Chapter 5, Problem 57P

Knickknack, Inc. manufactures two products: Odds and Ends. The firm uses a single, plantwide overhead rate based on direct-labor hours. Production and product-costing data are as follows:

Calculation of predetermined overhead rate:

Manufacturing overhead budget:

Predetermined overhead rate:

$\frac{\text{Budgeted}\text{manufacturing}\text{overhead}}{\text{Budgeted}\text{direct-labor}\text{hours}}=\frac{\$816,000}{(1,000)(2)+(5,000)(3)}=\$48\text{per}\text{direct-labor}\text{hour}$

Knickknack, Inc. prices its products at 120 percent of cost, which yields target prices of $199.20 for Odds and $298.80 for Ends. Recently, however, Knickknack has been challenged in the market for Ends by a European competitor, Bricabrac Corporation. A new entrant in this market, Bricabrac has been selling Ends for $220 each. Knickknack’s president is puzzled by Bricabrac’s ability to sell Ends at such a low cost. She has asked you (the controller) to look into the matter. You have decided that Knickknack’s traditional, volume-based product-costing system may be causing cost distortion between the firm’s two products. Ends are a high-volume, relatively simple product. Odds, on the other hand, are quite complex and exhibit a much lower volume. As a result, you have begun work on an activity-based costing system.

Required:

1. 1. Let each of the overhead categories in the budget represent an activity cost pool. Categorize each in terms of the type of activity (e.g., unit-level activity).
2. 2. The following cost drivers have been identified for the four activity cost pools.

You have gathered the following additional information:

• Each Odd requires 4 machine hours, whereas each End requires 1 machine hour.
• Odds are manufactured in production runs of 50 units each. Ends are manufactured in 250-unit batches.
• Three-quarters of the engineering activity, as measured in terms of change orders, is related to Odds.
• The plant has 1,920 square feet of space, 80 percent of which is used in the production of Odds.

For each activity cost pool, compute a pool rate. (Hint: Regarding the pool rate refer to Exhibit 5–6.)

1. 3. Determine the unit cost, for each activity cost pool, for Odds and Ends.
2. 4. Compute the new product cost per unit for Odds and Ends, using the ABC system.
3. 5. Using the same pricing policy as in the past, compute prices for Odds and Ends. Use the product costs determined by the ABC system.
4. 6. Show that the ABC system fully assigns the total budgeted manufacturing overhead costs of $816,000.
5. 7. Show how Knickknack’s traditional, volume-based costing system distorted its product costs. (Refer to Exhibit 5–10 for guidance.)

To determine

Categorize each in terms of the type of activity.

Explanation of Solution

Activity-based costing: It is a method that helps in finding the activities performed by a company and it tracks the indirect costs to the activities of the company that consumes resources.

Categorize each in terms of the type of activity are shown below:

Activity Cost Pool	Type of Activity
I: Machine related costs	Unit-level
II: Setup and inspection	Batch- level
III: Engineering	Product-sustaining-level
IV: Plant-related costs	Facility-level

Table (1)

To determine

Calculate pool rate of each activity cost pool.

Explanation of Solution

Activity Cost Pool	Cost (A)	Cost drivers (B)	Pool rate (A ÷ B)
I: Machine related costs	$450,000	9,000 machine hours	$50 per machine hour
II: Setup and inspection	$180,000	40 runs	$4,500 per run
III: Engineering	$90,000	100 change orders	$900 per change order
IV: Plant-related costs	$96,000	1,920 square feet	$50 square feet

Table (2)

To determine

Calculate unit cost for each activity cost pool for odds and ends.

Explanation of Solution

Calculate unit cost for machine related costs for odds.

$\begin{array}{c}\text{unit cost}=\text{Pool rate }\times \text{Number of machine hour per unit}\\ \text{=}\text{\$50}\text{per machine hour}\times 4\text{machine hours per unit}\\ \text{=}\text{\$200}\text{per unit}\end{array}$

Calculate unit cost for machine related costs for ends.

$\begin{array}{c}\text{unit cost}=\text{Pool rate }\times \text{Number of machine hour per unit}\\ \text{=}\text{\$50}\text{per machine hour}\times 1\text{machine hours per unit}\\ \text{=}\text{\$50}\text{per unit}\end{array}$

Calculate unit cost for setup and inspection costs for odds.

$\begin{array}{c}\text{Unit cost =}\frac{\text{Pool rate}}{\text{Number of units per run}}\\ =\frac{\$4,500}{50\text{units per run}}\\ =\$90\text{per unit}\end{array}$

Calculate unit cost for setup and inspection cost for ends.

$\begin{array}{c}\text{Unit cost =}\frac{\text{Pool rate}}{\text{Number of units per run}}\\ =\frac{\$4,500}{250\text{units per run}}\\ =\$18\text{per unit}\end{array}$

Calculate unit cost for engineering for odds.

$\begin{array}{c}\text{Unit cost =}\frac{\text{Pool rate}\times \text{Percentage of number of}\text{change orders}}{\text{Number of change orders}}\\ =\frac{\left(\$900\text{per change order}\times \text{75\%}\times \text{100}\text{change orders}\right)}{\text{1,000}\text{units}}\\ =\$67.50\text{per unit}\end{array}$

Calculate unit cost for engineering for ends.

$\begin{array}{c}\text{Unit cost =}\frac{\text{Pool rate}\times \text{Percentage of number of}\text{change orders}}{\text{Number of change orders}}\\ =\frac{\left(\$900\text{per change order}\times 25\text{\%}\times \text{100}\text{change orders}\right)}{\text{5,000}\text{units}}\\ =\$4.50\text{per unit}\end{array}$

Calculate unit cost for plant related costs of Odds.

$\begin{array}{c}\text{Unit cost =}\frac{\left(\text{Pool rate}\times \text{percentage of number of square feet}\right)}{\text{Number of square feet}}\\ =\frac{\left(\$50\times 80\%\times \text{1,920}\text{square feet}\right)}{1,000\text{units}}\\ =\$76.80\text{per unit}\end{array}$

Calculate unit cost for plant related cost of ends.

$\begin{array}{c}\text{Unit cost =}\frac{\left(\text{Pool rate}\times \text{percentage of number of square feet}\right)}{\text{Number of square feet}}\\ =\frac{\left(\$50\times 20\%\times \text{1,920}\text{square feet}\right)}{5,000\text{units}}\\ =\$3.84\text{per unit}\end{array}$

To determine

Calculate the new product cost per unit for odds and ends using activity based costing.

Explanation of Solution

Calculate the new product cost per unit for odds and ends using activity based costing are given below:

Particulars	Odds	Ends
Direct materials	$40	$60
Direct labor	$30	$45
Manufacturing overhead:
Machine related	$200	$50
Setup and inspection	$90	$18
Engineering	$67.50	$4.50
Plant related	$76.80	$3.84
Total cost per unit	$504.30	$181.34

Table (3)

To determine

Calculate the product costs using the same pricing policy as in the past for odds and ends.

Explanation of Solution

Calculate the product costs using the same pricing policy as in the past for odds and ends.

Particulars	Odds	Ends
New product cost (ABC)  (A)	$504.30	$181.34
Pricing policy (B)	120%	120%
New target price (A × B)	$605.16	$217.61

Table (4)

To determine

Display that the activity based costing system fully assigns the total budgeted manufacturing overhead costs of $816,000.

Explanation of Solution

Particulars	Odds	Ends	Total
Manufacturing overhead costs:
Machine related	$200	$50
Setup and inspection	$90	$18
Engineering	$67.50	$4.50
Plant-related	$76.80	$3.84
Total overhead cost per unit (A)	$434.30	$76.34
Production volume (B)	1,000	5,000
Total overhead cost assigned	$434,300	$381,700	$816,000

Table (5)

To determine

Prepare a table showing traditional based product costing system distorts the product costs of odds and evens.

Explanation of Solution

Prepare a table showing traditional based product costing system distorts the product costs of odds and evens.

Particulars	Product G	Product T
Traditional based costing system - reported cost system	$166.00	$249.00
Less: Activity based costing system - Reported cost system	$504.30	$181.34
Traditional system Over costs (Under costs) per unit (A)	($338.30)	$67.66
Product volume (B)	1,000	5,000
Total amount of cost distortion for entire product line (A × B)	($338,300)	$338,300

Table (1)

Traditional system overcosts ends by $67.66 per unit, and traditional system undercosts odds by $338.30 per unit.