Question

Plymouth Test Laboratories does heat testing​ (HT) and stress testing​ (ST) on materials and operates at capacity. Under its current simple costing​ system, Plymouth aggregates all operating costs of $1,200,000

into a single overhead cost pool. Plymouth calculates a rate per​ test-hour of $ 16($1,200,000 / 75,000

total​ test-hours). HT uses 50,000 test-hours, and ST uses 25,000 test-hours. Gary Lawler Plymouth​'s

​controller, believes that there is enough variation in test procedures and cost structures to establish separate costing and billing rates for HT and ST. The market for test services is becoming competitive. Without this​ information, any miscosting and mispricing of its services could cause Plymouth to lose business. Lawler divides Plymouth​'s costs into four​ activity-cost categories.

a.	​Direct-labor costs, $225,000. These costs can be directly traced to​ HT, $175,000​, and​ST, $50,000.
b.	​Equipment-related costs​ (rent, maintenance,​ energy, and so​ on), $375,000. These costs are allocated to HT and ST on the basis of​ test-hours.
c.	Setup​ costs, $360,000. These costs are allocated to HT and ST on the basis of the number of​ setup-hours required. HT requires 10,000 setup-hours, and ST requires 5,000 setup-hours.
d.	Costs of designing​ tests, $240,000. These costs are allocated to HT and ST on the basis of the time required to design the tests. HT requires 2,500 hours, and ST requires 1,500 hours.
1.	Classify each activity cost as output​ unit-level, batch-level,​ product- or​service-sustaining, or​ facility-sustaining. Explain each answer.
2.	Calculate the cost per​ test-hour for HT and ST. Explain briefly the reasons why these numbers differ from the $16 per​ test-hour that Plymouth calculated using its simple costing system.
3.	Explain the accuracy of the product costs calculated using the simple costing system and the ABC system. How might Plymouth​'s management use the cost hierarchy and ABC information to better manage its​ business?

Answer 1

Part 1 - Classification of each activity cost

Cost Item	Cost type	Explanation of Cost type
Direct labour cost	Output unit level	Related to number of unit tested
Equipment related cost	Output unit level	Related to number of unit tested
Setup cost	Batch Level	Related to group of unit of service
Designing cost	Service sustaining	Cost used to support individual service.

Other cost type:-

a) Facility Sustaining = Cost used to support company as a whole and cant be used to support individual service

Part 2 - Calculation of cost per test hour

Particulars	Heat Test (HT)	Stress Test (ST)
Direct Labour	$175000	$50000
Equipment related cost (in ratio of test hours) (50000:25000) i.e. 2:1	$250000 ($375000*2/3)	$125000 ($375000*1/3)
Setup cost (in ratio of setup hours 10000:5000) i.e. 2:1	$240000 ($360000*2/3)	$120000 ($360000*1/3)
Design cost (in ratio of design time i.e. 2500:1500)	$150000 ($240000*2500/4000)	$90000 ($240000*1500/4000)
Total Cost allocated	$815000	$385000
Test Hours Required	50000 hour	25000 hour
Cost per Test Hour	$16.3	$15.4

Explanation :

Cost calculated using simple costing system and ABC system always differ since ABC system distributes the cost to activity cost pools and then to products and services but simple costing system is volume based costing system and it distributes the cost to departments and then to products and services. Simple costing system uses a single overhead rate to distribute the whole cost and activity based system uses the activity cost pools to allocate the cost

Part 3 - ABC system produces more accurate cost. Since ABC system identifies appropriate activity cost pools for each cost item and also better uses the resources for the both products.

By this ABC system better use the cost hierarchy and utilise the fact that at which point cost may vary.

Hence ABC system can be used to better manage the business since by adopting this method, a much better pricing and product mix decisions can be made.