Review Problem 3.5

Menzies and Associates provides two products to its clients—tax services and audit services. Last year, total overhead costs of $1,000,000 were allocated based on direct labor hours. A total of 10,000 direct labor hours were required last year for tax clients at a cost of $350,000, and 30,000 direct labor hours were required for audit clients at a cost of $1,200,000. Direct materials used were negligible and are included in overhead costs. Sales revenue totaled $720,000 for tax services and $2,200,000 for audit services.

Management of Menzies and Associates would like to use activity-based costing to allocate overhead rather than use one plantwide rate based on direct labor hours (perhaps the term “officewide” rate would be more appropriate here). The following estimates are for the activities and related cost drivers identified as having the greatest impact on overhead costs.

Required:

1.  

   1. Using the plantwide allocation method, calculate the total cost for each product. (Hint: Product costs for this company include overhead and direct labor.)
   2. Calculate the profit for each product using this approach. Also calculate profit as a percent of sales revenue for each product.

2.  

   1. Using activity-based costing, calculate the predetermined overhead rate for each activity. (Hint: Step 1 through step 3 in the activity-based costing process have already been done for you; this is step 4.)
   2. Using activity-based costing, calculate the amount of overhead assigned to each product. (Hint: This is step 5 in the activity-based costing process.)
   3. Calculate the profit for each product using this approach. Also calculate profit as a percent of sales revenue for each product.
3. Comment on the results of using activity-based costing compared to plantwide allocation.

Solutions to Review Problem 3.5

1.  

   1. The plantwide allocation used by Menzies and Associates is based on direct labor hours. The rate is calculated as follows:

      $$\begin{array}{cc}\hfill \frac{\text{Estimated overhead cost}}{\text{Estimated activity in allocation base}}& =\frac{\text{\$}\text{1}\text{,}\mathrm{000,000}}{\text{4}\mathrm{0,000}\text{ hours}}\hfill \\ \hfill & =\text{ \$25 per direct labor hour}\hfill \end{array}$$

      Total product costs are as follows:

      

      *$250,000 = 10,000 direct labor hours × $25 rate.

      **$750,000 = 30,000 direct labor hours per unit × $25 rate.

   2.  

      

2.  

   1. Predetermined overhead rates are calculated for each activity as follows:

      

   2. Overhead costs are allocated as follows:

      

      *Overhead allocated equals the predetermined overhead rate times the cost driver activity.

   3. The profit and profit as a percent of sales revenue are calculated as follows:

      

3. Activity-based costing results in a significant increase of overhead costs allocated to the tax product and a decrease of overhead costs allocated to the audit product. The plantwide allocation approach allocates overhead based on direct labor hours, which results in 25 percent of all overhead costs being allocated to tax (= 10,000 direct labor hours in tax ÷ 40,000 total direct labor hours) and 75 percent to audit. However, ABC shows that tax uses 60 percent of scheduling and data entry resources (= 150 tax clients ÷ 250 total clients), 90 percent of advertising resources (= 45 tax ads ÷ 50 total ads), and 50 percent of computer resources (= 2,500 tax computer hours ÷ 5,000 total computer hours). Thus tax is allocated more overhead costs using ABC than using one plantwide rate based on direct labor hours. Note that total profit of $370,000 is the same regardless of the overhead cost allocation approach used. Using the plantwide allocation approach, $370,000 = $120,000 + $250,000. Using the ABC approach, $370,000 = ($210,000) + $580,000.

   Management must use this information to make improvements to the company’s operations. It would probably be unwise to eliminate tax services because of the connection they have with audit services (i.e., audit clients may appreciate the convenience of also having tax services available to them). However, management can look for ways to make the process more efficient by focusing on costly activities identified in the ABC analysis.

   Note that when calculating product costs for service organizations, it is difficult, if not impossible, to calculate a product cost per unit. Most service organizations do not have an easily defined unit of measure because services vary so much from one customer to another. One alternative is to calculate total profit as a percent of total sales revenue. This allows for a comparison of profitability between different types of services, similar to comparing the profitability for units of product.