Choosing an Activity-Based Costing System

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:


Income Statement

  Route 66 Main Street Alley Cat Total
Sales $7,600,000 $11,200,000 $9,500,000 $28,300,000
Direct costs        
Direct materials 3,000,000 4,800,000 4,000,000 11,800,000
Direct labor 288,000 480,000 1,080,000 1,848,000
Variable overhead        
Machine setup       468,000
Order processing       1,152,000
Warehousing costs       1,674,000
Energy to run machines       756,000
Shipping       648,000
Contribution margin       $ 9,954,000
Fixed overhead        
Plant administration       1,760,000
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?


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