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Hi-Tek Manufacturing, Inc., makes two types of industrial component parts—the B300 and the T500. An absorption costing income statement for the most recent period is shown:

Hi-Tek Manufacturing Inc.
Income Statement
Sales $ 2,100,000
Cost of goods sold 1,600,000
Gross margin 500,000
Selling and administrative expenses 550,000
Net operating loss $ (50,000 )

Hi-Tek produced and sold 70,000 units of B300 at a price of $20 per unit and 17,500 units of T500 at a price of $40 per unit. The company's traditional cost system allocates manufacturing overhead to products using a plantwide overhead rate and direct labor dollars as the allocation base. Additional information relating to the company's two product lines is shown below:

B300 T500 Total
Direct materials $ 436,300 $ 251,700 $ 688,000
Direct labor $ 200,000 $ 104,000 304,000
Manufacturing overhead 608,000
Cost of goods sold $ 1,600,000

The company has created an activity-based costing system to evaluate the profitability of its products. Hi-Tek's ABC implementation team concluded that $50,000 and $100,000 of the company's advertising expenses could be directly traced to B300 and T500, respectively. The remainder of the selling and administrative expenses was organization-sustaining in nature. The ABC team also distributed the company's manufacturing overhead to four activities as shown below:

Manufacturing
Overhead Activity
Activity Cost Pool (and Activity Measure) B300 T500 Total
Machining (machine-hours) $ 213,500 90,000 62,500 152,500
Setups (setup hours) 157,500 75 300 375
Product-sustaining (number of products) 120,000 1 1 2
Other (organization-sustaining costs) 117,000 NA NA NA
Total manufacturing overhead cost $ 608,000

Required:

1. Compute the product margins for the B300 and T500 under the company's traditional costing system.

2. Compute the product margins for B300 and T500 under the activity-based costing system.

3. Prepare a quantitative comparison of the traditional and activity-based cost assignments.

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1 Answer

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1. Under the traditional direct labor-dollar based costing system, manufacturing overhead is applied to products using the predetermined overhead rate computed as follows:

Predetermined overhead rate = Estimated total manufacturing overhead cost
Estimated total direct labor dollars

= $608,000 = $2.00 per DL$
$304,000

The product margins using the traditional approach would be computed as follows:

B300 T500 Total
Sales $ 1,400,000 $ 700,000 $ 2,100,000
Direct materials 436,300 251,700 688,000
Direct labor 200,000 104,000 304,000
Manufacturing overhead applied
@ $2.00 per direct labor-dollar 400,000 208,000 608,000
Total manufacturing cost 1,036,300 563,700 1,600,000
Product margin $ 363,700 $ 136,300 $ 500,000

Note that all of the manufacturing overhead cost is applied to the products under the company's traditional costing system.

2. The first step is to determine the activity rates:

(a) (b) (a) ÷ (b)
Activity Cost Pools Total Cost Total Activity Activity Rate
Machining $ 213,500 152,500 MH $ 1.40 per MH
Setups $ 157,500 375 setup hrs. $ 420 per setup hr.
Product sustaining $ 120,000 2 products $ 60,000 per product

*The Other activity cost pool is not shown above because it includes organization-sustaining and idle capacity costs that should not be assigned to products.

Under the activity-based costing system, the product margins would be computed as follows:

B300 T500 Total
Sales $ 1,400,000 $ 700,000 $ 2,100,000
Direct materials 436,300 251,700 688,000
Direct labor 200,000 104,000 304,000
Advertising expense 50,000 100,000 150,000
Machining 126,000 87,500 213,500
Setups 31,500 126,000 157,500
Product sustaining 60,000 60,000 120,000
Total cost 903,800 729,200 1,633,000
Product margin $ 496,200 $ (29,200 ) $ 467,000

3. The quantitative comparison is as follows:

B300 T500
Traditional Cost System
Direct materials $436,300/$688,000 = 63.4% $251,700/$688,000 = 36.6%
Direct labor $200,000/$304,000 = 65.8% $104,000/$304,000 = 34.2%
Manufacturing overhead $400,000/$608,000 = 65.8% $208,000/$608,000 = 34.2%

Activity-Based Costing System
Direct costs:
Direct materials $436,300/$688,000 = 63.4% $251,700/$688,800 = 36.6%
Direct labor $200,000/$304,000 = 65.8% $104,000/$304,000 = 34.2%
Advertising expense $50,000/$150,000 = 33.3% $100,000/$150,000 = 66.7%
Indirect costs:
Machining $126,000/$213,500 = 59.0% $87,500/$213,500 = 41.0%
Setups $31,500/$157,500 = 20.0% $126,000/$157,500 = 80.0%
Product sustaining $60,000/$120,000 = 50.0% $60,000/$120,000 = 50.0%

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