Question

10) ABC: Comparison to traditional costing

Palms Surf manufactures surfboards. The company produces two models: the starter board and the pro board. Data regarding the two boards are as follows:

Product	Direct Labour hours per unit	Annual Production	Total direct labour hours
Pro	2.5	10000 boards	25000
Starter	1.5	30000 boards	45000

The pro board requires $85 in direct materials per unit, whereas the started board requires $50. The company pays an average direct labour rate $14 per hour. The company has historically used direct labour hours as the activity base for applying overhead to the boards. Manufacturing overhead is estimated to be $1,664,000 per year. The pro board is more complex to manufacture than the starter board because it requires more machine time.

Gabriel, the company’s controller, is considering the use of activity-based costing to apply overhead because the surfboards require such different amounts of machining Gabriel has identified the following four separate activity centres.

Volume of annual activity
Activity Centre	Cost Driver	Traceable costs	Pro Board	Starter board
Machine set up	Number of set-ups	$100, 000	100	100
Special design	Design hours	$364,000	900	100
Production	Direct labour hours	$900,000	10000	30000
Machining	Machine hours	$300,000	9000	1000

a) Calculate the overhead rate based on traditional overhead allocation with direct labour hours as the base.

b) Determine the total cost to produce one unit of each product (use the overhead rate calculated in question a.)

c) Calculate the overhead rate for each activity centre based on activity- based costing techniques

d) Determine the total cost to produce one unit of each product. Use the overhead rates calculated in question c)

e) Explain why overhead cost shifted from the high- volume product to the low- volume product under the activity-based costing.

Answer 1

Part A

Overhead rate = total estimated manufacturing overhead / total direct labor hours = 1664000/(25000+45000) = 23.77 per direct labor hour

part B

	Pro	Starter
Direct materials	85	50
Direct labor (2.5*14); (1.5*14)	35	21
Overhead (2.5*23.77); (1.5*23.77)	59.43	35.66
Unit product cost	$179.43	$106.66

Part C

Activity Centre	Traceable costs	Cost Driver	Activity rate	Cost allocation to Pro	Cost allocation to Starter
Machine set up	100000	200 setups	5000 per set up	50000	50000
Special design	364000	1000 design hours	364 per design hour	327600	36400
Production	900000	40000 labor hours	22.5 per direct labor hour	225000	675000
machining	300000	10000 machine hours	30 per machine hour	270000	30000
Total overhead costs				872600	791400
Units produced				10000	30000
Overhead cost per unit				$87.26	$26.38

Part D

	Pro	Starter
Direct materials	85	50
Direct labor (2.5*14); (1.5*14)	35	21
Overhead	87.26	26.38
Unit product cost	$207.26	$97.38

Part E

In activity-based costing method, the manufacturing overhead costs often shift from high-volume to low-volume products because in this method, unlike traditional costing system, the overhead costs are allocated to products according activity usage. In traditional costing method, batch-level and product-level costs are allocated on the basis of one single volume-related allocation bases. Due to this low-volume products being under-cost and high-volume products being over-cost.