Question

Hansen Company uses activity-based costing.  The factory overhead budget for the coming period is $1,053,000, consisting of the following:

Cost Pool	Budgeted Amount
Supervision	$320,000
Machine usage	420,000
Machine setups	187,000
Design changes	126,000
Totals	$1,053,000

The potential allocation bases and their estimated amounts were as follows:

Allocation Base	Budgeted Amount
Number of design changes	35
Number of setups	110
Machine hours	6,000
Direct labor hours	10,000

a.       What is the reason behind the difference in the costs of the job using Activities-based costing vs. the direct labor hour method of applying overhead?

Answer 1

If Direct labor hour method of applying overhead is used, we will have a single overhead recovery rate ...

i.e 1053,000 / 10000 = 105.3 hours.

But Activity based costing method, makes the allocation more meaning full by allocating the overhead with multiple rates based on the activity demand. Such multiple overhead rate based on activity pools and drivers is as under

Activity	Amount	Activity		Over head rate
Job design	126000	35	Designs	3600
Machine setup	187000	110	Setups	1700
Supervision	320000	10000	Lab Hours	32
Machine usage	420000	6000	Mac Hours	70

Difference

In customized production scenarios ( Job work) we see high amount of hetrogeneity in each job we under take. That means some jobs require more design changes, while less machine work. Some other jobs require more machine work than labor and supervison work. In the absence of activity based costing approach, over head application based on direct labor hour method provides wrong cost allocation leading wrong prices being quoted for jobs. This results in loss from accepted jobs, oppurtunity loss from unsuccessful bids.

Thus true cost allocation is not possible with direct labor hour method, if there is absence of homogeneity in jobs being performed.