Question

Saddle Inc. has two types of handbags: standard and custom. The controller has decided to use a plantwide overhead rate based on direct labor costs. The president has heard of activity-based costing and wants to see how the results would differ if this system were used. Two activity cost pools were developed: machining and machine setup. Presented below is information related to the company’s operations.

Direct labor costs		$50,000		$100,000
Machine hours		1,200		1,500
Setup hours		90		390

Total estimated overhead costs are $285,000. Overhead cost allocated to the machining activity cost pool is $189,000, and $96,000 is allocated to the machine setup activity cost pool.

Answer 1

Total estimated overhead Costs = $285000

Firstly, according to the controller, if the overhead costs are allocated on the basis of direct labor costs then the overhead costs allocated to both types of handbags as follows :

1) Standard

   =$285000*($50000/$150000)

   =$95000

2) Custom

   =$285000*($100000/$150000)

   =$190000

And as per president if activity based costing is used then the overhead costs can be allocated on the basis of activity cost pools which are i) Machine Hours and ii) Setup Hours

i)Based on Machine Hours

a)Standard

   =$285000*(1200/2700)

   =$126667

b)Custom

   =$285000*(1500/2700)

=$158333

ii)Based on Machine Setup Hours

a)Standard

     =$285000*(90/480)

     =$53437.50

b)Custom

    =$285000*(390/480)

    =$231562.5

If the overheads are allocated as per direct labor costs then there is huge difference between both the allocations

in the amounts allocated and it would rather be justifiable if the allocation is made on the basis of activity cost pools.