Question

Problem 5-14B Comparing an ABC system with a traditional costing system

Since its inception, Batum Laboratory has produced a single product, Product S109. With the advent of automation, the company added the technological capability to begin producing a second product, Product N227. Because of the success of Product N227, manufacturing has been shifting toward its production. Sales of Product N227 are now 50 percent of the total annual sales of 20,000 units, and the company is optimistic about the new product’s future sales growth. One reason the company is excited about the sales potential of its new product is that the new product’s gross profit margin is higher than that of Product S109. Management is thrilled with the new product’s initial success but concerned about the company’s declining profits since the product’s introduction. Suspecting a problem with the company’s costing system, management hires you to investigate.In reviewing the company’s records, product specifications, and manufacturing processes, you discover the following information:

The company is in an extremely competitive industry in which markups are low and accurate estimates of cost are critical to success.

Product N227 has complex parts that require more labor, machine time, setups, and inspections than Product S109.

Budgeted costs for direct materials and labor follow:

Direct Cost per Unit	Product S109	Product N227
Direct materials	$25	$35
Direct labor	$10/hour × 2 hours production time	$10/hour × 2.8 hours production time

The company presently allocates overhead costs to its products based on direct labor hours. After carefully studying the company’s overhead, you identify four different categories of overhead costs. Using your knowledge of this company and similar companies in the same industry, you estimate the total costs for each of these categories and identify the most appropriate cost driver for measuring each product’s overhead consumption. Detailed information for each cost category follows:

Category	Estimated Cost	Cost Driver	Use of Cost Driver
Unit level	$ 540,000	Number of machine hours	S109: 20,000 hours; N227: 60,000 hours
Batch level	228,000	Number of machine setups	S109: 1,500; N227: 3,500
Product level	180,000	Number of inspections	S109: 200; N227: 600
Facility level	60,000	Equal percentage for products	S109: 50%; N227: 50%
Total	$1,008,000

Required

Determine the predetermined overhead rate the company is using.

Compute the amount of overhead the company assigns to each product using this rate.

Determine the cost per unit and total cost of each product when overhead is assigned based on direct labor hours.

To remain competitive, the company prices its products at only 20 percent above cost. Compute the price for each product with this markup.

Compute the overhead rate for each category of activity.

Determine the amount of overhead cost, both in total and per unit, that would be assigned to each product if the company switched to activity-based costing.

Assuming that prices are adjusted to reflect activity-based costs, determine the revised price for each product.

Based on your results for Requirements f and g, explain why Product N227 costs more to make than previously apparent and why sales prices therefore need to be adjusted.

Answer 1

Solution a:

Total annual sales = 20000 units

Estimated sales of S109 = 20000*50% = 10000 units

Estimated sales for N227 = 20000*50% = 10000 units

Estimated direct labor hours of S109 = 10000*2 = 20000 hours

Estimated direct labor hour of N227 = 10000*2.8 = 28000 hours

Total direct labor hours = 20000+28000 = 48000 hours

Estimated overhead = $1,008,000

Predetermined overhead rate basis direct labor hours = $1,008,000/48000 = $21 per hour

Solution b:

Overhead Allocation to Product - Plant wide rate
Particulars	Product S109	Product N227
Direct labor hours	20000	28000
Overhead rate	$21.00	$21.00
Allocated overhead	$420,000.00	$588,000.00
Nos of units	10000	10000
Overhead cost per unit	$42.00	$58.80

Solution c:

Computation of cost per unit and total cost of product
Particulars	Product S109	Product N227
Direct material per unit	$25.00	$35.00
Direct labor per unit	$20.00	$28.00
Overhead per unit	$42.00	$58.80
Unit Product Cost	$87.00	$121.80
Nos of units	10000	10000
Total cost of product	$870,000.00	$1,218,000.00

Solution d:

Computation of price of product
Particulars	Product S109	Product N227
Unit Product Cost	$87.00	$121.80
Markup on cost	20%	20%
Price of Product	$104.40	$146.16

Solution e & f:

Computation of Activity rate and allocation of overhead to product and computation of overhead cost per unit
Category	Activity Measure	Estimated overhead cost	Expected activity	Activity rate of activity cost pool	Product S109		Product S109
					Expected activity	Allocated overhead	Expected activity	Allocated overhead
Unit level	Machine Hours	$540,000.00	80000	$6.75	20000	$135,000.00	60000	$405,000.00
Batch level	Nos of machine Setups	$228,000.00	5000	$45.60	1500	$68,400.00	3500	$159,600.00
Product level	Nos of Inspections	$180,000.00	800	$225.00	200	$45,000.00	600	$135,000.00
facility level	Equal percentage of products	$60,000.00	2	$30,000.00	1	$30,000.00	1	$30,000.00
Total		$1,008,000.00				$278,400.00		$729,600.00
Total units						10000		10000
Overhead cost per unit						$27.84		$72.96

Solution g:

Computation of cost per unit and total cost of product - ABC
Particulars	Product S109	Product N227
Direct material per unit	$25.00	$35.00
Direct labor per unit	$20.00	$28.00
Overhead per unit	$27.84	$72.96
Unit Product Cost	$72.84	$135.96
Markup on cost	20%	20%
Price of Product	$87.41	$163.15