Question

Problem: ABC vs Traditional Chap 5
Domino Labs is a freestanding facility that conducts two kinds of tests for nearby physician practices. Test 1 is ordered in large volumes and can be processed in large batches. Test 2 is ordered in much smaller quantities and is processed in smaller batches. In addition, to ensure quality for test 2, Domino must purchase the necessary reagents in small quantities.
Domino has a single facility where it conducts all its tests. Its major direct cost is labor, although each test also requires small amounts of reagents. However, there is a substantial amount of overhead in the lab’s purchasing and material-handling activities. Many of these activities are highly automated, especially material handling. The expected direct costs for a single test of each type are as follows:

Test 1 Test 2
Direct material $0.50 $1.00
Direct labor $3.00 $3.00
Other direct costs $1.00 $1.00

Domino’s budget for the upcoming year includes overhead of $1.32 million, which currently is attached to each test on the basis of machine hours. However, Domino’s controller believes that this approach may be providing misleading information. She has developed the following analysis of the budgeted overhead costs:

Activity Cost Driver Number Cost
Purchasing Purchase order (POs) 1,200 POs $600,000
Material handling Batches 1,800 batches $720,000
TOTAL OVERHEAD COSTS $1,320,000

Budget data for producing the two tests throughout the upcoming year are as follows:
Test 1 Test 2 Total
Tests conducted 800,000 200,000 1,000,000
Machine hours 400,000 100,000 500,000
Purchase orders 400 800 1,200
Batches 500 1,300 1,800

Using these data and the table that follows, determine the cost of one test each type, first using the traditional approach of absorbing overhead based on machine hours, and then using an ABC approach.

Traditional Approach ABC Approach
Test 1 Test 2 Test 1 Test 2
Direct Material $0.50 $1.00 $0.50 $1.00
Direct labor 3.00 3.00 3.00 3.00
Other direct 1.00 1.00 1.00 1.00
Overhead ?_______ ?_______ ?_______ ?______
TOTAL

What accounts for the difference?

Answer 1

Traditonal method of overhead allocation
overhead	1320000
total machine hour	500000
overhead rate per machine hour	1320000/50000	26.4
total Overhead for test 1	400000*2.64	1056000
Overhead rate for test 1	1056000/800000	1.32
total Overhead for test 2	100000*2.64	264000
Overhead rate for test 1	264000/200000	1.32
overhead allocation under ABC costing
activity	cost driver	budgeted units	total cost	unit cost
purchasing	purchase order	1200	600000	500	per purchase order
material handling	batches	1800	720000	400	per batch
	test 1	test 2	total test 1	total test 2	total purchase cost of test 1 = (purchase order*per order cost)   total material handling cost = no of batches*cost per batch	total overhead cost = total purchase cost of test 2 = (purchase order*per order cost)   total material handling cost = no of batches*cost per batch	overhead cost per test = total purchase cost test 1/ no of test & total material handling cost test 1/ no of test 1	overhead cost per test = total purchase cost test 2/ no of test     &    total material handling cost test 2/ no of test 2
purchase order	400	800	800000	200000	200000	400000	0.25	2
batches	500	1300	800000	200000	200000	520000	0.25	2.6
total							0.5	4.6
	traditional basis			ABC method
	test 1	test 2		Test 1	test 2
direct material	0.5	1		0.5	1
direct labor	3	3		3	3
direct expense	1	1		1	1
overhead	1.32	1.32		0.5	4.6
total product cost	5.82	6.32		5	9.6
difference is due to the fact that test 1 was absorbing more of overheads which were associated with test 2 while in ABC costing more overheads are charged to test 2 because more purchase orders and batches are required by test 2