4. Although the bi-relay accounts for only 20% of the company’s total pro-
duction, it is responsible for two-thirds of the part types carried in inven-
tory and 60% of the machine-hours worked. It is also responsible for
well over half of the tests needed for quality control. These factors have
been concealed as a result of using direct labor-hours as the base for
assigning overhead cost to products. Since the bi-relay is responsible for
a majority of the activity, under activity-based costing it is assigned a
larger amount of overhead cost.
Managers should be cautious about drawing firm conclusions about the
profitability of products from the above activity-based cost analysis. The
ABC system used in this company is not completely suitable for making
decisions. Product costs probably include costs of idle capacity and or-
ganization-sustaining costs. They also exclude nonmanufacturing costs
that may be caused by the products. Nevertheless, the above analysis is
suggestive. The bi-relay may not be as profitable as management be-
lieves, and this may be the reason for the company’s declining profits.
Note that from part (1), the unit product cost of the bi-relay is $85. In
part (3), however, the activity-based costing system sets the unit prod-
uct cost of the bi-relay at $116.80. This is a difference of $31.80 per
unit. If the $85 cost figure is being used as the base for determining a
selling price for the bi-relay, the company may be losing money on this
product.
Case 8-31 (90 minutes)
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