CHAPTERFOUR

ACTIVITYBASEDCOSTINGANDMANAGEMENT

41BenefitsofABC
TheBrazosMilldoesnotneedABCbecauseitmakesasingleproduct.
Nomatterhowcomplextheprocess,howmanyingredients,howmanyprocesses,
allofthecostsofthemillrelatetotheoneproductflour.
TheRiverCityBakeryisaperfectcandidateforABC.Itmakesawide
rangeofproductsthatarehighlydiverse.Itmakestheminverydifferent
quantities.Itusesavarietyofmaterialsandprocesses.
SomestudentsthinkthatABCshouldbeappliedinanycircumstances.
42CostAnalysis
LeviStraussprobablydidanABCanalysislookingatcostsdrivenby
thenumberofordersastoremade,thedollaramountofeachstoresorders,
andbythenumberofstoresthecompanyservices.Somecostsofservicinga
singleorderareashighforasmallcustomer'sorderastheyareforalarge
customer's.Smallordersarerelativelymorecostlythanlargeordersand
smallcustomersprobablyplaceagoodmanyorders(asopposedtoorderingall
year'sworthofproductatonce).
Simplyhavingacustomergeneratescostsrelatedtorecordkeeping,
creditchecking,andotherservices.
43CostDrivers
Onedriverisprobablythetotalbaseofcustomers,regardlessofwhen
theyboughtthepackages,butrecentsalesprobablyarethekeydriver
becausebuyerswhohavehadthesoftwareforshortertimeperiodsaremore
likelytorequireassistance.
44CostsandActivities
Zydeco'snarrowerproductlinereducescostsgenerallyregardedas
fixed,becausetheydonotchangewithvolume.Suchcostsnonetheless
increaseordecreasewithsignificantchangesinactivities.Zydeco's
operationsarelessdiverseandlesscomplexthanthoseofitscompetitors,
soitscostsarelower.Zydecoprobablydoesnotdealwithasmany
suppliers,keepasmanyrecords,engageinasmanytransactions,useasmuch
space,oremployasmanypeopleasitscompetitors.Therefore,Zydecos
breakevenpointshouldbelowerthanitscompetitors.

41

45CostsofComplexity
Complexitydrivescostsbecauseitmakesoperationslesssmoothand
requiresmorepeopletoaccomplishtasks.Companiesthatmakeorsella
varietyofproductsincursomecostssimplybecauseofthecomplexityof
theiroperations.Forinstance,theymuststockpartsformoreproducts,and
mustchangemachineryoverfromoneproducttoanother.Theymightneed
severalsizesofcartonsforshipping.Theymustscheduleproductionand
coordinatemuchmorematerialandinprocessflowthanasingleproduct
operation.
46QualityCosts
Externalfailurecostsarethehardesttoestimatebecausesomuchof
thecostistheopportunitycostoflostsalesbecauseofyourdefects.The
othercategoriescontainrecordedcostsandsomeinvolveallocationsthat
generatedisagreement,butnottothedegreeofexternalfailurecosts.
47ClassifyingQualityCosts
1.Prevention,thoughsomeofthecostisnotqualityrelated.
2.Prevention,thoughagainsomeofthecostdoesnotrelatetoquality.
3.Prevention.
4.Internalfailure.
5.Prevention,thoughsomeisnotqualityrelated.
6.Externalfailure.
7.Somerelatestoexternalfailure,butsomeisrelatedtocolor,size,and
customerwhim.
48BasicAllocation(5minutes)
1.

$67,500toresidential,$112,500tocommercial

ResidentialCommercialTotal
Allocatedoverhead,6/16,10/16$67,500$112,500$180,000
2.
ResidentialCommercialTotals
Revenues
$100,000$300,000$400,000
Laborcosts
(60,000)(100,000)(160,000)
Overheadcosts
(67,500)(112,500)(180,000)
Income(loss)($27,500)$87,500$60,000

49ABCEstimates(Extensionof46)(15minutes)
1.
CostPool
CostinPoolCostDriverRate
Maintenance
$75,00025,000$3/hour
Schedulingandtransport45,0005,000$9/hour
General60,000$160,000$0.375/hour
Total$180,000
2.

42

ResidentialCommercialTotals

Revenues $100,000$300,000$400,000
Laborcosts60,000100,000160,000
Overheadcosts:
Maintenance,$3x5,000,20,00015,00060,00075,000
Scheduling,transportat$9/hour9,00036,00045,000
Generalat$0.375/labordollar22,50037,50060,000
Totalcosts106,500233,500340,000
Income($6,500)$66,500$60,000

3.Residentialworkstillappearstobeunprofitableinthelongterm.
Robertsmightthinkaboutraisingpricestoresidentialcustomers,making
explicitchargesfortraveltime,ordroppingtheresidentialbusinessover
time.Inthissituation,theconclusionsonemightreachdonotdiffer
betweenasingledriveranalysisandanABCanalysis,butthenumbersdo
differ.
Anotherreasonablesuggestionistoleavethegeneraloverhead
unassigned,thoughwearetoldthatitisdrivenbylaborcost.Thatlabor
costdoesdriveallofthegeneraloverheadisdoubtful.
410BasicAllocations(15minutes)
1.110,000hours,(10x10,000)+(20x500)
2.$6/hour,$660,000/110,000
3.
DoodlerSketcher
Materialcost$20$45
Assemblylaborat$20/hour200400
Overheadat$6/assemblyhour60120
Totalcost$280$565
4.
DoodlerSketcher
Revenue$320$950
Cost280565
Profit$40$385
411ABCEstimates(Extensionof410)(15minutes)
1.

SetupsTestingAssembly
Totalcostinpool$140,000$190,000$330,000
Activity3504,750110,000
Rate$400$40$3

43

2.
DoodlerSketcher
Materialcost
$20$45
Assemblylaborat$20/hour
200400
Overhead:
Setuprelated,$400x1/1004
$400x1/2200
Testingrelated,$40x0.208
$40x5.5220
Assemblylaborrelated3060
Totalcost$262$925
3.
DoodlerSketcher
Revenue$320$950
Cost262925
Profit$58$25
4.Thecostsofthetwoworkstationsdifferconsiderablyunderthetwo
approaches.TheABCapproachbettercapturestheconsumptionofresources,
especiallysetupsandtesting,thandoesthesimple,onedriverapproach.The
profitabilityofthetwoproductschangesaswell,withtheDoodlernow
seemingmoreprofitable,whiletheSketcherisjustbarelyprofitable.
412BasicAllocations(5minutes)
1.$18,$3,600,000/200,000
2.$0.45,$3,600,000/$8,000,000
3.$50,400,2,800x$18
$63,900,$142,000x$0.45
TheamountsdifferbecauseBarronusedrelativelyhighsalariedpeople.The
actualaveragesalarywas$50.71perhour($142,000/2,800)onworkdonefor
Barron,comparedtothe$40average($8,000,000/200,000).
Barronmightarguethatoverheadcostsaremorelikelytobedrivenbyhours
thanbydollars.Whyshoulda$70/hourconsultantgeneratemoreoverheadcost
thana$30/hourone?Theargumentisreasonable,asfarasitgoes.
413ABCEstimates(Extensionof412)(15minutes)
1.MarketProduct
ResearchPromotionFeasibility
Annualoverhead$800,000$1,800,000$1,000,000
Annualbillablehours100,00060,00040,000
Rate$8$30$25
2.$21,700
MarketProduct
ResearchPromotionFeasibilityTotal
Billablehours1,8008002002,800
Overheadcost$14,400$24,000$5,000$43,400
3.Themethodgivenheremakesmoresensebecauseclientspayforthe
actualresourcestheyconsume.Barronusedrelativelymoreofthelow

44

overheadmarketresearchservicesthanofthehigheroverheadpromotionand
productfeasibilityservices.Youmightwishtopointoutthat,overtime,
chargingbasedonhoursordollarswithoutreferencetothespecificservices
(theapproachusedin412)couldinfluencethekindsofbusinessthefirm
receives.Becauseusersofmarketresearchservicesareovercharged,they
willgravitatetowardotherfirms,whileusersofpromotionandproduct
feasibilityserviceswillmovetowardErffmeyerandSutton.
414QualityCosts(15minutes)

1. Ifnoinspectionismade:
8%1,000units$300=$24,000externalfailurecosts
Ifinspectionismade:
1,000units$10inspectioncost=$10,000appraisalcost
8%95%1,000units$50repaircost=$3,800internalfailurecost
8%5%1,000units$300=$1,200externalfailurecost
2.

Noinspection:$24,000
Inspect:$10,000+3,800+1,200=$15,000
Acmeshouldinstitutetheadditionalinspection.

415ClassifyingQualityCosts(10minutes)
Prevention
Qualitytraining$65,000
Appraisal
Incomingmaterialsinspection$120,000
Productinspection150,000
Total$270,000
Internalfailure
Rework$650,000
Scrap375,000
Total$1,025,000
Externalfailure
Productwarranty$950,000
416ABCforShippingDepartment(2025minutes)
1.Therateperdollarofordersis$0.1043,$1,252,000/$12,000,000
SupermarketsConvenienceStores
Shippingcost,$0.1043x$9,000,000$938,700
$0.1043x$3,000,000$312,900
Thetotalallocatedis$1,251,600,$400offbecauseofrounding.
2.AmountAmountof

CostPool/DriverinPoolActivityRate

Dollarvolumeoforders$492,000$12,000,000$0.04100
Numberofcustomers360,000560642.86

45

Numberoforders160,0001,360117.65
Numberofstocks240,0006,40037.50
Totalshippingcosts$1,252,000
SupermarketsConvenienceStores

Dollarvolumeofordersat$0.041$369,000$123,000
Numberofcustomersat$643102,880257,200
Numberofordersat$11851,920108,560
Numberofstocksat$37.50150,00090,000
Totals$673,800$578,760
TheABCcoststotal$1,252,560becauseofrounding.Studentsneed
remindingthatprecisionisnottheissuehere,noonewillmakeadifferent
decisionbasedon$560outofhundredsofthousands.Theassignmentalso
statesthatthisanalysisisroughandpreliminary,sostrivingfor
computationalaccuracyisnotuseful.
3.Theresultsarequitedifferent.Conveniencestoresuseconsiderable
amountsofresourcesthatarenotdrivenbydollarvolumeandsoare
undercostedusingthesingledriver.Itshouldproveworthwhiletoextend
andrefinetheanalysis.
417CostDrivers(20minutes)
NotetotheInstructor:Goodstudentswillgiveawidevarietyof
answershereandwillbeabletojustifymostofthem.Onepointtomakeis
thatdriversdonotcomeupandintroducethemselves:accountantsandother
managersmustseekthemout.
MachinemaintenanceMachinehours
WagesofworkerswhoresetmachinerywhenNumberofproductionruns
productschange
CostsofinspectingincomingmaterialsandNumberofincoming
shipments
components
CostsofkeepingrecordsonworkershowmuchNumberofemployees
theyproduce,whattheyearn
CostsofinspectingfinishedproductsProductioninunits
CoststoreworkdefectiveunitsProductioninunits,if
defectivesrunafairly
constantrelationshipto
output
BuildingmaintenanceSpaceinfactory
Personneldepartmentcosts,includingNumberofemployees
payrollprocessingcosts
Purchasingdepartmentcosts,includingNumberofvendors,
solicitingbidsfromvendorsNumberofpartsstocked
preparing,reviewing,andauditing
purchaseorders
CustomerbillingNumberofcustomers
Someofthesearearguable,andyoumightwishtodiscusstheconditions
underwhichadifferentdriver,listedornot,isappropriate.Forinstance,
machinemaintenancemightdependpartlyonthenumberofrunsbecausesetting
andtearingdowngeneratesadditionalwearandtear.Or,thecostsof
recordkeepingmightbedrivenpartlybythetypesofworkers,whether
salariedoronwages.Timekeepingforworkerssubjecttoovertimepayis

46

costlierthanforsalariedemployees.
Thenumberofpurchaseordersprobablydrivessomecostsinthe
purchasingdepartment.Amoreimportantdriverinsomepurchasing
departmentsisthecomplexityoruniquenessoforders.Thatis,the
departmentmightspendalotoftimeobtainingandevaluatingbidsonmajor,
uniqueitems.Thisischaracteristicofuniversitypurchasingdepartments.
418ActivityBasedCostAnalysis(1520minutes)
RegressionoutputfromExcelincludingbothunitsproducedandnumberof
productsappearsbelow.
SUMMARYOUTPUT
RegressionStatistics
MultipleR
0.933578
RSquare
0.871567
AdjustedRSquare
0.820194
StandardError
3,933.513
Observations
8

Intercept
UnitsProduced
NumberofProducts

Standard
Coefficients
Error
(25,580.10) 55,835.90
0.2348 0.1942
101.4761 17.8851

tStat Pvalue
Lower95%
Upper95%
0.458
0.666 (169,110.63) 117,950.43
1.209
0.281 (0.2644) 0.7340
5.674
0.002 55.5010 147.4513

ItisclearfromtheoutputthatUnitsProducedisnotastatistically
significantvariablesincethe95%confidenceintervalincludesavalueof
zero.Therefore,theregressionshouldbeperformedusingonlyNumberof
Productsasthexvariable.

47

SUMMARYOUTPUT
RegressionStatistics
MultipleR
0.913248
RSquare
0.834021
AdjustedRSquare
0.806358
StandardError
4,082.05
Observations
8

Intercept
NumberofProducts

Standard
Coefficients
Error
41,454.58 6,837.10
92.3155 16.8127

tStat Pvalue
Lower95%
Upper95%
6.063
0.001 24,724.80 58,184.36
5.491
0.002 51.1764 133.4547

Theoutputshowsthatthequarterlyfixedcostsareabout$41,455and
thatthereisavariablecomponentof$92.32perproduct.Thevariable
componentismostlikelystepvariable.Usingquarterlydatahelpstomake
thepointthatsomecostsrespondslowlytochangesinactivity.
Themeasuresoffitaregood.About83.4%ofthevariationincostis
associatedwithchangesinthenumberofproducts.Thestandarderrorofthe
estimateis4,082,sothat68%oftheobservationsshouldbewithin$4,082of
thepredictedvalueand95%within$8,160.ThevariableNumberofProducts
hasa95%confidenceintervalrangingfrom51.17to133.45.Sincethisrange
doesnotincludezero,thevariableisstatisticallysignificant.Wecan
concludethatthenumberofproductsisacostdriverintheproduction
schedulingdepartment.
Themajorconclusionaboutcostreductionisthatreducingthenumberof
productswillreducethesecosts.Itmightbepossibletoachievesome
reductionsbystandardizingproducts.
419ProductLineReport(25minutes)
1.PaperProductsDetergentsTotal
Sales$2,000,000$1,200,000$3,200,000
Variablecosts:
Costofgoodssold*1,400,000720,0002,120,000
Commissionsat10%200,000120,000320,000
Totalvariablecosts1,600,000840,0002,440,000
Contributionmargin400,000360,000760,000
Linesustainingcosts110,000150,000260,000
Productlinemargin$290,000$210,000500,000
Companysustainingcosts350,000
Profit$150,000
*70%ofsalesand60%ofsales

48

2.Paperproducts
PaperProductsDetergents
Currentcontributionmargin$400,000$360,000
10%increase$40,000$36,000
Lesspromotioncost30,00030,000
Increaseinprofit$10,000$6,000

3.Detergent
PaperProductsDetergents
Salesafterincrease$2,200,000$1,320,000
Costofgoodssold*1,540,000792,000
Commissionsat12%264,000158,400
Totalvariablecosts1,804,000950,400
Contributionmargin$396,000$369,600
Originalcontributionmargin400,000360,000
Increase(decrease)inprofit($4,000)$9,600
*$1,400,000x110%;$720,000x110%
NotetotheInstructor:Somestudentswilltrytosolvebydealingonly
withchanges,astheycouldinrequirement2.Mostofthesestudentswill
reachanincorrectanswerbecauseoffailuretorecognizethatthenew
commissionrateappliestoallsales,notjusttotheincreasedsales.
PaperProducts
Detergents
Salesincrease$200,000
$120,000timescontributionmarginpercentage,
30%12%;40%12%18%
28%Contributionfromsalesincrease$36,000$
33,600Additionalcommissionsonexistingsales
$2,000,000x2%;$1,200,000x2%40,000
24,000Increase(decrease)inprofit($4,000)
$9,600
4.ThisformatshowshoweachlineisperformingandalsomakesCVP
analysiseasierbecausethecontributionmarginpercentageisreadily
calculatedfromthereport.Areportshowingonlythecombinedresultsdoes
notpermityoutomakedecisionsaboutindividuallines,onlyaboutthe
businessasawhole(e.g.,increasevolumeofbothlinesbythesame
percentage).
NotetotheInstructor:Onepurposeofthisassignmentistoshowhow
profitabilityandchangesinitdependonbothvolumeandcontribution
margin.Theanswertorequirement2mustbeeitherpaperproductsorneither
line,becausea10%increaseinvolumewillincreasetotalcontribution
marginofthatproductlineby10%,andpaperproductshaveahighertotal
contributionmarginthandetergents.Thequestionisthenwhetherthe
increaseincontributionmarginisgreaterthantheincreaseinfixedcosts.
Inrequirement3,theproblemismoresubtlebecausenotonlyisvolume
increasingbutthecontributionmarginpercentageisdecreasingbytwo
percentagepoints.Itisthereforenotsoclearthatonelinewilldobetter
thantheother,muchlesswhetherchangingeithercommissionwillbe
profitable.Theschedulebelowshowstheeffectsinadifferentway.

49

PaperProductsDetergents
Originalcontributionmarginpercentage:
$400,000/$2,000,000;$360,000/$1,200,00020%30%
Lesstwopointsincreasedcommission18%28%
Timesnewvolume$2,200,000$1,320,000
Equalsnewtotalcontributionmargin$396,000$369,600
Ingeneral,reducingcontributionmarginpercentage(bydroppingprices,
increasingvariablecostssuchascommissions)toincreasevolumeisnot
profitableforlowcontributionmarginproducts.Itmightbeprofitablefor
highcontributionmarginproductsbutnotnecessarily.
420QualityCosts(1015minutes)
1.
Prevention
Employeetraining$50,000
Productdesign250,000
Vendorcertification80,000
Total$380,000
Appraisal
Inspectionofoutgoingshipments$70,000
Salariesoflaboratorypersonnel150,000
Inspectionofincomingshipments40,000
Total$260,000
Internalfailure
Reworkofdefectiveunits$40,000
Externalfailure
Salariesofcustomerservicepersonnel,40%$80,000
Somealternativesarepossible.Someemployeetrainingmightrelateto
qualityinspection,anappraisalcost.Customerservicepersonnelsalaries
areincludedaboveat40%,thepercentageoftimespentfixingproducts.
Someoftheremaining60%ofthosesalariesmightbepreventioncostsif
servicerepresentativestakecustomerrecommendationsbacktodesigners.
2.Thepointofthisquestionisthatopportunitycostsoflostsalesfrom
externalfailurearenotrecorded,norareinternalcostsoflostoutputfrom
timespentmakingandreworkingdefectiveproduct.
NotetotheInstructor:Youmightwishtointroducethequestionof
allocatingindirectcosts.Someofthecostsabovearesalariesonly,but
thecompanyincurscoststosupportthelaboratoryandthecustomerservice
representatives,aswellasotherqualityrelatedactivities.Therework
costsmightbelaboronly,orincludeappliedoverheadaswell.

410

421QualityCostsinaLawFirm(15minutes)
Activity
QualityCostCategory
1.Baddebtwriteoffs
Externalfailure
2.Billingorpayrollerrors
Internalfailure
3.Computerdowntime
Internalfailure
4.Employeeturnover
Internalfailure
5.Frequentbudgetrevisions
Internalfailure
6.Overstaffing
Internalfailure
7.Overtime
Internalfailure
8.Unplannedrevisionofdocuments
Internalfailure
9.Premiumsformalpracticeinsurance
Externalfailure
10.Reviewtimebypartners
Appraisal
11.Revisingorrecopyingofdocumentstocorrecterrors
Internalfailure
12.Settlementspaidoutbythefirm
Externalfailure
13.Timedevotedtoaddressingclientcomplaints
Externalfailure
14.Timespentdefendinglawsuitsfiledbyotherparties
Externalfailure
15.Traveltocontinuinglegaleducation
Prevention
16.Underutilizationofofficeequipment
Internalfailure
17.Unproductivemeetingtime
Internalfailure
NotetoInstructorNoticethatmostoftheactivitiesareeither
internalfailureorexternalfailure.
422ABC,ValueChain(15minutes)
TheABCratefororderfillingis$1,460perorder.
Orderfillingcosts$2,000,000
Numberoforders1,370((12x10)+(25x50))
Costperorder$1,460
Incomestatementsreflectingtheorderfillingcostsanddroppingtheother
sellingandadministrativeexpensesappearbelow.
TypicalTypical
LargeCustomerSmallCustomer
Numberperorder40,0001,600
Numberofordersannually1225
Totalannualvolume480,00040,000
Revenue$1,680,000$140,000
Variablemanufacturingcosts672,00056,000
Variablemanufacturingmargin1,008,00084,000
Fixedmanufacturingcosts288,00024,000
Manufacturingmargin720,00060,000
Orderfillingat$1,460perorder17,52036,500
Profit$702,480$23,500
Largecustomersarepayingformorecoststhantheyaregenerating.The
smallcustomersarenotasprofitableasoriginallycalculated,atleastover
areasonableperiodoftime.Thecompanycouldconsiderseveralapproaches.
Thementionofvaluechaininthetitlegivesonesuggestion.Kawishiwi
couldproposemeasurestoitssmallcustomersthatwouldreduceKawishiwi's
costs.Suchmeasuresmightincludeaskingthesmallcustomerstoorderless
frequently,ortopaymore.Onewaytodosoistochargedecliningperunit
amountsasordersizeincreases,ortoinstituteaflatchargeperorder,no
matterthesize.

411

Largecustomersshouldgetapricereduction,elsetheymightfindanother
suppliermorewillingtoaccommodatethem.
423ABCforaDistributor(25minutes)
1.Rates
ExpenseAmountDriverRate

Delivery$60,000500$120
Stocking30,00015,0002
Recordkeeping40,0002,00020
Other50,000$600,0008.33%rounded

SupermarketsConvenienceStores
Sales

$500,000$100,000
Costofsales300,00050,000
Grossprofit200,00050,000
Operatingexpenses
Delivery

48,000

12,000
Stocking8,000 22,000
Recordkeeping16,00024,000
Other41,650
8,350
Totaloperatingexpenses113,65066,350
Profit$86,350($16,350)

Severalrecommendationsarepossible.Oneistophaseoutconvenience
storesovertime.Anotheristochargeconveniencestorecustomers
separatelyfortheactivitiesthatconsumeresources.Thecompanymustmake
astrategicdecisionwhethertocontinuedoingbusinesswithconvenience
storesandifso,howtorecoverthecosts.
424CostDrivers,ActivityBasedAnalysis(20minutes)
RegressionoutputfromExcelfollows.
SUMMARYOUTPUT
RegressionStatistics
MultipleR
0.925124
RSquare
0.855855
AdjustedRSquare
0.831831
StandardError
2,899.44
Observations
8.00

Intercept
NumberofParts

Standard
Coefficients
Error
64,436.48 7,638.00
3.8448 0.6442

tStat Pvalue Lower95%

Upper95%
8.436
0.000 45,746.96 83,125.99
5.969
0.001 2.2686 5.4210

Theoutputsaysthatquarterlyfixedcostsareabout$64,436andthat
thereisavariablecomponentof$3.845perpart.Thefactsofthesituation

412

suggestthatthevariablecomponentisstepvariable.Weusedquarterlydata
tohighlightthepointthatsomecostsrespondslowlytochangesinactivity.
Themeasuresoffitaregood.About85.6%ofthevariationincostis
associatedwithchangesinthenumberofparts.Thestandarderrorofthe
estimateis$2,899,sothat68%oftheobservationsshouldbewithin$2,899
ofthepredictedvalue,95%within$5,798.ThevariableNumberofPartshas
a95%confidenceintervalrangingfrom2.27to5.42.Sincethisrangedoes
notincludezero,thevariableisstatisticallysignificant.Wecanconclude
thatthenumberofpartsbeingusedisanimportantdriverofpurchasing
departmentcosts.

Themajorrecommendationforcostreductionistostandardizepartsamong
theproducts.Thismightbeaccomplishedbystressingtheuseofcommon,
standardpartsinnewproducts,perhapsthroughchargesforusingnon
standardparts.
425CategorizingQualityCosts(15minutes)
Internal
External
Prevention
Designanalysis
Designengineering
Equipmentrepair/maintenance
Liabilityclaims
Manufacturinginspection
Manufacturingprocess/engineering
Marketing
Productacceptance
Qualityengineering
Qualityscrap
Qualitytesting
Qualitytraining
Receivinginspection
Returnedmerchandisecost
Repair
Rework
Travel

Appraisal
X

Failure Failure

X
X
X
X

X
X

X
X

X
X
X
X
X
X
X
X
X
X

NotetoInstructorTheremaybeminordifferencesinwhichcategoryany
specificcostisplaced.Someexpertsconsiderreceivinginspectiontobea
preventioncostwhileothersconsideritanappraisalcost.Likewise,
manufacturingandprocessengineeringexpendituresmaybeforanyofthe
categories.
426ABCforReceivingDepartment(20minutes)
1.Therateis$0.0814,$700,000/$8,600,000.

LineALineBLineC
Receivingcostsat$0.0814$366,300$179,080$154,660
Totalcostallocatedis$40offfromrounding.
2.
AmountofAmountof

CostDriverCostinPoolActivityRate

413

Totalmanufacturingcosts$440,000$8,600,000$0.051
Numberofshipmentsreceived180,0001,400129.00
Numberofordersrequiringinspection80,000240333.00
$700,000
Theratesarerounded.

LineALineBLineC

Totalmanufacturingcostsat$0.051$229,500$112,200$96,900
Numberofshipmentsreceivedat$12956,76041,28082,560
Ordersrequiringinspectionat$3333,3338,32568,265
Totals$289,593$161,805$247,725

Again,thetotalsareoffbecauseofrounding,butthisshouldnotbea
concernbecausetheanalysisispreliminary.
3.LineCcostsincreaseconsiderably,whileB'sdropsomeandA'sdecrease
considerably.LineCusesmoreresourcesthandotheotherlines.
Allocationsbasedontotalmanufacturingcostsdonotcapturethisresource
use.
WecannottellwhetheritwouldbedesirabletodoafullblownABC
studybecausewedonotknowwhethertotalcostswouldbesignificantly
different.Thatis,wedonotknowwhetherreceivingcostsarematerial.If
theyare,thecompanyshouldpursueABCbecausetheproductlinesconsume
quitedifferentamountsofreceivingdepartmentresources.
427ProductLineIncomeStatements(35minutes)
1.Thefirststepistofindthenumberofeachproductsold.
Saws:4,000($500,000x40%)/$50
Drills:7,500($500,000x30%)/$20
Sanders:3,750($500,000x30%)/$40
MifflanToolCompany
IncomeStatementforJanuary20X8

TotalSawsDrillsSanders
Sales$500,000$200,000$150,000$150,000
Costofsales(1)307,500120,000112,50075,000
Grossprofit192,50080,00037,50075,000
Shippinganddelivery(2)23,0008,0007,5007,500
Contributionmargin169,500$72,000$30,000$67,500
Fixedcosts(3)140,000
Incomebeforetaxes$29,500
(1)Saws=4,000x$30
Drills=7,500x$15
Sanders=3,750x$20
(2)Saws=4,000x$2
Drills=7,500x$1
Sanders=3,750x$2
(3)Rent,salaries,andotherexpensesof$40,000,$70,000,and$30,000
2.Attheexpectedmixthesalesofeachproductwouldhavebeenasfollows:
Saws:3,000($500,000x30%)/$50
Drills:5,000($500,000x20%)/$20
Sanders:6,250($500,000x50%)/$40

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MifflanToolCompany
ExpectedIncomeStatementforJanuary20X8

TotalSawsDrillsSanders
Sales$500,000$150,000$100,000$250,000
Costofsales290,00090,00075,000125,000
Grossprofit210,00060,00025,000125,000
Shippinganddelivery23,5006,0005,00012,500
Contributionmargin186,500$54,000$20,000$112,500
Fixedcosts140,000
Incomebeforetaxes$46,500
3.

ExpectedPercentages:TotalSawsDrillsSanders
Sellingprice$50.00$20.00$40.00
Costofsales30.0015.0020.00
Grossprofit$20.00$5.00$20.00
Grossprofitpercentage40%25%50%
Mixpercentage30%20%50%
Weightedaverage42%12%5%25%
Grossmargin,above$20.00$5.00$20.00
Lessshippinganddelivery2.001.002.00
Contributionmargin$18.00$4.00$18.00
Contributionmarginpercentage36%20%45%
Weightedaverage37.3%10.8%4.0%22.5%
ActualPercentages:

TotalSawsDrillsSanders
Grossprofitpercentage40%25%50%
Actualsalesmix40%30%30%
Weightedaverage38.5%16%7.5%15%
Contributionmarginpercentage36%20%45%
Weightedaverage33.9%14.4%6.0%13.5%
Theeffectofthechangeinmixwastoreducethegrossmarginpercentage
to38.5%from42%,3.5percentagepoints.Thisresultedina$17,500dropin
grossmargin($500,000x3.5%).Thepercentageofshippinganddelivery
expensesdroppedfrom4.7%($23,500/$500,000)to4.6%($23,000/$500,000).
This0.1%decreasegainedanadditional$500ofcontributionmarginand
profit.
SomestudentswilldealonlywiththechangeintheWACM(37.3%expected
versus33.9%actual),adropof3.4percentagepoints,givingthe$17,000
profitshortfall($500,000x3.4%).Whetherornotvariablecostsare
discussedindividually,thepresidentcanbetoldthattheshiftinmixwas
unfavorablebecausethelowestmarginproduct,drills,increaseditsshare
andthehighestmarginproduct,sanders,reduceditsshare.
428ProductLineReporting,ActivityAnalysis(35minutes)

KellyCompany
ProductlineIncomeStatementforApril20X7(000s)
Sport

SuitsClothesAccessoriesTotal
Sales(1)$240.0$400.0$160.0$800.0
Variablecosts:
Costofsales(2)192.0300.080.0572.0

415

Commissions(3)14.424.09.648.0
Totalvariablecosts206.4324.089.6620.0
Contributionmargin33.676.070.4180.0
Productlinesustainingcosts(4)12.08.05.225.2
Shorttermmargin21.668.065.2154.8
Directcommittedfixedcosts(5)6.08.86.020.8
Longtermmargin$15.6$59.2$59.2134.0
Facilitysustainingcosts:
Salaries($71.4$25.2)46.2
Rent21.4
Shippinganddelivery15.2
Insurance14.0
Totalcompanysustainingcosts96.8
Income$37.2
(1)$800,000timessalesmixpercentagesof30%,50%,and20%
(2)Salesdollarstimesvariablecostpercentagesof80%,75%,and50%
(3)Salesdollarstimes6%
(4)Salariesformanagersanddirectlyassociatedpersonnel,asgiven.
(5)Given
NotetotheInstructor:Somediscussionpointsregardingtheincome
statementfollow.
Statementsaboutprofitabilityofdepartmentsassumeindependenceamong
thedepartments.Itislikelyinthiscasethatsalesinotherdepartments
wouldbeadverselyaffectedifoneweredropped.Studentswillunderstand
thispointeventhoughithasnotyetbeenexplicitlyintroduced.
Suitshaverelativelylowmarginscomparedtotheotherlines,andwe
mightaskwhetherthisisnormal.Students,especiallymarketingmajors,
mightbeawarethattradeassociationspublishinformationthatwouldhelpto
determinewhetherthesuitdepartmentiswellbelowthoseofcompetitors.If
thereisreasontobelievethattheperformanceispoor,themanagerofthe
suitdepartmentshouldhavetoexplaintherelativelylacklusterperformance.
429ABCforaDistributor(35minutes)
1.ABCDE
Sales$400,000$440,000$660,000$800,000$1,400,000
Grossprofit192,000202,400277,200296,000476,000
Ordercosts82,60048,75039,60029,40025,500
Deliverycosts70,00062,50045,00030,00037,500
Stockingcosts13,44020,00017,28033,60045,600
Totalcosts166,040131,250101,88093,000108,600
Margin$25,960$71,150$175,320$203,000$367,400
Ordercosts,$240perorderplus$5.00peritemordered.
CustomerA=($240x140)+($5.00x140x70)=$82,600
Deliverycosts,$500xnumberofdeliveries.
CustomerA$500x140=$70,000
Shelfstockingcosts,$0.16xdeliveriesxtotalunitsperorder.
CustomerA=$0.16x140x600=$13,440
2.Youmightwishtopointoutthatthecontrollerallocated$600,002in
coststothecustomers,whiletheABCestimatesare$600,770,aslight
differencethatislikelytooccuranytime.Thepictureisquitedifferent
undertheABCanalysis.CustomerAhadappearedquiteprofitableunderthe
controllersanalysisbecauseofitshighgrossprofitpercentage,butits

416

relativelyhigherservicingcostsreduceditsapparentprofitability
considerablyundertheABCanalysis.CustomersCandDhadappearedalmost
equallyprofitableunderthecontrollersanalysis,butasharpdifference
opensupundertheABCanalysis.CustomerEsprofitabilityjumpednearly
50%undertheABCanalysis.
Thereasonsforthechangeslieinthedemandsthatthevarious
customersplaceonWesternsresources.Thesmallercustomersuserelatively
moreresourcesbecausetheyorderandreceivedeliveriesmoreoften.
430LineofBusinessReporting(60minutes)
RiparianCompany
QuarterlyIncomeStatement

TotalProductAProductBProductC
Sales$1,300,000$500,000$400,000$400,000
Variablecosts:
Manufacturing820,000300,000(60%)280,000(70%)
240,000(60%)
Selling31,00015,000(3%)8,000(2%)8,000
(2%)
Totalvariablecosts851,000315,000288,000248,000
Contributionmargin449,000185,000112,000152,000
Productsustaining(1)180,00042,00052,00086,000
Productmargin$269,000$143,000$60,000$66,000
Companysustainingcosts:
Manufacturing(2)50,000
Selling(3)34,000
Administrative52,000
Total136,000
Income$133,000
(1)$40,000avoidable,30%,30%,40%toproducts,plus$140,000product
sustainingmanufacturingcosts,$30,000,$40,000,$70,000
(2)Totalfixedmanufacturingcostof$190,000less$140,000product
sustaining
(3)Totalsellingexpenseof$105,000less$31,000variableless$40,000
avoidable,directsellingcosts.

417

2.RiparianCompany
QuarterlyIncomeStatement

TotalDomesticForeign
Sales$1,300,000$1,000,000$300,000
Variablecosts:
Manufacturing820,000630,000(A)190,000(A)
Selling31,00024,000(B)7,000(B)
Totalvariablecosts851,000654,000197,000
Contributionmargin449,000346,000103,000
Marketsustainingcosts(1)184,000126,000(C)58,000(C)
Marketmargin265,000$220,000$45,000
Companysustainingcosts
Manufacturing80,000
Administrative52,000
Total132,000
Income$133,000
(1)Sellingcostsof$36,000and$38,000(seebelow)plus$90,000and
$20,000manufacturingcosts
ScheduleAVariableManufacturingCosts
(1)(2)(3)(4)(5)(6)(7)
VariableVariableVariable
CostDomesticCostForeignCostTotal
ProductRatioSales(2)x(3)Sales(2)x(5)(4)+(6)
A60%$400,000$240,000$100,000$60,000$300,000
B70%300,000210,000100,00070,000280,000
C60%300,000180,000100,00060,000240,000
Totals$630,000$190,000$820,000

ScheduleBVariableSellingExpenses

A3%$400,000$12,000$100,000$3,000$15,000
B2%300,0006,000100,0002,0008,000
C2%300,0006,000100,0002,0008,000
Totals$24,000$7,000$31,000
ScheduleCFixedSellingCostsbyMarket
DomesticForeign
Totalsellingcosts$60,000$45,000
Variable(ScheduleB)24,0007,000
Fixed$36,000$38,000

418

3.Thechangewouldproduceanincreaseinprofitof$2,200perquarter.
SalesContributionAdditional
ProductIncreaseMarginPercentageContributionMargin
A$80,00037(100603)$29,600
B80,00028(100702)22,400
C40,00038(100602)15,200
Totals$200,000$67,200
Lostshorttermmarginforeignmarket
(seeRequirement2)($103,00038,000)65,000
Netincrease$2,200
4.Atleast$166,000.ProductCprovidesproductmarginof$136,000per
quarterandadditionalcostsof$30,000wouldbeincurred.
431DeterminingVariableCostsofProductsActivityBasedAnalysis(25
minutes)
1.Product816uses0.50DLH($8/$16)andproduct389uses1.0DLH
($16/$16).

AmountofDriverVariableOverheadCost
Product816Product389RatesProduct816Product389
DLH0.51$4.00$2.00$4.00
MH0.50.2$20.0010.004.00
Parts120185$0.078.4012.95
Processingtime105$4.0040.0020.00
Totalvariableoverhead$60.40$40.95
Materials15.0013.00
Directlabor8.0016.00
Totalvariablecost$83.40$69.95
2.
Overhead0.51$50.00$25.00$50.00
Materials15.0013.00
Directlabor8.0016.00
Totalvariablecost$48.00$79.00
3.Wedonotwishtofocusattentiontoomuchonthespecificdifferences
betweenthecosts,butratheronthegeneralpointthatestablishingcost
poolsmightbenefitthecompanythroughbetterinformationaboutthe
consumptionofresources.Thecostofproduct816ishigherusingthe
multiplepools,whilethatofproduct389islower.Thereasonisthe
relativeusesofthecostdrivers.Youmightwishtoshowhowthecosts
mightchangeforproductswith,say,largenumbersofpartsorlonger
processingtime.

419

432SegmentedIncomeStatementsforaDistributor,ActivityAnalysis,
Ethics(25minutes)
1.

TotalEasternSouthernWestern
Sales$2,896.0$589.0$752.0$1,555.0
Variablecosts:
Costofsales(1)1,231.9200.3300.8730.8
Sellingexpenses(2)429.182.597.8248.8
Totalvariablecosts1,661.0282.8398.6979.6
Contributionmargin1,235.0306.2353.4575.4
Districtsustainingcosts
Sellingexpenses(3)514.0152.0155.0207.0
Administrativeexpenses(4)40.09.012.019.0
Totaldistrictsustaining554.0161.0167.0226.0
Districtmargin$681.0$145.2$186.4$349.4
Companysustainingcosts(5)307.9
Income$373.1
(1)Asoriginallygiven
(2)Salesmultipliedbyvariablecostpercentages:$589x.14;$752x.
13;$1,555x.16.
(3)Given
(4)Given
(5)Totalcostslesscostsaccountedforabove
SellingCostsAdministrativeCosts
Totalinproblem$1,026.0$265.0
Variablecosts(429.1)0
Districtsustainingcosts(514.0)(40.0)
Companysustainingcosts$82.9$225.0
Totalcompanysustainingcosts=$307.9,$82.9+$225
2.Thememorandumcouldmakethefollowingpoints.
Thenewincomestatementsrearrangecostsbutdonotchangethem.Notice
thatincomeforthecompanyremainsthesameat$373.1thousand.Thenew
statementsreflecttheuseofresources,oractivities,foreachregion.Our
previousincomestatementsassumedthatsaleswastheonlycostdriver.The
newformatdoesnotattempttoallocatecommoncoststotheregions.

Thedistrictmarginsarethebestbasesforevaluatingtheregions.
Thesemarginsincludeallcostsincurredtosustainthesegments.Themargin
indicateshowmuchtheregioncontributestocoveringcompanysustaining
costsandprovidingaprofit.Usingthedistrictmargins,allterritories
appeartobedoingwell.Weneedtimetoassessperformanceinthenew
territories.TheopeningoftheseterritoriesshouldalsoaffecttheWestern
territory,becausecoststhatwereformerlyincurredonlyforthebenefitof
theWestnowarecommontoallthreeterritories.Examplesincludecorporate
overheadcostsandsomedataprocessingcosts.Acomparisonoftheincome
statementabovewithonessimilarlypreparedforpreviousperiodswouldhelp
ustoseehowtheWesternterritoryhasbeenprogressing.

Thenewterritorieshavesizabledistrictmarginsandtheircontribution
marginpercentagesareevenhigherthanthatoftheestablishedWestern
territory.Thishigherreturncouldberelatedtotheproductlinesthatwe
areselling.Taylormightbesellingmoreofthehighmarginlinesinthe
newterritories,asthelowercostofsalesratiosinthenewterritories
suggest.

420

Thenewstatementsshouldallowyoutomakebetterdecisionsand
evaluationsbecausetheyhighlightcontributionmarginandsegmentmarginfor
eachregion.
3.Thefollowingpointsarerelevantforthememorandum.
Regardlessofhowwepreparesegmentedincomestatements,wecouldhave
ethicalissueswiththeallocationsandassignmentsofcoststoregions.

TheIMAobjectivitystandardrequiresthatwecommunicateinformationfairly
andobjectivelyanddiscloseallrelevantinformation.Thecompetence
standardrequiresthatwemaintainprofessionalcompetenceandemployitin
developingreports.Takentogether,theseStandardsrequireustobesure
that(1)wehavereflectedthecostsofactivitiesinafairandreasonable
way,(2)wehavenotfavoredanyregionoveranotherinassigningcosts,and
(3)wehavereflectedthemostrelevantinformationinappropriateways.
433SegmentedIncomeStatementsCostsofActivities,Ethics(30minutes)
1.
Sporting

TotalGoodsHousewaresHardware

Sales$3,337.0$650.0$921.0
$1,766.0Variablecosts:
Costofsales(1)1,094.8182.0294.7
618.1
Sellingexpenses(2)58.613.013.8
31.8
Administrativeexpenses(3)47.65.96.4
35.3Totalvariablecosts1,201.0200.9314.9
685.2Contributionmargin2,136.0449.1606.1
1,080.8Productlinesustainingcosts
Costofsales496.0158.0141.0
197.0
Sellingexpenses276.056.087.0
133.0
Administrativeexpenses78.013.022.0
43.0Totallinesustainingcosts850.0227.0250.0
373.0Productmargin$1,286.0$222.1$356.1$
707.8Companysustainingcosts(4)1,180.0
Income$106.0
(1)Salesxpercentagevariablecost,$650x28%;$921x32%,$1,766x35%
(2)Salesxpercentagevariablecost,$650x2%;$921x1.5%,$1,766x1.8%
(3)Salesxpercentagevariablecost,$650x.9%;$921x.7%,$1,766x2%
(4)Costsremainingafterothersaccountedfor
Administrative
CostofSalesSellingCostsCosts
Totalinproblem$1,928.8$787.6$514.6
Variablecosts(1,094.8)(58.6)(47.6)
Linesustainingcosts(496.0)(276.0)(78.0)
Companysustainingcosts$338.0$453.0$389.0
Totalcompanysustainingcostsare$1,180,$338+$453+$389

421

2.
To:Controller
From:Student
Date:Today
Subj:Alternativeincomestatements

Irecommendthatweadoptthenewformofsegmentedincomestatement.
Thenewincomestatementisolatescostsbybehavior,whichgivesyouand
othermanagersbetterinformationforplanningandfordecisionsaboutissues
suchaswhichsegmentstoemphasize.Thecontributionmarginpercentages
(69.1%forsportinggoods,65.8%forhousewares,and61.2%forhardware)are
morehelpfulinevaluatingthesegmentsandindecidingwhichoneswemight
promoteordownplaythanarereturnonsalespercentages.Forinstance,the
65.8%forhousewarestellsusthatwewouldnotbesmarttoignoreit,asthe
originalincomestatementsuggested.
Theproductmarginsshownonthenewstatementshowthecontributions
eachlinemakestocoveringcommoncostsandprovidingaprofit.Again,we
seethatthehousewareslinemakesasignificantcontribution.Thesemargins
aremorehelpfulthanthegrossmarginorincomefiguresontheoriginal
statement.Evaluatingtheprofitabilityofsegmentsshouldcenterontheir
marginswithoutallocatedcommoncosts.Wewillthenbebetterablethan
beforetoassesstheeffectsofdroppingsegmentsorreplacingthem.
Thenewstatementprovidesmorerelevantinformationforvirtuallyany
decisionthatyouandothermanagerswishtomake.Thecontributionmargin
percentagesarevaluableforanydecisioninvolvingchangesinvolumes,
prices,orvariablecosts.Theproductmarginsarehelpfulinassessinghow
welleachlineisdoing.
3.Themanagerscanexpectthattheaccountantswillprepareobjective
reportsinacompetentway.TheIMAobjectivitystandardrequiresthatwe
communicateinformationfairlyandobjectivelyanddiscloseallrelevant
information.Thecompetencestandardrequiresthatwemaintainprofessional
competenceandemployitindevelopingreports.Takentogether,these
Standardsrequireustobesurethat(1)wehavereflectedthecostsof
activitiesinafairandreasonableway,(2)wehavenotfavoredanyregion
overanotherinassigningcosts,and(3)wehavereflectedthemostrelevant
informationinappropriateways.

422