Chapter 9, Problem 67P

MTI makes three types of lawn tractors: M3100, M4100, and M6100. In the past, it allocated overhead to products using machine-hours. Last year, the company produced 10,000 units of M3100, 17,500 units of M4100, and 10,000 units of M6100 and had the following revenues and costs:

MTI’s controller has heard about activity-based costing and puts together an employee team to recommend cost allocation bases. The employee team recommends the following:

The employee team recommends that plant administration costs not be allocated to products.

Required

1. a.      Using machine-hours to allocate overhead, complete the income statement for MTI. Do not allocate plant administrative costs to products.
2. b.      Complete the income statement using the activity-based costing method suggested by the employee team.
3. c.       Write a brief report indicating how activity-based costing might result in better decisions by MTI.
4. d.      After hearing the recommendations, the president expresses concern about failing to allocate plant administrative costs. If plant administrative costs were to be allocated to products, how would you allocate them?

To determine

Complete the income statement in accordance with the information given in the question.

Explanation of Solution

Activity-based costing:

Activity-based costing refers to the method of costing where the overhead cost is assigned to various products. This costing method identifies the relationship between the manufacturing overhead costs and the activities. This relationship is then used to allocate indirect costs to the products.

Complete the income statement:

Particulars	M3100	M4100	M6100	Total
Sales revenue	$9,000,000	$15,000,000	$13,500,000	$37,500,000
Add: Direct costs:
Direct material	$3,000,000	$4,500,000	$3,300,000	$10,800,000
Direct labor	$600,000	$900,000	$1,800,000	$3,300,000
Variable overhead $\left(\begin{array}{l}\text{Machine hour rate}\\ \times \text{ Machine-hours}\end{array}\right)$	$2,088,000	$3,132,000	$3,480,000	$8,700,000
Contribution margin	$3,312,000	$6,468,000	$4,920,000	$14,700,000
Less: Plant admin				$6,000,000
Gross profit				$8,700,000

Table: (1)

Working note 1:

Compute the machine hour rate:

$\begin{array}{c}\text{Machine-hour rate = }\frac{\text{Total overhead}}{\text{Total machine-hours}}\\ =\frac{\$2,400,000+\$1,800,000+\$2,400,000+\$1,200,000+\$900,000}{25,000}\\ =\frac{\$8,700,000}{25,000}\\ =\$348\end{array}$

To determine

Complete the income statement in accordance with the information given in the question.

Explanation of Solution

Activity-based costing:

Activity-based costing refers to the method of costing where the overhead cost is assigned to various products. This costing method identifies the relationship between the manufacturing overhead costs and the activities. This relationship is then used to allocate indirect costs to the products.

Compute the cost driver rates:

Particulars	Cost	Activity volume	Unit rate
Setting up machines	$2,400,000	50 Production runs	$48,000
Processing sales orders	$1,800,000	800 Sales orders	$2,250
Warehousing	$2,400,000	400 Units	$6,000
Operating machines	$1,200,000	25,000 Machine-hours	$48
Shipping	$900,000	37,500 Units shipped	$24

Table: (2)

Complete the income statement using the activity-based costing system:

Particulars	M3100	M4100	M6100	Total
Sales revenue	$9,000,000	$15,000,000	$13,500,000	$37,500,000
Direct costs:
Direct material	$3,000,000	$4,500,000	$3,300,000	$10,800,000
Direct labor	$600,000	$900,000	$1,800,000	$3,300,000
Variable overhead:
Setting up machines $\left(\begin{array}{l}\text{Rate per run}\\ \times \text{ Number of runs}\end{array}\right)$	$480,000	$960,000	$960,000	$2,400,000
Processing orders $\left(\begin{array}{l}\text{Rate per order}\\ \times \text{ Number of orders}\end{array}\right)$	$405,000	$900,000	$495,000	$1,800,000
Warehousing $\left(\begin{array}{l}\text{Rate per unit}\\ \times \text{ Number of units}\end{array}\right)$	$600,000	$1,200,000	$600,000	$2,400,000
Operating machines $\left(\begin{array}{l}\text{Rate per hour}\\ \times \text{Number of machine hours}\end{array}\right)$	$288,000	$432,000	$480,000	$1,200,000
Shipping $\left(\begin{array}{l}\text{Rate per unit shipped}\\ \times \text{ Number of units shipped}\end{array}\right)$	$240,000	$420,000	$240,000	$900,000
Contribution margin	$3,387,000	$5,688,000	$5,625,000	$14,700,000
Less: Plant admin				$6,000,000
Gross profit				$8,700,000

Table: (3)

To determine

Write a brief report according to the information given in the question.

Explanation of Solution

Activity-based costing:

Activity-based costing refers to the method of costing where the overhead cost is assigned to various products. This costing method identifies the relationship between the manufacturing overhead costs and the activities. This relationship is then used to allocate indirect costs to the products.

The relevance of the activity-based costing system according to the information given in the question:

The computed income statement by the machine-hour method and activity-based costing method are equal. Thus, the choice of method will not have any impact on the choice of the method used for the determination of profit and cost.

But, choosing the activity-based method of computation provides a better assessment of the costing structure. The allocation of cost on the basis of cost drivers helps management taking informed decision.

To determine

Determine the cost allocation according to the information given in the question.

Explanation of Solution

Activity-based costing:

Activity-based costing refers to the method of costing where the overhead cost is assigned to various products. This costing method identifies the relationship between the manufacturing overhead costs and the activities. This relationship is then used to allocate indirect costs to the products.

The relevance of plant administration cost with respect to the information given in the question:

The allocation of the cost should be in a manner that can establish a relationship between benefits and the plant administration cost. The more information related to the plant administration cost would help establish the correlation better for the identification of the parts of the plant administration cost.