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# overcosting and undercosting: traditional vs ABC costing

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Mott Manufacturing allocates factory overhead using one cost pool with direct labor hours as the allocation base.Mott has two production departments, P1 and P2.The new accountant at Mott estimates that next year, the total factory overhead costs will be \$5,000,000, and approximately 500,000 direct labor hours will be worked.The accountant also estimates that P1 will use 150,000 direct labor hours,and there will be about \$3,000,000 in overhead costs in P1. P2 will use 350,000 direct labor hours, and there will be \$2,000,000 in overhead costs in P2. Mott has two products, A1 and B1. It takes two direct labor hours in P1 and three direct labor hours in P2 to complete one unit of A1. It takes one direct labor hour in P1 and four direct labor hours in P2 to complete one unit of B1.

Required:

Which product will be undercosted and which will be overcosted with the one-cost-pool system?

#### Solution Summary

This is a classic issue! Allocating under different methods leads to different absorption of total overhead...with winners and losers. First, overcosting and undercosting is defined and then computations and discussion show how it applies in this circumstance. Once you get this, you are ready for most any "traditional vs abc" costing problem!

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## Activity based costing; cost analysis for Ontario, Inc.

Ontario, Inc. Manufactures two products, Standard and Enhanced, and applies overhead on the basis of direct-labor hours. Anticipated overhead and direct-labor time for the upcoming accounting period are \$800,000 and 25,000 hours, respectively. Information about the company's products follows.

Standard:
Estimated production volume, 3000 units
Direct-material cost, \$25 per unit
Direct-labor per unit, 3 hours at \$12 per hour
Enhanced:
Estimated production volume, 4000 units
Direct-material cost, \$40 per unit
Direct-labor per unit, 4 hours at \$12 per hour

Ontario's overhead of \$800,000 can be identified with three major activities: order processing (\$150,000), machine processing (\$560,000), and product inspection (\$90,000). these activities are driven by number of orders processed, machine hours worked, and inspection hours, respectively. Date relevant to these activities follows.

orders processed machine hours worked inspection hours

Standard.... 300 18,000 2000

Enhanced.... 200 22,000 8000

total..... 500 40,000 10,000

1. Assuming use of direct-labor hours to apply overhead to production, compute the unit manufacturing costs of the standard and enhanced products if the expected manufacturing volume is attained.

2. Assuming use of activity-based costing, compute the unit manufacturing costs of the standard and enhanced products if the expected manufacturing volume is attained.

3. Ontario's selling prices are based heavily on cost.

a. By using direct-labor hours as an application base, which product is overcosted and which product is undercosted? Calculate the amount of the cost distortion for each product

b. Is it possible that overcosting and undercosting, and the susequent determination of selling prices are contributing to the company's profit woes? Explain

4. Build the spreadsheet: construct an excel spreadsheet to solve requirements 1, 2 and 3 (a) above. how will the solution change if the following data change: the overhead associate with order processing is \$300,000 and the overhead associated with product inspection is \$270,000.

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