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