Problem:
Meditech, Inc. manufactures two types of medical devices, Medform and Procel, and applies overhead on the basis of direct-labor hours. Anticipates overhead and direct labor time for the upcoming accounting period are $710,000 and 20,000 hours, respectively. Information about the company’s products follows.
Medform:
Estimated production volume, 2500 units
Direct-Material Cost, $30 per unit
Direct Labor per unit, 3 hours at $15 per hour
Procel:
Estimated production volume, 3,125 units
Direct material cost, $45 per unit
Direct labor per unit, 4 hours at $15 per hour
Meditech’s overhead of $710,000 can be identified with three major activities: order processing ($120,000) machine processing ($500,000) and product inspection ($90,000). These activities are driven by number of orders processed, machine hours worked, and inspection hours, respectively. Data relevant to these activities follow
Orders Processed Machine hours worked Inspection hours
Medform 350 23,000 4,000
Procel 250 27,000 11,000
Total 600 50,000 15,000
Management is very concerned about declining profitability despite a healthy increase in sales volume. The decrease in income is especially puzzling because the company recently undertook a massive plant renovation during which new, highly automated machinery was installed… machinery that was expected to produce significant operating efficiencies.
1. Assuming use of direct labor hours to apply overhead to production, compute the unit manufacturing costs of the Medform and Procel products if the expected manufacturing volume is attained.
2. Assuming use of activity based costing, compute the unit manufacturing costs of the Medform and Procel products if the expected manufacturing volume is attained.
3. Meditech’s selling prices are based heavily on costs
a. By using direct labor hours as an application base, which product is over-costed and which product is under-costed? Calculate the amount of the cost distortion for each product.
b. Is it possible that over-costing and under-costing and the subsequent determination of selling prices are contributing to the company’s profit woes?