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Assign overhead using traditional costing and ABC. (LO 1, 2), AN EcoFabrics has budgeted overhead costs...

Assign overhead using traditional costing and ABC. (LO 1, 2), AN EcoFabrics has budgeted overhead costs of $945,000. It has assigned overhead on a plantwide basis to its two products (wool and cotton) using direct labor hours which are estimated to be 450,000 for the current year. The company has decided to experiment with activity-based costing and has created two activity cost pools and related activity cost drivers. These two cost pools are cutting (cost driver is machine hours) and design (cost driver is number of setups). Overhead allocated to the cutting cost pool is $360,000, and $585,000 is allocated to the design cost pool. Additional information related to these pools is as follows.

Wool Cotton Total

Machine hours 100,000 100,000 200,000

Number of setups 1,000 500 1,500

Instructions a. Determine the amount of overhead assigned to the wool product line and the cotton product line using activity-based costing.

b. What amount of overhead would be assigned to the wool and cotton product lines using the traditional approach, assuming direct labor hours were incurred evenly between the wool and cotton? How does this compare with the amount assigned using ABC in part a?

Solutions

Expert Solution

Answer (a)

Allocation of Overheads under Activity Based Costing

Statement of Cost Pool under ABC Costing

Cost Pool	Amount	Cost Driver	Quantity	Cost Per Driver
Cutting	$ 360,000	Machine Hours	2,00,000	$ 1.80
Design	$ 585,000	Number of Setups	1,500	$ 390

Statement of overhead Cost

Particulars	Wool	Cotton	Total
Machine Hours	1,00,000	1,00,000	2,00,000
Cost per machine hour	$ 1.80	$ 1.80
Cutting overheads (a)	$ 1,80,000	$ 1,80,000	$ 3,60,000
Number of Setups	1,000	500	1,500
Cost per setup	$ 390	$ 390
Designing Overheads (b)	$ 3,90,000	$ 1,95,000	$ 5,85,000
Total Overheads (a) + (b)	$ 5,70,000	$ 3,75,000	$ 9,45,000

Notes:

Cutting overheads = Machine hours X Cost per machine hour
Designing overheads = Cost per Setup X Number of Setups

Answer (b)

Calculation of overheads cost using Traditional Costing

For allocation of overheads under traditional costing, a single plantwide rate of overhead allocation will be used.

Single Plantwide rate = (Total Budgeted Overheads)/ (Total Budgeted Direct labour hours)

= $ 945,000/450,000 direct labour hours

= $ 2.10 per direct labour hour.

Since direct labour hours occur evenly between “Wool” and “Cotton”, out of the total direct labour hours of 450,000, each consume 225,000 direct labour hours.

Allocation of overheads to Wool (Under traditional costing)

Overhead allocated to Wool = (overhead cost per direct labour hour) X (Direct Labour hours consumed)

= $ 2.10 X 225,000 direct labour hours

= $ 4,72,500

Allocation of overheads to Cotton (Under traditional costing)

Overhead allocated to Cotton= (overhead cost per direct labour hour) X (Direct Labour hours consumed)

= $ 2.10 X 225,000 direct labour hours

= $ 4,72,500

Allocation of overheads under Activity Based Costing vis-a-vis Traditional Costing

Method of Allocation of Overheads	Wool	Cotton	Total
Overheads allocated under ABC	$ 5,70,000	$ 3,75,000	$ 9,45,000
Overheads allocated under traditional costing	$ 4,72,500	$ 4,72,500	$ 9,45,000

Conclusion: Activity Based Costing (ABC) is a latest method wherein overheads are allocated on the basis of activity consumed by each product. It is comparatively fairer than the traditional method of overhead cost allocation and results in justified cost determination and consequently profit of each product.

In the given question, burden of a share of overheads pertinent to “Wool” is borne by “Cotton” under traditional costing which will increase the cost per unit of “Cotton” and will not be a true measure of its profitability. On the contrary, under ABC overheads allocated to each product is based on its activity consumption and results in fair allocation. Since the number of setups for “Wool” is twice that of “Cotton”, double Setup overheads cost is allocated to “Wool” (i.e. $ 390,000) in comparison to “Cotton” (i.e. $ 195,000).

ekkarill92 answered 1 year ago

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