

50,000

200,000

Overhead per unit of Product

$93.20

$26.70

Labor related
Machine related
Machine setups
Production orders
Material receipts
Parts administration
Product testing
General Factory
Total

Rate x total
dirvers

500,000
1,000,000
4,000
1,200
5,000
700
20,000
1,000,000

$1.60
$2.10
$400.00
$375.00
$200.00
$500.00
$85.00
$2.00

The total manufacturing overhead costs for each product is divided by the total product
units manufactured. For example, for Product A, the total overhead costs of $4,660,000
are divided by the total units of Product A manufactured of 50,000 resulting in $93.20 of
manufacturing costs per unit of Product A. For Product B, the total overhead costs of
$5,340,000 are divided by the total units of Product B manufactured of 200,000 resulting
in $26.70 manufacturing costs per unit of Product B.

Direct materials per unit

Direct labor @ $10/hour per unit
Manufacturing overhead per unit
TOTAL COST PER UNIT

A units
$90.00
20.00
93.20
$ 203.20

B units
$50.00
20.00
26.70
$ 96.70