Question

Ontario, Inc. manufactures two products, Standard and Enhanced, and applies overhead on the basis of direct-labor hours. Anticipated overhead and direct-labor time for the upcoming accounting period are $800,000 and 25,000 hours, respectively. Information about the company’s products follows.

Standard: Est. production volume, 3000 units
   Direct-material cost, $25 per Unit
   Direct Labor per unit, 3 hrs at $12 per hr
Enhanced: Est. production volume, 4000 units
   Direct material cost, $40 per Unit
   Direct Labor per unit, 4 hrs at $12 per hr

Ontario’s overhead of $800,000 can be identified with three major activities: order processing ($150,000), machine processing ($560,000), and product inspection ($90,000). These activities are driven by number of orders processed, machine hours worked, and inspection hours, respectively. Data relevant to these activities follow.
               Orders Processed   Machine Hrs Worked       Inspection Hrs
Standard                300           18000               2000
Enhanced               200           22000               8000
500           40000               10000

Top management is very concerned about declining profitability despite a healthy increase in sales volume. The decrease in income is especially puzzling because the company recently undertook a massive plant renovation during which new, highly automated machinery was installed—machinery that was expected to produce significant operating efficiencies.

3. Ontario’s selling prices are based heavily on cost.
   a) by using direct-labor hrs as an application base, which product is overcosted and which product is undercosted? Calculate the amount for the cost distortion for each product. Be sure to show formulas in within the cells.
   b) Is it possible that overcosting and undercosting (i.e., cost distortion) and the subsequent determination of selling prices are contributing to the company’s profit woes? Explain.

DATA INPUT
Anticipated overhead
Anticipated direct labor		hours
Rate
Standard
Estimated production volume		units
Direct-material cost		per unit
Direct labor per unit		hours at		per hour
Enhanced
Estimated production volume		units
Direct-material cost		per unit
Direct labor per unit		hours at		per hour
	Order	Machine	Product
	Processing	Processing	Inspection
Overhead
	Orders	Machine Hours	Inspection
	Processed	Worked	Hours
Standard
Enhanced
Total

Answer 1

As per existing method overhead allocation is carried out on the base of labour hours, so let us calculate overhead allocation rate per labour hour :

Calculation of overhead allocation per labour hour

1	Total Overhead			800,000
2	Total Labour Hours
3	Standard (3000*3)		9,000
4	Enhanced (4000*4)		16,000	25,000
5	Overhead allocation rate per labour hour (1/5)			32

On the basis of overhead allocation rate per labour hour let us work out total overhead allocation product wise :

Existing Overhead allocation on labour hour basis

	Particulars	Standard	Enhanced
6	Labour Hour (As per 3,4)	9,000	16,000
7	Overhead allocation per hour (As per 5)	32	32
8	Total overhead allocation (6*7)	288,000	512,000

We have provided 3 different activities which actually contributes overhead, let us calculate overhead rate for respective activity :

Overhead rate calculation as per Activity wise

	Activities	Order processing	Machine Processing	Inspection
9	Total Cost	150,000	560,000	90,000
10	Total hours	500	40,000	10,000
11	Activity rate per hour (9/10)	300	14	9

The overhead is actually determined by respective activity unit & hence that will result in more appropriate allocation which is worked out as under

Overhead allocation as per activity rate

	Standard
		Order processing	Machine Processing	Inspection	Total
12	Hours	300	18,000	2,000
13	Rate (As per 11)	300	14	9
14	Overhead allocation (12*13)	90,000	252,000	18,000	360,000
	Enhanced
		Order processing	Machine Processing	Inspection	Total
15	Hours	200	22,000	8,000
16	Rate (As per 11)	300	14	9
17	Overhead allocation (15*16)	60,000	308,000	72,000	440,000

The comparison of overhead allocation under both method provide us under allocation and over allocation. The figure reported in bracket shows over allocation :

Comparison of total overhead allocation under both method   

	Products	Standard	Enhanced
18	Overhead allocation on labour hour basis (As per 8)	288,000	512,000
19	Overhead allocation on activity wise hour basis (As per 14 & 17)	360,000	440,000
20	(Over allocation) / Under allocation (19-18)	72,000	(72,000)

Q.1  a) by using direct-labor hrs as an application base, which product is overcosted and which product is undercosted? Calculate the amount for the cost distortion for each product. Be sure to show formulas in within the cells.

Response to Q.1 : As per above calculation Rs.72000 is over allocated to enhanced product and Rs.72000 under allocated to Standard product

Q.2 : Is it possible that overcosting and undercosting (i.e., cost distortion) and the subsequent determination of selling prices are contributing to the company’s profit woes? Explain.

Response to Q.2 : Let us calcuate overhead rate per product under both method

Comparison of Overhead allocation per Unit

	Products	Standard	Enhanced
21	Volume	3,000	4,000
22	Overhead allocation per unit under labour hour basis (18/21)	96	128
23	Overhead allocation per unit under activity wise basis (19/21)	120	110
24	Difference (23-22)	24	(18)

The selling price of product is determined on the basis of cost incurred. Especially the selling price of Enhanced would be distorted when calculated on existing overhead allocation on labour hour basis because it considers cost lower by 24 & hence even volume of standard increases it will result into lower profitability  

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