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Activity-based costing differ from Traditional costing

Bailey's Leisure Equipment uses a traditional overhead allocation scheme in its manufacturing plant. The company produces three products: umbrellas, sunshades, and lawn chairs. For 1994, the company incurred $1,000,000 of manufacturing overhead costs and produced 100,000 umbrellas, 10,000 sunshades, and 30,000 lawn chairs. The company's overhead application rate was $10 per direct labor hour. Based on this rate, the cost per unit for each product group in 1994 was as follows:

UMBRELLAS SUNSHADES LAWN CHAIRS
Direct materials $2.00 $20.00 $ 2.00
Direct labor 3.00 22.50 7.50
Overhead 4.00 30.00 10.00
TOTAL $9.00 $72.50 $19.50

Because profitability has been lagging and competition has been getting more keen, the company is considering the implementation of an activity-based costing system for 1995. In analyzing the 1994 data, management determined that all $1,000,000 of factory overhead could be assigned to four basic activities: quality control, setups, materials handling, and equipment operations. Data from 1994 on the costs associated with each of the four activities follows:

QUALITY MATERIALS EQUIPMENT
CONTROL SETUPS HANDLING OPERATION TOTAL
Costs $50,000 $50,000 $150,000 $750,000 $1,000,000

Management determined that it will use the following allocation bases (number in parenthesis indicates total 1994 volume for each allocation base):

Quality control # of units produced (140,000)
Setups # of setups (500)
Materials handling lbs. of material used (1,000,000)
Equipment operation machine hours (500,000)

Volume measures for 1994 for each product and each allocation base were as follows:

UMBRELLAS SUNSHADES LAWN CHAIRS
# of units 100,000 10,000 30,000
# of setups 100 200 200
lbs. of material 200,000 500,000 300,000
machine hours 100,000 200,000 200,000

A. For 1994, determine the total amount of overhead allocated to each product group using the traditional allocation based on direct labor hours.
B. For 1994, determine the total overhead that would be allocated to each product group using the activity-based costing allocation measures. Compute the cost per unit for each product group.
C. If the company has a policy of setting selling prices based on product costs, how would the sales prices using activity-based costing differ from those obtained using the traditional overhead allocation?

Solution Preview

Bailey's Leisure Equipment uses a traditional overhead allocation scheme in its manufacturing plant. The company produces three products: umbrellas, sunshades, and lawn chairs. For 1994, the company incurred $1,000,000 of manufacturing overhead costs and produced 100,000 umbrellas, 10,000 sunshades, and 30,000 lawn chairs. The company's overhead application rate was $10 per direct labor hour. Based on this rate, the cost per unit for each product group in 1994 was as follows:

UMBRELLAS SUNSHADES LAWN CHAIRS
Direct materials $2.00 $20.00 $ 2.00
Direct labor 3.00 22.50 ...

Solution Summary

This explains the difference between activity-based costing and the traditional overhead allocation

$2.19