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.

d、If you increase the number of indirect-cost pools in the company’s costing system, you will definitely increase the accuracy of the costs of outputs.’ Do you agree or disagree? Explain your answer in two points.

Answer 1

14 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. 15 Cost Type 16 Cost Item Reason 17 a) Direct Labor Output Unit Level Output Unit Level costs because they are incurred on each unit of material tested 18 b) Equipment related costs (e.g. rent, maintenance, energy) Output Unit Level Output Unit Level costs because they are incurred on each unit of material tested 19 C) Set up costs Batch Level Batch level costs as they are incurred each time a batch of materials is set up 20 d) Costs of designing tests Service Sustaining Service Sustaining costs as they are incurred to design the tests irespective of the number of batches tested. 21 22 b) Calculate the cost per test hour for heat testing and for stress testing. 23 24 Activity Cost Pool Overhead (A) Activity Usage (B) Activity Rate (A/B) 25 Direct Labor 450000 450,000 1.00 Per Direct Labor 26 Equipment related costs (e.g. rent, maintenance, energy) 750000 128000 5.86 Per test Hour 27 Set up costs 700000 17500 40.00 Per Set up Hour 28 Costs of designing tests 504000 6300 80.00 Per design Hour 29

30 31 32 Activity Rate (A) 1.00 5.86 33 34 Activity Cost Pool Direct Labor Equipment related costs (e.g. rent, maintenance, energy) Set up costs Costs of designing tests Total Cost (A) Number of Hours (B) Cost Per test hour (A/B) heat testing (B) 350000 80000 13500 4200 40.00 Assignment of Overheads stress testing (C) heat testing (A*B) stress testing (A* C) 100000 350000 100000 48000 468750 281250 4000 540000 160000 2100 336000 168000 1694750 709250 80000 48000 21.18 14.78 80.00 35 36 37 38 39 40 c) Explain how GTL's management could use the cost hierarchy and Activity Based Costing (ABC) information to manage its business better. 41 Activity based costing allocates the cost on the basis of activity consumed by each department. 43 therefore, it produces the better results and management can also fix the prices accordingly. 44 42 45