Descout Company for years produced only one product: backpacks. Recently, the company decided to add a line of duffel bags. With this addition, the company began assigning overhead costs using departmental rates. (Prior to this, the company used a predetermined plantwide rate based on units produced.) Departmental rates meant that overhead costs had to be assigned to each producing department to create overhead pools so that predetermined departmental rates could be calculated.
Surprisingly, after the addition of the duffel-bag line and the switch to departmental rates, the costs to produce the backpacks increased and their profitability dropped.
The marketing manager and the production manager both complained about the increase in the production cost of backpacks. The marketing manager was concerned because the increase in unit costs led to pressure to increase the unit price of backpacks. She was resisting this pressure because she was certain that the increase would harm the company's market share. The production manager was receiving pressure to cut costs also, yet he was convinced that nothing different was being done in the way the backpacks were produced. He was also convinced that further efficiency in the manufacture of the backpacks was unlikely. After some discussion, the two managers decided that the problem had to be connected to the addition of the duffel-bag line.
Upon investigation, they were informed that the only real change in product- costing procedures was in the way overhead costs are assigned. A two-stage procedure was now in use. First, overhead costs are assigned to the two producing departments, patterns and finishing. Some overhead costs are assigned to the producing departments using direct tracing, and some are assigned using driver tracing. For example, the salaries of the producing department's supervisors are assigned using direct tracing, whereas the costs of the factory's accounting department are assigned using driver tracing (the driver being the number of transactions processed for each department). Second, the costs accumulated in the producing departments are assigned to the two products using direct labor hours as a driver (the rate in each department is based on direct labor hours). The managers were assured that great care was taken to associate overhead costs with individual products. So that they could construct their own example of overhead cost assignment, the controller provided information necessary to show how accounting costs are assigned to products:
| Department |
Patterns
|
Finishing
|
Total
|
|
Accounting cost
|
$48,000
|
$72,000
|
$120,000
|
|
Transactions processed
|
32,000
|
48,000
|
80,000
|
|
Total direct labor hours
|
10,000
|
20,000
|
30,000
|
|
Direct labor hours per backpack*
|
0.10
|
0.20
|
0.30
|
|
Direct labor hours per duffel bag*
|
0.40
|
0.80
|
1.20
|
*Hours required to produce one unit of each product.
The controller remarked that the cost of operating the accounting department had doubled with the addition of the new product line. The increase came because of the need to process additional transactions, which had also doubled in number.
During the first year of producing duffel bags, the company produced and sold 100,000 backpacks and 25,000 duffel bags. The 100,000 backpacks matched the prior year's output for that product.
Required
1. Compute the amount of accounting cost assigned to a backpack before the duffel-bag line was added using a plantwide rate approach based on units produced. Is this assignment accurate? Explain.
2. Suppose that the company decided to assign the accounting costs directly to the product lines using the number of transactions as the activity driver. What is the accounting cost per unit of backpacks? per unit of duffel bags?
3. Compute the amount of accounting cost assigned to each backpack and duffel bag using departmental rates based on direct labor hours.
4. Which way of assigning overhead does the best job, the functional-based approach using departmental rates or the activity-based approach using transactions processed for each product? Explain. Discuss the value of activity-based costing before the duffel-bag line was added.