Ch.04 Kinney 9e SM_Final

CHAPTER 4 ACTIVITY-BASED MANAGEMENT AND ACTIVITY-BASED COSTING QUESTIONS 1. Activitybased management is a management model that associates an organization’s activities with the value customers derive from the organization’s products. Efficiency and effectiveness are achieved by reducing the level of activities that do not create value for the customer and by improving execution of activities that do create customer value. Specific tools used in ABM include activity analysis, cost driver analysis, activity based costing, continuous improvement, operational control, performance evaluation, and business process reengineering. 2. Activity analysis is used to separate activities into two groups: those that add value to the product or service and those that do not add value. Once the non valueadded activities are identified, managers seek to reduce or eliminate the level of the drivers of those activities. If such efforts are successful, NVA costs will be reduced without impairing the value of products or services to the consumer. The result should be an increase in profits. 3. Valueadded activities are defined from the customer’s perspective because it is the customer who is the final evaluator of a product’s or service’s “worth” and, therefore, the activities involved in creating that product or service. The customer is also the person who should, in the final analysis, be the one who determines whether he or she actually wants to pay the price for engaging in all of the activities that are incurred in the production of a product or the performance of a service. 4. In addition to approximately one hour of commercials, the remaining time is spent showing players standing around, network announcers, replays, cheerleaders, head coaches, and referees. In a televised football game, the valueadded activities are the actual game plays. Nonvalueadded activities consist of commercials and the time between plays. Activities such as “moving the chains,” measuring to determine if a first down was made, and moving the ball from the end of one play to the point where it will be put in play next are all nonvalueadded activities. People who believe that the commercials are informative and interesting and that the time between plays allows them an opportunity to examine the strategies of the teams and project what each team is likely to do may disagree with this assessment. Advertisers may also disagree that commercials are NVA: HomeAway estimated that 60 to 70 percent of its first Super Bowl ad cost was recouped in new business and GoDaddy says it obtained five percentage points of market share within the first 48 hours after a Super Bowl ad (R. Nakashima, “At $3 Million per 30 Seconds, an Ad Often Is Still Worth the Gamble,” Austin AmericanStatesman, 2/3/11, p. B5). 67 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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The cycle efficiency of the game would be 11 ÷ 180 = 6%. 5. The five people would probably not calculate the same MCE. First, times of processes will differ and a value chart will typically contain both minimum and maximum times for an activity; thus, the individuals may choose different times within the range to determine total cycle time. Additionally, some people may believe that certain activities (such as packaging and inspection) are valueadded, while others may believe the same activities to be nonvalueadded. However, all five would probably agree that a significant portion of “total” cycle time is NVA time from a customer’s perspective. 6. Service cycle efficiency is generally higher than manufacturing cycle efficiency because services are primarily acquired at the time they are needed, meaning that there is little storage time. Additionally, transfer time is commonly small in service businesses, with the exception of having to go from one location to another. 7. Yes, cost drivers exist in traditional accounting systems, although they are generally called “overhead allocation bases.” In traditional systems, a single cost pool is commonly used for overhead costs and a single cost driver such as direct labor hours or machine hours is used rather than multiple cost drivers. Also in traditional systems, volumebased cost drivers are more the norm than nonvolumebased (e.g., square footage or distance moved) cost drivers. Finally, traditional accounting stresses finding an allocation base that demonstrates strong statistical correlation to the cost, but ABC emphasizes searching for multiple cost drivers that bear causeandeffect relationships to the cost. However, regardless of how the drivers are titled or on what bases they are calculated, the use of the drivers is the same in both systems. Cost drivers are used to compute a predetermined overhead rate to assign overhead costs to products and services. 8. By using a single cost pool and a single cost driver to allocate overhead, the more traditional methods of overhead assignment ignore the influence on cost of the different activities that occur to make a product. In this manner, lowvolume specialty products, which cause a disproportionate amount of overhead costs, are only assigned an average charge for overhead, thereby shifting costs to the standard product lines. ABC does a better job of tracing costs to the products that caused the various costs by using multiple cost pools and multiple cost drivers. Additionally, most costs in a traditional costing system are viewed as being either variable on a perunitofactivity basis or fixed. Activitybased costing recognizes that the “unit” causing a change in variable costs may also be a batchlevel or a processlevel “unit.” Thus, rather than spreading costs over all units produced, ABC spreads costs over all units produced within the appropriate level of activity.

© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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9.

As is true with any management or costing system, an ABC system will not “last forever.” The system must be updated periodically to reflect changes in the company’s human and physical resources, products/services, and business environment. Additionally, the original system may not have been the “best” it could have been. For a discussion of changing the ABC system, see B. E. Waldrup, J. B. MacArthur, and J. E. Michelman, “Does Your Costing System Need a TuneUp?” Strategic Finance (June 2009), pp. 47–51.

10. All companies are not likely to benefit equally from adopting ABC. The greatest benefits are likely to be gained by firms with complex production processes; firms that make products that have substantial diversity relative to cost, complexity, and volume; and firms that have a high level of overhead costs that are fixed relative to production volume. 11. Some of the additional costs that will be incurred will relate to purchasing and storage to have the options available as customers make requests. (Interestingly, Chrysler has asked its suppliers to keep more parts on hand rather than incurring many of those costs.) Setup costs will increase when the production line has to change paint colors. Also, Chrysler incurred significant retooling costs for its plant in Mexico that manufactures the Fiat 500. However, one of the largest costs may occur on production for cars to be sent to dealers: if the company makes configurations not desired by the customers, the cars may not be sold and the customers will go elsewhere. Many customers are not willing to wait for the model they want to be delivered from another location. Customers may be willing to pay modest price variations for different options, but with a base price of $15,500, customers may likely be price sensitive—especially in urban markets where small cars such as the Fiat 500 may be driven less and garaged more. Many customers simply would not understand why paint color A should cost $X more than paint color B. The Pareto principle is likely to hold true as shown by the following quote. “[C]ar makers have tried hard to bundle features so they can produce a dozen or so versions of a vehicle that will satisfy most buyers. That limits the complexity on the factory floor and dealership lots.” (J. Bennett, “Options Overload for Fiat’s 500,” WSJ, 11/22/10, p. B1.) 12. Implementation of ABC requires a significant commitment of time and resources. Significant time is consumed by preparing process and value charts, identifying cost drivers, and determining how to split production costs into pools that are relatively homogeneous relative to a particular cost driver. Identifying cost drivers typically requires internal surveys and interviews with company personnel. Additional time is consumed evaluating, selecting, and implementing any software that is used to manage the ABC data collection and cost assignments.


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EXERCISES 13. Each student will have a different answer. No solution provided. 14. Each student will have a different answer. No solution provided. However, it is likely that students will determine that quality inspection is nonvalueadded for the clothing manufacturer and valueadded for the pharmaceutical company. 15. Each student will have a different answer. No solution provided. 16. a. (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14)

BVA (customers might view this as VA) BVA BVA NVA NVA BVA BVA (customers might view this as VA) BVA BVA BVA (customers might view this as VA) VA BVA VA VA

b. Pisana’s might want to have better relationships with suppliers so that they will provide the store with the most uptodate merchandise possible (given parameters established by Pisana’s) that have both barcodes and customer readable tags, and with a nodefect clause. 17. a. None of the items is a valueadded activity. Products should be designed so that schedule changes should not be needed. b. c.

Number of factory schedule changes is the driver. Eliminate factory schedule changes except for those asked for by a customer (in which case the customer should be charged for the cost of the change) or for critical changes necessary to realize significant quality improvements and cost reductions.

18. a. Cycle time = 9 + 264 + 3.5 + 6.5 + 3 + 5 = 291 hours Valueadded processing time = 6.5 hours of mixing and cooking + 3 hours of bottling MCE = (6.5 + 3.0) ÷ 291.0 = 9.5 ÷ 291.0 = 3.3%


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19. a. Valueadded activities: Remove sod and level site Build forms Mix and pour concrete Level concrete and smooth Remove forms Total b. Nonvalueadded activities: Purchase materials Obtain rental equipment Drying time Return rental tools Clean up Total

Time 20 10 5 6 2 43 hours Time 5 2 24 1 4 36 hours

c. Total cycle time = 43 + 36 = 79 hours MCE = 43 ÷ 79 = 54.4% 20. a. Valueadded activities: Measuring and cutting materials Assembling materials Building fireplace Pegging logs Cutting and framing doors/windows Sealing joints Total valueadded time b. Nonvalueadded activities Receiving materials Storing materials Handling materials Setting up and moving scaffolding Waiting for inspectors County inspections Total nonvalueadded time

Time 9 3 12 8 5 4 41 days Time 2 10 7 6 6 1 32 days

c. Total cycle time = 41 + 32 = 73 days MCE = 41 ÷ 73 = 56.2% d. Valueadded activities are those that increase the worth of the product or service in the eyes of the customer and for which the customer is willing to pay. Nonvalueadded activities are those that do not increase a product’s value in the customer’s perspective.


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21. a. Receiving ingredients Moving ingredients to stockroom Storing ingredients in stockroom Moving ingredients from stockroom Measuring ingredients Mixing ingredients Packaging ingredients Moving packaged seasoning to warehouse Storing packaged seasoning in warehouse Moving packaged seasoning from warehouse to trucks Total minutes of cycle time

60 80 8,200 8 30 60 50 100 20,000 120 28,708

b. The value added functions are (1) measuring ingredients, (2) mixing ingredients, and (3) packaging ingredients. (30 min. + 60 min. + 50 min. = 140 min.) c. MCE = 140 ÷ 28,780 = 0.5% d. The company could do many things to improve its MCE. The primary areas on which to concentrate are the times spent storing ingredients in the stockroom and storing packaged seasoning in the warehouse. Probably the most significant improvement in MCE would come from adopting JIT (justintime) management of all inventories, which would allow the firm to concentrate on reducing total cycle time by not purchasing materials until they are needed and not producing finished goods until they are demanded by customers. 22. Each student will have a different answer because determination of VA and NVA time in this situation depends on Reliance’s perspective of the various activities. An audit is, in fact, a type of quality control and, as such, could be viewed in its entirety as NVA. However, if Reliance views the audit process as valueadded to the organization, the following activities are most likely to be the ones the company would most likely “want” to pay for. Audit planning and discussion of audit risk Fieldwork, transaction testing, completing work papers Drafting and issuing audit report; discussion with board of directors 23 Total VA time Drafting engagement letter 4 Internal control review (likely seen as NVA b/c job is recurring and, if no changes have been made, assessment “should” have been performed previously) 32 Preparing audit program (likely seen as NVA b/c job is recurring and, if no changes have been made, program “could” be used again) 24 Client discussions and rework 16 Audit followup discussions Total NVA time 96 © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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Given these classifications, the SCE is [168 ÷ (168 + 96)] = 168 ÷ 264 = 63.6%. Other efficiency percentages are equally likely. 23. a. Step Patient arrives at doctor’s office and checks in with receptionist.

VA or NVA NVA

Patient is asked to review previously provided information for changes; there are none.

NVA

Patient returns forms to receptionist.

NVA

Receptionist verifies patient insurance and collects co-pay.

NVA

Patient waits in waiting room.

NVA

Nurse escorts patient to exam room and takes vital signs.

VA

Patient waits in exam room.

NVA

Physician examines and treats patient.

VA

Patient checks out with receptionist, if needed.

NVA

b. Total VA time = 11 minutes Total cycle time = 47 minutes SCE = 11 ÷ 47 = 23.4% 24. a. None of the activities should be perceived as valueadded because the product should have been properly designed originally so that no correction process should have been needed. b.

If the problem could not have been foreseen, then development of the solution (30 minutes) should be considered valueadded. All reviews may be seen as business valueadded, but that still means that those activities are NVA. Thus, cycle efficiency is Total time = (15 days × 24 hours × 60 minutes) = 21,600 minutes Cycle efficiency = 30 ÷ 21,600 = 0.0014

c. Cycle efficiency = 30 ÷ [30 + (4 hours × 60 minutes)] = 30 ÷ 270 = 11% d. 21,600 ÷ 10 minutes = 2,160 calls before the solution document is posted; 2,160 × $15 = $32,400 270 ÷ 10 minutes = 27 calls; 27 × $15 = $405 25. a. The production process in McAllen Co. must have a significant amount of non valueadded time built into the cycle time. The most likely cause of this NVA time is at least one bottleneck process that creates a long wait period when no production is occurring and goods are simply stored or stacked until they can pass through the process. A fairly simple way to determine where the bottlenecks are is to walk through the plant and see where materials or partially completed units are being stacked


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or being brought back into the production area from a storage location. Another indicator of a bottleneck is where labor is waiting for a machine to complete a process so that additional materials can be input. In addition to bottlenecks, the company could be engaging in rush orders that remove regularly scheduled production from processing. Always trying to catch up on backorders will create delays in processing current orders. It is possible that if all backorders were filled, the current orders could be processed at a much more rapid pace. Finally, defective units caused by rushing to complete orders will have to be reworked, thereby causing an even longer delay in processing time. b. A value chart allows a company to analyze all activities that comprise total cycle time. The role of the value chart is to identify those activities that do not add value in the eyes of the consumer. By focusing managerial attention on reducing or eliminating such activities, total cycle time is reduced and total costs are reduced. 26. Each student will have a different answer; the following are illustrative examples. a. b. c.

number of print ads (volume measure), seconds of air time (cost measure) usage)

number of clients (volume measure), number of invoices sent (for assessed value of factory building (cost measure)

d.

number of transactions processed (volume measure), number of calls (for usage), number of installations (for usage), number of documents processed (for usage)

e.

number of employees (volume measure), number of payroll checks processed (volume measure)

f.

hours of operation (time measure)

27. Each student will have a different answer; the following are illustrative examples. a. amount of investment in factory machinery and buildings (total cost basis for depreciation) b. pounds of materials received (volume measure), distance of average shipment received (cost driver for commercial freight carriers) c. number of setups (volume driver), total time of setups (alternative volume measure) d. number of transactions processed (volume measure), number of service calls (for usage), number of installations (for usage), number of viruses/worms (for usage), pages of documents printed (volume)


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e. average amount of material inventory (volume of material stored), square footage of storage area (storage capacity) f. pounds of material processed (volume of work processed), number of different types of material handled (complexity of material handling), number of purchase orders (volume of work processed by staff and number of suppliers used) g. number of engineering changes (volume of engineering changes), number of process changes (volume of changes to the manufacturing processes), number of engineering change orders (number of requests for changes to products and processes) h. number of print ads (volume measure), seconds of air time (cost measure), number of new ads developed (measure of professional time) i. machine hours (for machinedriven usage), outside air temperature (for weather related usage) j. number of product defects (volume of quality defects), pounds of scrap and waste (volume of quality defects), number of quality inspections (number of batches) k. machine hours (for maintenance related to the volume of usage of machinery), average age of equipment (for obsolescence and agerelated maintenance) 28. a. O O P O U (could be product/process if left on all the time) U O U O U (per order) 29. a. b. c. d. e. f. g. h. i.

P P U B U B P P O

30. a. Total setup cost = $20,445  6 = $122,670 Total setup cost per unit = $122,670 ÷ (68,500 + 15,200 + 900) © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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= $122,670 ÷ 84,600 = $1.45 Product #453 ($1.45  68,500) Product #529 ($1.45  15,200) Product #663 ($1.45  900) Total setup cost assigned

$ 99,325 22,040 1,305 $ 122,670

b.

Total cost ÷ # of Units = Cost per unit (rounded) Product #453 ($20,445  3) = $61,335 ÷ 68,500 = $0.90 (rounded) Product #529 ($20,445  1) = $20,445 ÷ 15,200 = $1.35 (rounded) Product #663 ($20,445  2) = $40,890 ÷ 900 = $45.43 (rounded)

c.

Total number of setups would have been three; total setup cost = ($20,445  3) = $61,335 Product #453 = $20,445 ÷ 68,500 = $0.30 (rounded) Product #529 = $20,445 ÷ 15,200 = $1.35 (rounded) Product #663 = $20,445 ÷ 900 = $22.72 (rounded)

31. a. Total cost per call = $20,980 ÷ 17,500 = $1.20 (rounded) $11,040 Client A [$1.20  (7,000 + 2,200)] = $1.20  9,200 5,160 Client B ($1.20  4,300) 4,800 Client C ($1.20  4,000) $21,000 Total setup cost assigned (off due to rounding) b.

Total cost ÷ # of units = Cost per unit Service #359: $5,810 ÷ 7,000 = $0.83 per call Service #360: $7,085 ÷ 6,500 = $1.09 per call Service #361: $3,198 ÷ 1,300 = $2.46 per call Service #362: $4,887 ÷ 2,700 = $1.81 per call

c.

Client A will be billed an additional $8,208 [$5,810 + ($1.09  2,200)] or ($5,810 + $2,398) for Babineaux’s equipment upgrades. Client A could choose to spread that cost over all calls ($8,208 ÷ 30,000 = $0.27) or could assign the cost only to the specific calls benefited by the upgrades. The latter would be a more reasonable allocation process. (For example, assume that the fees were for directory assistance. If you never used directory assistance, would it seem reasonable for you to be charged an additional $0.27 merely because you were a caller of Client A?)

32. a. Total support cost = $312,750 + $125,100 = $437,850 Partner hours = 5  2,100 = 10,500 Staff hours = 12  2,600 = 31,200 Total hours = 10,500 + 31,200 = 41,700 hours Support rate per hour = $437,850 ÷ 41,700 = $10.50


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b.

Total hours = 60 + 220 = 280 Total support cost = 280  $10.50 = $2,940

c.

Professional support rate per hour = $312,750 ÷ 41,700 = $7.50 Administrative support rate per hour = $125,100 ÷ 10,500 = $11.91

d. Professional support (280 total hours  $7.50) $2,100.00 Administrative support (60  $11.91) 714.60 Total support cost $2,814.60 33. a. Allocation rate = Cost ÷ Allocation base Contracts rate = $270,000 ÷ 500,000 = $0.54 per contract page Regulation rate = $379,500 ÷ 750 = $506 per review request Court rate = $862,500 ÷ 3,750 = $230 per professional hour

b Contracts: 21,000  $0.54 . Regulation: 27  $506 Court: 315  $230 Total c.

$11,340 13,662 72,450 $97,452

The rates will be used to bill other departments for the costs incurred in the legal department. If the legal department operates efficiently, its billings should equal or exceed the costs it incurs. The firm can hire an outside law firm to perform the legal work rather than do the work internally. It is difficult to determine, without more information, how this action would affect total costs. However, it would tend to make the legal costs much more variable and less fixed.

34. a. 60 beds  360 days = 21,600 b.

$3,620,400 ÷ 21,600 = $168 (rounded)

c Rooms [$504,000 ÷ (35  360)] = $504,000 ÷ 12,600 . Laundry [$151,200 ÷ (60  180)] = $151,200 ÷ 10,800 Nursing care ($1,314,000 ÷ 43,800) Physical therapy ($960,000 ÷ 8,000) General services ($691,200 ÷ 21,600)

$ 40 14 30 120 32

d. Traditional: 6  $168 = $1,008 ABC: Room ($40  6) Laundry ($14  3)

$ 240 42


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Nursing care ($30  6) Physical therapy ($120  30) General services ($32  6) Total e.

180 3,600 192 $4,254

Traditional: 6  $168 = $1,008 ABC: Room [($40 ÷ 2)  6)] Laundry ($14  3) Nursing care ($30  6) General services ($32  6) Total

$120 42 180 192 $534

35. a. $375,000 ÷ 75,000 calls = $5 per call $187,500 ÷ 46,875 purchase orders = $4 per purchase order $168,750 ÷ 28,125 receiving reports = $6 per receiving report Cost assignment: $125 25 calls  $5 200 50 purchase orders  $4 210 35 receiving reports  $6 Total cost assigned $535 b. $535 ÷ 100 units = $5.35 per unit c.

$731,250 ÷ 75,000 = $9.75 per call $9.75  25 calls = $243.75

36. a. $2,000,000 ÷ (170,000 + 30,000) = $2,000,000 ÷ 200,000 = $10 per MH Total OH assigned to regular dictionaries = $10  170,000 = $1,700,000 Total OH assigned to handsewn dictionaries = $10  30,000 = $300,000 b.

c.

Utilitiesrelated: $800,000 ÷ 200,000 = $4 per MH Inspectionrelated: $1,200,000 ÷ 60,000 = $20 per inspection hour Total OH to regular dictionaries = ($4  170,000) + ($20  10,000) = $680,000 + $200,000 = $880,000 Total OH to handsewn dictionaries = ($4  30,000) + ($20  50,000) = $120,000 + $1,000,000 = $1,120,000 Revenues Direct costs Overhead assigned Profit before tax

Regular $ 6,400,000 (5,000,000) (880,000) $ 520,000

HandSewn $ 5,600,000 (4,400,000) (1,120,000) $ 80,000

Management should not stop producing the regular dictionaries as these are generating a rate of return on revenues of 8 percent, while the handsewn © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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dictionaries are only generating 1.4 percent. 37. a. Overhead rate = $3,960,000 ÷ 330,000 units = $12 per unit Revenue Less: Direct material Direct labor Overhead* Profit (loss) Less: Admin. expense Income before tax Number of units Profit per unit

Mowers $19,500,000

Tractors $17,850,000

Total $37,350,000

(4,000,000) (2,800,000) (3,600,000) $ 9,100,000

(2,700,000) (6,000,000) (360,000) $ 8,790,000

(6,700,000) (8,800,000) (3,960,000) $17,890,000 (7,400,000) $10,490,000

÷ 300,000 $ 30.33

÷ 30,000 $ 293.00

*Mowers: $12  300,000 = $3,600,000; Tractors: $12  30,000 = $360,000 b.

Mowers: $2,800,000 ÷ $20 per hour = 140,000 direct labor hours Tractors: $6,000,000 ÷ $20 per hour = 300,000 direct labor hours Overhead rate = $3,960,000 ÷ 440,000 = $9 per DLH

Revenue Less: Direct material Direct labor Overhead* Profit (loss) Less: Admin. expense Income before tax Number of units Profit per unit (rounded)

Mowers $19,500,000


(4,000,000) (2,800,000) (1,260,000) $11,440,000

(2,700,000) (6,000,000) (2,700,000) $ 6,450,000

÷ 300,000 $ 38.13

÷ 30,000 $ 215.00

Total $37,350,000 (6,700,000) (8,800,000) 3,960,000) $17,890,000 (7,400,000) $10,490,000

*Mowers: $9  140,000 = $1,260,000; Tractors: $9  300,000 = $2,700,000 c.

Rate per DLH: $1,320,000 ÷ 440,000 = $3.00 Rate per MH: $2,640,000 ÷ 150,000 = $17.60 Revenue Less: Direct material Direct labor Overhead*

Mowers $19,500,000


(4,000,000) (2,700,000) (2,800,000) (6,000,000) (860,000) (3,100,000)

Total $ 37,350,000 (6,700,000) (8,800,000) (3,960,000)


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Profit (loss) Less: Admin. expense Income before tax Number of units Profit per unit (rounded)

$11,840,000

$ 6,050,000

÷ 300,000 $ 39.47

$ 17,890,000 (7,400,000) $ 10,490,000 ÷ 30,000 $ 201.67

*Mowers: ($3  140,000) + ($17.60  25,000) = $420,000 + $440,000 = $860,000 Tractors: ($3  300,000) + ($17.60  125,000) = $900,000 + $2,200,000 = $3,100,000 d.

The profit per unit in (c) provides the best picture. The solution to (a) does not recognize the difference in direct labor time and the solution to (b) does not recognize the difference in machine time. Costs should be attached to products using the most rationale and measurable bases of activity. However, given that the profits per unit are not significantly different, the allocation base in (b) would be acceptable if the additional tracking of machine hours is not easily nor inexpensively handled.

38. a. As variety in products increases, costs will also increase. Thus, the shift to small special orders will increase costs in purchasing (more orders, more calls to get prices, more space required for catalogs, etc.), receiving (more orders and receipts to handle and account for), storage (different products must be grouped together and differentiated from other products for easy accessibility), accounting (more inventory to account for, potentially more suppliers to pay), customer service (new larger catalogs, possible complaints from customers receiving wrong or slightly wrong orders, more time for sales calls), production scheduling (variety in setups, increase in movement of materials depending on production run), and laboratory work (research and development tests incurred to make certain that the products meet the appropriate environmental and technical requirements). b.

Yes, it is very possible that management is correct in its belief because total overhead costs are typically allocated to products based on some single allocation base such as direct labor hours or machine hours. These single allocation bases do not reflect the actual causeandeffect relationships between cost drivers and overhead costs.

c.

The memo should suggest that management consider the use of multiple overhead allocation bases and activitybased costing. This method of overhead allocation attempts to more fairly attach costs to the products and/or services that actually caused the costs to be incurred.

39. a. Outlined below are the purpose and several characteristics of the two noted cost systems: (1)

Inventory measurement  Meets external reporting requirements for aggregate balance sheet valuation and income determination. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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 (2)

Provides monthly and quarterly reporting.

Activitybased costing  Differentiates costs between valueadded and nonvalueadded activities.  Assigns costs to products according to activities involved in the production process that cause these costs. b.

A cost system developed to value inventory may distort product cost information because that system    

c.

was designed to value inventory in the aggregate and not relate to product cost information; uses a common departmental or factorywide measure of activity, such as direct labor hours or dollars (now a small portion of overall production costs) to distribute manufacturing overhead to products; deemphasizes longterm product analysis (when fixed costs become variable costs); and causes managers, who are aware of distortions in the traditional system, to make intuitive, imprecise adjustments to the traditional cost information without understanding the complete impact.

The benefits that management can expect from activitybased costing system are that such a system: 

Leads to a more competitive position by evaluating activity costs (that is, costs that are associated with the complexity of the transaction rather than the production volume) and the cost drivers that cause the activities.


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      d. 

Streamlines production processes by reducing nonvalueadded activities, thereby creating reduced setup times, optimal plant layout, and improved quality. Provides management with a more thorough understanding of product costs and product profitability for strategies and pricing decisions. Highlights interrelationships among activities. Provides feedback for opportunities for improvements in product design and production processes. Encourages use of nonfinancial measures of activity and performance. Provides a more appropriate means of assigning overhead to products.

The steps that a company, using a traditional cost system, would take to implement activitybased costing include:

Identify activity centers and cost drivers.  Assign costs to activity center cost pools using appropriate firststage cost drivers.  Assign activity center cost pools to products, services, or other cost objects using appropriate secondstage cost drivers, according to level of cost (unit, batch, products, process, and organizational levels). (CMA adapted) 40. a. In the modern competitive environment, firms must be willing to relinquish unprofitable customers so that the highest quality of service is provided to the most profitable customers. Small customers are not able to provide the same economy of operations that are available from larger customers. b.

There are ethical obligations in ending all business relationships. This is particularly true for firms that are sole suppliers of parts or materials that are critical to their customers. At a minimum, an ethical “firing” of a customer should

involve an explanation as to why service is being discontinued; be announced well in advance of discontinuing services to the customer; be accompanied by suggestions of alternative sources of supply; and  be sensitive to all negative effects that will be suffered by the customer when service is ended. c.

Activitybased costing is a financial management tool. It is not a tool for ethical management of a firm, nor is it a tool that can expressly impound non financial, qualitative information. To the extent that factors such as customer goodwill and market reputation are involved in decisions driven by ABC prescriptions, those factors will be ignored by activitybased management. However, it is important to acknowledge that these qualitative factors should not be ignored and, in fact, may be important enough to overturn the activity based prescriptions.


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PROBLEMS 41. a. Base wages: $63,000,000 ÷ 3,150,000 = $20 per regular hour worked Health care benefits: $10,500,000 ÷ 2,100 = $5,000 per worker Payroll taxes: $5,018,832 ÷ $71,697,600 = $0.07 per $1 of factory wages Overtime: $8,697,600 ÷ 288,000 = $30.20 per overtime hour Training: $1,875,000 ÷ 300 = $6,250 per new hire Retirement benefits: $6,898,500 ÷ 2,100 = $3,285 per worker Workers’ compensation: $1,199,940 ÷ 2,100 = $571.40 per worker b.

Although more laborrelated items are driven by the number of factory workers, the base wages account for most of the labor cost.

c.

It can be inferred that the use of overtime hours minimizes some cost drivers. In this example, use of overtime hours would help contain health care benefits, training costs, retirement benefits, and workers’ compensation.

42. a. Surgery: professional hours (this is an activity base that would drive many costs related to surgery and would be easy to track) Housing patients: days in hospital (this activity base would be easy to follow and would account for use of time and space) Outpatient care: professional hours (this would capture service provision to outpatients); or expected patient volume (this would capture those costs that are more related to capacity to provide service) b. c.

Total costs = $13,125,000 + $6,187,500 + $850,000 = $20,162,500 $20,162,500 ÷ 75,000 = $269 per professional hour (rounded) Professional salaries: $13,125,000 ÷ 75,000 = $175 per hr. Building costs: $6,187,500 ÷ 56,250 = $110 per sq. ft. Risk management: $850,000 ÷ 2,500 = $340 per patient d. Surgery = (3,750  $175) + (12,500  $110) + (500  $340) = $656,250 + $1,375,000 + $170,000 = $2,201,250 Housing = (70,000  $175) + (27,500  $110) + (1,250  $340) = $12,250,000 + $3,025,000 + $425,000 = $15,700,000 Outpatient care = (1,250  $175) + (16,250  $110) + (750  $340) = $218,750 + $1,787,500 + $255,000 = $2,261,250

e.

Surgery: $2,201,250 ÷ 3,750 = $587 per professional hour Housing: $15,700,000 ÷ 70,000 = $224 per professional hour (rounded) Outpatient care: $2,261,250 ÷ 1,250 = $1,809 per professional hour The cost per hour for housing patients is significantly lower than for the other two services because the majority of costs is fixed and are spread over a larger number of hours. The other two services create substantial variable costs for professional contact for short periods of time.


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43. a. The high–low method can be used to determine the variable and fixed cost portions: High 44 POs $ 12,400 Low 20 Pos (10,000) 24 $ 2,400 $2,400 ÷ 24 = $100 variable cost $10,000 – ($100  20) = $10,000  $2,000 = $8,000 fixed cost Variable purchasing costs could include supplies, longdistance telephone calls, postage, and equipment maintenance. Fixed purchasing costs could include purchasing agent’s and assistant’s salaries, depreciation on floor space and equipment, rental charges, or flat monthly fee for telephone and utilities. b. The number of machine setups could have increased by 14 for the following reasons: (1) all parts of the special orders were not run at the same time; (2) desk sizes could have differed substantially; (3) desks may have needed rework after quality inspections; or (4) special orders could have been interspersed with production of regular desks. c. The cost of quality control and inspections could have increased because (1) special orders may be inspected more carefully or more often than regular orders or (2) each desk in a special order may be inspected rather than the random selection of desks in regular orders. d. Engineering design and specification costs were not included in the original list of overhead costs because that list pertained only to regular production. It is only when special orders are obtained that new designs and specifications need to be developed. e. Purchasing cost: number of purchase orders Machine setup: number of different types of production; number of setups Utilities: number of machine hours Supervisors: number of supervisors; number of direct labor hours; number of production runs Depreciation: period of time Quality control and inspection: number of desks inspected; hours of quality control time; machine hours Engineering design and specification: number of special orders accepted; hours of design time f. OH rate based on MHs = $44,800 ÷ 6,400 = $7 per MH No. First, the method used did not consider additional costs such as engineering. Second, the method used failed to discriminate in costing between the regular and the special orders. Activitybased costing would overcome these difficulties. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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44. a. $2,362,500 ÷ (30,000 + 37,500) = $2,362,500 ÷ 67,500 = $35 Direct material cost = $544,500 ÷ 330,000 = $1.65 per pound Direct material cost Direct labor cost Overhead Total cost Divided by # of units Cost per unit b.

Product B $ 314,325 450,000 1,312,500 $2,076,825 ÷ 7,500 $ 276.91

$2,362,500 ÷ (52,500 + 22,500) = $2,362,500 ÷ 75,000 = $31.50 Direct material cost Direct labor cost Overhead Total cost Divided by # of units Cost per unit

c.

Product A $ 230,175 360,000 1,050,000 $1,640,175 ÷ 15,000 $ 109.345

Product A $ 230,175 360,000 1,653,750 $2,243,925 ÷ 15,000 $ 149.595

Product B $ 314,325 450,000 708,750 $1,473,075 ÷ 7,500 $ 196.41

Utilities: $750,000 ÷ 75,000 = $10 per MH Setup: $193,500 ÷ 1,290 = $150 per setup Material handling: $1,419,000 ÷ 330,000 = $4.30 per pound Direct material cost Direct labor cost Utilities Setup Material handling Total cost Divided by # of units Cost per unit

Product A $ 230,175 360,000 525,000 64,500 599,850 $1,779,525 ÷ 15,000 $ 118.635

Product B $ 314,325 450,000 225,000 129,000 819,150 $1,937,475 ÷ 7,500 $ 258.33

45. a. Umbrella: $24 ÷ $30 = 80% of an hour; 0.80  60 minutes = 48 minutes Gazebo: $180 ÷ $30 = 6 DLHs Chaise lounge: $60 ÷ $30 = 2 DLHs b. Umbrellas ($24  300,000) $ 7,200,000 Gazebos ($180  30,000) 5,400,000 Chaise lounge ($60  90,000) 5,400,000 Total $18,000,000


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c. Allocation rates: Quality control: $630,000 ÷ 420,000 = $1.50 per unit Setups: $600,000 ÷ 3,000 = $200 per setup Material handling: $1,800,000 ÷ 6,000,000 = $0.30 per pound Equipment operation: $14,970,000 ÷ 3,000,000 = $4.99 per MH


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OH Cost Allocation Umbrellas Quality control: $1.50  300,000 $1.50  30,000 $1.50  90,000 Setups: $200  600 $200  1,300 $200  1,100 Material handling: $0.30  1,200,000 $0.30  3,000,000 $0.30  1,800,000 Equipment operation: $4.99  600,000 $4.99  1,100,000 $4.99  1,300,000 Total overhead Number of units Cost per unit *Rounded Total cost per unit: DM DL OH Total d.

Chaise Lounge

$ 450,000 $ 45,000 $ 135,000 120,000 260,000 220,000 360,000 900,000 540,000

2,994,000 $3,924,000 ÷ 300,000 $ 13.08

$12.00 18.00 13.08 $43.08

5,489,000 $6,694,000 ÷ 30,000 $ 223.13*

6,487,000 $7,382,000 ÷ 90,000 $ 82.02*

$120.00 135.00 223.13 $478.13

$ 12.00 45.00 82.02 $139.02

If prices are set based on product costs, activitybased costing would generate lower prices for umbrellas and higher prices for the other two products.

46. a. Indirect labor Dept. 1 ($682,000  $375,000) Dept. 2 ($462,000  $200,000) Machine ($400,000 + $800,000) Power Building Purchasing Total b.

Gazebos

$ 307,000 262,000 1,200,000 400,000 1,000,000 100,000 $3,269,000

Total DLHs = Dept. 1 + Dept. 2 = 25,000 + 10,000 = 35,000 $3,269,000 ÷ 35,000 = $93.40 per DLH


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c.

DLH for Product A = 20,000 in Dept. 1 + 5,000 in Dept. 2 = 25,000 DLHs

DLH for Product B = 5,000 in Dept. 1 + 5,000 in Dept. 2 = 10,000 DLHs DM: (1/2 to each for X; all Y to B) DL: Dept. 1 (4/5, 1/5) Dept. 2 (1/2, 1/2) OH  $93.40 per DLH Total cost Number of units Cost per unit d.

Product A

Product B

$ 400,000 $300,000 100,000

400,000 2,335,000 $3,135,000 ÷ 10,000 $ 313.50

$ 600,000 $ 75,000 100,000

175,000 934,000 $1,709,000 ÷ 10,000 $ 170.90

Building occupancy: $1,000,000 ÷ 500,000 = $2 per sq. ft. Purchasing: 10,000  $2 = $20,000 Power: 40,000  $2 = $80,000 Dept. 1: 200,000  $2 = $400,000 Dept. 2: 250,000  $2 = $500,000 Purchasing: $100,000 direct costs + $20,000 allocated building occupancy cost = $120,000; $120,000 ÷ 500 purchase orders = $240 per purchase order Material X: 200  $240 = $48,000 Material Y: 300  $240 = $72,000 Power: $400,000 direct costs + $80,000 allocated building occupancy cost = $480,000; $480,000 ÷ 10,000,000 kWh = $0.048 per kWh Department 1: 1,500,000  $0.048 = $72,000 Department 2: 8,500,000  $0.048 = $408,000


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e.

Product A

Product B

Indirect labor Department 1 ($307,000) (Total ILHs for A = 2,500 + 5,000 + 252 = 7,752) (Total ILHs for B = 2,400 + 10,000 + 248 = 12,648) Total indirect labor hours = 20,400 (7,752 ÷ 20,400 = 38%) $116,660 (12,648 ÷ 20,400 = 62%) $ 190,340 Department 2 ($262,000) (Total ILHs for A = 2,680 + 1,000 + 250 = 3,930) (Total ILHs for B = 5,000 + 3,860 + 310 = 9,170) Total indirect labor hours = 13,100 (3,930 ÷ 13,100 = 30%) 78,600 (9,170 ÷ 13,100 = 70%) 183,400 Power Total MHs in Dept. 1 = 5,000 + 10,000 = 15,000 Dept. 1 = $72,000 (Product A, 1/3; Product B, 2/3) 24,000 48,000 Total MHs in Dept. 2 = 5,000 + 20,000 = 25,000 Dept. 2 = $408,000 (Product A, 1/5; Product B, 4/5) 81,600 326,400 Machineryrelated (same basis as Power) Department 1 (1/3, 2/3) 133,333 266,667 Department 2 (1/5, 4/5) 160,000 640,000 Building occupancy (same basis as Power) Department 1 (1/3, 2/3) 133,333 266,667 Department 2 (1/5, 4/5) 100,000 400,000 Purchasing Total lbs. of X = 50,000 + 50,000 = 100,000 Total lbs. of Y= 100,000 Material X $48,000 (Product A, 1/2; Product B, 1/2) 24,000 24,000 Material Y $72,000 (all Product B) 0 72,000 Total overhead cost $851,526 $2,417,474 f. Raw material X (1/2, 1/2) Raw material Y (all B) Direct labor––Dept. 1 (4/5, 1/5) Direct labor––Dept. 2 (1/2, 1/2) Overhead (from part e) Total product costs Number of units Cost per unit

Product A Product B $ 400,000 $ 400,000 0 200,000 300,000 75,000 100,000 100,000 851,526 2,417,474 $1,651,526 $3,192,474 ÷10,000 ÷10,000 $ 165.15* $ 319.25*

*Rounded [Adapted from Roth and Borthick, “Getting Closer to Real Product Costs,” Management Accounting (May 1989), pp. 28–33.]


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47. a. Allocation rates: Utilities: $1,800,000 ÷ 90,000 = $20 per MH; assigned to products using 45,000, 15,000, and 30,000 MHs, respectively Scheduling & setup: $1,638,000 ÷ 1,170 = $1,400 per setup; assigned to products using 195, 570, and 405 setups, respectively Material handling: $3,840,000 ÷ 2,400,000 = $1.60 per lb.; assigned to products using 750,000, 450,000, and 1,200,000 pounds, respectively

Direct costs Utilities Scheduling & setup Material handling Total Units produced Cost per unit

A $ 120,000 900,000 273,000 1,200,000 $ 2,493,000 ÷ 60,000 $ 41.55

PRODUCTS B $ 120,000 300,000 798,000 720,000 $1,938,000 ÷ 30,000 $ 64.60

C $ 135,000 600,000 567,000 1,920,000 $3,222,000 ÷ 90,000 $ 35.80

b. Total overhead = $1,800,000 + $1,638,000 + $3,840,000 = $7,278,000; Total DLHs = 48,000 + 27,000 + 75,000 = 150,000; Overhead rate = $7,278,000 ÷ 150,000 = $48.52; assigned to products using 48,000, 27,000, and 75,000 DLHs, respectively (1)

Direct costs Overhead Total Units produced Cost per unit

Product A $ 120,000 2,328,960 $ 2,448,960 ÷60,000 $ 40.82

Product B $ 120,000 1,310,040 $1,430,040 ÷30,000 $ 47.67

Product C $ 135,000 3,639,000 $ 3,774,000 ÷90,000 $ 41.93

(2) Traditional Product A: $40.82  1.25 = $51.03 Product B: $47.67  1.25 = $59.59 Product C: $41.93  1.25 = $52.41 ABC Product A: $41.55  1.25 = $51.94 Product B: $64.60  1.25 = $80.75 Product C: $35.80  1.25 = $44.75 c.

The traditional approach to product costing used only one allocation base, direct labor hours. This allocation base was unable to fully capture the causes of overhead cost incurrence. The ABC approach developed better overhead allocation because of the superior relationship between the cost pools and the cost drivers used to allocate the overhead cost. To the extent that there is error in determining costs, mispricing will also exist when prices are set based on costs, as is evident in this problem. Although


Chapter 4

Product A is relatively unaffected by the choice of costing system, Products B and C have substantially different costs and prices under the two systems. The traditional costing system would result in underpricing Product B and overpricing Product C, which would affect both sales volume and company profitability. 48. a. Predetermined rate using MHs: $5,850,000 ÷ 1,000,000 = $5.85 per MH b. Direct material Direct labor Applied overhead (5,000  $5.85) Total cost Divided by number of doors Cost per door c.

Predetermined rate per activity per unit of cost driver: Electric power: $500,000 ÷ 200,000 = $2.50 per kilowatt hour Work cells: $3,000,000 ÷ 300,000 = $10 per square foot Material handling: $1,000,000 ÷ 200,000 = $5 per material move Quality control inspections: $1,000,000 ÷ 50,000 = $20 per inspection Machine setups: $350,000 ÷ 25,000 = $14 per setup Cost per door: Direct material Direct labor Applied overhead Electric power ($2.50  500) Work cells ($10  1,000) Material handling ($5  20) Quality control ($20  15) Setups ($14  6) Total cost Number of doors Cost per door (rounded)

d.

$ 50,000 150,000 29,250 $229,250 ÷ 2,500 $ 91.70

$ 50,000 150,000 $ 1,250 10,000 100 300 84

11,734 $211,734 ÷ 2,500 $ 84.69

The activitybased costing method allocates the cost pools of manufacturing overhead to various cost drivers and then to products based on the amount or number or other bases that each product consumes in various cost drivers. Assume that Strickland’s policy is to add 40 percent to manufacturing costs as gross profit to cover costs such as administrative expenses, selling expenses, financial expenses, and research and development expenses, and the remainder will be a profit. In determining the selling price of the door under both methods, add 40 percent of total manufacturing costs: Unit costs Plus gross profit at 40% Selling price

Present System $ 91.70 36.68 $128.38

ABC System $ 84.69 33.88 $118.57


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It is evident that a selling advantage results from the ABC method. As illustrated in this case, the ABC method should result in a pricing decision that makes the company more competitive in the marketplace. Savings in applying manufacturing overhead costs to products will enable the company to sell its products at a lower price than competitors while maintaining the same gross margin ratio. e.

If ABM were implemented first, Strickland might be able to significantly reduce or eliminate the material handling and quality inspections costs. Both of these items are NVA and create $2,000,000 of the total $5,850,000 (or 34 percent) of manufacturing overhead costs. [Adapted from Nabil Hassa, Herbert E. Brown, and Paul M. Saunders, “Management Accounting Case Study: Beaver Window Inc.,” Management Accounting Campus Report (Fall 1990). Copyright Institute of Management Accountants, Montvale, NJ.]

49. a. Advantages associated with activitybased costing systems include:  highlighting nonvalueadded activities so that they can be reduced or eliminated;  improving the accuracy of product costing by tightening associations between costs and their causes;  better decision making in setting prices; and  improving processes by highlighting the associations among production activities. b.

VOH rate = $1,120,000 ÷ 280,000 = $4 per DLH Product #347

Direct material 65,000  $80 40,000  $140 Direct labor 65,000  1.5  $14 40,000  4  $14 Variable overhead 65,000  1.5  $4 40,000  4  $4 Machine charge 65,000  0.5  $10 40,000  1.5  $10 Material handling charge 65,000  $80  0.10 40,000  $140  0.10 Total cost of production

520,000 $7,800,000

Sales Total costs Contribution

$9,750,000 (7,800,000) $1,950,000

Product #658

$5,200,000 $ 5,600,000 1,365,000 2,240,000 390,000 640,000 325,000 600,000

560,000 $ 9,640,000 $12,000,000 (9,640,000) $ 2,360,000


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c.

Product #347 Direct material 65,000  $80 40,000  $140 Material overhead Procurement ($0.10 per part) Prod. scheduling ($2 per unit) Pack. & ship. ($4 per unit) Variable overhead Machine setup ($1.60 per setup) Waste disposal ($3 per pound) Quality contr. ($3.50 per insp.) General sup. ($0.60 per unit) Manufacturing: Mach. ins. ($0.40 per part) Manual ins. ($4 per part) Wave solder. ($1.20 per unit) Total costs Sales Total costs Contribution

d.

Product #658

$5,200,000 $ 5,600,000 162,500 130,000 260,000

220,000 80,000 160,000

208,000 3,900 227,500 39,000

192,000 42,000 280,000 24,000

624,000 260,000 78,000 $7,192,900 $9,750,000 (7,192,900) $2,557,100

560,000 3,200,000 48,000 $10,406,000 $12,000,000 (10,406,000) $ 1,594,000

Based on the calculations made in (a), Product #658 appears to be more profitable (in total dollars of gross profit) than Product #347. Under ABC allocations, Product #347 appears to generate a greater dollar contribution toward profits than Product #658; additionally the rate of return for Product #347 (26.2%) is much higher than that for Product #658 (13.3%). The difference is attributable to the fact that the standard cost system does not account for the cost of the complexities associated with the production of Product #658. These effects are most evident with the costs of manual insertions required for Product #658. (CMA adapted)

50. a. Assignment of overhead costs: Altamont Ballard General administration $155,420 $122,700 Project costing 21,600 13,920 A/P/Receiving 62,550 52,820 A/R 24,440 18,330 Payroll 10,200 11,700 Personnel recruiting 15,200 7,600 Employee ins. processing 4,760 5,460 Proposals 54,210 68,110

Circleville $130,880 12,480 23,630 4,230 8,100 15,200 3,780 16,680


.

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Sales meetings Shipping Ordering Duplicating costs Blueprinting Total Direct overhead Total overhead

b.

Sales Direct labor Direct material Net contribution c.

Net contribution Overhead Contribution

d.

96,960 74,740 30,300 9,600 12,000 2,400 20,160 16,320 11,520 19,780 17,940 8,280 34,650 27,720 14,630 $529,530 $449,360 $282,110 195,000 286,100 203,500 $724,530 $735,460 $485,610 Altamont Ballard Circleville $1,500,000 $1,419,000 $1,067,000 (382,000 (317,000) (325,000) ) (281,000 (421,000) (185,000) ) $ 837,000 $ $ 557,000 681,000 Altamont $ 837,000 (724,530 ) $ 112,470

Ballard $ 681,000 (735,460)

Circleville $ 557,000 (485,610)

$ $ 71,390 (54,460)

It is apparent that there are weaknesses in the traditional product costing system that are having a profound effect on profitability measures. Relative to profit measures based on the traditional costing measures, the ABC allocations make it apparent that the Ballard office is much less profitable and the Circleville office is much more profitable. (IMA adapted)

51. a. Send/receive goods: $50,000 ÷ 500,000 = $0.10 per lb. Store goods: $16,000 ÷ 80,000 = $0.20 per cubic foot Move goods: $20,000 ÷ 5,000 = $4.00 per square foot Identify goods: $8,000 ÷ 500 = $16.00 per package Barfield: (40,000  $0.10) + (3,200  $0.20) + (1,100  $4) + (15  $16) = $4,000 + $640 + $4,400 + $240 = $9,280 Glover: (40,000  $0.10) + (800  $0.20) + (600  $4) + (10  $16) = $4,000 + $160 + $2,400 + $160 = $6,720 Dozier: (40,000  $0.10) + (1,400  $0.20) + (1,900  $4) + (50  $16) = $4,000 + $280 + $7,600 + $800 = $12,680 Barfield: 40,000  $0.16 = $6,400 Glover: 40,000  $0.16 = $6,400 Dozier: 40,000  $0.16 = $6,400 c.

Barfield: $9,280  1.4 = $12,992 Glover: $6,720  1.4 = $9,408


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Dozier: $12,680  1.4 = $17,752 d. The current pricing plan captures only one dimension of cost causality: sending or receiving goods. Accordingly, the prices charged for warehousing services are almost independent of the causes of the costs. As indicated in a comparison of the answers to (b) and (c), the existing pricing plan generates the same price for the three customers whereas an ABCbased price results in very different prices to be charged to the three customers. [Adapted from Harold P. Roth and Linda T. Sims, “Costing for Warehousing and Distribution,” Management Accounting (August 1991), pp. 42–45. Published by Institute of Management Accountants, Montvale, NJ.]


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52. a. $1,200,000 ÷ 100,000 = $12 per unit b.

Setups: $360,000 ÷ 40 = $9,000 per setup Material handling: $480,000 ÷ $500,000 = $0.96 per $1 of DM cost Quality control: $120,000 ÷ 3,000 hours = $40 per hour Other overhead: $240,000 ÷ 100,000 units = $2.40 per unit Regular Special $180,000 $180,000 Setups (20  $9,000; 20  $9,000) 307,200 172,800 MH ($320,000  $0.96; $180,000  $0.96) 48,000 72,000 QC* (1,200  $40; 1,800  $40) 192,000 48,000 Other (80,000  $2.40; 20,000  $2.40) Total $727,200 $472,800 Number of units ÷ 80,000 ÷ 20,000 OH cost per unit $ 9.09 $ 23.64

Total $ 360,000 480,000 120,000 240,000 $1,200,000

*X = Regular unit hours; 1.5X = Special unit hours 2.5X = 3,000; X = 1,200 Regular; 1.5X = 1,800 Special c. Traditional system: Direct material Direct labor OH (80,000  $12; 20,000  $12) Total cost Number of units Cost per unit ABC system: Direct material Direct labor OH Total cost Number of units Cost per unit d. Cost per unit (traditional) Cost per unit (ABC) Increase (decrease) per unit Percentage increase (decrease)

Regular $ 320,000 480,000 960,000 $1,760,000 ÷ 80,000 $ 22.00

Special $180,000 140,000 240,000 $560,000 ÷ 20,000 $ 28.00

Total $ 500,000 620,000 1,200,000 $2,320,000

$ 320,000 480,000 727,200 $1,527,200 ÷ 80,000 $ 19.09

$180,000 140,000 472,800 $792,800 ÷ 20,000 $ 39.64

$ 500,000 620,000 1,200,000 $2,320,000

Regular Special $22.00 $28.00 19.09 39.64 $ (2.91) $11.64 (13.2)% 41.6%

Under the traditional volumebased system, 80 percent of all overhead cost is assigned to the regular units. Under activitybased costing, only “other overhead” costs appear to be directly correlated to volume. Under ABC, the regular units are assigned 50 percent of setup time, 64 percent of material handling costs, and 40 percent of inspection costs. Therefore, a total of 80 percent of the overhead has been allocated in a manner where the regular units are subsidizing the special units to some extent. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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e.   

A nonvalueadded (NVA) activity lengthens the production or performance time. increases the cost of product or services without adding product or service value. is one for which the customer would not be willing to pay. Potential nonvalueadded activities at Power Production include some material handling costs, setup costs, and quality control inspection. Given that the company produces only two products, 40 total setups of machinery seem excessive. Forty percent of overhead cost is related to material handling, and the company currently pays highly trained quality control inspectors to hand inspect every unit. All of these areas are potential areas for elimination of unnecessary costs or improvement of efficiencies in those that are deemed necessary.

f.

Power could reduce costs by considering some or all of the following actions: 



 

Negotiate with customers to take larger quantities of units with each delivery. It appears that the excessive number of setups is related to a large number of small shipments. If customers are unwilling to increase their order size, the company should study whether the cost savings of having larger production runs would exceed the cost of storing those units. Management could review the design of the company’s products and processes to standardize them. Both products’ designs should be studied to see if the most efficient processes are being used. The company may be able to reduce the complexity and number of parts, tools, and processes required, especially in the special model. Not only would materialrelated handling costs be reduced, but cost savings may also result in lower direct material cost for each product. The company should examine the factory layout; significant material handling costs could be resulting from an inefficient layout, resulting in excess movement of materials to work stations. Management should examine the need for hand inspection of each unit. The company should work with suppliers to be sure that incoming parts are defect free. Placing the burden of higher quality on the suppliers could potentially result in large savings in the area of quality control.

53. a. Machine setup: $20,000 ÷ 200 = $100 per setup Inspection: $130,000 ÷ 6,500 = $20 per inspection Material handling: $80,000 ÷ 8,000 = $10 per move Engineering: $50,000 ÷ 1,000 = $50 per hour Job 101: Machine setup (1  $100) Inspection (20  $20) Material handling (30  $10)

$ 100 400 300


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Engineering (10  $50) Total OH

b. Job 102: Machine setup (2  $100) Inspection (10  $20) Material handling (10  $10) Engineering (50  $50) Total OH Cost of Job 102: Direct material Direct labor OH Total cost Number of units Cost per unit c. Job 103: Machine setup (4  $100) Inspection (30  $20) Material handling (50  $10) Engineering (10  $50) Total OH Cost of Job 103: Direct material Direct labor OH Total cost Number of units Cost per unit

500 $1,300

$ 200 200 100 2,500 $ 3,000 $12,000 2,000 3,000 $17,000 ÷ 50 $ 340 $ 400 600 500 500 $ 2,000 $ 8,000 4,000 2,000 $14,000 ÷ 200 $ 70

Selling price = $70  1.4 = $98 per unit d. Total budgeted OH cost Total budgeted DL cost OH per DL $ Cost of Job 103: Direct material Direct labor OH ($2.80  $4,000) Total cost Number of units Cost per unit

$280,000 ÷ $100,000 $ 2.80 $ 8,000 4,000 11,200 $ 23,200 ÷ 200 $ 116


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The results show that Job 103 would be significantly overcosted using an OH allocation based on direct labor cost. The cost per unit under activitybased costing was $70; that cost increased by 66 percent to $116 per unit under a traditional costing system. Based on the company’s pricing system, this change would result in a selling price significantly higher than competitors’. The company would most likely be losing market share because of an excessively high selling price. Other products may have been significantly undercosted. The company might have chosen not to enter the market because it would have felt that it could not compete with the competition on this product. e.

A nonvalueadded (NVA) activity    

lengthens the production or performance time. increases the cost of product or services without adding product or service value. is one for which the customer would not be willing to pay. potential nonvalueadded activities at Jessica Corp. include machine setups, inspections, and material handling. Engineering could be value added but inefficient. Company management could reduce costs by considering some or all of the following actions: 





Some products seem to require excessive setups. For example, Job 103 required four setups to complete 200 units, while Job 101 required only one setup to complete 100 units. Company management should review the manufacturing procedures that require additional setups. Management could review the design of the company’s products and processes to standardize them. Job 102 required five times as many engineering hours as Jobs 101 and 103. All products’ designs should be studied to see if the most efficient processes are being used. Jessica Corp. may be able to reduce the complexity and number of parts, tools, and processes required, especially in the product produced in Job 102. Jessica Corp. should examine the design of the factory related to the number of material moves required. Job 102 used $12,000 of direct material, yet only required ten material moves, while Job 103 required 50 material moves for $8,000 of materials. Additional moves may be the result of inefficient plant design, where work stations are not located strategically for the most efficient production process.

f. Jessica Corp. currently has a budgeted cost of $130,000 for inspections. If the inspections were outsourced for $10 apiece and the total number of inspections was the same as budgeted, the cost of inspections would drop to $65,000 (6,500 inspections  $10), a savings of 50 percent. This projection assumes that the company would be able to eliminate $130,000 of inspection labor. If inspection labor personnel perform other duties, this might not be possible. Company management should also consider other qualitative factors: company morale may be affected by job reductions; the outsourced labor may not be as welltrained or reliable as the current workforce; or the company may lose control over the delivery of inspection services. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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(CIA adapted) 54. a. Predetermined OH rate = $1,800,000 ÷ 30,000 = $60 per MH. Each batch produces 5,000 units. Since there are 80 machine hours required for each batch, the MHs per unit are 80 ÷ 5,000 or 0.016. Allocated OH cost per unit = $60  0.016 = $0.96. Alternatively: Each batch has a total machine hours cost of $4,800 (80  $60); the overhead cost per unit is $4,800 ÷ 5,000 units per batch or $0.96 per unit. Perunit cost under traditional system:

b.

Direct material Direct labor Overhead Total

$4.40 0.75 0.96 $6.11

Material handling: $720,000 ÷ 6,000,000 = $0.12 per part Setups: $315,000 ÷ 750 = $420.00 per setup Machining: $540,000 ÷ 30,000 = $18.00 per MH Quality control: $225,000 ÷ 500 = $450.00 per batch OH per batch: Handling: 5,000 units per batch  5 parts per unit = 25,000 parts per batch  $0.12 per part Setups: 2 per batch  $420 per setup Machining: 80 MHs per batch  $18.00 per MH Quality control: 1 per batch  $450 Total per batch

$3,000.00 840.00 1,440.00 450.00 $5,730.00

Overhead cost per unit = $5,730 ÷ 5,000 = $1.146 per unit Perunit cost under ABC system: Direct material Direct labor Overhead

$4.400 0.750 1.146 $6.296 or $6.30 (rounded)

ABC system cost is $0.19 (3.1 percent) more than traditional system per unit. c.

Since the company desires a gross profit of 40 percent, the cost of each unit must be 60 percent of the selling price: Traditional: ABC:

$6.11 ÷ 0.6 = $10.18 $6.30 ÷ 0.6 = $10.50 (CIA adapted)

55. a. 50 guests at $0.90 per guest 1 tier at $34.41 per tier 1 order at $150 per order Purchased decorations Breakeven price of cake

$ 45.00 34.41 150.00 22.50 $251.91


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b. 164 guests at $0.90 per guest 5 tiers at $34.41 per tier 1 order at $150 per order Purchased decorations Cost of cake Selling price of Nussbaum cake Cost of Nussbaum cake Gross margin

$ 147.60 172.05 150.00 58.86 $ 528.51 $ 650.00 (528.51) $ 121.49

c. 200 guests at $0.90 per guest 4 tiers at $34.41 per tier 1 order at $150 per order Special flowers (20 × $5) Cost of cake

$180.00 137.64 150.00 100.00 $567.64

If the required gross margin on the O’Brien cake is 35 percent, then the cost of the cake equals 65 percent of the selling price: 0.65X = $567.64; X = $873.29. d.

If the company switched to a traditional system, the cost of cakes for weddings with fewer than average guests would tend to decrease and the cost of cakes with more than the average number of guests would tend to increase. This is contrary to the normal effect of switching to an activitybased costing system, where typically orders in smaller quantities tend to increase in cost per order and larger quantities tend to decrease. Because the cost per order is fixed at $150, the average perunit cost based on 125 guests is $150 ÷ 125, or $1.20 per guest. A wedding with fewer than the average number of guests will bear a proportionately lower total cost than a wedding with more guests. If Tillson bases the cost of a cake on the average wedding, the per guest cost would be as follows: 125 guests at $0.90 per guest 3 tiers at $34.41 per tier 1 order at $150 per order Cost of average wedding cake Average number of guests Average per guest cost

$112.50 103.23 150.00 $365.73 ÷ 125 $ 2.93

Compare the cost of the Sacks and Nussbaum wedding cake if the cost of cake is based on the number of guests instead of an activitybased cost: Number of guests Cost per guest Total cost ABC cost (without decorations) % increase (decrease) from ABC

Sacks 50 $ 2.93 $146.50 $229.41 (36.1)%

Nussbaum 164 $ 2.93 $480.52 $469.65 2.3% (CIA adapted)


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56. a. Engineering: $300,000 ÷ 3,000 = $100 per hour Machine setups: $50,000 ÷ 100 = $500 per setup Material purchase and support: $200,000 ÷ 2,000,000 = $0.10 per pound Machine sanding: $100,000 ÷ 10,000 = $10 per MH Product certification: $270,000 ÷ 6,000 = $45 per order Ravel Nortell $1,000 $200 Engineering hours (10  $100; 2  $100) 2,000 500 Machine setups (4  $500; 1  $500) 100 250 Material support (1,000  $0.10; 2,500  $0.10) 50 N/A Machine sanding (5  $10) 45 45 Product certification (1 order each  $45) Total overhead $3,195 $995 b. Total DLHs = 10 employees  2,000 hours = 20,000 DLHs OH per DLH = $920,000 ÷ 20,000 = $46 per DLH Ravel: 4 hours  $46.00 = $184.00 Nortell: 2 hours  $46.00 = $92.00 c.

Traditional costing: Direct material Direct labor (4  $25; 2  $25) Special packaging (1,000 units ÷ 250 per carton; 4  $5) Overhead (4  $46; 2  $46) Total order cost Number of units (in thousands) Cost per thousand

Ravel $200 100

Nortell $ 500 50

20 184 $504 ÷ 1 $504

92 $ 642 ÷ 10 $64.20

Ravel $ 200 100

Nortell $ 500 50

20 3,195 $3,515 ÷ 1 $3,515

995 $ 1,545 ÷ 10 $154.50

Activitybased costing: Direct material Direct labor (4  $25; 2  $25) Special packaging (1,000 units ÷ 250 per carton; 4  $5) Overhead Total order cost Number of units (in thousands) Cost per thousand d.

The results show a significant discrepancy in the per order cost using traditional costing. The most likely explanation is that the relative amount of direct labor is immaterial relative to other activities. Using direct labor as the cost driver does not capture the cause and effect of overhead costs, resulting in a significant undercosting of both products. Such undercosting can lead to a significant undercosting of the company’s product in the market, an


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inability of management to explain profits, and ultimately an inability of the company to maintain competitiveness in the marketplace. e.

To earn a 40 percent gross profit, the order cost must be 60 percent of the selling price. Ravel: $3,515 = 0.6X; X = $5,858 Nortell: $1,545 = 0.6X; X = $2,575

f. It is clear that the increased number of setups is a significant cost of the orders from Ravel. It is also unlikely that the company can set a selling price that allows it to recover this cost. Mahoney should meet with the buyer from Ravel and encourage orders in larger quantities. He might impose a setup charge of $500 on orders less than 10,000 units. Alternatively, the company could manufacture in larger quantities and store the units. The cost of storage may be less than the prohibitive cost of multiple setups. 57. a. Although difficult to quantify, some costs are associated with just carrying a part number in the database. Each part number must be originally set up in the system, built into the structure of a bill of materials, and maintained until it is no longer used. Moreover, each part must be planned, scheduled, negotiated with vendors, purchased, received, stored, moved, and paid for. Having two parts similar enough that one could be used for both applications requires unnecessary duplication of these activities and, therefore, unnecessary costs. Standardizing parts results in several indirect benefits. Fewer unique part numbers usually means fewer vendors and greater quality of delivered parts. It also means smoother JIT production, fewer shutdowns of manufacturing lines, and greater field reliability. b. To appropriately influence the behavior of design and costreduction engineers, the MOH allocation method should assign little cost to products for each highusage common part and more cost for each lowusage unique part, in proportion to the total usage of the parts. Annual cost to carry each part # = Budgeted MOH cost ÷ # of active part #s MOH rate for each part # = Annual cost to carry each part # ÷ Annual usage of each part # Annual cost to carry = $5,500,000 ÷ 8,000 = $687.50 MOH rate for highusage part = $687.50 ÷ 35,000 = $0.02 (rounded) MOH rate for lowusage part = $687.50 ÷ 200 = $3.44 (rounded) The MOH cost for each product is based on the part numbers in its bill of materials. The rate for each part number is multiplied by the number of times the part is used in the product. The resulting amounts are then aggregated for all part numbers in the bill of materials. The greater the number of parts in a product and the higher the percentage of unique parts, the greater the amount of allocated cost. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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c. Students will discuss the appropriateness of the allocation bases they selected, the ways in which their methods would communicate accurate information to design and costreduction engineers concerning the indirect costs of engineering products with unique versus common parts, and the need to provide those engineers with incentives to use the information in their part selection decisions. Regarding the latter point, engineers at Strategic Supply are in fact evaluated on the costs of the products they design. Although they are driven by emerging technologies and other considerations such as quality and customer needs, the evaluation process motivates them to seek minimum cost designs consistent with these considerations. With the part numberbased MOH allocation method, engineers will tend to design products differently. The product costing system will tell them that engineering lowvolume, unique parts into products causes overhead. Having the material overhead cost associated with each individual part number will help engineers to evaluate the use of a new part versus an existing part. Knowing the previously hidden costs of components, the engineers can properly assess not only the tradeoffs between parts proliferation and direct labor reduction but also the cost of selecting a unique component to satisfy a specific functional requirement of a customer. d. A MOH allocation method should provide accurate estimates of the longrun variable costs of all of the demands made on the organization’s material related overhead resources by each product in the product line. To approach 100 percent accuracy, the MOH cost pool would have to be decomposed into smaller homogeneous cost pools in which cost variations could be explained by a single cost driver. The resulting costing system would be marginally more accurate but substantially more complex, difficult to understand, and more costly to maintain than the singlecostpool method that was decided on in this situation. Also, adding more cost drivers to the system would probably have initially created confusion and definitely would have been resisted by manufacturing, engineering, and marketing personnel. Manufacturing costs are a crucial element of profitability in highly competitive markets of complex products. It is therefore very important that the benefits of more accurate tracing of costs to products exceed the cost of achieving the incremental accuracy (for example, the costs of determining and measuring additional cost drivers). It would be counterproductive to implement an elaborate overhead allocation system to cost products with very high accuracy if the system would cost so much to maintain that the companies would become less, not more, competitive. A singlecostdriver method may be a compromise that reflects the costs and benefits of achieving additional accuracy. A final consideration related to accuracy is the proper interpretation of computed rates. The $687.50 annual cost to carry each part number is not a © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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shortterm variable cost. Most of the costs in the MOH cost pool are fixed in the short term on a unit volume basis. Elimination of one part number in the database therefore will not immediately reduce the total materialrelated overhead cost by this amount. Nor in the case of the lowusage part will using one less save $3.44 in outofpocket costs. These rates reflect a longterm perspective; the company believes that, by supporting the manufacturing strategy, the allocation method will lead to real cost savings over time as the next generation of products is designed with fewer different part numbers. e. The costs of all demands made by products on both manufacturing and nonmanufacturing resources are proper elements of product costs used for management decisions, whereas inventory values for external reporting consist of manufacturing costs only. The MOH cost pool includes some or all of the costs of three types of cost areas. Because all such cost areas are manufacturing related, their costs are appropriately assigned to inventory, and the accurate MOH allocation method is an appropriate technique for making the assignments. The company, however, decided to use the MOH rates as “management costs” only and to continue to use the old allocation method to compute “financial costs.” One factor that led to this decision was the company’s desire to value inventory consistently. If the new method were used to compute financial costs, the reported inventory valuations would change because, among other reasons, more manufacturing support costs would be allocated to products. A more compelling reason for the “two sets of costs” approach is the need to maintain flexibility in product costing. The part numberbased MOH allocation method was developed to modify behavior to enact the strategy of parts standardization. It will cease to be an effective behavioral tool when design and costreduction engineers fully understand the costs of part number proliferation and naturally design products with common parts to the extent each situation allows. After parts standardization becomes second nature to engineers, management will change its strategy, and the accounting staff will develop a new product costing method to support the new strategy. In this way, product costs can continue to be effective management tools for influencing behavior without affecting the accountant’s ability to value inventory on a consistent basis. [Michael A. Robinson, ed., Cases from Management Accounting Practice No. 5 Instructor’s Manual (Montvale, NJ: National Association of Accountants, 1989), pp. 7– 11, adapted.]

58. a. In particular, the other initiatives would include management methods to improve quality. For example, an adoption of the TQM philosophy would be one of the initiatives; others could include adoption of ABC, employee empowerment, formation of quality circles, JIT inventory management, decentralization of decision making, and use of kaizen costing techniques. b.

These tools help orient the firm to managing based on a customer’s perspective of value. Worldclass competition is based on satisfying the customer. If a firm concentrates on accentuating those activities


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that are highly valued by customers and diminishing those activities that are not perceived as valueadding by customers, it should be successful in both managing costs and maintaining market share. c.

Yes. Activitybased costing is most useful if managers are willing to act based on the information provided by the ABC system. For example, activitybased costing could lead to changes in product mix and product pricing. Top management must support the ABC prescriptions for the costing system to lead to operational improvements.

d.

Preferably, both would be adopted. Without adopting ABC, the ABM prescriptions may not be understood by managers. But, without ABM, there may be reduced opportunity to identify and eliminate NVA activities. The ABC approach would require a separate information system to generate activitybased information. This would not necessarily be the system that managers would attend to; rather, they would continue to use the firm’s traditional and formal information systems. The two sources of information would inevitably give some conflicting signals and confuse managers. By using both an ABC system and ABM, actions taken by managers will be consistent with the information provided by the firms’ formal information systems.

59. a. This problem indicates that ABC and ABM can cause conflict among the various stakeholders in a business. The equipment installation would likely be viewed with favor by the stockholders. Analysis indicating that the equipment would be valueadding obviously underlies the decision to make the installation. Employees would be strongly against any move that would result in displacement of 60 percent of the workforce. Such an action would demoralize both those workers who were fired and those who remained. The customers would likely have both shortterm and longterm concerns. Short term customers would be very concerned about the impact on quality of laying off 60 percent of the workers. However, customers may have a favorable long term view of the move because of the potential to improve the quality and reduce the costs of products. b.

No matter how articulate the explanation given, it is difficult to visualize acceptance of the explanation by workers who may have dedicated much of their lives to learning skills required for their current positions. One approach, however, would be to discuss what customers value in the products currently produced by the business; then, explain how each internal area in the business contributes (or fails to contribute) to customer value. This explanation would need to clearly show that the function performed by the displaced workers is no longer valueadding in the eyes of the customer. Also, it would be important to explain to the employees that this conclusion holds no matter how well the employees perform the functions.

c. Cycle time is reduced or eliminated largely by reducing nonvalueadded activities. When nonvalueadded activities are reduced, work is no longer required of the employees who performed those activities. Only if the © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, duplicated, or posted to a publicly accessible website, in whole or in part.

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employees can be redeployed to other operational areas that are valueadding can employee layoffs be totally avoided. However, to the extent possible, the company could aggressively implement training programs to qualify displaced workers for other positions. Second, the company could seek market opportunities to expand the business so that growth would create an internal demand for those workers’ services in other areas of the business. Third, the company could provide employee counseling services to workers and help retrain them for work in other businesses.


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