Activity-based Costing Home Entertainment Inc. manufactures two types of DVD players:...

Activity-based Costing

Home Entertainment Inc. manufactures two types of DVD players: standard and deluxe. It attempts to set selling prices based on a 50% markup on manufacturing costs to cover selling and administrative expenses and to earn an acceptable return for shareholders. Tom Sales, vice president- Marketing, is confused because the numbers provided by Anne Cash, controller, indicate that standard DVD players should be priced at $150 per unit and deluxe DVD players at $300 per unit. The competition is selling comparable models for $145 and $525, respectively.

Sales informs Cash that there must be something wrong with the job costing system. He had recently attended a seminar where the speaker stated that “All production costs are not a function of how many units are produced, or of how many labor hours, labor dollars, or machine hours are expended.” He knows that the company uses direct labor dollars as its only cost allocation base. Tom thinks that perhaps this explains why the product costs and, therefore selling prices, are so different from those of the competitors. Currently, the costs per unit are determined as follows:

Factory overhead is currently applied using a plantwide rate based on direct labor cost. This year’s rate was computed as follows:

Budgeted factory overhead:

Direct labor support . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 300,000

Machine support . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

Setup costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000

Design costs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Budgeted direct labor cost is $333,333.

Budgeted factory overhead rate = $1,000,000/$333,333 = 300% of direct labor dollars

Cash, knowing that you had recently studied activity-based costing in your cost accounting course, employs you as a consultant to determine what effect its usage would have on the product costs. You first gathered the following data:

Required:

1. From the data that you gathered, determine the best allocation base for each of the four components of factory overhead.

2. Compute an overhead rate for each of the four components.

3. Determine the new unit cost for standard and deluxe models using activity-based costing.

4. Why are the product costs so dramatically different when activitybased costing is used?

5. Would Home Entertainment’s selling prices be closer to those of them competition if activity-based costing were used?