In: Accounting
Harry operated his own business selling pool equipment, materials and servicing swimming pools. Sales of equipment and materials were paid at the time of sale, however, pool services were carried out by his staff and invoices were left at the customer’s home and were generally paid by the homeowners within 30 days of service. Sales of equipment and materials and receipts for pool services were $930,000. Service calls which had been made during the prior year but paid in the current year were $30,000 (and are included in the $930,000 above) and at 30 June 2020 unpaid pool services totaled $43,000.
Harry also received a dividend of $28,000 franked to 30% with franking credits of $3,600.
On 1 April 2020 Harry won a jackpot of $150,000 in a lottery.
Harry’s opening stock was worth $130,000 (valued using cost price in the previous year). Purchases during the current year were $220,000 and at the end of the current year his stock on hand was worth $110,000 (cost price), $150,000 (market selling value) and $120,000 (replacement price).
Harry started his second outlet in its current premises on 1 August 2019. He took out a loan on that date for $400,000. Harry used his own mortgage broker to find him the best loan and paid the broker $400 to do this. In addition he paid stamp duty of $1,000 on the loan which was to be repaid in 3 years.
Expenses which relate primarily to the business are as follows:
$
Accounting fees 4,200
Bank fees 1,400
Donation to Australian political party 1,000
Electricity (this included $1,500 on his home) 10,000
Interest – the loan was an interest-only loan taken out 8 years ago. Harry used 15% of the loan for renovations to his home 8,000
Interest on new loan taken out on 1 August 2019 15,000
Rent – paid monthly on the first of each month 80,000
Rent – prepaid for 3 years on 1 April 2020 360,000
Stationery 3,300
Superannuation – staff 25,200
Superannuation – self 20,000
Telephone expenses 25,600
Wages - staff 280,000
Wages – family and friends. This included $50,000 to his girlfriend Elise who worked for 3 days a week in the business. Another worker who also did the same job for 3 days a week was only paid $40,000. Other wages to family were in accordance with award rates. 80,000
Notes:
Harry had a carried forward operating loss of $80,000 from the previous year this included a payment for his personal superannuation of $5,000.
Required:
Calculate Harry’s taxable income and net tax payable for the year ended 30 June 2020 including Medicare Levy.
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Managerial Accounting
Chapter 4: Activity-Based Costing
4.2 Activity Based-Costing Method
Traditional Costing method
In a traditional costing method, we calculate one plantwide allocation rate or we could calculate an overhead allocation rate for each department. We have a three step process:
Step 1: Determine the basis for allocating overhead or indirect costs. These can be anything a company decides but most common are direct labor cost, direct labor hours, direct material usage or machine hours.
Step 2: Calculated a predetermined overhead rate using estimates. This is typically calculated at the end of the year to be used during the following year. The formula we use for this is:
Predetermined Overhead Rate (POHR) = | Estimated Overhead |
Estimated Base (or cost driver) |
Step 3: Apply overhead throughout the period using the actual amount of our base and the predetermined overhead rate (POHR) calculated in step 2. We calculate this as:
Applied Overhead = | Actual amount of base x POHR |
This video will discuss the differences between the traditional costing method and activity based costing.
Traditional costing method example
Assume High Challenge Company makes two products, touring bicycles and mountain bicycles. The touring bicycles product line is a high-volume line, while the mountain bicycle is a low-volume, specialized product.
High Challenge Company allocated manufacturing overhead costs to the two products for the month of January. Department A had estimated overhead of $2,000,000 and used 20,000 machine hours. High Challenge has decided to allocate overhead on the basis of machine hours.
Predetermined Overhead Rate (POHR) = | Estimated Overhead | $2,000,000 |
Estimated Base (or cost driver) | 20,000 machine hours |
Touring Bicycle | Mountain Bicycle |
$150,000 | $50,000 |
(1,500 machine hours x $100 per hour) | (500 machine hours x $100 per hour) |
Methods used for activity-based costing
Activity-based costing requires accountants to use the following four steps:
The next section describes these four steps.
Step 1 is often the most interesting and challenging part of the exercise. This step requires people to understand all of the activities required to make the product. Imagine the activities involved in making a simple product like a pizza—ordering, receiving and inspecting materials, making the dough, putting on the ingredients, baking, and so forth. Or imagine the activities involved in making a complex product such as an automobile or computer.
One of the lessons of activity-based costing has been that the more complex the business, the higher the indirect costs. Imagine that each month you produce 100,000 gallons of vanilla ice cream and your friend produces 100,000 gallons of 39 different flavors of ice cream. Further, assume your ice cream is sold only in one liter containers, while your friend sells ice cream in various containers. Your friend has more complicated ordering, storage, product testing (one of the more desirable jobs, nevertheless), and packing in containers. Your friend has more machine setups, too. Presumably, you can set the machinery to one setting to obtain the desired product quality and taste. Your friend has to set the machines each time a new flavor is produced. Although both of you produce the same total volume of ice cream, it is not hard to imagine that your friend’s overhead costs would be considerably higher.
In Step 2, we identify the cost drivers. In the table below, we present several examples of the cost drivers companies use. Most cost drivers are related to either the volume of production or to the complexity of the production or marketing process.
Cost driver | Cost of assigned cost driver |
Miles driven | Automobile costs |
Machine-hours | Electricity to run machines |
Customers served | Overhead in a bank |
Flight hours | Airplane maintenance costs |
Number of customers | Selling costs |
In deciding which cost drivers to use, managers consider these three factors:
For step 3, we need to calculate the activity rates. These are calculated using the same formula for predetermined overhead rate (POHR) that we used for traditional costing. In general, predetermined rates for allocating indirect costs to products are computed as follows:
Predetermined Overhead Rate (POHR) = | Estimated Overhead |
Estimated Base (or cost driver) |
This formula applies to all indirect costs, whether manufacturing overhead, administrative costs, distribution costs, selling costs, or any other indirect cost.
In Step 4, we first define the notion of an activity center. An activity center is a unit of the organization that performs some activity. For example, the costs of setting up machines would be assigned to the activity center that sets up machines. This means that each activity has associated costs. When the cost driver is the number of inspections, for example, the company must keep track of the cost of inspections.
Workers and machines perform activities on each product as it is produced. Accountants allocate costs to products by multiplying each activity’s indirect cost rate by the volume of activity used in making the product. The formula we will use for each activity is:
Applied Overhead = | Actual amount of activity cost driver x activity POHR |
Activity-based costing example
Assume High Challenge Company makes two products, touring bicycles and mountain bicycles. The touring bicycles product line is a high-volume line, while the mountain bicycle is a low-volume, specialized product.
In using activity-based costing, the company identified four activities that were important cost drivers and a cost driver used to allocate overhead. These activities were (1) purchasing materials, (2) setting up machines when a new product was started, (3) inspecting products, and (4) operating machines.
Accountants estimated the overhead and the volume of events for each activity. For example, management estimated the company would purchase 100,000 pieces of materials that would require overhead costs of $200,000 for the year. These overhead costs included salaries of people to purchase, inspect, and store materials. Setting up machines for a new product would need 400 setups and overhead of $800,000. The company would have 4,000 inspections and overhead of $400,000. Finally, running machines would cost $600,000 for 20,000 machine hours.
These estimates were made last year and will be used during all of the current year. In practice, companies most frequently set rates for the entire year, although some set rates for shorter periods, such as a quarter.
Look at the overhead rates computed for the four activities in the table below. Note that the total overhead for current year is $2,000,000 using activity-based costing, just as it was using a traditional costing method. The total amount of overhead should be the same whether using activity-based costing or traditional methods of cost allocation to products. The primary difference between activity-based costing and the traditional allocation methods is the amount of detail; particularly, the number of activities used to assign overhead costs to products. Traditional allocation uses just one activity, such as machine-hours. Activity-based costing used four activities in this case. In practice, companies using activity-based costing generally use more than four activities because more than four activities are important. We used four to keep the illustration as simple as possible.
The activity cost rates (predetermined overhead rates) are calculated as follows:
Activity | Cost Driver (activity) | Overhead Cost | Estimated Units | Rate | |
Purchasing Materials | Pieces of materials | $ 200,000 | 100,000 pieces | $ 2 | per piece |
Machine Setups | Machine setups | 800,000 | 400 setups | 2,000 | per setup |
Inspections | Inspection hours | 400,000 | 4,000 inspect. hours | 100 | per inspect. hour |
Running Machine | Machine hours | 600,000 | 20,000 mach. Hours | 30 | per machine hour |
Total Overhead | $ 2,000,000 |
For January, the High Challenge Company has the following information about the actual number of cost driver units for each of the two products:
Touring | Mountain | |
Purchasing Materials | 6,000 pieces | 4,000 pieces |
Machine Setups | 10 setups | 30 setups |
Inspections | 200 hours | 200 hours |
Running Machine | 1,500 hours | 1,500 hours |
Multiplying the actual activity events for each product times the predetermined rates computed earlier resulted in the overhead allocated to the two products:
Touring | Mountain | |||
Purchasing Materials | $ 12,000 | (6,000 pieces x $2 per piece) | $ 8,000 | (4,000 pieces x $2 per piece) |
Machine Setups | 20,000 | (10 setups x $2,000 per setup) | 60,000 | (30 setups x $2,000 per setup) |
Inspections | 20,000 | (200 hours x $100 per hour) | 20,000 | (200 hours x $100 per hour) |
Running Machine | 45,000 | (1,500 hours x $30 per hour) | 15,000 | (500 hours x $30 per hour) |
Total Overhead | $ 97,000 | $ 103,000 |
Now we can compare the overhead allocated to the two product lines using the traditional method and activity-based costing, as follows:
Touring bicycles | Mountain bicycles | |
Traditional method | $150,000 | $50,000 |
Activity-based costing | 97,000 | 103,000 |
Notice how the total overhead for the month of January is the same at $200,000 but the amount allocated to each product is different.
Analysis More overhead is allocated to the lower volume mountain bicycles using activity-based costing. The mountain bicycles are allocated more overhead per unit primarily because activity-based costing recognizes the need for more setups for mountain bicycles and for as many inspection hours for the more specialized mountain bicycles as for the higher volume touring bicycles. By failing to assign costs to all of the activities, touring bicycles were subsidizing mountain bicycles. Many companies have found themselves in similar situations. Activity-based costing has revealed that low-volume, specialized products have been the cause of greater costs than managers had realized.
Here is a video example of activity based costing:
LICENSES AND ATTRIBUTIONS
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