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.)