Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 12

Volume-Based Costing Versus ABC ADA Pharmaceutical Company produces three drugs: Diomy-cin, Homycin, and Addolin belonging to the analgesic (pain-killer) family of medication. Since its inception four years ago, ADA has used a direct labor-hour-based system to assign manufacturing overhead costs to products.

Eme Weissman, the president of ADA Enterprises, has just read about activity-based costing in a trade journal. With some curiosity and interest, she asked her financial controller, Takedo Simon, to examine differences in product costs between the firm’s current costing and activity-based costing systems.

ADA has the following budget information for the year:

	Diomycin	Homycin	Addolin
Cost of direct materials	$ 205,000	$265,000	$258,000
Cost of direct labor	250,000	234,000	263,000
Number of direct labor-hours	7,200	6,800	2,000
Number of capsules	1,000,000	500,000	300,000

ADA has identified the following activities as cost drivers and has allocated them to total overhead cost of $200,000 as follows:

			Budgeted Cost
Activity	Cost Driver	Budgeted Overhead Cost	Driver Volume
Machine setup	Setup hours	$ 16,000	1,600
Plant management	Workers	36,000	1,200
Supervision of direct labor	Direct labor-hours	46,000	1,150
Quality inspection	Inspection-hours	50,400	1,050
Expediting orders	Customers served	51,600	645
Total overhead		$200,000

Takedo selected the cost drivers with the following justifications:

SETUP HOURS: The cost driver of setup hours is used because the same product takes about the same amount of setup time regardless of size of batch. For different products, however, the setup time varies.

NUMBER OF WORKERS: Plant management includes plant maintenance and corresponding managerial duties that make production possible. This activity depends on the number of workers. The more workers involved, the higher the cost.

SUPERVISION OF DIRECT LABOR: Supervisors spend their time supervising produc­tion. The amount of time they spend on each product is proportional to the direct labor-hours worked.

QUALITY INSPECTION: Inspection involves testing a number of units in a batch. The time varies for different products but is the same for all similar products.

NUMBER OF CUSTOMERS SERVED: The need to expedite production increases as the number of customers served by the company increases. Thus, the number of customers served by ADA is a good measure of expediting production orders.

Takedo gathered the following information about the cost driver volume for each product:

	Diomycin	Homycin	Addolin
Machine setups	200	600	800
Plant management	200	400	600
Supervision of direct labor	200	300	650
Quality inspection	150	200	700
Expediting production orders	45	100	500

Required

1. Use the firm’s current costing system to calculate the unit cost of each product.

2. Use the activity-based cost system to calculate the unit cost of each product.

3. The two cost systems provide different results; give several reasons for this. Why might these differences be strategically important to ADA Enterprises? How does ABC add to ADA’s competitive advantage?

4. How and why may firms in the pharmaceutical industry use ABC? What is the strategic advantage?

Step 1 of 6

The formula for calculating predetermined overhead rate as follows: