Exercise 5-20:

Kunkel Co makes two products and uses a traditional costing

system in which a single plant-wide overhead rate is computed
based on direct labour hours. Data for the two products for the
upcoming year is:

Mercon Wercon
Direct material cost per unit: $10.00 $ 8.00
Direct labour cost per unit: 3.00 3.75
Direct labour hours per unit: 0.20 0.25
# units produced: 10,000 40,000

These products are customized somewhat for specific customers.

Required:

1: The company’s manufacturing overhead costs for the year are

expected to be $336,000. Using the company’s traditional costing
system, compute the unit product cost for the two products.

2: Management is considering an activity-based costing system in

which half of the overhead would continue to be allocated on the basis
of direct labour hours and half would be allocated based on
engineering design time. The Mercon product is expected to need
4,000 engineering design hours and the Wurcon product is also
expected to need 4,000 engineering design hours. Compute the unit
product costs for the two products using the proposed ABC system.

3: Explain why the unit product costs differ between the two systems.
 Exercise 5-20 (45 minutes)
1.The unit product costs under the company's conventional
costing system would be computed as follows:
Mercon Wurcon Total
Number of units produced (a) 10,000 40,000
Direct labour-hours per unit (b)    0.20    0.25
Total direct labour-hours (a) × (b)  2,000 10,000 12,000

Total manufacturing overhead (a) $336,000

Total direct labour-hours (b) 12,000 DLHs

Predetermined overhead rate (a) ÷ (b) $28.00 per DLH

Mercon Wurcon
Direct materials $10.00 $ 8.00
Direct labour 3.00 3.75
Manufacturing overhead applied:
0.20 DLH per unit × $28.00 per DLH 5.60
  7.00
0.25 DLH per unit × $28.00 per DLH  
Unit product cost $18.60 $18.75
 The unit product costs with the proposed ABC
system can be computed as follows:

Estimated (b) (a) ÷ (b)

Overhead Expected Activity
Activity Cost Pool Cost* Activity Rate
direct labour-
$168,000 hours per direct labour-
Labour related 12,000 $14 hour
Engineering design engineering-
$168,000 8,000 hours $21 per engineering-hour
$336,000

*The total manufacturing overhead cost is split

evenly between the two activity cost pools.
 Manufacturing overhead is assigned to the
two products as follows:

Mercon:
Activity Cost (a) (b) (a) × (b)
Pool Activity Rate Activity ABC Cost
Labour related $14per DLH 2,000DLHs $28,000
Engineering $21per engineering- 4,000engineering-    84,000
design hour hours
Total $112,000

Wurcon:
Activity Cost (a) (b) (a) × (b)
Pool Activity Rate Activity ABC Cost
Labour related $14per DLH 10,00 DLHs $140,000
0
Engineering $21per engineering- 4,000engineering-    84,000
design hour hours
Total $224,000
 The unit product costs combine direct materials,
direct labour, and manufacturing overhead costs:

Mercon Wurcon
Direct materials $10.00 $ 8.00
Direct labour 3.00 3.75
Manufacturing overhead ($112,000 ÷
10,000 units; $224,000 ÷ 40,000 units)
 11.20    5.60
Unit product cost $24.20 $17.35
The unit product cost of the high-volume product, Wurcon, declines
under the activity-based costing system, whereas the unit product
cost of the low-volume product, Mercon, increases.

This occurs because half of the overhead is applied on the basis of

engineering design hours instead of direct labour-hours. When the
overhead was applied on the basis of direct labour-hours, most of
the overhead was applied to the high-volume product. However,
when the overhead is applied on the basis of engineering-hours,
more of the overhead cost is shifted over to the low-volume
product.

Engineering design is a product-level activity, so the higher the

volume, the lower the unit cost and the lower the volume, the
higher the unit cost.
Problem 5-25:

Vance Asbestos Removal Co removes potentially toxic asbestos insulation

and related products from buildings. The company’s estimator has been
involved in a long-simmering dispute with the on-site work supervisors.
The on-site work supervisors claim that the estimator does not adequately
distinguish between routine work such as removal of asbestos insulation
around heating pipes in older homes and non-routine work such as
removing asbestos contaminated ceiling plaster in industrial buildings. The
on-site supervisors believe that non-routine work is far more expensive
than routine work and should bear higher customer charges. The
estimator sums up his position in this way:

“My job is to measure the area to be cleared of asbestos. As directed by

top management, I simply multiply the area by $4,000 per thousand square
metres to determine the bid price. Since our average cost is $3,000 per
thousand square metres, that leaves enough cushion to take care of the
additional costs of non-routine work that show up. Besides, it is difficult to
know what is routine or not routine work until you actually start tearing
things apart.”
To shed light on this controversy, the company initiated an activity-based
costing study of all of its costs. Data from the activity-based costing study
are as follows:

Activity cost pool: Activity measure: Total activity:

Removing asbestos thousands of square metres 500,000

Estimating & job set-up # of jobs 200

Working on non-
routine jobs # non-routine jobs 25

Other (idle capacity & not applicable (these costs are

organization sustaining not allocated to jobs
costs
Wages & salaries: $ 200,000
Disposal fees: 600,000
Equipment depreciation: 80,000
On-site supplies: 60,000
Office expenses: 190,000
Licensing & insurance: 370,000
Total: $1,500,000

Distribution of resource consumption across activity cost pools:

Removing Estimating Non-routine Other Total

asbestos & set-up jobs

Wages & salaries: 40% 10% 35% 15% 100%

Disposal fees: 70% 0% 30% 0% 100%
Equipment depreciation: 50% 0% 40% 10% 100%
On-site supplies: 55% 15% 20% 10% 100%
Office expenses: 10% 40% 30% 20% 100%
Licensing & insurance: 50% 0% 40% 10% 100%
Required:

1: Using Exhibit 5-6 as a guide perform the first-stage allocation of

costs to the activity pools.

2: Using exhibit 5-7 as a guide, compute the activity rates for the
cost pools.

3: Using the activity rates you have computed, determine the total
cost and average cost per thousand square metres of each of the
following jobs according to the activity-based costing system:
a: a routine 2,000 square metre asbestos removal job;
b: a routine 4,000 square metre asbestos removal job;
c: a non-routine 4,000 square metre asbestos removal job.

4: Given the results you obtained in (3), do you agree with the
estimator that the company’s present policy for bidding on jobs is
adequate?
 The results of the first-stage allocation:
Working
Estimating on Non-
Removing and Job routine
Asbestos Setup Jobs Other Totals
Wages and salaries
$ 80,000 $  20,000 $  70,000 $  30,000 $   200,000
Disposal fees 420,000 0 180,000 0 600,000
Equipment
depreciation 40,000 0 32,000 8,000 80,000
On-site supplies 33,000 9,000 12,000 6,000 60,000
Office expenses 19,000 76,000 57,000 38,000 190,000
Licensing and
insurance  185,000            0  148,000    37,000     370,000
Total cost $777,000 $105,000 $499,000 $119,000 $1,500,000

According to the data in the problem, 40% of the wages and salaries cost of
$200,000 is attributable to activities related to job size.
$200,000 × 40% = $80,000
Other entries in the table are determined in a similar manner.
 (a)
Activity CostTotal (b) (a) ÷ (b)
Pool Cost Total Activity Activity Rate
Removing Thousand per thousand
asbestos $777,000 500 square metres $ 1,554 square metres
Estimating and
job setup $105,000 200 jobs $ 525 per job
Working on
nonroutine jobs Non-routine
$499,000 25 jobs $19,960 per non-routine job
a.
Routine two-thousand-square-metre job:

Removing asbestos
($1,554 per thousand square metres × 2
thousand square metres) $3,108
Estimating and job setup ($525 per job × 1 job)
525

Non-routine job (not applicable) 0

Total cost of the job $3,633

Average cost per thousand square metres ($3,633

÷ 2 thousand square metres) $1,816.50
b.
Routine four-thousand-square-metre job:

Removing asbestos
($1,554 per thousand square metres × 4 thousand
square metres) $6,216

Estimating and job setup ($525 per job × 1 job) 525

Non-routine job (not applicable)         0

Total cost of the job $6,741

Cost per thousand square metres ($6,741 ÷ 4

thousand square metres) $1,685.25
c.
Nonroutine two-thousand-square-metre job:

Removing asbestos
($1,554 per thousand square metres × 2 thousand
square metres) $ 3,108

Estimating and job setup ($525 per job × 1 job) 525

Non-routine job ($19,960 per non-routine job × 1 non-
routine job)  19,960

Total cost of the job $23,593

Cost per thousand square metres ($23,593 ÷ 2

thousand square metres) $11,796.50
The objectivity of the interview data can be questioned since the on-
site work supervisors were undoubtedly trying to prove their case
about the cost of non-routine jobs. Nevertheless, the activity-based
costing data certainly suggest that dramatic differences exist in the
costs of jobs. While some of the costs may be difficult to adjust in
response to changes in activity, it does appear that the standard bid
of $4,000 per thousand square metres may be substantially under
the company’s cost for non-routine jobs. Even though it may be
difficult to detect non-routine situations before work begins, the
average additional cost of $19,960 for non-routine work suggests
that the estimator should try. And if a non-routine situation is
spotted, this should be reflected in the bid price.

Savvy competitors are likely to bid less than $4,000 per thousand
square metres on routine work and substantially more than $4,000
per thousand square metres on non-routine work. Consequently,
Vance Asbestos Removal may find that its product mix shifts toward
non-routine work and away from routine work as customers accept
bids on non-routine work from the company and go to competitors
for routine work. This may have a disastrous effect on the
company’s profits.