Question

40. ABC and predetermined overhead rates. Assume that SunSpees Corporation makes three types of sunglasses, Razors, Slims, and Eagles, for major retailers such as Ray-Ban and Gucci. SunSpecs presently applies overhead using a predetermined rate based on direct labor hours. A consultant recommended that SunSpecs switch to activity-based cost- ing. Management decided to give ABC a try and identified the following activities, cost drivers, and estimated costs for Year 2 for each activity center. Estimated Activity Recommended Cost Driver Annual Costs Annual Cost Driver Units Production Setup Order Processing Materials Handling Equipment Depreciation and Maintenance Quality Management Packing and Shipping Total Estimated Overhead ... Number of Production Runs Number of Orders Pounds of Materials Used Machine Hours Number of Inspections Number of Units Shipped $ 60,000 100,000 40,000 120,000 100,000 80,000 $500,000 200 400 16,000 20,000 800 80,000 The company estimated 10,000 labor hours would be worked in all of Year 2. Assume the following activities occurred in February of Year 2: Razors Slims Eagles 3,000 58.000 300 2,000 $5,000 200 1,000 $4,000 100 16 Number of Units Produced ......... Direct Materials Costs ........... Direct Labor Hours .. Number of Production Runs ...... Number of Orders .. Pounds of Material Used ........ Machine Hours ........ Number of Inspections ............ Units Shipped . . . . . . . Direct labor costs are $20 per hour ................. 300 800 800 16 500 400 20 2,000 54.000 3,000 $6,000 20 1,000 $2,000 a. Compute an overhead allocation rate for each of the cost drivers recommended by the consultant and for direct labor. b. Compute the production costs for each product for February using the cost drivers recommended by the consultant. c. Compute the production costs for each product for February using direct labor hours as the overhead allocation base. d. Management has seen your numbers and wants to know how you account for the discrepancy between the product costs using only direct labor hours as the over head allocation base and the product costs using activity-based costing, Write a brief response to management. 41. Choosing an ABC system. Free Wheeler, Ltd., manufactures three bicycle models

Answer 1

a. Predetermined overhead rate using direct labor hours as the cost driver = $ 500,000 / $ 10,000 = $ 50 per direct labor hour.

Overhead allocation rate as per consultant recommendations:

Activity	Annual Costs	Annual Cost Driver Units	Overhead Allocation Rate
Production Setup	$ 60,000	200 production runs	$ 300 per production run
Order Processing	100,000	400 oders	250 per order
Material Handling	40,000	16,000 pounds	2.5 per pound
Equipment Depreciation and Maintenance	120,000	20,000 machine hours	6 per machine hour
Quality Management	100,000	800 inspections	125 per inspection
Packing and Shipping	80,000	80,000 units	1 per unit shipped
	$ 500,000

b.

	Razors	Slims	Eagles
Direct materials	$ 8,000	$ 5,000	$ 4,000
Direct labor	6,000	4,000	2,000
Production setup	600	1,200	3,000
Order processing	4,000	4,000	4,000
Materials handling	2,000	1,250	750
Equipment depreciation and maintenance	4,800	2,400	2,400
Quality management	2,500	2,500	2,500
Packing and shipping	3,000	2,000	1,000
Total production cost	$ 30,900	$ 22,350	$ 19,650
Units produced	3,000	2,000	1,000
Unit Product Cost	$ 10.30	$ 11.18	$ 19.65

c.

	Razors	Slims	Eagles
Direct materials	$ 8,000	$ 5,000	$ 4,000
Direct labor	6,000	4,000	2,000
Production overhead	15,000	10,000	5,000
Total production costs	$ 29,000	$ 19,000	$ 11,000
Units produced	3,000	2,000	1,000
Unit Product Cost	$ 9.67	$ 9.50	$ 11

d. Using direct labor hours as the allocation base, overhead allocation leads to under-costing for all the three products. This is probably happening since the three products are diverse in terms of volume of production, and also in terms of their respective demands on resources. Under-costing leads to under-pricing, which in turn leads to decreased profitability for the company as a whole.