49
CHAPTER 5 ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT 5-1 Cost smoothing or peanut-butter costing describes a costing approach that uses broad averages for assigning the cost of resources uniformly to cost objects when the individual products or services, in fact, use those resources in a nonuniform way. One way of determining if peanut-butter costing is occurring is to separately examine how individual products (services, customers, etc.) use the resources of the organization and to compare the results with the way the accounting system represents that usage. 5-2 Overcosting may result in competitors entering a market and taking market share for products that a company erroneously believes are low-margin or even unprofitable. Undercosting may result in companies selling products on which they are in fact losing money, when they erroneously believe them to be profitable. 5-3 Costing system refinement means making changes to an existing costing system that reduces the use of broad averages for assigning the cost of resources to cost objects and provides better measurement of the costs of overhead resources used by different cost objects. Three guidelines for refinement are: 1. Classify as many of the total costs as direct costs as is economically feasible. 2. Expand the number of indirect cost pools until each of these pools is more homogenous. 3. Use the cause-and-effect criterion, when possible, to identify the cost-allocation base for each indirect-cost pool. 5-4 An activity-based approach refines a costing system by focusing on individual activities as the fundamental cost objects. It uses the cost of these activities as the basis for assigning costs to other cost objects such as products or services. 5-5 Four levels of a manufacturing cost hierarchy are: (i) Output unit-level costs, costs of activities performed on each individual unit of a product or service. (ii) Batch-level costs, costs of activities related to a group of units of products or services rather than to each individual unit of product or service. (iii) Product-sustaining costs, or service-sustaining costs are the costs of activities undertaken, to support individual products or services regardless of the number of units or batches in which the units are produced. (iv) Facility-sustaining costs are the cost of activities that cannot be traced to individual products or services but support the organization as a whole. 5-6 The purpose for computing a product cost will determine whether unit costs should be based on total manufacturing costs in all or only some levels of the cost hierarchy. Inventory valuation for financial reporting requires total manufacturing costs (all levels of the hierarchy) to be expressed on a per output-unit basis. In contrast, for cost management purposes, the cost hierarchy need not be unitized, as the units of output is not the cost driver at each level in the hierarchy. 5-1

ACTIVITY-BASED COSTING

Embed Size (px)

DESCRIPTION

ACTIVITY-BASED COSTING

Citation preview

Page 1: ACTIVITY-BASED COSTING

CHAPTER 5ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT

5-1 Cost smoothing or peanut-butter costing describes a costing approach that uses broad averages for assigning the cost of resources uniformly to cost objects when the individual products or services, in fact, use those resources in a nonuniform way.

One way of determining if peanut-butter costing is occurring is to separately examine how individual products (services, customers, etc.) use the resources of the organization and to compare the results with the way the accounting system represents that usage.

5-2 Overcosting may result in competitors entering a market and taking market share for products that a company erroneously believes are low-margin or even unprofitable.

Undercosting may result in companies selling products on which they are in fact losing money, when they erroneously believe them to be profitable.

5-3 Costing system refinement means making changes to an existing costing system that reduces the use of broad averages for assigning the cost of resources to cost objects and provides better measurement of the costs of overhead resources used by different cost objects.

Three guidelines for refinement are:1. Classify as many of the total costs as direct costs as is economically feasible.2. Expand the number of indirect cost pools until each of these pools is more homogenous.3. Use the cause-and-effect criterion, when possible, to identify the cost-allocation base for

each indirect-cost pool.

5-4 An activity-based approach refines a costing system by focusing on individual activities as the fundamental cost objects. It uses the cost of these activities as the basis for assigning costs to other cost objects such as products or services.

5-5 Four levels of a manufacturing cost hierarchy are:

(i) Output unit-level costs, costs of activities performed on each individual unit of a product or service.

(ii) Batch-level costs, costs of activities related to a group of units of products or services rather than to each individual unit of product or service.

(iii) Product-sustaining costs, or service-sustaining costs are the costs of activities undertaken, to support individual products or services regardless of the number of units or batches in which the units are produced.

(iv) Facility-sustaining costs are the cost of activities that cannot be traced to individual products or services but support the organization as a whole.

5-6 The purpose for computing a product cost will determine whether unit costs should be based on total manufacturing costs in all or only some levels of the cost hierarchy. Inventory valuation for financial reporting requires total manufacturing costs (all levels of the hierarchy) to be expressed on a per output-unit basis. In contrast, for cost management purposes, the cost hierarchy need not be unitized, as the units of output is not the cost driver at each level in the hierarchy.

5-1

Page 2: ACTIVITY-BASED COSTING

5-7 An ABC approach focuses on activities as the fundamental cost objects. The costs of these activities are built up to compute the costs of products, and services, and so on. The traditional approach seeks to have one or a few indirect cost pools, irrespective of the heterogeneity in the facility. An ABC approach attempts to use cost drivers as the allocation base for indirect costs, whereas the traditional approach is less clear on this issue. The ABC approach classifies as many indirect costs as direct costs as possible. The traditional approach has more indirect costs.

5-8 Four decisions for which ABC information is useful are:1. pricing and product mix decisions,2. cost reduction and process improvement decisions,3. product design decisions, and4. planning and managing activities.

5-9 No. Department indirect-cost rates are similar to activity-cost rates if (1) a single activity accounts for a sizable fraction of the department’s costs, or (2) significant costs are incurred on different activities within a department but each activity has the same cost-allocation base, or (3) significant costs are incurred on different activities with different cost-allocation bases within a department but different products use resources from the different activity areas in the same proportions.

5-10 “Tell-tale” signs that indicate when ABC systems are likely to provide the most benefits are:

1. Significant amounts of indirect costs are allocated using only one or two cost pools.2. All or most indirect costs are identified as output-unit-level costs (i.e., few indirect costs

are described as batch-level, product-sustaining, or facility-sustaining costs).3. Products make diverse demands on resources because of differences in volume, process

steps, batch size, or complexity.4. Products that a company is well suited to make and sell show small profits, whereas

products that a company is less suited to produce and sell show large profits.5. Operations staff have significant disagreements with the accounting staff about the costs

of manufacturing and marketing products and services.

5-11 The main costs and limitations of ABC are the measurements necessary to implement the systems. Even basic ABC systems require many calculations to determine costs of products and services. Activity-cost rates often need to be updated regularly. Very detailed ABC systems are costly to operate and difficult to understand. Sometimes the allocations necessary to calculate activity costs often result in activity-cost pools and quantities of cost-allocation bases being measured with error. When measurement errors are large, activity-cost information can be misleading.

5-12 No, ABC systems apply equally well to service companies such as banks, railroads, hospitals, and accounting firms, as well merchandising companies such as retailers and distributors.

5-2

Page 3: ACTIVITY-BASED COSTING

5-13 No. An activity-based approach should be adopted only if its expected benefits exceed its expected costs. It is not always a wise investment. Simpler systems may suffice. If the jobs, products or services are alike in the way they consume indirect costs of a company, then a simple costing system will suffice.

5-14 Increasing the number of indirect-cost pools does NOT guarantee increased accuracy of product or service costs. If the existing cost pool is already homogeneous, increasing the number of cost pools will not increase accuracy. If the existing cost pool is not homogeneous, accuracy will increase only if the increased cost pools themselves increase in homogeneity vis-a-vis the single cost pool.

5-15 The controller faces a difficult challenge. The benefits of a better accounting system show up in improved decisions by managers. It is important that the controller have the support of these managers when seeking increased investments in accounting systems. Statements by these managers showing how their decisions will be improved by a better accounting system are the controller's best arguments when seeking increased funding. For example, the new system will result in more accurate product costs which will influence pricing and product mix decisions. The new system can also be used to reduce product costs which will lower selling prices. As a result, the customer will benefit from the new system.

5-16 (30 min.) Cost smoothing or peanut-butter costing, cross-subsidization.

1. Cost smoothing or peanut-butter costing is a costing approach that uniformly assigns the cost of resources to customers when the individual customers use those resources in a nonuniform way. The reunion dinner averages the costs across all five people. These five people differ sizably in what they consume.

2.Diner Entree Dessert Drinks Total

ArmstrongGonzalesKingPoffoYoungAverage

$2724213115

$23.60

$83664

$5.40

$240

13126

$11.00

$5927404925

$40.00The average-cost pricing will result in each person paying $40.

Amount Over- or(Undercosted)

Accurately costed person• King, $40 – $40 $ 0

Undercosted people• Armstrong, $40 – $59 $(19)• Poffo, $40 – $49 $( 9)

Overcosted people• Gonzales, $40 – $27 $ 13• Young, $40 – $25 $ 15

5-3

Page 4: ACTIVITY-BASED COSTING

5-16 (Cont’d.)

Yes, Young's complaint is justified. He is "overcharged" $15. He could point out likely negative behaviors with this approach to costing. These include:

a. It can lead some people to order the most expensive items because others will "subsidize" their extravagance.

b. It can lead to friction when those who dine economically are forced to subsidize those who dine extravagantly. At the limit, some people may decide not to attend the reunion dinners.

Likely benefits of this approach are:a. it is simple, andb. it (purportedly) promotes a group atmosphere at the dinner.

3. Each one of the costs in the data is directly traceable to an individual diner. This makes it straightforward to compute the individual cost per diner. Examples where this is not possible include:• A plate of hors d'oeuvres is shared by two or more diners• A loaf of garlic bread is shared by two or more diners• A bottle of mineral water or wine is shared by two or more diners

Each of these items cannot be directly traced to only one diner.Some possible behaviors if each person pays for his or her own bill are:

a. Some people may reduce their ordering of more expensive items because they will not be subsidized by other diners.

b. May encourage some potential diners to attend who otherwise would have stayed away.c. May encourage a person "trying to impress others with his or her success" to order the

most expensive items.

5-17 (20 min.) Cost hierarchy.

1. a. Product-sustaining costs are costs of activities undertaken to support individual products regardless of the number of units or batches in which the product is produced. Costs of designing processes, drawing process charts, and making engineering changes for individual products, $800,000, are product-sustaining costs.

b. Batch-level costs are costs of activities that are related to a group of units of a product rather than each individual unit of a product. Purchase order-related costs (including costs of receiving materials and paying suppliers) of $500,000 are batch-level costs

c. Output unit-level costs are costs of activities performed on each individual unit of a product. Direct materials costs of $6,000,000 are output unit-level costs.

d. Setup costs of $600,000 are batch-level costs.e. Direct manufacturing labor costs of $1,000,000 are output unit-level costs.f. Machine-related overhead costs (depreciation and maintenance) of $1,100,000 are

output unit-level costs.g. Facility-sustaining costs are costs of activities that cannot be traced to individual

products or services but support the organization as a whole. Plant management, plant rent, and insurance costs of $900,000 are facility-sustaining costs.

5-4

Page 5: ACTIVITY-BASED COSTING

5-17 (Cont’d.)

2. The complex boom box made in many batches will use significantly more batch-level overhead resources compared to the simple boom box that is made in a few batches. In addition, the complex boom box will use more product-sustaining overhead resources because it is complex. Because each boom box requires the same amount of machine-hours, both the simple and the complex boom box will be allocated the same amount of overhead costs per boom box if Telecom uses only machine-hours to allocate overhead costs to boom boxes. As a result, the complex boom box will be undercosted (it consumes a relatively high level of resources but is reported to have a relatively low cost) and the simple boom box will be overcosted (it consumes a relatively low level of resources but is reported to have a relatively high cost).

3. Using the cost hierarchy to calculate activity-based costs can help Telecom to identify both the costs of individual activities and the cost of activities demanded by individual products. Telecom can use this information to manage its business in several ways.

(1) Pricing and product mix decisions. Knowing the resources needed to manufacture and sell different types of boom boxes can help Telecom to price the different boom boxes and also identify which boom boxes are more profitable. It can then emphasize its more profitable products.

(2) Telecom can use information about the costs of different activities to improve processes and reduce costs of the different activities. Telecom could have a target of reducing costs of activities (setups, order processing, etc.) by, say, 3% and constantly seek to eliminate activities and costs (such as engineering changes) that its customers perceive as not adding value.

(3) Telecom management can identify and evaluate new designs to improve performance by analyzing how product and process designs affect activities and costs.

(4) Telecom can use its ABC systems and cost hierarchy information to plan and manage activities. What activities should be performed in the period and at what cost?

5-5

Page 6: ACTIVITY-BASED COSTING

5-18 (25 min.) ABC, distribution.

1. Total distribution costs (given), $2,130,000

=shipped neregular wi and

premium of cases Total

costson distributi Total

= 200,000

$2,130,000= $10.65 per case

Regular Premium Per Case Per Case

Total (2) = Total (4) =

(1) (1) ÷ 120,000 (3) (3) ÷ 80,000 Distribution costs$10.65 × 120,000; $10.65 × 80,000 $1,278,000 $10.65 $852,000 $10.65

2. Regular Premium

Per Case Per Case Total (2) = Total (4) =

(1) (1) ÷ 120,000 (3) (3) ÷ 80,000 Delivery costs

$8 × 120,000 cases $ 960,000 $8.00$8 × 80,000 cases $ 640,000 $ 8.00

Ordering costs$300 × 10 orders/year × 10 distr. 30,000 0.25$300 × 20 orders/year × 30 distr. 180,000 2.25

Promotion costs$8,000 × 10 distributors 80,000 0.67$8,000 × 30 distributors 240,000 3.00

Total costs $1,070,000 $8.92 $1,060,000 $13.25

3. The existing costing system uses cases shipped as the only cost allocation base for distribution costs. As a result, the distribution cost per case is the same for premium and regular wines ($10.65). In fact, premium wine uses distribution resources more intensively than regular wine: (a) Sonoma spends $8,000 on promotional costs at each distributor independent of cases sold. Premium wine distributors sell fewer cases a year than regular wine distributors. As a result the promotional cost per case of wine sold is higher for premium wine than for regular wine. (b) Sonoma’s cost per order is $300 regardless of the number of cases sold in each order. Because premium wine distributors order fewer cases per order, the ordering costs per case are higher for premium wines than for regular wines.

The existing costing system undercosts distribution costs per case for premium wine and overcosts distribution costs per case for regular wine.

Sonoma’s management can use the information from the ABC system to make better pricing and product mix decisions, to reduce costs by eliminating processes and activities that do not add value, to reduce the costs of doing various activities, and to plan and manage activities.

5-6

Page 7: ACTIVITY-BASED COSTING

5-7

Page 8: ACTIVITY-BASED COSTING

5-19 (25 min.) ABC, cost hierarchy, service.

1. Output unit-level costsDirect-labor costs, $240,000Equipment-related costs (rent, maintenance, energy, and so on), $400,000

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 costsSetup costs, $350,000

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 costsCosts of designing tests, $210,000.

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.

2. Heat Testing (HT) Stress Testing (ST)

Total(1)

Per Hour(2) =

(1) ÷ 50,000Total

(3)

Per Hour(4) =

(3) ÷ 30,000

Direct labor costs (given) $180,000 $ 3.60 $ 60,000 $ 2.00Equipment-related costs $5 per hour* × 50,000 hours $5 per hour* × 30,000 hours

250,000 5.00150,000 5.00

Setup costs $20 per setup-hour† × 13,500 setup-hours $20 per setup-hour† × 4,000 setup-hours

270,000 5.4080,000 2.67

Costs of designing tests $50 per hour** × 2,800 hours $50 per hour** × 1,400 hours

140,000

2.80 70,000 2 .33

Total costs $840,000 $16 .80 $360,000 $12 .00

*$400,000 ÷ (50,000 + 30,000) hours = $5 per test-hour†$350,000 ÷ (13,500 + 4,000) setup hours = $20 per setup-hour**$210,000 ÷ (2,800 + 1,400) hours = $50 per hour

At a cost per test-hour of $15, the existing costing system undercosts heat testing ($16.80) and overcosts stress testing ($12.00). The reason is that heat testing uses direct labor, setup, and design resources per hour more intensively than stress testing. Heat tests are more complex, take longer to set up, and are more difficult to design. The existing costing system assumes that testing costs per hour are the same for heat testing and stress testing.

5-8

Page 9: ACTIVITY-BASED COSTING

5-19 (Cont’d.)

3. 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.

Plymouth’s 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. Plymouth should watch if competitors are underbidding Plymouth in stress testing, and causing it to lose business. Plymouth 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.

5-20 (15 min.) Alternative allocation bases for a professional services firm.

1.Direct Professional Time Support Services Amount

ClientRate per

HourNumberof Hours Total Rate Total

Billed toClient

(1) (2) (3) (4) = (2) × (3) (5) (6) = (4) × (5) (7) = (4) + (6)SEATTLEDOMINION

WolfsonBrownAnderson

$50012080

153

22

$7,500360

1,760

30%3030

$2,250108528

$ 9,750468

2,288 $12,506

TOKYOENTERPRISES

WolfsonBrownAnderson

$50012080

28

30

$1,000960

2,400

30%3030

$300288720

$1,3001,248

3,120 $5,668

5-9

Page 10: ACTIVITY-BASED COSTING

5-20 (Cont’d.)

2.Direct Professional Time Support Services Amount

ClientRate per

HourNumberof Hours Total

Rate per Hour Total

Billed toClient

(1) (2) (3) (4) = (2) × (3) (5) (6) = (3) × (5) (7) = (4)+(6)SEATTLEDOMINIONWolfsonBrownAnderson

$50012080

153

22

$7,500360

1,760

$505050

$ 750150

1,100

$ 8,250510

2,860 $11,620

TOKYOENTERPRISESWolfsonBrownAnderson

$50012080

28

30

$1,000960

2,400

$505050

$ 100400

1,500

$1,1001,360

3,900 $6,360

Requirement 1 Requirement 2

Seattle Dominion $12,506 $11,620Tokyo Enterprises 5,668 6,360

$18,174 $17,980

Both clients use 40 hours of professional labor time. However, Seattle Dominion uses a higher proportion of Wolfson's time (15 hours), which is more costly. This attracts the highest support-services charge when allocated on the basis of direct professional labor costs.

3. Assume that the Wolfson Group uses a cause-and-effect criterion when choosing the allocation base for support services. You could use several pieces of evidence to determine whether professional labor costs or hours is the driver of support-service costs:

a. Interviews with personnel. For example, staff in the major cost categories in support services could be interviewed to determine whether Wolfson requires more support per hour than, say, Anderson. The professional labor costs allocation base implies that an hour of Wolfson's time requires 6.25 ($500 ÷ $80) times more support-service dollars than does an hour of Anderson's time.b. Analysis of tasks undertaken for selected clients. For example, if computer-related costs are a sizable part of support costs, you could determine if there was a systematic relationship between the percentage involvement of professionals with high billing rates on cases and the computer resources consumed for those cases.

5-10

Page 11: ACTIVITY-BASED COSTING

5-21 (10−15 min.) Plantwide indirect-cost rates.

1. =

=

= $77.15 per machine-hour

2. UnitedMotors

HoldenMotors

LelandVehicle

Plantwide MOH $77.15×120; $77.15×2,800; $77.15×1,080 $9,258 $216,020 $83,322

3. The conditions that would enable machine-hours to provide an accurate estimate of variable manufacturing overhead cost incurred on each individual contract are:

a. machine-hours is the sole cost driver, and there is a linear relation between variable manufacturing overhead cost and machine-hours, and

b. machine-hours used per contract can be accurately measured.

c. each automobile assembly company under contract is alike in the way they consume variable manufacturing overhead.

5-11

Page 12: ACTIVITY-BASED COSTING

5-22 (30 min.) Department indirect-cost rates as activity rates(continuation of 5-21).

1. 2004 VariableMOH Costs

TotalDriver Units Rate

Design-CADEngineeringProduction

$ 39,00029,600

240,000

390370

4,000

$100 per design-hour$ 80 per engineer-hour$ 60 per machine

2. United Motors Holden Motors Leland VehicleDesign $100 × 110; $100 × 200; $100 × 80Engineering $80 × 70; $80 × 60; $80 × 240Production $60 × 120; $60 × 2,800; $60 × 1,080Total

$11,000

5,600

7,200 $23,800

$ 20,000

4,800

168,000 $192,800

$ 8,000

19,200

64,800 $92,000

3.United Motors

HoldenMotors

LelandVehicle

a. Department rate (Exercise 5-22)

b. Plantwide rate (Exercise 5-21)

$23,800

9,258

$192,800

216,020

$92,000

83,322

Ratio of (a) ÷ (b) 2.57 0.89 1.10

The three contracts differ sizably in the way they use the resources of the three departments. The percentage of total driver units in each department used by the contract companies is:

DepartmentUnited Motors

HoldenMotors

LelandVehicle

DesignEngineeringProduction

28%193

51%1670

21%6527

The United Motors contract uses only 3% of total machines-hours in 2004, yet uses 28% of CAD design-hours and 19% of engineering hours. The result is that the plantwide rate, based on machine-hours, will greatly underestimate the cost of resources used on the United Motors contract. Hence, the 257% increase in indirect costs assigned to the United Motors contract when department rates are used.

In contrast, the Holden Motors contract uses less of design (51%) and engineering (16%) than of machine-hours (70%). Hence, the use of department rates will report lower indirect costs for Holden Motors than does a plantwide rate.

5-12

Page 13: ACTIVITY-BASED COSTING

5-23 (10-15 min.) ABC, process costing.

Rates per unit cost driver.

Activity Cost Driver Rate Machining Machine-hours $375,000 ÷ (25,000 + 50,000)

= $5 per machine-hour

Set up Production runs $120,000 ÷ (50 + 50) = $1,200 per production run

Inspection Inspection-hours $105,000 ÷ (1,000 + 500) = $70 per inspection-hour

Overhead cost per unit: Mathematical Financial

Machining: $5 × 25,000; 50,000 $125,000 $250,000

Set up: $1,200 × 50; $1,200 × 50 60,000 60,000Inspection: $70 × 1,000; $70 × 500 70,000 35,000Total manufacturing overhead costs 255,000 345,000Divide by number of units ÷ 50,000 ÷100,000Manufacturing overhead cost per unit $ 5.10 $ 3.45

2. Mathematical FinancialManufacturing cost per unit:

Direct materials $150,000 ÷ 50,000 $3.00 $300,000 ÷ 100,000 $3.00

Direct manufacturing labor $50,000 ÷ 50,000 1.00$100,000 ÷ 100,000 1.00

Manufacturing overhead (from Requirement 1) 5.10 3.45Manufacturing cost per unit $9.10 $7.45

5-13

Page 14: ACTIVITY-BASED COSTING

5-24 (30 min.) ABC, retail product-line profitability.

1. The previous costing system (Panel A of Solution Exhibit 5-24) reports the following:

BakedGoods

Milk &Fruit Juice

FrozenProducts Total

RevenuesCostsCost of goods soldStore support (30% of COGS) Total costsOperating income

Operating income ÷ Revenues

$57,000

38,000 11,400 49,400 $ 7,600

13.33%

$63,000

47,000 14,100 61,100 $ 1,900

3.02%

$52,000

35,000 10,500 45,500 $ 6,500

12.50%

$172,000

120,000 36,000 156,000 $ 16,000

9.30%

2. The ABC system (Panel B of Solution Exhibit 5-24) reports the following:

BakedGoods

Milk &Fruit Juice

FrozenProducts Total

RevenuesCostsCost of goods soldOrdering ($100 × 30; 25; 13)Delivery ($80 × 98; 36; 28)Shelf-stocking ($20 × 183; 166; 24)Customer support ($0.20 × 15,500; 20,500; 7,900) Total costsOperating income

Operating income ÷ Revenues

$57,000

38,0003,0007,8403,660

3,100 55,600 $ 1,400

2.46%

$63,000

47,0002,5002,8803,320

4,100 59,800 $ 3,200

5.08%

$52,000

35,0001,3002,240

480

1,580 40,600 $11,400

21.92%

$172,000

120,0006,800

12,9607,460

8,780 156,000 $ 16,000

9.30%

These activity costs are based on the following:

Activity Cost Allocation RateBakedGoods

Milk &Fruit Juice

FrozenProducts

OrderingDeliveryShelf-stockingCustomer support

$100 per purchase order$80 per delivery$20 per hour$0.20 per item sold

3098

18315,500

2536

16620,500

132824

7,900

The rankings of products in terms of relative profitability are:

Previous Costing System ABC System1. Baked goods 13.33%2. Frozen products 12.503. Milk & fruit juice 3.02

Frozen products 21.92%Milk & fruit juice 5.08Baked goods 2.46

5-14

Page 15: ACTIVITY-BASED COSTING

5-24 (Cont’d.)

The percentage revenue, COGS, and activity costs for each product line are:

BakedGoods

Milk &Fruit Juice

FrozenProducts Total

RevenuesCOGSActivity areas:OrderingDeliveryShelf-stockingCustomer support

33.1431.67

44.1260.4949.0635.31

36.6339.17

36.7622.2244.5046.70

30.2329.16

19.1217.296.44

17.99

100.00100.00

100.00100.00100.00100.00

3. The baked goods line drops sizably in profitability when ABC is used. Although it constitutes 31.67% of COGS, it uses a higher percentage of total resources in each activity area, especially the high cost delivery activity area. In contrast, frozen products draws a much lower percentage of total resources used in each activity area than its percentage of total COGS. Hence, under ABC, frozen products is much more profitable.

Family Supermarkets may want to explore ways to increase sales of frozen products. It may also want to explore price increases on baked goods.

5-15

Page 16: ACTIVITY-BASED COSTING

5-24 (Cont’d.)

SOLUTION EXHIBIT 5-24Product-Costing Overviews of Family Supermarkets

PANEL A: PREVIOUS COSTING SYSTEM

COST OBJECT:PRODUCT LINE

Indirect Costs

Direct Costs

StoreSupport

COGS

COGS

INDIRECTCOSTPOOL

COSTALLOCATION

BASE}

}

}

}

DIRECTCOST

PANEL B: ABC COSTING SYSTEM

5-16

Ordering DeliveryShelf-

StockingCustomerSupport

Number ofPurchase Order

Number ofDeliveries

Hours ofShelf-Stocking

Number ofItems Sold

Indirect Costs

Direct Costs

COGS

Page 17: ACTIVITY-BASED COSTING

5-25 (15-20 min.) ABC, wholesale, customer profitability.

Chain 1 2 3 4

Gross sales $50,000 $30,000 $100,000 $70,000Sale returns 10,000 5,000 7,000 6,000Net sales 40,000 25,000 93,000 64,000Cost of goods sold (80%) 32,000 20,000 74,400 51,200Gross margin 8,000 5,000 18,600 12,800Customer-related costs:

Regular orders$20 × 40; 150; 50; 70 800 3,000 1,000 1,400Rush orders$100 × 10; 50; 10; 30 1,000 5,000 1,000 3,000Returned items$10 × 100; 26; 60; 40 1,000 260 600 400Catalogs and customer support 1,000 1,000 1,000 1,000Customer related costs 3,800 9,260 3,600 5,800

Contribution (loss) margin $ 4,200 $ (4,260) $ 15,000 $ 7,000Contribution (loss) margin as percentage

of gross sales 8.4% (14.2%) 15.0% 10.0%

The analysis indicates that customers’ profitability (loss) contribution varies widely from (14.2%) to 15.0%. Immediate attention to Chain 2 is required which is currently showing a loss contribution. The chain has a disproportionate number of both regular orders and rush orders. Villeagas should work with the management of Chain 2 to find ways to reduce the number of orders, while maintaining or increasing the sales volume. If this is not possible, Villeagas should consider dropping Chain 2, if it can save the customer-related costs.

Chain 1 has a disproportionate number of the items returned as well as sale returns. The causes of these should be investigated so that the profitability contribution of Chain 1 could be improved.

5-17

Page 18: ACTIVITY-BASED COSTING

5-26 (50 min.) ABC, activity area cost-driver rates, product cross-subsidization.

1.Direct costs

Direct materials $ 150,000Indirect costs

Product support 983,000Total costs $1,133,000

Cost per pound of potato cuts =000,000,1

000,133,1$= $1.133

2. Cost Costs in Number of Costs per Pool Pool Driver Units Driver Unit

Cleaning $120,0001,200,000 raw pounds$ 0.10Cutting $231,000 3,850 hours* $60.00Packaging $444,000 37,000 hours**$12.00

*(900,000 ÷ 250) + (100,000 ÷ 400) = 3,600 + 250 = 3,850**(900,000 ÷ 25) + (100,000 ÷ 100) = 36,000 + 1,000 = 37,000

3. Retail Potato Cuts Institutional Potato Cuts Direct costs

Direct materials $135,000 $15,000Packaging 180,000 $ 315,000 8,000 $23,000

Indirect costsCleaning $0.10 × 90% × 1,200,000 108,000 $0.10 × 10% × 1,200,000 12,000Cutting $60 × 3,600 hours 216,000 $60 × 250 hours 15,000Packaging $12 × 36,000 432,000 $12 × 1,000 756,000 12,000 39,000Total costs $1,071,000 $62,000 Pounds produced 900,000 100,000Costs per pound $1.19 $0.62

Note: The total costs of $1,133,000 ($1,071,000 + $62,000) are the same as those in Requirement 1.

4. There is much evidence of product-cost cross-subsidization.

Cost per Pound Retail InstitutionalCurrent system $1.133 $1.133ABC system $1.190 $0.620

Assuming the ABC numbers are more accurate, potato cuts sold to the retail market are

5-18

Page 19: ACTIVITY-BASED COSTING

undercosted while potato cuts sold to the institutional market are overcosted.5-26 (Cont’d.)

The current system assumes each product uses all the activity areas in a homogeneous way. This is not the case. Institutional sales use sizably less resources in the cutting area and the packaging area. The percentage of total costs for each cost category are:

Retail Institutional TotalDirect costs

Direct materials 90.0% 10.0% 100.0%Packaging 95.7 4.3 100.0

Indirect costsCleaning 90.0 10.0 100.0Cutting 93.5 6.5 100.0Packaging 97.3 2.7 100.0

Units produced 90.0% 10.0% 100.0%

Idaho can use the revised cost information for a variety of purposes:

a. Pricing/product emphasis decisions. The sizable drop in the reported cost of potatoes sold in the institutional market makes it possible that Idaho was overpricing potato products in this market. It lost the bid for a large institutional contract with a bid 30% above the winning bid. With its revised product cost dropping from $1.133 to $0.620, Idaho could have bid much lower and still made a profit. An increased emphasis on the institutional market appears warranted.b. Product design decisions. ABC provides a road map as to how to reduce the costs of individual products. The relative components of costs are:

Retail InstitutionalDirect costs

Direct materials 12.6% 24.20%Packaging 16.8 12.90

Indirect costsCleaning 10.1 19.35Cutting 20.2 24.20Packaging 40.3 19.35

Total costs 100.0% 100.00%

Packaging-related costs constitute 57.1% (16.8% + 40.3%) of total costs of the retail product line. Design efforts that reduce packaging costs can have a big impact on reducing total unit costs for retail.c. Process improvements. Each activity area is now highlighted as a separate cost. The three indirect cost areas comprise over 60% of total costs for each product, indicating the upside from improvements in the efficiency of processes in these activity areas.

5-19

Page 20: ACTIVITY-BASED COSTING

5-27 (20−25 min.) Activity-based costing, job-costing system.

1. An overview of the activity-based job-costing system is:

2.Activity Area Indirect Manufacturing

Costs Allocated1. Axial insertion2. Dip insertion3. Manual insertion4. Wave solder5. Backload6. Test7. Defect analysisTotal

$ 0.080.250.503.500.70

90.0080.00

× 45× 24× 11× 1× 6× .25× .10

= $ 3.60= 6.00= 5.50= 3.50= 4.20= 22.50= 8.00

$53.30

Direct manufacturing costs:Direct materials $75.00Direct manufacturing labor 15 .00 $ 90.00

Indirect manufacturing costs:Manufacturing overhead (see above) 53.30

Total manufacturing costs $143.30

3. The manufacturing manager likely would find the ABC job-costing system useful in cost management. Unlike direct manufacturing labor costs, the seven indirect cost pools are systematically linked to the activity areas at the plant. The result is more accurate product costing. Productivity measures can be developed that directly link to the management accounting system.

Marketing managers can use ABC information to price jobs as well as to advise customers about how selecting different product features will affect price.

5-20

POOL

BASE

COSTDirect

Materials

INDIRECTCOST

COSTALLOCATION

DIRECT

}

}

}

}

COST OBJECT:PC BOARD

Indirect Costs

Direct Costs

AxialInsertion

Number ofAxial

Insertions

DipInsertion

Number ofDip

Insertions

ManualInsertion

Number ofManual

Insertions

WaveSolder

Number ofBoards

Soldered

Backload

Number ofBackloadInsertions

Test

BudgetedTime in

Test

DefectAnalysis

BudgetedTime inAnalysis

ManufacturingDirect

Labor

Page 21: ACTIVITY-BASED COSTING

5-28 (30 min.) ABC, product-costing at banks, cross-subsidization.1.

Robinson Skerrett Farrel TotalRevenues Spread revenue on annual basis

(3% × ; $1,100, $800, $25,000) Monthly fee charges

($20 ×; 0, 12, 0)Total revenues

$ 33

0 33

$ 24

240 264

$750.0

0 .0 750 .0

$ 807.0

240 .0 1,047 .0

Costs Deposit/withdrawal with teller

$2.50 × 40; 50; 5 Deposit/withdrawal with ATM

$0.80 × 10; 20; 16 Deposit/withdrawal on prearranged basis:

$0.50 × 0; 12; 60 Bank checks written

$8.00 × 9; 3; 2 Foreign currency drafts

$12.00 × 4; 1; 6 Inquiries

$1.50 × 10; 18; 9Total costs

Operating income (loss)

100

8

0

72

48

15 243 $(210 )

125

16

6

24

12

27 210 $ 54

12.5

12.8

30.0

16.0

72.0

13 .5 156 .8 $593 .2

237.5

36.8

36.0

112.0

132.0

55 .5 609 .8 $ 437 .2

The assumption that the Robinson and Farrel accounts exceed $1,000 every month and the Skerrett account is less than $1,000 each month means the monthly charges apply only to Skerrett.

One student with a banking background noted that in this solution 100% of the spread is attributed to the "depositor side of the bank." He noted that often the spread is divided between the "depositor side" and the "lending side" of the bank.

2. Cross-subsidization across individual Premier Accounts occurs when profits made on some accounts are offset by losses on other accounts. The aggregate profitability on the three customers is $437.20. The Farrel account is highly profitable ($593.20), while the Robinson account is sizably unprofitable. The Skerrett account shows a small profit but only because of the $240 monthly fees. It is unlikely that Skerrett will keep paying these high fees and that FIB would want Skerret to pay such high fees from a customer relationship standpoint.

The facts also suggest that the customers do not use the bank services uniformly. For example, Robinson and Skerret have a lot of transactions with the teller or ATM, and also inquire about their account balances more often than Farrell. This suggests cross-subsidization. FIB should be very concerned about the cross-subsidization. Competition likely would "understand" that high-balance low-activity type accounts (such as Farrel) are highly profitable. Offering free services to these customers is not likely to retain these accounts if other banks offer higher interest rates. Competition likely will reduce the interest rate spread FIB can earn on the high-balance low-activity accounts they are able to retain.

5-21

Page 22: ACTIVITY-BASED COSTING

5-28 (Cont’d.)

3. Possible changes FIB could make are:a. Offer higher interest rates on high-balance accounts to increase FIB's competitiveness in attracting and retaining these accounts.a. Introduce charges for individual services. The ABC study reports the cost of each service.

FIB has to decide if it wants to price each service at cost, below cost, or above cost. If it prices above cost, it may use advertising and other means to encourage additional use of those services by customers. Of course, in determining its pricing strategy, FIB would need to consider how other competing banks are pricing their products and services.

5.29 (15 min.) Job costing with single direct-cost category, single indirect-costpool, law firm.

1. Pricing decisions at Wigan Associates are heavily influenced by reported cost numbers. Suppose Wigan is bidding against another firm for a client with a job similar to that of Widnes Coal. If the costing system overstates the costs of these jobs, Wigan may bid too high and fail to land the client. If the costing system understates the costs of these jobs, Wigan may bid low, land the client, and then lose money in handling the case.

2. Widnes Coal St. Helen’s Glass TotalDirect professional labor,

$70 × 104; $70 × 96 $ 7,280 $ 6,720 $14,000Indirect costs allocated,

$105 × 104; $105 × 96 10,920 10,080 21,000Total costs to be billed $18,200 $16,800 $35,000

5-22

Page 23: ACTIVITY-BASED COSTING

5-30 (20-25 min.) Job costing with multiple direct-cost categories, single indirect-cost pool, law firm (continuation of 5-29).

Indirect costs = $7,000Total professional labor-hours = 200 hours (104 hours on Widnes Coal + 96 hours on St. Helen’s Glass)

Indirect cost allocated per professional labor-hour = $7,000 ÷ 200 = $35 per hour

2. Widnes Coal St. Helen’s Glass Total

Direct costs:Direct professional labor, $70 × 104; $70 × 96 $ 7,280 $ 6,720 $14,000Research support labor 1,600 3,400 5,000Computer time 500 1,300 1,800Travel and allowances 600 4,400 5,000Telephones/faxes 200 1,000 1,200Photocopying 250 750 1,000

Total direct costs 10,430 17,570 28,000

Indirect costs allocated,$35 × 104; $35 × 96 3,640 3,360 7,000

Total costs to be billed $14,070 $20,930 $35,000

3.Widnes Coal St. Helen’s Glass Total

Problem 5-29 $18,200 $16,800 $35,000Problem 5-30 14,070 20,930 35,000

The Problem 5-30 approach directly traces to the individual jobs $14,000 that is allocated in the Problem 5-29 approach on the basis of direct professional labor-hours. The averaging assumption implicit in the Problem 5-29 approach appears incorrect—for example, the St. Helen’s Glass job has travel costs over seven times higher than the Widnes Coal case despite having lower direct professional labor-hours.

5-23

Page 24: ACTIVITY-BASED COSTING

5-31 (30 min.) Job costing with multiple direct-cost categories,multiple indirect-cost pools, law firm (continuation of 5-29 and 5-30).

1. Widnes Coal St. Helen’s Glass Total

Direct costs:Partner professional labor,

$100 × 24; $100 × 56 $ 2,400 $ 5,600 $ 8,000Associate professional labor,

$50 × 80; $50 × 40 4,000 2,000 6,000Research support labor 1,600 3,400 5,000Computer time 500 1,300 1,800Travel and allowances 600 4,400 5,000Telephones/faxes 200 1,000 1,200Photocopying 250 750 1,000

Total direct costs 9,550 18,450 28,000Indirect costs allocated:

Indirect costs for partners,$57.50 × 24; $57.50 × 56 1,380 3,220 4,600Indirect costs for associates,$20 × 80; $20 × 40 1,600 800 2,400Total indirect costs 2,980 4,020 7,000

Total costs to be billed $12,530 $22,470 $35,000

Comparison Widnes Coal St. Helen’s Glass Total

Single direct cost/Single indirect cost pool $18,200 $16,800 $35,000

Multiple direct costs/Multiple indirect cost pools $12,530 $22,470 $35,000

The higher the percentage of costs directly traced to each case, the more accurate the product cost of each individual case.

The Widnes and St. Helen’s cases differ in how they use “resource areas” of Wigan Associates:

Widnes Coal St. Helen’s GlassPartner professional labor 30.0% 70.0%Associate professional labor 66.7 33.3Research support labor 32.0 68.0Computer time 27.8 72.2Travel and allowances 12.0 88.0Telephones/faxes 16.7 83.3Photocopying 25.0 75.0

5-24

Page 25: ACTIVITY-BASED COSTING

5-31 (Cont’d.)

The Widnes Coal case makes relatively low use of the higher-cost partners but relatively higher use of the lower-cost associates than does St. Helen’s Glass. The Widnes Coal case also makes relatively lower use of the support labor, computer time, travel, phones/faxes, and photocopying resource areas than does the St. Helen’s Glass case.

2. The specific areas where the multiple direct/multiple indirect (MD/MI) approach can provide better information for decisions at Wigan Associates include:

Pricing and product (case) emphasis decisions. In a bidding situation using single direct/single indirect (SD/SI) data, Wigan may win bids for legal cases on which it will subsequently lose money. It may also not win bids on which it would make money with a lower-priced bid.

From a strategic viewpoint, SD/SI exposes Wigan Associates to cherry-picking by competitors. Other law firms may focus exclusively on Widnes Coal-type cases and take sizable amounts of “profitable” business from Wigan Associates. MD/MI reduces the likelihood of Wigan Associates losing cases on which it would have made money.

Client relationships. MD/MI provides a better “road map” for clients to understand how costs are accumulated at Wigan Associates. Wigan can use this road map when meeting with clients to plan the work to be done on a case before it commences. Clients can negotiate ways to get a lower-cost case from Wigan, given the information in MD/MI—for example, (a) use a higher proportion of associate labor time and a lower proportion of a partner time, and (b) use fax machines more and air travel less. If clients are informed in advance how costs will be accumulated, there is less likelihood of disputes about bills submitted to them after the work is done.

Cost control. The MD/MI approach better highlights the individual cost areas at Wigan Associates than does the SD/SI approach:

MD/MI SD/SINumber of direct cost categories 7 1Number of indirect cost categories 2 1Total 9 2

MD/MI is more likely to promote better cost-control practices than SD/SI (as the nine cost categories in MD/MI may differ in terms of how to effectively manage costs in each cost category).

5-25

Page 26: ACTIVITY-BASED COSTING

5-32 (30 min.) Plantwide, department, and activity-cost rates.

1. Budgeted manufacturing overhead rates:

i. Plantwide rate:

= $17.00 per direct manufacturing labor-hour

ii. Departmental rates:

Department 1: $240,000 ÷ 10,000 = $24.00 per direct manufacturing labor-hourDepartment 2: $100,000 ÷ 10,000 = $10.00 per direct manufacturing labor-hour

Manufacturing overhead portion of ending inventories:

i. Using plantwide overhead rate: 800 units × 5 hours × $17.00 $68,000

ii. Using department overhead rates:

Product A: 200 × [(4 × $24.00) + (1 × $10.00)] = $21,200Product B: 600 × [(1 × $24.00) + (4 × $10.00)] = 38,400

$59,600The difference in inventory costs due to the different methods of allocating manufacturing

overhead is $8,400 ($68,000 – $59,600).

2. Product APlantwide Department

Overhead Rate Overhead Rates

Direct materials $120.00 $120.00Direct manufacturing labor 80.00 80.00Manufacturing overhead:

$17 × 5 85.00($24 × 4) + ($10 × 1) 106.00

Total manufacturing costs 285.00 306.00Markup

($285 × 120%; $306 × 120%) 342.00 367.20Selling price $627.00 $673.20

5-26

Page 27: ACTIVITY-BASED COSTING

5-32 (Cont’d.)Product B

Plantwide DepartmentOverhead Rate Overhead Rate

Direct materials $150.00 $150.00Direct manufacturing labor 80.00 80.00Manufacturing overhead:

$17 × 5 85.00($24 × 1) + ($10 × 4) 64.00

Total manufacturing costs 315.00 294.00Markup

($315 × 120%; $294 × 120%) 378.00 352.80Selling price $693.00 $646.80

3. Sayther Company should use budgeted department manufacturing overhead rates because:a. The two manufacturing departments differ sizably in their overhead cost structures, despite having the same budgeted direct manufacturing labor-hours. Department 1 has $240,000 budgeted overhead, and Department 2 has $100,000 budgeted overhead.b. The two products use resources in the two manufacturing departments quite differently. The direct manufacturing labor-hours used in each department are:

Department Product A Product B

1 4 12 1 4

Differences a. and b. mean that more refined product costs will be calculated with budgeted department manufacturing overhead rates.

4. Sayther should further subdivide the department cost pools into activity-cost pools if (a) significant costs are incurred on different activities within the department, (b) the different activities have different cost-allocation bases, and (c) different products use the different activities in different proportions.

5-27

Page 28: ACTIVITY-BASED COSTING

5-33 (30 min.) Plantwide versus department overhead cost rates.

1. Amounts (in thousands) Molding Component Assembly Total

Manufacturing department overhead $21,000 $16,200 $22,600$59,800

Service departments:Power 18,400

Maintenance 4,000Total budgeted plantwide overhead $82,200

Budgeted direct manufacturing labor-hours (DMLH):Molding 500Component 2,000Assembly 1,500

Total budgeted DMLH 4,000

Plantwide overhead rate =DMLH Budgeted

overheard plantwide Budgeted

= 4,000

$82,200 = $20.55 per DMLH

2. The department overhead cost rates are shown in Solution Exhibit 5-33

3. MumsDay Corporation should use department rates to allocate plant overhead because: (1) the cost drivers of resources used in each department differ and (2) the departments do not use resources from the support departments in the same proportion. Hence, department rates better capture cause-and-effect relationships at MumsDay than does a plantwide rate.

4. MumsDay should further subdivide the department cost pools into activity-cost pools if (a) significant costs are incurred on different activities within the department, (b) the different activities have different cost drivers, and (c) different products use different activities in different proportions.

5-28

Page 29: ACTIVITY-BASED COSTING

5-33 (Cont’d)

SOLUTION EXHIBIT 5-33

Departments (in thousands) Service Manufacturing

Power Maintenance Molding Component Assembly

2 (a)Departmental overhead costs $18,400 $4,000 $21,000 $16,200 $22,600

Allocation of maintenance costs (direct method)$4,000 × 90/125, 25/125, 10/125 (4,000) 2,880 800 320

Allocation of power costs$18,400 × 360/800, 320/800, 120/800 (18,400) 8,280 7,360 2,760

Total budgeted overhead of manufacturingdepartments $ 0 $ 0 $32,160 $24,360 $25,680

2 (b) Allocation Base 875 MH 2,000 DMLH 1,500 DMLH

Budgeted Rate (Budgeted overhead ÷ Alloc. Base) $36.75/MH $12.18/DMLH$17.12/DMLH

5-29

Page 30: ACTIVITY-BASED COSTING

5-34 (30-40 min.) Activity-based costing, merchandising.

1. GeneralSupermarket

ChainsDrugstore

Chains

Ma and PaSingleStores Total

Revenuesa $3,708,000 $3,150,000 $1,980,000 $8,838,000Cost of goods soldb 3,600,000 3,000,000 1,800,000 8,400,000Gross margin $ 108,000 $ 150,000 $ 180,000 438,000Other operating costs 301,080Operating income $ 136,920

Gross margin % 2.91% 4.76% 9.09%

a($30,900 × 120); ($10,500 × 300); ($1,980 × 1,000)b($30,000 × 120); ($10,000 × 300); ($1,800 × 1,000)

The gross margin of Figure Four Inc. was 4.96% ($438,000 ÷ $8,838,000). The operating income margin of Figure Four Inc. was 1.55% ($136,920 ÷ $8,838,000).

2. The per-unit cost driver rates are:

1. Customer purchase order processing, $80,000 ÷ 2,000 orders = $40 per order2. Line item ordering, $63,840 ÷ 21,280 line items = $ 3 per line item3. Store delivery, $71,000 ÷ 1,420 deliveries = $50 per delivery4. Cartons shipped, $76,000 ÷ 76,000 cartons = $ 1 per carton5. Shelf-stocking, $10,240 ÷ 640 hours = $16 per hour

3. The activity-based costing of each distribution market for August 2002 is:

GeneralSupermarket

ChainsDrugstore

Chains

Ma and PaSingleStores

1. Customer purchase order processing, ($40 × 140; 360; 1,500) $ 5,600 $14,400 $ 60,000

2. Line item ordering,($3 × (140 × 14; 360 × 12; 1,500 × 10)) 5,880 12,960 45,000

3. Store delivery,($50 × 120, 300, 1,000) 6,000 15,000 50,000

4. Cartons shipped,($1 × (120 × 300; 300 ×80; 1,000 × 16)) 36,000 24,000 16,000

5. Shelf-stocking,($16 × (120 × 3; 300 × 0.6; 1,000 × 0.1)) 5,760 2,880 1,600

$59,240 $69,240 $172,600

5-30

Page 31: ACTIVITY-BASED COSTING

5-34 (Cont’d.)

The revised operating income statement is:General

SupermarketChains

DrugstoreChains

Ma and PaSingleStores Total

Revenues $3,708,000 $3,150,000 $1,980,000 $8,838,000Cost of goods sold 3,600,000 3,000,000 1,800,000 8,400,000Gross margin 108,000 150,000 180,000 438,000Operating costs 59,240 69,240 172,600 301,080Operating income $ 48,760 $ 80,760 $ 7,400 $ 136,920

Operating income margin 1.31% 2.56% 0.37% 1.55%

The ranking of the three markets are:

Using Gross Margin Using Operating Income

1. Ma and Pa Single Stores 9.09% 1. Drugstore Chains 2.56%2. Drugstore Chains 4.76% 2. General Supermarket Chains 1.31%3. General Supermarket Chains 2.91% 3. Ma and Pa Single Stores 0.37%

The activity-based analysis of costs highlights how the Ma and Pa Single Stores use a larger amount of Figure Four resources per revenue dollar than do the other two markets. The ratio of the operating costs to revenues across the three markets is:

General Supermarket Chains 1.60% ($59,240 ÷ $3,708,000)Drugstore Chains 2.20% ($69,240 ÷ $3,150,000)Ma and Pa Single Stores 8.72% ($172,600 ÷ $1,980,000)

This is a classic illustration of the maxim that "all revenue dollars are not created equal." The analysis indicates that the Ma and Pa Single Stores are the least profitable market. Figure Four should work to increase profits in this market through: (1) a possible surcharge, (2) decreasing the number of orders, (3) offering discounts for quantity purchases etc.

4. a. Choosing the appropriate cost drivers for each area. The problem gives a cost driver for each chosen activity area. However, it is likely that over time further refinements in cost drivers would occur. For example, not all store deliveries are equally easy to make, depending on parking availability, accessibility of the storage/shelf space to the delivery point, etc. Similarly, not all cartons are equally easy to deliver––their weight, size, or likely breakage component are factors that can vary across carton types.

b. Developing a reliable data base on the chosen cost drivers. For some items, such as the number of orders and the number of line items, this information likely would be available in machine readable form at a high level of accuracy. Unless the delivery personnel have hand-held computers that they use in a systematic way, estimates of shelf-stocking time are likely to be unreliable. Advances in information technology likely will reduce problems in this area over time.

c. Deciding how to handle costs that may be common across several activities. For example, (3) store delivery and (4) cartons shipped to stores have the common cost of the same trip. Some organizations may treat (3) as the primary activity and attribute only incremental costs to (4). Similarly, (1) order processing and (2) line item ordering may have common costs.

5-31

Page 32: ACTIVITY-BASED COSTING

5-34 (Cont’d.)

d. Choice of the time period to compute cost rates per cost driver. Flair calculates driver rates on a monthly basis (August 2002). He may want to consider using longer time periods that may be less affected by seasonal or random variations in demand.

e. Behavioral factors are likely to be a challenge to Flair. He must now tell those salespeople who specialize in Ma and Pa accounts that they have been less profitable than previously thought.

5-34 Excel ApplicationActivity-Based Costing

Figure Four, Inc.

Financial DataGeneral Drugstore Ma and Pa

Supermarket Chains StoresAverage Rev. Per Delivery $30,900 $10,500 $1,980

Average Cogs. Per Delivery $30,000 $10,000 $1,800 Number of Deliveries 120 300 1000

Cost-Allocation DataUnits of Cost- Rate per unit of

Total Costs Allocation Base Used Cost-Allocation Activity Area Aug. 1999 Aug. 1999 Base

Order Processing $80,000 2,000 $40 per orderLine Item Ordering 63,840 21,280 $3 per line item per order

Store Deliveries 71,000 1,420 $50 per deliveryCartons Shipped 76,000 76,000 $1 per carton per delivery

Shelf-Stocking 10,240 640 $16 per hour per delivery $301,080

Activity DataGeneral Drugstore Ma and Pa

Supermarket Chains StoresTotal Orders 140 360 1500

Average line items per order 14 12 10Total deliveries 120 300 1000

Average number of cartons per delivery

300 80 16

Average hours shelf-stocking per delivery

3 0.6 0.1

5-32

Page 33: ACTIVITY-BASED COSTING

5-34 (Cont’d.)

Profitability AnalysisGeneral Drugstore Ma and Pa Figure Four Inc.

Supermarket Chains StoresRevenue $3,708,000 $3,150,000 $1,980,000 $8,838,000

Cost of Goods Sold 3,600,000 3,000,000 1,800,000 $8,400,000 Gross Profits 108,000 150,000 180,000 438,000

Gross Margin Percentage 2.9% 4.8% 9.1% 5.0%Order Processing Cost 5,600 14,400 60,000

Line Item Ordering Cost 5,880 12,960 45,000 Delivery Cost 6,000 15,000 50,000

Cost of Cartons 36,000 24,000 16,000 Shelf Stocking Cost 5,760 2,880 1,600

Total Operating Costs 59,240 69,240 172,600 301,080

Operating Income $48,760 $80,760 $7,400 $136,920 Operating Margin Percentage 1.3% 2.6% 0.4% 1.5%

5-33

Page 34: ACTIVITY-BASED COSTING

5-35 (30−40 min.) Activity-based costing, product-cost cross-subsidization.

The motivation for Problem 5-35 came from "ABC Minicase: Let them Eat Cake," Cost Management Update (Issue No. 31).

1.Budgeted MOH

rate in 2001 =

= $1.054 per one-pound unit of cake

Raisin Cake Layered Carrot CakeDirect manufacturing cost per unit Direct materials Direct manufacturing laborIndirect manuf. cost per unit Manufacturing overhead ($1.054 × 1, $1.054 ×1) Total manufacturing cost per unit

$0.600 0 .140

$1.054

$0.740

1 .054 $1 .794

$0.900 0 .200

$1.054

$1.100

1 .054 $2 .154

2. ABC costs for 120,000 one-pound units of raisin cake and 80,000 one-pound units of layered carrot cake in 2004 follow:

Raisin Cake Layered Carrot CakeTotal Costs

(1)Per Unit Cost

(2) = (1) ÷ 120,000Total Costs

(3)Per Unit Cost

(4) = (3) ÷ 80,000

Direct costsDirect materials $ 72,000 $0.60 $ 72,000 $0.90Direct manufacturing labor 16,800 0 .14 16,000 0 .20 Total direct costs 88,800 0 .74 88,000 1 .10 Indirect costs

Mixing $0.04 × 600,000 24,000 0.20 $0.04 × 640,000 25,600 0.32

Cooking $0.14 × 240,000 33,600 0.28 $0.14 × 240,000 33,600 0.42

Cooling $0.02 × 360,000 7,200 0.06 $0.02 × 400,000 8,000 0.10

Creaming/Icing $0.25 × 0 0 0 $0.25 × 240,000 60,000 0.75

Packaging $0.08 × 360,000 28,800 0.24 $0.08 × 560,000 44,800 0 .56 Total indirect costs 93,600 0 .78 172,000 2 .15 Total costs $182,400 $1 .52 $260,000 $3 .25

5-35 (Cont’d.)

5-34

Page 35: ACTIVITY-BASED COSTING

Note that the significant shift in product mix will cause absorbed costs (based on budgeted rates and actual quantities of the cost-allocation base) to be different from the budgeted manufacturing overhead costs.

3. The unit product costs in requirements 1 and 2 differ only in the assignment of indirect costs to individual products.

The ABC system recognizes that indirect resources used per pound of layered carrot cake is 2.76 ($2.15 ÷ $0.78) times the indirect resources used per pound of raisin cake. The existing costing system erroneously assumes equal usage of activity areas by a pound of raisin cake and a pound of layered carrot cake.

4. Uses of activity-based cost numbers include:

a. Pricing decisions. BD can use the ABC data to decide preliminary prices for negotiating with its customers. Raisin cake is currently overcosted, while layered carrot cake is undercosted. Actual production of layered carrot cake is 100% more than budgeted. One explanation could be the underpricing of the layered carrot cake.

b. Product emphasis. BD has more accurate information about the profitability of the products with ABC. BD can use this information for deciding which products to push (especially if there are production constraints).

c. Product design. ABC provides a road map on how a change in product design can reduce costs. The percentage breakdown of total indirect costs for each product is:

Raisin Cake Layered Carrot CakeMixing 25.6% ($0.20/$0.78) 14.9% ($0.32/$2.15)Cooking 35.9 19.5Cooling 7.7 4.7Creaming/Icing 0.0 34.9Packaging 30 .8 26 .0

100 .0 % 100 .0 %

BD can reduce the cost of either cake by reducing its usage of each activity area. For example, BD can reduce raisin cake's cost by sizably reducing its cooking time or packaging time. Similarly, a sizable reduction in creaming/icing will have a marked reduction in the costs of the layered carrot cake. Of course, BD must seek efficiency improvements without compromising quality.

d. Process improvements. Improvements in how activity areas are configured will cause a reduction in the costs of products that use those activity areas.

e. Cost planning and flexible budgeting. ABC provides a more refined model to forecast costs of BD and to explain why actual costs differ from budgeted costs.

5-35

Page 36: ACTIVITY-BASED COSTING

5-36 (40 min.) ABC, health care.

1a. Medical supplies rate = years-patient ofnumber Total

costs supplies Medical =

150

$300,000 = $2,000/patient-year

= space offeet square ofamount Total

costs maint. clinic andRent =

30,000

$180,000 = $6 per square foot

= years-patient ofnumber Total

laundry food, charts,

patient manage tocosts Admin.

= 150

$600,000 = $4,000/patient-year

Laboratory services rate = testslaboratory ofnumber Total

costs services Laboratory =

2,500

$100,000 = $40 per test

These cost drivers are chosen as the ones that best match the descriptions of why the costs arise. Other answers are acceptable, provided clear explanations are given.

1b. Activity-based costs for each program and cost per patient-year of the alcohol and drug program follow:

Alcohol Drug After-Care Direct labor

Physicians at $150,000 × 0; 4; 0 — $ 600,000 — Psychologists at $75,000 × 6; 4; 8 $450,000 300,000 $600,000Nurses at $30,000 × 4; 6; 10 120,000 180,000 300,000

Direct labor costs 570,000 1,080,000 900,000Medical supplies1 $2,000 × 40; 50; 60 80,000 100,000 120,000Rent and clinic maintenance2

$6 × 9,000; 9,000; 12,000 54,000 54,000 72,000Administrative costs to manage

patient charts, food, and laundry3

$4,000 × 40; 50; 60 160,000 200,000 240,000Laboratory services4 $40 × 400; 1,400; 700 16,000 56,000 28,000Total costs $880,000 $1,490,000 $1,360,000

Cost per patient-year 40

$880,000= $22,000

50

$1,490,000 = $29,800

1Allocated using patient-years2Allocated using square feet of space3Allocated using patient-years4Allocated using number of laboratory tests

5-36

Page 37: ACTIVITY-BASED COSTING

5-36 (Cont’d.)

1c. The ABC system more accurately allocates costs because it identifies better cost drivers. The ABC system chooses cost drivers for overhead costs that have a cause-and-effect relationship between the cost drivers and the costs. Of course, Clayton should continue to evaluate if better cost drivers can be found than the ones they have identified so far.

By implementing the ABC system, Clayton can gain a more detailed understanding of costs and cost drivers. This is valuable information from a cost management perspective. The system can yield insight into the efficiencies with which various activities are performed. Clayton can then examine if redundant activities can be eliminated. Clayton can study trends and work toward improving the efficiency of the activities.

In addition, the ABC system will help Clayton determine which programs are the most costly to operate. This will be useful in making long-run decisions as to which programs to offer or emphasize. The ABC system will also assist Clayton in setting prices for the programs that more accurately reflect the costs of each program.

2. The concern with using costs per patient-year as the rule to allocate resources among its programs is that it emphasizes “input” to the exclusion of “outputs” or effectiveness of the programs. After-all, Clayton’s goal is to cure patients while controlling costs, not minimize costs per-patient year. The problem, of course, is measuring outputs.

Unlike many manufacturing companies, where the outputs are obvious because they are tangible and measurable, the outputs of service organizations are more difficult to measure. Examples are “cured” patients as distinguished from “processed” or “discharged” patients, “educated” as distinguished from “partially educated” students, and so on.

5-37

Page 38: ACTIVITY-BASED COSTING

5-37 (15 min.) Activity-based job costing.

Executive Chair Chairman Chair1. Direct manufacturing costs:

Direct materials $ 600,000 $25,000Direct manufacturing labor,

$20 × 7,500; $20 × 500 150,000 10,000Direct manufacturing costs 750,000 35,000

Indirect manufacturing costsMaterials handling,

$0.25 × 100,000; $0.25 × 3,500 25,000 875Cutting,

$2.50 × 100,000; $2.50 × 3,500 250,000 8,750Assembly,

$25.00 × 7,500; $25.00 × 500 187,500 12,500Total indirect manufacturing costs 462,500 22,125

Total manufacturing costs $1,212,500 $57,125

Unit CostsExecutive chair: $1,212,500 ÷ 5,000 = $242.50Chairman chair: $57,125 ÷ 100 = $571.25

2. Executive Chair Chairman ChairUpstream costs $ 60.00 $146.00Manufacturing costs 242.50 571.25Downstream costs 110.00 236.00Total costs $412.50 $953.25

3. In requirement 1, the costs for each chair include only manufacturing costs. In requirement 2, the costs for each chair include manufacturing costs as well as upstream costs and downstream costs. It is important for Schramka Company to take into account other than manufacturing costs for strategic decisions, especially long-term pricing decisions and product emphasis. When comparing the Executive Chair and the Chairman Chair, the Chairman Chair uses more of the upstream and downstream activities per unit than does the Executive Chair. The Chairman Chair also uses more of the manufacturing activities per unit than the Executive Chair.

5-38

Page 39: ACTIVITY-BASED COSTING

5-38 (40−50 min.) Activity-based job costing, unit-cost comparisons.

An overview of the product-costing system is:

1.Job Order 410 Job Order 411

Direct manufacturing costs:Direct materialsDirect manufacturing labor

$30 × 25; $30 × 375Indirect manufacturing costs

$115 × 25; $115 × 375Total manufacturing costsNumber of unitsManufacturing costs per unit

$9,700

750 $10,450

2,875$13,325

÷ 10 $ 1,332 .50

$59,900

11,250 $ 71,150

43,125$114,275÷ 200 $ 571 .375

5-39

INDIRECTCOSTPOOL

COSTALLOCATION

BASE

DIRECTCOST

}

}

}

MaterialsHandling

Number ofParts

DirectMaterials

}

COST OBJECT:COMPONENTS

Indirect Costs

Direct Costs

DirectManufacturing

Labor

LatheWork

Number ofTurns

Milling

Number ofMachine-Hours

Grinding

Number ofParts

Testing

Number ofUnits

Tested

Page 40: ACTIVITY-BASED COSTING

5-38 (Cont’d.)2. Job Order 410 Job Order 411

Direct manufacturing costs:Direct materialsDirect manufacturing labor

$30 × 25; $30 × 375Indirect manufacturing costs:

Materials handling $0.40 × 500; $0.40 × 2,000Lathe work $0.20 × 20,000; $0.20 × 60,000Milling $20.00 × 150; $20.00 × 1,050Grinding $0.80 × 500; $0.80 × 2,000Testing $15.00 × 10; $15.00 × 200

Total manufacturing costsNumber of units per jobUnit manufacturing cost per job

$9,700

750 $10,450

200

4,000

3,000

400

150 7,750$18,200

÷ 10$ 1,820

$59,900

11,250 $ 71,150

800

12,000

21,000

1,600

3,000 38,400$109,550÷ 200 $ 547 .75

3. Job Order 410 Job Order 411Number of units in job 10 200Costs per unit with prior costing system $1,332.50 $571.375Costs per unit with activity-based costing 1,820.00 547.75

Job order 410 has an increase in reported unit cost of 36.6% [($1,820 – $1,332.50) ÷ $1,332.50], while job order 411 has a decrease in reported unit cost of 4.1% [($547.75 – $571.375) ÷ $571.375].

A common finding when activity-based costing is implemented is that low-volume products have increases in their reported costs while high-volume products have decreases in their reported cost. This result is also found in requirements 1 and 2 of this problem. Costs such as materials-handling costs vary with the number of parts handled (a function of batches and complexity of products) rather than with direct manufacturing labor-hours, an output-unit level cost driver, which was the only cost driver in the previous job-costing system.

The product cost figures computed in requirements 1 and 2 differ because:a. the job orders differ in the way they use each of five activity areas, andb. the activity areas differ in their indirect cost allocation bases (specifically, each area does not use the direct manufacturing labor-hours indirect cost allocation base).

The following table documents how the two job orders differ in the way they use each of the five activity areas included in indirect manufacturing costs:

5-40

Page 41: ACTIVITY-BASED COSTING

5-38 (Cont’d.)Usage Based on Analysis ofActivity Area Cost Drivers

Usage Assumed with Direct Manuf.Labor-Hours as Application Base

Activity Area Job Order 410 Job Order 411 Job Order 410 Job Order 411Materials handling 20.0% 80.0% 6.25% 93.75%Lathe work 25.0 75.0 6.25 93.75Milling 12.5 87.5 6.25 93.75Grinding 20.0 80.0 6.25 93.75Testing 4.8 95.2 6.25 93.75

The differences in product cost figures might be important to Tracy Corporation for product pricing and product emphasis decisions. The activity-based accounting approach indicates that job order 410 is being undercosted while job order 411 is being overcosted. Tracy Corporation may erroneously push job order 410 and deemphasize job order 411. Moreover, by its actions, Tracy Corporation may encourage a competitor to enter the market for job order 411 and take market share away from it.

4. Information from the ABC system can also help Tracy manage its business better in several ways.

a. Product design. Product designers at Tracy Corporation likely will find the numbers in the activity-based costing approach more believable and credible than those in the existing system. In a machine-paced manufacturing environment, it is unlikely that direct labor-hours would be the major cost driver. Activity-based costing provides more credible signals to product designers about the ways the costs of a product can be reduced––for example, use fewer parts, require fewer turns on the lathe, and reduce the number of machine-hours in the milling area.b. Cost management. Tracy can reduce the cost of jobs both by making process improvements that reduce the activities that need to be done to complete jobs and by reducing the costs of doing the activities.c. Cost planning. ABC provides a more refined model to forecast costs and to explain why actual costs differ from budgeted costs.

5-41

Page 42: ACTIVITY-BASED COSTING

5-39 (50 min.) ABC, implementation, ethics.

1. Applewood Electronics should not emphasize the Regal model and phase out the Monarch model. Under activity-based costing, the Regal model has an operating income percentage of less than 3%, while the Monarch model has an operating income percentage of nearly 43%.

Cost driver rates for the various activities identified in the activity-based costing (ABC) system are as follows:

Soldering $ 942,000 ÷ 1,570,000 = $ 0.60 per solder point

Shipments 860,000 ÷ 20,000 = 43.00 per shipmentQuality control 1,240,000 ÷ 77,500 = 16.00 per inspectionPurchase orders 950,400 ÷ 190,080 = 5.00 per orderMachine power 57,600 ÷ 192,000 = 0.30 per machine-hourMachine setups 750,000 ÷ 30,000 = 25.00 per setup

Applewood ElectronicsCalculation of Costs of Each Model

under Activity-Based Costing

Monarch RegalDirect costs

Direct materials ($208 × 22,000; $584 × 4,000)$ 4,576,000 $2,336,000Direct manufacturing labor ($18 × 22,000; $42 × 4,000)396,000 168,000

Machine costs ($144 × 22,000; $72 × 4,000) 3,168,000 288,000Total direct costs 8,140,000 2,792,000

Indirect costsSoldering ($0.60 × 1,185,000; $0.60 × 385,000) 711,000 231,000

Shipments ($43 × 16,200; $43 × 3,800) 696,600 163,400Quality control ($16 × 56,200; $16 × 21,300) 899,200 340,800

Purchase orders ($5 × 80,100; $5 × 109,980) 400,500 549,900Machine power ($0.30 × 176,000; $0.30 × 16,000) 52,800 4,800Machine setups ($25 × 16,000; $25 × 14,000) 400,000 350,000

Total indirect costs 3,160,100 1,639,900Total costs $11,300,100 $4,431,900

5-42

Page 43: ACTIVITY-BASED COSTING

5-39 (Cont’d.)

Profitability analysisMonarch Regal Total

Revenues $19,800,000 $4,560,000 $24,360,000Cost of goods sold 11,300,100 4,431,900 15,732,000Gross margin $ 8,499,900 $ 128,100 $ 8,628,000

Per-unit calculations:Units sold 22,000 4,000

Selling price ($19,800,000 ÷ 22,000; $4,560,000 ÷ 4,000) $900.00 $1,140.00Cost of goods sold ($11,300,100 ÷ 22,000;

$4,431,900 ÷ 4,000) 513.64 1,107.98 Gross margin $386.36 $ 32.02Gross margin percentage 42.9% 2.8%

2. Applewood’s existing costing system allocates all manufacturing overhead other than machine costs on the basis of machine-hours, an output unit-level cost driver. Consequently, the more machine-hours per unit that a product needs, the greater the manufacturing overhead allocated to it. Because Monarch uses twice the number of machine-hours per unit compared to Regal, a large amount of manufacturing overhead is allocated to Monarch.

The ABC analysis recognizes several batch-level cost drivers such as purchase orders, shipments, and setups. Regal uses these resources much more intensively than Monarch. The ABC system recognizes Regal’s use of these overhead resources. Consider, for example, purchase order costs. The existing system allocates these costs on the basis of machine-hours. As a result, each unit of Monarch is allocated twice the purchase order costs of each unit of Regal. The ABC system allocates $400,500 of purchase order costs to Monarch (equal to $18.20 ($400,500 ÷ 22,000) per unit) and $549,900 of purchase order costs to Regal (equal to $137.48 ($549,900 ÷ 4,000) per unit). Each unit of Regal uses 7.55 ($137.48 ÷ $18.20) times the purchases order costs of each unit of Monarch.

Recognizing Regal’s more intensive use of manufacturing overhead results in Regal showing a much lower profitability under the ABC system. By the same token, the ABC analysis shows that Monarch is quite profitable. The existing costing system overcosted Monarch, and so made it appear less profitable.

3. Duvals comments about ABC implementation are valid. When designing and implementing ABC systems, managers and management accountants need to trade off the costs of the system against its benefits. Adding more activities makes the system harder to understand and more costly to implement but would probably improve the accuracy of cost information, which, in turn, would help Applewood make better decisions. Similarly, using inspection-hours and setup-hours as allocation bases would also probably lead to more accurate cost information but would increase measurement costs.

5-43

Page 44: ACTIVITY-BASED COSTING

5-39 (Cont’d.)

4. Activity-based management (ABM) is the use of information from activity-based costing to make improvements in a firm. For example, a firm could revise product prices on the basis of revised cost information. For the long term, activity-based costing can assist management in making decisions regarding the viability of product lines, distribution channels, marketing strategies, etc. ABM highlights possible improvements, including reduction or elimination of non-value-added activities, selecting lower cost activities, sharing activities with other products, and eliminating waste. ABM is an integrated approach that focuses management’s attention on activities with the ultimate aim of continuous improvement. As a whole-company philosophy, ABM focuses on strategic, as well as tactical and operational activities of the company.

5. Incorrect reporting of ABC costs with the goal of retaining both the Monarch and Regal product lines is unethical. In assessing the situation, the specific “Standards of Ethical Conduct for Management Accountants” (described in Exhibit 1-7) that the management accountant should consider are listed below.

CompetenceClear reports using relevant and reliable information should be prepared. Preparing reports on the basis of incorrect costs in order to retain product lines violates competence standards. It is unethical for Benzo to change the ABC system with the specific goal of reporting different product cost numbers that Duval favors.

IntegrityThe management accountant has a responsibility to avoid actual or apparent conflicts of interest and advise all appropriate parties of any potential conflict. Benzo may be tempted to change the product cost numbers to please Duval, the Division President. This action, however, would violate the responsibility for integrity. The Standards of Ethical Conduct require the management accountant to communicate favorable as well as unfavorable information.

ObjectivityThe management accountant’s standards of ethical conduct require that information should be fairly and objectively communicated and that all relevant information should be disclosed. From a management accountant’s standpoint, adjusting the product cost numbers to make both the Monarch and Regal lines look profitable would violate the standard of objectivity.

Benzo should indicate to Duval that the product cost calculations are, indeed, appropriate. If Duval still insists on modifying the product cost numbers, Benzo should raise the matter with one of Duval’s superiors. If, after taking all these steps, there is continued pressure to modify product cost numbers, Benzo should consider resigning from the company, rather than engage in unethical behavior.

5-44

Page 45: ACTIVITY-BASED COSTING

5-40 (40-60 min.) Activity-based costing, cost hierarchy.

This solution is adapted from the CMA suggested solution.

1a. Budgeted manufacturing overhead rate = costlabor direct Budgeted

overhead ingmanufactur Budgeted

= $600,000

$3,000,000

= $5 per direct labor-dollar1b.

Mauna Loa MalaysianDirect costs

Direct materials $4.20 $3.20Direct labor 0.30 0.30

4.50 3.50Indirect costs

Manufacturing overhead(0.30 × $5.00) 1.50 1.50

Total costs $6.00 $5.00

Budgeted selling prices per pound:Mauna Loa ($6.00 × 1.30) = $7.80Malaysian ($5.00 × 1.30) = $6.50

2. The total budgeted unit costs per pound are:

Mauna Loa Coffee Malaysian Coffee Direct costs per unit Direct costs per unit Direct materials $4.20 Direct materials $3.20

Direct labor 0.30 $4.50 Direct labor 0.30 $3.50

Indirect costs per unit Indirect costs per unitPurchase orders Purchase orders (4 orders × $500 ÷ 100,000 lbs.) 0.02 (4 orders × $500 ÷ 2,000 lbs.) 1.00Material handling Material handling (30 setups × $400 ÷ 100,000 lbs.) 0.12 (12 setups × $400 ÷ 2,000 lbs.) 2.40Quality control Quality control (10 batches × $240 ÷ 100,000 lbs.) 0.02 (4 batches × $240 ÷ 2,000 lbs.) 0.48Roasting Roasting (1,000 hours × $10 ÷ 100,000 lbs.) 0.10 (20 hours × $10 ÷ 2,000 lbs.) 0.10Blending Blending (500 hours × $10 ÷ 100,000 lbs.) 0.05 (10 hours × $10 ÷ 2,000 lbs.) 0.05Packaging Packaging (100 hours × $10 ÷ 100,000 lbs.) 0.01 0.32 (2 hours × $10 ÷ 2,000 lbs.) 0.01 4.04

Total cost per unit $4.82 Total cost unit $7.54

5-45

Page 46: ACTIVITY-BASED COSTING

5-40 (Cont’d.)

The comparative cost numbers are:

Mauna Loa Malaysian

Requirement 1 $6.00 $5.00Requirement 2 4.82 7.54

The ABC system in requirement 2 reports a decreased cost for the high-volume Mauna Loa and an increased cost for the low-volume Malaysian.

3. The traditional costing approach leads to cross-subsidization between the two products.With the traditional approach, the high-volume Mauna Loa is overcosted, while the low-volume Malaysian is undercosted. The ABC system indicates that Mauna Loa is profitable and should be emphasized.

Pricing of Mauna 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. Coffee Bean may wish to have lower margins with its low-volume products in an attempt to build up volume.

5-46

Page 47: ACTIVITY-BASED COSTING

Chapter 5 Internet Exercise

The Internet exercise is available to students only on the Prentice Hall Companion Website www.prenhall.com/horngren. Students can click on Cost Accounting, 11th ed., and access the Internet Exercise for the chapter, which links to the Web site of a company or organization. The Internet Exercise on the Web will be updated periodically so that it is current with the latest information available on the subject organization's Web site. A printout copy of the Internet exercise for this chapter as of early 2002 appears below.

The solution to the Internet exercise, which will also be updated periodically, is available to instructors from the Companion Website's faculty view. To access the solution, click on Cost Accounting, 11th ed., Faculty link, and then register once to obtain your password through the online form. After the initial registration, you will have a personal login ID and password to use to log in. A printout of the solution to the Internet exercise for this chapter as of early 2002 follows. The exercise and solution provide instructors with an idea of the content of the Internet exercise for this chapter.

Internet Exercise

Southwest Airlines provides an excellent example of how activity-based costing (ABC) can affect Southwest’s strategic planning and pricing decisions. Southwest is the nation's fifth largest domestic carrier, and just marked its twenty-eighth consecutive year of profitability. Southwest has the lowest operating cost structure in the domestic airline industry. Several factors contribute to this success. One is Southwest's commitment to a single type of aircraft, Boeing 737s. Another is its focus on short haul point-to-point service.

Go to www.iflyswa.com/, and click on the "About SWA" link, followed by the "Investor Relations" link. From here you can access Southwest's 2000 annual report in Adobe Acrobat pdf format. Skim pages 7-15 of the 2000 annual report and answer the following questions:

1. How does Southwest's commitment to a single type of aircraft reduce costs?

2a. Aircraft maintenance costs include training, wages, parts, maintenance facilities, special tools, and aircraft downtime. Explain how Southwest's commitment to a single type of aircraft might reduce each of these costs.

2b. What cost driver(s) might Southwest use to allocate maintenance costs?

3. Southwest provides shorthaul point-to-point service. Its average flight is 509 miles and lasts about an hour and a half. It does not serve in-flight meals, and it utilizes open seating (first come, first served) for aircraft boarding. How does this strategy reduce costs?

4. What cost driver(s) might Southwest use to allocate fuel and oil costs, agency commissions, aircraft rentals, landing fees, and depreciation?

5. Salaries, wages, and benefits are Southwest's most significant cost, accounting for more than one-third of all operating expenses. What cost driver(s) might Southwest use to allocate salaries, wages, and benefits? Consider pilots, flight crews, ground support, and back-office personnel.

6. What impact has the Internet had on Southwest's ticketing costs and fare structure?

5-47

Page 48: ACTIVITY-BASED COSTING

Internet Exercise (Cont’d.)Solution to Internet Exercise

1. Its commitment to a single type of aircraft simplifies its operations in terms of maintenance, scheduling, staffing, and training. Pilots can fly any plane, mechanics can service any plane, and flight crews can staff any flight. This minimizes training costs, spare part inventories, the time aircraft spend at the gate being serviced, maintenance costs, scheduling costs, and staffing costs.

2a. Training costs are likely to be lower due to fewer training seminars and single aircraft certifications. Scheduling flexibility may result in less overtime and greater efficiency at performing maintenance. Southwest can hold fewer replacement parts to meet scheduled maintenance and unexpected repairs. A single size hanger can handle all planes, eliminating the need for oversized hangers to accommodate a few large aircraft. Aircraft maintenance requires special tools. Use of a single aircraft reduces the need for tools. Since any mechanic can handle any aircraft, lost-flight time is minimized.

2b. Flight time (hours) would be an appropriate cost driver for allocating most maintenance costs. A wage rate differential might be considered if labor costs vary significantly from market to market. In addition, the cost of maintenance facilities should be allocated to flights arriving and departing at each location.

3. The shorthaul point-to-point service minimizes the ground time for aircraft at the gate and results in higher aircraft and airport utilization. Southwest does not serve meals on most flights so this reduces operating costs and the time the planes are at the gate. The open seating policy reduces office and processing costs, and also reduces downtime of the planes.

4. Flight time (hours) would be an appropriate cost driver for allocating fuel and oil costs, depreciation, and aircraft rentals. Number of passengers would be an appropriate cost driver for agency commissions. Landing fees should be allocated to flights arriving and departing at each location. Fixed landing fees should be allocated on a per flight basis, while passenger-based fees should be allocated based on the number of passengers.

5.Pilots: Flight time would be an appropriate cost driver for pilots’ salaries. Flight attendants: Since the number of flight attendants increases with the number of passengers, flight time and the number of passengers would be appropriate cost drivers for flight attendants’ salaries.Ground Support: Cost drivers for salaries and wages of gate attendants, baggage handlers, and other airport staff are the number of passengers and the number of flights. Costs should be allocated to arrivals and departures at each location.Back-office personnel: Back-office personnel handle tasks such as scheduling and processing tickets. The number of flights and number of passengers would be appropriate cost drivers for salaries and wages of back-office personnel. 6. Southwest sells over 30% of its seats through its Web site. In addition to lowering commission costs, this has resulted in a greater use of e-tickets (electronic tickets). E-tickets speed check-in times and reduce back-office processing costs. These factors result in lower costs and lower fares.

5-48

Page 49: ACTIVITY-BASED COSTING

Internet Exercise (Cont.’d)

Airlines don't make money flying empty planes, and the marginal (variable) cost of flying an additional passenger is very low. Southwest's Web site allows it to better manage its inventory of vacant seats through promotions and special fares. Its load factor, the proportion of a plane's seats that are occupied on each flight, is consistently the highest in the industry. Its load factor was a record 70.5% in 2000.

Chapter 5 Video Case

The video case can be discussed using only the case writeup in the chapter. Alternatively, instructors can have students view the videotape of the company that is the subject of the case. The videotape can be obtained by contacting your Prentice Hall representative. The case questions challenge students to apply the concepts learned in the chapter to a specific business situation.

DELL COMPUTER CORPORATION ACTIVITY-BASED COSTING

1. Each functional area was going to be affected by the change to activity-based costing, so it was critical to have the participation and buy-in of managers in every functional area. The participants from each area also brought knowledge specific to their functions that was needed to complete the picture of activities across the company and understand the cost drivers of each activity.

2. In Dell’s situation, job costing was used to collect costs for direct labor, direct materials, and overhead (facilities costs). Overhead was allocated to jobs – computers – based on a predetermined allocation rate such as machine-hours, square footage, or something else. Dell actually used “engineering complexity” as its basis for allocation. Computers that took more time to “engineer” received a higher proportion of overhead costs. The problem with this approach was that some product lines received overhead allocations that didn’t make sense and led to incorrect product cost information.

The risk of not making a change was bad decisions. For example, Dell used to distribute computers through various consumer retail outlets. After analyzing the cost of such distribution channels as part of its ABC system, managers discovered that this approach was not nearly as profitable as the direct sales model that Dell now uses exclusively. The information generated by ABC can be used to pinpoint areas in operations where cost control may need tightening, or activities need closer monitoring.

3. In retrospect, it was a good decision. Ten activities seemed to be a good, manageable number to keep managers on task. Too many activities, and the process of developing an ABC system could be overwhelming, especially when people have other job responsibilities. Too few activities, and the benefits of ABC might not be realized. For Dell, the chosen activities mirrored the flow of production and business, so it made sense to design the ABC system around these activities.

5-49