Question

ADA Pharmaceutical Company produces three drugs—Diomycin, Homycin, and Addolin—belonging to the analgesic (pain-killer) family of medication. Since its inception four years ago, ADA has used a direct labor hour–based system to assign manufacturing overhead costs to products. Eme Weissman, the president of ADA Pharmaceutical, has just read about activity-based costing in a trade journal. With some curiosity and interest, she asked her financial controller, Takedo Simon, to examine differences in product costs between the firm’s current costing and activity-based costing systems. ADA has the following budget information for the year: Diomycin Homycin Addolin Cost of direct materials $ 195,000 $ 255,000 $ 248,000 Cost of direct labor 240,000 224,000 253,000 Number of direct labor hours 7,100 6,700 1,900 Number of capsules 900,000 490,000 290,000 ADA has identified the following activities and cost drivers and has assigned them a total overhead cost of $195,000. Activity Cost Driver Budgeted Overhead Cost Budgeted Cost Driver Volume Machine setup Setup hours $ 15,000 1,500 Plant management Number of Workers 35,000 1,100 Supervision of direct labor Direct labor hours 45,000 15,000 Quality inspection Inspection hours 49,400 1,000 Order expediting Customers served 50,600 595 Total overhead $ 195,000 Takedo selected the cost drivers with the following justifications: SETUP HOURS: The cost driver of setup hours is used because the same product takes about the same amount of setup time regardless of size of batch. For different products, however, the setup time varies. NUMBER OF WORKERS: Plant management includes plant maintenance and corresponding managerial duties that make production possible. This activity depends on the number of workers. The more workers involved, the higher the cost. DIRECT LABOR HOURS: Supervisors spend their time supervising production. The amount of time they spend on each product is proportional to the direct labor hours worked. INSPECTION HOURS: Inspection involves testing a number of units in a batch. The time varies for different products but is the same for all similar products. NUMBER OF CUSTOMERS SERVED: The need to expedite production increases as the number of customers served by the company increases. Thus, the number of customers served by ADA is a good measure of expediting production orders. Takedo gathered the following information about the cost driver volume for each product: Diomycin Homycin Addolin Setup hours 150 550 750 Number of workers 150 350 550 Direct labor hours 7,100 6,700 1,900 Inspection hours 100 150 650 Customers served 35 90 450 Required: 1. Use the firm’s current costing system to calculate the unit cost of each product. 2. Use the activity-based cost system to calculate the unit cost of each product.

Answer 1

Solution 1:

Estimated overhead = $195,000

Estimated direct labor hours = Budgeted overhead / Budgeted direct labor hours = $195,000 / 15000 = $13 per hour

Computation of unit cost of each product
Particulars	Diomycin	Homycin	Addolin
Direct materials	$195,000.00	$255,000.00	$248,000.00
Direct labor	$240,000.00	$224,000.00	$253,000.00
Applied overhead	$92,300.00	$87,100.00	$24,700.00
Total manufacturing costs	$527,300.00	$566,100.00	$525,700.00
Nos of capsules	900000	490000	290000
Cost per unit	$0.59	$1.16	$1.81

Solution 2:

Computation of overhead assigned to product - Activity Based Costing
Activity	Cost	Cost Driver	Qty of cost driver	Allocation rate	Diomycin		Homycin		Addolin
					Allocation Qty	Allocated Overhead	Allocation Qty	Allocated Overhead	Allocation Qty	Allocated Overhead
Machine Setup	$15,000.00	Setup hours	1500	$10.00	150	$1,500	550	$5,500	750	$7,500
Plant management	$35,000.00	Nos of workers	1100	$31.82	150	$4,773	350	$11,136	550	$17,500
Supervision of direct labor	$45,000.00	Direct labor hours	15000	$3.00	7100	$21,300	6700	$20,100	1900	$5,700
Quality Inspection	$49,400.00	Inspection hours	1000	$49.40	100	$4,940	150	$7,410	650	$32,110
Order expediting	$50,600.00	Customer served	595	$85.04	35	$2,976	90	$7,654	450	$38,269
Total	$195,000.00					$35,489		$51,800		$101,079

Computation of unit cost of each product
Particulars	Diomycin	Homycin	Addolin
Direct materials	$195,000.00	$255,000.00	$248,000.00
Direct labor	$240,000.00	$224,000.00	$253,000.00
Applied overhead	$35,489	$51,800	$101,079
Total manufacturing costs	$470,489	$530,800	$602,079
Nos of capsules	900000	490000	290000
Cost per unit	$0.52	$1.08	$2.08