Question

SHORT CASE STUDY Green Test Laboratory (GTL) performs heat testing and stress testing on materials and operates at full capacity. Under its current simple costing system, GTL aggregates all operating costs of $2,404,000 into a single cost pool. GTL calculates a rate per test-hour of $18.78, ($2,404,000/128,000 total tests-hours). Heat testing uses 80,000 test-hours and stress testing uses 48,000 test-hours. Lee Chang, GTL's management accountant, believes that there is enough variation in test procedures and cost structures to establish separate costing and billing rates for heat testing and stress testing. The market for test services is becoming increasingly competitive. Without this information, any incorrect costing and pricing of its services could cause GTL to lose business. Lee divides GTL's costs into four activity cost categories as follows: 1) Direct labour costs, $450,000. These costs can be directly traced to heat testing, $350,000, and to stress testing, $100,000. 2) Equipment related costs (e.g. rent, maintenance, energy), $750,000. These costs are allocated to heat and stress testing on the basis of test hours. 3) Set up costs, $700,000. These costs are allocated to heat and stress testing on the basis of the number of set up hours required. Heat testing requires 13,500 set up hours and stress testing requires 4,000 set up hours. 4) Costs of designing tests, $504,000. These costs are allocated to heat and stress testing on the basis of the time required to design the tests. Heat testing requires 4,200 design hours, and stress testing requires 2,100 design hours. REQUIRED: a) Classify each activity cost as either: output unit level cost, batch level cost, product or service sustaining cost, or organisation sustaining cost. Justify the classification of each activity cost. b) Calculate the cost per test hour for heat testing and for stress testing. c) Explain how GTL's management could use the cost hierarchy and Activity Based Costing (ABC) information to manage its business better.

Answer 1

a) Activity cost Classification Justification Direct labor cost Output unit level cost Variable unit cost based on output Equipment related costs Organisation Sustaining cost Fixed cost Set up costs Batch level cost incurred at batch level for set up Design tests Product sustaining cost incurred for design at product level b) Cost per test hour Direct labor cost Equipment related costs Set up costs Design tests Total cost Total testing hours Cost per test hour Heat Testing $350,000 $468,750 $540,000 $336,000 $1,694,750 80,000 $21.18 Stress Testing $100,000 $281,250 $160,000 $168,000 $709,250 48,000 $14.78 Working notes: Cost Activity Cost pool Equipment related costs Set up costs Design tests Total Overheads Pool $750,000 $700,000 $504,000 $1,954,000 Total Activities 128,000 17,500 6,300 Activity Rate $5.86 per test hour $40.00 per set up hour $80.00 per design hour Allocation of overheads as per ABC method Heat Testing Activity- Expected use Based of cost drivers Overhead rates Direct labor cost Equipment related costs 80,000 $5.86 Set up costs 13,500 $40.00 Design tests 4,200 $80.00 Total Cost assigned Stress Testing Activity Based Overhead rates Cost Assigned Expected Cost use Assigned of cost drivers $350,000 $468,750 48,000 $540,000 4,000 $336,000 2,100 $1,694,750 $5.86 $40.000 $80.00 $100,000 $281,250 $160,000 $168,000 $709,250 c) Cost hierarchy and Activity Based Costing Information helps in following ways to a business: The use of cost hierarchy in the ABC costing helps in cost management through cost control and cost reduction The use of ABC costing increases the accuracy of product cost since allocation of overheads is based on rational method The accuracy of product cost helps in reliable product pricing for various purpose like bidding, special order serving Activity Based costing helps in elimination of non-value adding activities Activity based costing helps in taking reliable decisions for the business. For example: Target costing, continue or discontinue product lines, product mix, etc