Practice Problem ABC vs Traditional Costing

Q1: Double Bounce Trampolines produces two models of trampolines for backyard fun. The
“Original”, and the recently introduced “Deluxe”. The Deluxe model introduced several safety
features that were intended to scare overly protective parents into upgrading. Since its
introduction, the deluxe model has been increasing in sales, but at the same time, the company’s
profits have been declining. The CFO believes that the company’s traditional costing system may
be to blame. Currently, the company uses direct-labour hours as the basis for allocation of its
overheads. The company estimates that it will incur $600,000 in Manufacturing Overhead (MOH)
costs in the next year.
The following cost data is known:
Original Deluxe
Particular
Model Model
Direct Materials $50 $75
Direct Labour ($10 per hour) $20 $30
Number of units produced 7,000 units 2,000 units

The CFO wishes to explore an activity-based costing system and has gathered following
information regarding activities and cost drivers underlying its estimated MOH costs of $600,000:

Expected Activity
Estimated
Activity Cost Driver Original Deluxe
MOH Total
Model Model
Assembly Labour Hours $100,000 14,000 6,000 20,000
Receiving Receiving Reports $ 200,000 2,000 2,000 4,000
Testing Number of Tests $ 300,000 200 800 1,000
$600,000

Required:
a.) Under the traditional costing method:
i. Compute the predetermined overhead rate. (1 Marks)
ii. Determine the unit cost of each product. (3 Marks)
b.) Under activity-based costing:
i. Compute the activity rates for each activity. (3 Marks)
ii. Determine the expected unit cost of each product. (3 Marks)
c.) Compare and comment on your answers from parts a.) and b.) above. (2 Marks)
d.) If ABC produces more accurate cost data, why is it not more widely used? (1 Marks)

Ans:

a)
i)
To calculate Predetermined overhead rate:
Predetermined overhead rate (Burden Rate) = Estimated manufacturing overhead / Estimated base
Base driver in this case is direct labour hours as stated in the question.
Direct labour hours can be calculated by using the direct labour cost for the ‘Original’ and the direct
labour cost for the ‘Deluxe’ and dividing each of those by the direct labour cost per hour to give you
the hours. Then you would multiply the hours for the ‘Original’ by the number of units produced and
add that to the number of hours for the ‘Deluxe’ multiplied by the number of units produced. (Note
that in this question the actual number of direct labour hours is given to you as part of the Assembly
cost driver.)
 Original Deluxe
Particular
Model Model
Direct Materials $50 $75
Direct Labour ($10 per hour) 20 30
Direct labour hours per unit 2 3
Number of units produced 7,000 units 2,000 units
Total Direct Labour Hours 14000 6000

Predetermined overhead rate = $600,000 / 20,000

Predetermined overhead rate = $30 per direct labour hour (estimate)
Overhead Cost per unit ($) 60 90

ii)
Original Deluxe
Direct materials $50 $75
Direct labour 20 30
Est. MOH 60 90
Total cost per unit $130 $195

b)i)
Total Cost Total Cost per Driver Original Deluxe
Estimate ($) Driver ($) ($) ($)
Estimate
Assembly (Labour hrs) 100,000 20,000 5 per labour hr 70,000 30,000
Receiving (Rec. reports) 200,000 4,000 50 per report 100,000 100,000
Testing (# of tests) 300,000 1,000 300 per test 60,000 240,000
Total MOH Cost 230,000 370,000
Number of units 7,000 2,000
MOH per unit (Est.) 32.86 185
ii)
Original Deluxe
Direct materials $50 $75
Direct labour 20 30
Est. MOH 32.86 185
Total cost per unit $102.86 $290
c)

Per Unit Costs

Costing Original Deluxe
Traditional Costing $130 $195
Activity Based Costing $102.86 $290
Difference $27.14 $95
Activity Based Costing shows that the Original model is less expensive to produce than the Traditional
Costing method would have us believe while the Deluxe model is more expensive to produce than the
Traditional Costing method would have us believe. In other words, we have overcosted the Original
model and undercosted the Deluxe model when using the Traditional Costing method. The Traditional
Costing method would have us believe that we are making less profit selling Original more profit selling
Deluxe, when Activity Based Costing is telling us that isn’t the case.

d) Not every company has such a large difference if they used Activity Based Costing as opposed to
Traditional Costing. Also, it is possible that the company in this example used the wrong base driver
(labour hours) and a change in driver might give a more accurate estimate. However, the main reason
more companies don’t use Activity Based Costing is because it is more expensive and time consuming
to collect the data and perform the calculations. Often the difference in accuracy between the methods
can’t be financially justified.