Question

SP 17 After reading an article about activity-based costing in a trade journal for the furniture industry, Santana Rey wondered if it was time to critically analyze overhead costs at Business Solutions. In a recent month, Santana found that setup costs, inspection costs, and utility costs made up most of its overhead. Additional information about overhead follows.

Activity Cost Driver

Setting up machines ……………….. \( 20,000 25 batches

Inspecting components …………… \) 7,500 5,000 parts

Providing utilities …………………… \( 10,000 5,000 machine hours

Overhead has been applied to output at a rate of 50% of direct labor costs. The following data pertain to Job 615.

Direct materials ……………………………………….. \)2,500

Direct labor …………………………………………….. $3,500

Batches …………………………………………………. 2 batches

Number of parts ……………………………………….. 400 parts

Machine hours …………………………………………. 600 machine hours

Required

1. Classify each of its three overhead activities as unit level, batch level, product level, or facility level.

2. What is the total cost of Job 615 if Business Solutions applies overhead at 50% of direct labor cost?

3. What is the total cost of Job 615 if Business Solutions uses activity-based costing?

4. Which approach to assigning overhead gives a better representation of the costs incurred to produce Job 615? Explain.

Short answer

Cost of job under the traditional method:$7,750

Cost of job under the ABC method: $9,400

Step-by-step solution

Classification of activities

1) Setting up machines: Setting up machines is a batch-level activity as it is done to prepare for production for a specific batch. Furthermore, the cost driver for this activity is batch number.

2) Inspecting components: It is a unit level cost as inspection is done at the unit level and this cost is dependent on the production level.

3) Providing Utilities: it is a facility-level cost. The utility is provided for the entire facility irrespective of production activity.

Calculation of total cost

$\begin{array}{rcl}\mathbf{\text{TotalcostofJob615}}& \mathbf{=}& \mathbf{\text{Directmaterialcost}}\mathbf{+}\mathbf{\text{DirectLaborcost}}\mathbf{+}\mathbf{50}\mathbf{\%}\mathbf{}\mathbf{\text{oflaborcostasoverhead}}\\ & \mathbf{=}& \mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{500}\mathbf{+}\mathbf{\$}\mathbf{3}\mathbf{,}\mathbf{500}\mathbf{+}\left(\frac{\$3,500\times 50}{100}\right)\\ & \mathbf{=}& \mathbf{\$}\mathbf{6}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{\$}\mathbf{1}\mathbf{,}\mathbf{750}\\ & \mathbf{=}& \mathbf{\$}\mathbf{7}\mathbf{,}\mathbf{750}\end{array}$

Calculation of overhead cost under ABC method

$\begin{array}{rcl}\mathbf{\text{TotalcostofJob}}\mathbf{}\mathbf{615}& \mathbf{=}& \mathbf{\text{Directmaterialcost}}\mathbf{+}\mathbf{\text{DirectLaborcost}}\mathbf{+}\mathbf{\text{Overheadcostbased}}\mathbf{}\mathit{o}\mathit{n}\mathbf{}\mathit{A}\mathit{B}\mathit{C}\\ & \mathbf{=}& \mathbf{\$}\mathbf{2}\mathbf{,}\mathbf{500}\mathbf{+}\mathbf{\$}\mathbf{3}\mathbf{,}\mathbf{500}\mathbf{+}\left(\frac{\$20,000\times 2}{25}+\frac{\$7,500\times 400}{5,000}+\frac{\$10,000\times 600}{5,000}\right)\\ & \mathbf{=}& \mathbf{\$}\mathbf{6}\mathbf{,}\mathbf{000}\mathbf{+}\mathbf{\$}\mathbf{3}\mathbf{,}\mathbf{400}\\ & \mathbf{=}& \mathbf{\$}\mathbf{9}\mathbf{,}\mathbf{400}\end{array}$

Comparison between two approaches

ABC is the better approach for the representation of cost as it determines cost on the basis of the level of activity. So under the ABC method, the total cost is more than the traditional method but it is accurately allocated to job 615.