Question

Pillar Company manufactures a product in three different qualities, called ‘Basic’, ‘Average’ and ‘Super’. The ‘Basic’ and ‘Average’ both requires 2.0 direct labor hours while ‘Super’ requires 2.5 direct labor hours. The company is able to sell these products at a price that gives a standard profit mark-up of 25 % of full manufacturing cost. The company manufactures and sold 90,000 units, 60,000 units and 40,000 units of ‘Basic’, ‘Average’ and ‘Super’ respectively. Management is concerned by the deterioration of profit.

Material and labor costs per unit are as follows:

	Basic	Average	Super
Direct materials	$20.00	$30.00	$40.00
Direct labor (all $8/hour)	$16.00	$16.00	$20.00

The total overheads are $10,000,000. Currently, the company is using direct labor-hour as an allocation base to apply overheads.

Recently, the business management accountant has undertaken an exercise to try to identify activities and cost drivers in an attempt to be able to deal with the overheads on a more precise basis using the activity based costing approach. An analysis has provided the following information:

Activity (and cost driver)	Costs	Annual number of activities
		Total	Basic	Average	Super
Number of machine setups	$3,000,000	5,000	1,000	1,500	2,500
Number of quality inspections	2,000,000	8,000	3,000	1,800	3,200
Number of production orders	1,700,000	1,700	550	470	680
General production (MH)	3,300,000	330,000	110,000	100,000	120,000
Total	$10,000,000

Required:

1. Calculate the predetermined overhead rate using the current basis of allocation and determine the overhead per unit, total cost per unit and the selling price for the three models.

2. Calculate the activity rate, the overhead per unit, the total cost per unit for the three models using the activity based costing approach.

3. What conclusions do you draw based on the above results? What advice would you offer the management of the company?

Answer 1

		Basic	Average	Super	Total
	Units	90,000	60,000	40,000
	Direct Labor Hours	2.00	2.00	2.50
	Direct Labor -Total	180,000	120,000	100,000	400,000
	Total Overheads	10,000,000
	Direct Labor Hours	400,000
	Predetermined OH Rate	25.00
		Basic	Average	Super
	Direct Material	20.00	30.00	40.00
	Direct Labor	16.00	16.00	20.00			Basic	Average	Super
	Overhead(25*DLH PU)	50.00	50.00	62.50			2*25	2*25	2.5*25
	Total Cost	86.00	96.00	122.50
	Standard Margin @ 25%	21.50	24.00	30.63
	Sales Price	107.50	120.00	153.13
								Activity Rate*Activity
			Annual number of activities				Cost/Activity	Annual number of activities
	Activity (and cost driver)	Costs	Total	Basic	Average	Super	Activity Rate	Basic	Average	Super
	Number of machine setups	3,000,000	5,000	1,000	1,500	2,500	600	600,000	900,000	1,500,000
	Number of quality inspections	2,000,000	8,000	3,000	1,800	3,200	250	750,000	450,000	800,000
	Number of production orders	1,700,000	1,700	550	470	680	1,000	550,000	470,000	680,000
	General production (MH)	3,300,000	330,000	110,000	100,000	120,000	10	1,100,000	1,000,000	1,200,000
	Total	10,000,000					Total Costs	3,000,000	2,820,000	4,180,000
							Total Units	90,000	60000	40000
							Overhead Cost PU	33.33	47.00	104.50
		Basic	Average	Super
	Direct Material	20.00	30.00	40.00
	Direct Labor	16.00	16.00	20.00
	Overhead(25*DLH PU)	33.33	47.00	104.50
	Total Cost	69.33	93.00	164.50
	Standard Margin @ 25%	17.33	23.25	41.13
	Sales Price	86.67	116.25	205.63
	ABC Method gives more precise results, since it uses individual allocation activity factors to allocate Overheads
	The company should use ABC method to calculate costs. And then to arrive at Sales Price