ABC Blocher Solutions

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.

Blocher,Stout,Cokins,Chen:Cost Management, 4e

5-1

©The McGraw-Hill Companies, Inc., 2008

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.


5-2


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.


5-2


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.


5-3


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. .


5-4


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) Difference = $21 – $20 = $1

= $21

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 Labor Cost Inspection Cost Packaging Cost

= $3,000,000 / 100,000 = $30 per camera = $500,000 / (100,000 x .5) = $10 per camera = $1,000,000 / (100,000 x .2) = $50 per camera = $500,000 / 100,000 = $5 per camera

5-24

Direct Labor Copying Total Job Cost

= $8 x 5 = $40 = $0.05 x 1,000 = $50 = $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


5-5


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


5-6


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


5-7


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


5-8


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


5-9


5-32 Activity Levels and Cost Drivers - Service Company (15 min)

1. Output unit-level costs: a. Salaries and wages of lab technicians b. Equipment-related costs

$1,200,000 $ 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)

ST PRT

Setup Hours Test-Hours Total Per Test-Hour 10,000 8,500 0.850 20,000

11,500


0.575

5-10

Test Design Hours Total Per Test-Hour 5,800 0.58 4,200

0.21


5-32 (continued) 3.

ST

$540,000

Per Hour 10,000 54.00

100,000

$10.00

Total

Test hours Salaries and Wages Equipment-related costs* ST PRT Setup costs# ST PRT Test design costs & ST PRT TOTAL *Equipment-related costs Test hours Per test hour Total # Setup costs: Setup hours Per hour Total & Test design costs: Test design hours Per hour Total

PRT Total

Per Hour TOTAL 20,000 30,000 $660,000 $33.00 $1,200,000

200,000

$10.00

138,000

$6.90

208,800 $20.88 ________ ______ 151,200 $950,800 $95.08 $1,149,200

7.56 $57.46

102,000

$10.20

10,000

20,000

100,000

200,000

8,500

11,500

102,000

138,000

5,800

4,200

208,800

151,200


5-11

$300,000 30,000 $10 $240,000 20,000 $12.00 $360,000 10,000 $36.00


5-32 (continued-2) 4. ST Total Per Hour 2,500 $135,000 $54.00

PRT Total Per Hour TOTAL 5,000 7,500 $165,000 $33.00 $300,000

Test hours Salaries and Wages Equipment-related costs* ST 100,000 $40.00 PRT 200,000 Setup costs# ST 255,000 $102.00 PRT $345,000 Test design costs & ST 522,000 $208.80 PRT _________ _______ 378,000 TOTAL $1,012,000 $404.80 $1,088,000 *Equipment-related costs: Test hours Per test hour Total # Setup costs: Setup hours Per hour Total & Test design costs: Test design hours Per hour Total

2,500

5,000

100,000 $240,000 $360,000 8,500

200,000

255,000 $360,000 $540,000 5,800

345,000

522,000

11,500

4,200

$40.00

$69.00

$75.60 $217.60

$300,000 7,500 $40 $600,000 20,000 $30.00 $900,000 10,000 $90.00

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. Blocher,Stout,Cokins,Chen:Cost Management, 4e

5-12


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 volumebased 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.


5-13


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-valueadded activities.


5-14


5-34 Activity-Based Costing   H akara Company (10 min)

Cost Pools

Activity Costs

Machine setup Materials handling Electric power

$360,000 100,000 40,000

Cost Drivers

Overhead Rate

3,000 setup hours

$120

25,000 pounds

4

40,000 kilowatt hours

1

A Direct materials

B $40,000

$50,000

24,000

40,000

Direct labor 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 Production units COST PER UNIT


$94,000

$134,800

4,000

÷ 20,000

$23.50

$6.74

÷

5-15


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 highpaying 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 .


5-16


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.


5-17


5-37 Activity-Based Costing in the Fashion Apparel Industry (20 min) The ABC-costing solution follows:

(all figures in £) Price Total Revenue

20.525 205,250

Direct Materials Labour and Overhead Costs Pattern cutting Grading Lay planning Sewing Finishing Inspection Boxing up Storage Labor and Overhead (ABC-based) Total Product Cost Unit Product Cost Non-manufacturing Expenses Total Cost

33,750 22,000 19,000 18,500 21,000 14,300 6,500 3,500 7,000 111,800 145,550 14.56 31500 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 volumebased 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) Blocher,Stout,Cokins,Chen:Cost Management, 4e

5-18


5-38 Service Industry   G WS 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 =

Total ICU applied overhead costs:

$60 x 5,900 =

$60 $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 Cost Pool Beds

Budgeted Cost $810,000

Activity 900

Budgeted Total Applied OH Rate Activity Overhead $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.


5-19


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.


5-20


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


5-21


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

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

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


5-22


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

Cost per completed board

50% $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

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)


115.00

5-23

$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.


5-24


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

Frozen Food Baked Goods Fresh Produce Sales Cost of goods sold Gross margin

$120,000

$90,000

$158,125

105,000

67,000

110,000

$ 15,000

$23,000

$ 48,125

24,000

18,000

31,625

($ 9,000)

$ 5,000

$ 16,500

-7.50%

5.56%

10.43%

Store support (20% of Sales) Operating income Operating margin (OI/S)

2. Product-line profitability under ABC Frozen Food Baked Goods Fresh Produce Sales Cost of goods sold Gross margin

$120,000

$90,000

$158,125

105,000

67,000

110,000

$ 15,000

$23,000

$ 48,125

800

4,400

7,200

1,100

7,700

13,200

300

525

7,200

6,000

8,000

17,200

8,200

20,625

44,800

$ 6,800

$ 2,375

5.67%

2.64%

Store support: Order processing Receiving Shelf-stocking Customer support Total store support cost Operating income Operating margin (OI/S)

$

3,325 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.


5-25


5-46 Customer Profitability Analysis Analysis (25 minutes)

Requirement 1 Jerry Inc.

Donald Co.

Customer unit-level cost Sales returns(40x5;175x5) Customer batch-level costs: Order processing(5x300;30x300) Sales returns(2x100;5x100) Delivery(5x500;30x500) Customer sustaining costs: Sales calls(12x1000;4x1000) TOTAL

$200

$875

$1,500 200 2,500

$9,000 500 15,000

12,000 $16,400

4,000 $29,375

Requirement 2 Jerry Inc. Sales(5x1000x200;200x30x200) Sales return(40x200;175x200) Net Sales Cost of goods sold(75%) Gross margin(25%) Sales support cost (from req. 1) Operating income Operating margin %


5-26

Donald Co.

$1,000,000 8,000 $992,000 744,000 $248,000 16,400 $231,600

$1,200,000 35,000 $1,165,000 873,750 $291,250 29,375 $261,875

23.35%

22.48%


5-47 Customer Profitability Analysis 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 Number of orders per block

40,200 ÷

Total number of blocks Cost per block

60 670

x $60,000

Total cost of order blocks

$ 40,200,000

Total number of orders Per order order-filling cost

40,200 x $1,500

Total cost per order

+

Total order-filling cost

$100,500,000

Total units sold

÷

Order-filling cost per unit


60,300,000

1,000,000 $100.50

5-27


5-47 (continued)

2. Order filling cost per unit sold to PC: Total number of orders

2

Number of orders per block

÷

Total number of blocks

60 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


+ 3,000


$5,000 ÷ 5,000

Total units sold 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 Order-filling cost/unit

$600.00 +

Total cost per unit

601.00

Net Profit per unit

$ 99.00

Profit margin per unit


1.00

14.14%

5-28


5-47 (continued-2)

3. Order filling cost per order by SC: Cost per block Number of orders per block

$60,000

Block cost per order Number of orders per SC

60

)

$1,000 x

10

Total block cost per SC

$10,000

Order-filling cost per order Number of orders per SC

$1,500 x

10


+ 15,000


$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

$

Profit margin


0

0

5-29


PROBLEMS

5-48 Activity-Based Costing; Customer Group Cost Analysis (30 minutes)

1. First, obtain the total levels for activity cost drivers: Product Lines Units Produced Direct Materials cost per unit Total Direct Materials Cost Number of Parts per unit Total parts Direct Labor Hours per unit Total Labor hours Machine Hours per unit Total Machine Hours Production Orders Production Setups Orders Shipped

Value 15,000 $ 80

Quality 5,000 $ 50

Luxury 500 $ 110

Total 20,500 $ 240

$ 30

50

120

1,505,000

200 760,000

4

5

7

16 88,500

3

7

15

25 87,500

50 20 1,000

70 50 2,000

200 50 300

320 120 3,300

Then, obtain the activity rates:

Materials handling Product Scheduling Setup Labor Automated Machinery Finishing Pack and Ship

Budgeted Cost $ 349,600 160,000 216,000 1,750,000 619,500 285,000

Cost Driver Number of Parts Number of Production orders Number of setups Machine hours Direct labor hours Number of orders shipped


5-30

Activity Rate $ 0.460 500.00 1,800.00 20.00 7.00 86.364

=$349,600/760,000 =160,000/320 =216,000/120 =1,750,000/87,500 =619,500/88,500 =285,000/3,300


5-48 (continued)

The activity-based unit and total cost is as follows:

Direct Materials Direct Labor Overhead: Materials handling Product Scheduling Setup Labor Automated Machinery Finishing Pack and Ship Total ABC Overhead Unit ABC Cost

$ $

Value 80.00 48.00

$ $

Quality 50.00 60.00

Total ABC Cost

$ $

Luxury 110.00 84.00

$

13.80 1.67 2.40 60.00 28.00 5.76 111.62 239.6242

$

23.00 7.00 18.00 140.00 35.00 34.55 257.55 367.5455

$

55.20 200.00 180.00 300.00 49.00 51.82 836.02 1,030.0182

$

3,594,364

$

1,837,727

$

515,009

2. Direct Materials Direct Labor Overhead Cost per unit Total Cost

$

$ $

Value 80.00 48.00 152.77

280.7729 4,211,593


$

$ $

Quality 50.00 60.00 190.97

300.9661 1,504,831

5-31

$

$ $

Luxury 110.00 84.00 267.35

461.3525 230,676


5-48 (continued)

3. The new activity rates based on practical capacity are as follows.

Materials handling Product Scheduling Setup Labor Automated Machinery Finishing Pack and Ship

Budgeted Cost $ 349,600 160,000 216,000 1,750,000 619,500 285,000 $

Cost Driver Number of Parts Number of Production orders Number of setups Machine hours Direct labor hours Number of orders shipped

Practical Capacity 990,000 800 200 100,000 123,900 5,000

Practical Capacity-Based Rates $ 0.353 200.00 1,080.00 17.50 5.00 57.00

3,380,100

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.


5-32


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 Electrical power (machining) Machine maintenance - labor Machine maintenance - materials Total

$40,000 30,000 11,000 9,000 $90,000

Cost pool 4: Cost driver: Factory space Depreciation, building Electrical power (factory building) Insurance Property taxes Natural gas (for heating) Custodial labor Total

$ 50,000 6,000 20,000 15,000 8,000 51,000 $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 Cost pool 6: Cost driver: engineering hours Engineering design Total


5-33

$7,000 $600,000 $600,000


5-49 (continued)

2.

Overhead Rates: Cost pool 1: Total cost Number of purchase orders Cost per purchase order

$33,000 6 $5,500

Cost pool 2:

Total cost Number of production runs Cost per production run

$20,000 40 $500

Cost pool 3:

Total cost Number of machine hours Cost per machine hour

$ 90,000 100,000 $0.90

Cost pool 4:

Total cost Number of machine hours Cost per machine hour

$150,000 100,000 $1.50

Cost pool 5:

Total cost Number of units Cost per unit

$

Cost pool 6:

Total cost Total engineering hours Cost per engineering hour

$600,000 20,000 $30.00


5-34

7,000 100,000 $0.07


5-49 (continued-2)

Manufacturing overheads: Unit level: Cost pool 3 – Cost per machine hour Number of machine hours

$ 0.90 x 4,250

$ 3,825

Cost pool 5 – Cost per unit $ 0.07 Number of units x 4,000 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 Number of purchase orders

$5,500 x 1

5,500

$ 30 100

3,000

Cost pool 6 – Cost per engineering hour Number of engineering hours Facility-level level*: Cost pool 4 – Cost per machine hour Number of machine hours Total manufacturing overhead Number of units Manufacturing overhead per unit


5-35

x

$ 1.50 x 4,250

280

6,375 $19,980 4,000 ÷ $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) Number of machine hours Cost per machine hour

$150,000 100,000 $1.50

Which is the cost driver for the answer above. Alternatively, the firm may use number of units to assign facilitylevel 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 Cost pool 5

$ 3,825 280

Batch level: Cost pool 2

1,000

Product-level level: Cost pool 1 Cost pool 6

5,500 3,000

Facility-level level: Cost pool 4 – Cost per unit Number of units Total manufacturing overhead Number of units Manufacturing overhead per unit


$ 1.50 x 4,000

5-36

6,000 $ 19,605 4,000 ÷ $4.90125


5-50 Activity-Based Costing, Value Chain Activities (25 min)

1. Prime costs Manufacturing overheads: Material handling Machining Assembly Inspection Total manufacturing costs Number of units Cost per unit

80 x $1,200 =

$ 96,000

80 x 105 x $0.45 = 80 x 3x $51 = 80 x 105 x $2.85 = 80 x $30 =

3,780 12,240 23,940 2,400 $138,360 80 ÷ $1,729.50

2. Upstream activities Manufacturing Downstream activities Full product cost per unit

$180.00 1,729.50 250.00 $2,159.50

8.33% 80.09% 11.58% 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.


5-37


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 machinehours = $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 Cost Pool

Budgeted Overhead

Level of Cost Driver

Predetermined 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

Other overheads

100,000 10,000 machine hrs

$200 per inspection $10 per MH

Overhead Per Barrel: Overhead Cost Pool Rate

Manufacturing Overhead P5 G23 Activity Overhead Activity Overhead

Machine set-ups $1,000 Material handling Quality control Other overheads

1

$ 1,000

50

$50,000

$10

500

5,000

500

5,000

$200

2

400

20

4,000

$10

1,000

10,000

1,000

10,000

Total overhead Number of barrels Cost per barrel Blocher,Stout,Cokins,Chen:Cost Management, 4e

$16,400 500

÷

$ 32.80 5-38

$69,000 ÷

500 $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 volumebased 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.


5-39


5-52 Volume-based Costing Versus ABC (35 min) 1. Product A Product B (1) Target price $279.00 $294.00 (2) Manufacturing cost (1) ÷ 150% $186.00 $196.00 Prime cost - 70.00 - 126.40 Overhead cost per unit $116.00 $ 69.60 Number of units x 1,000 x 5,000 Total overhead $116,000 $348,000

Product C $199.50 $133.00 - 75.00 $ 58.00 x 500 $29,000

2. Current Costing system Actual selling price Product manufacturing cost Gross margin Gross margin ratio

Product A $280 186 $ 94 33.57%

Product B $250 196 $ 54 21.6%

Product C $300 133 $167 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 Direct materials Direct labor Factory overhead: Setups (a) Materials handling (b) Hazardous control (c) Quality control (d) Utilities (e) Total Actual selling price Product manufacturing cost Gross margin Gross margin ratio

Product A $ 50.00 20.00

Product B $114.40 12.00

Product C $ 65.00 10.00

1.60 40.00 62.50 22.50 12.00 $208.60

0.80 5.00 22.50 5.25 8.40 $168.35

4.80 70.00 150.00 52.50 12.00 $364.30

$280.00 208.60 $ 71.40 25.50%

$250.00 168.35 $ 81.65 32.66%

$300.00 364.30 ($64.30) (21.43)%


5-40


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


5-41


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%) Actual selling price Difference in price

$312.90 $252.53 $280.00 $250.00 <$32.90> <$2.53>

Direct-labor based costing system Gross margin Gross margin ratio

$ 94 33.57%

$ 54 21.6%

$167 55.67%

Activity-based costing system: Gross margin Gross margin ratio

$71.40 25.50%

$81.65 32.66%

$(64.30) <21.43%>

$546.45 $300.00 <$246.45>

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


5-42


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.


5-43


5-54

Volume-Based Costing Versus ABC (25 min)

1. Current costing system (direct-labor hour) Deluxe % Speedy Price $475 100 $300.00 Prime Cost 180 38 110.00 Overhead 20 4 153.60 Unit gross profit $275 58 $ 36.40

% 100 37 51 12

2. Multiple drivers costing system Calculation of unit overhead costs - Deluxe: Setups Machine costs Engineering Packing Total overhead Number of Units Overhead per unit

Deluxe $ 560,000 10,000,000 1,800,000 1,000,000 $13,360,000 50,000 ÷ $267.20

$2,800 x 200 = $100 x 100,000 = $40 x 45,000 = $20 x 50,000 =

Calculation of unit overhead costs - Speedy: Setups Machine costs Engineering Packing Total overhead Number of Units Overhead per unit

$2,800 x 100 = $100 x 400,000 = $40 x 120,000 = $20 x 200,000 =

Price Cost Prime cost $180.00 Overhead 267.20 Unit gross profit

Speedy $ 280,000 40,000,000 4,800,000 4,000,000 $49,080,000 400,000 ÷ $122.70

Deluxe % $475.00 100 447.20 $27.80


94 6

5-44

$110.00 122.70

Speedy $300.00

% 100

232.70 $67.30

78 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

Activity Consumption Deluxe Speedy

Setups Machine costs Engineering Packing

250 units per setup

4,000 units per setup

2 MH per unit

1 MH per unit

0.9 Engr. Hr. per unit

0.3 Engr. Hr. per unit

1 unit per packing order

2 units per packing order

Supporting calculations Activity Consumption Deluxe Total Per Activity Measure Units Setups Machine costs

50,000

400,000

200 250 units per setup 100,000

2 MH per unit

Engineering 45,000 0.9 Engineering Hours per unit Packing

50,000

Speedy Total Per Activity Measure 100 4,000 units per setup 400,000 1 MH per unit 120,000 0.3 Engineering hours per unit

1 unit per packing 200,000 order

2 units per packing 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.


5-45


5-55 Volume-Based Costing Versus ABC (10 min)

1. Predetermined overhead rates: Budgeted Budgeted OH Cost Cost Driver

Cost Pool

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

Total overhead

$980,000 15.00% DM cost

$906,000

Total overhead for each product order: Overhead Cost Pool Material purchase

Men Shavers Women Shavers $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: Women Shavers:

$7,200 / 15,000 =

$ 0.48

$3,600 / 20,000 =

$ 0.18


5-46


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.

Salaries Supplies Factory Expense

Factory Costs Setup Assembly $ 850,000 $ 127,500 $ 467,500 150,000 30,000 90,000 550,000 440,000 $ 1,550,000 $ 157,500 $ 997,500

Inspect & Finishing Packaging $ 170,000 $ 85,000 30,000 110,000 $ 310,000 $ 85,000

2. The activity rates are determined as follows:

Safe-V

Batches Units Finishing hours/unit Packaging

250 60,000 0.2 0.1

Safe-T 600 72,000 0.3 0.15

Total Activity Activity-based Consumption Activity Costs Rates 850 $ 157,500 $ 185.29 132,000 997,500 7.557 33,600 310,000 9.226 16,800 85,000 5.060

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

Setup Assembly Inspect and Finish Packaging Materials per unit Total Cost per unit

Activity Requirements Activity-Based Costs/Unit Safe-V Safe-T Safe-V Safe-T 0.772 $ 1.544 250 600 $ 7.557 7.557 60,000 72,000 1.845 2.768 0.2 0.3 0.506 0.759 0.1 0.15 3.500 6.000 $ 3.50 $ 6.00 $

14.180

$

18.628

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


5-47


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.

Resource Rate $ 50,000 15,000 25

Setup Assembly $ 50,000 $ 500,000 15,000 75,000 50,000 275,000 $ 115,000 $ 850,000

Inspect & Finishing Packaging $ 250,000 $ 50,000 60,000 125,000 100,000 $ 435,000 $ 150,000

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.

Batches Units Finishing hour Packaging

Safe-V 250 60,000 0.2 0.1

Safe-T 600 72,000 0.3 0.15

Total Activity Activity-based Consumption Activity Costs Rates 850 $ 115,000 $ 135.29 132,000 850,000 6.439 33,600 435,000 12.946 16,800 150,000 8.929

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

Setup Assembly Inspect and Finish Packaging Materials per unit Total Cost per unit

Activity Requirements Activity-Based Costs/Unit Safe-V Safe-T Safe-V Safe-T 0.564 $ 1.127 250 600 $ 6.439 6.439 60,000 72,000 2.589 3.884 0.2 0.3 0.893 1.339 0.1 0.15 3.500 6.000 $ 3.50 $ 6.00


$

5-48

13.985

$

18.790


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

1. Manufacture Costs – Direct-Labor Cost Based Luxury Pendant Total

Ceiling Fixture

Per Unit

Selling Price

Total

$70.00

Direct Materials

Per Unit $40.00

$ 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

$176,000

44.00

$1,000,000

25.00

Manufacturing Cost 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


5-49


5-58 (continued-1) Applied overheads

Luxury Pendants

Machine Operation Support labor

Ceiling Fixtures

Overhead Activities Overhead Activities Overhead Rate Cost Cost $ 16.00 1,500 $ 24,000 8,500 $136,000 0.35

32,000

11,200

200,000

70,000

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

Machine Setup

Total Overhead

$131,250

Manufacture Costs Report - ABC System Luxury Pendants Total Per Unit Number of units 4,000 Sales $280,000 $70.00 Direct Materials 80,000 $20.00 Direct Labor 32,000 $ 8.00 Overhead: Machine Operation 24,000 Support Labor 11,200 Machine Setup 27,200 Assembly 42,350 Inspection 26,500 Total Overhead $131,250 $32.8125 Total Manufacturing Costs $243,250 $60.8125 Gross Margin $ 36,750 $9.1875 Gross margin ratio 13.13%

$332,750

Ceiling Fixtures Total Per Unit 40,000 $1,600,000 $40.00 $400,000 $10.00 $200,000 $ 5.00 136,000 70,000 40,800 46,200 39,750 $332,750 $ 8.3188 $932,750 $23.3188 $667,250 $16.6813 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. Blocher,Stout,Cokins,Chen:Cost Management, 4e

5-50


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. Blocher,Stout,Cokins,Chen:Cost Management, 4e

5-51


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: Diomycin 7,200

Homycin 6,800

Addolin 2,000

Overhead rate

$12.50

$12.50

$12.50

Total overhead

$90,000

$85,000

$25,000

Direct labor-hours

Cost per unit: Diomycin $205,000

Homycin $265,000

Addolin $258,000

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

$0.545

$1.168

$1.820

Direct Materials Direct Labor

Cost per capsule


5-52


5-59 (continued-1)

2. Overhead rates for Activity-Based Costing:

Activity Machine setup

Budgeted Overhead Cost

Cost Driver Setup hours

Budgeted Cost Driver Overhead Volume Rate

$ 16,000

1,600

$10.00

Plant management Workers

36,000

1,200

$30.00

Supervision of direct labor

46,000

1,150

$40.00

50,400

1,050

$48.00

51,600

645

$80.00

Direct laborhours

Quality inspection Inspectionhours Expediting orders

Customers serviced

Total overhead

$200,000

Overhead Costs Assigned to Products Using Activity-Based Costing: Diomycin Homycin Addolin Driver Overhead Driver Applied Driver Applied Applied Volume Overhead Volume Overhead Volume Overhead Rate Machine setup $10 200 $2,000 600 $6,000 800 $8,000 Plant management Supervision of direct labor Quality inspection Expediting production Total

$30

200

$6,000

400

$12,000

600

$18,000

$40

200

$8,000

300

$12,000

650

$26,000

$48

150

$7,200

200

$9,600

700

$33,600

$80

45

$3,600

100

$8,000

500

$40,000

$26,800


5-53

$47,600

$125,600


5-59 (continued-2)

Cost per capsule under Activity-Based Costing: Diomycin Direct Materials

Homycin

Addolin

$205,000.00

$265,000.00

$258,000.00

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

1,000,000

500,000

300,000

$0.4818

$1.0932

$2.1553

Direct Labor

Packets produced Cost per capsule

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

Overhead

$26,800

$47,600

$125,600

Cost per capsule

$0.4818

$1.0932

$2.1553

Activity-Based Costing system

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).


5-54


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.


5-55


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.


5-56


5-60 Volume-based Costing Versus ABC   A laire 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

$120

$7,800,000

$ 30

$1,950,000

Total cost Contribution margin

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


5-57


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: Per Unit Totals for 40,000 units Revenue

$300

$ 12,000,000

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

Direct materials

* 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: Quality control: General supplies:

$48,000 / 16,000 = $3.00 per pound $560,000 / 160,000 = $3.50 per inspection $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


5-58


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. Per Unit Totals for 65,000 units Revenue

$150.00

$ 9,750,000

80.00

5,200,000

Procurement ($.10 x 25)

2.50

162,500

Production scheduling

2.00

130,000

Packaging & shipping

4.00

260,000

3.20

208,000

.06

3,900

3.50

227,500

.60

39,000

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

Direct materials Materials overhead:

Variable overhead: Machine set-ups ($1.60 x 2) Waste disposal ($3 x .02) Quality control General supplies Manufacturing overhead:

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.


5-59


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. Per Unit Totals for 40,000 units Revenue

$300.00

$ 12,000,000

140.00

5,600,000

Procurement ($.10 x 55)

5.50

220,000

Production scheduling

2.00

80,000

Packaging & shipping

4.00

160,000

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

.60

24,000

Machine insertion ($.40 x 35)

14.00

560,000

Manual insertion ($4 x 20)

80.00

3,200,000

1.20

48,000

`Total cost

$260.15

$10,406,000

Contribution margin

$ 39.85

$ 1,594,000

Direct materials Materials overhead:

Variable overhead:

General supplies Manufacturing:

Wave soldering


5-60


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


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 $4.50

.30 $3.50

1.50

1.50

$6.00

$5.00

30%

30%

$7.80

$6.50

Indirect costs: Factory overhead (0.30 x $5.00) Total costs Mark-up Budgeted selling prices per pound 2. The cost per driver unit is: Activity Purchasing

Budgeted Cost Driver Cost Purchase orders $579,000

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


5-62

Budgeted Activity 1,158

Cost per Unit $500


5-61 (continued-1)

The budgeted unit costs per pound are: Mona Loa Coffee Direct unit costs: Direct materials $4.20 Direct labor 0.30 $4.50 Indirect unit costs: Purchasing 0.02 (4 orders x $500 /100,000 lbs.)

Material handling

Malaysian Coffee $3.20 0.30 $3.50 1.00 (4 orders x $500/2,000 lbs.)

0.12 (30 setups x $400/100,000 lbs.)

Quality control

2.40 (12 setups x $400/2,000 lbs.)

0.02 (10 batches x $200/100,000 lbs.)

Roasting

0.40 (4 batches x $200/2,000 lbs.)

0.10 (1,000 hours x $10/100,000 lbs.)

Blending

0.10 (20 hours x $10/2,000 lbs.)

0.05 (500 hrs. x $10/100,000 lbs.)

Packaging

0.05 (10 hrs. x $10/2,000 lbs.)

0.01

0.01

(100 hrs. x $10/100,000 lbs.)

Total unit cost

(2 hrs. x$10/2,000 lbs.)

$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.


5-63


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.


5-64


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.


5-65


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.

Purchasing Materials Handling Quality Control Roasting Blending Packaging

Driver Usage 1,158 1,800 720 96,100 33,600 26,000

Cost $ 579,000 720,000 144,000 961,000 336,000 260,000 $ 3,000,000

UsageBased Rate $ 500 400 200 10 10 10

Practical Capacity at Current Usage Spending Percent 1,400 83% 2,400 75% 1,200 60% 100,000 96% 36,000 93% 30,000 87%

Practical Cost of Capacity Unused Unused Rate Capacity Capacity $ 413.57 242 $ 100,084 $ 300.00 600 180,000 $ 120.00 480 57,600 $ 9.610 3,900 37,479 $ 9.333 2,400 22,400 $ 8.667 4,000 34,667 $ 432,230

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.

1

2

Driver Usage Cost Purchasing 1,158 $ 579,000 Materials Handling 1,800 720,000 Quality Control 720 144,000 Roasting 96,100 961,000 Blending 33,600 336,000 Packaging 26,000 260,000

3 4 5 6 Capacity Step: Number Cost per at Current of Employees Unused Step Spending or Machines Capacity =(2)/(4) 1,400 8 242 $ 72,375 2,400 20 600 36,000 1,200 4 480 36,000 100,000 10 3,900 96,100 36,000 10 2,400 33,600 30,000 3 4,000 86,667


5-66

7 8 Step Size Steps =(3)/(4) Not Used 175 1.38 120 5.00 300 1.60 10,000 0.39 3,600 0.67 10,000 0.40


5-63 Customer Profitability Analysis (30 Min) 1. Service cost rate per unit of activity Estimated Estimated Service Activities Annual Cost Driver Annual Cost Cost Expense Driver Units 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 $10 per delivery (requisition) + $0.30 per mile charge

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 Sales

City of Albion

$ 80,000

$80,000

Product Cost

(50,000)

(48,000)

Service costs

( 9,450)

(28,010)

Gross Margin Gross Margin %

$20,550

$ 3,990

25.69%


4.99% 5-67


5-63 (continued-1)

The above profitability analysis indicates that, under activitybased 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.


5-68


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 Columbus Cincinnati Direct labor dollar 37.61% 31.19% Timesheet entries 45.11% 28.57% Vendor invoices 44.93% 37.44% Client invoices 52.13% 39.36% Employees 34.33% 38.81% New hires 42.11% 21.05% Insurance claims filed 34.33% 38.81% Proposals 39.22% 49.02% Contracted sales 48.07% 36.88% Projects shipped 39.13% 49.01% Purchase orders 41.54% 33.85% Copies duplicated 43.48% 39.13% Blueprints 45.24% 36.19%

ABC costing: Dayton Total 31.20% 100% 26.32% 100% 17.62% 100% 8.51% 100% 26.87% 100% 36.84% 100% 26.87% 100% 11.76% 100% 15.05% 100% 11.86% 100% 24.62% 100% 17.39% 100% 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


5-69


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 Sales

Dayton

Total

$1,500

$1,419

$1,067

$3,986

382

317

317

1,016

281

421

185

887

180

270

177

627

$657

$411

$388

$1,456

Less: Direct labor Direct materials Direct overhead Contribution margin

Cincinnati

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

Sales

Total

$1,500

$1,419

$1,067

$3,986

Less: Direct labor

382

317

317

1,016

Direct materials

281

421

185

887

180

270

177

627

$657

$411

$388

$1,456

529 $128

453 ($42)

278 $110

1,261 $195

Direct overhead Contribution margin Activity-based overhead Operating income


5-70


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.


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

Baldwin

Customer revenue analysis Total sales

$600,000

$750,000

$900,000

12,000

22,500

18,000

$588,000

$727,500

$882,000

11,760

7,275

26,460

$576,240

$720,225

$855,540

Less: Sales discount Net invoice Less: Sales returns Net sales Less: Cash discounts

11,525 (7,530) 1

Finance charge Net proceeds

$572,245

21,606 2 $698,619

$855,540

200

$ 125

$ 450

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

800

800

1,600

Total customer cost

$2,850

$4,850

$27,800

Net customer profit

$569,395

$693,769

$827,740

Customer cost analysis Customer unit-level cost: Sales return (restocking)3

$

Customer batch-level costs:

Customer sustaining costs: Sales visits


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ABC Blocher Solutions

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