Question

Villegas Corporation has been using normal costing based on direct labor cost. In an attempt to better understand their costs, they conducted an activity study and identified the following overhead costs and drives for the coming year:

            Overhead Item         Cost Driver           Budgeted Cost            Budgeted Activity Level
            Machine Setup           Number of Setups      $ 20,000                        200
            Inspection              Number of Inspections   $ 130,000                      6,500
            Material Handling     Number of Material Moves $ 80,000                       8,000
            Engineering                     Engineering Hours      $ 50,000                       1,000
            Total                                                                    $ 280,000

The following information was collected on three jobs taht were completed during the year:
                                               Job 101                 Job 102                 Job 103
Direct Materials                    $ 5,000    $ 12,000 $ 8,000
Direct Labor                         $ 2,000                  $ 2,000                    $ 4,000
Units Completed                    100                         50                            200
Number of Setups                    1                           2                               4
Number of Inspections           20                         10                             30
Number of Material Moves     30                         10                             50
Engineering Hours                  10                         50                             10

Budgeted direct labor cost was $100,000 and budgeted direct material cost was $300,000

1) Using normal costing, the cost of Job 103 would be...

2) Using activity based costing, the cost of Job 103 would be...

3) Frank Aquilino, president of Villegas Corporation is concerned that his current system may not have been given them useful cost information and has head that Job 103 was miscosted. He asks "what the heck is going on here?"
With respoect to Job 103, was the job overcosted or undercosted under their current normal costing procedure?
Frank also needs an explanation as to why this is occuring. Specificially, for Job 103, WHY was this inaccurately costed? Explain to Frank what is going on that is causing this?

Show all work.

Answer 1

1) . Cost of job 103 using normal costing method is as follows :-

Particulars	amount
Direct material	8000
Direct labour	4000
Overhead cost (2.80x4000) [wn i]	11200
Total cost	23200

Working note :-

i . Overhead is to be absorbed in the basis of labour cost. Thus, overhead rate per dollar of direct labour cost = 280000/100000= 2.80 per dollar of labour cost.

2) . Cost of job 103 using activity based costing will be as follows :-

Particulars	amount
Direct material	8000
Direct labour	4000
Overheads :
Set up cost (100 [WN ii] ) x4	400
Inspection cost (20 [wn ii] x30)	600
Material handling cost (10 [wn ii] x50)	500
Engineering cost (50 [wn ii ] x10)	500
Total cost	14000

ii Calculation of cost per unit of cost driver

Overhead item	cost driver	budgeted cost	Budgeted activity level	cost per unit of driver
Machine setup	no of setup	20000	200	100
Inspection	no of inspection	130000	6500	20
Material handling	no of material movement	80000	8000	10
Engineering cost	engineering hours	50000	1000	50

3) . As per the ongoing method of charging overhead cost in relation to direct labour cost, cost of job 3 is coming out to be $23200 whereas as per activity based costing total cost of job 3 is coming out to be $14000. Therefore , clearly we can see that cost of job 3 calculated based on ongoing system is overcosted compared to the activity based costing

Now coming to the reason why this is happening, it is because in the ongoing system we are charging all the overhead cost on the basis of a single blanket rate based on direct labour cost irrespective of efforts involved in each overhead cost item we are only considering extent of labour cost involved in the present case total budgeted labour cost is $100000, and labour cost on job 3 is $4000, which is 4% of total labour cost thus 4% of total overhead cost will be charged on job 3 as per Current method. But overhead consider of different heads of exp all requiring different level of efforts . For instance total no. Of setups are 200, whereas no of setup on job 3 is only 4 i.e. 2% of total therefore 2% of overhead concerning setup cost will only attributable to job 3, total inspection is 6500, whereas inspection involved in job 3 is 30 only i.e. only 0?4% of total inspections this only 0.4% of total inspection is attributable to job 3. Material movements is 8000, and that for job 3 is 50 which is 0.625% of total and engineering hours are 1000 and those for job 3 is only 10 thus only 1% of total.

We can see above that proprtion of efforts in job 3 is quite low, whereas it's proportion of total labour cost was more that's why more cost get charged on job 3 as per ongoing method which was wrong.

So, it would be better to apply activity costing method considering the whole discussion .