4.

ABC - Activity Based Costing

1.Meditech, Inc. manufactures two types of medical devices, Medform

and Procel, and applies overhead on the basis of direct-labor hours.
Anticipated overhead and direct-labor time for the upcoming accounting
period are $710,000 and 20,000 hours, respectively. Information about
the company’s products follows.
Medform:
Estimated production volume, 2,500 units
Direct-material cost, $30 per unit
Direct labor per unit, 3 hours at $15 per hour
Procel:
Estimated production volume, 3,125 units
Direct-material cost, $45 per unit
Direct labor per unit, 4 hours at $15 per hour
Meditech’s overhead of $710,000 can be identified with three major
activities: order processing ($120,000), machine processing ($500,000),
and product inspection ($90,000). These activities are driven by number
of orders processed, machine hours worked, and inspection hours,
respectively. Data relevant to these activities follow.
Orders Processed Machine Hours Worked Inspection Hours
Medform ................350 23,000 4,000
Procel ....................250 27,000 11,000
Total ......................600 50,000 15,000
Management is very concerned about declining profitability despite a
healthy increase in sales volume. The decrease in income is especially
puzzling because the company recently undertook a massive plant
renovation during which new, highly automated machinery was
installed—machinery that was expected to produce significant operating
efficiencies.
Required:
1. Assuming use of direct-labor hours to apply overhead to production,
compute the unit manufacturing costs of the Medform and Procel
products if the expected manufacturing volume is attained.
2. Assuming use of activity-based costing, compute the unit
manufacturing costs of the Medform and Procel products if the expected
manufacturing volume is attained.
3. Meditech’s selling prices are based heavily on cost.
a. By using direct-labor hours as an application base, which product is
overcosted and which product is undercosted? Calculate the amount of
the cost distortion for each product.
b. Is it possible that overcosting and undercosting (i.e., cost distortion)
and the subsequent determination of selling prices are contributing to
the company’s profit woes? Explain.
2. Rapid City Technology, Inc. manufactures chemicals used in
agricultural pest control. The controller has established the following
activity cost pools and cost drivers.

An order for 1,000 boxes of a chemical product designated JLRP has the
following production requirements.
Machine setups ............................................................................... 6 setups
Raw material ............................................................................. 9,000 pounds
Hazardous materials ................................................................ 2,100 pounds
Inspections ............................................................................. 8 inspections
Machine hours ................................................................ 550 machine hours
Required:
1. Compute the total overhead that should be assigned to the JLRP
order.
2. What is the overhead cost per box of JLRP chemicals?
3. Suppose the company were to use a single predetermined overhead
rate based on machine hours. Compute the rate per hour.
4. Under the approach in requirement (3), how much overhead would be
assigned to the JLRP chemical order?
a. In total.
b. Per box of JLRP chemical.
5. Explain why these two product-costing systems result in such widely
differing costs. Which system do you recommend? Why?
3. Refer to the original data given in the preceding problem for Rapid
City Technology, Inc.
Required:
Calculate the unit cost of a production order for 100 specially coated
containers used in transporting chemicals. In addition to direct material
costing $210 per container and direct labor costing $60 per container,
the order requires:
Machine setups ............................................................................................. 4
Raw material ................................................................................ 800 pounds
Hazardous materials ................................................................... 400 pounds
Inspections ................................................................................................... 4
Machine hours ............................................................................................. 60
4. FiberCom, Inc., manufactures fiber optic cables for the computer and
telecommunications industries. At the request of the company vice
president of marketing, the cost management staff has recently
completed a customer-profitability study. The following activity-based
costing information was the basis for the analysis.

Prepare a customer-profitability analysis for Caltex Computer and Trace

Telecom.
 5. A Company has been using a cost system that allocates all factory
overheads costs to products based on 350 percent of direct labour cost.
The company has just decided to use ABC system that traces indirect
costs to products based on consumption of major activities as indicated
below:
Compare the total annual costs of the product using both traditional and
ABC system.

Activity Annual cost driver Cost (in Rs.) Product cost driver
quantity consumption

Machining 20,000 hours 5,00,000 800 hours

Set up 10,000 hours 1,00,000 100 hours
Production order 2,000 orders 2,00,000 12 orders
Material handling 1,000 requisitions 20,000 5 requisitions
Parts administration 12,000 parts 4,80,000 18 parts
Labour Rs 300000 30,000 Rs 10,000