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CHAPTER 5: ACTIVITY-BASED COSTING AND MANAGEMENT

QUESTIONS 5-1 Product costs are likely distorted when a firm uses a volume-based rate if the plant has more than one activity in its operations and not all activities consume overhead in the same proportion. The more diverse the product mixes of the plant are in volume, sizes, manufacturing processes, or product complexities, the greater the cost distortions are likely to be in using a volume-based rate. Undercosting a product may appear to have increased the reported profit the product earned (assuming the firm did not lower its selling price because of the reported lower product cost). However, the increased profit is, at best, a twist in truth. Costs of the product not charged to the product itself are borne by other products of the firm. Worse, undercosting a product may result in managers erroneously believing the product to be more profitable than other products and shifting the limited resource the firm has into manufacturing, promotion, and sales of the product when, in fact, other products are more profitable to the firm. Severe cost distortions may lead firms not to drop unprofitable products because the cost data show these products are profitable. 5-3 Overcosting does not increase revenues. A firm can increase the selling price of a product, thereby increasing the total revenue from the product only if the market allows. Increases in the selling price of a product without experiencing noticeable decrease in the sales quantity of the product is likely an indication that the product was not priced properly, which might be a result of undercosting of the product. Furthermore, overcosting a product is likely accompanied by undercosting of the firms other products and, as a result, underpricing of one or more of the firms other products. When a firm sets a high selling price that is a result of overcosting, competitors also are likely to enter the market and take away the firms market share. A firm also may drop or de-emphasize an erroneously overcosted product when it erroneously believes the product is either unprofitable or having a low-margin.

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

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Based on the activities of most manufacturing firms, the general levels of cost hierarchy of an activity-based costing system are: Unit-level cost; Batch-level cost; Product-level cost; and Facility-level cost. In an activity-based costing system, the second-stage procedure in tracing costs to products or services is a process by which the costs of activities or activity pools are assigned to cost objects using one or more appropriate activity consumption cost drivers. All firms should use an ABC system when the benefits of such a system exceed the costs of implementing it. It is especially beneficial to firms with product diversity and/or process complexity. Unit-level activities are activities performed on individual units of product or service. The frequency of a unit-level activity varies in proportion with the units of product manufactured or service provided. Examples of unit-level activities are using direct materials, using direct labor hours, inserting a component, inspecting each unit, and consuming power to run machines.

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Batch-level activities are activities performed for a group of units of products or services rather than for each individual unit of product or service. The frequency of batch-level activity is determined by both the size of the group and the total number of units to be manufactured or provided. Examples of batch-level activities are setting up machines, processing and placing of purchase orders, scheduling production runs, inspecting products by batch, and handling materials.

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5-10 Product-level activities are activities undertaken to support individual products or services rather than for each individual unit of product or service or a group of individual units of products or services. Examples of product-level activities include product design, parts administration, and product modification. 5-11 Facility-level activities are activities performed for the entire organization or division to meet the required operating procedure or support the operation of the organization or division. Examples of facility-level activities include providing security for the facility, maintaining general equipment and facility, plant management, plant depreciation, and property taxes and insurance premium for facilities. 5-12 A product-costing system that uses a single volume-based cost driver is likely to overcost high-volume products because high-volume products do not consume support resources in proportion to their production volumes. As a result, a product-costing system that uses a single volume-based cost driver often overcosts high-volume products or services and undercosts low-volume products or services. The cross-subsidizations of low-volume products by high-volume products is likely to lead the firm not to price its products properly. This may also decrease the profits of the firm and reduce managements confidence in the product cost predictions. Poor pricing can lead a firm to promote less profitable products while not spending sufficient resources on more profitable items. 5-13 Activity-based management is the use of an activity-based costing system to improve operations, increase customer value, and enhance profitability. 5-14 Examples of high-value-added activities include insertion of parts, assembling of components, machining to meet specification, reducing response time, and reduction of defective characteristics. Examples of low-value-added activities include moving parts between workstations, transporting finished units to warehouse, waiting for materials or parts to arrive, inspecting, repairing, and storing. Service organizations such as banks, hospitals, transportation companies, law firms, and trading companies can use activity-based costing and management in all phases of their operations as manufacturing firms do. For example, a bank can use ABC to calculate the cost to process a check, a hospital can use ABC to determine costs per patient day for different kinds of patients and the cost to admit a patient, etc.
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Opportunities afforded by customer profitability analysis are: Providing better services to highly profitable customers; Identifying and securing highly profitable customers from competitors; Setting prices based on the cost to serve; Negotiating with customers to set mutually beneficial levels of services; Transforming unprofitable customers into profitable ones through targeted negotiations on price, quantity, product mix, order processing, delivery terms, and payment arrangements; Identifying and conceding permanent loss customers to competitors. .

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BRIEF EXERCISES 5-18 Total Cost per Batch = $50 + (.1 x 5,000) = $550 Cost to produce 100,000 cans = (50 x (100,000/5,000)) + (.1 x 100,000) = $11,000 5-19 5-20 ((30,000 x 0.2) / 60) x $10= $1,000 Cost for 50 Heads = (60 / 20) x 5 + (50 x $0.1) = $20 Cost for 60 Heads = (60 / 20) x 5 + (60 x $0.1) Difference = $21 $20 = $1 = $21

5-21 (($15 x .5) + $5) x 5 cars x 5 days = $312.50 per week 5-22 Cost per computer = $1,000,000 / 5,000 = $200 per computer $200 = (2 x (cost of one technician hour)) + (5 x $10) Cost for technician time = $200 - $50 = $150 $150 = 2 x (cost of one technician hour) technician hourly rate = $75 per technician hour 5-23

Materials Cost Labor Cost Inspection Cost Packaging Cost

= $3,000,000 / 100,000 = $30 per camera = $500,000 / (100,000 x .5) = $10 per camera = $1,000,000 / (100,000 x .2) = $50 per camera = $500,000 / 100,000 = $5 per camera = $8 x 5 = $40 = $0.05 x 1,000 = $50 = $50 + $40 = $90

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Direct Labor Copying Total Job Cost

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Data Entry = $2,000,000 / 100,000 = $20 per hour Data Analysis = $3,000,000 / 30,000 = $100 per hour

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

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$150 x .2 = $30 million 500,000 x 20 = 10 million $30/10 = $3 per part Total inspection cost: $3 x 20 = $60 for 20 parts $3 x 50 = $150 for 50 parts

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6 x 10,000 x $.50 = $30,000

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EXERCISES 5-29 Activity Levels (5 min) 1. Cost Hierarchy a. Unit-level b. c. d. e. Unit-level Facility-level Unit-level Unit-level f. g. h. i. Product-level Facility-level Facility-level Batch-level

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

2. Cost Driver a. b. c. d. e. f. g. h. i. j. Number of hamburgers Number of hours Square feet Number of hamburgers; Size of hamburgers Number of hamburgers Number of times the advertising is run Number of hours store is open Square feet Number of coupons redeemed; Number of multiple orders; Number of hamburgers Number of customers

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5-30 Activity Levels and Cost Drivers (5 min) 1. Activity Levels a. b. c. d. e. Unit-level Batch-level Batch-level Batch-level; Product-level Product-level f. g. h. i. j. Facility-level Product-level Product-level Unit-level; Batch-level Batch-level.

2. Cost Drivers a. Machine hours b. Number of setups or setup hours c. Number of production orders d. Number of material receipts; Number of purchase orders e. Number of products f. Number of machine hours g. Number of engineering change notices; number of modifications; Number of products h. Number of parts; Number of products; Number of purchase orders i. Number of inspection hours; Number of units; Number of batches j. Number of loads; Number of material moves; Material weights

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5-31 Activity Levels and Cost Drivers (5 min) 1. Activity Levels a. b. c. d. e. Product-level Product-level Product-level Product-level Batch-level f. g. h. i. j. Batch-level Unit-level Facility-level Product-level Facility-level

2. Cost Drivers a. Number of products b. Number of products c. Number of products d. Number of products e. Number of batches or setups f. Number of batches g. Number of units h. Purchase costs; Replacement costs; Book values i. Number of purchase orders; Number of products; Number of suppliers j. Square feet

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

These costs are likely to vary with the number of test-hours, which are functions of the output units (test). Batch-level costs: c. setup costs $240,000 Setup costs are incurred each time a batch of tests is setup for either ST or PRT, regardless of the number of hours of the tests. Product-level costs: d. Costs of test designs $360,000 These costs are incurred in designing ST and PRT tests, regardless of the number of test-hours or number of batches tested. 2. As shown in the calculation below, the current costing system of charging $70 per test-hour for overhead undercosts the soil test (ST) and overcosts the pesticide residues test (PRT). One reason is that ST uses more setup costs and test design costs than PRT does, while ST has lower test hours than PRT. On average, ST tests take longer to setup (0.85 versus 0.575 setup hour per test hour) and it is more difficult to design the test (0.58 versus 0.21 setup hours per test hour) Setup Hours Test-Hours Total Per Test-Hour 10,000 8,500 0.850 20,000 11,500 0.575 Test Design Hours Total Per Test-Hour 5,800 0.58 4,200 0.21

ST PRT

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5-32 (continued)
3.

ST Total $540,000 100,000

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

Per Hour 10,000 $54.00 $10.00

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

200,000

$10.00

102,000

$10.20

138,000

$6.90

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

7.56 $57.46 $300,000 30,000 $10 $240,000 20,000 $12.00 $360,000 10,000 $36.00

10,000 100,000 8,500 102,000 5,800 208,800

20,000 200,000 11,500 138,000 4,200 151,200

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5-32 (continued-2) 4.

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

ST Total Per Hour 2,500 $135,000 $54.00

PRT Total Per Hour TOTAL 5,000 7,500 $165,000 $33.00 $300,000 $40.00

$69.00

$75.60 $217.60 $300,000 7,500 $40 $600,000 20,000 $30.00 $900,000 10,000 $90.00

2,500 100,000 $240,000 $360,000 8,500 255,000 $360,000 $540,000 5,800 522,000

5,000 200,000 11,500 345,000 4,200 378,000

The cost per test-hour increased from $95.08 to $404.80 for ST and from $57.46 to $217.60 for PRT. Platte Valley needs to reexamine the appropriateness for using test-hours as the basis for costing. The bulk of the cost is for setup and test-design and the direct cost related to test-hour is only a fraction of the setup and test-design costs. A costing system based on the direct test-hour is likely to distort the true cost of testing.
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5-33 Volume-Based Costing vs. ABC (20 minutes) 1. The volume-based cost system developed for inventory valuation is likely to distort product cost information because the cost system: a. is designed to value inventory in the aggregate and not related to product cost information. b. uses a common departmental or volume-based measure of activity, such as direct labor hours or dollars (now a small portion of overall production costs) to distribute manufacturing overhead to products. c. de-emphasizes long-term product analysis (when fixed costs become variable costs). d. causes managers, who are aware of distortions in the volumebased system, to make intuitive, imprecise adjustments to the volume-based cost information without understanding the complete impact. 2. Outlined below are the purpose and several characteristics of the three noted cost systems. a. Inventory Valuation Meets external reporting requirements for aggregate balance sheet valuation and income determination. Provides monthly and quarterly reporting. b. Operational Control Evaluates operations to quickly detect problems to allow for implementation of corrective action. Compares costs against budget for monitoring variances. c. Activity-based costing Differentiates costs between high-value added and low-value-added activities. Costs products according to activities involved in the production process.

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5-33 (continued) 3. The benefits that management can expect from activity-based costing include these: a. Leads to a more competitive position by evaluating cost drivers, i.e., costs associated with the complexity of the transaction rather than the production volume. b. Streamlines production processes by reducing low-value-added activities, e.g., reduced set-up times, optional plant layout, and improved quality. c. Provides management with a more thorough understanding of product costs and product profitability for strategies and pricing decisions. 4. The steps that a company, using a volume-based cost system, would take to implement activity-based costing include: a. evaluation of the existing system to assess how well the system supports the objective of an activity-based cost system. b. identification of the activities for which cost information is needed with differentiation between high-value added and low-valueadded activities.

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5-34 Activity-Based Costing Hakara Company (10 min) Cost Pools Machine setup Materials handling Electric power Activity Costs $360,000 100,000 40,000 A Direct materials Direct labor Factory overhead: Machine setup Materials handling Electric power Total product costs Production units COST PER UNIT $120 x 200 = $4 x 1,000= $1 x 2,000 = $40,000 24,000 24,000 4,000 2,000 $94,000 4,000 $23.50 $120 x 240 = $4 x 3,000 = $1 x 4,000 = Cost Drivers 3,000 setup hours 25,000 pounds 40,000 kilowatt hours B Overhead Rate $120 4 1 . $50,000 40,000 28,800 12,000 4,000 $134,800 20,000 $6.74

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

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

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5-37 Activity-Based Costing in the Fashion Apparel Industry (20 min) The ABC-costing solution follows:
(all figures in ) Price Total Revenue Direct Materials Labour and Overhead Costs Pattern cutting Grading Lay planning Sewing Finishing Inspection Boxing up Storage Labor and Overhead (ABC-based) Total Product Cost Unit Product Cost Non-manufacturing Expenses Total Cost Net Margin for Trousers 20.525 205,250 33,750 22,000 19,000 18,500 21,000 14,300 6,500 3,500 7,000 111,800 145,550 14.56 31500 177,050 28,200

The results suggest that the trouser line is more profitable than previously thought (using volume-based costing). This is likely due to the common situation in which the high-volume products are overcosted using volumebased costing.

Source of data used in the example: Andrew Hughes, ABC/ABM: A profitability Model for SMEs Manufacturing Clothing in the UK, Journal of Fashion Marketing and Management, 2005, Vol 9 Is 1, pp8-19. (SME means small to medium size company)
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5-38 Service IndustryGWS Hospital (10 min)


1. GWSs ICU overhead costs for the month of June using: a. Hospital Wide Rate Based on Nurse-Hours Per nurse-hour: $69,120,000 /1,152,000 = $60 x 5,900 = $60 $354,000 Total ICU applied overhead costs: Total budgeted ICU overhead: $810,000 + $422,500 + $457,500 = $1,690,000 Overhead rate per patient-day: $1,690,000 / 845 = c. Activity Cost Driver Rates Budgeted Cost Pool Beds Equipment Personnel Budgeted Cost $810,000 422,500 457,500 Activity 900 845 6,000 Budgeted Total Applied OH Rate Activity Overhead $900.00 900 $810,000 500.00 76.25 870 5,900 435,000 449,875 $1,694,875 $2,000 Total ICU applied overhead costs: $2,000 x 870 = $1,740,000

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

Total applied overhead costs

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

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5-39 Product Selection (5 min)


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

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5-40 High-value-added and Low-value-added ActivitiesRadiology (5 min)


(Note to instructor: Answer may vary if students perceive a different operation) a. High-value-added b. Low-value-added (Patients are likely to perceive waiting to have low-value) c. Low-value-added (Any need for lab work should have been determined prior to arriving at the Radiology Department) d. Low-value-added e. High-value-added f. High-value-added g. Low-value-added h. Low-value-added i. High-value-added

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5-41 High-value-added and Low-value-added ActivitiesNurse (5 min)


(Note to instructor: Answer may vary if students perceive a different operation) a. High-value-added b. High-value-added c. High-value-added d. Low-value-added e. Low-value-added f. High-value-added g. High-value-added h. Low-value-added i. High-value-added

5-42 High-value-added and Low-value-added Activitiese-Retailing (5 min)


(Note to instructor: Answer may vary if students perceive a different operation) a. Low-value-added b. Low-value-added c. Low-value-added d. Low-value-added e. Low-value-added f. High-value-added g. Low-value-added h. High-value-added

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


A: B: C: D: $0.15 x 30 = $37 / 1.85 = $35.50 / 5 = $0.08 x 100 = $ 4.50 $20.00 $ 7.10 $ 8.00 $240.00 x 50% $120.00 $25.00 5.00

Cost per board that passed the final inspection Rejection rate Cost per completed board Direct materials Direct labor Other manufacturing overhead: Axial insertion Hardware insertion Hand load Masking $ 4.50 37.00 35.50 8.00 85.00

115.00 $5.00 10 $0.50

Manufacturing overhead for final test (E) Units of cost driver for final test Manufacturing overhead rate per unit of test time(F)

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5-44 Cost of Meal

(5 min)

Below is a suggestion for Annies response:

Dear Totem Pole: If these are business-related dinners, you should talk to your accountant about deducting them from your expenses or billing your share to the clients. If that isnt feasible, agree to meet these folks for cocktails, but leave before dinner, claiming you have to be elsewhere. No other excuse is needed.
Note: This example illustrates the advantages of ABC in a familiar situation. Put all in one check and then split the bill equally is an example of volume-based overhead rate. Split-up the bill based on the number of meals is like using machine hours, labor hours, or other measures, rather than the activities themselves, to determine costs of products or services. Products having the same total machine hours pay for the same amount of overhead, regardless of the differences in the amount of setup times, product design hours, etc. these products might have used. Having separate checks is an ABC system. Each check tracks activities of an activity cost center. The person who engages in more activities drinks or eats more than others pays a higher bill.

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5-45 Product-line Profitability, ABC (25 min) 1. Product-line profitability under the current costing system
Frozen Food Baked Goods Fresh Produce Sales Cost of goods sold Gross margin Store support (20% of Sales) Operating income Operating margin (OI/S) $120,000 105,000 $ 15,000 24,000 ($ 9,000) -7.50% $90,000 67,000 $23,000 18,000 $ 5,000 5.56% $158,125 110,000 $ 48,125 31,625 $ 16,500 10.43%

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

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

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5-46 Customer Profitability Analysis (25 minutes)

Requirement 1 Jerry Inc.


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

Donald Co.

Requirement 2 Jerry Inc.


Sales(5x1000x200;200x30x200) Sales return(40x200;175x200) Net Sales Cost of goods sold(75%) Gross margin(25%) Sales support cost (from req. 1) Operating income Operating margin % $1,000,000 8,000 $992,000 744,000 $248,000 16,400 $231,600 23.35%

Donald Co.

$1,200,000 35,000 $1,165,000 873,750 $291,250 29,375 $261,875 22.48%

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5-47 Customer Profitability Analysis (25 min)


1. Determination of the $100.50 order-filling cost per unit Total number of orders: Total number of orders Number of orders per block Total number of blocks Cost per block Total cost of order blocks Total number of orders Per order order-filling cost Total cost per order Total order-filling cost Total units sold Order-filling cost per unit 40,200 x $1,500 + 60,300,000 $100,500,000 1,000,000 $100.50 2 x 100 PCs + 10 x 4,000 SCs = 40,200 40,200

60 670

x $60,000 $ 40,200,000

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5-47 (continued)
2. Order filling cost per unit sold to PC: Total number of orders Number of orders per block Total number of blocks Cost per block Total block cost Total number of orders Order-filling cost per order Total cost per order Total order-filling cost Total units sold Order-filling cost per unit Net profit per unit at $700 selling price per unit to preferred customers: Preferred Customer Selling price per unit Manufacturing cost Order-filling cost/unit Total cost per unit Net Profit per unit Profit margin per unit + $600.00 1.00 601.00 $ 99.00 $700.00 2 x $1,500 + 3,000 $5,000 2

60 1/30

x $60,000 $2,000

5,000
$1.00

14.14%

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5-47 (continued-2)
3. Order filling cost per order by SC: Cost per block Number of orders per block Block cost per order Number of orders per SC Total block cost per SC Order-filling cost per order Number of orders per SC Total cost per order Total order-filling cost Total units sold Order-filling cost/unit x $1,500 10 + 15,000 $25,000 x $60,000

60 $1,000 10 $10,000

125 $200

Profitability per unit at $800 selling price per unit to SC Selling price per unit Manufacturing cost Order-filling cost/unit Total cost per unit Net profit or loss per unit Profit margin $ + $600.00 200.00 800.00 0 0 $800.00

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PROBLEMS 5-48 Activity-Based Costing; Customer Group Cost Analysis (30 minutes)
1. First, obtain the total levels for activity cost drivers:
Product Lines Units Produced Direct Materials cost per unit Total Direct Materials Cost Number of Parts per unit Total parts Direct Labor Hours per unit Total Labor hours Machine Hours per unit Total Machine Hours Production Orders Production Setups Orders Shipped Value 15,000 $ 80 30 4 3 50 20 1,000 Quality 5,000 $ 50 50 5 7 70 50 2,000 Luxury 500 $ 110 120 7 15 200 50 300 Total 20,500 $ 240 200 16 25 320 120 3,300

1,505,000 760,000 88,500 87,500

Then, obtain the activity rates:

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

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

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

Activity Rate $ 0.460 500.00 1,800.00 20.00 7.00 86.364

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

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5-48 (continued)
The activity-based unit and total cost is as follows:
Value 80.00 48.00 13.80 1.67 2.40 60.00 28.00 5.76 111.62 239.6242 3,594,364 Quality 50.00 60.00 23.00 7.00 18.00 140.00 35.00 34.55 257.55 367.5455 1,837,727 Luxury 110.00 84.00 55.20 200.00 180.00 300.00 49.00 51.82 836.02 1,030.0182 515,009

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

$ $

$ $

$ $

$ $

$ $

$ $

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

$ $

Value 80.00 48.00 152.77 280.7729 4,211,593

$ $

Quality 50.00 60.00 190.97 300.9661 1,504,831

$ $

Luxury 110.00 84.00 267.35 461.3525 230,676

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5-48 (continued)
3. The new activity rates based on practical capacity are as follows.
Budgeted Cost $ 349,600 160,000 216,000 1,750,000 619,500 285,000
$ 3,380,100

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

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

Practical Practical Capacity-Based Capacity Rates 990,000 $ 0.353 800 200.00 200 1,080.00 100,000 17.50 123,900 5.00 5,000 57.00

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

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5-49 Cost Pools and Cost Drivers (20 min) Note to instructor: The answer below is but one possible solution. 1. Cost pool 1: Cost driver: Number of purchase orders Receiving $10,000 Inspection of direct materials 3,000 Purchasing 20,000 Total $33,000
Cost pool 2: Cost driver: Number of production runs Setup wages Cost pool 3: Cost driver: Machine hours Depreciation, machine Electrical power (machining) Machine maintenance - labor Machine maintenance - materials Total Cost pool 4: Cost driver: Factory space Depreciation, building Electrical power (factory building) Insurance Property taxes Natural gas (for heating) Custodial labor Total $20,000 $40,000 30,000 11,000 9,000 $90,000 $ 50,000 6,000 20,000 15,000 8,000 51,000 $150,000

Note: However, the problem indicated that the firm uses machine hours as the base for assigning facility-level costs. An alternative solution is to combine cost pools 3 and 4. Cost pool 5: Cost driver: production (in units) Inspection of finished goods Cost pool 6: Cost driver: engineering hours Engineering design Total $7,000 $600,000 $600,000

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5-49 (continued)
2. Overhead Rates: Cost pool 1: Total cost Number of purchase orders Cost per purchase order Cost pool 2: Total cost Number of production runs Cost per production run Total cost Number of machine hours Cost per machine hour Total cost Number of machine hours Cost per machine hour Total cost Number of units Cost per unit Total cost Total engineering hours Cost per engineering hour $33,000 6 $5,500 $20,000 40 $500 $ 90,000 100,000 $0.90 $150,000 100,000 $1.50 $ 7,000 100,000 $0.07

Cost pool 3:

Cost pool 4:

Cost pool 5:

Cost pool 6:

$600,000 20,000 $30.00

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5-49 (continued-2)
Manufacturing overheads: Unit level: Cost pool 3 Cost per machine hour Number of machine hours

$ 0.90 x 4,250

$ 3,825 280

Cost pool 5 Cost per unit $ 0.07 Number of units x 4,000 Batch level: Cost pool 2 Cost per production run $500 Number of production runs (4,000 units / 2,500 = 1.6) x 2 Product-level level: Cost pool 1 Cost per purchase order Number of purchase orders Cost pool 6 Cost per engineering hour Number of engineering hours Facility-level level*: Cost pool 4 Cost per machine hour Number of machine hours Total manufacturing overhead Number of units Manufacturing overhead per unit $5,500 x 1 x $ 30 100

1,000

5,500 3,000

$ 1.50 x 4,250

6,375 $19,980 4,000 $4.995

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

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5-49 (continued-3)
* There are at least two alternative activity consumption drivers for assigning facility-level cost: Based on machine hours: Total facility-level cost (Cost pool 4) Number of machine hours Cost per machine hour Which is the cost driver for the answer above. Alternatively, the firm may use number of units to assign facilitylevel cost. Based on number of units: Total facility-level cost (Cost pool 4) $150,000 Units of production 100,000 Cost per unit $1.50 Unit level: Cost pool 3 Cost pool 5 Batch level: Cost pool 2 Product-level level: Cost pool 1 Cost pool 6 Facility-level level: Cost pool 4 Cost per unit Number of units Total manufacturing overhead Number of units Manufacturing overhead per unit $ 1.50 x 4,000 $ 3,825 280 1,000 5,500 3,000 $150,000 100,000 $1.50

6,000 $ 19,605 4,000 $4.90125

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

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


1. Prime costs Manufacturing overheads: Material handling Machining Assembly Inspection Total manufacturing costs Number of units Cost per unit 2. Upstream activities Manufacturing Downstream activities Full product cost per unit 80 x $1,200 = 80 x 105 x $0.45 = 80 x 3x $51 = 80 x 105 x $2.85 = 80 x $30 = $ 96,000 3,780 12,240 23,940 2,400 $138,360 80 $1,729.50 8.33% 80.09% 11.58% 100%

$180.00 1,729.50 250.00 $2,159.50

Strategic implications: (1) Knowing the full cost of a product including upstream and downstream costs allows the firm to be aware of all costs attributable to the product. (2) (3) The amounts and proportions of upstream, manufacturing, and downstream costs facilitate comparisons with competitors. The company should consider ways of spending less cost in the manufacturing activity, and more on upstream and downstream activities in order to improve its competitive position by pursuing the differentiation strategy in both the new product design and the customer service.

3. The total value chain cost provides the firm a long-term perspective of the product cost, in addition to the short term manufacturing cost. Different industries have different cost structures. For example, firms in the computer software industry are likely to have high upstream costs while firms in the retailing industry tend to have high downstream costs.

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5-51 Volume-based Costing Versus ABC (10 min)


1. Predetermined overhead rate based on machine hours = Total budgeted overhead cost / Selected level of production activity = ($100,000 + $80,000 + $200,000 + $100,000) / 10,000 machinehours = $480,000 / 10,000 machine-hours = $48.00 per machine-hour Product P5 G23 Overhead Cost Pool Machine set-ups Material handling Quality control Other overheads Overhead Per Barrel: Overhead Cost Pool Rate Machine set-ups $1,000 Material handling Quality control Other overheads Total overhead Number of barrels Cost per barrel
Blocher,Stout,Cokins,Chen:Cost Management, 4e

Total Manufacturing Overhead $48.00 x 1,000 MH = $48,000 $48.00 x 1,000 MH = $48,000 Budgeted Overhead $100,000 80,000 200,000 Level of Cost Driver 100 setups 8,000 barrels

Barrel 500 500

OH per Barrel $96.00 $96.00

2. Overhead Rates: Predetermined Overhead Rate $1,000 per setup $10 per barrel $200 per inspection $10 per MH

1,000 inspections

100,000 10,000 machine hrs

Manufacturing Overhead P5 G23 Activity Overhead Activity Overhead 1 500 2 1,000 $ 1,000 5,000 400 10,000 $16,400 50 500 20 1,000 $50,000 5,000 4,000 10,000 $69,000

$10 $200 $10

500 $ 32.80

500 $138.00

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5-51 (continued)
j. The volume-based rate significantly undercosts the G23 product which requires several times the amount of machine setup and quality inspection effort relative to product P5. This means that pricing and analysis of product line profitability will be distorted. Strategic planning based on profitability analysis will also be misguided as a result. Suppose, for example, that CCO, using volume-based accounting, is asked to bid on a rather larger order for the G23 product; it is likely to win the order because the volumebased cost is distorted too low. The problem then is that CCO must produce and sell this order at very low or negative profits, because its actual costs of producing the order will be closer to the ABC costs. Similarly, bidding for a potential order on the P5 product will likely fail under the volume-based system, as CCOs costs are distorted again this time too high. CCO will lose these potentially profitable orders. Under volume-based costing, CCO will likely see its order mix shift to G23 and away from P5, as competitors that use ABC costing will use proper pricing and get the most profitable orders. The result might be that CCOs sales will continue to increase (lots of G23), but its profitability will decline (G23 is not priced properly). This is a good signal of a firm that needs ABC costing sales up but profits down, in this case, because of an unprofitable shift in the product mix due to cost distortions in volume-based costing.

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The McGraw-Hill Companies, Inc., 2008

5-52 Volume-based Costing Versus ABC (35 min) 1. Product A Product B $294.00 (1) Target price $279.00 (2) Manufacturing cost (1) 150% $186.00 $196.00 Prime cost - 70.00 - 126.40 Overhead cost per unit $116.00 $ 69.60 Number of units x 1,000 x 5,000 Total overhead $116,000 $348,000
2. Current Costing system Actual selling price Product manufacturing cost Gross margin Gross margin ratio Product A $280 186 $ 94 33.57% Product B $250 196 $ 54 21.6%

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

Product C $300 133 $167 55.67%

Based on the current cost data, it is true that product B is the least profitable product with a gross margin per unit of $54.00 (21.6%) and product C is the most profitable product with a gross margin per unit of $167.00 (55.67%). However, the validity of this conclusion is based on the accuracy of the reported product costs. Product costs based on the activity-based costing system Direct materials Direct labor Factory overhead: Setups (a) Materials handling (b) Hazardous control (c) Quality control (d) Utilities (e) Total Actual selling price Product manufacturing cost Gross margin Gross margin ratio Product A $ 50.00 20.00 1.60 40.00 62.50 22.50 12.00 $208.60 $280.00 208.60 $ 71.40 25.50%
5-40

Product B $114.40 12.00 0.80 5.00 22.50 5.25 8.40 $168.35 $250.00 168.35 $ 81.65 32.66%

Product C $ 65.00 10.00 4.80 70.00 150.00 52.50 12.00 $364.30 $300.00 364.30 ($64.30) (21.43)%

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5-52 (continued)
Notes: (a) Setups: Cost per setup: $8,000 / (2 + 5 + 3) = $800 per setup Product A = 2 x $800 = $1,600; $1,600 /1,000 = $1.60 per unit Product B = 5 x $800 = $4,000; $4,000 /5,000 = $0.80 per unit Product C = 3 x $800 = $2,400; $2,400 /500 = $4.80 per unit (b) Materials handling: Cost per pound = $100,000 / (400 + 250 + 350) = $100 per pound Product A = 400 x $100 = $40,000; $40,000/1,000 = $40.00 per unit Product B = 250 x $100 = $25,000; $25,000/5,000 = $ 5.00 per unit Product C = 350 x $100 = $35,000; $35,000/500 = $70.00 per unit (c) Waste and hazardous disposals: Cost per disposal: $250,000/(25 + 45 + 30) = $2,500 per disposal Product A = 25 x $2,500 = $ 62,500; $ 62,500/1,000 = $ 62.50/unit Product B = 45 x $2,500 = $112,500; $112,500/5,000 = $ 22.50/unit Product C = 30 x $2,500 = $ 75,000; $ 75,000/500 = $150.00/unit (d) Quality inspections: Cost per inspection = $75,000/(30 + 35 + 35) = $750 per inspection Product A = 30 x $750 = $22,500; $22,500/1,000 = $22.50 per unit Product B = 35 x $750 = $26,250; $26,250/5,000 = $ 5.25 per unit Product C = 35 x $750 = $26,250; $26,250/500 = $52.50 per unit (e) Utilities: Cost per MH = $60,000 / (2,000 + 7,000 + 1,000) = $6.00 per MH Product A = 2,000 x $6 = $12,000; $12,000/1,000 = $12.00 per unit Product B = 7,000 x $6 = $42,000; $42,000/5,000 = $ 8.40 per unit Product C = 1,000 x $6 = $ 6,000; $ 6,000/500 = $12.00 per unit

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5-52 (continued-2)
3. Comparison of reported product costs, new target price, actual selling price, and gross margin (loss): Product A Product B Product C Product costs: 1. Direct-labor based system $186.00 $196.00 $133.00 2. Activity-based system $208.60 $168.35 $364.30 ABC-based product costs: Target price (150%) Actual selling price Difference in price Direct-labor based costing system Gross margin Gross margin ratio Activity-based costing system: Gross margin Gross margin ratio $312.90 $252.53 $546.45 $280.00 $250.00 $300.00 <$32.90> <$2.53> <$246.45> $ 94 33.57% $71.40 25.50% $ 54 21.6% $81.65 32.66% $167 55.67% $(64.30) <21.43%>

4. Strategic and Competitive Analysis 1. Emphasizing Product C as suggested by the current directlabor-cost based overhead costing system is likely to harm the firms competitiveness. The activity-based costing system shows that the manufacturing cost of Product C is $364.30 per unit and, at the current selling price, the firm suffers a $64.30 loss for each unit it manufactures and sells. 2. If the actual selling prices of products A & B are fair market prices for these products and a markup of 150% is a common industry practice, the firm needs to examine the manufacturing cost of product A. The fact that the firms target price, determined using 150% of the manufacturing cost, is more than 10 percent over the fair market price of the product suggests possible wastes and inefficiencies in the manufacturing of product A.

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5-53 Ethics, Cost System Selection (5 min)


Unfortunately, there are a number of reasons why ABC costing systems are studied by firms and then not adopted. In some cases the reason is to protect a product line that is favored by top executives, even though the ABC results show it to be unprofitable. Other times it is because a customer that is considered critical to the firm is shown to be unprofitable by the ABC results In the case of Aero Dynamics, the reason has to do with an ethical issue, that is, the use of cost allocation to improperly charge a cost-plus customer (the federal government) for overhead costs. The management accountant should keep the professional ethics code in mind. First, he or she should try to persuade other ABC pilot project members and the company controller to strongly recommend that top management adopt the more accurate ABC method. If the company top management still would not listen, then the management accountant should report the situation to the companys audit committee. Because of the management accountants responsibility for confidentiality, he or she should not report the matter outside the firm. (See the Institute of Management Accountants Code of Ethics in Exhibit 1-4). An interesting footnote to the case is that the Government Accounting Office, to assist the Dept of Defense, in part due to issues of this nature, developed in the 1970s a series of cost accounting standards. These standards apply generally to companies contracting with the federal government, especially the DOD. See http://www.gao.gov/casb1.htm for the CASB website. Also, the Federal Government in 1990 created the Federal Accounting Standards Advisory Board (www.fasab.gov) which sets standards for financial and managerial reporting within the federal government. The FASAB web site is an interesting place to see the progress/continuing issues of accounting at the federal government.

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5-54

Volume-Based Costing Versus ABC (25 min)


% 100 37 51 12

1. Current costing system (direct-labor hour) % Speedy Deluxe Price $475 100 $300.00 Prime Cost 180 38 110.00 Overhead 20 4 153.60 Unit gross profit $275 58 $ 36.40 2. Multiple drivers costing system Calculation of unit overhead costs - Deluxe: Setups Machine costs Engineering Packing Total overhead Number of Units Overhead per unit $2,800 x 200 = $100 x 100,000 = $40 x 45,000 = $20 x 50,000 =

Deluxe $ 560,000 10,000,000 1,800,000 1,000,000 $13,360,000 50,000 $267.20 Speedy $ 280,000 40,000,000 4,800,000 4,000,000 $49,080,000 400,000 $122.70 Speedy $300.00 $110.00 122.70 232.70 $67.30 % 100 78 22

Calculation of unit overhead costs - Speedy: Setups Machine costs Engineering Packing Total overhead Number of Units Overhead per unit $2,800 x 100 = $100 x 400,000 = $40 x 120,000 = $20 x 200,000 =

Price Cost Prime cost $180.00 Overhead 267.20 Unit gross profit

Deluxe % $475.00 100 447.20 $27.80 94 6

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5-54 (continued) 3. Using the activity-based costing, a much different picture on profitability of the Deluxe and Speedy models emerges. The Speedy model is actually more profitable than the Deluxe model. The revised cost data suggests that shifting the emphasis to the Deluxe model may very well be a mistake. The Deluxe printer is a much heavier user of overhead resources as can be seen in the table below that compares uses of overhead.
Overhead Activity Setups Machine costs Engineering Packing Activity Consumption Deluxe Speedy 250 units per setup 2 MH per unit 0.9 Engr. Hr. per unit 1 unit per packing order 4,000 units per setup 1 MH per unit 0.3 Engr. Hr. per unit 2 units per packing order

Supporting calculations Deluxe Total Per Activity Measure Units Setups Machine costs 50,000 200 250 units per setup 100,000 2 MH per unit Activity Consumption Speedy Total Per Activity Measure 100 4,000 units per setup 400,000 1 MH per unit 120,000 0.3 Engineering hours per unit 2 units per packing order

400,000

Engineering 45,000 0.9 Engineering Hours per unit Packing 50,000

1 unit per packing 200,000 order

4. The ABC method is likely to provide Gorden Company a more accurate product cost picture. It also directs the managements attention to the high volume, more profitable Speedy printers. Given the low profit margin of the Deluxe, the firm may want to investigate the feasibility of raising the price, the possibility of reducing product cost, or both.

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The McGraw-Hill Companies, Inc., 2008

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


1. Predetermined overhead rates: Cost Pool Machine depr./maint. Factory depr./util./insur. Product design Materials purch./stor. Total overhead Budgeted Budgeted OH Cost Cost Driver $135,000 $120,000 $504,000 $147,000 $906,000 27,000 30,000 Overhead Rate $5.00 per MH $4.00 per MH

42,000 $12.00 per Design hour $980,000 15.00% DM cost

Total overhead for each product order: Overhead Cost Pool Material purchase Product design Machine depreciation Factory depreciation Total overhead cost 2. Overhead cost per unit: Number of units Overhead cost per unit Men Shavers Women Shavers $30,000 x 15% = $4,500 $26,000 x 15% = $3,900 $12 x 15 = $5.00 x 50 = $4.00 x 50 = 180 250 200 $5,130 15,000 $ 0.342 $12 x 37.5 = $5.00 x 40 = $4.00 x 40 = 450 200 160 $4,710 20,000 $ 0.2355

3. Overhead rate: $906,000 / 3,020 = $300 per direct labor hour 4. Total overhead using volume-based overhead rate: Men Shavers: Women Shavers: 5. Men Shavers: Women Shavers: $7,200 / 15,000 = $3,600 / 20,000 =
5-46

$300 x 24 = $300 x 12 = $ 0.48 $ 0.18

$7,200 $3,600

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5-56 Resource and Activity-Based Cost Drivers (25 min)


1. The activity based cost pools are determined from the percent-of-use information; for example, total setup cost = $157,500 = .15 x $850,000 + .2 x $150,000.
Inspect & Factory Costs Setup Assembly Finishing Packaging $ 850,000 $ 127,500 $ 467,500 $ 170,000 $ 85,000 150,000 30,000 90,000 30,000 550,000 440,000 110,000 $ 1,550,000 $ 157,500 $ 997,500 $ 310,000 $ 85,000

Salaries Supplies Factory Expense

2. The activity rates are determined as follows:


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

Safe-V Batches Units Finishing hours/unit Packaging 250 60,000 0.2 0.1

Safe-T 600 72,000 0.3 0.15

3. The per unit activity-based costs are $14.18 for Safe-V and $18.63 for the Safe-T
Activity Requirements Activity-Based Costs/Unit Safe-V Safe-T Safe-V Safe-T 250 600 $ 0.772 $ 1.544 60,000 72,000 7.557 7.557 0.2 0.3 1.845 2.768 0.1 0.15 0.506 0.759 $ 3.50 $ 6.00 3.500 6.000
$ 14.180 $ 18.628

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

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

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

Resource Rate $ 50,000 15,000 25

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

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

2. The new activity consumption rates are shown in the right column, using the same activity drivers as before, with the new activity cost pool amounts.
Total Activity Activity-based Safe-T Consumption Activity Costs Rates 600 850 $ 115,000 $ 135.29 72,000 132,000 850,000 6.439 0.3 33,600 435,000 12.946 0.15 16,800 150,000 8.929

Safe-V Batches 250 Units 60,000 Finishing hours, per unit 0.2 Packaging 0.1

3. The new ABC product costs are shown below; there is very little change from the solution in 5-56 above.
Activity Requirements Activity-Based Costs/Unit Safe-V Safe-T Safe-V Safe-T 250 600 $ 0.564 $ 1.127 60,000 72,000 6.439 6.439 0.2 0.3 2.589 3.884 0.1 0.15 0.893 1.339 $ 3.50 $ 6.00 3.500 6.000
$ 13.985 $ 18.790

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

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5-48

The McGraw-Hill Companies, Inc., 2008

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


1. Manufacture Costs Direct-Labor Cost Based Luxury Pendant Total Selling Price Direct Materials Direct Labor Overhead* Manufacturing Cost Gross Margin $ 80,000 32,000 64,000 $176,000 Per Unit $70.00 20.00 8.00 16.00 44.00 $26.00 Ceiling Fixture Total $ 400,000 200,000 400,000 $1,000,000 Per Unit $40.00 10.00 5.00 10.00 25.00 $15.00

* Overhead is allocated based on direct labor costs at the rate of $2.00 per direct labor dollar LP: $ 32,000 x $2.00 = $ 64,000 CF: $200,000 x $2.00 = $400,000 2. Overhead Costs Reported by ABC System: Overhead rates Overhead Costs Total Activities Overhead Rate Machine Operation Support labor Machine Setup Assembly Inspection Total $160,000 81,200 68,000 88,550 66,250 $464,000 10,000 232,000 2,500 402,500 4,000 $16.00 0.35 27.20 0.22 16.5625

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5-58 (continued-1) Applied overheads


Luxury Pendants Ceiling Fixtures Overhead Activities Overhead Activities Overhead Rate Cost Cost $ 16.00 1,500 $ 24,000 8,500 $136,000 0.35 32,000 11,200 200,000 70,000 27.20 0.22 16.5625 1,000 192,500 1,600 27,200 26,500 $131,250 1,500 2,400 40,800 46,200 39,750 $332,750 42,350 210,000

Machine Operation Support labor Machine Setup Assembly Inspection Total Overhead

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

Ceiling Fixtures Total Per Unit 40,000 $1,600,000 $40.00 $400,000 $10.00 $200,000 $ 5.00 136,000 70,000 40,800 46,200 39,750 $332,750 $ 8.3188 $932,750 $23.3188 $667,250 $16.6813 41.7%

3. The above profitability analysis indicates that the Luxury Pendant is not as profitable as the vice president of marketing thinks it is.
Blocher,Stout,Cokins,Chen:Cost Management, 4e 5-50 The McGraw-Hill Companies, Inc., 2008

5-58 (continued-2) 4. Unit Cost Comparison between the current and ABC costing systems Reported Overhead Costs Current ABC Difference $32.8125 +$16.8125 Luxury Pendants $16.00
Ceiling Fixtures $10.00 $ 8.3188 - $ 1.6822 According to the ABC cost data, a shift to more Luxury Pendant units and fewer Ceiling Fixture units would be ill advised. The apparent higher unit gross margin of the Luxury Pendants relative to the Ceiling Fixtures indicates that the current costing system distorted relative unit profitability. 5. Among the reasons for the difference are: a. The current direct labor based costing system focused on only one manufacturing activity of the entire production process. It measures only one attribute of the individual product: the number of direct labor hours consumed. By contrast, the ABC system considered all activities of the manufacturing processes. Costs were traced from activities to products based on the products demand for these activities during the production process. The allocation bases used in ABC were thus measures of the activities performed. For Moden Lighting Inc., the ABC systems listed not only the unit-level activities (machine operation, support labor overhead) but also the batch-level ones (setup, assembly, and inspection.) b. Under the volume-based costing system, the high-volume ceiling fixtures were overcosted and the low-volume luxury pendants were undercosted. The source of this distortion is the choice of a single volume-related allocation base, direct labor hours, for tracing of costs from manufacturing to products. Using a volume-related allocation base alone to trace costs to products distorted reported product costs if some of the product-related activities were not related to volume, such as the setup hours. c. Differences in the complexity of the products also contribute to cost distortion. Using a volume-based costing system, overhead costs differ only when different number of units are manufactured. Although the luxury pendants were low-volume products, they actually consume more resources a result not related to volume.
Blocher,Stout,Cokins,Chen:Cost Management, 4e 5-51 The McGraw-Hill Companies, Inc., 2008

5-59 Volume-Based Costing vs. ABC (30 min)


1. Current Costing System Direct-Labor-Hour Based Overhead rate = Budgeted overhead / Budgeted direct labor hours = $200,000 / (7,200 + 6,800 + 2,000) = $200,000 / 16,000 = $ 12.50 per direct labor hour Overhead cost allocation: Direct labor-hours Overhead rate Total overhead Diomycin 7,200 $12.50 $90,000 Homycin 6,800 $12.50 $85,000 Addolin 2,000 $12.50 $25,000

Cost per unit: Direct Materials Direct Labor Overhead: Total Cost Packets produced Cost per capsule Diomycin $205,000 250,000 90,000 $545,000 1,000,000 $0.545 Homycin $265,000 234,000 85,000 $584,000 500,000 $1.168 Addolin $258,000 263,000 25,000 $546,000 300,000 $1.820

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

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

Activity Machine setup

Cost Driver Setup hours

Budgeted Overhead Cost


$ 16,000 36,000 46,000 50,400 51,600 $200,000

Budgeted Cost Driver Overhead Volume Rate


1,600 1,200 1,150 1,050 645 $10.00 $30.00 $40.00 $48.00 $80.00

Plant management Workers Supervision of Direct labordirect labor hours Quality inspection Inspectionhours Expediting orders Customers serviced Total overhead

Overhead Costs Assigned to Products Using Activity-Based Costing: Diomycin Homycin Addolin Driver Applied Overhead Driver Applied Driver Applied Volume Overhead Volume Overhead Volume Overhead Rate Machine setup $10 200 $2,000 600 $6,000 800 $8,000 Plant management Supervision of direct labor Quality inspection Expediting production orders Total $30 $40 $48 $80 200 200 150 45 $6,000 400 $8,000 300 $7,200 200 $3,600 100 $26,800 $12,000 $12,000 $9,600 $8,000 $47,600 600 650 700 500 $18,000 $26,000 $33,600 $40,000 $125,600

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

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The McGraw-Hill Companies, Inc., 2008

5-59 (continued-2)
Cost per capsule under Activity-Based Costing: Diomycin Direct Materials Direct Labor Overhead Total Cost Packets produced Cost per capsule $205,000.00 250,000.00 26,800.00 $481,800.00 1,000,000 $0.4818 Homycin $265,000.00 234,000.00 47,600.00 $546,600.00 500,000 $1.0932 Addolin $258,000.00 263,000.00 125,600.00 $646,600.00 300,000 $2.1553

3. Comparison of Product Costs Using Current Costing and ABC Costing: Diomycin Current Costing System Overhead Cost per capsule Activity-Based Costing system Overhead Cost per capsule $26,800 $0.4818 $47,600 $1.0932 $125,600 $2.1553 $90,000 $0.5450 $85,000 $1.1680 $25,000 $1.8200 Homycin Addolin

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

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

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

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5-59 (continued-4)
4. Among major uses of ABC in the Pharmaceutical Industry are: a. Strategic Use of ABC to Reduce Costs One of the important ways companies develop competitive advantages is to become a low-cost producer. Many companies in the pharmaceutical industry have learned to use the information they have gained from their costing systems to make substantial price cuts to increase market share. b. Use of ABC to Eliminate Low-Value-Added Costs ABC can be used to identify and eliminate activities that add costs but not value to the products in the pharmaceutical industry. A company can eliminate low-value added activities and costs without reducing quality or value. In the pharmaceutical industry, the following activities typically do not add value to a product: storage, moving items, and waiting for work. Analyses of activities facilitate firms to identify low-value-added activities. c. Use of ABC in Marketing and Distribution In the pharmaceutical industry, ABC can be applied to marketing or administrative activities. The cost of performing marketing services such as distributing products through different distribution channels can be computed and the information used in making informed decisions. For example, some of the different channels of distribution in the pharmaceutical industry are: grocery stores, convenience stores, pharmacy shops, each having different activities. The cost of alternative channels of distribution is useful to marketing managers who make decisions about which channel to use. d. Use of ABC to Make Better Pricing Decisions ABC enables managers to make better pricing decisions by providing managers with more accurate product cost data for pricing decisions. e. Use of ABC to Make Better Product Mix Decisions ABC provides a firm with more detailed and better estimation of product costs. Thus, it allows a company the opportunity to decide which products to make and which ones to eliminate.

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

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The McGraw-Hill Companies, Inc., 2008

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


1. a. Using the current volume-based standard costs, the total contribution expected in 2007 by Alaire Corporation from the TV Board is $1,950,000, calculated as follows: Per Unit Totals for 65,000 units Revenue Direct materials Direct labor ($14 x 1.5 hours) Materials overhead (10% of material) Variable overhead ($4 x 1.5 hours)* Machine time overhead ($10 x .5) Total cost Contribution margin $150 80 21 8 6 5 $120 $ 30 $ 9,750,000 5,200,000 1,365,000 520,000 390,000 325,000 $7,800,000 $1,950,000

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

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5-60 (continued-1)
1. b. Using traditional volume-based standard costs, the total contribution expected in 2007 by Alaire Corporation from the PC Board is $2,360,000, calculated as follows: Per Unit Totals for 40,000 units Revenue Direct materials Direct labor ($14 x 4 hours) Materials overhead (10% of materials) Variable overhead ($4 x 4 hours)* Machine time overhead ($10 x 1.5) Total cost Contribution margin $300 140 56 14 16 15 241 $ 59 $ 12,000,000 5,600,000 2,240,000 560,000 640,000 600,000 9,640,000 $ 2,360,000

* Variable overhead rate: $1,120,000 / 280,000 hours = $4 per hour. 2. Shown below are the calculations of the activity-based cost drivers, which apply to both 2.a. and 2.b. Procurement: Production scheduling: Packing & shipping: Machine setups: Hazardous waste disposal: Quality control: General supplies: Machine insertion: Manual insertion: Wave soldering: $400,000 / 4,000,000 = $0.10 per part $220,000 / 110,000 = $2.00 per board $440,000 / 110,000 = $4.00 per board $446,000 / 278,750 = $1.60 per setup $48,000 / 16,000 = $3.00 per pound $560,000 / 160,000 = $3.50 per inspection $66,000 / 110,000 = $0.60 per board $1,200,000 / 3,000,000 = $0.40 per insertion $4,000,000 / 1,000,000 = $4.00 per insertion $132,000 / 110,000 = $1.20 per board
5-58 The McGraw-Hill Companies, Inc., 2008

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

5-60 (continued-2)
a. Using activity-based costing, the total contribution expected in 2007 by Alaire Corporation from the TV Board is $2,557,100 calculated as follows. Per Unit Totals for 65,000 units Revenue Direct materials Materials overhead: Procurement ($.10 x 25) Production scheduling Packaging & shipping Variable overhead: Machine set-ups ($1.60 x 2) Waste disposal ($3 x .02) Quality control General supplies Manufacturing overhead: Machine insertion ($.40 x 24) Manual insertion Wave soldering Total cost Contribution margin 9.60 4.00 1.20 $110.66 $ 39.34 624,000 260,000 78,000 $7,192,900 $2,557,100 3.20 .06 3.50 .60 208,000 3,900 227,500 39,000 2.50 2.00 4.00 162,500 130,000 260,000 $150.00 80.00 $ 9,750,000 5,200,000

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

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

5-59

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5-60 (continued-3)
b. Using activity-based costing, the total contribution expected in 2007 by Alaire Corporation from the PC Board is $1,594,000 calculated as follows. Per Unit Totals for 40,000 units Revenue Direct materials Materials overhead: Procurement ($.10 x 55) Production scheduling Packaging & shipping Variable overhead: Machine set-ups ($1.60 x 3) Waste disposal ($3 x .35) Quality control ($3.50 x 2) General supplies Manufacturing: Machine insertion ($.40 x 35) Manual insertion ($4 x 20) Wave soldering ` Total cost Contribution margin 14.00 80.00 1.20 $260.15 $ 39.85 560,000 3,200,000 48,000 $10,406,000 $ 1,594,000 4.80 1.05 7.00 .60 192,000 42,000 280,000 24,000 5.50 2.00 4.00 220,000 80,000 160,000 $300.00 140.00 $ 12,000,000 5,600,000

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

5-60

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

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

5-61

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5-61 Volume-based Costing Versus ABC (40 min)


1. a. Predetermined factory overhead rate b. Product costs and selling prices Product Costs Direct costs: Direct materials Direct labor Indirect costs: Factory overhead (0.30 x $5.00) Total costs Mark-up Budgeted selling prices per pound 2. The cost per driver unit is: Activity Purchasing Material handling Quality control Roasting Blending Packaging Budgeted Cost Driver Cost Purchase orders $579,000 720,000 144,000 961,000 336,000 260,000 $4.20 .30 $4.50 1.50 $6.00 30% $7.80 Budgeted Activity 1,158 1,800 720 96,100 33,600 26,000 $3.20 .30 $3.50 1.50 $5.00 30% $6.50 Cost per Unit $500 400 200 10 10 10 = $3,000,000 / $600,000 = $5 per direct-labor dollar Mona Loa Malaysian

Setups Batches Roasting hours Blending hours Packaging hours

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

5-62

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5-61 (continued-1)
The budgeted unit costs per pound are: Mona Loa Coffee Direct unit costs: Direct materials $4.20 Direct labor 0.30 $4.50 Indirect unit costs: Purchasing 0.02 Material handling Quality control Roasting Blending Packaging Total unit cost
(4 orders x $500 /100,000 lbs.) (30 setups x $400/100,000 lbs.) (10 batches x $200/100,000 lbs.) (1,000 hours x $10/100,000 lbs.) (500 hrs. x $10/100,000 lbs.) (100 hrs. x $10/100,000 lbs.)

Malaysian Coffee $3.20 0.30 $3.50


(4 orders x $500/2,000 lbs.) (12 setups x $400/2,000 lbs.)

1.00

0.12

2.40

0.02

0.10

(4 batches x $200/2,000 lbs.) (20 hours x $10/2,000 lbs.)

0.40

0.10 0.05

0.05

0.01

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

0.01

$4.82

$7.46

The comparative cost numbers are: Mona Loa Requirement 1 Requirement 2 $6.00 4.82 Malaysian $5.00 7.46

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

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

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5-61 (continued-2) 3. Three of the indirect cost items can be classified as output-unit driven: Malaysian Coffee Mona Loa Coffee Roasting $0.10 $0.10 Blending 0.05 0.05 Packaging 0.01 0.01 Total output-unit overhead $0.16 $0.16
The other three indirect cost items are batch-level driven: Malaysian Coffee Mona Loa Coffee Purchasing $0.02 $1.00 Material handling 0.12 2.40 Quality control 0.02 0.40 Total batch-level overhead $0.16 $3.80 Malaysian coffee has a greater number of setups per output unit than does Mona Loa coffee. The result is that the unit cost of the lower-volume Malaysian coffee is much higher than that of the higher-volume coffee, even though its cost of direct materials is lower. With the current costing system, the high-volume Mona Loa is overcosted, while the low-volume Malaysian is undercosted. Pricing of Mona Loa can be reduced to make it more competitive. In contrast, Malaysian should be priced at a much higher level if the strategy is to cover the current periods cost. CBI may wish to have lower margins with its low-volume products such as Malaysian in an attempt to build up volume. The company can use the ABC cost information to compare its two product costs with competitors, and decide which product has a low cost competitive advantage. Then the company can change its pricing and product mix strategies by using the ABC cost information.

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

5-64

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5-61 (continued-3)
ABC cost data also point out that the reason for the Malaysian Coffee to have a higher unit cost is not because of high-priced ingredients. In fact, Malaysian Coffee has a lower cost of direct materials than that of Mona Loa Coffee. The costs of roasting, blending, and packaging are $0.16 per pound for both coffees. The higher cost of Malaysian is because of the way in which it is processed. The batch-level cost per pound is $0.16 for Mona Loa and $3.80 for Malaysian. CBI can increase its profit margin or lower its price on Malaysian Coffee if it can change the way in which it handles purchasing, material handling, and quality control functions of Malaysian coffee.

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

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5-62 Cost of Capacity; Continuation of 5-61 (25 min)


1. The calculation of the new activity rates and the cost of unused capacity is determined below.
UsageBased Rate $ 500 400 200 10 10 10 Practical Capacity at Current Usage Spending Percent 1,400 83% 2,400 75% 1,200 60% 100,000 96% 36,000 93% 30,000 87% Practical Cost of Capacity Unused Unused Rate Capacity Capacity $ 413.57 242 $ 100,084 $ 300.00 600 180,000 $ 120.00 480 57,600 $ 9.610 3,900 37,479 $ 9.333 2,400 22,400 $ 8.667 4,000 34,667 $ 432,230

Purchasing Materials Handling Quality Control Roasting Blending Packaging

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

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

2. The information on cost of capacity can alert management to the total cost of unused capacity, in this case $432,230 or approximately 14% of total overhead cost. This information can be used to identify activities where there is extensive over-capacity, and to consider how the capacity might be managed to reduce overall costs. For example, the calculations in part 1 suggest there is substantial excess capacity in materials handling, and the cost of the unused capacity is $180,000. 3. The analysis below shows the number of employees unused in column 8. The analysis assumes that each employee (or machine) contributes an equal share to the work of the activity. Note that the materials handling activity appears to have as many as 5 unused employees.
1 2 3 4 5 Capacity Step: Number at Current of Employees Unused Spending or Machines Capacity 1,400 8 242 2,400 20 600 1,200 4 480 100,000 10 3,900 36,000 10 2,400 30,000 3 4,000 6 Cost per Step =(2)/(4) $ 72,375 36,000 36,000 96,100 33,600 86,667 7 8 Step Size Steps =(3)/(4) Not Used 175 1.38 120 5.00 300 1.60 10,000 0.39 3,600 0.67 10,000 0.40

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

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5-63 Customer Profitability Analysis (30 Min) 1. Service cost rate per unit of activity Estimated Estimated Service Activities Annual Cost Driver Annual Cost Cost Expense Driver Units Per Unit Requisition $3,000,000 Requisitions 300,000 $10.00 Handling Warehouse $1,050,000 Cartons 70,000 $15.00 Pick $ 900,000 (PP) Lines 600,000 $ 1.50 Packing Data Entry $ 600,000 (PP) Lines 600,000 $ 1.00 Delivery $10 per delivery (requisition) + $0.30 per mile charge
2. Service Costs Omega International City of Albion

Requisition Handling $3,000 $ 7,000 (300 requisitions x $10/requisition) (700 requisitions x $10/requisition) Warehouse Activity 750 7,500 (50 cartons x $15.00 per carton) (500 cartons x $15.00 per carton) Pick-Packing 1,350 3,150 (900 pick-pack lines x $1.50) (2,100 pick-pack lines x $1.50) Data Entry 900 2,100 (900 lines x $1.00/line) (2,100 lines x $1.00/line) Freight Out 3,450 8,260 ($10 x 300) + ($0.30 x 5 x 300) ($10 x 700) + ($0.30 x 6 x 700) Total Service Costs $9,450 $28,010 3. Customer Profitability Analysis-Activity Based Omega International Sales Product Cost Service costs Gross Margin Gross Margin % $ 80,000 (50,000) ( 9,450) $20,550 25.69%
5-67

City of Albion $80,000 (48,000) (28,010) $ 3,990 4.99%

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5-63 (continued-1)
The above profitability analysis indicates that, under activitybased costing, Omega International, not City of Albion, is more profitable to Boston Depot. The apparent higher gross margin percentage of the City of Albion relative to the Omega International was the result of not recognizing differences in the service activities requested by different customers under the firms existing costing system. City of Albion is a much heavier user of services provided by Boston Depot. Although both customers had the same total sales, City of Albion made more desktop delivery requests in smaller quantities and maintained more inventory by Boston Depot. 4. The answer depends on the competitive strategy of the firm. The gross profit margin ratios show that Omega is the better customer of the two. Omega does not use much of the desktop delivery service Boston offers. Most likely Omega is a buyer of commodity items and does not need the convenience of desktop delivery. However, Bostons pricing is likely to have incorporated the average cost of desktop deliveries. If Omega realizes that it is paying for services not used, it may buy the commodity it needs elsewhere, unless Boston lowers the price to Omega. All custom-printed business forms by different suppliers are likely to be the same. Delayne wanted to differentiate its forms from those of competitors by offering desktop delivery services. In the long-run, Omega is not likely to be a customer staying with Boston Depot. Boston Depot needs to be prepared to lower the price to Omega. If the firm desires to compete on a differentiation strategy it needs to price accordingly. Boston Depot needs to raise prices to City of Albion. If City of Albion is willing to pay a higher price for the convenience of desktop delivery, it is the kind of customer that Delayne wants.

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5-64 Activity-Based Costing (35-40 min) (Miami Valley Architects, Inc. by Beth M. Chaffman, CPA and John Talbott, CMA, Management Accounting Campus Report, Fall 1992, p.4)
1. Overhead Cost assigned to each branch under the ABC costing: Columbus Cincinnati Dayton Total Direct labor dollar 37.61% 31.19% 31.20% 100% Timesheet entries 45.11% 28.57% 26.32% 100% Vendor invoices 44.93% 37.44% 17.62% 100% Client invoices 52.13% 39.36% 8.51% 100% Employees 34.33% 38.81% 26.87% 100% New hires 42.11% 21.05% 36.84% 100% 38.81% 26.87% 100% Insurance claims filed 34.33% Proposals 39.22% 49.02% 11.76% 100% Contracted sales 48.07% 36.88% 15.05% 100% Projects shipped 39.13% 49.01% 11.86% 100% 33.85% 24.62% 100% Purchase orders 41.54% Copies duplicated 43.48% 39.13% 17.39% 100% Blueprints 45.24% 36.19% 18.56% 100%

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

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5-64 (continued-1) Calculation for general administration allocated to branches:


Total direct labor dollar: $382,413 + $317,086 + $317,188 = $1,016,687 Allocation of general administration based on direct labor dollar: Proportion Columbus Cincinnati Dayton Allocated Amount $382,413 / $1,016,687 = 37.61% $409 x 37.61% = $153.84 $317,086 / $1,016,687 = 31.19% $409 x 31.19% = $127.56 $317,188 / $1,016,687 = 31.20% $409 x 31.20% = $127.60

2. Contribution of each branch: Columbus Sales Less: Direct labor Direct materials Direct overhead Contribution margin $1,500 382 281 180 $657

Cincinnati
$1,419 317 421 270 $411

Dayton
$1,067 317 185 177 $388

Total
$3,986 1,016 887 627 $1,456

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

Columbus Cincinnati Dayton


Sales Less: Direct labor Direct materials Direct overhead Contribution margin Activity-based overhead Operating income
Blocher,Stout,Cokins,Chen:Cost Management, 4e

Total
$3,986 1,016 887 627 $1,456 1,261 $195

$1,500 382 281 180 $657 529 $128


5-70

$1,419 317 421 270 $411 453 ($42)

$1,067 317 185 177 $388 278 $110

The McGraw-Hill Companies, Inc., 2008

5-64 (continued-2)
4. Evaluating management concerns: Overhead costs are usually aggregated in pools and allocated to products and other cost objects based on volume measures such as direct labor dollars or machine hours. The cost object, therefore, supposedly shares proportionally in those costs necessary for its production or existence. If however, overhead varies in accordance with variables other than volume, then product costs and other cost objects will be erroneously determined. As the solution indicates, the profitability of the Cincinnati and Dayton offices is vastly different employing direct tracing and ABC than under the current approach. The obvious benefit to the company is a more equitable distribution of bonuses and resources to these locations. In addition, existing marketing strategy may be promoting the wrong location and strategic planning may be based on spurious assumptions concerning relative profitability. This case also illustrates that ABC is applicable to service organizations as well as to manufacturing and that cost objects can consist of projects, locations, customers, etc., as well as products. In essence, the better information we have about the profitability of any cost object, the better chance of keeping organizations profitable. However, the process of identifying activities and allocating costs from the general ledger to the activities is a difficult, time consuming process. Extensive interviews with functional managers and workers are normally required. This process is time consuming and often costly.

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

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


Customer revenue analysis Total sales Less: Sales discount Net invoice Less: Sales returns Net sales Less: Cash discounts Finance charge Net proceeds Customer cost analysis Customer unit-level cost: Sales return (restocking)3 Customer batch-level costs: Order taking Order processing Sales return Delivery Expediting order Customer sustaining costs: Sales visits Total customer cost Net customer profit 800 $2,850 $569,395 800 $4,850 $693,769 500 750 600 250 375 800 1,500 1,000 $ 200 $ 125 $600,000 12,000 $588,000 11,760 $576,240 11,525 (7,530) $572,245
1

Baldwin $900,000 18,000 $882,000 26,460 $855,540

$750,000 22,500 $727,500 7,275 $720,225 21,606 2 $698,619

$855,540

$ 450 2,500 3,750 2,000 15,000 2,500 1,600 $27,800 $827,740

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

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5-65 (continued)
1

Net proceeds:

$576,240 - $11,525 = $564,715 x 2% x 20/30 =

$564,715 $7,530

Savings of not having to finance working capital:

Payment received on the 60th day:

$720,225 ) 2 = $360,112.50

Finance charge for 30 days


Payment received on the 90th day:

$360,112.50 x 2% =
$720,225 ) 2 = $360,112.50

$ 7,202 14,404 $21,606

Finance charge for 60 days Net finance charge


3

$360,112.50 x 2% x 2 = 10 x 100 x 2% x $10 = 5 x 250 x 1% x $10 = 50 x 30 x 3% x $10 = $200 $125 $450

Restocking cost:

HS Inc: Adventix: Baldwin:

Customer profitability analysis helps the company become more competitive by identifying the most profitable and least profitable customers. This information can then be used by management to adjust pricing policies, identify ways to reduce the cost to serve customers, and change the customer mix for a more profitable group of customers.

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

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The McGraw-Hill Companies, Inc., 2008