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Traditional costing vs activity based costing


Gigantic, Inc. manufactures three products for the computer industry:

Gizmoz (product G): annual sales, 8,000 units
Thangz (product T): annual sales, 15,000 units
Whatziz (product W): annual sales, 4,000 units

The company uses a traditional, volume based product costing system with manufacturing overhead applied on the basis of direct labor dollars. The product costs have been computed as follows:

Product G Product T Product W

Raw material $35.00 $52.50 $17.50

Direct labor $16.00(.8hr@$20) $12.00(.6hr@$20) $8.00(.4hr@$20)

overhead** $140.00 $105.00 $70.00

Total product cost $191.00 $169.50 $95.50

** Calculation of predetermined overhead rate:

Manufacturing overhead budget:

Machine setup $5,250

Machinery $1,225,000

Inspection $525,000

Material handling $875,000

Engineering $344,750

Total $2,975,000

Direct-labor budget (based on budgeted annual sales):

Product G 8,000 x $16.00= $128,000

Product T 15,000 x $12.00 $180,000

Product W 4,000 x $8.00 $32,000

Total $340,000

Predetermined overhead rate = Budgeted overhead ÷ Budgeted direct labor = 875%

Gigantic pricing method has been set to a target price equal to 150% of the full product cost. However, only in the Thangz have been selling at their target price. The target and actual current prices for all three products are following:

Product G Product T Product W

Product cost $191.00 $169.50 $95.50

Target price $286.50 $254.25 $143.25
Actual current
selling price $213.00 $254.25 $200.00

Gigantic has been forced to lower the price of Gizmoz in order to get orders. In contrast, Gigantic has raised the price of Whatziz several times, but there has been no apparent loss of sales. Gigantic, Inc.has been under increasing pressure to reduce the price even further on Gizmoz. In contrast, Gigantic's competitors do not seem to be interested in the market for Whatziz. Gigantic apparently has this market to itself.


1. Is product G the company's least profitable product?

2. Is product W a profitable product for Gigantic, Inc?

3. Comment on the reactions of Gigantic's competitors to the firm's pricing strategy. What dangers does Gigantic, Inc face?

Gigantic's controller, Anita Penney, recently attended a conference at which activity based costing systems were discussed. She became convinced that such a system would help Gigantic's management to understand its product costs better. She got top management's approval to design an activity-based costing system, and an ABC project team was formed. In stage one of the ABC project, each of the overhead items listed in the overhead budget was placed into its own activity cost pool. Then a cost driver was identified for each activity cost pool. Finally, the ABC project team compiled data showing the percentage of the each cost driver that was consumed by each of Gigantic's product lines.

These and data are summarized as follows:

Activity Cost Pool Cost Driver Product G Product T Product W

Machine setup Number of setups 20% 30% 50%

Machinery Machine hours 25% 50% 25%

Inspection Number of
inspections 15% 45% 40%

Material handling Raw-material costs 25% 69% 6%

Engineering # of change orders 35% 10% 55%

4. Show how the controller determined the percentages given above for raw-material costs. (Round to the nearest whole percent.)

5. Develop product costs for the three products on the basis of an activity-based costing system. (Round to the nearest cent.)

6. Calculate a target price for each product, using Gigantic's pricing formula. Compare the new target prices with the current actual selling prices and previously reported product costs.

7. Build a spreadsheet: Construct an Excel spreadsheet to solve requirements (5) and (6) above. Show how the solution will change if the inspection activity was divided among the three products in the following manner: product G, 20%; product T, 40%, and product W, 40%.


Solution Summary

The solution explains the calculation differences between traditional costing and activity based costing