Question

Brief Exercise 17-1 (Essay)

Digger Inc. sells a high-speed retrieval system for mining information. It provides the following information for the year.

		Budgeted		Actual
Overhead cost		$975,000		$950,000
Machine hours		50,000		45,000
Direct labor hours		100,000		92,000

Overhead is applied on the basis of direct labor hours.

(c)

Explain how an activity-based costing system might differ in terms of computing a predetermined overhead rate.

Answer 1

(c) Activity based costing allocates overhead cost on the basis of level of activity used by each product. While in the other case predetermined overhead rate is multiplied by the hours worked to calculate the overhead cost. This may lead to underapplying or overapplying of overhead since the actual overhead cost may differ.

While activity based costing is more realistic and practical approach, using predetermined overhaed rate on the basis of direct labour hours is traditional approach.

The rate of applying each overhead, under activity based costing, is calculated by dividing the cost pool by the level of activity. Overheads are first divided into cost pools such as set up cost, inspection cost, ordering cost, etc. and activity level of each cost pool is determined. The overhead rate for each cost pool is then calculated by dividing cost pool by the level of activity.