Chapter 5, Problem 55P

Production-Based Costing versus Activity-Based Costing, Assigning Costs to Activities, Resource Drivers

Willow Company produces lawnmowers. One of its plants produces two versions of mowers: a basic model and a deluxe model. The deluxe model has a sturdier frame, a higher horsepower engine, a wider blade, and mulching capability. At the beginning of the year, the following data were prepared for this plant:

Additionally, the following overhead activity costs are reported:

Facility-level costs are allocated in proportion to machine hours (provides a measure of time the facility is used by each product). Receiving and materials handling use three inputs: two forklifts, gasoline to operate the forklift, and three operators. The three operators are paid a salary of $40,000 each. The operators spend 25% of their time on the receiving activity and 75% on moving goods (materials handling). Gasoline costs $3 per move. Depreciation amounts to $8,000 per forklift per year.

Required:

(Note: Round answers to two decimal places.)

1. 1. Calculate the cost of the materials handling activity. Label the cost assignments as driver tracing or direct tracing. Identify the resource drivers.
2. 2. Calculate the cost per unit for each product by using direct labor hours to assign all overhead costs.
3. 3. Calculate activity rates, and assign costs to each product. Calculate a unit cost for each product, and compare these costs with those calculated in Requirement 2.
4. 4. Calculate consumption ratios for each activity.
5. 5. CONCEPTUAL CONNECTION Explain how the consumption ratios calculated in Requirement 4 can be used to reduce the number of rates. Calculate the rates that would apply under this approach.

To determine

Compute the costs of the material handling activity and label the activities into driver tracing or direct tracing. Also, identify the resource drivers of the various activities.

Explanation of Solution

Activity Based Costing (ABC):

Activity based costing is an apportionment of costs that first considers the activity drivers that helps in the allocation of costs to various activities and then allocates costs to different cost objects by using the drivers.

Particulars	Rate (R) ($)	Quantity (Q)	Amount $\left(R\times Q\right)$ ($)
Labor	120,000	0.75	90,000
Gasoline	3	6,000	18,000
Depreciation	16,000	0.75	12,000
Total Cost			120,000

Table (1)

Labor and Gasoline are driver tracing.

Identification of resource driver:

Activity	Resource driver
Labor	Time
Gasoline	Number of moves
Depreciation	Time

Table (2)

To determine

Compute the costs per unit for each product with the help of direct labor hours.

Explanation of Solution

Computation of costs per account by customer category:

Particulars	Basic ($)	Deluxe ($)
Prime costs	80	160
Overhead costs	7.501	152
Total costs	87.50	175

Table (3)

Working Note:

1. Calculation of overhead costs:

First, the amount of plant wide rate is computed so as to calculate the overhead costs of basic:

$\begin{array}{c}\text{Plantwide Rate}=\frac{\text{Total Costs}}{\text{Direct Labor Hours}}\\ =\frac{\$600,000}{20,000}\\ =\$\text{30 per direct labor hours}\end{array}$

$\begin{array}{c}\text{Overhead Costs}=\frac{\text{Direct Labor Hours}}{\text{Number Of Units}}\times \text{Plantwide Rate}\\ \text{=}\frac{\text{10,000 hours}}{\text{40,000 units}}\times \$30\\ =\$7.50\end{array}$

2. Calculation of overhead costs of deluxe:

$\begin{array}{c}\text{Overhead Costs}=\frac{\text{Direct Labor Hours}}{\text{Number Of Units}}\times \text{Plantwide Rate}\\ \text{=}\frac{\text{10,000 hours}}{\text{20,000 units}}\times \$30\\ =\$15\end{array}$

To determine

Compute the activity rates and assign this cost to each product. Compute unit cost for each product and compare the costs.

Explanation of Solution

Computation of costs per account by customer category:

Activity	Rate(R)	Quantity (Q)	Basic $\left(R\times Q\right)$($)	Deluxe$\left(R\times Q\right)$ ($)
(A)Prime costs	80	40,000	3,200,000
	160	20,000		3,200,000
(B)Maintenance	28.501	1,000	28,500
	28.501	3,000		85,500
(C)Engineering	20.002	1,500	30,000
	20.002	4,500		90,000
(D)Materials handling	20.003	1,200	24,000
	20.003	4,800		96,000
(E)Setting up	1,2004	16	19,200
	1,2004	64		76,800
(F)Purchasing	2005	100	20,000
	2005	200		40,000
(G)Receiving	53.336	250	13,333
	53.336	500		26,665
(H)Paying Suppliers	407	250	10,000
	407	250		20,000
(I)Paying Space	28	5,000	10,000
	28	5,000		10,000
Total Cost $\left(\text{A}+\text{B+C+D+E+F+G+H+I}\right)$			3,355,033	3,644,965
Units produced			40,000	20,000
Units costs (ABC) $\left(\frac{\text{Total Costs}}{\text{Units Produced}}\right)$			83.88	182.25
Units Costs(Traditional)			87.50	175.00

Table (4)

The ABC approach is more accurate in assigning the cost to each product as compared to the traditional approach. The traditional approach shows that the basic model was overstated and deluxe model was understated because traditional model used the plant wide overhead rate.

Working Note:

1. Calculation of maintenance rates:

$\begin{array}{c}\text{Maintenance Rate}=\frac{\text{Maintenance Costs}}{\text{Number of Maintenance Hours}}\\ =\frac{\text{\$114,000}}{\text{4,000 hours}}\\ =\$\text{28}\text{.50 per maintenance hours}\end{array}$

2. Calculation of engineering rate:

$\begin{array}{c}\text{Engineering Rate}=\frac{\text{ Engineering Costs}}{\text{Number Of Engineering Hours}}\\ =\frac{\text{\$120,000}}{\text{6,000 hours}}\\ =\$\text{20 per engineering hours}\end{array}$

3. Calculation of material handling rate:

$\begin{array}{c}\text{Material Handling Rate}=\frac{\text{Material Handling Costs}}{\text{Number Of Moves}}\\ =\frac{\text{\$120,000}}{\text{6,000 moves}}\\ =\text{\$20 per move}\end{array}$

4. Calculation of setting up rate:

$\begin{array}{c}\text{Setting Up Rate}=\frac{\text{Setting Up Costs}}{\text{Number Of Setups}}\\ =\frac{\text{\$96,000}}{\text{80 setups}}\\ =\text{\$1,200 per setup}\end{array}$

5. Calculation of purchasing rate:

$\begin{array}{c}\text{Purchasing Rate}=\frac{\text{Purchasing Costs}}{\text{Number Of Requisition}}\\ =\frac{\text{\$60,000}}{\text{300 requisition}}\\ =\text{\$200 per requisition}\end{array}$

6. Calculation of receiving rate:

$\begin{array}{c}\text{Receiving Rate}=\frac{\text{Receiving Costs}}{\text{Number Of Orders}}\\ =\frac{\text{\$40,000}}{\text{750 orders}}\\ =\text{\$53}\text{.33 per orders}\end{array}$

7. Calculation of paying suppliers rate:

$\begin{array}{c}\text{Paying Suppliers Rate}=\frac{\text{Paying Suppliers Costs}}{\text{Number Of Invoices}}\\ =\frac{\text{\$30,000}}{\text{750 invoices}}\\ =\text{\$40 per invoices}\end{array}$

8. Calculation of providing space rate:

$\begin{array}{c}\text{Providing Space Rate}=\frac{\text{Providing Space Costs}}{\text{Number Of Machine Hours}}\\ =\frac{\text{\$20,000}}{\text{10,000 machine hours}}\\ =\text{\$2 per machine hours}\end{array}$

To determine

Compute the consumption ratios for each activity.

Explanation of Solution

Use the following formula to calculate consumption ratio of basic model:

$\text{Consumption Ratio}=\frac{\text{Amount Of Activity Driver Per Product}}{\text{Total Driver Quantity}}$

Consumption Ratio
Overhead Activity	Amount of Activity Driver Per Product	Total Driver Quantity	Basic
	(A)	(B)	(A/B)
Maintenance	1,000	4,000	0.25
Engineering	1,500	6,000	0.25
Material handling	1,200	6,000	0.20
Setups	16	80	0.20
Purchasing	100	300	0.33
Receiving	250	750	0.33
Paying suppliers	250	750	0.33
Providing space	5,000	10,000	0.50

Table (5)

Use the following formula to calculate consumption ratio of deluxe model:

$\text{Consumption Ratio}=\frac{\text{Amount Of Activity Driver Per Product}}{\text{Total Driver Quantity}}$

Consumption Ratio
Overhead Activity	Amount of Activity Driver Per Product	Total Driver Quantity	Deluxe
	(A)	(B)	(A/B)
Maintenance	3,000	4,000	0.75
Engineering	4,500	6,000	0.75
Material handling	4,800	6,000	0.80
Setups	64	80	0.80
Purchasing	200	300	0.67
Receiving	500	750	0.67
Paying suppliers	500	750	0.67
Providing space	5,000	10,000	0.50

Table (6)

Working Note:

Total driver quantity hours are computed by adding total hours of basic hours and deluxe hours. Total hours are 4,000$\left(1,000+3,000\right)$. Similarly, calculate for other activities.

To determine

Discuss the impact of consumption ratio on reducing the taxes. Also, compute the rate of taxes that would apply under this approach.

Explanation of Solution

The activities with the same proportions are combined into one pool, if the products are consumed in same proportion. The pooled activity costs will be apportioning in the similar proportion according to the individual activity costs. Therefore, the rate of pool is reduced from 8 to 4 with the help of consumption ratio. The calculation of pool is explained below:

Calculation of pool rate by grouping together maintenance activity and engineering activity:

Particulars	Amount ($)
Maintenance	114,000
Engineering	120,000
Total	234,000
Maintenance hours	4,000
Pool rate $\left(\frac{\text{Total}}{\text{Maintenance Hours}}\right)$	58.50

Table (7)

Therefore, the pool rate of same consumption ratio activities is $58.50.

Calculation of pool rate by grouping together material handling activity and setups activity:

Particulars	Amount ($)
Material handling	120,000
Setups	96,000
Total	216,000
Number of moves	6,000
Pool rate $\left(\frac{\text{Total}}{\text{Number Of Moves}}\right)$	36

Table (8)

Therefore, the pool rate of same consumption ratio activities is $36.00.

Calculation of pool rate by grouping together purchasing, receiving and paying suppliers activity:

Particulars	Amount ($)
Purchasing	60,000
Receiving	40,000
Paying suppliers	30,000
Total	130,000
Orders processed	750
Pool rate $\left(\frac{\text{Total}}{\text{Orders Processed}}\right)$	173.33

Table (9)

Therefore, the pool rate of same consumption ratio activities is $173.33.

Calculation of pool rate of providing space:

Particulars	Amount ($)
Providing space	20,000
Machine hours	10,000
Pool rate $\left(\frac{\text{Providing Space}}{\text{Machine hours}}\right)$	2

Table (10)

Therefore, the pool rate of providing space is $2.