Question

Exercise 4-4 d (Essay) Altex Inc. manufactures two products: car wheels and truck wheels. To determine the amount of overhead to assign to each product line, the controller, Robert Hermann, has developed the following information. Car Truck Estimated wheels produced 40,000 10,000 Direct labor hours per wheel 1 3 Overhead cost assigned to the car wheels is $440,000 and truck wheels is $330,000. Total estimated overhead costs for the two product lines are $770,000. Hermann is not satisfied with the traditional method of allocating overhead because he believes that most of the overhead costs relate to the truck wheels product line because of its complexity. He therefore develops the following three activity cost pools and related cost drivers to better understand these costs. Activity Cost Pools Estimated Use of Cost Drivers Estimated Overhead Costs Setting up machines 1,000 setups $220,000 Assembling 70,000 labor hours 280,000 Inspection 1,200 inspections 270,000 You are given the following information. Estimated Use of Cost Drivers per Product Car Truck Number of setups 200 800 Direct labor hours 40,000 30,000 Number of inspections 100 1,100 Car Wheels Truck Wheels Total cost assigned using activity-based $226,500 $543,500

(d) What do you believe Hermann should do?

Answer 1

(d) As is seen from the data provided, the overhead cost allocated to the truck wheels product line is much higher using the activity-based method of allocating overhead costs rather than the traditional method of allocating overhead costs. This is also in line with the complexity of each product line as believed by Hermann.

The activity-based cost allocation method allocates the overhead costs after taking into consideration the amount of resources (cost driver) used by each product line. It is thus a better method for allocating the overhead costs for multiple product lines. Better cost allocation would also result in appropriate setting of selling prices.

In view of the above, Hermann should use the activity-based cost allocation method for allocating overhead costs to the car wheels and truck wheels product lines.