Question

CASE STUDY 4-1: TRADITIONAL versus ABC COSTING

Top-Line Suitcases manufactures three lines of suitcases from basic to deluxe to heavy-duty. The company uses a traditional job-order costing system with manufacturing overhead allocated based on direct labor hours.

The company has been losing market share. Upon analysis, the basic model was overpriced compared to competitors. Competitors were selling basic suitcase for $115, yet this is the cost of the basic suitcase for Top-Line. The company president said “how can our competitors sell for this price? What are we doing wrong?” The new CFO anxiously responded “I think your job-order costing system is outdated and distorting product costs.” The president requested an analysis of alternative product-costing systems.

In her analysis, the CFO compared the traditional job-order costing system with an activity-based costing system. She determined three manufacturing overhead activity cost pools:

Cost Pool                    Cost Driver                                        Product Line Breakdown                               

                                                                                    Basic              Deluxe            Heavy-Duty

Purchasing                  # of purchase orders               48%                  10%                  42%            

Maintenance               # of machine hours                 40%                  12%                  48%

Inspection                   # of inspections                       45%                  10%                  45%

REQUIRED:

1. Calculate the traditional predetermined overhead rate with manufacturing overhead allocated based on direct labor hours.
   1. Calculate the unit cost for each product line using the traditional job-order costing system currently used by Top-Line Suitcases.
2. Calculate the unit cost for each product line using the activity-based costing system.
3. Top-Line Suitcases prices its suitcases at 110% of product cost. Assuming the CFO has decided to keep this formula, determine the target price for each product under both methods, traditional and activity-based systems.  

Assume you are the CFO. Write a memo to the company president explaining your analysis including your recommendation for target pricing.

	Basic Model	Deluxe Model	Heavy Duty Model
Annual Sales (in units)	20,000	1,000	10,000
Selling Price per unit	$120	$215	$280
Product Costs:
Raw Material	$10	$25	$42
Direct Labor ($20/hour)
Manufacturing Overhead
Total Product Costs
Direct Labor Budget (in hours)	10,000 hours	800 hours	10,000 hours
Manufacturing Overhead Budget:
Purchasing	$257,000
Maintenance	$1,780,000
Inspections	$1,915,000
	$3,952,000

Answer 1

Traditional Method
Manufacturing Overhead rate = $3952000 / 20800 = $190 per hour

	Basic	Deluxe	Heavy Duty
Raw Material	$             10.00	$                25.00	$              42.00
Labor	$             10.00	$                16.00	$              20.00
Overhead	$             95.00	$              152.00	$            190.00
Total Cost per unit	$          115.00	$              193.00	$            252.00
Margin	$             11.50	$                19.30	$              25.20
Target Selling Price	$          126.50	$              212.30	$            277.20

Activity Based Costing

	Basic	Deluxe	Heavy Duty
Raw Material	$             10.00	$                25.00	$              42.00
Labor	$             10.00	$                16.00	$              20.00
Overhead	$             84.86	$              430.80	$            182.41
Total Cost per unit	$          104.86	$              471.80	$            244.41
Margin	$             10.49	$                47.18	$              24.44
Target Selling Price	$          115.35	$              518.98	$            268.85

Cost Pool	Basic	Deluxe	Heavy Duty
Purchasing	$        123,360	$              25,700	$         107,940
Maintenance	$        712,000	$            213,600	$         854,400
Inspection	$        861,750	$            191,500	$         861,750
Total Overhead allocated	$    1,697,110	$            430,800	$      1,824,090