Question

Corbett Company develops software. The market is very competitive and Corbett's competitors continue to introduce new products at low prices. Corbett offers a wide variety of software - from simple programs to extremely complex programs. Like most software companies Corbett's raw materials costs are insignificant. You have recently been hired by Corbett as a business analyst and attended a seminar on Activity-Based Costing (ABC) and are considering using it at Corbett. Working with the Software Department Manager you identigy the following activities, related costs, and cost-allocation bases.

Activity Estimated indirect acitivity costs Allocation base estimated quantity of allocation base

Applications development $1,800,000 New applications 6 new applications

Content production 2,800,000 Lines of code 14 million lines

Testing 248,000 Testing hours 1,600 testing hours

Total indirect costs 4,848,000   

Corbett is planning to develop the following new applications

1) X-Page

2) X-Secure

X-page requires 680,000 lines of code and 90 hours of testing, while x-secure requires 10.2 million lines of code and 540 hours of testing. Corbett expects to produce and sell 20,000 units of x-page and 8 units of x-secure.

1) Compute the cost allocation rate for each activity.

2) Use the ABC allocation rates to compute the indirect cost of each unit of x-page and x-secure.

3) The company's original single-allocation based cost system allocated indirect costs to products at $113 per programmer hour. x-page requires 8,000 programmer hours while x-secure requires 12,000 programmer hours. Compute the total indirect costs allocated to x-page and x-secure under the original system. Compute the indirect cost per unit for each product.

4) Write a memo to the General Manager of Corbett Company comparing the ABC costs per unit to the costs from the simpler original system. Explain why the unit costs changed and whether you think the new ABC system is likely to pass the cost-benefit test.

Answer 1

Solution 1:

Computation of cost allocation rate of each activity
Activity	Allocation Base	Estimated Qty of allocation base	Estimated indirect activity cost	Allocation rate (Estimated indiect cost / esitmated qty of allocation base)
Application devlopment	New Applications	6	$1,800,000.00	$300,000.00
Content Production	Lines of Code	14000000	$2,800,000.00	$0.20
Testing	Testing hours	1600	$248,000.00	$155.00

Solution 2:

Computation of indirect cost of application basis ABC
Particulars	X - Page	X - Secure
Nos Application development	1	1
Allocation rate for application development	$300,000.00	$300,000.00
Indirect application development cost (A)	$300,000.00	$300,000.00
Required lines of code	680000	10200000
Allocation rate for content production	$0.20	$0.20
Indirect content production cost (B)	$136,000.00	$2,040,000.00
Testing hours	90	540
Allocation rate for testing cost	$155.00	$155.00
Indirect Testing Cost ( C )	$13,950.00	$83,700.00
Total Indirect Cost (A+B+C)	$449,950.00	$2,423,700.00
Nos of units	20000	8
Indirect Cost per unit (Total indirect cost / Nos of units)	$22.50	$302,962.50

Solution 3:

Computation of indirect cost of application basis single allocation based on programme hours
Particulars	X - Page	X - Secure
Number of programmer hours	8000	12000
Allocation rate per program hour	$113.00	$113.00
Total indirect cost	$904,000.00	$1,356,000.00
Nos of units	20000	8
Indirect cost per unit	$45.20	$169,500.00

Solution 4:

Under ABC system of cost allocation, indirect cost per unit fo X page is $22.50 and in original cost system, indirect cost per unit is $45.20. For X-secure, indirect cost per unit under ABC system is $302962.50, while as per original cost system, indirect cost per unit is $169,500. The unit cost is changed in ABC system, because under ABC, every activity cost is allocated to product on the basis of activity usage to total usage of that particular activity. While in original cost system, total indirect cost is allocated to products on the basis of single predetermined rate that can be direct labor hours, machine hours or programmer hours. Therefore in original system, it does not represent true picture of unit cost as may be predetermined activity usage may not vary in product as much, that varies in individual activity wise. Therefore ABC cost allocation is represent the true cost of product on the basis of efforts undertaken in each acitivty is included in the cost.