Question

EcoFabrics has budgeted overhead costs of $945,000. It has allocated overhead on a plantwide basis to its two products (wool and cotton) using direct labor hours which are estimated to be 450,000 for the current year. The company has decided to experiment with activity-based costing and has created two activity cost pools and related activity cost drivers. These two cost pools are cutting (cost driver is machine hours) and design (cost driver is number of setups). Overhead allocated to the cutting cost pool is $360,000, and $585,000 is allocated to the design cost pool.Additional information related to these pools is as follows:Machine hours wool: 100,000Number of set ups wool: 1,000Machine hours cotton: 100,000Number of set ups cotton: 500Machine hours total: 200,000Number of setups total: 1,500The amount of overhead allocated to the wool product line and the cotton product line using activity-based costing & traditional approach is as follows:ABC wool: $570,000Traditional wool: $472,500ABC cotton: $375,000Traditional cotton: $472,500Required:How does allocation using the traditional approach compare with the amount allocated using ABC?

Answer 1

The main advantage of using ABC costing method is that it is more exact than traditional costing, and overhead costs are generally allocated on different basis (cost drivers) which results in a more fair distribution.

In this case, overhead costs allocated based solely on direct labor hours might be over or under stated since certain manufacturing procedures might require a lot of labor but few machines, while others might require few labor and a lot of machines.

Cutting is done mostly by machines while design is done mostly by employees. Allocating cutting overhead costs based on machine hours makes sense. Since both wool and cotton require the same amount of machine hours, cutting costs are allocated equally between them.

On the other hand, design is carried out by employees, so allocating design costs based on set ups (which is also carried out by employees) makes sense. That is why most of design costs are allocated to wool (wool requires 67% of setups).

Before under the traditional method, overhead costs were allocated evenly, but once we start allocating them based on more real cost drivers, the total amounts change.