Question

Hi-Tek Manufacturing, Inc., makes two types of industrial component parts—the B300 and the T500. An absorption costing income statement for the most recent period is shown:

Hi-Tek Manufacturing Inc. Income Statement
Sales	$	1,651,600
Cost of goods sold		1,257,459
Gross margin		394,141
Selling and administrative expenses		550,000
Net operating loss	$	(155,859	)

Hi-Tek produced and sold 60,400 units of B300 at a price of $19 per unit and 12,600 units of T500 at a price of $40 per unit. The company’s traditional cost system allocates manufacturing overhead to products using a plantwide overhead rate and direct labor dollars as the allocation base. Additional information relating to the company’s two product lines is shown below:

	B300		T500		Total
Direct materials	$	400,400	$	162,200	$	562,600
Direct labor	$	120,900	$	42,800		163,700
Manufacturing overhead						531,159
Cost of goods sold					$	1,257,459

The company has created an activity-based costing system to evaluate the profitability of its products. Hi-Tek’s ABC implementation team concluded that $58,000 and $105,000 of the company’s advertising expenses could be directly traced to B300 and T500, respectively. The remainder of the selling and administrative expenses was organization-sustaining in nature. The ABC team also distributed the company’s manufacturing overhead to four activities as shown below:

	Manufacturing Overhead			Activity
Activity Cost Pool (and Activity Measure)				B300	T500	Total
Machining (machine-hours)	$	202,559		90,200	62,100	152,300
Setups (setup hours)		168,300		74	300	374
Product-sustaining (number of products)		100,200		1	1	2
Other (organization-sustaining costs)		60,100		NA	NA	NA
Total manufacturing overhead cost	$	531,159

Required:

1. Compute the product margins for the B300 and T500 under the company’s traditional costing system.

2. Compute the product margins for B300 and T500 under the activity-based costing system.

3. Prepare a quantitative comparison of the traditional and activity-based cost assignments.

Answer 1

Solution:

Part 1 – Product Margin under traditional costing

Product Margin is the difference between selling price and product cost.

Product cost is the cost of making the product.

Under traditional costing, product cost is the sum of direct materials, direct labor, variable manufacturing overhead and fixed manufacturing overhead.

In this costing system, overheads are allocated on the basis of predetermined overhead rate by taking actual activity level achieved by the company.

So, first of all we need to calculate the Predetermined Overhead Rate.

Allocation base is direct labor dollars.

Predetermined overhead rate = total estimated manufacturing $531,159 / Direct labor dollars $163,700

Assigned Manufacturing Overhead Cost to Product B300 = Direct labor dollar 120,900 x 531,159 / 163,700

= $392,285

Assigned Manufacturing Overhead Cost to Product T500 = Direct labor dollar 42,800 x 531,159 / 163,700

= $138,874

Calculation of Product Margin under traditional costing system

	B300	T500
Units Sold	60,400	12,600
Unit Selling Price	$19	$40
Sales Value (Unit Sold x Unit Selling Price)	$1,147,600	$504,000
Product Cost
Direct Material Cost	$400,400	$162,200
Direct labor	$120,900	$42,800
Applied Manufacturing Overhead (Refer Above working)	$392,285	$138,874
Total Product Cost	$913,585	$343,874
Product Margin (Sales Value - Product Cost)	$234,015	$160,126
/ Units Sold	60400	12600
Unit Product Margin	$3.87	$12.71

Part 2 – Product Margin Under ABC System

Activity Based Costing System

- ABC is a costing method which identifies the activities in the organization and assigns the cost of each activity with resources to all the products or services according to the actual consumption of activity by the product or service.

- This system determines all the activities related to product or production process.

- This system calculates the cost of those activities which are related to product or production process and thereafter determine the cost of the product.

- In ABC costing the overhead costs are distributed to the product on the basis of benefit received from indirect activity.

- It helps to distribution of overheads on the basis of activities.

The Activity based overhead rate = Estimated Overheads related to the activity / Total Cost Driver per activity)

First we need to calculate the overhead rate and then assigned the overhead cost by using actual activity usage by each product and overhead rate as follows:

						B300		T500
Activity Cost Pool	Expected Overhead Costs (A)	Total Expected Activity (B)		Overhead Rate per Unit of Activity (C = A/B)		Activity Driver USAGE (H)	Overhead Assigned (C*H)	Activity Driver USAGE (E)	Overhead Assigned (C*E)
Machining	$202,559	152300	Machine Hours	$1.33	per MH	90200	$119,966	62100	$82,593
Setups	$168,300	374	Setup hours	$450.00	per setup hour	74	$33,300	300	$135,000
Product Sustaining	$100,200	2	Products	$50,100.00	per product	1	$50,100	1	$50,100
Other	$60,100					0	$0		$0
Total Overhead Assigned (O)	$531,159						$203,366		$267,693

Product Margin

	B300	T500
Units Sold	60,400	12,600
Unit Selling Price	$19	$40
Sales Value (Unit Sold x Unit Selling Price)	$1,147,600	$504,000
Product Cost
Direct Material Cost	$400,400	$162,200
Direct labor	$120,900	$42,800
Applied Manufacturing Overhead (Refer Above working)	$203,366	$267,693
Total Product Cost	$724,666	$472,693
Product Margin (Sales Value - Product Cost)	$422,934	$31,307
/ Units Sold	60400	12600
Unit Product Margin	$7.00	$2.48

Part 3 – Quantitative Comparison

Applied manufacturing Overhead	B300	T500
As per Traditional Costing	$392,285	$138,874
As per Activity Based Costing	$203,366	$267,693

As per traditional costing the overheads are allocated on predetermined basis and using allocation base. Allocation base may be direct labor hours, machine hours, direct labor dollars as specified and decided the management.

As per ABC System, the overheads are categorized on the basis of activity and number of activity involved in making the product.

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