Question

8. Activity Based Costing Sterling Industries produces machine parts as a contract provider for a large manufacturing company. Sterling produces two particular parts, shafts and gears. The competition is keen among contract pro- ducers, and Sterling's top management realizes how vulnerable its market is to cost-cutting competitors. Hence, having a very accurate understanding of costs is important to Sterling's survival. Sterling's president, Sheila Hudson, has observed that the company's current cost to produce shafts is $21.41, and the current cost to produce gears is $12.73. She indicated to the controller that she suspects some problems with the cost system because Sterling is suddenly experiencing extraordinary competition on shafts, but it seems to have a virtual corner on the gears market. She is even considering dropping the shaft line and converting the company to a one-product manufacturer of gears. She asked the controller, George Coleman, to conduct a thorough cost study and to consider whether changes in the cost system are necessary. The controller collected the following data about the company's costs and various manufacturing activities for the most recent month: Shafts Gears 47,000 $31.95 $12.34 $9.07 Production units .................................... Selling price............ Overhead per unit (based on direct labor hours) ....... Materials and direct labor cost per unit..... Number of production runs...................... Number of purchasing and receiving orders processed. Number of machine hours......... Number of direct labor hours ..... Number of engineering hours.................. Number of material moves................ ................................. 16,000 $23.50 $6.25 $6.48 25 110 6,000 5,000 5,000 50 12,750 29,000 5,000 40 30 The controller was able to summarize the company's total manufacturing overhead into the following pools: Setup costs.......... Machine costs ........... Purchasing and receiving costs....... Engineering costs............ Materials handling costs......... Total ........... $ 40,000 180,000 200,000 190,000 70,000 $680,000 Required a. Calculate Sterling's current plantwide overhead rate based on direct labor hours. b. Verify Sterling's calculation of overhead cost per unit of $12.34 for shafts and $6.25 for gears. c. Calculate the manufacturing overhead cost per unit for shafts and gears using activity-based costing, assuming each of the five cost pools represents a separate activity pool. Use the most appropriate activity driver for assigning activity costs to the two products. d. Comment on Sterling's current cost system and the reason the company is facing fierce competition for shafts but little competition for gears.

Answer 1

w Calculation of Overhead rate Sterlings (based current plantwider direct labour houre) on Overhead Rate 20 = Total Duerhead Total Labour house. 680,000 34000 - = 20/ Labour hour (b) Verification of Oueshead cost per unit mang Shafts Gears- Total Overheads [ A 580,000 $100,00 47000 16000. No. of unite (B2 Ouvihead per writ (A+B) $12.34 $6.25 Be The Overhead Shafte of gears in calculation of or Correct.

(O Calulation Come cost per of manufacturing ouabead unit using Activity based . Costing Particulars Basis Shafts Gears Produtien_15000 Setup Lost ($1000) 25000 Machine wost ($9.6) Machine hour 12240057600 Engineering cost + Engineering 95000 9500D hours Material handling Material cost a mousc4DDDD ($1000) 30,000 Purchasing & No. of purch- tuiving lost asing I receiving 62500 {$1230) ordón processed 137500 Total Overhead 334900 345100 47000 16000 . No. of units Cost per unit 7.1255, 21:5688

According to the Sterlings worrent cost system the manufacturing ouorheads are allocated between shafte & gears on the basis of Direct Labour hours. Allocating the manufacturing on the basis of direct labour hours gives the querhead cost per unit as $12.34 & $ 6.25 for shafts & geare respectively But in actual when the manufacturing overhead are allocated on the basis of activities then manufacturing overhead cost per unit will be & 7. 1255 & $ 21. 5688 for shafte & gear respectively This due to inappropriate cost allocating the company is experiening heavy competetion for shafts of little competition for gears.
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