Question

Activity-based costing, manufacturing. Decorative Doors, Inc., produces two types of doors, interior and exterior. The company’s simple costing system has two direct-cost categories (materials and labor) and one indirect-cost pool. The simple costing system allocates indirect costs on the basis of machine-hours. Recently, the owners of Decorative Doors have been concerned about a decline in the market share for their interior doors, usually their biggest seller. Information related to Decorative Doors production for the most recent year follows: Table shows the information of decorative doors, Inc.’s production for the two types interior, and exterior. The details of production are as follows: Interior Units sold: 3,200 Selling price: $125 Direct material cost per unit: $30 Direct manufacturing labor cost per hour: $16 Direct manufacturing labor-hours per unit: 1.50 Production runs: 40 Material moves: 72 Machine setups: 45 Machine-hours: 5,500 Number of inspections: 250 Exterior Units sold: 1,800 Selling price: $200 Direct material cost per unit: $45 Direct manufacturing labor cost per hour: $16 Direct manufacturing labor-hours per unit: 2.25 Production runs: 85 Material moves: 168 Machine setups: 155 Machine-hours: 4,500 Number of inspections: 150 Interior Exterior Units sold 3,200 1,800 Selling price $ 125 $ 200 Direct material cost per unit $ 30 $ 45 Direct manufacturing labor cost per hour $ 16 $ 16 Direct manufacturing labor-hours per unit 1.50 2.25 Production runs 40 85 Material moves 72 168 Machine setups 45 155 Machine-hours 5,500 4,500 Number of inspections 250 150 The owners have heard of other companies in the industry that are now using an activity-based costing system and are curious how an ABC system would affect their product costing decisions. After analyzing the indirect-cost pool for Decorative Doors, the owners identify six activities as generating indirect costs: production scheduling, material handling, machine setup, assembly, inspection, and marketing. Decorative Doors collected the following data related to the indirect-cost activities: Table shows the cost and driver for various activities. The details of the cost and driver are as follows: Production scheduling Activity Cost: $95,000 Activity Cost Driver: Production runs Material handling Activity Cost: $45,000 Activity Cost Driver: Material moves Machine setup Activity Cost: $25,000 Activity Cost Driver: Machine setups Assembly Activity Cost: $60,000 Activity Cost Driver: Machine-hours Inspection Activity Cost: $8,000 Activity Cost Driver: Number of inspections Activity Activity Cost Activity Cost Driver Production scheduling $95,000 Production runs Material handling $45,000 Material moves Machine setup $25,000 Machine setups Assembly $60,000 Machine-hours Inspection $ 8,000 Number of inspections Marketing costs were determined to be 3% of the sales revenue for each type of door. Required Calculate the cost of an interior door and an exterior door under the existing simple costing system. Calculate the cost of an interior door and an exterior door under an activity-based costing system. Compare the costs of the doors in requirements 1 and 2. Why do the simple and activity-based costing systems differ in the cost of an interior door and an exterior door? How might Decorative Doors, Inc., use the new cost information from its activity-based costing system to address the declining market share for interior doors?

Answer 1

Answer 1:

Interior door:

Direct manufacturing labor cost per hour: $16

Direct manufacturing labor-hours per unit =1.50

Direct manufacturing labor cost per unit = $16 * 1.50 = $24

Exterior door:

Direct manufacturing labor cost per hour = $16

Direct manufacturing labor-hours per unit = 2.25

Direct manufacturing labor cost per hour = $16 * 2.25 = $36

Simple costing system:

Total indirect cost is alloacted based machine hours:

Total Indirect costs:

Total machine hours = 5,500 + 4,500 = 10,000 hours

Indirect cost per machine hour = $255,800 / 10,000 = $25.58

Allocation to Interior door = $25.58 * 5,500 =$140,690

Allocation to Exterior door = $25.58 * 4,500 = $115,110

Cost of an interior door and an exterior door under the existing simple costing system:

Answer 2:

Activity-based costing system:

Calculation of cost per cost driver:

Calculation of cost of an interior door and an exterior door under an activity-based costing system:

Answer 3:

Comparison of cost of an interior door and an exterior door under simple costing system and ABC:

Answer 4:

Cost differs under simple and activity-based costing (ABC) systems since:

Under simple costing system entire indirect cost is allocated based on machine hours. In ABC cost has been pooled at activity level and allocated based on more appropriate basis. Under simple costing system since Interior door production has higher machine hours, higher costs have been allocated whereas under ABC, we observe indirect costs for activities like production scheduling, material handling, machine set up costs allocated to Interior door are lower ( since it is based on more appropriate basis of cause and effect). Costing under ABC is more appropriate and precise compared to simple costing system.

Answer 5:

Interior door is biggest seller Decorative Doors, Inc. The decline in the market share for their interior doors could be because of error in pricing based on wrong costing. With ABC, now observe the cost per unit of interior door is $85.10 (instead of $97.97 under simple costing system), the company should review its pricing based on new costing of product. They should revise the price of interior door downwards to address the declining market share for interior doors.