Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 37

Activity-Based Costing and Predetermined Overhead Allocation Rates

Kitchen Supply, Inc. (KSI), manufactures three types of flatware: institutional, standard, and silver. It applies all indirect costs according to a predetermined rate based on direct labor-hours. A consultant recently suggested that the company switch to an activity-based costing system and prepared the following cost estimates for year 2 for the recommended cost drivers.

Activity	Recommended Cost Driver	Estimated Cost	Estimated Cost Driver Activity
Processing orders	Number of orders	$ 54,000	200 orders
Setting up production	Number of production runs	216,000	100 runs
Handling materials	Pounds of materials used	360,000	120,000 pounds
Machine depreciation
and maintenance	Machine-hours	288,000	12,000 hours
Performing quality control .	Number of inspections	72,000	45 inspections
Packing	Number of units	144,000	480,000 units
Total estimated cost		$1,134,000

In addition, management estimated 7,500 direct labor-hours for Year 2.

Assume that the following cost driver volumes occurred in January Year 2:

	Institutional	Standard	Silver
Number of units produced	60,000	24,000	9,000
Direct materials costs	$39,000	$24,000	$15,000
Direct labor-hours	450	450	600
Number of orders	12	9	6
Number of production runs	3	3	6
Pounds of material	15,000	6,000	3,000
Machine-hours	580	140	80
Number of inspections	3	3	3
Units shipped	60,000	24,000	9,000

Actual labor costs were $15 per hour.

Required

a.Compute a predetermined overhead rate for year 2 for each cost driver using the estimated costs and estimated cost driver units prepared by the consultant. Also compute a predetermined rate for year 2 using direct labor-hours as the allocation base.

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b.Compute the production costs for each product for January using direct labor-hours as the allocation base and the predetermined rate computed in requirement (a).

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c.Compute the production costs for each product for January using the cost drivers recommended by the consultant and the predetermined rates computed in requirement (a). (Note: Do not assume that total overhead applied to products in January will be the same for activity- based costing as it was for the labor-hour-based allocation.)

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d.Management has seen your numbers and wants an explanation for the discrepancy between the product costs using direct labor-hours as the allocation base and the product costs using activity-based costing. Write a brief response to management.

Step 1 of 4

a.?Computing overhead allocation rates

Activity	CostDriver		Est.Costs		DriverUnits		Rate
Processing orders	No. of orders		$?54,000	÷	200	=	$?270
Setting up production	No. of  runs		216,000	÷	100	=	2,160
Handling materials	Pounds		360,000	÷	120,000	=	3.00
Using machines	Machine-hrs.		288,000	÷	12,000	=	24
Performing quality control	No. of insp.		72,000	÷	45	=	1,600
Packing	No. of units		144,000	÷	480,000	=	0.30
Total est. overhead			$1,134,000

Predetermined rate for direct labor-hour	=	Estimated activity ÷ Estimated allocation base
	=	$1,134,000 ÷ 7,500 hours
	=	$151.20 per hour