THE CLASSIC PEN

COMPANY

Traditional Costing System

Overhead allocation
Single plant wide OH rate
2 steps in OH allocation
Calculate OH rate = Total budgeted OH / Total budgeted
activities
= $60,000 / $20,000 direct labour costs
= $ 3 per @ 300 % of direct labour costs
Overhead applied = OH rate x Actual direct labour costs
= 300 % x $10,000
= $30,000 (Blue Pen)

What are the limitation of traditional

costing system?

Limitations of traditional costing

system
Suitable for previous production (Blue & Black Pen)
Traditional costing system adequate for the financial reporting
role of inventory valuation
Production operations were mostly manual and both had
similar production volume and batches
Direct labor are the appropriate cost drivers in motivating the
production cost to incur
High correlation exists between direct labor and changes in
overhead cost.

Limitations of traditional costing

system
Current production
Automation direct labour costs have decreased, indirect
expenses have decreased
Custom low volume of products such as RED and PURPLE are
added which require more scheduling, setups, computer
system
Traditional costing system in adequate when indirect expenses
were low and product variety was limited
May give distorted signal about the relative profitability of
different products.

Limitation of traditional costing

systems
The way production cost were allocated to products
Using unit level drivers direct labour hour, direct
labour dollars, machine hours
High volume products, BLUE and BLACK, their overhead
will be overestimated absorbing higher percentage of
overhead allocation
Custom low volume products, RED and PURPLE, their
overhead will be underestimated absorbing low
percentage of overhead allocation
RED and PURPLE required more indirect expenses to
produce

Activity & Activity Expenses

Total
expense
s

Handle
Set
up Support

prod run
machine
product
Run machine
50%=
Indirect costs & 1/2 fringe
14,000 40%= 11,200 10%=2,800

*28000

Computer expenses

80%=8,000

Machine depreciation

100% = 8,000

8000

Maintenance

100%= 4,000

4000

Energy

100%=2,000

2000

14000

52000

Activity Expenses

22000

* Indirect costs = $20,000 + Fringe

benefits for indirect labour ($16,000
(0.4 x $20,000))

20%=2,000

11200

4800

10000

Activity Based Costing

Calculate the activity rate
Activity

Cost driver

Handle production runs

Set up machines
Support products
Run Machine

Number
Number
Number
Number

of
of
of
of

production runs
setup hours
products
machines hours

Assign the activity costs to product

Calculate Activity Rate

ACTIVITY

ACTIVITY
EXPENSES

ACTIVITY
DRIVER

ACTIVITY
COST
COST DRIVER
QUANTITY

ACTIVITY
COST DRIVER
RATE

HPR

22000No.of prod run

150

146.67

STM

11200set up time

526

21.29

1200.00

10000

1.40

SP

4800no. of product

RM

14000machine hours

TOTAL

52000