After Reading An Article About Activity-Based Costing

After Reading An Article About Activity Based Costing In A Trade Journ

After reading an article about activity-based costing in a trade journal for the furniture industry, Santana Rey wondered if it was time to critically analyze overhead costs at Business Solutions. In a recent month, Rey found that setup costs, inspection costs, and utility costs made up most of its overhead. Additional information about overhead follows. Activity Cost Driver Setting up machines $ 19,240 26 batches Inspecting components $ 5,400 5,400 parts Providing utilities $ 10,800 5,400 machine hours Overhead has been applied to output at a rate of 55% of direct labor costs. The following data pertain to Job 6.15. Direct materials $ 2,600 Direct labor $ 3,100 Batches 6 batches Number of parts 430 parts Machine hours 560 machine hours Required: 1. Classify each of its three overhead activities as unit level, batch level, product level, or facility level. Setting up machines Inspecting components Providing utilities 2. What is the total cost of Job 6.15 if Business Solutions applies overhead at 55% of direct labor cost? (Omit the "$" sign in your response.) 3. What is the total cost of Job 6.15 if Business Solutions uses activity-based costing? (Omit the "$" sign in your response.)

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After Reading An Article About Activity Based Costing In A Trade Journ

The adoption of activity-based costing (ABC) provides more precise insights into overhead costs by associating expenses directly with activities that generate costs. In the context of Business Solutions in the furniture industry, understanding and classifying overhead activities is an essential first step to applying ABC effectively. The classification of overhead activities into unit, batch, product, or facility levels helps allocate costs more accurately and supports strategic decision-making aimed at improving profitability and efficiency.

Step 1: Classifying Overhead Activities

The first task involves categorizing three two main overhead activities—setting up machines, inspecting components, and providing utilities. Each activity can be classified based on how it relates to products and production processes:

• Setting up machines: This activity is performed each time production shifts to a different order or batch and involves preparing equipment for specific production runs. Because it is associated with batches rather than individual units or entire facilities, it is classified as a batch-level activity.
• Inspecting components: Inspection occurs at specific points during the production process, specifically each batch or set of parts. Since it is performed per batch or group of parts, this activity is best classified as batch level.
• Providing utilities: Utility costs are consumed continuously throughout production, regardless of batch or individual product, and are necessary for ongoing operations. Since utilities support the entire production process and facility operation, this activity is classified as facility level.

Step 2: Computing Overhead Costs under Traditional Rate

Business Solutions applies overhead at 55% of direct labor costs. The direct labor cost for Job 6.15 is $3,100. To find overhead applied:

Overhead Applied = 55% of Direct Labor Cost = 0.55 × 3,100 = 1,705

Adding direct materials and direct labor to overhead gives the total cost:

Total Cost (traditional costing) = Direct Materials + Direct Labor + Overhead Applied = 2,600 + 3,100 + 1,705 = 7,405

Step 3: Calculating ABC Overhead Costs

Activity-based costing assigns overhead costs based on specific activities' resource consumption. First, determine activity rates by dividing total overhead costs by activity drivers:

• Setup activity rate: $19,240 / 26 batches = approximately $740 per batch
• Inspection activity rate: $5,400 / 5,400 parts = $1 per part
• Utilities activity rate: $10,800 / 5,400 machine hours = $2 per machine hour

Next, multiply activity rates by the respective consumption quantities for Job 6.15:

• Setup costs: 6 batches × $740 = $4,440
• Inspection costs: 430 parts × $1 = $430
• Utilities costs: 560 machine hours × $2 = $1,120

Total overhead under ABC is the sum of these allocated costs:

Overhead ABC = 4,440 + 430 + 1,120 = 6,000

Finally, the total job cost using ABC is the sum of direct materials, direct labor, and allocated overhead:

Total Job Cost (ABC) = 2,600 + 3,100 + 6,000 = 11,700

Conclusion

Classifying activities accurately allows companies like Business Solutions to allocate overhead more precisely, leading to better product costing and pricing strategies. The traditional method, applying a broad percentage to direct labor, tends to oversimplify overhead distribution, whereas ABC provides detailed insights aligned with actual resource consumption. Implementing ABC can result in more accurate product costing, ultimately supporting improved profitability analysis and operational efficiency.

References

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