Question

Hi-Tek Manufacturing, Inc., makes two types of industrial component parts—the B300 and the T500. An absorption costing income statement for the most recent period is shown:

Hi-Tek Manufacturing Inc. Income Statement
Sales	$	1,704,000
Cost of goods sold		1,222,415
Gross margin		481,585
Selling and administrative expenses		590,000
Net operating loss	$	(108,415	)

Hi-Tek produced and sold 60,000 units of B300 at a price of $20 per unit and 12,600 units of T500 at a price of $40 per unit. The company’s traditional cost system allocates manufacturing overhead to products using a plantwide overhead rate and direct labor dollars as the allocation base. Additional information relating to the company’s two product lines is shown below:

	B300		T500		Total
Direct materials	$	400,200	$	162,800	$	563,000
Direct labor	$	120,500	$	42,600		163,100
Manufacturing overhead						496,315
Cost of goods sold					$	1,222,415

The company has created an activity-based costing system to evaluate the profitability of its products. Hi-Tek’s ABC implementation team concluded that $57,000 and $108,000 of the company’s advertising expenses could be directly traced to B300 and T500, respectively. The remainder of the selling and administrative expenses was organization-sustaining in nature. The ABC team also distributed the company’s manufacturing overhead to four activities as shown below:

	Manufacturing Overhead			Activity
Activity Cost Pool (and Activity Measure)				B300	T500	Total
Machining (machine-hours)	$	207,495		90,800	62,900	153,700
Setups (setup hours)		126,420		71	230	301
Product-sustaining (number of products)		101,800		1	1	2
Other (organization-sustaining costs)		60,600		NA	NA	NA
Total manufacturing overhead cost	$	496,315

Required:

1. Compute the product margins for the B300 and T500 under the company’s traditional costing system.

2. Compute the product margins for B300 and T500 under the activity-based costing system.

3. Prepare a quantitative comparison of the traditional and activity-based cost assignments.

Answer 1

Solution

Hi-Tek Manufacturing Inc

1. Computation of the product margins for the B300 and T500 under the company’s traditional costing system:

B 300 T 500 Total Sales $1,200,000 $504,000 $1,704,000 Direct materials $400,200 $162,800 $563,000 Direct labor $120,500 $42,600 $163,100 Manufacturing overhead $366,683 $129,632 $496,315 Selling and administrative costs $57,000 $108,000 $165,000 Total product costs $944,383 $443,032 $1,387,415 Product margin $255,617 $60,968 $316,585

Working:

Determination of predetermined manufacturing overhead rate using direct labor cost as allocation basis:

Total manufacturing overhead $496,315

Direct labor cost $163,100

Predetermined overhead rate = $496,315/$163,100 = $3.04 per direct labor cost

1. Computation of product margins for B300 and T500 under the activity based costing system:

	B300	T500	Total
Sales	$1,200,000	$504,000	$1,704,000
Direct materials	$400,200	$162,800	$563,000
Direct labor	$120,500	$42,600	$163,100
Manufacturing overhead	$203,300	$232,415	$435,715
Total direct costs	$724,000	$437,815	$1,161,815
Product margin	$476,000	$66,185	$542,185

Activity Rates
Activity cost pools	Total cost	Usage	Activity Rate
Machining	$207,495	153,700 MHs	$1.35 per hour
Setups	$126,420	301 setup hours	$420 per setup
Product Sustaining	$101,800	2 products	$50,900 per product
Overhead Assigned to:
B300	Usage	Activity rate	Total cost
Machining	90,800 MHs	$1.35 per hour	$122,580
Setups	71	$420 per setup hr	$29,820
Product Sustaining	1	50900 per product	$50,900
Total overhead			$203,300
T500	Usage	Activity rate	Total cost
Machining	62,900 MHs	$1.35 per hour	$84,915
Setups	230	$420 per setup hr	$96,600
Product Sustaining	1	50900 per product	$50,900
Total overhead			$232,415

Note: the other activity pool (organization-sustaining costs) does not form part of the product margin statement under activity based costing as the same is not assigned for the products – B300 and T500.

1. Quantitative comparison of the traditional and activity based cost assignments:

Traditional Costing System:	B300	% to total cost	T500		Total
Direct materials	$400,200	71.08%	$162,800	28.92%	$563,000
Direct labor	$120,500	73.88%	$42,600	26.12%	$163,100
Manufacturing overhead	$366,683	73.88%	$129,632	26.12%	$496,315
selling and administration costs	$57,000	34.55%	$108,000	65.45%	$165,000
Total costs assigned to products	$944,383	68.08%	$443,032	31.93%	$1,387,415
other selling and administration costs					$425,000
Total					$1,812,415
Activity based costing:
Direct materials	$400,200	71.08%	$162,800	28.92%	$563,000
Direct labor	$120,500	73.88%	$42,600	26.12%	$163,100
Manufacturing overhead -
machining	$122,580	59.07%	$84,915	40.93%	$207,495
Setups	$29,820	23.59%	$96,600	76.41%	$126,420
product -sustaining	$50,900	50%	$50,900	50%	$101,800
other manufacturing overhead					$60,600
selling and administration costs					$590,000
					$1,812,415

The comparison between traditional costing system and activity based costing system reveals a significant difference in the way the manufacturing overhead is assigned to products. Under the activity based costing approach, the overhead costs are assigned based on usage and hence shows accurate allocation, unlike the predetermined rate based on direct labor costs used under traditional costing method.