Assume that Master File, Inc., makes two lines of file cabinets: (1) metal file cabinets, sold through office supply outlets for commercial use, and (2) wooden file cabinets, sold through fine furniture stores for home use.
In a typical year, the company produces and sells approximately 42,000 metal cabinets and 9,000 wooden cabinets. Total manufacturing overhead at this level of production is expected to average $249,600 per year and is currently allocated to products at a rate of $1.60 per direct labor hour (DLH), as computed below.
Step 1: Compute total direct labor hours at normal levels of production.
Overhead rate using direct labor hours
Metal cabinets (42,000 units per year ⫻ 2 DLH per unit) . . . 84,000 DLH Wooden cabinets (9,000 units per year ⫻ 8 DLH per unit) . . . 72,000 DLH Total DLH at normal production levels . . . 156,000 DLH
Step 2: Compute the overhead application rate per DLH.
Overhead application rate ($249,600 ⫼ 156,000 DLH) . . . $1.60 per DLH
Using direct labor hours as a single activity base, the company’s total manufacturing costs per unit average $38.20 for metal cabinets and $117.80 for wooden cabinets, as shown below.
Master File sets its selling prices at 160 percent of total manufacturing costs. Thus, the company sells its metal cabinets for $61.12 (total unit cost of $38.20 ⫻ 160%) and its wooden cabinets for $188.48 (total unit cost of $117.80 ⫻ 160%). At these prices, the metal cabinets sell for about $3 less per unit than comparable cabinets sold by Master File’s competitors.
However, the price of wooden cabinets averages $10 more per unit than comparable products available on the market.
Glen Brown, Master File’s marketing director, believes that sales of the wooden cabinets have suffered as a result of the company’s pricing policy. He recently hired a consultant, Lisa Scott, to evaluate how prices are set. Scott drafted the memo in Exhibit 17–3 summarizing her findings:
Metal Wooden
Cabinets Cabinets
Direct materials . . . $15.00 $ 25.00 Direct labor (at $10.00 per hour) . . . 20.00 80.00 Manufacturing overhead (at $1.60 per DLH) . . . . 3.20 12.80 Total manufacturing costs per unit . . . . $38.20 $117.80 Total unit cost
Confirming Pages
Activity-Based Costing (ABC) 771
MEMO
DATE: January 16
TO: Glen Brown, Marketing Director, Master File, Inc.
FROM: Lisa Scott, Consultant, Scott & Associates
Having carefully examined Master File’s pricing policy, I find it consistent with pricing policies used throughout the office furniture industry. Therefore, I recommend that you continue setting prices at 160% of total manufacturing costs.
I do, however, strongly encourage management to change the method currently used to allocate manufacturing overhead to products. The use of direct labor hours as an activity base is causing an excessive share of total overhead costs to be allocated to the wooden cabinet line. Let me explain what is happening.
The wooden product line is very labor intensive in comparison to the metal cabinet line (that is, it takes an average of eight direct labor hours to manufacture a wooden cabinet, compared to an average of two direct labor hours to manufacture a metal cabinet). Because manufacturing over- head is allocated on the basis of direct labor hours, each wooden cabinet receives a far greater cost allocation than each metal cabinet. This would be appropriate if direct labor hours were the primary overhead cost driver. The fact is, however, that direct labor hours are not a significant driver of your overhead costs.
My analysis of manufacturing overhead at Master File, Inc., reveals that the most significant cost drivers are activities most closely associated with the metal cabinet line. Thus, it would make sense if your company selected activity bases that allocate more overhead costs to the metal cabinets.
This would indicate a lower cost for the wooden cabinets and provide justification for lowering their selling prices, making them more in line with the competition.
I suggest that we make an appointment to discuss using activity-based costing at Master File, Inc.
Exhibit 17–3
MEMO ABOUT OVERHEAD ALLOCATIONS
Assume that Master File decides to implement ABC as suggested by the consultant.
Remember that the company’s expected total overhead costs at normal levels of production average $249,600 per year . Let us assume that these overhead costs fall into two broad cat- egories: (1) Maintenance Department costs and (2) utilities costs. Recall that ABC is typically undertaken in two stages—first, identify separate activity cost pools and, second, allocate each cost pool to the product with an appropriate cost driver. We will create an ABC system for Master File, Inc., by using these two stages. Exhibit 17–4 illustrates stage 1 of the ABC system for Master File.
STAGE 1: SEPARATE ACTIVITY COST POOLS
Maintenance Department Costs The Maintenance Department incurs approx- imately $180,000 of Master File’s total overhead costs. The department has five full-time employees. Three employees are responsible for repair work, such as fixing the large cutting and bending machines used to manufacture metal file cabinets. The other two employees are responsible for set-up activities, such as adjusting machinery prior to each production run.
Using ABC, Master File identifies repair activities and set-up activities as separate activity cost pools. Thus each pool is assigned a portion of the department’s $180,000 in total costs.
Management believes that the number of employees engaged in each activity is the most sig- nificant cost driver of the Maintenance Department’s total costs. As shown in Exhibit 17–4 , by using the number of employees as an activity base, $108,000 is assigned to the repair cost pool, and $72,000 is assigned to the set-up cost pool . These computations are shown beneath Exhibit 17–4 on the following page.
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Assigning Maintenance Department Costs to Activity Pools
Step 1: Establish the percentage of total Maintenance Department costs to be assigned to each activity cost pool using the number of employees as an activity base.
Exhibit 17–4 STAGE 1: CREATING ACTIVITY COST POOLS
Repair cost pool
$108,000 Activity Cost
Pools Basis for
Allocation
Employees:
2 of 5 = 40%
Heating cost pool
$24,360 kWh expected:
175,000 of 500,000 = 35%
kWh expected:
325,000 of 500,000 = 65%
Utilities costs
$69,600 (500,000 kWh)
Overhead Costs
Machinery cost pool
$45,240 Allocation
Employees:
3 of 5 = 60%
Set-up cost pool
$72,000 Maintenance
Department costs
$180,000 (5 employees)
ACTIVITY COST POOLS MASTER FILE, INC.
% of total Employees engaged in repair activities . . . 3 60%
Employees engaged in set-up activities . . . 2 40%
Employees in the Maintenance Department . . . 5 100%
Step 2: Assign total Maintenance Department costs of $180,000 to each activity cost pool based on the percentages computed in step 1.
Utilities Costs Utilities costs account for nearly $69,600 of Master File’s total manu- facturing overhead costs. A large portion of this amount is incurred to heat the factory and supply power to the large machines used in manufacturing the metal cabinet line.
Thus, using ABC, Master File identifies heating demands and machinery power demands as separate activity cost pools. As shown in Exhibit 17–4 , each of these pools is assigned a portion of the $69,600 utilities costs. Management believes that the number of kilowatt hours (kWh) required for each activity is the most significant driver of utilities costs. With kilowatt hours as an activity base, $24,360 is assigned to the heating cost pool, whereas $45,240 is assigned to the machinery cost pool, as computed at the top of the following page.
Assigning Utilities Costs to Activity Pools
Step 1: Establish the percentage of total utilities costs to be assigned to each activity cost pool using the number of kilowatt hours as an activity base.
Costs assigned to the repair cost pool ($180,000 ⫻ 60%) . . . $108,000 Costs assigned to the set-up cost pool ($180,000 ⫻ 40%) . . . 72,000 Total Maintenance Department costs assigned . . . $180,000 Maintenance costs
assigned to cost pools
Confirming Pages
Activity-Based Costing (ABC) 773
Step 2: Assign total utilities costs of $69,600 to each activity cost pool based on the percent- ages computed in step 1.
% of total kWh per year for heating requirements . . . 175,000 35%
kWh per year for machinery requirements . . . . 325,000 65%
kWh required per year . . . . 500,000 100%
Utilities costs assigned to cost pools
Costs assigned to the heating cost pool ($69,600 ⫻ 35%) . . . $24,360 Costs assigned to the machinery cost pool ($69,600 ⫻ 65%) . . . . 45,240 Total utilities costs assigned . . . . $69,600