Question

For many years, Waiters Company manufactured a single product called a mono-relay. Then three years ago, the company automated a portion of its plant and at the same time introduced a second product, called a bi-relay, which has become increasingly popular. The bi-relay is a more complex product, requiring one hour of direct labor time per unit to manufacture and extensive machining in the automated portion of the plant. The mono-relay requires only 0.75 hour of direct labor time per unit and only a small amount of machining. Manufacturing overhead costs are currently assigned to products based on direct labor-hours.

Despite the growing popularity of the company’s new bi-relay, profits have been declining steadily. Management is beginning to believe that there may be a problem with the company’s costing system. Material and labor costs per unit are as follows:

   Mono-Relay                      Bi-Relay

Direct materials                                                                      $35                              $48

Direct labor (0.75 hour and 1.0 hour @ $12 per hour)          $9                              $12

Management estimates that the company will incur $1,000,000 in manufacturing overhead costs during the current year and 40,000 units of the mono-relay and 10,000 units of the bi-relay will be produced and sold.

Management is considering using activity-based costing to apply manufacturing overhead cost to products for external financial reports. The activity-based costing system would have the following four activity cost pools.

                                                                                    Estimated                    Mono- Bi-

Activity Cost (and Activity Measure)                                Cost         Total   Relay   Relay

Maintaining parts inventory (number of part types) $ 180,000           225       75      150

Processing purchase orders (number of orders)              90,000        1,000     800      200

Quality control (number of tests)                                  230,000        5,750   2,500   3,250

Machine-related (machine-hours)                                 500,000      10,000   4,000   6,000

Total overhead cost                                                  $1,000,000       

                        Required:

1. Determine the unit product cost for each product using the current system.
2. Determine the unit product cost for each product using the activity-based costing system.
3. In view of the outcomes for the two costing systems, explain which costing system would be more appropriate.

Answer 1

Answer a:

Manufacturing overhead costs are currently assigned to products based on direct labor-hours.

Total manufacturing overhead cost = $1,000,000

Total direct labor hours = 40,000 * 0.75 + 10,000 * 1 = 40,000

Manufacturing overhead rate = $1,000,000 / 40,000 = $25

Manufacturing overhead applied to per unit of Mono-relay = $25 * 0.75 = $18.75

Manufacturing overhead applied to per unit of Bi-relay = $25 *1 = $25

Unit product cost for each product using the current system is as calculated below:

Answer b:

Cost driver rate and cost allocation based on ABC:

Unit product cost for each product using the activity-based costing system

Answer c:

We observe from above that there is significant difference in unit costs calculated under two costing methods. Under ABC method unit cost Bi-Relay is $116.80 as compared unit cost of $85 under current costing system.

Activity based Costing (ABC) system will be more accurate since:

1. Total Manufacturing overhead amounts to $1,000,000 which is approximately 30% of total cost and it is inappropriate to allocate such significant cost on a basis like direct labor hour in an automated plant.

2. ABC system establishes by identifying activity cost pools and their quantities, establishes cause and effect relations and cost allocated based of cause and effect is more accurate than cost allocation based on direct labor hour which does not have any such cause and effect relation.

3. The current costing system is the reason because of which despite the growing popularity of the company’s new bi-relay, profits have been declining steadily. Based on inaccurate costing, pricing must have been faulty and cause of such decline in profit. It will be prudent for Waiters Company to move to ABC system and review their pricing based on cost as calculated based on ABC and also vis-a-vis industry.