Question

Part 6 – Activity Based Cost

A company reports the following information about its indirect costs:

1.   Total indirect costs of $3,000,000 for the next year.
2.   There two products: Product A and Product B.
3.   Direct labour hours for Product A is 40,000 and Product B is 60,000
4.   The company’s accountant has suggested an alternative to the traditional allocation of indirect overhead based on direct labour hours. The accountant suggested the following:
a.   Indirect costs can be broken down into supervisory wages $500,000, machine set up $250,000, machinery operating costs including depreciation $1,250,000, engineering changes $500,000, quality inspection costs $250,000, shipping costs $250,0000.
b.   Activity drivers are supervisory wages (direct labour hours), machine set up (2,500 set up hours), machinery operating (12,500 machine hours), engineering changes (2,500 engineering hours), inspection (2,500 inspection hours), shipping (5,000 shipments)

Driver   Product A   Product B
DLH   40,000   60,000
Machine set up   750   1,750
Machine operating   3,500   9.000
Engineering changes   1,000   1,500
Inspections   500   2,000
Shipping Units   1,500   3,500

  
Questions:

A.   Under the traditional allocation method, what is the amount of indirect cost allocated to Product A and Product B?
____________________________________________________________
B.   Under the Activity Based Accounting (ACB) method, what is the amount of indirect cost allocated to Product A and Product B?
____________________________________________________________
C.   Would the ABC method add value to the company, Yes or No and Why or Why Not?
____________________________________________________________
D.   The accountant alternatively suggested a “standard costing system” for indirect costs. This would be a set / fixed amount for the year for each unit of Product A or Product B shipped. What is the standard cost per unit for Product A and Product B assuming a traditional cost allocation approach?
____________________________________________________________

Answer 1

A. Indirect Cost Allocation Using Traditional Costing Method:-

Particulars	Allocation	Product A	Product B	Total
Supervisory Costs($)	A= $500000/100000 *40000 B=$500000/100000*60000	200000	300000	500000
Machine Set up($)	A=$250000/100000*40000 B=$250000/100000*60000	100000	150000	250000
Machinery operating Costs-Depreciation($)	A=$1250000/100000*40000 B=$1250000/100000*60000	500000	750000	1250000
Engineering Costs ($)	A=$500000/100000*40000 B=$500000/100000*60000	200000	300000	500000
Quality Inspection Costs($)	A=$250000/100000*40000 B=$250000/100000*60000	100000	150000	250000
Shipping Costs($)	A=$250000/100000*40000 B=$250000/100000*60000	100000	150000	250000
Total Indirect Costs($)		1200000	1800000	3000000

B. Indirect Cost Allocation Using Activity Based Costing:-

Particulars	Cost Driver	Costs	Product A	Product B
Supervisory Costs($)	Labour Hours 40000:60000	500000	500000/100000 *40000 =200000	500000/100000 *60000 =300000
Machine Set up($)	Machine Set up 750:1750	250000	250000/2500*750 =75000	250000/2500*1750 =175000
Machinery operating Costs-Depreciation($)	Machine Operating 3500:9000	1250000	1250000/12500 *3500 =350000	1250000/12500 *9000 =900000
Engineering Costs ($)	Engineering Changes 1000:1500	500000	500000/2500 *1000 200000	500000/2500 *1500 =300000
Quality Inspection Costs($)	Inspections 500:2000	250000	250000/2500*500 =50000	250000/2500*2000 =200000
Shipping Costs($)	Shipping Units 1500:3500	250000	250000/5000*1500 =75000	250000/5000*3500 175000
Total Indirect Costs		3000000	950000	2050000

C.

Yes,

ABC Costing provides a more accurate method of product/service costing, leading to more accurate pricing decisions. It increases understanding of overheads, activity drivers and makes costly and non-value added activities more visible, allowing managers to reduce or eliminate them. ABC analysis enables effective challenge of operating costs to find better way of allocating & eliminating overheads.

It also enables improved product and customer profitability analysis. It supporst performance management techniques such as continuous improvements and scorecards.

D

Since there is no information about the units produced during the year in the question, we will calculate standard cost per labour hour because whole calculations are based upon the labour hours. The total indirect costs for the year is $3000000 and as per Traditional Costing Method, all expenses are to be charged at direct labour hours. Thus. the indirect costs of $3000000 will be allocated based on direct labour hours of 100000

Standard Rate for Allocation will be :- $3000000/100000 hours = $30 per hour