Orange Test Laboratories does heat testing (HT) and stress testing (ST) on mater

Question

Orange Test Laboratories does heat testing (HT) and stress testing (ST) on materials and operates at capacity. Under its current simple costing system, orange aggregates all operating costs of $1,200,000 into a single overhead cost pool. Orange calculates a rate per test-hour of $16 (1,200,000/75,000 total test hours). HT uses 50,000 test hours, and ST uses 25,000 test-hours. Gary Celeste, Orange's controller, believes that there is enough variation in test procedures and cost structures to establish separate costing and billing rates for HT and ST. The market for test services is becoming competitive. Without this information, any miscosting and mispricing of its services could cause Orange to lose business. Celeste divides Orange's costs into four activity-costs into four activity-cost categories.

Explanation / Answer

Four activity-cost categories are as shown below:

a. Direct-labor costs, $145,000

b. Equipment-related costs (rent, maintenance, energy, and so on), $540,000

These costs are output unit-level costs because they are incurred on each unit of materials tested, that is, for every hour of testing.

            Batch-level costs

c. Setup costs, $300,000

These costs are batch-level costs because they are incurred each time a batch of materials is set up for either HT or ST, regardless of the number of hours for which the tests are subsequently run.

            Service-sustaining costs

d. Costs of designing tests, $290,000.

These costs are service-sustaining costs because they are incurred to design the HT and ST tests, regardless of the number of batches tested or the number of hours of test time.

The ABC system better captures the resources needed for heat testing and stress testing because it identifies all the various activities undertaken when performing the tests and recognizes the levels of the cost hierarchy at which costs vary. Hence, the ABC system generates more accurate product costs.

Orange management can use the information from the ABC system to make better pricing and product mix decisions. For example, it might decide to increase the prices charged for the more costly heat testing and consider reducing prices on the less costly stress testing. Orange should watch if competitors are underbidding orange in stress testing, and causing it to lose business. 0range can also use ABC information to reduce costs by eliminating processes and activities that do not add value, identifying and evaluating new methods to do testing that reduce the activities needed to do the tests, reducing the costs of doing various activities, and planning and managing activities.

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