Question

Problem 6.11 (LO2) Activity-Based Costing Summit Surfboard produces two surfboards. One is a recreational model made from polyurethane foam covered with fiberglass cloth and epoxy resin. The other is a high performance competition board that uses carbon fiber instead of fiberglass. The carbon fiber boards are custom-made and require more hand finishing and setup time.

Most of the company’s sales come from the recreational model, but recently sales of the competition boards have been increasing. The following information is related to the products for the most recent year:

	Recreational	Competition
Sales and production (number of surfboards)	1,500	200
Sales price per board	$    600	$1,200
Unit costs:
Direct materials	175	250
Direct labor	120	300
Overhead*	168	420
Total unit cost	463	970
Gross profit	$    137	$  230
Overhead* costs:
Building depreciation	$ 50,000
Equipment depreciation	60,000
Materials ordering	25,000
Quality control	65,500
Maintenance and security	37,500
Setup and drafting	38,000
Supervision	60,000
Total overhead	$336,000
Overhead rate based on direct labor dollars:
Total overhead	$336,000
Total labor ($120 × 1,500) + ($300 × 200)	$240,000
*Overhead rate = $1.40 per direct labor dollar. ($336,000 ÷ $240,000)

Vikki Mason, the president of Summit, is concerned that the traditional cost system used by Summit may not be providing accurate cost information and that the sales price of the competition surfboard might not be enough to cover its true cost.

Required

1. The traditional system that Summit is using assigns 83 percent of the $336,000 total overhead to the recreational surfboard because 83 percent of the direct labor dollars are spent on the recreational surfboards. Discuss why this might not be an accurate way to assign overhead to surfboards.
2. Discuss how Summit might be able to improve cost allocation by using an ABC system.
3. Assume that Summit retains a consultant to create an activity-based costing system, and the consultant develops the following data:

			Driver Activity
Cost Pool	Amount	Driver	Recreational Boards	Competition Boards
Building	$ 50,000	Square footage	8,000	2,000
Equipment	60,000	Machine hours	4,250	750
Materials ordering	25,000	Number of orders	100	300
Quality control	65,500	Number of inspections	100	400
Maintenance and security	37,500	Square footage	8,000	2,000
Setup and drafting	38,000	Number of setups	50	200
Supervision	60,000	Direct labor cost	$180,000	$60,000
	$336,000

5. Determine the overhead allocation to each line of surfboards using an activity-based costing approach, and compute the total unit costs for each model surfboard. Round to two decimal places.
6. Discuss why activity-based allocations are different from those generated by the traditional allocation method used by Summit.

Answer 1

DETAILS GIVEN IN QUESTION:

COST DETAILS OF 2 PRODUCTS USING TRADITIONAL METHOD OF OVERHEAD ABSORPTION IS GIVEN. COMPANY IS THINKING OF USING ABC METHOD FOR ABSORPTION OF OVERHEADS. ACTIIVTY COST DRIVER DETAILS ARE PROVIDED FOR CALCULATING TOTAL COST UNDER ABC METHOD.

ANSWER:

WHY TRADITIONAL METHOD OF ALLOCATING OVERHEADS ON THE BASIS OF LABOR COST

IS NOT AN ACCURATE METHOD?

ALLOCATING OVERHEADS ON THE BASIS OF LABOR COST IS NOT ACCURATE AS ALL

OVERHEADS ARE NOT BASED ON LABOR COST.

EACH OVERHEAD ACTIVITY HAS DIFFERENT COST POOL WHICH IS CONSUMED BY PRODUCTS

IN DIFFERENT RATIOS.

CURRENTLY, 83% OF OVERHEADS ARE GETTING CHARGED TO RECREATIONAL SURFBOARD.

THIS MAY NOT BE TRUE CONSIDERING THE OVERHEADS INCURRED FOR RECREATIONAL

SURFBOARD. THIS MAY RESULT IN OVER OR UNDER ABSORPTION OF OVERHEADS.

How Summit might be able to improve cost allocation by using an ABC system.

UNDER ABC SYSTEM, OVERHEADS ARE CATEGORISED INTO ACTIVITY. EACH ACTIVITY HAS A COST POOL

(COST DRIVER), AND EACH COST POOL HAS DIFFERENT BASIS. ACTIVITY WISE COST POOL RATES ARE

CALCULATED AND ARE CHARGED TO PRODUCTS BASED ON THE CONSUMPTION OF COST POOLS.

THIS ENSURES THAT THERE IS NO UNDER / OVER ABSORPTION OF OVERHEADS. ABC IS MORE ADVANCED

AND SCIENTIFIC METHOD OF ABSORBING OVERHEADS.

Do Overhead allocation to each line of surfboards using an ABC approach,

and compute the total unit costs for each model surfboard.

COST DRIVER RATES
Cost Pool	Amount $	Driver	Recreational Boards	Competition Boards	TOTAL DRIVER	COST DRIVER RATE
Building	50,000	Square footage	8,000	2,000	10,000	$ 5.00	PER SQ. FT.
Equipment	60,000	Machine hours	4,250	750	5,000	$ 12.00	PER HOUR
Materials ordering	25,000	Number of orders	100	300	400	$ 62.50	PER ORDER
Quality control	65,500	Number of inspections	100	400	500	$ 131.00	PER INSPECTION
Maintenance and security	37,500	Square footage	8,000	2,000	10,000	$ 3.75	PER SQ. FT.
Setup and drafting	38,000	Number of setups	50	200	250	$ 152.00	PER SET UP
Supervision	60,000	Direct labor cost	$180,000	$60,000	240,000	$ 0.25	PER LABOR COST
	336,000

ACTIVITY	Recreational Boards	Competition Boards	TOTAL
Building @ $5 PER SQ.FT.	$ 40,000.00	$ 10,000.00	$          50,000.00
Equipment @ $ 12 PER HOUR	$ 51,000.00	$ 9,000.00	$          60,000.00
Materials ordering @ $ 62.50 PER ORDER	$ 6,250.00	$ 18,750.00	$          25,000.00
Quality control @ $ 131 PER INSPECTION	$ 13,100.00	$ 52,400.00	$          65,500.00
Maintenance and security @ $ 3.75 PER SQ. FT.	$ 30,000.00	$ 7,500.00	$          37,500.00
Setup and drafting @ $ 152 PER SET UP	$ 7,600.00	$ 30,400.00	$          38,000.00
Supervision @ $ 0.25 PER LABOR COST	$ 45,000.00	$ 15,000.00	$          60,000.00
TOTAL (A)	$ 192,950.00	$ 143,050.00	$        336,000.00
NO. OF UNITS (B)	1500	200
OVERHEAD COST PER UNIT (A / B)	$ 128.63	$ 715.25

TOTAL UNIT COST
PARTICULARS	Recreational Boards	Competition Boards
DIRECT MATERIAL	175.00	250.00
DIRECT LABOR	120.00	300.00
OVER HEADS	128.63	715.25
TOTAL	$ 423.63	$  1,265.25

Why activity-based allocations are different from those generated by the traditional allocation method?

UNDER ABC METHOD, EACH ACTIVITY HAS A DIFFERENT COST DRIVER. HENCE, ACTIVITY WISE COST DRIVER RATES ARE USED FOR CHARGING OVERHEADS TO PRODUCTS. WHEREAS, UNDER TRADITIONAL METHOD, ALL THE OVERHEADS ARE ABSORBED USING SINGLE RATE

i.e. LABOR COST BASIS IN THE GIVEN CASE. HENCE,ABC ALLOCATIONS ARE DIFFERENT FROM TRADITIONAL METHOD.