LO5 C2-32. Activity Cost Drivers and Cost Estimation Market Street Soup Company
ID: 2548710 • Letter: L
Question
LO5 C2-32. Activity Cost Drivers and Cost Estimation Market Street Soup Company produces ten varieties of soup in large vats, several thousand gallons at a time. The soup is distributed to several categories of customers. Some soup is packaged in large containers and sold to college and university food services. Some is packaged in half-gallon or small containers and sold through wholesale distributors to grocery stores. Finally, some is packaged in a variety of individual servings and sold directly to the public from trucks owned and operated by Market Street Soup Company. Management has always assumed that costs fluctuated with the volume of soup, and cost-estimating equations have been based on the following cost function: Estimated costs Fixed costs Variable costs per gallon x Production in gallons Lately, however, this equation has not been a very accurate predictor of total costs. At the same time, management has noticed that the volumes and varieties of soup sold through the three distinct distribution channels have fluctuated from month to month. Required a. What relevant major assumption is inherent in the cost-estimating equation currently used by Market b. Why might Market Street Soup Company wish to develop a cost-estimating equation that recognizes c. Develop the general form of a more accurate cost-estimating equation for Market Street Soup Com Street Soup Company? the hierarchy of activity costs? Explain. pany. Clearly label and explain all elements of the equation, and provide specific examples of costs for each elementExplanation / Answer
(a) The current equation assumes that Fixed cost remains Fixed irrespective of units produced or budgeted.
(b) Simply because those who consume more should bear more and Activity Based Costing is exactly based on this concept.
Activity-based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity-based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities.
For this, Management should identify the activities as per each cost center and then divide the total fixed cost into cost per activity.
Under the ABC system, an activity can also be considered as any transaction or event that is a cost driver. A cost driver, also known as an activity driver, is used to refer to an allocation base. Examples of cost drivers include machine setups, maintenance requests, the power consumed, purchase orders, quality inspections or production orders.
(c) Example and Explanation :
The activity cost rates (predetermined overhead rates) for Blue Dairy Company are to be calculated as follows:
Activity
Cost Driver (activity)
Overhead Cost
Estimated Units
Rate
Purchasing Materials
Pieces of materials
200,000
100,000 pieces
$ 2
per piece
Machine Setups
Machine setups
800,000
400 setups
2,000
per setup
Inspections
Inspection hours
400,000
4,000 inspect. hours
100
per inspect. hour
Running Machine
Machine hours
600,000
20,000 mach. Hours
30
per machine hour
Total Overhead
$ 2,000,000
For January, the Blue Dairy Company has the following information about the actual number of cost driver units for each of the two products:
Bottles
Pitchers
Purchasing Materials
6,000 pieces
4,000 pieces
Machine Setups
10 setups
30 setups
Inspections
200 hours
200 hours
Running Machine
1,500 hours
1,500 hours
Multiplying the actual activity events for each product times the predetermined rates computed earlier resulted in the overhead allocated to the two products:
Bottles
Pitchers
Purchasing Materials
$ 12,000
(6,000 pieces x $2 per piece)
$ 8,000
(4,000 pieces x $2 per piece)
Machine Setups
20,000
(10 setups x $2,000 per setup)
60,000
(30 setups x $2,000 per setup)
Inspections
20,000
(200 hours x $100 per hour)
20,000
(200 hours x $100 per hour)
Running Machine
45,000
(1,500 hours x $30 per hour)
15,000
(500 hours x $30 per hour)
Total Overhead
$ 97,000
$ 103,000
Total Cost
Activity
Cost Driver (activity)
Overhead Cost
Estimated Units
Rate
Purchasing Materials
Pieces of materials
200,000
100,000 pieces
$ 2
per piece
Machine Setups
Machine setups
800,000
400 setups
2,000
per setup
Inspections
Inspection hours
400,000
4,000 inspect. hours
100
per inspect. hour
Running Machine
Machine hours
600,000
20,000 mach. Hours
30
per machine hour
Total Overhead
$ 2,000,000
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