Question

Hard Drive Corporation (HDC) manufactures three types of disk drives, designated as Galaxy, Classic and Trendy for the computer industry. The company has been using a traditional, volume- based product costing system that allocates manufacturing overhead costs based on direct labour dollars. The average direct labour rate is $15 per hour.

Data relevant to the three products are as follows:

	Gallery Model	Classic Model	Trendy Model
Annual sales (units)	5,000	18,000	10,000
Actual current selling price per unit	$ 150.00	$ 234.00	$ 180.00
Raw material costs per unit	$ 18.00	$ 54.00	$ 36.00
Direct labour hour per unit	0.5	0.8	1.0

Manufacturing overhead budget (based on budgeted annual sales):
Machine setup	$ 6,500
Machinery	1,315,000
Inspection	625,000
Material handling	875,000
Engineering	204,750
Total	$ 3,026,250

HDC’s pricing method has been to set a target price equal to 150% of full product cost. However, only the Classic model has been selling at its target selling price. HDC has been forced to lower the price of the Trendy model in order to get orders. In contrast, HDC has raised the price of the Galaxy model several times, but there has been no apparent loss of sales. HDC has been under increasing pressure to reduce the price even further on its Trendy model. In contrast, HDC’scompetitors do not seem interested in the market for its Galaxy model. HDC apparently has this market to itself.

Required: (Show all your workings/ calculations for your answers.)

1. Show how HDC’s predetermined overhead rate of $7.50 per direct labour dollar (or 750% of direct labour cost) was calculated. (2.5 marks)

2. Compute the product cost per unit for each of the three models based on the traditional method of allocating manufacturing overhead costs based on direct labour dollars.

3. Of the three models, which is the most profitable (in term of gross profit per unit)? Explain.

4. HDC’s controller, Patricia Chan, recently attended a conference at which activity-based costing systems were discussed. She became convinced that such a system would help HDC’s management to understand its product costs better. She got top management’s approval to design an activity-based costing system, and an ABC project team was formed. In stage one of the ABC project, each of the overhead items listed in the overhead budget was placed into its own activity cost pool. Then a cost driver was identified for each activity cost pool. Finally, the ABC project team compiled data showing the percentage of each cost driver that was consumed by each of HDC’s product lines. These data are summarized as follows:

Activity Cost Pool	Cost Driver	Galaxy Model	Classic Model	Trendy Model
Machine setup	Number of setups	55%	10%	35%
Machinery	Machine hours	25%	50%	25%
Inspection	Number of inspections	30%	55%	15%
Material handling	Raw material costs	6%	69%	25%
Engineering	Number of change orders	50%	30%	20%

4(i) Compute the product cost and target price per unit for each of the three models, based on an activity-based costing system and using the new data collected by the controller. Round off to the nearest cent. (8.5 marks)

4(II) By how much is the Galaxy model under-costed or over-costed under the current traditional costing system? Explain the reason for the difference in Galaxy’s product costs.

4(iii) Assume that you are HDC’s controller, Patricia Chan. Write a memo to the CEO, Patrick Tan, to report your findings/ analysis on both the traditional, volume-based and activity-based costing system. You are to include the options available to the management as well as your recommendations in the memo. You can also comment on the situation HDC faced regarding the market for its products and the actions of its competitors.

Answer 1

1. Total direct labor hours = 5,000 units x 0.5 hours + 18,000 units x 0.8 hours + 10,000 units x 1.0 hours = 26,900 hours

Direct labor cost = 26,900 hours x $ 15 per hour = $ 403,500

Predetermined overhead rate = Budgeted Total Overhead / Budgeted Total Direct Labor Cost = $ 3,026,250 / $ 403,500 = $ 7.50 per direct labor dollar.

2. Product cost per unit: Traditional method:

	Gallery Model	Classic Model	Trendy Model
Raw material cost per unit	$ 18.00	$ 54.00	$ 36.00
Direct labor cost per unit	7.50	12.00	15.00
Overhead cost per unit	56.25	90.00	112.50
Product cost per unit	$ 81.75	$ 156.00	$ 163.50

3. Of the three models, the Classic Model seems to be most profitable.

	Gallery Model	Classic Model	Trendy Model
Selling price per unit	$ 150.00	$ 234.00	$ 180.00
Product cost per unit	81.75	156.00	163.50
Gross profit per unit	$ 68.25	$ 78.00	$ 16.50

4.i.

	Gallery Model	Classic Model	Trendy Model
Machine Setup	$ 3,575	$ 650	$ 2,275
Machinery	328,750	657,500	328,750
Inspection	187,500	343,750	93,750
Material Handling	52,500	603,750	218,750
Engineering	102,375	61,425	40,950
Total Overhead	$ 674,700	$ 1,667,075	$ 684,475
Number of units	5,000	18,000	10,000
Overhead cost per unit	$ 134.94	$ 92.62	$ 68.45

	Gallery Model	Classic Model	Trendy Model
Raw material cost per unit	$ 18.00	$ 54.00	$ 36.00
Direct labor cost per unit	7.50	12.00	15.00
Overhead cost per unit	134.94	92.62	68.45
Product cost per unit	$ 160.44	$ 158.62	$ 119.45
Target price per unit	$ 240.66	$ 237.93	$ 179.18

4.ii.

Cost of Galaxy Model under Traditional Costing	$ 81.75
Cost of Galaxy Model under ABC	$ 160.44
Undercosting per unit under the traditional method	$ 78.69

Under the traditional method, overhead cost allocation is done using direct labor cost. As the number of direct labor hours consumed by the Galaxy Model is the lowest of the three lines, its direct labor cost too was much lower, and accordingly, the amount of overhead allocated to the Galaxy Model was the lowest.

However, on applying ABC, it is found that in spite of the lower number of units produced and sold for the Galaxy Model, it makes a healthy consumption of the five main activities which are the cost drivers for overhead allocation under activity based costing. Therefore, under ABC, the amount allocated to the Galaxy Model is much higher. 5,000 units of the model have consumed $ 674,700 of total overhead cost. That is the reason why the overhead cost per unit under ABC is the highest among the three models, leading to a high product cost per unit.

4.iii. We have computed the full cost for all the three of our models under both traditional and activity based costing, and compared the same. There are very minor differences for the Classic Model and the Trendy Model.However, a huge discrepancy has been revealed for the Galaxy Model. It seems that we have been undercosting the Galaxy Model by a whopping $ 78.69, and have been losing hugely in that line. We have priced the Galaxy Model at only $ 150, which is less than its full cost of $ 160.44.If we continue to follow our policy of selling at 150% of full cost, the selling price of the Galaxy Model should not be less than $ 240.66.