To better understand the differences between the traditional and activity-based costing and how those differences affect product profitability analysis as well as management decisions, we will look at the following example.

Friends Company, a manufacturer of valves, produces and sells two types of valves: Gas Safety Valves (GSV) and MSC Valves (MSC). Friends Company has the following data for the two products:

Let’s calculate the unit product cost using volume-based costing. Under traditional costing, the factory overhead cost is assigned based on direct labor-hours (DLH). The factory overhead rate is determined as follows:

In this case, the factory overhead rate per DLH = $600,000 / 50,000 = $12 per DLH (i.e. plant-wide rate). Using this information, we can determine the total amount of factory overhead assigned to each product and the factory overhead cost per unit for both products:

Note: $360,000 = $12.00 x 30,000 and $240,000 = $12.00 x 20,000.

Now we can calculate the unit margin profit for each product and determine how profitable the products are:

Note C: $36.00 = $12.00 x 3 hrs and $48.00 = $12.00 x 4 hrs.

Therefore, using the volume-based costing we can see that the product MSC is much more profitable than the product GSV. However, let’s use the activity-based costing and see if we can get the same or similar results.