Question

Palmer Electricals (PE) manufactures two products, Cut Regular and Cuff Premium, and applies overhead on the basis of direct labour hours. Anticipated overhead and direct labour time for the upcoming accounting period are $800,000 and 25,000 hours, respectively. Information about the PE's products follows:

Cut Regular:

Estimated product volume Direct material cost Direct labour per unit

Cuff Premium:

Estimated product volume Direct material cost Direct labour per unit

3,000 units
$25 per unit
3 hours at $12 per hour

4,000 units
$40 per unit
4 hours at $12 per hour

PE 's overhead of $800 000 can be identified with three major activities:

Order processing	$150,000
Machine processing	$560,000
Product inspection	$90,000
Total	$800,000

These activities are driven by number of orders processed, machine hours worked, and inspection hours, respectively. Data relevant to these activities as follow:

	Cut Regular	Cuff Premium
Order processed	300	200
Machine hours worked	18,000	22,000
Inspection hours	2,000	8,000

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The senior manager is very concerned about declining profitability despite a healthy increase in sales volume. The decrease in profit 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.

Required:

(i) Calculate the unit manufacturing cost of the two products (Cut Regular and Cuff Premium)

if the conventional costing approach is used to allocate overhead with direct labour hours as the cost driver. Assume that the expected manufacturing volume is attained. (2 marks)

(ii) Using the activity-based costing, calculate the unit manufacturing costs of the Cut Regular and Cuff Premium products. Assume that the expected manufacturing volume is

attained.

marks)

(5

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(iii) PE's selling prices are based heavily on cost.

(a) Using direct labour hours as an application base, which product is over-costed and which product is under-costed? Calculate the amount of the cost distortion for each product. (2 marks)

(b) Is the over-costing and under-costing (ie cost distortions) and the subsequent determination of selling prices of the products contributing to the company's profit woes? Explain. (3 marks)

(iv) Provide two circumstances under which the benefits from Activity-based costing are the

greatest.

(2 marks)

Answer 1

i) Calculate the unit manufacturing cost using conventional method of costing: Compute the OH cost rate: Overhead Rate = Estimated Overhead cost Estimated Direct labor hours = $800,000 25,000 = $32/hr Description Cut Cuff Regular Premium $ 25 $ 40 $ 36 $ 48 Direct Material per unit Direct labor per unit: (3hrs@12 per hr=$36) (4hrs@12 per hr=$48) Overheads (3hrs@32 per hr=$96) (4hrs@32 per hr=$128) Manufacutring cost per unit $ $ 96 157 $ $ 128 216

ii) Calculate the unit manufacturing cost using ABC method of costing: Description Cut Cuff Regular Premium Production Volume (B) 3,000 4,000 Direct Material cost ($25x3000 units) (540x 4000 units) $ 75,000 $160,000 Direct labor cost (3hrs @12 per hr=$36) (4hrs @12 per hr=$48) $ 108,000 $ 192,000 Overheads: Odering cost $ 90,000 $ 60,000 Machine processing cost $ 252,000 $308,000 Product inspection cost $ 18,000 $ 72,000 Total manufacturing cost (A) $ 543,000 $ 792,000 Manufacutring cost per unit (AB) S 181 S 198 $ 90,000 $ 60,000 Working Ordering cost (S150,000/(300+200) ($300x300) ($ 300x200) Machine processing cost (5560,000/(18,000+22,000) ($40x18000) (540x22000) Product Inspection cost (590,000 (2,000+8,000)) (59x2000) |(59x8000) $ 252,000$ 308,000 $ 18,000$ 72,000

iii) Determine the comparison of both the methods: When compared to both the methods, the product Cut regular cost is less in Conventional method of costing. The cost of this product under first method is $157 whereas under ABC the cost is $181, Therefore, it is clear that under conventional method of costing it is less. For Product Cuff Premium, the cost is less under ABC method of costing. The cost under this method is $198 whereas under Conventional method of costing it is $216. Therefore, using direct labor hours as application rate, Cut Regular product is under costed and the Product Cuff Premium is over-costed. Cost distortion of CR: S24x3000 units under cost and $18x4000 units over cost. Ie. $72,000. There will be no change overall in for the company as the cost remains the same but the cost allocation for the two products differs basing on the method applied. iv) 1. ABC costing is advantageous when there is cost allocation for the products. 2. When the cost structure is complex. 3. Multiple products are involved and process costing need to be followed there ABC method is beneficial.