Gibson Pharmaceuticals manufactures an over-the-counter allergy medications called Breathe. Gibson is trying to win market share from Sudafed and Tylenol. The company has developed several different Breathe products tailored to specific markets. For example, the company sells large commercial containers of 1,000 capsules to health-care facilities and travel packs of 20 capsules to shops in airports, train stations, and hotels

Gibson's controller, Sandy Dwyer, has just returned from a conference on ABC. She asks Kadeem Yeng, supervisor of the Breather product line, to help her develop an ABC system. Dwyer and Yeng indentify the following activities. related costs, and cost allocation bases:

Data Table:
Activity/Est. Indirect Activity Costs/Allocation Base/Est. Qty. of Allocation Base
Materials handling/$130,000/Kilo/13,000 kilos
Packaging/$460,000/Machine hours/2,300 hours
Quality assurance/$118,000/Samples/2,000 samples
Total indirect costs ...$708,000 ($130,000+$460,000+$118,000=$708,00 0)

The commercial-container Breather product line had a total weight of 8,096 kilos, used 1,800 machine hours, and required 260 samples. The travel-pack line had a total weight of 5,976 kilos, used 600 machine hours, and required 360 samples. Gibson produced 2,700 commercial containers of Breathe and 30,000 travel packs.

Requirements
1. Compute the cost allocation rate for each activity.
2. Use the activity-based cost allocation rates to compute the indirect cost of each unit of the commercial containers and the travel packs. (HINT: Compute the total activity costs allocated to each product line and then compute the cost per unit.)
3. The company's original single-allocation-based cost system allocated indirect costs to products at $300 per machine hour. Compute the total indirect cost allocated to the commercial containers and to the travel packs under the original system. Then compute the indirect cost per unit for each product.
4. Compare the activity-based costs per unit to the costs from the original system. How have the unit costs changed? Explain why the costs changed as they did.

Explanation:

(1) Overhead Absorption Rate (OAR) = Overhead cost/No of Activities

Materials Handling Cost :

Cost driver ⇒ Kilos ( 13,000 kilos)

OAR = $130,000/13,000 =  $10

Packaging Costs

Cost driver ⇒Machine hours ( 2,300 hours)

OAR = $460,000/ 2300=  $200

Quality Assurance Cost

Cost driver ⇒ Samples

OAR = $118,000/ 2,000  =$59

(2) Total Overhead Cost Allocated to each unit

Commercial containers

Materials Handling Cost = $10 X 8,096 = $80,960

Packaging Costs = $200 X 1,800 = $360,000

Quality Assurance Cost = $59 X 260 = $15,340

Total Costs = $80,960 + $360,000 + $15,340 = $456,300

Total commercial containers produced = 2,700

Overhead cost per unit of Container produced = $456,300/ 2,700 = $169 per unit

Travel-pack line

Materials Handling Cost = $10 x 5,976 = $59,760

Packaging Costs             = $200 x  600 = $120,000

Quality Assurance Cost = $59 x 360      =$21,240

Total Costs = $59,760 + $120,000 + $21,240 = $201,000

Total Travel packs produced = 30,000

Overhead cost per unit of travel pack = $201,000/ 30,000 = $6.7

(3) Using Original System ( Cost per machine hours)

Commercial containers

Total Overhead cost (using Machine hours) = $300 x 1,800   = $540,000

Total Overhead cost per unit = $540,000/2,700 = $200

Travel-pack line

Total Overhead cost (using machine hours) = $300 x 600 = $180,000

Total Overhead cost per unit = $180,000/30,000 = $ 6

(4)

Activity Based costing : this approach make use of activities that drive cost as a basis to determine the overhead cost per unit. This is more relevant in the current day manufacturing system where there are major activities that drive cost other than just machine hours. Using ABC allowed for fair sharing of overhead costs among different products lines which also help in determining the right pricing and identify which product consumed more activities that drive cost.

Whereas, traditional system relied on the assumption that overhead costs are majorly driven by machine hours which obviously may not be true in the current day production system. Using this approach may lead to a wrong pricing of products and also lead to  wrong decision being made on a products most especially where the company has more than one product lines.

In the case of Gibson, commercial  containers overhead unit cost was over estimated while Travel-pack line overhead unit cost was under-estimated using original costing system.

The error under original system was latter corrected using ABC