Chapter 9, Problem 59P

Choosing an Activity-Based Costing System

Pickle Motorcycles, Inc. (PMI), manufactures three motorcycle models: a cruising bike (Route 66), a street bike (Main Street), and a starter model (Alley Cat). Because of the different materials used, production processes for each model differ significantly in terms of machine types and time requirements. Once parts are produced, however, assembly time per unit required for each type of bike is similar. For this reason, PMI allocates overhead on the basis of machine-hours. Last year, the company shipped 1,000 Route 66s, 4,000 Main Streets, and 10,000 Alley Cats and had the following revenues and expenses:

PMI’s chief financial officer (CFO) hired a consultant to recommend cost allocation bases. The consultant recommended the following:

The consultant found no basis for allocating the plant administration and other fixed overhead costs and recommended that these not be applied to products.

Required

1. a.      Using machine-hours to allocate production overhead, complete the income statement for Pickle Motorcycles. (See the “using energy” activity for machine-hours.) Do not attempt to allocate plant administration or other fixed overhead.
2. b.      Complete the income statement using the bases recommended by the consultant.
3. c.       How might activity-based costing result in better decisions by Pickle Motorcycles’s management?
4. d.      After hearing the consultant’s recommendations, the CFO decides to adopt activity-based costing but expresses concern about not allocating some of the overhead to the products (plant administration and other fixed overhead). In the CFO’s view, “Products have to bear a fair share of all overhead or we won’t be covering all of our costs.” How would you respond to this comment?

To determine

Complete the income statement.

Explanation of Solution

Traditional labor-hour based costing method:

Traditional labor-hour based costing method assumes that the direct labor-hour is the base allocation of the process. The process of allocation of overhead computes the indirect overhead with respect to the labor-hours only.

Complete the income statement:

Particulars	Route 66	Main street	Alley cat	Total
Sales revenue	$7,600,000	$11,200,000	$9,500,000	$28,300,000
Direct costs:
Direct materials	$3,000,000	$4,800,000	$4,000,000	$11,800,000
Direct labor	$288,000	$480,000	$1,080,000	$1,848,000
Variable overhead $\left(\begin{array}{l}Variable\text{ rate}\\ \times \text{ Number of machine hours}\end{array}\right)$	$939,600	$1,503,360	$2,255,040	$4,698,000
Contribution margin	$3,372,400	$4,416,640	$2,164,960	$9,954,000
Fixed overhead:
Plant admin				$1,760,000
Other				$2,800,000
Gross profit				$5,394,000

Table: (1)

Compute the rate of variable overhead:

$\begin{array}{c}Variable\text{ overhead rate}=\left(\frac{Total\text{ variable overhead}}{Number\text{ of machine-hours}}\right)\\ =\frac{\$4,698,000}{50,000}\\ =\$93.96\end{array}$

Thus, the rate of variable overhead is $93.96.

To determine

Complete the income statement using the recommendations.

Explanation of Solution

Activity-based costing (ABC):

Activity-based costing is the method of costing where the overhead cost is assigned to various products. This method of costing establishes the relationship between the manufacturing overhead costs and the activities. The relationship is then implemented for the allocation of indirect costs to the products.

Complete the income statement using the recommendations:

Particulars	Route 66	Main street	Alley cat	Total
Sales revenue	$7,600,000	$11,200,000	$9,500,000	$28,300,000
Direct costs:
Direct materials	$3,000,000	$4,800,000	$4,000,000	$11,800,000
Direct labor	$288,000	$480,000	$1,080,000	$1,848,000
Variable overhead
Machine setup $\left(\begin{array}{l}Applicable\text{ rate}\\ \times N\text{umber of runs}\end{array}\right)$	$102,960	$159,120	$205,920	$468,000
Order processing $\left(\begin{array}{l}Applicable\text{ rate}\\ \times N\text{umber of order}\end{array}\right)$	$288,000	$432,000	$432,000	$1,152,000
Warehousing $\left(\begin{array}{l}Applicable\text{ rate}\\ \times N\text{umber of units}\end{array}\right)$	$418,500	$418,500	$837,000	$1,674,000
Energy $\left(\begin{array}{l}Applicable\text{ rate}\\ \times N\text{umber of machine-hours}\end{array}\right)$	$151,200	$241,920	$362,880	$756,000
Shipping $\left(\begin{array}{l}Applicable\text{ rate}\\ \times Units\text{ shipped}\end{array}\right)$	$43,200	$172,800	$432,000	$648,000
Contribution margin $\left(\begin{array}{l}\text{Sales revenue}\\ -\text{ Direct cost}\\ -\text{ Variable overhead}\end{array}\right)$	$3,308,140	$4,495,660	$2,150,200	$9,954,000
Fixed overhead
Plant admin				$1,760,000
Other				$2,800,000
Gross profit				$5,394,000

Table: (2)

Compute the applicable rate:

Particulars	Total cost	Total respective units	Applicable rate
Machine setup	$468,000	100	$4,680
Order processing	$1,152,000	1,600	$720
Warehousing	$1,674,000	800	$2,093
Energy	$756,000	50,000	$15
Shipping	$648,000	15,000	$43

Table: (3)

To determine

Determine how activity-based costing result is better.

Explanation of Solution

Activity-based costing (ABC):

Activity-based costing is the method of costing where the overhead cost is assigned to various products. This method of costing establishes the relationship between the manufacturing overhead costs and the activities. The relationship is then implemented for the allocation of indirect costs to the products.

Traditional labor-hour based costing method:

Traditional labor-hour based costing method assumes that the direct labor-hour is the base allocation of the process. The process of allocation of overhead computes the indirect overhead with respect to the labor-hours only.

The relevance of ABC method:

The ABC method gives a better and detailed cost structure of the process. A better cost report will provide a better assessment of the costing. The information that is churned out enables the management to take appropriate decisions.

To determine

Provide the appropriate response to the statement in question.

Explanation of Solution

Activity-based costing (ABC):

Activity-based costing is the method of costing where the overhead cost is assigned to various products. This method of costing establishes the relationship between the manufacturing overhead costs and the activities. The relationship is then implemented for the allocation of indirect costs to the products.

The statement in question:

“Products have to bear a fair share of all overhead, or we won’t be covering all of our costs.”

The relevance of statement with respect to the ABC:

There are few costs that do not correlate with volume or any other base of activity. Allocation of such costs would make information distorted. Preferable means to record these costs would require determination of contribution margin from each product.