Assignment: Activity-Based Costing versus Traditional Cost Allocation
C. Berry Manufacturing Company produces two guitar models. One is a standard acoustic guitar that sells for $600 and is constructed from medium-grade materials. The other model is a custom-made amplified guitar with pearl inlays and a body constructed from special woods. The custom guitar sells for $900. Both guitars require 10 hours of direct labor to produce, but the custom guitar is manufactured by more experienced workers who are paid at a higher rate.
Most of Berry’s sales come from the standard guitar, but sales of the custom model have been growing. Following is the company’s sales, production, and cost information for last year:
Standard Guitar Custom Guitar
Sales and production volume in units 900 100
Unit costs:
Direct materials $150 $375
Direct labor 180 240
Manufacturing overhead 135 135
Total unit costs $465 $750
Manufacturing overhead costs:
Building depreciation $ 40,000
Maintenance 15,000
Purchasing 20,000
Inspection 12,000
Indirect materials 15,000
Supervision 30,000
Supplies 3000
Total manufacturing overhead costs $135,000
The company allocates overhead costs using the traditional method. Its activity base is direct labor hours. The predetermined overhead rate, based on 10,000 direct labor hours, is $13.50 ($135,000 ÷ 10,000 direct labor hours).
Nick Fessler, president of Berry, is concerned that the traditional cost-allocation system the company is using may not be generating accurate information and that the selling price of the custom guitar may not be covering its true cost.
For Discussion
A. The cost-allocation system Berry has been using allocates 90% of overhead costs to the standard guitar because 90% of direct labor hours were spent on the standard model.
How much overhead was allocated to each of the two models last year?
Discuss why this might not be an accurate way to assign overhead costs to products.
B. How would the use of more than one cost pool improve Berry’s cost allocation?
C. Merry’s controller developed the following data:
Manufacturing Standard Custom
Overhead Cost Amount Cost Driver Guitar Guitar
Building depreciation $40,000 Square footage 3000 1000
Maintenance 15,000 Direct labor hours 9000 1000
Purchasing 20,000 # of purchase orders 1500 500
Inspection 12,000 # of inspections 400 600
Indirect materials 15,000 # of units 900 100
Supervision 30,000 # of inspections 400 600
Supplies 3000 # of units 900 100
Use activity-based costing to allocate the costs of overhead per unit and in total to each model of guitar.
E. Calculate the cost of a custom guitar using activity-based costing.
F. Why is the cost different from the cost calculated using the traditional allocation method?
G. At the current selling price, is the company covering its true cost of production? Briefly discuss.