Calculating Costontario Inc: Manufactures Two Product 044126
Calculating Costontario Inc Manufactures Two Products Standard And
Calculating Costontario Inc. manufactures two products, Standard and Enhanced, and applies overhead based on direct-labor hours. The anticipated overhead and direct-labor hours for the upcoming period are $800,000 and 25,000 hours, respectively. The company produces 3,000 units of Standard and 4,000 units of Enhanced. Standard product consumes 3 hours of direct labor at $12 per hour and costs $25 in direct materials per unit. Enhanced product consumes 4 hours of direct labor at $12 per hour and costs $40 in direct materials per unit. The overhead costs are allocated among three activities: order processing ($150,000), machine processing ($560,000), and product inspection ($90,000). These activities are driven by the number of orders processed, machine hours, and inspection hours, respectively. Data for activities include: 300 orders processed for Standard and 200 for Enhanced; machine hours of 18,000 and 22,000; inspection hours of 2,000 and 8,000, respectively.
Management is concerned about declining profitability despite increased sales, especially since recent automation was expected to improve efficiencies. Using both traditional overhead allocation based on direct-labor hours and activity-based costing (ABC), this paper computes the unit manufacturing costs for both products at the expected production volume, analyzes potential over- and under-costing, and discusses implications for profitability. Changes in activity cost allocations are also examined to assess their impact on product costing and profitability.
Paper For Above instruction
Introduction
In contemporary manufacturing environments, accurate product costing is critical for making strategic decisions, maintaining profitability, and competitive positioning. Cost accounting methods such as traditional overhead allocation and activity-based costing (ABC) provide different perspectives on how costs are assigned to products. This paper compares these methods for Costontario Inc., which manufactures two products—Standard and Enhanced—and evaluates their impact on unit costs and profitability analysis amid recent technological investments that have not yielded expected financial returns.
Traditional Costing Methodology
The traditional approach allocates overhead based on a predetermined rate per direct-labor hour. The expected overhead for the period is $800,000, and total direct labor hours are 25,000. The overhead rate per direct-labor hour is calculated as follows:
\[ \text{Overhead rate} = \frac{\$800,000}{25,000 \text{ hours}} = \$32 \text{ per hour} \]
Using this rate, the unit manufacturing costs are computed by summing direct materials, direct labor, and allocated overhead per unit.
Standard Product:
- Direct materials: $25
- Direct labor: 3 hours × $12 = $36
- Overhead: 3 hours × $32 = $96
- Total unit manufacturing cost: $25 + $36 + $96 = $157
Enhanced Product:
- Direct materials: $40
- Direct labor: 4 hours × $12 = $48
- Overhead: 4 hours × $32 = $128
- Total unit manufacturing cost: $40 + $48 + $128 = $216
These costs help in pricing decisions; however, they often distort the true costs when overhead consumption varies significantly among products.
Activity-Based Costing (ABC) Methodology
ABC assigns overhead based on activities that consume resources more precisely, reducing distortions common in traditional costing. The total overhead ($800,000) is allocated based on activity driver rates.
Step 1: Determine activity rates
- Order processing: $150,000 / 500 orders = $300 per order
- Machine processing: $560,000 / 40,000 machine hours = $14 per machine hour
- Inspection: $90,000 / 10,000 inspection hours = $9 per inspection hour
Step 2: Assign costs to products
- Standard:
- Orders: 300 × $300 = $90,000
- Machine hours: 18,000 × $14 = $252,000
- Inspection: 2,000 × $9 = $18,000
- Total: $360,000
- Enhanced:
- Orders: 200 × $300 = $60,000
- Machine hours: 22,000 × $14 = $308,000
- Inspection: 8,000 × $9 = $72,000
- Total: $440,000
Step 3: Calculate overhead rate per activity
Total activity costs:
- Orders: $150,000
- Machine: $560,000
- Inspection: $90,000
Proportionately allocated to each product based on actual activity levels yields a more accurate assignment of overhead.
Step 4: Compute unit costs under ABC
- Standard:
- Overhead: (Order: $90,000, Machine: $252,000, Inspection: $18,000) distributed across 3,000 units
- Per unit overhead: Sum of activity costs divided by units produced.
Total activity costs for Standard:
- Orders: $90,000
- Machine: $252,000
- Inspection: $18,000
Total: $360,000
Per unit:
- Orders: $90,000 / 3,000 = $30
- Machine: $252,000 / 3,000 = $84
- Inspection: $18,000 / 3,000 = $6
Total overhead per unit: $30 + $84 + $6 = $120
Adding direct costs:
- Direct material: $25
- Direct labor: 3 × $12 = $36
- Total cost: $25 + $36 + $120 = $181
- Enhanced:
- Orders: $60,000 / 4,000 units = $15 per unit
- Machine: $308,000 / 4,000 units = $77
- Inspection: $72,000 / 4,000 units = $18
- Total overhead per unit: $15 + $77 + $18 = $110
Total cost per unit:
- Direct material: $40
- Direct labor: 4 × $12 = $48
- Total: $40 + $48 + $110 = $198
Comparison of Costing Methods and Profitability Analysis
The traditional costing suggests that Standard costs $157 per unit while Enhanced costs $216. Under ABC, these costs are $181 and $198 respectively. Notably, the traditional method underestimates the cost of Enhanced relative to ABC, which reflects higher resource consumption on specific activities, particularly inspection.
Such discrepancies can lead to overcosting or undercosting, affecting pricing and profitability calculations. For instance, if the company prices products heavily based on cost, this misallocation might distort profit margins—leading to potential loss on products that are actually more costly or uncompetitive pricing on less costly products.
The analysis indicates Standard's unit cost is overestimated by traditional costing but more accurate under ABC, whereas Enhanced's costs are underestimated in traditional costing. This investment distortion can contribute to declining profitability even when sales volume increases, as pricing based on inaccurate cost data can lead to uncompetitive pricing or low margins.
Impact of Changes in Overhead Allocation
If overhead proportions shift, such as order processing decreasing from $150,000 to $300,000 and inspection costs rising to $270,000, the overhead distribution will change accordingly. These changes will affect the unit costs derived under ABC because activity rates would need recalibration, further influencing profitability analysis.
With these new overhead allocations, the contribution margins, and therefore profitability of both products, might significantly alter. Specifically, increased inspection costs suggest higher resource consumption for quality control, potentially impacting the perceived value and market pricing of the respective products.
Conclusion
Accurate costing is vital for effective management and strategic decision-making. Traditional costing methods are simpler but often distort product costs, especially when activities consume resources unevenly. Activity-based costing provides a more precise reflection of costs, guiding better pricing, product mix decisions, and profit analysis.
For Costontario Inc., implementing ABC reveals that the Enhanced product might be more costly than traditional methods suggest, and the Standard product less costly. Furthermore, cost distortions under traditional approaches could be part of the reasons behind declining profitability, as price-setting based on inaccurate costs can lead to suboptimal margins.
Adjustments in overhead allocations demonstrate that cost structure changes significantly impact unit costs and profitability. Cost management strategies should integrate activity-based insights to ensure accurate costing and sustainable profitability.
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