Company is an automotive component supplier. O’Sullivan has been approached by Honda Canada’s Alliston, Ontario, plant to consider expanding its production of part 24Z2 to a total annual quantity of 2,000 units. This part is a low-volume, complex product with a high gross margin that is based on a proposed (quoted) unit sales price of $7.50.

O’Sullivan uses a traditional costing system that allocates indirect manufacturing costs based on direct labour costs. The rate currently used to allocate indirect manufacturing costs is 400 percent of direct labour cost. This rate is based on the $3,200,000 annual factory overhead cost divided by $800,000 annual direct labour cost. To produce 2,000 units of 24Z2 requires $5,000 of direct materials and $1,000 of direct labour. The unit cost and gross margin percentage for part 24Z2 based on the traditional cost system are computed as follows:

                                                                                                            Total Per Unit (÷2,000)
Direct materials ...................................................................................$ 5,000 $2.50
Direct labour .............................................................................................1,000 0.50
Indirect production: (400% direct labour) .............................................4,000 2.00
Total cost .............................................................................................$10,000 $5.00
Sales price quoted ..............................................................................................7.50
Gross margin .....................................................................................................$2.50
Gross margin percentage ................................................................................33.3%

The management of O’Sullivan decided to examine the effectiveness of their traditional costing system versus an activity-based costing system. The following data have been collected by a team consisting of accounting and engineering analysts:

Activity Centre                                                 Factory Overhead Costs (annual)
Quality .............................................................................$ 500,000
Production scheduling .......................................................50,000
Setup...................................................................................700,000
Shipping .............................................................................300,000
Shipping administration ....................................................50,000
Production .....................................................................1,600,000
Total indirect production cost $3,200,000

Activity Centre: Cost Drivers                                                 Annual Cost-Driver Quantity
Quality: Number of pieces scrapped ......................................................10,000
Production scheduling and setup: Number of setups ..............................500
Shipping: Number of containers shipped .............................................60,000
Shipping administration: Number of shipments ....................................1,000
Production: Number of machine-hours ................................................10,000

The accounting and engineering team has performed activity analysis and provides the following estimates for the total quantity of cost drivers to be used to produce 2,000 units of part 24Z2:

Cost Driver                             Cost-Driver Consumption
Pieces scrapped ....................................120
Setups ........................................................4
Containers shipped ...............................10
Shipments ................................................5
Machine-hours ......................................15

Required

1. Prepare a schedule calculating the unit cost and gross margin of part 24Z2 using the activity-based costing approach.

2. Based on the ABC results, which course of action would you recommend regarding the proposal by Honda Canada? List the benefits and costs associated with implementing an ABC system at O’Sullivan.