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: Estimated production volume, 3,000 units Direct-material cost, $25 per unit Direct labor per unit, 3 hours at $12 per hour Enhanced: Estimated production volume, 4,000 units Direct-material cost, $40 per unit Direct labor per unit, 4 hours at $12 per hour 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. Machine Hours Worked 18,000 22,000 40,000 Orders Processed 300 200 500 Inspection Hours 2,000 8,000 10,000 Standard Enhanced Total 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, Required: 1. Assuming use of direct labor hours to apply overhead to production, compute the unit manufacturing costs of the Standard and Enhanced products if the expected manufacturing volume is attained. 2. Assuming use of activity-based costing, compute the unit manufacturing costs of the Standard and Enhanced products if the expected manufacturing volume is attained. 3. Ontario's selling prices are based heavily on cost.

Answer 1

Answer :

1.

  Predetermined overhead rate = budgeted overhead ÷ budgeted direct-labor hours

                                                               = $800,000 ÷ 25,000* = $32 per direct labor hour

*25,000 budgeted direct-labor hours = (3,000 units of Standard)(3 hrs./unit) +

(4,000 units of Enhanced)(4 hrs./unit)

	Standard	Enhanced
Direct material…………….	$  25	$  40
Direct labor:
3 hours x $12…………	36
4 hours x $12…………		48
Manufacturing overhead:
3 hours x $32…………	96
4 hours x $32…………		128
Total cost………………….	$157	$216

2.

Activity-based overhead application rates:

Activity	Cost		Activity Cost Driver		Application Rate
Order processing	$150,000	÷	500 orders processed (OP)	=	$300 per OP
Machine     processing	560,000	÷	40,000 machine hrs. (MH)	=	$14 per MH
Product inspection	90,000	÷	10,000 inspection hrs. (IH)	=	$9 per IH

Order processing, machine processing, and product inspection costs of a Standard unit and an Enhanced unit:

Activity	Standard	Enhanced
Order processing:
300 OP x $300……………...	$  90,000
200 OP x $300……………...		$  60,000
Machine processing:
18,000 MH x $14…………...	252,000
22,000 MH x $14…………...		308,000
Product inspection:
2,000 IH x $9………………..	18,000
8,000 IH x $9……………….		72,000
Total	$360,000	$440,000
Production volume (units)	3,000	4,000
Cost per unit	$120*	$110**

                        * $360,000 ÷ 3,000 units = $120

                        ** $440,000 ÷ 4,000 units = $110

The manufactured cost of a Standard unit is $181, and the manufactured cost of an Enhanced unit is $198:

	Standard	Enhanced
Direct material……………………………….	$  25	$  40
Direct labor:
3 hours x $12……………………………	36
4 hours x $12……………………………		48
Order processing, machine processing, and product inspection………………..	120	110
Total cost…………………………………….	$181	$198

3.    

a.

The Enhanced product is overcosted by the traditional product-costing system.  The labor-hour application base resulted in a $216 unit cost; in contrast, the more accurate ABC approach yielded a lower unit cost of $198.  The opposite situation occurs with the Standard product, which is undercosted by the traditional approach ($157 vs. $181 under ABC).

b.

Yes, especially since the company's selling prices are based heavily on cost. An overcosted product will result in an inflated selling price, which could prove detrimental in a highly competitive marketplace. Customers will be turned off and will go elsewhere, which hurts profitability. With undercosted products, selling prices may be too low to adequately cover a product's more accurate (higher) cost. This situation is also troublesome and will result in a lower income being reported for the company.