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Techniques & Controversial Issues

Chapter 7 Class Problem and Solution

James R. Martin, Ph.D., CMA

Professor Emeritus, University of South Florida

The Robin Ritchie Company produces two products, A and B. Information for the previous year is provided in the table below.

Type of Information | Product A | Product B | Total |

Total units produced | 1,000 | 9,000 | 10,000 |

Total direct labor costs | $25,000 | $135,000 | $160,000 |

Total number of machine hours | 6,000 | 34,000 | 40,000 |

Total number of machine setups | 4 | 2 | 6 |

Total number of purchase orders | 50 | 50 | 100 |

Total direct materials costs | $30,000 | $270,000 | $300,000 |

Total number of engineering work orders | 20 | 20 | 40 |

The Company is currently using machine hours as a basis for allocating all overhead costs to products, but is considering the ABC method based on the activity cost pools and activity measurements below.

Activity Cost Pool | Annual Activity Costs | Activity Measurements |

1. Machine Processing | $100,000 | Number of machine hours |

2. Machine set-up | 5,000 | Number of machine setups |

3. Purchasing | 10,000 | Number of purchase orders |

4. Materials planning & handling | 20,000 | Number of material dollars |

5. Engineering | 15,000 | Number of engineering work orders |

Total | $150,000 |

1. The total overhead (activity) costs allocated using the current method is

a. 3,750 to A and 33,750 to B

b. 15,000 to A and 135,000 to B

c. 22,500 to A and 127,500 to B

d. 23,437.50 to A and 126,562.50 to B

e. None of the above.

2. Based on the information given above, what is the minimum number of homogeneous cost pools that can be used to accurately allocate the Company’s activity costs using the ABC method?

a. 5 b. 4 c. 3 d. 2 e. 1

3. Using the ABC method, the machine setup costs allocated (rounded to dollars) is

a. 3,333 to A and 1,667 to B

b. 500 to A and 4,500 to B

c. 750 to A and 4,250 to B

d. 2,500 to A and 2,500 to B

e. None of the above.

4. Now, considering only purchasing costs, the current allocation method based on machine hours

a. overstates the allocation to A by approximately $4,500.

b. understates the allocation to A by approximately $4,500.

c. overstates the allocation to A by approximately $3,500.

d. understates the allocation to A by approximately $3,500.

e. None of the above.

5. The ABC activity cost per unit for product A (rounded to dollars) is

a. $15.00

b. $ 22.5

c. $ 32.83

d. $ 100.00

e. None of the above.

6. The current cost allocation method based on machine hours

a. accurately states the costs allocated to
A for all five activity cost pools.

b. distorts the costs allocated to A for all five activity cost pools.

c. accurately states the costs allocated to
A for only activity cost pool number 4.

d. accurately states the costs allocated to A for only activity cost pool number 1.

e. None of these.

7. Comparing the production volume based allocations and ABC allocations, the total cost distortion for this company is approximately

a. $7,500

b. $10,330

c. $67,170

d. $150,000

e. None of these.

**Solution**

1. The total overhead (activity) costs allocated using the current method is

c. 22,500 to A and 127,500 to B

(6/40)($150,000) = $22,500 to A and

(34/40)($150,000) = $127,500 to B.

Or we can use the overhead rate of $150,000/40,000 MHs = $3.75 per machine hour.

Then the allocation to A is ($3.75)(6,000MH) = $22,500, and

the allocation to B = ($3.75)(34,000MH) = $127,500.

2. Based on the information given above, what is the minimum number of homogeneous cost pools that can be used to accurately allocate the Company’s activity costs using the ABC method?

b. 4

Four pools are needed, rather than five because Purchasing and Engineering can be combined. The proportions for the other activities are all different and cannot be combined.

3. Using the ABC method, the machine setup costs allocated (rounded to dollars) is

a. 3,333 to A and 1,667 to B

(2/3)(5,000) = $3,333 to A and

(1/3)(5,000) = $1,667 to B.

Or we can use the activity rate of $5,000/6 SU = $833.33 per set up.

Then the the cost assignment to A =
($833.33)(4) = $3,333, and

the assignment to B = ($833.33)(2) = $1,667.

4. Now, considering only purchasing costs, the current allocation method based on machine hours

d. understates the allocation to A by approximately $3,500.

The Purchasing costs allocated to A based on machine hours is (6/40)(10,000) = $1,500

The Purchasing costs allocated to A based on PO’s is (½)(10,000) = $5,000

$5,000 - $1,500 = $3,500 understated cost of product A if current traditional method is used.

Or using activity rates we have $10,000/40,000 MHs = $.25 per machine hour and

$10,000/100 POs = $100 per purchase order.

Then the ABC allocation is ($100)(50 POs) = $5,000, and

the traditional allocation is ($.25)(6,000 MHs) = $1,500

5. The ABC activity cost per unit for product A (rounded to dollars) is

c. $ 32.83

The ABC cost assigned to product A is:

(6/40)($100,000 Processing costs) + (4/6)($5,000 Set up costs) + (½)($25,000
combined Purchasing and Engineering costs) + (1/10)($20,000 Materials planning
costs) = $32,833.33

Then the unit cost is $32,833.33/1,000 units of A = $32.83.

We could also make the calculations using the activity rates rather than using the proportions.

6. The current cost allocation method based on machine hours

d. accurately states the costs allocated to A for only activity cost pool number 1.

It is only accurate for the machining pool.

7. Comparing the production volume based allocations and ABC allocations, __ the total cost distortion__ for this company is approximately

b. $10,330

Based on the answers to questions 1 and 5:

From question 5, the ABC unit cost of Product A = $32.83.

From question 1 the PVB unit cost of Product A = $22,500/1,000 units = $22.50

($32.83 - $22.50)(1,000 units) = ($10.33)(1,000) = $10,330 understatements for A

Since the understatement for A has to be equal to the overstatement for B, we know this is the total cost distortion.

Extra Multiple Choice Questions