ABC Blocher Solutions

Blocher,Stout,Cokins,Chen:Cost Management, 4e 5-1 ©The McGraw-Hill Companies, Inc., 2008

CHAPTER 5: ACTIVITY-BASED COSTING AND MANAGEMENT

QUESTIONS 5-1 Product costs are likely distorted when a firm uses a volume-based rate if the

plant has more than one activity in its operations and not all activities consume overhead in the same proportion. The more diverse the product mixes of the plant are in volume, sizes, manufacturing processes, or product complexities, the greater the cost distortions are likely to be in using a volume-based rate.

5-2 Undercosting a product may appear to have increased the reported profit the

product earned (assuming the firm did not lower its selling price because of the reported lower product cost). However, the increased profit is, at best, a twist in truth. Costs of the product not charged to the product itself are borne by other products of the firm.

Worse, undercosting a product may result in managers erroneously believing the

product to be more profitable than other products and shifting the limited resource the firm has into manufacturing, promotion, and sales of the product when, in fact, other products are more profitable to the firm. Severe cost distortions may lead firms not to drop unprofitable products because the cost data show these products are profitable.

5-3 Overcosting does not increase revenues. A firm can increase the selling price of

a product, thereby increasing the total revenue from the product only if the market allows. Increases in the selling price of a product without experiencing noticeable decrease in the sales quantity of the product is likely an indication that the product was not priced properly, which might be a result of undercosting of the product.

Furthermore, overcosting a product is likely accompanied by undercosting of the firm’s other products and, as a result, underpricing of one or more of the firm’s other products.

When a firm sets a high selling price that is a result of overcosting, competitors also are likely to enter the market and take away the firm’s market share. A firm also may drop or de-emphasize an erroneously overcosted product when it erroneously believes the product is either unprofitable or having a low-margin.


5-4 Activity-based costing recognizes that resources are spent on activities and the cost of a product or service is the sum of the costs of activities performed in manufacturing the product or providing the service.

An activity-based costing system traces costs to the activity that consumes resources. Costs are determined based on the activities performed for cost objects and their underlying cost drivers that consume resources. Product or service costs determined using activity-based costing reflect costs of resources consumed for activities performed in manufacturing products or providing services. In contrast, a volume-based costing system uses cost allocations to channel indirect costs to products or services. As a result, the cost of a product or service often bears little or no relationship to activities performed in the manufacturing of the product or service.

5-5 Based on the activities of most manufacturing firms, the general levels of cost

hierarchy of an activity-based costing system are: Unit-level cost; Batch-level cost; Product-level cost; and Facility-level cost.

5-6 In an activity-based costing system, the second-stage procedure in tracing costs to products or services is a process by which the costs of activities or activity pools are assigned to cost objects using one or more appropriate activity consumption cost drivers.

5-7 All firms should use an ABC system when the benefits of such a system exceed

the costs of implementing it. It is especially beneficial to firms with product diversity and/or process complexity.

5-8 Unit-level activities are activities performed on individual units of product or

service. The frequency of a unit-level activity varies in proportion with the units of product manufactured or service provided.

Examples of unit-level activities are using direct materials, using direct labor hours, inserting a component, inspecting each unit, and consuming power to run machines.

5-9 Batch-level activities are activities performed for a group of units of products or

services rather than for each individual unit of product or service. The frequency of batch-level activity is determined by both the size of the group and the total number of units to be manufactured or provided.

Examples of batch-level activities are setting up machines, processing and placing of purchase orders, scheduling production runs, inspecting products by batch, and handling materials.


5-10 Product-level activities are activities undertaken to support individual products or services rather than for each individual unit of product or service or a group of individual units of products or services.

Examples of product-level activities include product design, parts administration,

and product modification. 5-11 Facility-level activities are activities performed for the entire organization or

division to meet the required operating procedure or support the operation of the organization or division.

Examples of facility-level activities include providing security for the facility, maintaining general equipment and facility, plant management, plant depreciation, and property taxes and insurance premium for facilities.

5-12 A product-costing system that uses a single volume-based cost driver is likely to

overcost high-volume products because high-volume products do not consume support resources in proportion to their production volumes. As a result, a product-costing system that uses a single volume-based cost driver often overcosts high-volume products or services and undercosts low-volume products or services.

The cross-subsidizations of low-volume products by high-volume products is likely to lead the firm not to price its products properly. This may also decrease the profits of the firm and reduce management’s confidence in the product cost predictions. Poor pricing can lead a firm to promote less profitable products while not spending sufficient resources on more profitable items.

5-13 Activity-based management is the use of an activity-based costing system to

improve operations, increase customer value, and enhance profitability.

5-14 Examples of high-value-added activities include insertion of parts, assembling of components, machining to meet specification, reducing response time, and reduction of defective characteristics.

5-15 Examples of low-value-added activities include moving parts between

workstations, transporting finished units to warehouse, waiting for materials or parts to arrive, inspecting, repairing, and storing.

5-16 Service organizations such as banks, hospitals, transportation companies, law

firms, and trading companies can use activity-based costing and management in all phases of their operations as manufacturing firms do. For example, a bank can use ABC to calculate the cost to process a check, a hospital can use ABC to determine costs per patient day for different kinds of patients and the cost to admit a patient, etc.


5-17 Opportunities afforded by customer profitability analysis are:

• Providing better services to highly profitable customers; • Identifying and securing highly profitable customers from competitors; • Setting prices based on the cost to serve; • Negotiating with customers to set mutually beneficial levels of services; • Transforming unprofitable customers into profitable ones through targeted

negotiations on price, quantity, product mix, order processing, delivery terms, and payment arrangements;

• Identifying and conceding permanent loss customers to competitors.

.


BRIEF EXERCISES

5-18 Total Cost per Batch = $50 + (.1 x 5,000) = $550 Cost to produce 100,000 cans = (50 x (100,000/5,000)) + (.1 x 100,000) = $11,000 5-19 ((30,000 x 0.2) / 60) x $10= $1,000 5-20 Cost for 50 Heads = (60 / 20) x 5 + (50 x $0.1) = $20 Cost for 60 Heads = (60 / 20) x 5 + (60 x $0.1) = $21 Difference = $21 – $20 = $1 5-21 (($15 x .5) + $5) x 5 cars x 5 days = $312.50 per week 5-22 Cost per computer = $1,000,000 / 5,000 = $200 per computer $200 = (2 x (cost of one technician hour)) + (5 x $10) Cost for technician time = $200 - $50 = $150 $150 = 2 x (cost of one technician hour) technician hourly rate = $75 per technician hour 5-23 Materials Cost = $3,000,000 / 100,000 = $30 per camera Labor Cost = $500,000 / (100,000 x .5) = $10 per camera Inspection Cost = $1,000,000 / (100,000 x .2) = $50 per camera Packaging Cost = $500,000 / 100,000 = $5 per camera 5-24 Direct Labor = $8 x 5 = $40 Copying = $0.05 x 1,000 = $50 Total Job Cost = $50 + $40 = $90 5-25 Data Entry = $2,000,000 / 100,000 = $20 per hour Data Analysis = $3,000,000 / 30,000 = $100 per hour


5-26 Volume Based Rate = 2 x $10 = $20 overhead per mattress Activity Based Rate: Materials Handling = 30 x $.10 = $3 materials handling cost per mattress Setup Cost = $5 x 2 = $10 per mattress Total ABC = $3 + $10 = $13 per mattress Overstatement = $20 – $13 = $7 per mattress 5-27

$150 x .2 = $30 million 500,000 x 20 = 10 million

$30/10 = $3 per part

Total inspection cost: $3 x 20 = $60 for 20 parts

$3 x 50 = $150 for 50 parts

5-28 6 x 10,000 x $.50 = $30,000


EXERCISES 5-29 Activity Levels (5 min) 1. Cost Hierarchy

a. Unit-level f. Product-level

b. Unit-level g. Facility-level

c. Facility-level h. Facility-level

d. Unit-level i. Batch-level

e. Unit-level j. Batch-level (one bag per customer).

2. Cost Driver

a. Number of hamburgers

b. Number of hours

c. Square feet

d. Number of hamburgers; Size of hamburgers

e. Number of hamburgers

f. Number of times the advertising is run

g. Number of hours store is open

h. Square feet

i. Number of coupons redeemed; Number of multiple orders; Number

of hamburgers

j. Number of customers


5-30 Activity Levels and Cost Drivers (5 min)

1. Activity Levels

a. Unit-level f. Facility-level

b. Batch-level g. Product-level

c. Batch-level h. Product-level

d. Batch-level; Product-level i. Unit-level; Batch-level

e. Product-level j. Batch-level.

2. Cost Drivers

a. Machine hours

b. Number of setups or setup hours

c. Number of production orders

d. Number of material receipts; Number of purchase orders

e. Number of products

f. Number of machine hours

g. Number of engineering change notices; number of modifications;

Number of products

h. Number of parts; Number of products; Number of purchase

orders

i. Number of inspection hours; Number of units; Number of batches

j. Number of loads; Number of material moves; Material weights


5-31 Activity Levels and Cost Drivers (5 min) 1. Activity Levels

a. Product-level f. Batch-level

b. Product-level g. Unit-level

c. Product-level h. Facility-level

d. Product-level i. Product-level

e. Batch-level j. Facility-level

2. Cost Drivers

a. Number of products

b. Number of products

c. Number of products

d. Number of products

e. Number of batches or setups

f. Number of batches

g. Number of units

h. Purchase costs; Replacement costs; Book values

i. Number of purchase orders; Number of products; Number of

suppliers

j. Square feet


5-32 Activity Levels and Cost Drivers - Service Company (15 min) 1. Output unit-level costs: a. Salaries and wages of lab technicians $1,200,000 b. Equipment-related costs $ 300,000

These costs are likely to vary with the number of test-hours, which are functions of the output units (test). Batch-level costs: c. setup costs $240,000 Setup costs are incurred each time a batch of tests is setup for either ST or PRT, regardless of the number of hours of the tests. Product-level costs: d. Costs of test designs $360,000 These costs are incurred in designing ST and PRT tests, regardless of the number of test-hours or number of batches tested.

2. As shown in the calculation below, the current costing system of charging $70 per test-hour for overhead undercosts the soil test (ST) and overcosts the pesticide residues test (PRT). One reason is that ST uses more setup costs and test design costs than PRT does, while ST has lower test hours than PRT. On average, ST tests take longer to setup (0.85 versus 0.575 setup hour per test hour) and it is more difficult to design the test (0.58 versus 0.21 setup hours per test hour)

Setup Hours Test Design Hours Test-Hours Total Per Test-Hour Total Per Test-Hour ST 10,000 8,500 0.850 5,800 0.58

PRT 20,000 11,500 0.575 4,200 0.21


5-32 (continued) 3. ST PRT

Total Per

Hour Total Per Hour TOTAL Test hours 10,000 20,000 30,000 Salaries and Wages $540,000 $54.00 $660,000 $33.00 $1,200,000 Equipment-related costs* ST 100,000 $10.00 PRT 200,000 $10.00 Setup costs# ST 102,000 $10.20 PRT 138,000 $6.90 Test design costs& ST 208,800 $20.88 PRT ________ ______ 151,200 7.56 TOTAL $950,800 $95.08 $1,149,200 $57.46 *Equipment-related costs $300,000 Test hours 10,000 20,000 30,000 Per test hour $10 Total 100,000 200,000 #Setup costs: $240,000 Setup hours 8,500 11,500 20,000 Per hour $12.00 Total 102,000 138,000 &Test design costs: $360,000 Test design hours 5,800 4,200 10,000 Per hour $36.00 Total 208,800 151,200


5-32 (continued-2) 4.

ST PRT Total Per Hour Total Per Hour TOTAL Test hours 2,500 5,000 7,500 Salaries and Wages $135,000 $54.00 $165,000 $33.00 $300,000 Equipment-related costs* ST 100,000 $40.00 PRT 200,000 $40.00 Setup costs# ST 255,000 $102.00 PRT $345,000 $69.00 Test design costs& ST 522,000 $208.80 PRT _________ _______ 378,000 $75.60 TOTAL $1,012,000 $404.80 $1,088,000 $217.60 *Equipment-related costs: $300,000 Test hours 2,500 5,000 7,500 Per test hour $40 Total 100,000 200,000 #Setup costs: $240,000 $360,000 $600,000 Setup hours 8,500 11,500 20,000 Per hour $30.00 Total 255,000 345,000 &Test design costs: $360,000 $540,000 $900,000 Test design hours 5,800 4,200 10,000 Per hour $90.00 Total 522,000 378,000

The cost per test-hour increased from $95.08 to $404.80 for ST and from $57.46 to $217.60 for PRT. Platte Valley needs to reexamine the appropriateness for using test-hours as the basis for costing. The bulk of the cost is for setup and test-design and the direct cost related to test-hour is only a fraction of the setup and test-design costs. A costing system based on the direct test-hour is likely to distort the true cost of testing.


5-33 Volume-Based Costing vs. ABC (20 minutes)

1. The volume-based cost system developed for inventory valuation is likely to distort product cost information because the cost system:

a. is designed to value inventory in the aggregate and not related to product cost information.

b. uses a common departmental or volume-based measure of activity, such as direct labor hours or dollars (now a small portion of overall production costs) to distribute manufacturing overhead to products.

c. de-emphasizes long-term product analysis (when fixed costs become variable costs).

d. causes managers, who are aware of distortions in the volume-based system, to make intuitive, imprecise adjustments to the volume-based cost information without understanding the complete impact.

2. Outlined below are the purpose and several characteristics of the

three noted cost systems.

a. Inventory Valuation Meets external reporting requirements for aggregate balance sheet

valuation and income determination. Provides monthly and quarterly reporting.

b. Operational Control

Evaluates operations to quickly detect problems to allow for implementation of corrective action.

Compares costs against budget for monitoring variances. c. Activity-based costing

Differentiates costs between high-value added and low-value-added activities.

Costs products according to activities involved in the production process.


5-33 (continued) 3. The benefits that management can expect from activity-based

costing include these: a. Leads to a more competitive position by evaluating cost drivers,

i.e., costs associated with the complexity of the transaction rather than the production volume.

b. Streamlines production processes by reducing low-value-added activities, e.g., reduced set-up times, optional plant layout, and improved quality.

c. Provides management with a more thorough understanding of product costs and product profitability for strategies and pricing decisions.

4. The steps that a company, using a volume-based cost system, would

take to implement activity-based costing include: a. evaluation of the existing system to assess how well the system

supports the objective of an activity-based cost system. b. identification of the activities for which cost information is needed

with differentiation between high-value added and low-value-added activities.


5-34 Activity-Based Costing Hakara Company (10 min)

Cost Pools Activity Costs Cost Drivers Overhead Rate

Machine setup $360,000 3,000 setup hours $120

Materials handling 100,000 25,000 pounds 4

Electric power 40,000 40,000 kilowatt hours 1

A B .

Direct materials $40,000 $50,000

Direct labor 24,000 40,000

Factory overhead: Machine setup $120 x 200 = 24,000 $120 x 240 = 28,800

Materials handling $4 x 1,000= 4,000 $4 x 3,000 = 12,000

Electric power $1 x 2,000 = 2,000 $1 x 4,000 = 4,000

Total product costs $94,000 $134,800

Production units ÷ 4,000 ÷ 20,000

COST PER UNIT $23.50 $6.74


5-35 Customer Profitability Analysis: Hotels (15 min) 1. The information gathering program are a logical fit for the luxury type hotels described here. These firms compete on their ability to attract high-paying customers to their luxury hotels. These additional services can give the hotel a competitive edge. 2. There is a good application for activity-based costing here. The program should be analyzed by activity (the different types of premium services offered), and then the cost drivers of these activities should then be identified, and traced to the cost object, which in this case is the individual customer. It is likely that the hotel rates are sufficiently high, that the cost of the extra services is covered by the room charges, but those managing the program should be able to know how effective it is in general, and for each customer. This type of information will help them revise the program if necessary, and to better target their most profitable customers. 3. Some will argue there is not ethical issue with the information gathering. Others might argue that the guest should be informed that the information is being obtained and used throughout the hotel chain’s system. For example, Marriott has guests fill out a form to participate, so the program is entirely optional. Other ethical issues arise, for example, if the hotel chain chooses to sell the information to third parties, such as magazine publishers, retail stores, or other businesses. This exercise is based on information obtained from the article by Avery Johnson, “Hotels Take ‘Know Your Customer’ to New Level,” The Wall Street Journal, February 6, 2006, p D1.


5-36 Applications of ABC Costing in Government (20 min) 1,2. A variety of examples are possible here. For additional examples: Gary Cokins, Activity-Based Cost Management in Government, Management Concepts, Inc., 2001. Also, see case studies of governmental agencies in Cost & Effect, by Robert S. Kaplan and Robin Cooper, Harvard Business School Press, 1998, pp 245-250. Kaplan and Cooper explain application at the U.S. Veterans Affairs Department, the U.S. Immigration and Naturalization Service, the U.S. Internal Revenue Service, and the City of Indianapolis.


5-37 Activity-Based Costing in the Fashion Apparel Industry (20 min) The ABC-costing solution follows: (all figures in £)Price 20.525Total Revenue 205,250

Direct Materials 33,750 Labour and Overhead CostsPattern cutting 22,000 Grading 19,000 Lay planning 18,500 Sewing 21,000 Finishing 14,300 Inspection 6,500 Boxing up 3,500 Storage 7,000 Labor and Overhead (ABC-based) 111,800 Total Product Cost 145,550 Unit Product Cost 14.56 Non-manufacturing Expenses 31500 Total Cost 177,050

Net Margin for Trousers 28,200 The results suggest that the trouser line is more profitable than previously thought (using volume-based costing). This is likely due to the common situation in which the high-volume products are overcosted using volume-based costing. Source of data used in the example: Andrew Hughes, “ABC/ABM: A profitability Model for SME’s Manufacturing Clothing in the UK,” Journal of Fashion Marketing and Management, 2005, Vol 9 Is 1, pp8-19. (SME means small to medium size company)


5-38 Service IndustryGWS Hospital (10 min) 1. GWS’s ICU overhead costs for the month of June using:

a. Hospital Wide Rate Based on Nurse-Hours

Per nurse-hour: $69,120,000 /1,152,000 = $60

Total ICU applied overhead costs: $60 x 5,900 = $354,000

b. The ICU Department Wide Rate Based on Patient-Day

Total budgeted ICU overhead:

$810,000 + $422,500 + $457,500 = $1,690,000

Overhead rate per patient-day:

$1,690,000 / 845 = $2,000

Total ICU applied overhead costs: $2,000 x 870 = $1,740,000

c. Activity Cost Driver Rates

Budgeted Budgeted Budgeted Total Applied Cost Pool Cost Activity OH Rate Activity Overhead Beds $810,000 900 $900.00 900 $810,000

Equipment 422,500 845 500.00 870 435,000

Personnel 457,500 6,000 76.25 5,900 449,875

Total applied overhead costs $1,694,875 2. The first method uses a hospital-wide overhead rate, which likely

bears no relationship with the overhead activities performed in the intensive care unit (ICU). The second method uses the patient-day overhead rate for the ICU department. This is an improvement over the first method. But a single patient-day cost driver may not have direct relationships with some of the activities performed in the ICU department. The third method is the preferred method because it uses a cost driver for each of the cost pools that reflects the resources consumed by activities of the cost pool.


5-39 Product Selection (5 min)

Before deciding on which of the two products the firm should focus, the company should review its costing system. It is likely that Johans’ product costing system is providing misleading cost information. The company is probably using a volume-based product costing system, which tends to overcost the high-volume product (Desktop Computer) and undercost the low-volume product (Tablet Computer). When competitors can sell a product at a price ($380) much lower than our cost for the desktop model ($550), it is likely that the costing system fails to determine product costs properly or that the applied manufacturing process is very inefficient. The company should install an activity-based product costing system. If the reported product cost indicates that the price of the high-volume desktops is too high compared to the competitor’s price, then the company should adjust the price accordingly.


5-40 High-value-added and Low-value-added Activities—Radiology (5 min)

(Note to instructor: Answer may vary if students perceive a different operation)

a. High-value-added

b. Low-value-added (Patients are likely to perceive waiting to have

low-value)

c. Low-value-added (Any need for lab work should have been

determined prior to arriving at the Radiology Department)

d. Low-value-added

e. High-value-added

f. High-value-added

g. Low-value-added

h. Low-value-added

i. High-value-added


5-41 High-value-added and Low-value-added Activities—Nurse (5 min)


a. High-value-added f. High-value-added

b. High-value-added g. High-value-added

c. High-value-added h. Low-value-added

d. Low-value-added i. High-value-added

e. Low-value-added

5-42 High-value-added and Low-value-added Activities—e-Retailing

(5 min)


a. Low-value-added e. Low-value-added

b. Low-value-added f. High-value-added

c. Low-value-added g. Low-value-added

d. Low-value-added h. High-value-added


5-43 ABC and Job-Costing (20 min)

A: $0.15 x 30 = $ 4.50

B: $37 / 1.85 = $20.00

C: $35.50 / 5 = $ 7.10

D: $0.08 x 100 = $ 8.00

Cost per board that passed the final inspection $240.00

Rejection rate x 50%

Cost per completed board $120.00

Direct materials $25.00

Direct labor 5.00

Other manufacturing overhead:

Axial insertion $ 4.50

Hardware insertion 37.00

Hand load 35.50

Masking 8.00 85.00 115.00

Manufacturing overhead for final test (E) $5.00

Units of cost driver for final test 10

Manufacturing overhead rate per unit of test time(F) $0.50


5-44 Cost of Meal (5 min) Below is a suggestion for Annie’s response:

Dear Totem Pole: If these are business-related dinners, you should talk to your accountant about deducting them from your expenses or billing your share to the clients. If that isn’t feasible, agree to meet these folks for cocktails, but leave before dinner, claiming you have to be elsewhere. No other excuse is needed. Note: This example illustrates the advantages of ABC in a familiar situation. Put all in one check and then split the bill equally is an example of volume-based overhead rate. Split-up the bill based on the number of meals is like using machine hours, labor hours, or other measures, rather than the activities themselves, to determine costs of products or services. Products having the same total machine hours pay for the same amount of overhead, regardless of the differences in the amount of setup times, product design hours, etc. these products might have used. Having separate checks is an ABC system. Each check tracks activities of an activity cost center. The person who engages in more activities – drinks or eats more than others – pays a higher bill.


5-45 Product-line Profitability, ABC (25 min) 1. Product-line profitability under the current costing system

Frozen Food Baked Goods Fresh Produce Sales $120,000 $90,000 $158,125 Cost of goods sold 105,000 67,000 110,000 Gross margin $ 15,000 $23,000 $ 48,125 Store support (20% of Sales) 24,000 18,000 31,625 Operating income ($ 9,000) $ 5,000 $ 16,500 Operating margin (OI/S) -7.50% 5.56% 10.43%

2. Product-line profitability under ABC

Frozen Food Baked Goods Fresh Produce Sales $120,000 $90,000 $158,125 Cost of goods sold 105,000 67,000 110,000 Gross margin $ 15,000 $23,000 $ 48,125 Store support: Order processing 800 4,400 7,200 Receiving 1,100 7,700 13,200 Shelf-stocking 300 525 7,200 Customer support 6,000 8,000 17,200 Total store support cost 8,200 20,625 44,800 Operating income $ 6,800 $ 2,375 $ 3,325 Operating margin (OI/S) 5.67% 2.64% 2.10%

3. Both baked goods and fresh produce have a drop in profitability when

ABC is used. The decrease in profitability of fresh produce is most noticeable. The profitability of fresh produce decreases from 10.43 percent of the sales revenues under the current system, the highest of the three products, to 2.10 percent under ABC, the lowest of the three. This is because fresh produce requires more support activities than the other two products.


5-46 Customer Profitability Analysis (25 minutes)

Requirement 2Jerry Inc. Donald Co.

Sales(5x1000x200;200x30x200) $1,000,000 $1,200,000Sales return(40x200;175x200) 8,000 35,000Net Sales $992,000 $1,165,000Cost of goods sold(75%) 744,000 873,750Gross margin(25%) $248,000 $291,250Sales support cost (from req. 1) 16,400 29,375Operating income $231,600 $261,875

Operating margin % 23.35% 22.48%

Requirement 1Jerry Inc. Donald Co.

Customer unit-level cost -

Sales returns(40x5;175x5) $200 $875Customer batch-level costs: Order processing(5x300;30x300) $1,500 $9,000 Sales returns(2x100;5x100) 200 500 Delivery(5x500;30x500) 2,500 15,000Customer sustaining costs: Sales calls(12x1000;4x1000) 12,000 4,000TOTAL $16,400 $29,375


5-47 Customer Profitability Analysis (25 min) 1. Determination of the $100.50 order-filling cost per unit

Total number of orders: 2 x 100 PCs + 10 x 4,000 SCs = 40,200

Total number of orders 40,200

Number of orders per block ÷ 60

Total number of blocks 670

Cost per block x $60,000

Total cost of order blocks $ 40,200,000

Total number of orders 40,200

Per order order-filling cost x $1,500

Total cost per order + 60,300,000

Total order-filling cost $100,500,000

Total units sold ÷ 1,000,000

Order-filling cost per unit $100.50


5-47 (continued)

2. Order filling cost per unit sold to PC:

Total number of orders 2

Number of orders per block ÷ 60

Total number of blocks 1/30

Cost per block x $60,000

Total block cost $2,000

Total number of orders 2

Order-filling cost per order x $1,500

Total cost per order + 3,000

Total order-filling cost $5,000

Total units sold ÷ 5,000

Order-filling cost per unit $1.00

Net profit per unit at $700 selling price per unit to preferred customers:

Preferred Customer

Selling price per unit $700.00

Manufacturing cost $600.00

Order-filling cost/unit + 1.00

Total cost per unit 601.00

Net Profit per unit $ 99.00

Profit margin per unit 14.14%


5-47 (continued-2)

3. Order filling cost per order by SC:

Cost per block $60,000

Number of orders per block ) 60

Block cost per order $1,000

Number of orders per SC x 10

Total block cost per SC $10,000

Order-filling cost per order $1,500

Number of orders per SC x 10

Total cost per order + 15,000

Total order-filling cost $25,000

Total units sold ) 125

Order-filling cost/unit $200

Profitability per unit at $800 selling price per unit to SC

Selling price per unit $800.00

Manufacturing cost $600.00

Order-filling cost/unit + 200.00

Total cost per unit 800.00

Net profit or loss per unit $ 0

Profit margin 0


PROBLEMS 5-48 Activity-Based Costing; Customer Group Cost Analysis (30 minutes) 1. First, obtain the total levels for activity cost drivers:

Then, obtain the activity rates:

Product Lines Value Quality Luxury TotalUnits Produced 15,000 5,000 500 20,500 Direct Materials cost per unit 80$ 50$ 110$ 240$ Total Direct Materials Cost 1,505,000$ Number of Parts per unit 30 50 120 200 Total parts 760,000 Direct Labor Hours per unit 4 5 7 16 Total Labor hours 88,500 Machine Hours per unit 3 7 15 25 Total Machine Hours 87,500 Production Orders 50 70 200 320Production Setups 20 50 50 120Orders Shipped 1,000 2,000 300 3,300

Budgeted Cost ActivityCost Driver Rate

Materials handling 349,600$ Number of Parts 0.460$ =$349,600/760,000Product Scheduling 160,000 Number of Production orders 500.00 =160,000/320Setup Labor 216,000 Number of setups 1,800.00 =216,000/120Automated Machinery 1,750,000 Machine hours 20.00 =1,750,000/87,500Finishing 619,500 Direct labor hours 7.00 =619,500/88,500Pack and Ship 285,000 Number of orders shipped 86.364 =285,000/3,300


5-48 (continued) The activity-based unit and total cost is as follows:

Value Quality LuxuryDirect Materials 80.00$ 50.00$ 110.00$ Direct Labor 48.00$ 60.00$ 84.00$ Overhead:

Materials handling 13.80 23.00 55.20 Product Scheduling 1.67 7.00 200.00 Setup Labor 2.40 18.00 180.00 Automated Machinery 60.00 140.00 300.00 Finishing 28.00 35.00 49.00 Pack and Ship 5.76 34.55 51.82

Total ABC Overhead 111.62 257.55 836.02 Unit ABC Cost 239.6242$ 367.5455$ 1,030.0182$

Total ABC Cost 3,594,364$ 1,837,727$ 515,009$ 2.

Value Quality LuxuryDirect Materials 80.00$ 50.00$ 110.00$ Direct Labor 48.00 60.00 84.00 Overhead 152.77 190.97 267.35 Cost per unit 280.7729$ 300.9661$ 461.3525$ Total Cost 4,211,593$ 1,504,831$ 230,676$


5-48 (continued) 3. The new activity rates based on practical capacity are as follows.

Note that the rates have changed significantly from the calculations in part 1 above, because there is a significant level of unused capacity in many of the activities. This information could be used by management to calculate unit ABC-based costs using the practical capacity rates, and thereby identify the cost of unused capacity. Moreover, the information about capacity utilization can be used to help bring resource spending in line with resource usage. As the firm plans to grow (particularly in the Luxury line), some additional capacity will be needed, but careful planning will allow a balance of planned future capacity needs versus current spending on these resources, probably allowing some capacities to be reduced. The potential for overcapacity appears to be greatest in product scheduling and pack and ship. 4. The ABC costing shows clearly how expensive the Luxury line is to produce. The volume-based approach fails to account for the activity usage of the Luxury line, and undercosts it significantly. ABC allows HPI to better understand how its costs will increase with the expected increased production of the Luxury line, and how it will have to adapt its pricing practices accordingly. Continued use of the volume-based approach at a time when sales of the Luxury line are increasing would mean significantly under-pricing the Luxury line, and undermining the profitability of the entire firm.

Practical Budgeted Cost Practical Capacity-Based

Cost Driver Capacity RatesMaterials handling 349,600$ Number of Parts 990,000 0.353$ Product Scheduling 160,000 Number of Production orders 800 200.00Setup Labor 216,000 Number of setups 200 1,080.00Automated Machinery 1,750,000 Machine hours 100,000 17.50Finishing 619,500 Direct labor hours 123,900 5.00Pack and Ship 285,000 Number of orders shipped 5,000 57.00

3,380,100$


5-49 Cost Pools and Cost Drivers (20 min) Note to instructor: The answer below is but one possible solution. 1. Cost pool 1: Cost driver: Number of purchase orders Receiving $10,000 Inspection of direct materials 3,000 Purchasing 20,000 Total $33,000

Cost pool 2: Cost driver: Number of production runs Setup wages $20,000

Cost pool 3: Cost driver: Machine hours Depreciation, machine $40,000 Electrical power (machining) 30,000 Machine maintenance - labor 11,000 Machine maintenance - materials 9,000 Total $90,000

Cost pool 4: Cost driver: Factory space Depreciation, building $ 50,000 Electrical power (factory building) 6,000 Insurance 20,000 Property taxes 15,000 Natural gas (for heating) 8,000 Custodial labor 51,000 Total $150,000

Note: However, the problem indicated that the firm uses machine

hours as the base for assigning facility-level costs. An alternative solution is to combine cost pools 3 and 4.

Cost pool 5: Cost driver: production (in units)

Inspection of finished goods $7,000

Cost pool 6: Cost driver: engineering hours Engineering design $600,000 Total $600,000


5-49 (continued)

2. Overhead Rates: Cost pool 1: Total cost $33,000 Number of purchase orders 6 Cost per purchase order $5,500 Cost pool 2: Total cost $20,000 Number of production runs 40 Cost per production run $500 Cost pool 3: Total cost $ 90,000 Number of machine hours 100,000 Cost per machine hour $0.90

Cost pool 4: Total cost $150,000 Number of machine hours 100,000 Cost per machine hour $1.50 Cost pool 5: Total cost $ 7,000 Number of units 100,000 Cost per unit $0.07

Cost pool 6: Total cost $600,000 Total engineering hours 20,000 Cost per engineering hour $30.00


5-49 (continued-2) Manufacturing overheads: Unit level: Cost pool 3 – Cost per machine hour $ 0.90 Number of machine hours x 4,250 $ 3,825 Cost pool 5 – Cost per unit $ 0.07 Number of units x 4,000 280 Batch level: Cost pool 2 – Cost per production run $500 Number of production runs (4,000 units / 2,500 = 1.6) x 2 1,000 Product-level level: Cost pool 1 – Cost per purchase order $5,500 Number of purchase orders x 1 5,500 Cost pool 6 – Cost per engineering hour $ 30 Number of engineering hours x 100 3,000 Facility-level level*: Cost pool 4 – Cost per machine hour $ 1.50 Number of machine hours x 4,250 6,375 Total manufacturing overhead $19,980 Number of units ÷ 4,000 Manufacturing overhead per unit $4.995


5-49 (continued-3)

* There are at least two alternative activity consumption drivers for assigning facility-level cost:

Based on machine hours:

Total facility-level cost (Cost pool 4) $150,000 Number of machine hours 100,000 Cost per machine hour $1.50

Which is the cost driver for the answer above. Alternatively, the firm may use number of units to assign facility-

level cost. Based on number of units:

Total facility-level cost (Cost pool 4) $150,000 Units of production 100,000 Cost per unit $1.50

Unit level: Cost pool 3 $ 3,825 Cost pool 5 280 Batch level: Cost pool 2 1,000 Product-level level: Cost pool 1 5,500 Cost pool 6 3,000 Facility-level level: Cost pool 4 – Cost per unit $ 1.50 Number of units x 4,000 6,000 Total manufacturing overhead $ 19,605 Number of units ÷ 4,000 Manufacturing overhead per unit $4.90125


5-50 Activity-Based Costing, Value Chain Activities (25 min) 1. Prime costs 80 x $1,200 = $ 96,000

Manufacturing overheads: Material handling 80 x 105 x $0.45 = 3,780 Machining 80 x 3 x $51 = 12,240 Assembly 80 x 105 x $2.85 = 23,940 Inspection 80 x $30 = 2,400

Total manufacturing costs $138,360 Number of units ÷ 80

Cost per unit $1,729.50

2. Upstream activities $180.00 8.33% Manufacturing 1,729.50 80.09% Downstream activities 250.00 11.58% Full product cost per unit $2,159.50 100%

Strategic implications: (1) Knowing the full cost of a product including upstream and

downstream costs allows the firm to be aware of all costs attributable to the product.

(2) The amounts and proportions of upstream, manufacturing, and downstream costs facilitate comparisons with competitors.

(3) The company should consider ways of spending less cost in the manufacturing activity, and more on upstream and downstream activities in order to improve its competitive position by pursuing the differentiation strategy in both the new product design and the customer service.

3. The total value chain cost provides the firm a long-term perspective

of the product cost, in addition to the short term manufacturing cost. Different industries have different cost structures. For example, firms in the computer software industry are likely to have high upstream costs while firms in the retailing industry tend to have high downstream costs.


5-51 Volume-based Costing Versus ABC (10 min) 1. Predetermined overhead rate based on machine hours

= Total budgeted overhead cost / Selected level of production activity

= ($100,000 + $80,000 + $200,000 + $100,000) / 10,000 machine-hours

= $480,000 / 10,000 machine-hours

= $48.00 per machine-hour

Product Total Manufacturing Overhead Barrel OH per Barrel

P5 $48.00 x 1,000 MH = $48,000 500 $96.00

G23 $48.00 x 1,000 MH = $48,000 500 $96.00

2. Overhead Rates:

Overhead Budgeted Level of Predetermined Cost Pool Overhead Cost Driver Overhead Rate

Machine set-ups $100,000 100 setups $1,000 per setup

Material handling 80,000 8,000 barrels $10 per barrel

Quality control 200,000 1,000 inspections $200 per inspection

Other overheads 100,000 10,000 machine hrs $10 per MH

Overhead Per Barrel: Manufacturing Overhead Overhead P5 G23 Cost Pool Rate Activity Overhead Activity Overhead

Machine set-ups $1,000 1 $ 1,000 50 $50,000

Material handling $10 500 5,000 500 5,000

Quality control $200 2 400 20 4,000

Other overheads $10 1,000 10,000 1,000 10,000

Total overhead $16,400 $69,000

Number of barrels ÷ 500 ÷ 500

Cost per barrel $ 32.80 $138.00


5-51 (continued)

j. The volume-based rate significantly undercosts the G23 product which requires several times the amount of machine setup and quality inspection effort relative to product P5. This means that pricing and analysis of product line profitability will be distorted. Strategic planning based on profitability analysis will also be misguided as a result. Suppose, for example, that CCO, using volume-based accounting, is asked to bid on a rather larger order for the G23 product; it is likely to win the order because the volume-based cost is distorted – too low. The problem then is that CCO must produce and sell this order at very low or negative profits, because its actual costs of producing the order will be closer to the ABC costs. Similarly, bidding for a potential order on the P5 product will likely fail under the volume-based system, as CCOs costs are distorted again – this time too high. CCO will lose these potentially profitable orders.

Under volume-based costing, CCO will likely see its order mix shift to G23 and away from P5, as competitors that use ABC costing will use proper pricing and get the most profitable orders. The result might be that CCO’s sales will continue to increase (lots of G23), but its profitability will decline (G23 is not priced properly). This is a good signal of a firm that needs ABC costing – sales up but profits down, in this case, because of an unprofitable shift in the product mix due to cost distortions in volume-based costing.


5-52 Volume-based Costing Versus ABC (35 min) 1. Product A Product B Product C

(1) Target price $279.00 $294.00 $199.50 (2) Manufacturing cost (1) ÷ 150% $186.00 $196.00 $133.00 Prime cost - 70.00 - 126.40 - 75.00 Overhead cost per unit $116.00 $ 69.60 $ 58.00 Number of units x 1,000 x 5,000 x 500 Total overhead $116,000 $348,000 $29,000

2. Current Costing system

Product A Product B Product C Actual selling price $280 $250 $300 Product manufacturing cost 186 196 133 Gross margin $ 94 $ 54 $167 Gross margin ratio 33.57% 21.6% 55.67%

Based on the current cost data, it is true that product B is the least profitable product with a gross margin per unit of $54.00 (21.6%) and product C is the most profitable product with a gross margin per unit of $167.00 (55.67%). However, the validity of this conclusion is based on the accuracy of the reported product costs.

Product costs based on the activity-based costing system

Product A Product B Product C Direct materials $ 50.00 $114.40 $ 65.00 Direct labor 20.00 12.00 10.00 Factory overhead: Setups (a) 1.60 0.80 4.80 Materials handling (b) 40.00 5.00 70.00 Hazardous control (c) 62.50 22.50 150.00 Quality control (d) 22.50 5.25 52.50 Utilities (e) 12.00 8.40 12.00 Total $208.60 $168.35 $364.30 Actual selling price $280.00 $250.00 $300.00 Product manufacturing cost 208.60 168.35 364.30 Gross margin $ 71.40 $ 81.65 ($64.30) Gross margin ratio 25.50% 32.66% (21.43)%


5-52 (continued) Notes: (a) Setups: Cost per setup: $8,000 / (2 + 5 + 3) = $800 per setup

Product A = 2 x $800 = $1,600; $1,600 /1,000 = $1.60 per unit Product B = 5 x $800 = $4,000; $4,000 /5,000 = $0.80 per unit

Product C = 3 x $800 = $2,400; $2,400 /500 = $4.80 per unit (b) Materials handling: Cost per pound = $100,000 / (400 + 250 + 350) = $100 per pound Product A = 400 x $100 = $40,000; $40,000/1,000 = $40.00 per unit Product B = 250 x $100 = $25,000; $25,000/5,000 = $ 5.00 per unit Product C = 350 x $100 = $35,000; $35,000/500 = $70.00 per unit (c) Waste and hazardous disposals: Cost per disposal: $250,000/(25 + 45 + 30) = $2,500 per disposal

Product A = 25 x $2,500 = $ 62,500; $ 62,500/1,000 = $ 62.50/unit Product B = 45 x $2,500 = $112,500; $112,500/5,000 = $ 22.50/unit Product C = 30 x $2,500 = $ 75,000; $ 75,000/500 = $150.00/unit

(d) Quality inspections: Cost per inspection = $75,000/(30 + 35 + 35) = $750 per inspection Product A = 30 x $750 = $22,500; $22,500/1,000 = $22.50 per unit Product B = 35 x $750 = $26,250; $26,250/5,000 = $ 5.25 per unit Product C = 35 x $750 = $26,250; $26,250/500 = $52.50 per unit (e) Utilities: Cost per MH = $60,000 / (2,000 + 7,000 + 1,000) = $6.00 per MH Product A = 2,000 x $6 = $12,000; $12,000/1,000 = $12.00 per unit Product B = 7,000 x $6 = $42,000; $42,000/5,000 = $ 8.40 per unit Product C = 1,000 x $6 = $ 6,000; $ 6,000/500 = $12.00 per unit


5-52 (continued-2) 3. Comparison of reported product costs, new target price, actual selling

price, and gross margin (loss): Product A Product B Product C

Product costs: 1. Direct-labor based system $186.00 $196.00 $133.00 2. Activity-based system $208.60 $168.35 $364.30 ABC-based product costs: Target price (150%) $312.90 $252.53 $546.45 Actual selling price $280.00 $250.00 $300.00 Difference in price <$32.90> <$2.53> <$246.45> Direct-labor based costing system Gross margin $ 94 $ 54 $167

Gross margin ratio 33.57% 21.6% 55.67% Activity-based costing system: Gross margin $71.40 $81.65 $(64.30)

Gross margin ratio 25.50% 32.66% <21.43%>

4. Strategic and Competitive Analysis 1. Emphasizing Product C as suggested by the current direct-

labor-cost based overhead costing system is likely to harm the firm’s competitiveness. The activity-based costing system shows that the manufacturing cost of Product C is $364.30 per unit and, at the current selling price, the firm suffers a $64.30 loss for each unit it manufactures and sells.

2. If the actual selling prices of products A & B are fair market

prices for these products and a markup of 150% is a common industry practice, the firm needs to examine the manufacturing cost of product A. The fact that the firm’s target price, determined using 150% of the manufacturing cost, is more than 10 percent over the fair market price of the product suggests possible wastes and inefficiencies in the manufacturing of product A.


5-53 Ethics, Cost System Selection (5 min) Unfortunately, there are a number of reasons why ABC costing systems are studied by firms and then not adopted. In some cases the reason is to protect a product line that is favored by top executives, even though the ABC results show it to be unprofitable. Other times it is because a customer that is considered critical to the firm is shown to be unprofitable by the ABC results In the case of Aero Dynamics, the reason has to do with an ethical issue, that is, the use of cost allocation to improperly charge a cost-plus customer (the federal government) for overhead costs. The management accountant should keep the professional ethics code in mind. First, he or she should try to persuade other ABC pilot project members and the company controller to strongly recommend that top management adopt the more accurate ABC method. If the company top management still would not listen, then the management accountant should report the situation to the company’s audit committee. Because of the management accountant’s responsibility for confidentiality, he or she should not report the matter outside the firm. (See the Institute of Management Accountant’s Code of Ethics in Exhibit 1-4).

An interesting footnote to the case is that the Government Accounting Office, to assist the Dept of Defense, in part due to issues of this nature, developed in the 1970s a series of cost accounting standards. These standards apply generally to companies contracting with the federal government, especially the DOD. See http://www.gao.gov/casb1.htm for the CASB website. Also, the Federal Government in 1990 created the Federal Accounting Standards Advisory Board (www.fasab.gov) which sets standards for financial and managerial reporting within the federal government. The FASAB web site is an interesting place to see the progress/continuing issues of accounting at the federal government.


5-54 Volume-Based Costing Versus ABC (25 min) 1. Current costing system (direct-labor hour) Deluxe % Speedy % Price $475 100 $300.00 100 Prime Cost 180 38 110.00 37 Overhead 20 4 153.60 51 Unit gross profit $275 58 $ 36.40 12 2. Multiple drivers costing system

Calculation of unit overhead costs - Deluxe: Deluxe

Setups $2,800 x 200 = $ 560,000 Machine costs $100 x 100,000 = 10,000,000

Engineering $40 x 45,000 = 1,800,000 Packing $20 x 50,000 = 1,000,000 Total overhead $13,360,000 Number of Units ÷ 50,000 Overhead per unit $267.20 Calculation of unit overhead costs - Speedy:

Speedy Setups $2,800 x 100 = $ 280,000 Machine costs $100 x 400,000 = 40,000,000 Engineering $40 x 120,000 = 4,800,000 Packing $20 x 200,000 = 4,000,000 Total overhead $49,080,000 Number of Units ÷ 400,000 Overhead per unit $122.70

Deluxe % Speedy % Price $475.00 100 $300.00 100 Cost Prime cost $180.00 $110.00 Overhead 267.20 447.20 94 122.70 232.70 78 Unit gross profit $27.80 6 $67.30 22


5-54 (continued) 3. Using the activity-based costing, a much different picture on profitability

of the Deluxe and Speedy models emerges. The Speedy model is actually more profitable than the Deluxe model. The revised cost data suggests that shifting the emphasis to the Deluxe model may very well be a mistake. The Deluxe printer is a much heavier user of overhead resources as can be seen in the table below that compares uses of overhead.

Overhead Activity Consumption Activity Deluxe Speedy

Setups 250 units per setup 4,000 units per setup

Machine costs 2 MH per unit 1 MH per unit

Engineering 0.9 Engr. Hr. per unit 0.3 Engr. Hr. per unit

Packing 1 unit per packing order 2 units per packing order

Supporting calculations

Activity Consumption Deluxe Speedy Total Per Activity Measure Total Per Activity Measure

Units 50,000 400,000

Setups 200 250 units per setup 100 4,000 units per setup

Machine costs 100,000 2 MH per unit 400,000 1 MH per unit

Engineering 45,000 0.9 Engineering 120,000 0.3 Engineering Hours per unit hours per unit

Packing 50,000 1 unit per packing 200,000 2 units per packing order order

4. The ABC method is likely to provide Gorden Company a more accurate

product cost picture. It also directs the management’s attention to the high volume, more profitable Speedy printers.

Given the low profit margin of the Deluxe, the firm may want to investigate the feasibility of raising the price, the possibility of reducing product cost, or both.


5-55 Volume-Based Costing Versus ABC (10 min) 1. Predetermined overhead rates:

Budgeted Budgeted Cost Pool OH Cost Cost Driver Overhead Rate

Machine depr./maint. $135,000 27,000 $5.00 per MH

Factory depr./util./insur. $120,000 30,000 $4.00 per MH

Product design $504,000 42,000 $12.00 per Design hour

Materials purch./stor. $147,000 $980,000 15.00% DM cost

Total overhead $906,000 Total overhead for each product order:

Overhead Cost Pool Men Shavers Women Shavers Material purchase $30,000 x 15% = $4,500 $26,000 x 15% = $3,900

Product design $12 x 15 = 180 $12 x 37.5 = 450

Machine depreciation $5.00 x 50 = 250 $5.00 x 40 = 200

Factory depreciation $4.00 x 50 = 200 $4.00 x 40 = 160

Total overhead cost $5,130 $4,710

2. Overhead cost per unit: Number of units 15,000 20,000

Overhead cost per unit $ 0.342 $ 0.2355 3. Overhead rate: $906,000 / 3,020 = $300 per direct labor hour

4. Total overhead using volume-based overhead rate:

Men Shavers: $300 x 24 = $7,200

Women Shavers: $300 x 12 = $3,600 5. Men Shavers: $7,200 / 15,000 = $ 0.48

Women Shavers: $3,600 / 20,000 = $ 0.18


5-56 Resource and Activity-Based Cost Drivers (25 min) 1. The activity based cost pools are determined from the percent-of-use information; for example, total setup cost = $157,500 = .15 x $850,000 + .2 x $150,000.

2. The activity rates are determined as follows:

3. The per unit activity-based costs are $14.18 for Safe-V and $18.63 for the Safe-T

4. The activity-based information can be used by EEI to set prices and assess the profitability of its two product lines.

Inspect &Factory Costs Setup Assembly Finishing Packaging

Salaries 850,000$ 127,500$ 467,500$ 170,000$ 85,000$ Supplies 150,000 30,000 90,000 30,000 - Factory Expense 550,000 - 440,000 110,000

1,550,000$ 157,500$ 997,500$ 310,000$ 85,000$

Total Activity Activity-based Safe-V Safe-T Consumption Activity Costs RatesBatches 250 600 850 157,500$ 185.29$ Units 60,000 72,000 132,000 997,500 7.557 Finishing hours/unit 0.2 0.3 33,600 310,000 9.226 Packaging 0.1 0.15 16,800 85,000 5.060

Safe-V Safe-T Safe-V Safe-TSetup 250 600 0.772$ 1.544$ Assembly 60,000 72,000 7.557 7.557 Inspect and Finish 0.2 0.3 1.845 2.768 Packaging 0.1 0.15 0.506 0.759 Materials per unit 3.50$ 6.00$ 3.500 6.000

Total Cost per unit 14.180$ 18.628$

Activity Requirements Activity-Based Costs/Unit


5-57 Resource and Activity-Based Cost Drivers; Continuation of 5-56 (20 min) 1. The resource consumption cost driver rates and the activity cost polls are determined as follows. For example the activity cost pool, setup, is $115,000 = 1 x $50,000 + 1 x $15,000 + 2,000 x $25.

2. The new activity consumption rates are shown in the right column, using the same activity drivers as before, with the new activity cost pool amounts.

3. The new ABC product costs are shown below; there is very little change from the solution in 5-56 above.

Resource Inspect &Rate Setup Assembly Finishing Packaging

50,000$ 50,000$ 500,000$ 250,000$ 50,000$ 15,000 15,000 75,000 60,000 -

25 50,000 275,000 125,000 100,000 115,000$ 850,000$ 435,000$ 150,000$

Total Activity Activity-based Safe-V Safe-T Consumption Activity Costs RatesBatches 250 600 850 115,000$ 135.29$ Units 60,000 72,000 132,000 850,000 6.439 Finishing hours, per unit 0.2 0.3 33,600 435,000 12.946 Packaging 0.1 0.15 16,800 150,000 8.929

Safe-V Safe-T Safe-V Safe-TSetup 250 600 0.564$ 1.127$ Assembly 60,000 72,000 6.439 6.439 Inspect and Finish 0.2 0.3 2.589 3.884 Packaging 0.1 0.15 0.893 1.339 Materials per unit 3.50$ 6.00$ 3.500 6.000

Total Cost per unit 13.985$ 18.790$

Activity-Based Costs/UnitActivity Requirements


5-58 Volume-Based Costing vs. ABC (30 min)

1. Manufacture Costs – Direct-Labor Cost Based

Luxury Pendant Ceiling Fixture

Total Per Unit Total Per Unit Selling Price $70.00 $40.00 Direct Materials $ 80,000 20.00 $ 400,000 10.00 Direct Labor 32,000 8.00 200,000 5.00 Overhead* 64,000 16.00 400,000 10.00 Manufacturing Cost $176,000 44.00 $1,000,000 25.00 Gross Margin $26.00 $15.00

* Overhead is allocated based on direct labor costs at the rate of

$2.00 per direct labor dollar LP: $ 32,000 x $2.00 = $ 64,000

CF: $200,000 x $2.00 = $400,000 2. Overhead Costs Reported by ABC System:

Overhead rates

Overhead Costs Total Activities Overhead Rate

Machine Operation $160,000 10,000 $16.00 Support labor 81,200 232,000 0.35 Machine Setup 68,000 2,500 27.20 Assembly 88,550 402,500 0.22

Inspection 66,250 4,000 16.5625

Total $464,000


5-58 (continued-1) Applied overheads

Manufacture Costs Report - ABC System Luxury Pendants Ceiling Fixtures Total Per Unit Total Per Unit Number of units 4,000 40,000 Sales $280,000 $70.00 $1,600,000 $40.00 Direct Materials 80,000 $20.00 $400,000 $10.00 Direct Labor 32,000 $ 8.00 $200,000 $ 5.00 Overhead: Machine Operation 24,000 136,000 Support Labor 11,200 70,000 Machine Setup 27,200 40,800 Assembly 42,350 46,200 Inspection 26,500 39,750 Total Overhead $131,250 $32.8125 $332,750 $ 8.3188 Total Manufacturing Costs $243,250 $60.8125 $932,750 $23.3188 Gross Margin $ 36,750 $9.1875 $667,250 $16.6813 Gross margin ratio 13.13% 41.7% 3. The above profitability analysis indicates that the Luxury Pendant is not

as profitable as the vice president of marketing thinks it is.

Luxury Pendants Ceiling Fixtures Overhead

Rate Activities Overhead

Cost Activities Overhead

Cost Machine Operation $ 16.00 1,500 $ 24,000 8,500 $136,000 Support labor 0.35 32,000 11,200 200,000 70,000 Machine Setup 27.20 1,000 27,200 1,500 40,800 Assembly 0.22 192,500 42,350 210,000 46,200 Inspection 16.5625 1,600 26,500 2,400 39,750

Total Overhead $131,250 $332,750


5-58 (continued-2) 4. Unit Cost Comparison between the current and ABC costing systems

Reported Overhead Costs Current ABC Difference Luxury Pendants $16.00 $32.8125 +$16.8125 Ceiling Fixtures $10.00 $ 8.3188 - $ 1.6822

According to the ABC cost data, a shift to more Luxury Pendant units and fewer Ceiling Fixture units would be ill advised. The apparent higher unit gross margin of the Luxury Pendants relative to the Ceiling Fixtures indicates that the current costing system distorted relative unit profitability.

5. Among the reasons for the difference are:

a. The current direct labor based costing system focused on only one manufacturing activity of the entire production process. It measures only one attribute of the individual product: the number of direct labor hours consumed. By contrast, the ABC system considered all activities of the manufacturing processes. Costs were traced from activities to products based on the product’s demand for these activities during the production process. The allocation bases used in ABC were thus measures of the activities performed. For Moden Lighting Inc., the ABC systems listed not only the unit-level activities (machine operation, support labor overhead) but also the batch-level ones (setup, assembly, and inspection.)

b. Under the volume-based costing system, the high-volume ceiling fixtures were overcosted and the low-volume luxury pendants were undercosted. The source of this distortion is the choice of a single volume-related allocation base, direct labor hours, for tracing of costs from manufacturing to products. Using a volume-related allocation base alone to trace costs to products distorted reported product costs if some of the product-related activities were not related to volume, such as the setup hours.

c. Differences in the complexity of the products also contribute to cost distortion. Using a volume-based costing system, overhead costs differ only when different number of units are manufactured. Although the luxury pendants were low-volume products, they actually consume more resources – a result not related to volume.


5-59 Volume-Based Costing vs. ABC (30 min) 1. Current Costing System – Direct-Labor-Hour Based

Overhead rate = Budgeted overhead / Budgeted direct labor hours

= $200,000 / (7,200 + 6,800 + 2,000)

= $200,000 / 16,000

= $ 12.50 per direct labor hour Overhead cost allocation:

Cost per unit:

Diomycin Homycin Addolin Direct labor-hours 7,200 6,800 2,000

Overhead rate $12.50 $12.50 $12.50

Total overhead $90,000 $85,000 $25,000

Diomycin Homycin Addolin Direct Materials $205,000 $265,000 $258,000

Direct Labor 250,000 234,000 263,000

Overhead: 90,000 85,000 25,000

Total Cost $545,000 $584,000 $546,000

Packets produced 1,000,000 500,000 300,000

Cost per capsule $0.545 $1.168 $1.820


5-59 (continued-1) 2. Overhead rates for Activity-Based Costing:

Activity Cost Driver

Budgeted Overhead

Cost

Budgeted Cost Driver

Volume Overhead

Rate Machine setup Setup hours $ 16,000 1,600 $10.00 Plant management Workers 36,000 1,200 $30.00 Supervision of direct labor

Direct labor-hours 46,000 1,150 $40.00

Quality inspection Inspection-hours 50,400 1,050 $48.00

Expediting orders Customers serviced 51,600 645 $80.00

Total overhead $200,000 Overhead Costs Assigned to Products Using Activity-Based Costing:

Diomycin Homycin Addolin Overhead

Rate Driver

Volume Applied

Overhead Driver

Volume Applied

Overhead Driver

Volume Applied

Overhead Machine setup $10 200 $2,000 600 $6,000 800 $8,000

Plant management $30 200 $6,000 400 $12,000 600 $18,000

Supervision of direct labor $40 200 $8,000 300 $12,000 650 $26,000

Quality inspection $48 150 $7,200 200 $9,600 700 $33,600

Expediting production orders

$80 45 $3,600 100 $8,000 500 $40,000

Total $26,800 $47,600 $125,600


5-59 (continued-2) Cost per capsule under Activity-Based Costing:

Diomycin Homycin Addolin

Direct Materials $205,000.00 $265,000.00 $258,000.00

Direct Labor 250,000.00 234,000.00 263,000.00

Overhead 26,800.00 47,600.00 125,600.00

Total Cost $481,800.00 $546,600.00 $646,600.00

Packets produced 1,000,000 500,000 300,000

Cost per capsule $0.4818 $1.0932 $2.1553

3. Comparison of Product Costs Using Current Costing and ABC Costing:

Diomycin Homycin Addolin

Current Costing System

Overhead $90,000 $85,000 $25,000

Cost per capsule $0.5450 $1.1680 $1.8200

Activity-Based Costing system

Overhead $26,800 $47,600 $125,600

Cost per capsule $0.4818 $1.0932 $2.1553

Analysis of the Differences Under the current costing system, ADA applies overhead based on direct labor hour, and high-volume products such as Diomycin (1,000,000 capsules) are allocated relatively more overhead ($90,000) than the low-volume products such as Addolin (300,000 capsules). High-volume products “subsidize” low-volume products in this case. Because of lack of detailed costing information, ADA ends up undercosting Addolin ($1.82 under the current costing) and overcosting Diomycin ($0.545 under the current costing).


5-59 (continued-3) Activity-based costing provides ADA with more detailed and better estimates of product costs. For example by using ABC, ADA becomes aware that the cost of Diomycin is lower ($0.4818 per capsule compared to $0.545 under current costing), meaning that it can set the price of Diomycin lower and be more competitive. Also, ABC revealed how costly Addolin is ($2.1553 per capsule compared to $1.82 under the current costing). Thus, this opportunity would allow ADA to properly price Addolin or if it is not profitable, stop producing. From the schedule, activity-based costing assigns more overhead to the lower-volume Addolin because the production of Addolin requires more setups, inspection, supervision, formulation and management. The current direct-labor-hours based costing system failed to assign costs of all activities. As a result, Diomycin and Homycin subsidized Addolin. The production department at ADA also benefits under ABC. ABC provides better costing information on the cost of each of the activities and identifies cost drivers and the activities that consume resources and raise cost. The additional information enables production mangers to manage cost by managing activities and cost drivers. Adopting the ABC method is strategically important for ADA. Because the ABC method provides ADA with a more accurate product cost picture and directs management’s attention to the high-volume, more profitable products, the firm can gain competitive advantages and profits by focusing on the high-volume products.


5-59 (continued-4) 4. Among major uses of ABC in the Pharmaceutical Industry are:

a. Strategic Use of ABC to Reduce Costs One of the important ways companies develop competitive advantages is to become a low-cost producer. Many companies in the pharmaceutical industry have learned to use the information they have gained from their costing systems to make substantial price cuts to increase market share.

b. Use of ABC to Eliminate Low-Value-Added Costs ABC can be used to identify and eliminate activities that add costs but not value to the products in the pharmaceutical industry. A company can eliminate low-value added activities and costs without reducing quality or value. In the pharmaceutical industry, the following activities typically do not add value to a product: storage, moving items, and waiting for work. Analyses of activities facilitate firms to identify low-value-added activities.

c. Use of ABC in Marketing and Distribution In the pharmaceutical industry, ABC can be applied to marketing or administrative activities. The cost of performing marketing services such as distributing products through different distribution channels can be computed and the information used in making informed decisions. For example, some of the different channels of distribution in the pharmaceutical industry are: grocery stores, convenience stores, pharmacy shops, each having different activities. The cost of alternative channels of distribution is useful to marketing managers who make decisions about which channel to use.

d. Use of ABC to Make Better Pricing Decisions ABC enables managers to make better pricing decisions by providing managers with more accurate product cost data for pricing decisions.

e. Use of ABC to Make Better Product Mix Decisions ABC provides a firm with more detailed and better estimation of product costs. Thus, it allows a company the opportunity to decide which products to make and which ones to eliminate.


5-60 Volume-based Costing Versus ABCAlaire Corporation (40 min)

1. a. Using the current volume-based standard costs, the total contribution

expected in 2007 by Alaire Corporation from the TV Board is $1,950,000, calculated as follows:

Per Unit Totals for 65,000 units

Revenue $150 $ 9,750,000

Direct materials 80 5,200,000

Direct labor ($14 x 1.5 hours) 21 1,365,000

Materials overhead (10% of material) 8 520,000

Variable overhead ($4 x 1.5 hours)* 6 390,000

Machine time overhead ($10 x .5) 5 325,000

Total cost $120 $7,800,000

Contribution margin $ 30 $1,950,000

* Variable overhead rate: $1,120,000 / 280,000 hours = $4 per hour.


5-60 (continued-1) 1. b. Using traditional volume-based standard costs, the total contribution

expected in 2007 by Alaire Corporation from the PC Board is $2,360,000, calculated as follows:


Revenue $300 $ 12,000,000

Direct materials 140 5,600,000

Direct labor ($14 x 4 hours) 56 2,240,000

Materials overhead (10% of materials) 14 560,000

Variable overhead ($4 x 4 hours)* 16 640,000

Machine time overhead ($10 x 1.5) 15 600,000

Total cost 241 9,640,000

Contribution margin $ 59 $ 2,360,000 * Variable overhead rate: $1,120,000 / 280,000 hours = $4 per hour. 2. Shown below are the calculations of the activity-based cost drivers,

which apply to both 2.a. and 2.b. Procurement: $400,000 / 4,000,000 = $0.10 per part

Production scheduling: $220,000 / 110,000 = $2.00 per board

Packing & shipping: $440,000 / 110,000 = $4.00 per board

Machine setups: $446,000 / 278,750 = $1.60 per setup

Hazardous waste disposal: $48,000 / 16,000 = $3.00 per pound

Quality control: $560,000 / 160,000 = $3.50 per inspection

General supplies: $66,000 / 110,000 = $0.60 per board

Machine insertion: $1,200,000 / 3,000,000 = $0.40 per insertion

Manual insertion: $4,000,000 / 1,000,000 = $4.00 per insertion

Wave soldering: $132,000 / 110,000 = $1.20 per board


5-60 (continued-2) a. Using activity-based costing, the total contribution expected in 2007 by

Alaire Corporation from the TV Board is $2,557,100 calculated as follows.


Revenue $150.00 $ 9,750,000

Direct materials 80.00 5,200,000

Materials overhead:

Procurement ($.10 x 25) 2.50 162,500

Production scheduling 2.00 130,000

Packaging & shipping 4.00 260,000

Variable overhead:

Machine set-ups ($1.60 x 2) 3.20 208,000

Waste disposal ($3 x .02) .06 3,900

Quality control 3.50 227,500

General supplies .60 39,000

Manufacturing overhead:

Machine insertion ($.40 x 24) 9.60 624,000

Manual insertion 4.00 260,000

Wave soldering 1.20 78,000

Total cost $110.66 $7,192,900

Contribution margin $ 39.34 $2,557,100

Note that the only cost that remains the same for both cost methods is the cost of direct materials. Under the ABC method, direct labor cost becomes part of the manufacturing manual insertion overhead cost.


5-60 (continued-3) b. Using activity-based costing, the total contribution expected in 2007 by

Alaire Corporation from the PC Board is $1,594,000 calculated as follows.


Revenue $300.00 $ 12,000,000

Direct materials 140.00 5,600,000

Materials overhead:

Procurement ($.10 x 55) 5.50 220,000

Production scheduling 2.00 80,000

Packaging & shipping 4.00 160,000

Variable overhead:

Machine set-ups ($1.60 x 3) 4.80 192,000

Waste disposal ($3 x .35) 1.05 42,000

Quality control ($3.50 x 2) 7.00 280,000

General supplies .60 24,000

Manufacturing:

Machine insertion ($.40 x 35) 14.00 560,000

Manual insertion ($4 x 20) 80.00 3,200,000

Wave soldering 1.20 48,000

T̀otal cost $260.15 $10,406,000

Contribution margin $ 39.85 $ 1,594,000


5-60 (continued-4) 3. The analysis using volume-based standard costs shows that the unit contribution of the PC Board is almost double that of the TV Board. On this basis, Alaire’s management is likely to accept the suggestion of the production manager and concentrate promotional efforts on expanding the market for the PC Boards. However, the analysis using activity-based costs does not support this decision. This analysis shows that the unit dollar contribution from each of the boards is almost equal, and the total contribution from the TV Board exceeds that of the PC Board by almost $1,000,000. As a percentage of selling price, the contribution from the TV Board is double that of the PC Board, 26 percent versus 13 percent. Therefore, it may not be advisable to concentrate promotional efforts only on expanding the market for the PC Board. The analysis using ABC can help the company be more competitive because it provides accurate cost information that allows the company to make better decisions. As noted above, the ability to correctly identify the most and least profitable products is critical to building a successful company.


5-61 Volume-based Costing Versus ABC (40 min) 1. a. Predetermined factory overhead rate = $3,000,000 / $600,000

= $5 per direct-labor dollar b. Product costs and selling prices

Product Costs Mona Loa Malaysian

Direct costs:

Direct materials $4.20 $3.20

Direct labor .30 .30 $4.50 $3.50

Indirect costs:

Factory overhead (0.30 x $5.00) 1.50 1.50

Total costs $6.00 $5.00

Mark-up 30% 30%

Budgeted selling prices per pound $7.80 $6.50 2. The cost per driver unit is: Budgeted Budgeted Cost per Activity Cost Driver Cost Activity Unit

Purchasing Purchase orders $579,000 1,158 $500

Material handling Setups 720,000 1,800 400

Quality control Batches 144,000 720 200

Roasting Roasting hours 961,000 96,100 10

Blending Blending hours 336,000 33,600 10

Packaging Packaging hours 260,000 26,000 10


5-61 (continued-1) The budgeted unit costs per pound are: Mona Loa Coffee Malaysian Coffee Direct unit costs: Direct materials $4.20 $3.20 Direct labor 0.30 $4.50 0.30 $3.50 Indirect unit costs: Purchasing 0.02 1.00 (4 orders x $500 /100,000 lbs.) (4 orders x $500/2,000 lbs.) Material handling 0.12 2.40 (30 setups x $400/100,000 lbs.) (12 setups x $400/2,000 lbs.) Quality control 0.02 0.40 (10 batches x $200/100,000 lbs.) (4 batches x $200/2,000 lbs.) Roasting 0.10 0.10 (1,000 hours x $10/100,000 lbs.) (20 hours x $10/2,000 lbs.) Blending 0.05 0.05 (500 hrs. x $10/100,000 lbs.) (10 hrs. x $10/2,000 lbs.) Packaging 0.01 0.01 (100 hrs. x $10/100,000 lbs.) (2 hrs. x$10/2,000 lbs.) Total unit cost $4.82 $7.46 The comparative cost numbers are:

Mona Loa Malaysian

Requirement 1 $6.00 $5.00

Requirement 2 4.82 7.46 The ABC system in requirement 2 reports a decreased cost for the high-volume Mona Loa and an increased cost for the low-volume Malaysian. The current costing system leads to cross-subsidization between the two products.


5-61 (continued-2) 3. Three of the indirect cost items can be classified as output-unit driven:

Mona Loa Coffee Malaysian Coffee Roasting $0.10 $0.10 Blending 0.05 0.05 Packaging 0.01 0.01 Total output-unit overhead $0.16 $0.16 The other three indirect cost items are batch-level driven: Mona Loa Coffee Malaysian Coffee Purchasing $0.02 $1.00 Material handling 0.12 2.40 Quality control 0.02 0.40 Total batch-level overhead $0.16 $3.80

Malaysian coffee has a greater number of setups per output unit than does Mona Loa coffee. The result is that the unit cost of the lower-volume Malaysian coffee is much higher than that of the higher-volume coffee, even though its cost of direct materials is lower. With the current costing system, the high-volume Mona Loa is overcosted, while the low-volume Malaysian is undercosted. Pricing of Mona Loa can be reduced to make it more competitive. In contrast, Malaysian should be priced at a much higher level if the strategy is to cover the current period’s cost. CBI may wish to have lower margins with its low-volume products such as Malaysian in an attempt to build up volume. The company can use the ABC cost information to compare its two product costs with competitors, and decide which product has a low cost competitive advantage. Then the company can change its pricing and product mix strategies by using the ABC cost information.


5-61 (continued-3)

ABC cost data also point out that the reason for the Malaysian Coffee to have a higher unit cost is not because of high-priced ingredients. In fact, Malaysian Coffee has a lower cost of direct materials than that of Mona Loa Coffee. The costs of roasting, blending, and packaging are $0.16 per pound for both coffees. The higher cost of Malaysian is because of the way in which it is processed. The batch-level cost per pound is $0.16 for Mona Loa and $3.80 for Malaysian. CBI can increase its profit margin or lower its price on Malaysian Coffee if it can change the way in which it handles purchasing, material handling, and quality control functions of Malaysian coffee.


5-62 Cost of Capacity; Continuation of 5-61 (25 min) 1. The calculation of the new activity rates and the cost of unused capacity is determined below.

2. The information on cost of capacity can alert management to the total cost of unused capacity, in this case $432,230 or approximately 14% of total overhead cost. This information can be used to identify activities where there is extensive over-capacity, and to consider how the capacity might be managed to reduce overall costs. For example, the calculations in part 1 suggest there is substantial excess capacity in materials handling, and the cost of the unused capacity is $180,000. 3. The analysis below shows the number of employees “unused” in column 8. The analysis assumes that each employee (or machine) contributes an equal share to the work of the activity. Note that the materials handling activity appears to have as many as 5 unused employees.

PracticalUsage- Capacity Practical Cost of

Driver Based at Current Usage Capacity Unused UnusedUsage Cost Rate Spending Percent Rate Capacity Capacity

Purchasing 1,158 579,000$ 500$ 1,400 83% 413.57$ 242 100,084$ Materials Handling 1,800 720,000 400 2,400 75% 300.00$ 600 180,000 Quality Control 720 144,000 200 1,200 60% 120.00$ 480 57,600 Roasting 96,100 961,000 10 100,000 96% 9.610$ 3,900 37,479 Blending 33,600 336,000 10 36,000 93% 9.333$ 2,400 22,400 Packaging 26,000 260,000 10 30,000 87% 8.667$ 4,000 34,667 3,000,000$ 432,230$

1 2 3 4 5 6 7 8 Capacity Step: Number Cost per Step

Driver at Current of Employees Unused Step Size StepsUsage Cost Spending or Machines Capacity =(2)/(4) =(3)/(4) Not Used

Purchasing 1,158 579,000$ 1,400 8 242 72,375$ 175 1.38 Materials Handling 1,800 720,000 2,400 20 600 36,000 120 5.00 Quality Control 720 144,000 1,200 4 480 36,000 300 1.60 Roasting 96,100 961,000 100,000 10 3,900 96,100 10,000 0.39 Blending 33,600 336,000 36,000 10 2,400 33,600 3,600 0.67 Packaging 26,000 260,000 30,000 3 4,000 86,667 10,000 0.40


5-63 Customer Profitability Analysis (30 Min) 1. Service cost rate per unit of activity

Activities

Estimated Annual

Expense

Cost Driver

Estimated Annual Cost Driver Units

Service Cost

Per Unit Requisition Handling

$3,000,000

Requisitions

300,000

$10.00

Warehouse $1,050,000 Cartons 70,000 $15.00 Pick Packing

$ 900,000

(PP) Lines

600,000

$ 1.50

Data Entry $ 600,000 (PP) Lines 600,000 $ 1.00 Delivery charge $10 per delivery (requisition) + $0.30 per mile

2. Service Costs Omega International City of Albion

Requisition Handling $3,000 $ 7,000 (300 requisitions x $10/requisition) (700 requisitions x $10/requisition) Warehouse Activity 750 7,500 (50 cartons x $15.00 per carton) (500 cartons x $15.00 per carton) Pick-Packing 1,350 3,150 (900 pick-pack lines x $1.50) (2,100 pick-pack lines x $1.50) Data Entry 900 2,100 (900 lines x $1.00/line) (2,100 lines x $1.00/line) Freight Out 3,450 8,260 ($10 x 300) + ($0.30 x 5 x 300) ($10 x 700) + ($0.30 x 6 x 700) Total Service Costs $9,450 $28,010

3. Customer Profitability Analysis-Activity Based Omega International City of Albion Sales $ 80,000 $80,000 Product Cost (50,000) (48,000) Service costs ( 9,450) (28,010) Gross Margin $20,550 $ 3,990 Gross Margin % 25.69% 4.99%


5-63 (continued-1)

The above profitability analysis indicates that, under activity-based costing, Omega International, not City of Albion, is more profitable to Boston Depot. The apparent higher gross margin percentage of the City of Albion relative to the Omega International was the result of not recognizing differences in the service activities requested by different customers under the firm’s existing costing system. City of Albion is a much heavier user of services provided by Boston Depot. Although both customers had the same total sales, City of Albion made more desktop delivery requests in smaller quantities and maintained more inventory by Boston Depot.

4. The answer depends on the competitive strategy of the firm. The gross profit margin ratios show that Omega is the better customer of the two. Omega does not use much of the desktop delivery service Boston offers. Most likely Omega is a buyer of “commodity” items and does not need the convenience of desktop delivery. However, Boston’s pricing is likely to have incorporated the average cost of desktop deliveries. If Omega realizes that it is paying for services not used, it may buy the commodity it needs elsewhere, unless Boston lowers the price to Omega.

All custom-printed business forms by different suppliers are likely to be the same. Delayne wanted to “differentiate” its forms from those of competitors’ by offering desktop delivery services. In the long-run, Omega is not likely to be a customer staying with Boston Depot. Boston Depot needs to be prepared to lower the price to Omega.

If the firm desires to compete on a differentiation strategy it needs to price accordingly. Boston Depot needs to raise prices to City of Albion. If City of Albion is willing to pay a higher price for the convenience of desktop delivery, it is the kind of customer that Delayne wants.


5-64 Activity-Based Costing (35-40 min) (Miami Valley Architects, Inc. by Beth M. Chaffman, CPA and John Talbott, CMA, Management Accounting Campus Report, Fall 1992, p.4) 1. Overhead Cost assigned to each branch under the ABC costing:

Columbus Cincinnati Dayton Total Direct labor dollar 37.61% 31.19% 31.20% 100% Timesheet entries 45.11% 28.57% 26.32% 100% Vendor invoices 44.93% 37.44% 17.62% 100% Client invoices 52.13% 39.36% 8.51% 100% Employees 34.33% 38.81% 26.87% 100% New hires 42.11% 21.05% 36.84% 100% Insurance claims filed 34.33% 38.81% 26.87% 100% Proposals 39.22% 49.02% 11.76% 100% Contracted sales 48.07% 36.88% 15.05% 100% Projects shipped 39.13% 49.01% 11.86% 100% Purchase orders 41.54% 33.85% 24.62% 100% Copies duplicated 43.48% 39.13% 17.39% 100% Blueprints 45.24% 36.19% 18.56% 100%

Activity-based overhead allocation Colum. Cinci. Dayton Total Cost Driver General administration $153.84 $127.56 $127.60 $ 409 Direct labor dollar Project costing 21.65 13.71 12.63 48 Timesheet entries Accounts payable/receiving 62.46 52.05 24.49 139 Vendor invoices Accounts receivable 24.50 18.50 4.00 47 Client invoices Payroll/Mail sort & delivery 10.30 11.64 8.06 30 Employees Personnel recruiting 16.00 8.00 14.00 38 New hires Employee insurance process. 4.81 5.43 3.76 14 Insurance claims filed Proposals 54.51 68.14 16.35 139 Proposals Sales meetings/Sales aids 97.10 74.49 30.40 202 Contracted sales Shipping 9.39 11.76 2.85 24 Projects shipped Ordering 19.94 16.25 11.82 48 Purchase orders Duplicating costs 20.00 18.00 8.00 46 Copies duplicated Blueprinting 34.84 27.87 14.29 77 Blueprints Total $529.34 $453.41 $278.26 $1,261


5-64 (continued-1)

Calculation for general administration allocated to branches:

Total direct labor dollar: $382,413 + $317,086 + $317,188 = $1,016,687

Allocation of general administration based on direct labor dollar:

Proportion Allocated Amount

Columbus $382,413 / $1,016,687 = 37.61% $409 x 37.61% = $153.84

Cincinnati $317,086 / $1,016,687 = 31.19% $409 x 31.19% = $127.56

Dayton $317,188 / $1,016,687 = 31.20% $409 x 31.20% = $127.60

2. Contribution of each branch: Columbus Cincinnati Dayton Total

Sales $1,500 $1,419 $1,067 $3,986

Less: Direct labor 382 317 317 1,016

Direct materials 281 421 185 887

Direct overhead 180 270 177 627 Contribution margin $657 $411 $388 $1,456

3. Profitability of each branch using activity-based costing: Columbus Cincinnati Dayton Total

Sales $1,500 $1,419 $1,067 $3,986

Less: Direct labor 382 317 317 1,016

Direct materials 281 421 185 887

Direct overhead 180 270 177 627 Contribution margin $657 $411 $388 $1,456 Activity-based overhead 529 453 278 1,261 Operating income $128 ($42) $110 $195


5-64 (continued-2)

4. Evaluating management concerns:

Overhead costs are usually aggregated in pools and allocated to products and other cost objects based on volume measures such as direct labor dollars or machine hours. The cost object, therefore, supposedly shares proportionally in those costs necessary for its production or existence. If however, overhead varies in accordance with variables other than volume, then product costs and other cost objects will be erroneously determined.

As the solution indicates, the profitability of the Cincinnati and Dayton offices is vastly different employing direct tracing and ABC than under the current approach. The obvious benefit to the company is a more equitable distribution of bonuses and resources to these locations. In addition, existing marketing strategy may be promoting the wrong location and strategic planning may be based on spurious assumptions concerning relative profitability.

This case also illustrates that ABC is applicable to service organizations as well as to manufacturing and that cost objects can consist of projects, locations, customers, etc., as well as products. In essence, the better information we have about the profitability of any cost object, the better chance of keeping organizations profitable.

However, the process of identifying activities and allocating costs from the general ledger to the activities is a difficult, time consuming process. Extensive interviews with functional managers and workers are normally required. This process is time consuming and often costly.


5-65 Customer Profitability Analysis (30 minutes) HS Inc. Adventix Baldwin

Customer revenue analysis

Total sales $600,000 $750,000 $900,000

Less: Sales discount 12,000 22,500 18,000

Net invoice $588,000 $727,500 $882,000

Less: Sales returns 11,760 7,275 26,460

Net sales $576,240 $720,225 $855,540

Less: Cash discounts 11,525

Finance charge (7,530) 1 21,606 2

Net proceeds $572,245 $698,619 $855,540 Customer cost analysis

Customer unit-level cost:

Sales return (restocking)3 $ 200 $ 125 $ 450

Customer batch-level costs:

Order taking 500 250 2,500

Order processing 750 375 3,750

Sales return 600 800 2,000

Delivery 1,500 15,000

Expediting order 1,000 2,500

Customer sustaining costs:

Sales visits 800 800 1,600

Total customer cost $2,850 $4,850 $27,800

Net customer profit $569,395 $693,769 $827,740


5-65 (continued) 1 Net proceeds: $576,240 - $11,525 = $564,715

Savings of not having to finance working capital:

$564,715 x 2% x 20/30 = $7,530 2 Payment received on the 60th day: $720,225 ) 2 = $360,112.50

Finance charge for 30 days $360,112.50 x 2% = $ 7,202

Payment received on the 90th day: $720,225 ) 2 = $360,112.50

Finance charge for 60 days $360,112.50 x 2% x 2 = 14,404

Net finance charge $21,606 3 Restocking cost: HS Inc: 10 x 100 x 2% x $10 = $200

Adventix: 5 x 250 x 1% x $10 = $125

Baldwin: 50 x 30 x 3% x $10 = $450 Customer profitability analysis helps the company become more competitive by identifying the most profitable and least profitable customers. This information can then be used by management to adjust pricing policies, identify ways to reduce the cost to serve customers, and change the customer mix for a more profitable group of customers.

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