Erte, Inc., manufactures two models of high-pressure steam valves, the XR7 model and the ZD5 model. Data regarding the two products follow
General StudiesGeneralWorked Solution
Erte, Inc., manufactures two models of high-pressure steam valves, the XR7 model and the ZD5 model. Data regarding the two products follow:
.:.
Additional information about the company follows:
a. Product XR7 requires $35 in direct materials per unit, and product ZD5 requires $25.
b. The direct labor rate is $20 per hour.
c. The company has always used direct labor-hours as the base for applying manufacturing overhead cost to products. Manufacturing overhead totals $1,480,000 per year.
d. Product XR7 is more complex to manufacture than product ZD5 and requires the use of a special milling machine.
e. Because of the special work required in (d) above, the company is considering the use of activity based costing to apply overhead cost to products. Three activity cost pools have been identified and the first-stage allocations have been completed. Data concerning these activity cost pools appear below:
.:.
Required:
1. Assume that the company continues to use direct labor-hours as the base for applying overhead cost to products.
a. Compute the predetermined overhead rate.
b. Determine the unit product cost of each product.
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2. Assume that the company decides to use activity-based costing to apply overhead cost to products.
a. Compute the activity rate for each activity cost pool. Also compute the amount of overhead cost that would be applied to each product.
b. Determine the unit product cost of each product.
3. Explain why overhead cost shifted from the high-volume product to the low-volume product under activity-based costing.
SOLUTION:
1. a. When direct labor-hours are used to apply overhead cost to products, the company’s predetermined overhead rate would be:
b.
Model
Model
XR7
ZD5
Direct materials
$35.00
$25.00
Direct labor: $20 per hour × 0.2 DLH, 0.4 DLH
4.00
8.00
Manufacturing overhead: $74 per hour × 0.2 DLH, 0.4 DLH
14.80
29.60
Total unit product cost
$53.80
$62.60
2.
a.
Predetermined overhead rates for the activity cost pools:
Activity Cost Pool
(a) Estimated Total Cost
(b) Estimated Total Activity
(b) Estimated Total Activity
(a) ÷ (b) Activity Rate
(a) ÷ (b) Activity Rate
Machine setups
$180,000
250
setups
$720
per setup
Special milling
$300,000
1,000
MHs
$300
per MH
General factory
$1,000,000
20,000
DLHs
$50
per DLH
The overhead applied to each product can be determined as follows:
Model XR7
Activity Cost Pool
(a) Predetermined Overhead Rate
(a) Predetermined Overhead Rate
(b) Activity
(b) Activity
(a) × (b) Overhead Applied
Machine setups
$720
per setup
150
setups
$108,000
Special milling
$300
per MH
1,000
MHs
300,000
General factory
$50
per DLH
4,000
DLHs
200,000
Total manufacturing overhead cost (a)
$608,000
Number of units produced (b)
20,000
Overhead cost per unit (a) ÷ (b)
$30.40
Model ZD5
Activity Cost Pool
(a) Predetermined Overhead Rate
(a) Predetermined Overhead Rate
(b) Activity
(b) Activity
(a) × (b) Overhead Applied
Machine setups
$720
per setup
100
setups
$ 72,000
Special milling
$300
per MH
0
MHs
0
General factory
$50
per DLH
16,000
DLHs
800,000
Total manufacturing overhead cost (a)
$872,000
Number of units produced (b)
40,000
Overhead cost per unit (a) ÷ (b)
$21.80
b.
The unit product cost of each model under activity-based costing would be computed as follows:
Model
Model
XR7
ZD5
Direct materials
$35.00
$25.00
Direct labor ($20 per DLH × 0.2 DLH; $20 per DLH × 04.DLH)
4.00
8.00
Manufacturing overhead (above)
30.40
21.80
Total unit product cost
$69.40
$54.80
Comparing these unit cost figures with the unit costs in Part 1(b), we find that the unit product cost for Model XR7 has increased from $53.80 to $69.40, and the unit product cost for Model ZD5 has decreased from $62.60 to $54.80.
3.
It is especially important to note that, even under activity-based costing, 68% of the company’s overhead costs continue to be applied to products on the basis of direct labor-hours:
Machine setups (number of setups)
$ 180,000
12
%
Special milling (machine-hours)
300,000
20
General factory (direct labor-hours)
1,000,000
68
Total overhead cost
$1,480,000
100
%
Thus, the shift in overhead cost from the high-volume product (Model ZD5) to the low-volume product (Model XR7) occurred as a result of reassigning only 32% of the company’s overhead costs.
The increase in unit product cost for Model XR7 can be explained as follows: First, where possible, overhead costs have been traced to the products rather than being lumped together and spread uniformly over production. Therefore, the special milling costs, which are traceable to Model XR7, have all been assigned to Model XR7 and none assigned to Model ZD5 under the activity-based costing approach. It is common in industry to have some products that require special handling or special milling of some type. This is especially true in modern factories that produce a variety of products. Activity-based costing provides a vehicle for assigning these costs to the appropriate products.
Second, the costs associated with the batch-level activity (machine setups) have also been assigned to the specific products to which they relate. These costs have been assigned according to the number of setups completed for each product. However, since a batch-level activity is involved, another factor affecting unit costs comes into play. That factor is batch size. Some products are produced in large batches and some are produced in small batches. The smaller the batch, the higher the cost per unit of the batch activity. In the case at hand, the data can be analyzed as shown below.
Model XR7:
Cost to complete one setup [see 2(a)]
$720
(a)
Number of units processed per setup (20,000 units ÷ 150 setups)
133.33
(b)
Setup cost per unit (a) ÷ (b)
$5.40
Model ZD5:
Cost to complete one setup (above)
$720
(a)
Number of units processed per setup (40,000 units ÷ 100 setups)
400
(b)
Setup cost per unit (a) ÷ (b)
$1.80
Thus, the cost per unit for setups is three times as great for Model XR7, the low-volume product, as it is for Model ZD5, the high-volume product. Such differences in cost are obscured when direct labor-hours (or any other volume measure) is used as the basis for applying overhead cost to products.
In sum, overhead cost has shifted from the high-volume product to the low-volume product as a result of more appropriately assigning some costs to the products on the basis of the activities involved, rather than on the basis of direct labor-hours.