Question

Dexter Inc. makes and sells two types of decoration plates. One plate displays a hand-painted image of a lion- family resting under a tree; the other plate displays a machine-pressed image of three dogs playing in the garden! The lion-plates require 25,000 hours of direct labor whereas the dogs-plate require only 5,000 hours of direct labor. Overhead costs are composed of two parts: 1. $140,000 machine-related activity costs including indirect labor, utility, and depreciation 2. $100,000 labor-related activity costs including overtime pay, fringe benefit and payroll taxes. Required: a. Assuming that Dexter Inc. use direct labor as the allocation base, determine the amount of the total $240,000 overhead cost that will be allocated to each type of plate. b. Explain why using direct labor hours may distort the allocation of overhead cost to the two products. C. Describe the structure and idea of Activity Based Costing (ABC) and explain how this (maybe) could improve the accuracy of the overhead cost allocation.

Answer 1

a. Total Direct Labor hours = 25000 + 5000 = 30000 hours
Overhead rate per hour = $240000 / 30000 = $8 per hour

Allocation of overhead
Lion-Plate = 25000 x $8 = $200,000
Dogs-Plate = 5000 x $8 = $40,000

b.
Since $140,000 overhead consists of machine related activity which is used exclusively for Dogs-plate, it should be allocated to Dogs plate entirely. But under current method of allocation, most of the overhead is allocated to Lions-plate since it uses more labor hours, therefore allocation of overhead is distorted as it gives wrong product cost.

c.
Under Activity Based costing, Overhead cost is divided into identifiable separate type of costs and separate cost drivers are used to allocate those overhead costs. For instance in this situation, $140,000 machine related costs should have been allocated based on machine hours used by each type of product and $100,000 overhead cost should have been allocated on the basis of direct labor hours used, thereby giving correct product cost.