Question

Ramsey Company produces speakers (Model A and Model B). Ramsey’s controller, Mr. Jacks, is evaluating the different methods of allocating manufacturing overhead to the products. Both products pass through two producing departments. Model A’s production is much more labor-intensive than that of Model B. Model B is also more popular of the two speakers. The following data have been gathered for the two products.

		Product Data
		Model A		Model B
Units produced & sold per year		20,000		200,000
Sales Revenue		$600,000.00		$6,000,000.00
Prime cost		$100,000.00		$1,000,000.00
Direct Labor Hours		140,000		300,000
Machine hours		20,000		180,000
Set Ups		40		160
Inspection runs		600		1,400
Packing Orders		9,000		81,000
Estimated Manufacturing Overhead:
Machining costs	$160,000.00
Setup costs	$180,000.00
Inspection costs	$140,000.00
Packing costs	$180,000.00
Total Manufacturing Overhead	$660,000.00

Suppose that Ramsey decides to use departmental overhead rates. There are two departments: Department 1 (machine intensive) with an MOH rate of $2.75 per machine hour and Department 2 (labor intensive) with an MOH rate of $1.25 per direct labor hour. The actual consumption of these two drivers is as follows:

	Department 1	Department 2
	Machine Hours	Direct Labor Hours
Model A	55,000	110,000
Model B	145,000	330,000

Compare the results for the simple cost allocation system (plant-wide), departmental cost allocation and the ABC cost allocation systems. Which do you think is more accurate and why?   What circumstances would favor Ramsey adopting ABC as their allocation method (provide at least three reasons)?

Answer 1

Plant wide means single OH recovery rate based on total machine hours

= 660,000 / 200,000 = 3.30 Per hour

Overhead allocation based on Plant wide OH recovery rate =

Model - A ....... 55000 * 3.30 = 181,500

Model - B ...... 145,000 * 3.3 = 478,500

Thus total overhead of 660,000 is allocated to model A and B using plant wide overhead rate.

When departmental OH recovery rates are used ..........

	Model - A	Model - B
Dep - 1
55000 * 1.75 and 145000 * 1.75	151250	398750
Dep - 2
110000*0.25 and 330000*0.25	27500	82500
over head allocated	178750	481250

Note : Question says 1.25 per labor hour......... but this is error...... it should be 0.25 per labor hour.

For ABC Method ............. following basic calculations are needed

	Cost pool	Activity		Cost rate Per Activity
Machining cost	160000	Machine hrs	200000	0.8
Setup costs	180000	No of setups	200	900
Inspection costs	140000	Runs	2000	70
Packing costs	180000	Packing orders	90000	2
	660000

OVERHEAD ALLOCATION BASED ON ABC METHOD

	Model-A	Model - B
Machining cost	16000	144000
Setup costs	36000	144000
Inspection costs	42000	98000
Packing costs	18000	162000
	112000	548000

(1) Ramsey is dealing two models which are not homogenous in nature. Activities demand for each model is highly different. Hence addption of single blanket rate or departmental OH recovery rates are charging high cost to low popular product.

(2) OH recovery based on ABC is more accurate then departmental recovery system. A comparision of OH allocated for Model - A among the three methods indicate that Model - A was allocated with high cost in traditional methods compared to ABC.

(3) When cost recovery is based on activity demanded by the model, maximum justification in cost allocation is possible, otherwise not at all possible.