Choosing an Activity-Based Costing System
Pickle Motorcycles, Inc. (PMI), manufactures three motorcycle models: a cruising bike (Route 66), a street bike (Main Street), and a starter model (Alley Cat). Because of the different materials used, production processes for each model differ significantly in terms of machine types and time requirements. Once parts are produced, however, assembly time per unit required for each type of bike is similar. For this reason, PMI allocates overhead on the basis of machine-hours. Last year, the company shipped 1,000 Route 66s, 4,000 Main Streets, and 10,000 Alley Cats and had the following revenues and expenses:
PICKLE MOTORCYCLES, INC.
|Route 66||Main Street||Alley Cat||Total|
|Energy to run machines||756,000|
|Contribution margin||$ 9,954,000|
|Other fixed overhead||2,800,000|
|Gross profit||$ 5,394,000|
PMI’s chief financial officer (CFO) hired a consultant to recommend cost allocation bases. The consultant recommended the following:
|Activity||Cost Driver||Activity Level|
|Route 66 Main Street||Alley Cat|
|Setting up machines||Number of production runs||22 34||44|
|Processing orders||Number of sales orders received||400 600||600|
|Warehousing||Number of units held in inventory||200 200||400|
|Using energy||Machine-hours||10,000 16,000||24,000|
|Shipping||Number of units shipped||1,000 4,000||10,000|
The consultant found no basis for allocating the plant administration and other fixed overhead costs and recommended that these not be applied to products.
a. Using machine-hours to allocate production overhead, complete the income statement for Pickle Motorcycles. (See the “using energy” activity for machine-hours.) Do not attempt to allocate plant administration or other fixed overhead.
b. Complete the income statement using the bases recommended by the consultant.
c. How might activity-based costing result in better decisions by Pickle Motorcycles’s management?
d. After hearing the consultant’s recommendations, the CFO decides to adopt activity-based costing but expresses concern about not allocating some of the overhead to the products (plant administration and other fixed overhead). In the CFO’s view, “Products have to bear a fair share of all overhead or we won’t be covering all of our costs.” How would you respond to this comment?