Chapter 3 Traditional Cost Management Systems

QUESTIONS 4-1 Costs need to be estimated for individual jobs in order to bid for them and to price them competitively. Estimated costs are also useful for comparison with actual costs for management control purposes. Costs may differ across individual jobs because jobs may differ in their materials content, the hours of labor required to manufacture them and in the demand they place on support activity resources. 4-2 A typical job bid sheet has the following five distinct parts: 1. The name of the customer, product and quantity required. 2. Estimated quantity and current price for different materials. 3. The wage rate and hours required for direct labor. 4. Estimated manufacturing support cost. 5. Estimated total cost, bid price, unit cost and unit price. Two types of information are required to estimate direct material cost for a job. The quantity required for each item of material is estimated based on standard engineering specifications. Information on the price of each item of material is obtained from the purchasing department. Two types of information are required to estimate direct labor cost. Direct labor hours are estimated based on industrial engineering specifications (e.g. work and motion studies) or by analogy with comparable standard products. Wage rates for each grade of labor required for the operations performed are obtained from personnel records. Cost driver rates are determined by dividing the cost of the resources committed to the support activity, by the capacity made available by the resources committed to the activity.

4-3

4-4

4-5

4-6

Support cost for a job is estimated by multiplying the cost driver rate(s) by the number of units of the support cost driver(s) associated with the job. Markup rate is the percentage addition to the estimated job cost to calculate the bid price. The markup rate depends on a variety of factors, including: • Proportion of indirect costs excluded from the numerator in the computation of the cost driver rate • Target rate of return desired by the firm • Past bidding strategies of key competitors • Demand conditions • Overall product-market strategies Each cost pool is a portion of the total support costs associated with a distinct cost driver. Multiple cost pools are required when support costs are driven by more than one factor (cost driver). Determination of cost driver rates based on planned or actual short term usage will result in rates that are too high in periods of low demand and that are too low in periods of high demand. As a consequence, job costs are distorted in such a job costing system.

4-7

4-8

4-9

4-10 The normal cost of a support activity is the cost of the resources committed to it divided by the number of units of the activity cost driver made available by those resources. Normal cost, therefore, excludes fluctuations in costs that are caused by short-term adjustments, such as abnormal idle time or overtime premium. 4-11 Yes. A separate cost driver rate must be determined for each cost pool when there are multiple cost drivers involved, or else job cost estimates may be distorted. However, if the different cost drivers vary together in the same proportion then any one of them will be sufficient. 4-12 Cost pools collect support costs into separate groups, for each of which a separate cost driver rate is used. The general principle in determining the number of cost pools is that a separate cost pool should be used for the cost of an activity if the pattern of demand for it varies across products in proportions different from those reflected

in existing cost pool drivers. The increase in measurement costs for a more detailed cost system, however, must be traded off against the benefit of increased accuracy in estimating product costs. 4-13 Tracking the actual cost of individual jobs allows managers to compare the actual cost against the estimated cost and determine if there are unexpected variations in the efficiency in using activity resources. Such comparisons between actual and estimated costs help managers bid more accurately on future jobs and take corrective actions to alleviate unfavorable variations in costs. 4-14 Unlike direct material costs and direct labor costs, support costs cannot be traced easily to each job. When actual costs are recorded for a job during the course of a fiscal period, the total support costs for the period and consequently the actual cost driver is not yet determined. Therefore, costs are applied to jobs using predetermined rates. 4-15 Conversion costs are the costs of converting raw materials into finished products. They include the costs of production labor and support activities at each process stage. 4-16 Continuous processing plants are characterized by the fact that production flows continuously, semi-continuously, or in large batches from one process stage to the next. At each successive process stage, further progress is made toward converting the raw materials into finished products. Therefore, the product costing system must accumulate conversion costs assigned to individual products for successive process stages. Product costs must also reflect the yield rates—the fraction of the input materials in a process stage that is transferred to the next process. 4-17 Multistage process costing systems have the same objective as job order costing systems. Both types of systems assign material, labor, and manufacturing support activity costs to products. The two types of systems differ, however, on some dimensions. In a job order environment, production requirements vary across different jobs, so production occurs job by job and costs are measured for individual jobs. In addition, cost reports that compare actual to estimated costs may be determined for individual jobs. In a multistage process

environment, production requirements are homogeneous across products or jobs, so production occurs continuously, semicontinuously, or in large batches, and costs are measured for individual process stages. Because of the homogeneous production, cost reports that compare actual to estimated costs are likely to be determined only for individual process stages. 4-18 Production departments are those directly responsible for transforming raw materials into finished products. Service departments are departments that perform support activities, such as production engineering and machine maintenance. 4-19 Conventional product costing systems assign indirect costs to jobs or products in two stages. In the first stage, indirect costs are identified with various production and service departments, and all the service department costs are then allocated to production departments. In the second stage, the accumulated indirect costs for the production departments are assigned to individual jobs or products based on predetermined departmental cost driver rates. 4-20 Because jobs are worked on only in a production department, conventional costing systems assume that we cannot obtain direct measures of the use of service department resources on individual jobs as conveniently as we can of production department resources. Therefore, these costing systems allocate service department costs first to the production departments before assigning them to individual jobs. 4-21 The direct method is used when service department activities only benefit production departments. This method assumes no interaction among service departments and assigns their costs directly to production departments. The sequential method is used when there are no reciprocal interactions between service departments. Costs are allocated one at a time to other service departments in a sequential order. The reciprocal method recognizes reciprocal interactions between different service departments and allocates costs between service departments simultaneously. 4.40 Conventional two-stage cost allocation systems are likely to systematically distort product costs because they break the link

between the cause for the costs and the basis for assignment of the cost to the individual products. 4-23 Two factors that contribute to cost distortions when using conventional two-stage cost accounting systems are (1) the use of unit-related measures and (2) differences in relative consumption ratios. Unit-related measures are used to allocate support costs to products, but the demand for activities might be driven by batchrelated and product-sustaining cost drivers. Also, costs distortions tend to be greater when the differences between relative proportions of the activity cost drivers and the base for second-stage assignment are greater. Support Cost Driver Rate:

4-24 (a)

(b)

Consulting Engagement Cost: Labor cost $20,000 Support cost 40,000 2 × labor cost Total cost $60,000 Plantwide Cost Driver Rate:
³Èa;  Lj L : ä à ³Èa;  Lj L : ä à

4-25 (a)

(b)

Departmental Cost Driver Rates: Cutting Department:

Assembly Department:

. (c) The company may favor the method in (b) if support activity costs in the cutting department have a cause-and-effect relationship with machine hours, while those in the assembly department have a cause-and-effect relationship with direct labor costs. The company may use the method in (a) because it is simpler than the method in (b), which is potentially more accurate. Actual Machine Month Hours January 1,350 February 1,400 March 1,500 April 1,450 May 1,450 June 1,400 July 1,400 August 1,400 September 1,500 October 1,600 November 1,600 December 1,600 Total Hours 17,650 Monthly Support Costs $51.85 $50.00 $46.67 $48.28 $48.28 $50.00 $50.00 $50.00 $46.67 $43.75 $43.75 $43.75

4-26 (a)

(b) The support cost driver rate should be determined as the ratio of the normal cost of a support activity accumulated in the cost pool to the normal level of the cost driver for the activity. For Toki’s machine-related support costs, the computation is:

If the cost driver rate is based instead on actual or budgeted activity levels that fluctuate over time, then support activity costs will be understated in periods of high demand and overstated in periods of low demand, as shown in part (a). If Toki’s support costs are caused by multiple cost drivers, the company may develop a more accurate cost system by using multiple cost driver rates. 4-27 $4,000 12,000

Ingredient A: Ingredient B: Conversion costs: Total costs: Number of gallons of blended vegetable juice Cost per gallon of blended vegetable juice
³j L Lä È : ;  a à ³j L Lä È : ;  a à ³j L Lä È : ;  a à ³j L Lä È : ;  a à

$16,000 $16,500 $32,500 27,000 $1.204

4-28 Direct materials Direct labor Support costs Disposal costs of waste product Total costs Number of pounds of Goody Cost per pound of Goody 4-29 (a) Allocation of Setup Costs:
³j L Lä Èà : ; a  ³j L Lä Èà : ; a 

$232,000 120,000 60,000 20,000 $432,000 200,000 $2.16

Assembly Dept.:

Finishing Dept.: (b) Allocation of Inspection Costs: Assembly Dept.:

Finishing Dept.: 4-30 Service Departments Production Departments S1 S2 P1 P2 $65,000 $55,000 $160,000 $240,000 15,000 (70,000) $0 20,000 33,600 $213,600 30,000 36,400 $306,400

Directly identified costs Allocation of S1 units (65,000) Allocation of S2 units — Total Allocated $0 Support Costs

4-31 (a) Portland Electronics, Inc.: Job Cost Sheet Customer: Video Shack Product: Computer monitors, 1000 units Direct Material Quantity Price Part A327 1,000 units $60 Part B149 1,000 units 120 Total Direct Material Cost: Direct Labor Hours Rate Assembly 6,000 $10 Inspection 1,000 12 Total Direct Labor Cost: 7,000 Support Costs 7,000 Direct Labor Hours @ $5 per Hour Total Cost Number of Units Produced (b) Cost per monitor

Amount $60,000 120,000 $180,000 Amount $60,000 12,000 $72,000 Amount $35,000 $287,000 1,000 $287

4-32 Baker Auto Shop: Job Cost Sheet for Job #379. Direct Material Engine Oil Lubricant Total Direct Material Cost: Direct Labor Direct Labor Support Costs 3 Direct Labor Hours @ $10 per Hour Total Cost
4.40

Quantity 11 ounces 2 ounces Hours 3

Price $2 3 Rate $15

Amount $22 6 $28 Amount $45 Amount $ 30 $103

(a) Plantwide Cost Driver Rate =
³ È aä L: L; j à ³ È aä L: L; j à

Job Cost Sheet: Job #691 Direct Materials Milling Assembly Total Direct Material Cost: Direct Labor Milling Assembly Total Direct Labor Cost: Manufacturing Support 50 Direct Labor Hours @ $14 per Hour Total Cost

Amount $800 50 $850 Amount $100 600 $700 Amount $ 700 $2,250

³ Èa ;  L: Là j ä

³ Èa ;  L: Là j ä

(b)

Cost Driver Rate – Milling

Cost Driver Rate – Assembly Job Cost Sheet: Job #691 Direct Materials Direct Materials Milling Assembly Total Direct Material Cost: Direct Labor Milling Assembly Total Direct Labor Cost: Support Milling: 18 Machine Hours @ $10 per Hour Assembly: 40 Direct Labor Hours @ $13.33 per Hour Total Overhead Cost Total Cost (c) Manufacturing cost 25% markup Bid price Part (a) $2,250.00 562.50 $2,812.50 Part (b) $2,263.00 565.75 $2,828.75 Amount $800 50 $850 Amount $100 600 $700 Amount $180 533 $713 $2,263

(d) The company may favor the method in (b) if support activity costs in the milling department have a cause-andeffect relationship with machine hours, while those in the assembly department have a cause-and-effect relationship with direct labor costs. In this case, the computed total

manufacturing cost in part (a) is of similar magnitude to the cost in part (b), and therefore the bid prices are also of similar magnitude. Given this result, one might be inclined to use the simpler method in part (a) rather than the more accurate but more complex method in part (b). However, comparisons across different products may produce greater differences in computed costs and bid prices. 4-34 (a) Cost driver rate for Machining:

Cost driver rate for Finishing:

of direct labor cost. (b) Machining Department Direct material cost $12,000 Direct labor cost 300 Manufacturing support 2,000a Total costs of Job 134 $14,300
³j L Lä È :a  à ; ³j L Lä È :a  à ;

Finishing Department $2,000 1,200 960b $4,160

Total $14,000 1,500 2,960 $18,460

of 1,200 (c) Gonzalez Company likely believes that its manufacturing support costs are driven by different factors. Specifically, support activity costs in the machining department has a cause-and-effect relationship with machine hours, while those in the finishing department have a cause-and-effect relationship with direct labor costs. 4-35 Beginning work-inprocess: Job 101 $25,500 Job 102 $32,400 Job 103 $0

Direct materials: Dept. 1 Dept. 2 Dept. 3 Direct labor: Dept. 1 Dept. 2 Dept. 3 Mfg.suppor t: Dept. 1 Dept. 2 Dept. 3

$40,000 3,000 0 $43,000
Lä ³ a È  j à : ; L

$26,000 5,000 0 $31,000

$58,000 14,000 0 $72,000

Lä ³ a È  j à : ; L

$18 × 200 = $3, 600 $18 × 250 = $4 , 500 $15 × 1,500 = $22,500 $15 × 1, 800 = $27, 000

$15 × 2 , 500 = $37 , 500

$32,100
150% × $43, 000 = $64 , 500 $8 × 1, 200 = 9 , 600 200% × $32 , 100 = $64 , 200

$36,300
150% × $31, 000 = $46, 500 $8 × 1, 500 = 12 , 000 200% × $36, 300 = $72, 600

$47,400
150% × $72 , 000 = $108, 000 $8 × 2, 700 = 21, 600 200% × $47 , 400 = $94 , 800

$138,300 Totalcosts (a) $238,900

$131,100 $230,800

$224,400 $343,800

Total cost of completed Job 101 = $238,900

(b) Total cost of completed Job 102 = $230,800 (c) Work-in-process for Job 103 at April 30, 2000 = $343,800 4-36 (a) Brumelle Electronic Company: Job bid sheet Job Bid Sheet Customer: Takayama, Inc. Product: ICB371 Number of units: 1,000 Direct material Direct labor Manufacturing support

Quantity 2000 units 1000 hours

Price Amount $10 per unit $10 per hour $6 per direct labor hour $20,000 10,000 6,000

Total estimated costs Markup (20%) Bid price (b)Brumelle Electronic Company: Job cost sheet Job Cost Sheet Customer: Takayama, Inc. Product: ICB371 Number of units: 1,000 Direct material Direct labor Manufacturing support Total actual costs

$36,000 7,200 $43,200

Quantity 2100 units 1000 hours

Price Amount $9.75 per unit $11 per hour $6 per direct labor hour $20,475 11,000 6,000 $37,475

(c)The differences between actual and estimated material quantity and material price per unit could reflect poorer quality materials (for example, a higher percentage of defects) that resulted in requisitioning a larger number of units of material than expected. Although the job required the same number of labor hours as estimated, the hourly rate was higher than estimated. This may be because there are several grades of labor with differing wage rates, while a single common rate is used for estimating labor costs on jobs. 4-37 (a) Directly identifiedcosts Allocation ofPersonnel Dept. costs Allocation ofMaintenance Dept. costs Service Departments Personnel Maintenance $100,000 $200,000 (100,000) — (200,000) $ 0 $0 176,471c $587,582 23,529d $412,418 — Production Departments Machining Assembly $400,000 $300,000 11,111a 88,889b

³ È aä L : L; j à

³ È aä L : L; j à

a

c

b

d

(b) Cost Driver Rate: Machining Cost Driver Rate: Assembly
³ L ³ L

Direct materials and labor costs: Support costs from Machining Department ($58.7582 × 3 machine hours) Support costs from Assembly Department ($41.2418 × 5 direct labor hours) Total unit cost Markup (30%) Bid price (c) Directly identifiedcosts Allocation of Personnel Dept. costs

$ 450.00 176.27 206.21 $ 832.48 249.74 $1,082.22

Service Department Production Department Personnel Maintenance Machining Assembly $100,000 $200,000 $400,000 $300,000

30,000a

(200,000)

150,000b

20,000c

Allocation ofMaintenance Dept.costs

(130,000)

— 14,444d 115,556e $435,556

$0
³ Èa ;  Lj Là : ä ³ Èa ;  Lj Là : ä

$0

$564,444

a

d

b

e

c

(d) Cost Driver Rate: Machining

Cost Driver Rate: Assembly Direct materials and labor costs: Support costs from Machining Department ($56.4444 × 3 machine hours) Support costs from Assembly Department ($43.5556 × 5 direct labor hours) Total unit cost Markup (30%) Bid price 4-38 (a) Service Department Maintenance Grounds $450.00 169.33 217.78 $837.11 251.13 $1,088.24 Production Department Machining Assembly

Directly identified costs Allocation of Maintenance Dept. costs Allocation of Grounds Dept. costs

$18,000 (18,000)

$14,000 —

$45,000 12,000a

$25,000 6,000b

— $0

(14,000) $0

6,000c $63,000

8,000d $39,000

³ Èa;  Lj L : ä à

³ Èa;  Lj L : ä à

a

c

b

d

(b) Directly identifiedcosts Allocation ofPersonnel Dept. costs Allocation of Maintenance Dept. costs

Service Department Production Department Maintenance Grounds Fabricating Assembly $18,000 $14,000 $45,000 $25,000

(18,000)

1,385a

11,077b

5,538c

— $0

(15,385) $0

6,594d $62,671

8,791e $39,329

³ Èa;  Lj L : ä à

³ Èa;  Lj L : ä à

a

d

b

e

c

(c)

Service Department

Production Department

Directly identifiedcosts Allocation ofMaintenance Dept.costs ($19,193.481) Allocation of GroundsDept. costs($15,515.274 )

Maintenance $18,000.000

Grounds $14,000.000

Fabricating $45,000.000

Assembly $25,000.000

($19,193.481) 1,476.422a 11,811.372b 5,905.686c

1,224.890d (15,515.274)

6,124.450e $62,936.000 round-off errors

8,165.934f $39,072.000

³ : a;  Lj L È ä à

³ : a;  Lj L È ä à

a

d

b

e

c

f

Therefore,

4-39 (a) Support cost Direct labor hours
³È L L a; : ä  j à ³È L L a; : ä  j à

Cutting $42,000 5,000

Grinding Drilling $192,000 $228,000 8,000 12,000

Total $462,000 25,000

Plantwide Cost Driver Rate Support Cost

Applied

to

Job

ST101

(b) Cost Driver Rate: Cutting

Cost Driver Rate: Grinding

Cost Driver Rate: Drilling Support Cost Applied to Job ST101: Dept Cutting Grinding Drilling Rate $0.525 $24.00 $19.00 Units of Base Used 20,000 MH 2,500 DLH 3,000 DLH Overhead Cost $10,500 60,000 57,000 $127,500

(c) The company may favor departmental support cost driver rates if support activity costs in the cutting department have a cause-andeffect relationship with machine hours, while those in the grinding and drilling departments have a cause-and-effect relationship with direct labor costs. The company may use the method a plant-wide cost driver rate because it is simpler than using multiple departmental rates, though the departmental rate method is potentially more accurate. 4.40 A good case can be made for any of the three alternatives presented below: Alternative 1: Allocate in the proportion of actual passengers Week Boston Cambridge 1 $4,800 $2,400 2 3 4 5
³ÈL  Ljaà : ä ; ³ÈL  Ljaà : ä ;

4,500@ 5,118 5,200@@ 5,100

2,700 2,482 2,600 2,100

@ @@ This method is justified by the argument that all costs should be spread equally over all passengers.

Alternative 2: Charge normal cost @ Week 1 2 3 4 5 Boston $4,800@ 4,500 4,950 5,100 5,100

per passenger

Cambridge Unallocated $2,400 – 2,700 – 2,400 $250 2,550 150 2,100 –

@ 1,600 passengers × normal cost Using normal cost per passenger to allocate service center costs is justified by the argument that the service center costs are caused primarily by the level of capacity that is made available rather than the level of actual usage of the committed resources. Alternative 3: Allocate normal costs 2:1 based on long run demand and additional help costs in the proportion of additional demand. Week 1 2 3 4 5
³a L È :ä  j ; L à

Boston $4,800 4,800 5,200@ 5,200@@ 4,800

Cambridge $2,400 2,400 2,400 2,600 2,400

@

³a L È :ä  j ; L à

@@ This method best reflects the factors that cause the costs to be incurred. 4-41 (a) Service Dept. Cost Allocation: Direct Method Service Departments Maintenance Directly identified costs Allocation of Maint. Dept. costs $750,000 (750,000) Power $450,000 — Production Departments Casting $150,000 500,000 Assembly $110,000 250,000

Allocation of Power Dept. costs

(450,000)

250,000 200,000

$0
³È a;  Lj L : ä à

$0

$900,000

$560,000

³È a;  Lj L : ä à

Cost Driver Rate: Casting

Cost Driver Rate: Assembly

Maintenance: Casting

M ³ ³ ÉD ÜL ± D È

M ³ ³ ÉD ÜL ± D È

Assembly
M ³ ³ É$ ÜL ± D È M ³ ³ É$ ÜL ± D È

Power:
M ³ ³ É$ ÜL ± D È M ³ ³ É$ ÜL ± D È

Casting

Assembly
M ³ ³ É$ ÜL ± D È M ³ ³ É$ ÜL ± D È

Direct labor and material costs Support costs: Casting (1 × $11.25) Assembly (0.5 × $9.33) $11.250 4.665

$32.000

15.915

Unit cost Number of units per month Total manufacturing costs per month Mark up (25%) Bid price (per month) (b)

$47.915 1,000.000 $47,915.000 $11,978.750 $59,893.750

Service Departments Production Departments Maintenance Power Casting Assembly Directly identified $750,000 $450,000 $150,000 $110,000 costs Allocation of Maint. Dept. costs Allocation of Power Dept. costs (750,000) — $0 = $300,000 (750,000) $0 300,000 416,667 $866,667 150,000 333,333 $593,333

$866, 667 80, 000 = $10.833 per machine hour Cost Driver Rate: Casting $593, 333 = 60, 000 Cost Driver Rate: Assembly = $9.889 per labor hour Direct labor and material costs Support costs: Casting (1 × $10.833) $10.833 $32.000

Assembly (0.5 × $9.889) Unit cost Number of units per month Total manufacturing costs per month Mark up (25%) Bid price (per month) (c) M = $750,000 + 0.1P P = $450,000 + 0.4M Therefore, M = $750,000 + 0.1 × (450,000 + 0.4M) M = $795,000 + 0.04M 0.96M = $795.000 $795,000 M = 0.96 =$828,125

4.944

15.777 $47.777 1,000.000 $47,777.000 $11,944.250 $59,721.250

P = 450,000 + 0.4 × $828,125 = $781,250

Casting Directly identified costs Allocation of Maint. Dept. costs $828,125 × 40% = $150,000

Assembly $110,000

$331,250 $828,125 × 20% =

$165,625

Allocation of Power Dept. costs

$781,250 × 50% =

$390,625 $781,250 × 40% =

$312,500

$871,875 =

$588,125

$871, 875 80, 000 = $10.8984 per machine hour Cost Driver Rate: Casting $588,125 = 60, 000 Cost Driver Rate: Assembly = $9.8021 per labor hour Direct labor and material costs Support costs: Casting (1 × $10.8984) Assembly (0.5 × $9.8021) Unit cost Number of units per month Total manufacturing costs per month Mark up (25%) Bid price (per month) $10.8984 4.9011 15.7995 $47.7995 1,000.0000 $47,799.5000 $11,978.7500 $59,749.3750 $32.0000

4-42 (a) Let salaries be denoted as follows: M = manager, S = senior mechanic, and J = junior mechanic. The estimated total support costs are:

Personnel costs ( M + 4S + 4 J )+ Fixed costs 1 = $75,000 + (4 × $65,000) + (4 × $45,000) + $96,800 = $611,800 Estimated total number of hours on customer jobs = 8 × 1, 750 × 95% = 13, 300 hours . Therefore, the cost driver rate $611,800 = = $46 per hour 13,300 hours . Furthermore,
(b) Estimated Total Overhead Costs Estimated Total Hours on Customer Jobs Overhead Cost per Customer Job Hour Price per Hour

51.06 = 1 + 

x   × 46 100  , so x = 11% .
Class A Repairs Class B Repairs

611, 800 × 60% = $367 , 080 611, 800 × 40% = $244 , 720 13, 300 × 367 , 080 6, 650 1 2 = 6, 650 13, 300 × 244 , 720 6, 650 1 2 = 6, 650

= $55. 20 per hour

= $36. 80 per hour

$55. 2 × 1.11 = $61. 27 per hour $36.8 × 1.11 = $40.85 per hour

(c) Job 101: 4.5 A + 1.5B Job 102: 2B (Note: A = class A repair hours, B = class B repair hours) Under the present accounting system, costs charged to: Job 101: 6 × 51. 06 = $306. 36 Job 102: 2 × 51. 06 = $102.12 Under the proposed accounting system, costs charged to: Job 101: 4.5 × 61. 27 + 1.5 × 40.85 = $337. 00 Job 102: 2 × 40.85 = $81. 70 Therefore, under the present accounting system:

Job 101 is undercosted and underpriced. Job 102 is overcosted and overpriced. (d) Depending on competition for repairs, the proportion of Class B repairs may increase and the proportion of Class A repairs may decrease because of the price change. (e) The current costing system is simple to administer and results in pricing at a uniform labor rate (that includes coverage of support costs). The proposed costing system more accurately reflects resource usage, but is more complex to administer and to communicate to customers in pricing.

Chapter 4

Activity-BasedCost Management Systems
QUESTIONS 5-1 Production departments are those directly responsible for transforming raw materials into finished products. Service departments are departments that perform support activities, such as production engineering and machine maintenance. 5-2 Conventional product costing systems assign indirect costs to jobs or products in two stages. In the first stage, indirect costs are identified with various production and service departments, and all the service department costs are then allocated to production departments. In the second stage, the accumulated indirect costs for the production departments are assigned to individual jobs or products based on predetermined departmental cost driver rates. Conventional two-stage cost allocation systems are likely to systematically distort product costs because they break the link between the cause for the costs and the basis for assignment of the cost to the individual products. Two factors that contribute to cost distortions when using conventional two-stage cost accounting systems are: (1) the use of unit-related measures and (2) differences in relative consumption

5-3

5-4

ratios. Unit-related measures are used to allocate support costs to products, but the demand for activities

might be driven by batch-related and product-sustaining cost drivers. Also, costs distortions tend to be greater when the differences between relative proportions of the activity cost drivers and the base for second-stage assignment are greater. 5-5 The fundamental assumption in the two-stage allocation method is the absence of a direct link between the support activities and individual products, services and customers. This assumption often leads to distortions in the allocation of support costs. Activity-based costing systems reject this fundamental assumption. Activity cost driver is the unit of measurement for the level (or quantity) of the activity performed. Activity cost drivers identify the linkage between activities and cost objects, such as products, services, and customers. Activity cost driver rate is the ratio of the cost of the resources required to provide an activity to the level of the capacity made available by those resources. The major steps to determine activity cost driver rates are: Step 1. Identify the activities performed by the organization (prepare an activity dictionary). Step 2. Determine the cost of performing each activity. Step 3. Identify a cost driver for each activity. Step 4. Determine the number of units of the cost driver made available by the resources committed to each activity. Step 5. Divide activity cost by activity cost driver units to obtain the activity cost driver rate. 5.49 One special consideration is that unlike physical products, services cannot be inventoried for future sales. Service companies must supply virtually all their resources in advance to provide the capacity to perform work for customers during each period, and demand often fluctuates. For some service industries, the increase in spending resulting from an incremental transaction or customer is essentially zero.

5-6

5-7

Another special consideration is that it can be difficult to identify and measure the outputs for a service organization. The variation in demand for

organizational resources is much more customer-driven in service organizations than in manufacturing organizations. A service company can determine and control the efficiency of its internal activities, but customers determine the quantity of demands for these operating activities. For example, customers may vary greatly in the number of transactions and the balances in their checking accounts. Finally, a customer may have multiple relationships with a service company. Therefore, the cost system should provide information that supports determining profitability of the entire relationship with the customer. 5-9 Using the number of setups instead of setup hours is appropriate when all products require approximately the same number of setup hours per batch.

5-10 Under the framework of a conventional two-stage cost allocation system, costs are allocated to products based on unit-related measures such as machine hours and direct labor hours. Distortion caused by the use of unit related measures to allocate costs is corrected in activitybased costing systems because batch-related activity costs are assigned to jobs on the basis of batch-related cost drivers, and product-sustaining activity costs are assigned to jobs on the basis of product-sustaining cost drivers. 5-11 Conventional product costing systems are designed primarily for external financial reporting that requires tracking of manufacturing costs to allocate between cost of goods sold and inventories. Selling and distribution costs are not included in cost of goods sold or inventories. Their inclusion would require maintaining a parallel accounting system which, until the advent of inexpensive data processing, was considered to be not cost effective. Also, selling and distribution costs used to be small relative to other manufacturing costs and their exclusion did not have a serious impact on managerial decisions. 5-12 Customer service and technological innovation have become more important in a firm’s quest for a competitive edge over its rivals. As more resources are used on these and related activities, the proportion of non-manufacturing costs has increased recently. Therefore, it has

become more important to assign these costs to products for managerial purposes. 5-13 Conventional costing systems allocate batch-related and productsustaining costs in proportion to a unit-related measure. In a highly automated plant, costs of batch-related and product-sustaining activities are greater. Allocating these costs based on a unit-related measure distorts costs. Activity-based costing systems correct the distortion by employing appropriate cost drivers for different activities to assign costs to products. 5.49 Yes, conventional costing systems are more likely to overcost high volume products because batch-related and product-sustaining costs are assigned to products in proportion to the number of production units. 5-15 Activity-based costing systems use cost drivers that link the activities performed to the cost objects that use the activities. For example, the cost objects might be products, services, or customers. 5-16 Selecting an activity cost driver involves a subjective trade-off between accuracy and the cost of measurement. Transaction drivers, which count how often an activity is performed, are the least expensive type of cost driver, but also the least accurate. Duration drivers, which represent the amount of time required to perform an activity, are desirable when significant variation exists in the amount of activity required for different outputs. Choosing between a duration and transaction driver will involve balancing the benefits of increased accuracy against the increased measurement costs. Intensity drivers, which directly charge for the resources used each time an activity is performed, are the most accurate activity drivers, but are also the most expensive to implement. Intensity drivers are justified when the resources associated with performing an activity are both expensive and variable each time an activity is performed. 5-17 The activity cost driver rate should reflect the underlying efficiency of the process − the cost of resources to handle each production order − and this efficiency is measured better by using the capacity of the resources supplied (practical capacity) as the denominator when

calculating activity cost driver rates. The numerator in an activity cost driver rate calculation represents the costs of supplying resource capacity to do work. The denominator should match the numerator by representing the quantity of work the resources can perform. The cost of unused capacity should be used as feedback to managers on their supply and demand decisions. 5-18 Immediate financial improvement may not follow even after process improvements reduce the demand for indirect and support resources. This is because the support costs are often committed. The organization must

actively manage the unused capacity by increasing the volume of business or reducing the supply of unused resources. 5-19 Activity-based costing systems are more flexible in using different cost drivers to better link the activities performed to the products manufactured. The reason they provide more accurate product costs is that they take into account the demand placed on activities by different products, not because they use more cost drivers. A system that uses many cost drivers that do not match the activity costs is also likely to distort product costs. 5-20 (a) Number of machine hours (b) Number of setup hours (c) Number of machine hours or number of kilowatt hours (d) Number of inspections (e) Number of orders (f) Number of production runs (g) (h) (i) (j) (k) (l) Number of square feet Number of square feet Direct labor hours Number of workers Number of square feet Number of workers

5-21 Potter Corporation should switch to activity-based costing because its current system appears to be distorting product costs, resulting in prices of specialty products that are too low (hence increasing their market share) and price of simple products that are too high (thus, lowering their market share). This, in turn, leads to lower overall profitability as Potter pushes products that, in reality, produce low profit margins or even lose money. In implementing an activity-based costing system, Potter will need to identify activity cost drivers in its plant such as the number of setups, purchase orders, and quality inspections, and then allocate costs to products in the proportion of the amount of activity demanded by each product.

5-22 A variety of solutions may be proposed. The solution below adds the $15,000 quality inspection costs per quarter to the “handle production runs” activity described in the chapter. Handle Set Up Support Run Total Prod. Machines Products Machines Expense Runs Indirect labor & _ 50% 40% 10% $84,000 fringe Computer expense 80% 20% 30,000 Machine depreciation 100% 24,000 Maintenance 100% 12,000 Energy 100% 6,000 Quality Inspections 100% 15,000 $171,000 Handle Set Up Support Run Total Prod. Machines Products Machines Expense Runs $42,000 $33,600 $8,400 $84,000 24,000 6,000 24,000 12,000 6,000 15,000 $81,000 $33,600 $14,400 $42,000 30,000 24,000 12,000 6,000 15,000 $171,000

Indirect labor & _ fringe Computer expense Machine depreciation Maintenance Energy Quality Inspections

The revised activity cost of $81,000 is used to derive a new activity cost driver rate for “handle production runs,” and the product costs are revised.

Activity Expense

Handle Set Up Prod. Runs Machines $81,000 $33,600

Support Products $14,400

Run Machines $42,000 Number of machine hours 10,000 $4.20 per hour Run Machines

Activity Cost Driver Number of Number of Number of runs setup hours products Activity Cost Driver Quantity Activity Cost Driver Rate 150 526 4 $3,600 per product

$540 per $63.88 per run hour

Handle Set Up Support Prod. Runs Machines Products

Activity Cost Driver $540 per $63.88 per $3,600 per $4.20 per Rate run hour product hour Activity Cost Driver 50 200 1 5,000 Quantity: Blue Total Activity $27,000 $12,776 $3,600 $21,000 Expenses: Blue Activity Cost Driver 50 50 1 4,000 Quantity: Black Total Activity $27,000 $3,194 $3,600 $16,800 Expenses: Black Activity Cost Driver 38 228 1 900 Quantity Red Total Activity $20,520 $14,565 $3,600 $3,780 Expenses: Red Activity Cost Driver 12 48 1 100 Quantity: Purple Total Activity $6,480 $3,066 $3,600 $420 Expenses: Purple

5-23 (a)
Activity

Estimated Costs

Activity Cost Drivers

Monthly Planned Cost Activity Driver Level Rate

Process deposits $29,630 Process withdrawals 26,080 Answer inquiries 24,860 Sell negotiable 4,860 Instruments Balance drawers 4,290 $89,720

# of deposits processed # of withdrawals processed # of inquiries # of instruments sold # of drawers balanced

33,250 22,750 45,000 1,100 1,300

$0.89 1.15 0.55 4.42 3.30

(b)

Activity Process deposits Process withdrawals Answer customer inquiries Sell negotiable instruments

Average Monthly Rate 2.3 6.0 2.1 0.5

Activity Cost Driver Rate $0.89 1.15 0.55 4.42

Total Support Costs $2.05 6.90 1.16 2.21 $12.32

5-24 Cost pool
Machine setups Material handling Electric power Direct material cost Direct labor cost Support costs: Machine setups Materials handling Electric power

Activity costs Cost drivers $360,000 6,000 setup hours 100,000 40,000

Overhead rate $60 per setup hour

50,000 pounds of materials $2 per pound 80,000 kilowatt hours V203 $25,000.00 14,000.00 $0.5 per kilowatt hour G179 $33,000.00 16,000.00

$60 × 120 = $2 × 5,000 = $0.5 × 2,000 =

7,200.00 10,000.00 1,000.00 $57,200.00 5,000.00 $11.44

$60 × 150 = $2 × 10,000 = $0.5 × 3,000 =

$9,000.00 20,000.00 1,500.00 $79,500.00 15,000.00 $5.30

Total manufacturing costs # of units produced Unit cost

5-25 (a) Based on number of setups:
Direct labor costs Other costs Total setup costs Number of setups Cost driver rate Week 1 $5,520.00 @ $4,000.00 @@ $9,520.00 160 $59.50 Week 2 $5,520.00 $4,000.00 $9,520.00 160 $59.50 Week 3 $5,520.00 $4,000.00 $9,520.00 160 $59.50

@ (=$10 per hour × 10 workers × 40 hours ) × 1.38 @@ (=$25× 160 setups)

Based on number of setup hours: Direct labor costs Other costs Total setup costs Number of setup hours Cost driver rate Week 1 $5,520.00 $4,000.00 $9,520.00 395@ $24.10 Week 2 $5,520.00 $4,000.00 $9,520.00 390@@ $24.41 Week 3 $5,520.00 $4,000.00 $9,520.00 400@@@ $23.80

@ (2× 85) + (3× 75) = 395@@ (2× 90) + (3× 70) = 390

@@@ (2× 80) + (3× 80) = 400\

(b) If only one cost driver can be used, then it may be preferable to base the cost driver rate on the number of setup hours because the setup time is different for these two products. However, both cost drivers are required in this case because some costs ($25 per set up) depend on the number of setups and some ($13.80 per setup hour) depend on setup hours. 5-26 Carl’s previous average committed cost per meal was $1650 ÷ 600 = $2.75. With the drop in demand, the average committed cost is now $1650 ÷ 550 = $3. If demand decreases further and Carl continues to use the same method to determine his costs of serving a meal, the average committed cost will continue to increase, and Carl will want to raise his prices even more. However, the rising prices may contribute to further declines in demand, leading Carl into a downward spiral. Carl should use the practical capacity level of 600 meals per day to determine cost per meal, and should monitor the cost of unused capacity. Carl may be able to reduce the capacity costs or to find other profitable uses for the capacity. 5-27 This question is designed to generate discussion on what constitutes a desirable customer. Although a credit customer who charges a large dollar volume and pays the balance in full on time each month is probably a good credit risk, the customer is not the most profitable to the credit card issuer. (However, some credit card issuers may generate indirect additional revenue from such customers by working with advertisers to selectively add advertising inserts to these customers.) All credit card purchases generate merchant fees; the

credit card issuer hopes to generate additional income through interest payments and late fees. Type 6 is the least desirable type of customer because that type generates no revenue but causes the issuer to incur costs to send statements. Type 1 is preferable to Type 6, but less preferable than all the remaining types because of the short-term, low-interest arrangement. Type 3 is preferable to type 4 because of the late fees, and type 4 is preferred to type 5 because of the higher balances on which interest is paid. Type 2 is probably less preferred than types 3 and 4, and possibly type 5. The suggested complete ordering will depend on the relative dollar magnitudes assumed. A reasonable ordering, from most preferred to least preferred, is 3, 4, 2, 5, 1, 6. 5-28 As Inkslinger contemplated implementing activity-based costing, the company faced a number of implementation barriers. Some managers either did not understand a clear business purpose (though they understood the increased accuracy of activity-based costing) or they feared the ramifications of the new cost information. Possible negative repercussions included decreasing executive compensation, eliminating the new product line, or even closing the entire Kentucky plant. Consequently, there was overt resistance to implementing activity-based costing. Managers can be reassured that the new product line will be given sufficient time to prove itself. Activity-based costing can be presented as a management tool that can provide useful information as Inkslinger redesigns or improves processes, evaluates product design decisions, or seeks to better manage customer relationships. That is, there are many avenues to improving performance at the Kentucky plant and ultimately, at Inkslinger. The managers can participate in choosing the specific business purpose for activity-based costing, and should be informed that the cost system will be designed to support the primary purpose of the model. For example, the cost system may be designed differently if its primary purpose is be to support process improvement rather than to support strategic decision making (for example, pricing, product mix, or customer relationships). The cost system will be only as complex as it needs to be for the chosen business purposes.

5-29 (a) Budgeted support costs Predetermined cost driver rate Direct material costs Direct labor costs Support costs ($5 × 1,800) Total manufacturing costs Number of units Unit costs (b)
Activity Electric Power Material Handling Setups Quality Inspections Costs $40,000 90,000 80,000 40,000

= $250,000.00 = $5 per machine hour $20,000.00 18,000.00 9,000.00 47,000.00 1,000.00 $47.00
Cost Driver Kilowatt hours Material moves Machine setups Number of inspection Available Capacity 20,000 kwh 5,000 moves 1,000 setups 2,000 inspections 20.00 Overhead Rates $2.00 18.00 80.00

Direct material costs Direct labor costs Support costs: Electric Power ($2 × 2,000) Material Handling ($18 × 40) Setups ($80 × 5) Quality Inspections ($20 × 20) Total manufacturing costs Number of units Unit costs $4,000.00 720.00 400.00 400.00

$20,000.00 18,000.00

5,520.00 $43,520.00 1,000.00 $43.52

5-30 (a)
Direct material cost Direct labor cost Support cost Total manufacturing cost Number of units Unit cost
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J101 $10,000.00 8,000.00 7,000.00a 25,000.00 2,000.00 $12.50

J102 $7,500.00 5,500.00 6,500.00b 19,500.00 1,500.00 $13.00

a

b

J101 Direct material cost Direct labor cost Support costs: Maintenance Material move Machine setup Inspection Total manufacturing cost Number of units Unit cost $2 × 700 = $100× 40 = $30 × 80 = $50 × 35 = 1,400.00 4,000.00 2,400.00 1,750.00 $27,550.00 2,000.00 $13.78 $10,000.00 8,000.00

J102 $7,500.00 5,500.00

$2 × 650 = $100× 15 = $30 × 40 = $50 × 15 =

1,300.00 1,500.00 1,200.00 750.00 $17,750.00 1,500.00 $11.83

(c) Activity-based costing produces more accurate estimates of job costs because it takes into account the cost drivers that give rise to support costs.

5-31 (a) Manufacturing
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Support

Cost

Driver

Rate

Costs Per Unit Direct materials cost Direct labor cost Manufacturing support cost Unit cost

Product X21 $120.00 20.00 28.75 × 2.00 $197.50

Product Y37 $140.00 45.00 28.75 × 3.00 $271.25 Costs Allocated to Products

(b)
Activity Handling Number of Parts Design changes

Activity Costs Cost Driver Cost Driver Level Rate X21 $3,000,000 60,000 50 50 × 40,000 2,400,000 3,300,000 20,000 3,000 120 120 × 12,000 1,100

Y37 50 × 20,000 120 × 8,000

1,100 × 1,100 × 1,000 2,000 200 × 8,000 $7,240,000 200 × 6,000 $4,260,000

Setups Total Costs Per Unit Direct materials cost Direct labor cost

2,800,000 $11,500,000

14,000

200

X21 $120.00 20.00
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Y21 $140.00 45.00

Manufacturing support cost

144.80 Unit cost $284.80

42.60 $227.60

5-32 (a) Managers need accurate product cost data in a broad range of decision-making situations. Without accurate cost data, managers would find it very difficult to set selling prices for products and services. A knowledge of product costs is also vital in a number of special decision areas, such as whether to add or drop product lines, whether to make or buy product components, whether to expand or contract operations, and whether to accept special orders at special prices.
³ È aä L > L?? $ ™š € ³ È aä L > L?? $ ™š €

(b) Number of inspection hours: School Model

Number of inspection hours: Hiker Model
School Model
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Hiker Model $1,800.00 $30,000.00 $71,880.00

Cutting & Sewing

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$18,000.00 = $67,500.00 = $107,820.00

Orders Inspections

= = =

Total manufacturing support costs Number of units Manufacturing support cost per unit

$193,320.00 90,000.00 $2.15

=

$103,680.00 6,000.00 $17.28

(c)

Product profitability analysis:
School Model Sales price Less: Manufacturing costs Selling and admin. costs Profit
@ $2.00 + $2.00 + $2.15 = $6.15 @@ $10.00 + $3.00 + $17.28 = $30.28

Hiker Model $30.00 ($30.28)@@ (1.00) ($1.28)

$10.00 ($6.15)@ (0.50) $3.35

5-33 (a)

Activity Set tables Seat customers Take orders Cook food Serve orders Take dessert orders Serve dessert Present bills and collect Clean tables

Cost Driver Number of tables Number of tables Number of customers Number of customers Number of customers Number of customers Number of customers Number of tables Number of tables

(b) For some of the activities, it does not matter how many people are at the table; what really matters is that the staff has to go to the table to clean or serve the table. For other activities, the number of customers is a better cost driver than number of tables. Using the appropriate cost driver should produce more accurate costs of resource usage.

5-34 (a)Activity cost driver rates: Activity Activity Costs Cost Driver $425,000 Setup hours 10,000 Number of orders 6,000,000 Machine hours 36,000 Number of batches Number of 64,000 shipments $6,535,000 Activity Cost Practical Driver Capacity Rate 6,500 $65.38 100 $100.00 75,000 $80.00 1,200 $30.00 1,600 $40.00

Activity Machine setups Purchase ordering Machining Inspection Packing and Shipping

Support costs per unit: Activity Cost Driver Units Cost Assigned to Activity Rate K33 K77 K33 K77 Machine setups $65.38 2,000 4,200 $130,769 $274,615 Purchase ordering $100.00 25 50 $2,500 $5,000 Machining $80.00 40,000 15,000 $3,200,000 $1,200,000 Inspection $30.00 400 600 $12,000 $18,000 Packing and Shipping $40.00 80 1,500 $3,200 $60,000 Total 3,348,469 $1,557,615 Per Unit $8.37 $10.38

Manufacturing cost per unit: Direct material cost Direct labor cost Support cost Unit cost K33 K77 $30.00 $45.00 24.00 60.00 8.37 10.38 $62.37 $115.38

(b) The direct material cost and direct labor cost are obviously much higher for K77 than for K33. Examination of the support costs shows that machining costs are the same per unit for both products, but the other support costs are three to four times higher per unit for K77 than for K33. The higher support costs for K77 result from the relatively large number of machine setups, purchase orders, inspections (batches), and shipments. (c) The company can consider the trade-offs in running K77 in larger batches and possibly maintaining larger inventories. Running larger batches would reduce the number of machine setups and inspections, and possibly the number of purchase orders. The company should realize, however, that such operational changes might not provide immediate financial improvements if capacity for these activities remains the same if not used profitably. (d) (d) Activity Machine setups Purchase ordering Machining Inspection Packing and shipping Activity Costs $425,000 10,000 6,000,000 36,000 64,000 $6,535,000 K33 $130,769 2,500 3,200,000 12,000 3,200 $3,348,469 Support Costs Assigned K77 $274,615 5,000 1,200,000 18,000 60,000 $1,557,615 Total $405,385 7,500 4,400,000 30,000 63,200 $4,906,085 Variance= Estimated – Assigned $19,615 2,500 1,600,000 6,000 800 $1,628,915

(e)The variances in part (d) indicate the cost of unused capacity. The company should monitor the variances and evaluate whether some of the capacity can be eliminated or whether there are alternative profitable uses for the capacity.

(f) Kohlman should base its activity cost driver rates on practical capacity because the rates should reflect the underlying efficiency of the process— the cost of resources to handle each activity— and this efficiency is measured better by using the capacity of the resources supplied (practical capacity) as the denominator when calculating activity cost driver rates. The numerator in an activity cost driver rate calculation represents the costs of supplying resource capacity to do work. The denominator should match the numerator by representing the quantity of work the resources can perform. The cost of unused capacity should be used as feedback to managers on their supply and demand decisions. 5-35 (a) Customer Customer Customer Customer 1 2 3 4 Sales $1,000 $1,000 $2,500 $3,000 Less returns 0 200 500 1,500 Net sales $1,000 $800 $2,000 $1,500 Cost of goods sold, 75% of sales 750 600 1,500 1,125 Processing mail orders, 0 30 20 0 $5 per nonphone order Process phone orders, 20 0 0 80 $80 per hour Process returns, 0 20 10 120 $5 per item returned Process overnight delivery 4 0 0 48 requests, $4 per request Maintain customer relations 50 50 50 50 Profit $176 $100 $420 $77 0.18 0.10 0.17 0.03 Profit ÷ Sales (b) Although customer 4 has the highest sales, it has the highest dollar returns and the lowest profit. Customer 3 is by far the most profitable, even though its sales are less than customer 4’s (but customer 3’s net sales exceed

customer 4’s). Customers 1 and 2 are more profitable than customer 4 in total dollars and in percent of sales. Customer 1 returns the highest profit as a percent of sales, slightly above customer 3’s ratio. Cost of goods sold represents 75% of sales revenue, so the remaining costs as a percent of sales pertain to each customer’s interaction with the company. Customer 4 is the most expensive to service because it orders frequently, places orders in a costly manner (one hour on the phone), returns many items, and requests overnight deliveries. Customer 1 is fairly low-cost to serve in spite or ordering by phone and requesting overnight delivery because the customer orders only once a year and does not return merchandise. Aside from returns, customers 2 and 3 are fairly low-cost to serve because they order via mail and request regular delivery rather than overnight delivery. (c) Kronecker can seek to reduce the service activity usage or improve efficiency to reduce the cost of providing services. For example, Kronecker might ask customers the reason for returns, and follow up with ways to reduce problems that caused the returns. The company might also explore ways to make phone ordering more efficient, to reduce the time spent on the phone. Kronecker may also charge fees to handle overnight delivery requests. 5-36 (a) Cost driver rate based on expected number of billings:
June $70,000.00 $10,000.00 $80,000.00 20,000.00 $4.00 July $70,000.00 $10,500.00 $80,500.00 21,000.00 $3.83

Regular wages (=$2,800 × 25) Other costs (=$0.50 × number of billings) Total costs Expected number of billings Cost driver rate

(b) Cost driver rate based on expected number of billing labor hours:

Regular wages (=$2,800 × 25) Other costs (=$0.50 × number of billings Total costs Expected number of billing hours (=25 × 160) Cost driver rate

June $70,000.00 $10,000.00 $80,000.00 4,000.00 $20.00

July $70,000.00 $10,500.00 $80,500.00 4,000.00 $20.13

(c) The expected number of billing labor hours may be preferred for determining the billing activity cost driver rate because the time spent on billing is different for the two types of customers. However, billing costs depend on both the number of billing hours and the number of

billings. Therefore, both cost drivers should be used by dividing up the costs into two separate activities. (d) Both the number of billings and the number of billing labor hours should be employed to obtain two cost driver rates as described in (c) above. 5-37 (a) Activity measures that seem most related to patient-days rather than number of patients or sustaining the facility include number of meals, number of nurse days, number of procedures or tests, nursing hours, and pounds of laundry. Square feet and value of property seem most related to sustaining facilities. (See the detailed list in part (b)). In practice, pharmacy costs may be directly assignable to each patient. (b) Number Activity Cost Cost Driver Unit (patient-day)-related 101 Nursing services $2,973,154 Nursing hours 102 Nursing administration 1,269,762 Nursing hours 103 Pharmacy 496,629 Number of patient days 104 Laboratory 312,347 Number of tests 105 Medical supplies 482,165 Number of patient days 106 Linen and laundry 358,736 Pounds of laundry 107 Dietary 813,148 Number of meals 108 Employee cafeteria 167,239 Number of nurse days 116 Medical equipment Number of operations 496,275 procedures Total unit-related costs $7,369,455 Number of patient-days 45,606 Cost per patient-day $161.59

110 111 112 113

Batch (patient)-related Medical records and library Social services Patient scheduling and administration Billing and collection Total batch-related costs Number of patients Cost per patient

$250,345 Number of patients 199,026 Number of patients 60,238 Number of patients 112,280 Number of patients $621,889 8,367 $74.33

109 114 115 117 118

Facility-sustaining Housekeeping $706,308 Square feet of space Plant operations 301,238 Square feet of space Plant maintenance 386,622 Square feet of space Property insurance 38,350 Value of property Depreciation 960,573 Value of property Total facility-sustaining costs $2,393,091

Minimum Reimbursement for 14-Day Stay Unit-related: $2,262.25 $161.59 × 14 days Batch-related: $74.33 $74.33 × 1 patient Total $2,336.58 (c) Riverside must make choices in balancing the cost of measurement with the cost of errors from less accurate estimates. To reduce the cost of measurement, it is common to use the same activity cost driver for activities triggered by the same event, as Ana has suggested, for example, with number of patients. The unit-related activities are somewhat related to patient-days, so grouping the unit-related activities as shown in part (b) may represent a reasonable cost-benefit trade-off.

5-38 (a) Total manufacturing support costs = $1,000,000 Total direct labor hours = [5,000 2 + 40,000 × 1] = 50,000 Manufacturing support cost rate = $20 per direct labor hour. (b)
Direct material Direct labor Manufacturing support Unit cost Deluxe $45 $20 $40 $105 Regular $30 $10 $20 $60

(c) Activity
Purchase Orders

Rate per unit of cost driver
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Quality Control

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Production Setups

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Machine Maintenance

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Activity Purchase Orders Quality Control Production Setups

Activity costs assigned to products Deluxe Regular (=220 × 300) $60,000 (=400 × 300) $120,000 (=1,000 × 125) (=100 × 1,100) 125,000 (=1,000 × 125) 110,000 (=100 × 1,100) $200,000 (=15,000 × 10) $495,000 5,000 $99 125,000 110,000 $150,000 $505,000 40,000 $12.625

Machine Maintenance (=20,000 × 10) Total manufacturing support costs Number of units Unit manufacturing support costs

Direct material Direct labor Manufacturing support Unit cost

Deluxe $45.000 $20.000 $99.000 $164.000

Regular $30.000 $10.000 $12.625 $52.625

(d) Activity
³ È $ L? ? L > aä ™ š  €

Deluxe
³ È $ L? ? L > aä ™ š  €

Regular

Ratio of Deluxe:Regular 4:1 8:1 8:1 10.67:1

Purchase Orders Quality Control Production Setups Machine Maintenance

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Unit costs are distorted by the old system because it assigns manufacturing support cost to products using direct labor hours as a base. Although the deluxe model requires twice as much labor time as the regular model, it was not allocated adequate support overhead cost. When the company’s activity costs are analyzed, it becomes obvious that the deluxe model is very expensive to manufacture as compared to the regular model because (i) the deluxe model requires 4 times as many purchase orders as the regular model, (ii) the deluxe model requires 8 times as many inspections and setups as the regular model, and (iii) the deluxe model requires over 10 times as many machine hours as the regular model. (e) No, the deluxe model is not as profitable as the company thinks. Under ABC, the following profitability analysis for each product line can be done:
Selling price per unit Unit cost Gross margin per unit Deluxe $140.000 $164.000 ($24.000) Regular $80.000 $52.625 $27.375

(f) Recommendation to marketing staff: The regular model is more profitable than the deluxe model. Therefore, (i) push the regular model (increase commissions on the regular model, and/or decrease commission on the deluxe model), and/or (ii) raise the price of the deluxe model. Recommendation to production staff: Re-engineer the deluxe product to decrease its high demand for activity resources. 5-39 (Unofficial CMA Answer) (a) At least four general advantages associated with activity-based costing include the following: Provides management with a thorough understanding of complex product costs and product profitability for improved resource management and pricing decisions. • Allows management to focus on value-added and nonvalueadded activities so that nonvalue-added activities can be controlled or eliminated, thus streamlining production processes. • Highlights the interrelationships (cause and effect) of activities and identifies opportunities to reduce costs, e.g., designing products with fewer parts to reduce the cost of the manufacturing process. • Provides more appropriate means of charging support costs to products.

(b) 1. Using standard costs, the total contribution expected in 1997 by Alaire Corporation from the TV board is $1,950,000, calculated as follows:

Revenue Direct material Material support (10% of material) Direct labor ($14 × 1.5 hours) Variable support ($4 × 1.5 hours)* Machine time ($10 × 0.5) Total cost Unit contribution Total contribution (65,000 × 30)
*

Per Unit $150 80 8 21 6 5 $120 $30

Totals for 65,000 units $9,750,000 5,200,000 520,000 1,365,000 390,000 325,000 $7,800,000

$1,950,000

Variable support rate: $1,120,000 ÷ 280,000 hours = $4 per hour.

2. Using standard costs, the total contribution expected in 1997 by Alaire Corporation from the PC Board is $2,360,000, calculated as follows:
Revenue Direct material Material support (10% of material) Direct labor ($14 × 4 hours) Variable support ($4 × 4 hours)* Machine time ($10 × 1.5) Total cost Unit contribution Total contribution (65,000 × $30) $241 $59 $2,360,000 Per Unit $300 140 14 56 16 15 Totals for 40,000 units $12,000,000 5,600,000 560,000 2,240,000 640,000 600,000 $9,640,000

*

Variable support rate: $1,120,000 ÷ 280,000 hours = $4 per hour.

5-40 (Unofficial CMA Answer) (a) 1. Manufacturing support costs include all indirect production costs (all production costs except direct material and direct labor). These costs cannot be practically or economically traced to end products and, therefore, must be assigned by some allocation methods. Typical manufacturing support costs include: • Indirect labor, e.g., lift-truck driver’s wages, maintenance and inspection labor, engineering labor, and supervisors. • Other indirect factory costs, e.g., building maintenance, machine and tool maintenance, property taxes, property insurance, pension costs, depreciation on plant and equipment, rent expense, and utility expense. 2. Companies develop manufacturing support cost driver rates to facilitate the costing of products as they are completed and shipped, rather than waiting until actual costs are accumulated at the end of a fiscal period. (b) The cost driver rate increase should not have a negative impact on Moss Manufacturing because the increase in indirect costs was offset by a decrease in direct labor costs. (c) Rather than using a universal plant-wide rate, Moss Manufacturing could implement separate cost pools for different activities. Examples are as follows: • Accumulate separate costs into departmental accounts (or other relevant pools), with one account for each production and service department. Each department would allocate its support costs to products on the basis that best reflects the use of these services. • Individual machines (or other more relevant allocation bases) could be treated as separate cost centers with the machine costs collected and charged to the products using the machine(s).

(b) An activity-based costing system might benefit Moss Manufacturing because it • differentiates costs between value adding and nonvalue adding activities. • costs products according to the activities involved in the production process. 5-41 (a) A call-related activity cost driver would better identify the linkage to call center support costs. The number of calls (a transaction driver) per product can be used because of its simplicity. The number of minutes of calls (a duration driver) provides better linkage to call center support costs, but it is more time-consuming to measure. (b) Previous system Allocated support costs: 5% of sales Activity-based costs: $.70 per minute Product X $20,000 Product Y $5,000

$4,900

$21,000

(c) Under the previous system, product managers can only reduce the assigned call center costs by reducing sales. Under the new system, product managers can work with other functional areas to find ways to reduce the number of calls or to reduce the length of calls. For example, product Y’s manager can work with package designers or the marketing group to develop clearer instructions for consumers. The instructions might include answers to frequently asked questions, based on call center on the company’s web site. (b) Product Y’s manager is likely to resist implementation of the activity-based cost system if the manager understands the relative usage of call center resources devoted to product Y. Call center staff may resist implementation of activity-based costing because it will involve tracking of staff activity. The staff may resent tracking the number of calls or minutes of calls, and may resent the additional

monitoring because it may lead to pressure to reduce the minutes per call. The call center staff may also fear that the desire for cost or efficiency improvements will lead to staff reduction or to outsourcing the entire call center. (e) The company will need to consider the broader management issues related to job loss if the call center activities are outsourced. As an input to that decision, however, the company can benchmark its costs per minute to other call centers, or compare it to the cost of outsourcing. The company may also pursue an intermediate course of communicating the current costs per minute and benchmarked or competitive costs, and allowing the call center staff to improve efficiency and lower costs per minute. 5-42 (a) Stage 1: Allocation of S1 and S2 costs to production depts.
Overhead Department P1 Department P2

Directly traceable S1

$480,000

$780,000

420,000

756,000

S2

280,000

840,000

Total support DLH Cost drivenrate

$1,180,000 80,000 $14.75 per DLH

$2,376,000 120,000 $19.80 per DLH

Stage 2: Allocation of P1 and P2 costs to products
Product R361
L ³ È >$ a L ä ?  ?   L ³ È >$ a L ä ?  ?  

Product R572 $885,000 14.75 × 20,000 = 295,000 950,400 $1,245,400

14.75 × 60,000 = 19.8 × 72,000 =

³ LÈ> $ aL ä?  ?  

³ LÈ> $ aL ä?  ?  

1,425,600 19.80 × 48,000 = $2,310,600

Product costing
Dir. Mat. Dir. Lab: P1 P2 Support Total cost Total units Unit cost Sales price Gross margin Gross margin % Product R361 Product R572 $4,000,000 10 × $400,000 = 4,000,000 8 × $500,000 = 15 × 60,000 = 18 × 72,000 = 900,000 15 × 20,000 = 1,296,000 18 × 48,000 = $2,310,600 $8,506,600 500,000 $17.0132 19.0000 $1.9868 10.4600% 300,000 864,000 $1,245,400 $6,409,400 400,000 $16.0235 20.0000 $3.9765 19.88%

(b) Let x denote the number of hours required for each R361 setup. Then the number of hours required for each R572 setup .
³L $ ä  È a?? > L  ³L $ ä  È a?? > L 

R361 Number of setups Setup hours 2,000 2,000x (25%) 4,000

R572

6,000x (=4,000 × 1.5x) (75%)

Number of transactions Activity Cost Drivers P1-DLH P2-DLH Setup hours Traceable Costs $240,000 360,000 1,676,000 Total R361 R572 20,000 48,000 6,000x $ P1-MH P2-MH 380,000 900,000 40,000 30,000 120,000 72,000 10,000 48,000

Activity Cost Driver Rate $3/P1 DLH $3/P2 DLH
³L $a ? È> Lä ? š ™ € ³L $a ? È> Lä ? š ™ €

80,000 60,000 120,000 72,000 8,000x 2,000x

/Setup Hour

$9.50/P1 MH $7.50/P2 MH

Total Support Costs Activity Cost Drivers P1-DLH P2-DLH
³ È a? ? L$ä >L ™š  €

Product R361 3 × $60,000 =
3 × 72,000 =
³ È a? ? L$ä >L ™š  €

Product R572 3 × $20,000 = 3 × 48,000 = $60,000 144,000 1,257,000

$180,000 216,000 419,000

Setup hours

P1-MH P2-MH

9.5 × 30,000 = 7.5 × 72,000 =

285,000 540,000 $1,640,000

9.5 × 10,000 = 7.5 × 48,000 =

95,000 360,000 $1,916,000

Alternatively,
Activity Cost Drivers
³È aä L> L?? $ ™š €

Total Support Costs Product R361
³È aä L> L?? $ ™š €

Product R572 $180,000 $60,000

P1-DLH

P2-DLH
³ >L L a È ä ? $ ? ™ €  š ³ >L L a È ä ? $ ? ™ €  š

216,000

144,000

Setup hours

419,000

1,257,000

P1-MH

285,000

95,000

P2-MH

540,000 $1,640,000

360,000 $1,916,000

Product costing

Product R361 Dir. Mat. Dir. Lab: P1 P2 Support costs Total cost Total units Unit cost Sales price Gross margin Gross margin % $4,000,000.000 900,000.000 1,296,000.000 $1,640,000.000 $7,836,000.000 500,000.000 $15.672 19.000 3.328 17.520%

Product R572 4,000,000.000 300,000.000 864,000.000 $1,916,000.000 7,080,000.000 400,000.000 $17.700 20.000 2.300 11.500%

(c) The old cost accounting system ignored the fact that a large part of support costs is driven by setup hours. Under the old cost accounting system, R572 was undercosted because it had disproportionally more setup hours compared to direct labor hours. The ratio of setup hours per unit of R361 to the setup hours per
³ È$ L ? L >a ä ? ™ š  € ³ È$ L ? L >a ä ? ™ š  €

unit of R572 equals

:

= 4.15

Old Cost Accounting System R361 Sales price Unit cost Gross margin Gross margin % $19.0000 17.0132 1.9869 10.4600% R572 $20.0000 16.0235 3.9765 19.8800%

ABC system R361 $19.0000 15.6720 3.3280 17.5200% R572 $20.0000 17.7000 2.3000 11.5000%

Recommendation for marketing 1. R361 is more profitable than R572. Therefore, push R361 by increasing the commission on R361 or decreasing the commission on R572. 2. Raise the price of R572. Recommendation for production 1. A large part of support costs is driven by setup hours. Therefore, re-engineer the products to decrease setup hours. 2. Offer discounts to customers for larger batch sizes to reduce the number of setups. (d) The experienced production manager is likely to have an intuitive understanding of the higher production complexity for R572 and will likely agree with the activity-based cost analysis. However, the sales manager will likely want to keep sales high and has already built up relations with R572 customers. Therefore, the sales manager will likely oppose increasing the price of R572 since it will reduce its sales.

5-43 (a) Stage 1: Allocation of Department S costs to production departments.
Overhead
³Èa ? L$ ä? >L ™ €  š

Department P1
³Èa ? L$ ä? >L ™ €  š

Department P2

Department S

$1,320,000 680,000 $2,000,000 100,000

$420,000 240,000 $660,000 60,000

Directlytraced Total support Direct laborhours Cost driverrate

$20 per DLH

$11 per DLH

Stage 2: Allocation of P1 and P2 costs to products
Department P1 P2 Product W101 $20 × 80,000 = 11 × 40,000 = $1,600,000 440,000 $2,040,000 Product W202 $20 × 20,000 = 11 × 20,000 = $400,000 220,000 $620,000

Product Costing
Department Product W101 Product W202

Direct materials $4 × 600,000 = Direct labor Support Total costs Total units Unit cost Sales price Gross margin Gross margin % 20 × 120,000 =

$2,400,000.00 $5 × 300,000 = 2,400,000.00 20 × 40,000 = 2,040,000.00 $6,840,000.00 600,000.00 $11.40 11.50 $0.10 0.87%

$1,500,000.00 800,000.00 $620,000.00 $2,920,000.00 300,000.00 $9.73 12.25 $2.52 20.57%

(b) Let x denote the number of hours required for each W101 setup. Then the number of hours required for each W202 setup 1.25x.
W101 Number of setups Setup hours 2,000 2,000x W202 4,000 5,000x Total 6,000 7,000x

Activity-Based Cost Allocations
Activity Cost Drivers
³L $L Èa? > ä ? ™ š € ³L $L Èa? > ä ? ™ š €

Product W101

Product W202

P1-DLH

$256,000

$64,000

L> a ? ³È$ L ä

?

™ š  €

L> a ? ³È$ L ä

?

™ š  €

P2-DLH

120,000

60,000

³È a ? L $L > ä

?

™ š  €

³È a ? L $L > ä

?

™ š  €

Setup Hours

410,000

1,025,000

³È a ? L> L $ ä

?

™ š €

³È a ? L> L $ ä

?

™ š €

P1-MH

400,000

150,000

³ È$ L L> a ? ä

?

™ š  €

³À L

³ È$ L L> a ? ä

?

™ š  €

³À L

P2-MH

100,000 $1,286,000

75,000 $1,374,000

Product Costing
Product W101 Direct materials Direct labor Support costs $2,400,000.00 2,400,000.00 1,286,000.00 $6,086,000.00 Total units Unit costs Sales price Gross margin 600,000.00 $10.14 $11.50 $ 1.36 Product W202 $1,500,000.00 800,000.00 1,374,000.00 $3,674,000.00 300,000.00 $12.25 $12.25 $0.00

Gross margin %

11.83%

0.00%

(c)

The old cost accounting system ignored the fact that more than half of support costs are caused by setup hours. Under the old cost accounting system, W202 was undercosted because it had disproportionately more setup hours compared to direct labor hours. The ratio of setup hours per unit of W101 to the setup hours per unit of (d)
Sales price Unit cost Gross margin Gross margin % Old Cost Accounting System W101 W202 $11.50 11.40 $0.10 0.86% $12.25 9.73 $2.52 20.57% ABC System W101 $11.50 10.14 $1.36 11.83% W202 $12.25 12.25 $0.00 0%

Recommendation for marketing: Product W101 is more profitable than W202. Therefore, Hibeem Corporation sales force must push W101 rather than W202 (e.g. increase commissions on W101 and decrease commissions on W202, or lower the price of W101 and increase the price of W202). Recommendation for production: More than half of the support costs are caused by setup hours. Therefore Hibeem Corporation needs to decrease setup hours or offer discounts to customers for fewer setups.

³>ä La ÈL $ ??

™€  š

³>ä La ÈL $ ??

™€  š

5-44 (a) Plantwide cost driver rate
Direct costs: Cutting Assembly Support costs Total costs Number of units Unit cost
³>ä ? La È ? $  L  ³>ä ? La È ? $  L 

per DLH
BB $7,500.00 LL $9,000.00

6,000.00 4,898.00a $18,398.00 1,000.00 $18.40

7,200.00 8,082.00b $24,282.00 3,000.00 $8.09

a b

(b) STAGE 1
Step 1: Cutting Step 2: Direct Method Maintenance Setup Accumulated Support Costs Cost Driver Rate
³ È$ L? L > aä ? ™ š  € ³ È$ L? L > aä ? ™ š  €

Cutting 440,000.00

Assembly 200,000.00

90,040.00a 261,538.00b $791,578.00 27,800.00 MH $28.47

69,960.00c 138,462.00d $408,422.00 27,600.00 DLH $14.80

a

b

c

d

STAGE 2 Direct costs: Cutting Assembly Total Mfg. Cost Number of units Unit cost
L a ³ >ä ? È ?  $ L  L a ³ >ä ? È ?  $ L 

BB $7,500.00 1,776.00f $19,831.00 1,000 $19.83

LL $9,000.00 2,664.00h $23,135.00 3,000 $7.71
h

e

f

g

(c)
³ LÈ>$ a Lä ? ?š€ ™

Rate Maintenance
³ LÈ>$ a Lä ? ?š€ ™

$ 3.24

per machine hour

³L È>$ aL ™? š€ ä? 

Setup

³L È>$ aL ™? š€ ä? 

769.23

per setup hour

³L È>$ aL ™? š€ ä? 

Cutting Supervision

³L È>$ aL ™? š€ ä? 

823.53

per setup hour

³L È>$ aL ™? š€ ä? 

Cutting Depreciation

³L È>$ aL ™? š€ ä? 

5.76

per machine hour

³L È>$ aL ™? š€ ä? 

Assembly Supervision

³L È>$ aL ™? š€ ä? 

5.80

per direct labor hour

³LÈ>$ a Lä? ™š€ ?

Assembly Depreciation

³LÈ>$ a Lä? ™š€ ?

1.85

per machine hour

BB

LL

Direct costs Maintenance Setup Cutting Supervision Cutting Depreciation Assembly Supervision Assembly Depreciation Total cost Cost per pair

$13,500 907 (=280 × 3.24) 3,077 (=4 × 7.69.23) 2,471 (3 × 823.53) 922 (=160 × 5.76) 696 (=120 × 5.80) 222 (=120 × 1.85) $21,795
³L > a ä È $ L? ? ™ š €

$16,200 875 (=270 × 3.24) 1,538 (=2 × 769.23) 824 (=1 × 823.53) 864 (=150 × 5.76) 1,044 (=180 × 5.80) 222 (=120 × 1.85) $21,567
³L > a ä È $ L? ? ™ š €

$21.80

$7.19

(d) Unit costs for product BB are higher when departmental cost driver rates are used than when a single plant-wide rate is used because the cutting department has more machine related costs than the assembly department and BB requires relatively more machine hours in the cutting department. (e) Activity-based costs for product LL are lower than the corresponding costs based on a single plant-wide rate because setup costs and cutting supervision costs are batch-level costs related to setup hours and LL requires relatively fewer setup hours because it is made in larger batches. 5-45 (a) The old cost accounting system failed to recognize that a large amount of support costs are driven by setup hours. The proportions of setup hours required for the three products were different from the proportions of direct labor hours used to apply support costs to the products in Stage 2 of the old system. As a result, product costs were distorted under the old cost accounting system.

(b) Product Costs Using the Old Cost Accounting System: Purchasing and Inventory (PI)
Material Costs Production Departments MC PL AS Total

GT 101 (formula)

$150,000 $50,000 (500,000 × .3) (500,000 × .1) $50,000 $20,000 (200,000 × 25) (200,000 × 1)

— $200,000

GT 102 (formula)

— $70,000

GT 103 (formula) $56,000 $20,000 (200,000 × 2.8) (200,000 × .1) Total $256,000 $90,000 $13,000

$76,000

— $346,000 — $50,000

PI costs allocated $37,000

Setup and Scheduling (SS)
Production Departments MC Direct labor hours SS costs allocated 12,000 $61,200 PL 7,000 $36,000 AS 4,500 $22,800 Total 23,500 $120,000

Quality Control (QC)
Production Departments MC PL AS Direct labor hours QC costs allocated 5,200 $36,400 1,900 $13,300 2,900 $20,300 Total 10,000 $70,000

Summary of Overhead Costs
Production Departments MC Direct PI applied SS applied QC applied Total $40,000 37,000 61,200 36,400 $174,600 PL $50,000 13,000 36,000 13,300 $112,300 AS $15,000 — 22,800 20,300 $58,100 Total $105,000 50,000 120,000 70,000 $345,000

Stage 2 Allocations—Productions
Products GT101 Direct Material: MC PL Total Volume Per unit $150,000.00 50,000.00 $200,000.00 5,000,000.00 $.40 $50,000.00 20,000.00 $70,000.00 200,000.00 $.35 $56,000.00 20,000.00 $76,000.00 200,000.00 $.38 $256,000 90,000 $346,000 GT102 GT103 Total

Dir. labor ($10 wage rate) MC PL AS Total Volume Per unit Cost driver rate per DLH
³ È$ L? L> aä ? ™š € ³ È$ L? L> aä ? ™š €

$70,000.00 35,000.00 25,000.00 $130,000.00 500,000.00 $.26

$28,000.000 17,000.000 10,000.000 $55,000.000 200,000.000 $.275

$22,000.00 18,000.00 10,000.00 $50,000.00 200,000.00 $.25

$120,000 70,000 45,000 $235,000

$101,850.0000a $40,740.0000 $32,010.000

$174,600

MC
³È aä L> L?? $ ™š € ³È aä L> L?? $ ™š €

56,150.0000

27,273.0000

28,877.000

112,300

PL
³È a ? ? L> L $ ä ™ š € ³È a ? ? L> L $ ä ™ š €

32,278.0000

12,911.0000

12,911.000

58,100

AS Total Volume Per unit
È ? LL? ³ a $ > ä

$190,278.0000 500,000.0000 $.3806

$80,924.0000 $73,798.000 200,000.0000 200,000.000 $.4046 $.369

$345,000

a

È ? LL? ³ a $ > ä

Gross margin per unit
GT101 Selling price per unit Cost per unit Gross margin per unit
L? ³ä > È $ L a ?   

GT102 $1.2000 1.0296 $0.1704

GT103 $1.300 0.999 $0.301

$1.2500 1.0406a $0.2094

a

L? ³ä > È $ L a ?   

Product Costs Using the New Cost Accounting System: Stage 1 Allocations – Pools
Department MC MC PL AS PI SSa QC Total Cost Driver Units Cost driver rate $12,000 $35,000 12,000 DLH $1/DLH
³ LÈ aLä??š >$ ™ € ³ LÈ aLä??š >$ ™ €

Activity Pools PL AS Setup $28,000 $35,000 $9,000 15,000 6,000 20,000 96,000a 49,000 $9,000 4,500 DLH $214,000 319 setups $30,000 24,000a 21,000 $75,000 75 orders Orders Total $40,000 50,000 15,000 50,000 120,000 70,000 $345,000

$12,000

7,000 DLH

$5/DLH $2/DLH $670.85/setup $1,000/order

a

(SS costs are allocated

to setups and

to orders)

Stage 2 Allocations – Products
Overhead Pool MC PL AS Setups Orders Total Volume Per unit Cost $12,000 35,000 9,000 214,000 75,000 GT101 Cost Driver Units 7,000 3,500 2,500 110 25 Costs Allocated $7,000 17,500 5,000 73,793 25,000 $128,293 500,000 $.257 GT102 Cost Driver Units 2,800 1,700 1,000 43 10 Costs Allocated $2,800 8,500 2,000 28,846 10,000 $52,146 200,000 $.261 GT103 Cost Driver Units 2,200 1,800 1,000 166 40 Costs Allocated $2,200 9,000 2,000 111,361 40,000 $164,561 200,000 $.823

Gross margin per unit
GT101 Selling price per unit Cost per unit Gross margin per unit
a
L  ³ ? È $ > L a ä    ? L  ³ ? È $ > L a ä    ?

GT102 $1.200 0.886 $0.314

GT103 $1.300 1.453 $(.153)

$1.250 0.917a $0.333

(c)

Old cost accounting system GT101 Sales price Unit cost Gross margin $1.2500 1.0406 $0.2094 GT102 $1.2000 1.0296 $0.1704 GT103 $1.300 0.999 $0.301 GT101 $1.250 0.917 $0.333

ABC System GT102 $1.200 0.886 $0.314 GT103 $1.300 1.453 $(0.153)

Gross margin 16.7500% 14.2000% 23.150% 26.640% 26.160% 11.760% %

Recommendation for marketing: GT101 and GT102 are profitable but GT103 has negative gross margin. Therefore, (i) push GT101 and GT102 (increase commission on GT101 and GT102 or decrease commission on GT103), (ii) raise the price of GT103. Recommendation for production: A large portion of support costs is driven by setup hours. Therefore, (i) re-engineer products to decrease setup hours, (ii) offer discounts to customers with larger orders. (d) The experienced production manager will likely understand the production complexity for GT103 and support the ABC analysis. However, the sales manager will likely want to keep sales high and maintain already-built BT103 customer relations. Therefore, the sales manager will likely oppose increasing the price of GT103. (a) The old cost accounting system failed to recognize that a large amount of support costs is driven by setup hours. The proportions of setup hours required for the three products were different from the proportions of direct labor hours used to apply support costs to the products in Stage 2 of the old system. As a result, product costs were distorted under the old cost accounting system.

(b) Product Costs Using the Old Cost Accounting System: Purchasing and Inventory (PI)
Production Departments Material Costs MC PL AS Total

GT 101 (formula) $150,000(500,00 $50,000 0 × .3) (500,000 × .1) GT 102 (formula) $50,000 $20,000 (200,000 × 25) (200,000 × 1) $56,000 $20,000 (200,000 × 2.8) (200,000 × .1) $256,000 $90,000 $13,000

— $200,000

— $70,000

GT 103(formula)

$76,000

Total

— $346,000 — $50,000

PI costs allocated $37,000

Setup and Scheduling (SS)
Production Departments MC Direct labor hours SS costs allocated 12,000 $61,200 PL 7,000 $36,000 AS 4,500 $22,800 Total 23,500 $120,000

Quality Control (QC)
Production Departments MC PL AS 5,200 1,900 2,900 $36,400 $13,300 $20,300 Total 10,000 $70,000

Direct labor hours QC costs allocated

Summary of Overhead Costs

Production Departments MC Direct PI applied SS applied QC applied Total $40,000 37,000 61,200 36,400 $174,600 PL $50,000 13,000 36,000 13,300 $112,300 AS $15,000 — 22,800 20,300 $58,100 Total $105,000 50,000 120,000 70,000 $345,000

Stage 2 Allocations—Productions
Products GT101 Direct Material: MC PL Total Volume Per unit $150,000.00 50,000.00 $200,000.00 5,000,000.00 $.40 $50,000.00 20,000.00 $70,000.00 200,000.00 $.35 $56,000.00 20,000.00 $76,000.00 200,000.00 $.38 $256,000 90,000 $346,000 GT102 GT103 Total

Dir. labor ($10 wage rate) MC PL AS Total Volume Per unit Cost driver rate per DLH
³ È$ L? L> aä ? ™š € ³ È$ L? L> aä ? ™š €

$70,000.00 35,000.00 25,000.00 $130,000.00 500,000.00 $.26

$28,000.000 17,000.000 10,000.000 $55,000.000 200,000.000 $.275

$22,000.00 18,000.00 10,000.00 $50,000.00 200,000.00 $.25

$120,000 70,000 45,000 $235,000

$101,850.0000a $40,740.0000 $32,010.000

$174,600

MC
³È aä L> L?? $ ™š € ³È aä L> L?? $ ™š €

56,150.0000

27,273.0000

28,877.000

112,300

PL
³È a ? ? L> L $ ä ™ š € ³È a ? ? L> L $ ä ™ š €

32,278.0000

12,911.0000

12,911.000

58,100

AS Total Volume Per unit
La ³ >? È  $ L ? ä

$190,278.0000 500,000.0000 $.3806

$80,924.0000 $73,798.000 200,000.0000 200,000.000 $.4046 $.369

$345,000

a

La ³ >? È  $ L ? ä

Gross margin per Unit
Selling price per unit Cost per unit Gross margin per unit
L? ³ä > È $ L a  ?  

GT101 $1.2500 1.0406a $0.2094

GT102 $1.2000 1.0296 $0.1704

GT103 $1.300 0.999 $0.301

a

L? ³ä > È $ L a  ?  

Product Costs Using the New Cost Accounting System:

Stage 1 Allocations – Pools
Department MC MC PL AS PI SSa QC Total Cost DriverUnits Cost driverrate $12,000 $35,000 12,000 DLH $1/DLH 7,000 DLH $9,000 4,500 DLH $12,000 $35,000 $9,000 PL Activity Pools AS Setup $28,000 15,000 6,000 20,000 96,000a 49,000 $214,000 319 setups $30,000 24,000a 21,000 $75,000 75 orders Orders Total $40,000 50,000 15,000 50,000 120,000 70,000 $345,000

$5/DLH $2/DLH $670.85/setup $1,000/order

³ LÈ aLä??š >$ ™ €

³ LÈ aLä??š >$ ™ €

a

(SS costs are allocated

to setups and

to orders)

Stage 2 Allocations – Products
Overhead Pool MC PL AS Setups Orders Total Volume Per unit Cost $12,000 35,000 9,000 214,000 75,000 GT101 Cost Costs Driver Allocated Units 7,000 3,500 2,500 110 25 $7,000 17,500 5,000 73,793 25,000 $128,293 500,000 $.257 GT102 Cost Costs Driver Allocated Units 2,800 1,700 1,000 43 10 $2,800 8,500 2,000 28,846 10,000 $52,146 200,000 $.261 GT103 Cost Costs Driver Allocated Units 2,200 1,800 1,000 166 40 $2,200 9,000 2,000 111,361 40,000 $164,561 200,000 $.823

Gross margin per unit
GT101 Selling price per unit Cost per unit Gross margin per unit
a
L  ³ ? È $ > L a ä    ? L  ³ ? È $ > L a ä    ?

GT102 $1.200 0.886 $0.314

GT103 $1.300 1.453 $(.153)

$1.250 0.917a $0.333

(c)

Old cost accounting system GT101 Sales price Unit cost Gross margin $1.2500 1.0406 $0.2094 GT102 $1.2000 1.0296 $0.1704 GT103 $1.300 0.999 $0.301 GT101 $1.250 0.917 $0.333

ABC System GT102 $1.200 0.886 $0.314 GT103 $1.300 1.453 $(0.153)

Gross margin 16.7500% 14.2000% 23.150% 26.640% 26.160% 11.760% %

Recommendation for marketing: GT101 and GT102 are profitable but GT103 has negative gross margin. Therefore, (i) push GT101 and GT102 (increase commission on GT101 and GT102 or decrease commission on GT103), (ii) raise the price of GT103. Recommendation for production: A large portion of support costs is driven by setup hours. Therefore, (i) re-engineer products to decrease setup hours, (ii) offer discounts to customers with larger orders. (d) The experienced production manager will likely understand the production complexity for GT103 and support the ABC analysis. However, the sales manager will likely want to keep sales high and maintain already-built BT103 customer relations. Therefore, the sales manager will likely oppose increasing the price of GT103.

5-46 (a) Stage 1: Allocation of service department costs to production departments
Overhead costs Traced directly Service Dept.
³È a ?? L$ ä >L ™ €  š ³È a ?? L$ ä >L ™ €  š

Machining

Assembly

$192,000 312,000

$168,000 48,000 $216,000 3,000 + 5,000 = 8,000 $27

Total support DLH Cost driver rate per DLH 15,000 + 13,000 =

$504,000 28,000 $18

Stage 2: Allocation of production department costs to products.
Regular Machine Assembly Accum. supportcosts $351,000 $369,000 15,000 × $18 = 3,000 × $27 = $270,000 81,000 Deluxe 13,000 × 8 = 5,000 × $27 = $234,000 135,000

Product Costs
Regular Direct material $240,000.00 Direct labor Support costs Total costs Total units Unit cost Sales price Gross margin Gross % margin 180,000.00 351,000.00 $771,000.00 300,000.00 $2.57 4.00 $1.43 35.75% (=$0.8 × 300,000) Deluxe $220,000.000 180,000.000 369,000.000 $769,000.000 200,000.000 $3.845 6.000 $2.155 35.920% (=$1.10 × 200,000)

(b) Number of Cost Driver Units
Traceable Total Units Costs Cost Drivers $112,000 96,000 272,000 240,000 $720,000 28,000 8,000 680 160 No. of Cost Driver Units Regular 15,000 3,000 180 60 Deluxe 13,000 5,000 500 100 Overhead Rate $4 12 400 1,500

Activity Cost Driver Machinery Dept. DLH Assembly Dept. DLH Setup hours Number of orders

Allocation of support costs
Regular MachiningDept. 15,000 × $4 = DLH AssemblyDept. DLH Setup hours Number oforders 3,000 × 12 = 180 × 400 = 60 × 1,500 = $60,000 36,000 72,000 90,000 $258.000 Deluxe 13,000 × $4 = 5,000 × 12 = 500 × 400 = 100 × 1,500 = $52,000 60,000 200,000 150,000 $462,000

Product Costs
Regular Direct material Direct labor Support costs Total costs Total units Unit cost Sales price Gross margin Gross margin % Sales COGS Gross margin Sales commission Advert. & promo. exp. Selling & Admin. exp. Net income Total units Profit per unit $240,000.0000 180,000.0000 258,000.0000 $678,000.0000 300,000.0000 $2.2600 4.0000 $1.7400 43.5000% $1,200,000.0000 (678,000.0000) $522,000.0000 (60,000.0000) (50,000.0000) (90,000.0000) $322,000.0000 300,000.0000 $1.0733 Deluxe $220,000.00 180,000.00 462,000.00 $862,000.00 200,000.00 $4.31 6.00 $1.69 28.17% $1,200,000.00 (862,000.00) $338,000.00 (120,000.00) (90,000.00) (90,000.00) $38,000.00 200,000.00 $0.19

(c) The old system relies on direct labor hours as a basis for allocation of costs. The two products use roughly equal amounts of direct

labor but the Deluxe model consumes relatively more of the other cost drivers

(73.5% of setup hours and 62.5% of the number of orders can be traced to the Deluxe product). By allocating the costs of these two activities (setups, orders) on the basis of direct labor hours, the company distorts costs by overstating costs caused by the regular model (which consumes a smaller proportion of the two activities relative to direct labor hours) and understating the costs of the deluxe model (which consumes a larger proportion of the two activities relative to DLH). (d) The regular model is more profitable than the deluxe model ($1.0733/unit for regular vs. $0.19/unit for deluxe). Since the deluxe model is profitable, it should not be discontinued. However, the sale price of the regular model should be reduced to capture greater market share, while the price of the deluxe model should be increased. Advertising expenditures should be redirected to promote the regular product over the deluxe product. Also, commissions for regular sales should be increased while those for deluxe sales should be reduced to motivate the sales force to push regular sales. In production, the company should look for ways to reduce the number of orders and setups needed to produce the deluxe model. (e)Mr. O’Reilly will likely question the wisdom of raising prices and changing commission rates on the deluxe model, especially since he and his staff may have been earning large commissions from its sale. The company will need to prove that refocusing its products can be beneficial to his people through increased sales of the Regular product and a better margin on the Deluxe product.

5-47 (a) Present cost accounting system: Week 45 Stage 1 Allocation:
MNT QLCb Accumulated support costs DLHc Cost driver rate per DLH
a a

FAB $21,900.000 3,155.000 $25,055.000 2,620.000 $9.563
2,190 1,310 3,500 $21,900

ASM $13,100.000 3,155.000 $16,255.000 2,190.000 $7.422

Machine hours:

FAB: (2 × 450 + 3 × 430) = ASM: (1 × 450 + 2 × 430) = Total Machine Hours:
³ L È a Lä ?™š€ >$ ? ³ L È a Lä ?™š€ >$ ?

× $35,000 =
³ L È a Lä ?™š€ >$ ? ³ L È a Lä ?™š€ >$ ?

× $35,000 =
b

$13,100

Inspection: FAB: (1 × 450 + 1 × 430) = ASM: (1 × 450 +1 × 430) = Total Inspections:
³LÈ aL >$ ä? ™ š€ ? ³LÈ aL >$ ä? ™ š€ ?

880 880 1,760 $3,155

× $6,310 =
c

FAB: (2 × 450 + 4 × 430) = ASM: (2 × 450 + 3 × 430) =

DLH:

2,620 2,190

Stage 2 Allocation:
FAB: ASM: Total support REG $8,606.68 6,680.14 $15,286.82 DLX $16,448.32 9,574.86 $26,023.18 Total $25,055 16,255 $41,310

FAB-REG: (2 × 450) × $9.563 = FAB-DLX: (4 × 430) × $9.563 = ASM-REG: (2 × 450) × $7.422 = ASM-DLX: (3 × 430) × $7.422 =

$8,606.679 $16,448.321 $ 6,680.137 $ 9,574.863

Product Cost (Per Unit): Direct material Direct labor Support costs Unit cost REG $50.000 $40.000 33.971 $123.971 DLX $100.000 70.000 60.519 $230.519

Week 46
Stage 1 Allocation: MNT QLCb Accumulated support costs DLHc Cost driver rate per DLH
a a

FAB $22,125.000 3,175.000 $25,300.000 2,700.000 $9.370
2,250 1,350 3,600 $22,125

ASM $13,275.000 3,175.000 $16,450.000 2,250.000 $7.311

Machine hours: FAB: (2 × 450 + 3 × 450) = ASM: (1 × 450 + 2 × 450) = Total Machine Hours:
³LÈ>$ aLä? ™ š ? € ³LÈ>$ aLä? ™ š ? €

× $35,400 =
³ L È a Lä ?™š€ >$ ? ³ L È a Lä ?™š€ >$ ?

× $35,400 =
b

$13,275

Inspection:
1,350 1,350 2,700 $3,175 × $6,350 =

FAB: (1 × 450 + 2 × 450) = ASM: (1 × 450 + 2 × 450) = Total Inspections:
³LÈ>$ aLä? ™ š ? € ³LÈ>$ aLä? ™ š ? €

c

DLH:
2,700 2,250

FAB: (2 × 450 + 4 × 450) = ASM: (2× 450 + 3 × 450) =

Stage II Allocation: FAB: ASM: Total support REG $8,433.33 6,580.00 $15,013.33 DLX $16,866.67 9,870.00 $26,736.67 Total $25,300 16,450 $41,500

FAB-REG: (2 × 450) × $9.370 = FAB-DLX: (4 × 450) × $9.370 = ASM-REG: (2 × 450) × $7.311 = ASM-DLX: (3 × 450) × $7.311 = Product Cost (Per Unit): Direct material Direct labor Support costs Unit cost

$8,433.33 $16,866.67 $ 6,580.00 $ 9,870.00 REG $50.000 $40.000 33.363 $123.363 DLX $100.000 70.000 59.415 $229.415

(b) ABC SYSTEM Week 45
MNT QLC
a

Cost $35,000 $6,310

Cost driver Activity Level Machine hours 3,500 Inspection hoursa 1,310

OH rate $10.000 $4.817

0.5 + 0.5) × 450 + (1 + 1) × 430 = 1,310

Product Cost (Per Unit): Direct material Direct labor Support: MNT Support: QLC Unit cost REG $50.000 $40.000 30.000 4.817 $124.817 DLX $100.000 70.000 50.000 9.634 $229.634

Week 46
MNT QLC
a

Cost $35,400 $6,350

Cost driver Machine hours Inspection hoursa

Activity Level 3,600 1,350

OH rate $9.833 $4.704

0.5 + 0.5) × 450 + (1 + 1) × 450 = 1,310

Product Cost (Per Unit): Direct material Direct labor Support: MNT Support: QLC Unit cost REG $50.000 $40.000 29.500 4.704 $124.204 DLX $100.000 70.000 49.167 9.407 $228.574

5-48 (a)

The analysis requires five steps for each department: Step 1. Identify the activities performed by the organization. Step 2. Determine the cost of performing each activity. Step 3. Identity a cost driver for each activity. Step 4. Determine the number of units of the cost driver made available by the resources committed to each activity. Step 5. Divide the activity cost by the number of cost driver units made available to determine the activity cost driver rate. Machine Setup Activity Cost Driver Rate Step 1. Roger Smith’s department performs machine setups. Step 2. Last year, the cost of the resources to perform this activity was $516,000. Step 3. The appropriate cost driver in this case is the number of setup hours (a duration driver) rather than the number of setups because the setup time differs for different products. Step 4. The resources supplied, at the cost of $516,000, made 13,500 hours available for machine setups. (See the discussion with Roger.) Step 5. The activity cost driver rate for the activity, performing setups, equals $38.22 per setup hour ($516,000 ÷ 13,500 hours). Based on Roger’s estimates for this year, 14,400 setup hours will be available. If we expect the costs of both wages and benefits and tools and supplies to increase proportionally with the number of setup hours made available, we would expect the total activity cost this year to be $550,368 (= $38.22 × 14,400). Material Receipts Activity and Final Inspection Activity Cost Driver Rates Step 1. David Carlson’s department performs two different activities: inspecting materials received from suppliers and inspecting materials produced by Montex.

Step 2. There are 12 people working on each of these two activities, plus David. David and the 12 workers spend about 25% of their time inspecting materials and about 75% of their time inspecting production. Last year’s total department costs were $540,000. The material receipts inspection activity cost $135,000 (= $540,000 × 25%) and the final inspection activity cost $405,000 (=$540,000 × 75%). Step 3. Given David’s comments the number of material receipts (a transaction driver) is an appropriate cost driver for inspection of materials from suppliers, and the number of units produced (a transaction driver) is an appropriate cost driver for inspection of pumps produced. Step 4. The resources made available for inspecting material receipts allow 5000 such inspections to take place. Similarly, it is possible to inspect 250,000 finished pumps with the resources currently supplied for this activity. Step 5. The activity cost driver rate is $27 (= $135,000 ÷ 5,000) per pump for materials receipt inspection. The cost driver rate is $1.62 (= $405,000 ÷ 250,000) per pump for finished product inspection. (b) If Montex managers desire to reduce or eliminate inspection of materials purchased from outside suppliers, it should train and certify suppliers to ensure Montex receives defect-free materials. In addition, Montex should carefully manage the issue of needing far fewer hours of material inspection. The affected inspectors can be redeployed to other productive uses within the company. 5.49 Please see the discussion on 1-27 in the Chapter 1 solutions. 5.49 Please see the discussion on 1-28 in the Chapter 1 solutions. 5.49 Please see the discussion on 1-29 in the Chapter 1 solutions.

Chapter 5

Management Accounting Information for Activity and Process Decisions
QUESTIONS 6-1 In evaluating the different alternatives from which managers can choose, it is better to focus only on the relevant costs that differ across different alternatives because it does not divert the manager’s attention with irrelevant facts. If some costs remain the same regardless of what alternative is chosen, then those costs are not useful for the manager’s decisions, as they are not affected by the decision. Therefore, it is better to omit them from the cost analysis used to support the decision. No, sunk costs are not relevant costs. Sunk costs are the costs of resources that have already been committed and, regardless of what decision is made by the managers, these costs cannot be avoided. Therefore, they are irrelevant for the decision. The general principal is that sunk costs are not relevant costs. But, some managers may consider sunk costs to be relevant because they may be concerned about how others will perceive their original

6-2

6-3

decision to incur these costs, and may want to cover up their initial poor judgment.

6-4

Both direct labor (DL) and material (DM) costs can be either relevant or irrelevant depending on the decision context and the alternatives that are available to the managers. When considering the purchase of automated equipment that will decrease the defect rate, both DL and DM are, in general, relevant costs because these costs are likely to decrease if the new machine is purchased. However, DM can be a sunk cost in the short-run if the materials usable only with the old machine have been already purchased or purchase commitments have been made. Similarly, if labor has been contracted for a specified period and the company cannot eliminate the extra labor when the automated equipment is purchased, then the DL cost also will be irrelevant in the short-run. In the context of a make or buy decision, product sustaining costs such as production engineering staff salaries are relevant if these costs can be eliminated by assigning the staff to other tasks, or by laying off the engineers not required when a part is outsourced. If it is possible to find an alternative use for the facilities made available because of the elimination of a product or a component, the facility-sustaining (business-sustaining) costs also are relevant. Cash flows at different points in time cannot be compared directly because of the time value of money that requires interest to be paid on bank deposits and on borrowings from financial institutions. Yes, avoidable costs are relevant because they can be eliminated when a part, a product, a product line or a business segment is discontinued. Two examples of costs that are not relevant in the short-run, but are relevant in the long-run: 1. Costs of production engineering, if the number of engineers cannot be changed in the short-run. 2. Facility rental costs, if the lease commits the firm for the short-run. These costs can be avoided in the long-run.

6-5

6-6

6-7 6-8

6-9

Facility-sustaining (business-sustaining) costs are often not relevant for make-or-buy decisions because the costs are incurred regardless of whether the company makes or buys the products. However, if the

freed-up facility can be used for another purpose, or its lease agreement can be terminated, then these costs become relevant. 6-10 There are several qualitative considerations that must be evaluated in a make-or-buy decision. For example, one must question whether the outside supplier has quoted a lower price to obtain the order, and plans to increase the price. Also, the reliability of the supplier in meeting the required quality standards and in making deliveries on time is important. A. When a decision to outsource frees up space to produce an alternative product, then the contribution margin on the alternative production is a relevant opportunity cost in a make-or-buy decision.

6-12 The throughput contribution is the difference between revenues and direct materials for the quantity of product sold. Investments equal the materials costs contained in raw materials, work-in-process, and finished goods inventories. Operating costs are all other costs, except for direct materials costs, that are needed to obtain throughput contribution. 6-13 In process layouts, all similar equipment and functions are grouped together. Process layouts typically occur in organizations in which production is done in small batches of unique products. In process layouts, products are moved and processed from one area to another until the product is completed. In contrast, in product layouts, equipment is organized to accommodate the production of a specific product. Product layouts are most effective for companies producing high-volume products. Typically, products move and are processed along an assembly line. 6-14 Cellular manufacturing involves the organization of a plant into a number of cells. Within each cell, machines that are needed to manufacture a group of similar products are arranged close to one another. This organization reduces production cycle time, which is the time from receipt of raw materials from the supplier to delivery of the finished good.

6-15 A JIT system is very different from a conventional manufacturing system. In a JIT system, a good or service is produced or delivered only when a customer requires it. JIT production requires a product layout with a continuous flow once production starts. Underlying the JIT system is a continuous improvement philosophy of eliminating or reducing delay, error, and waste, such as materials movement, storage, rework, and waiting time. In a typical JIT system, all types of inventories (raw materials, work-in-process, and finished goods) are minimized. The ultimate measure of success with JIT occurs when manufacturing cycle efficiency ratio equals 1. Under many conventional manufacturing systems, goods or services are produced to a production schedule that may not be directly tied to when customers require the goods or services. All types of inventories are kept on hand just in case unforeseen events occur. Little attention is given to studying efficient and inefficient activities, and materials movement, storage, rework, and waiting time are part of the conventional work environment. 6-16 Waiting for the machines to be freed up at the beginning of the next stage of production, and the desire to keep the production lines busy all the time create the need to maintain work-in-process inventory. Because cellular manufacturing and just-in-time production reduce the production cycle time, and quality improvement programs reduce the defect rate, work-in-process inventory is likely to decrease on the implementation of these production systems. 6-17 Reduction in time spent waiting for the next stage of production reduces both production cycle time and work-in-process inventory levels. 6-18 The following three types of costs are incurred when implementing a cellular manufacturing layout: 1. Costs of moving machines 2. Costs of reinstallation of machines 3. Costs of training the workers

6-19 Financial benefits resulting from a shift to cellular manufacturing, just-in-time production, or continuous quality improvements may include the following: 1. Increased sales because the short production cycle time enables a company to win customers by cutting the delivery time. 2. Reduction in workers needed to move materials from one area to another, due to close proximity of manufacturing processes and reduction in work-in-process inventory levels. 3. Reduction in material waste because of reduction in the damage caused by materials handling. Lower work-in-process inventory levels also reduce the potential for products to become obsolete. 4. Reduction in cost of storage because less space is used to store the reduced work-in-process inventory. 6-20 The term “cost of nonconformance” refers to the cost to the organization of producing poor quality products or services. 6-21 Waste, rework and net cost of scrap are examples of internal failure costs. 6-22 Quality engineering, quality training, statistical process control and supplier certification are examples of prevention costs. 6-23 Three examples of each of the following quality costs are: (a) prevention costs—quality training, supplier certification and statistical process control; (b) appraisal costs—inspection and testing of incoming materials, process control monitoring and product quality audits; (c) internal failure costs—waste downtime due to defectives, rework costs and scrap; (d) external failure costs—product liability lawsuits, product recalls, and warranty claims. 6-24 The additional cost of replacing a rejected unit that must be scrapped includes all the incremental conversion costs already incurred on such

a unit. Furthermore, additional costs such as handling, storage, etc. corresponding to the material that is lost also are included. 6-25 Direct rework labor, any additional direct materials used, and unitand batch-related overhead are included in rework costs. 6-26 When evaluating the profit impact of an increase in the sales of a product, it is important to evaluate the contribution margins on the increase in sales for that product, and on the decrease in sales of other cannibalized products (other products that lose customers to the product being evaluated). In addition, if inventory and accounts receivable increase with sales, then the cost of carrying these additional current assets are also relevant. 6-27 It appears to be good advice because it will avoid distracting attention and will simplify decisions made by managers by eliminating irrelevant details. However, it must be recognized that managers make a variety of nonroutine decisions, and the relevant costs for these decisions depend on the context and the alternatives available. Therefore, a single system reporting costs

relevant for only one set of routine decisions may prove inadequate for supporting the full range of managerial decisions. EXERCISES 6-28 (a) Relevant costs:
• • • •

Acquisition cost of Chevette Repairs on the Camaro Annual operating costs on the Chevette Annual operating costs on the Camaro

Irrelevant costs: • Acquisition cost of Camaro (b) Don will buy the Chevette if he bases the decision only on the available cost information. Year 1: (If Don buys the Chevette) Cash savings: Repairs on the Camaro Operating cost—Camaro Cash expenditures: Acquisition cost—Chevette Operating cost—Chevette First Year Savings

5,400 2,900 8,300 5,400 1,800 7,200 1,100

(c) Additional quantitative considerations: 1. Number of years before car is replaced (decision horizon). 2. Expected resale values of both cars when they will be replaced. 3. Cost of capital (interest rate) to consider the time value of money. See Chapter 8. Qualitative consideration: 1. Subjective preference for driving a Camaro rather than a Chevette. 6-29 Per Unit Sales price Rework cost Net after rework
³LÈôÐ  a LäöF ³LÈôÐ  a LäöF

As Is

Rework $10.00 $5.50 $4.50

@

Gilmark should rework the lamps. 6-30 (a) The original cost of $50,000, accumulated depreciation of $40,000, and annual operating costs (before overhaul) of $18,000 are all irrelevant when the choice is between overhauling the old machine and replacing it with a new machine. Note that the $18,000 operating costs are not sunk costs, yet they are irrelevant. (b) Relevant costs include the acquisition cost of the new machine, the cost of overhauling the old machine, current salvage of $4,000 for the old machine and the annual operating costs for both the new machine and the overhauled old machine.

Net acquisition cost Operating costs for 5 years Total relevant costs

Replacement $66,000a 65,000b $131,000

Overhauling $25,000 70,000c $95,000

Difference $41,000 (5,000) $36,000

a

$70,000 – $4,000 = $66,000 $13,000 × 5 = $65,000 $14,000 × 5 = $70,000

b

c

It costs Ideal Company $36,000 more with the new grinding machine than overhauling the old one. Therefore, the plant manager should overhaul the old grinding machine. However, this analysis is incomplete as it ignores the time value of money, considered in Chapter 8. 6-31 (a)
TV sets: $600 × 1,000 Picture tube: $55.00 × 1,000 $65.00 × 1,000 Relevant costs $655,000 55,000 65,000 $665,000 $600,000 $600,000 Insource (Make) Outsource (Buy)

Insource (Make) TV sets: $500 × 1,000 Picture tube: $42.00 × 1,000 $65.00 × 1,000 Relevant costs $642,000 42,000 $600,000

Outsource (Buy) $600,000

65,000 $665,000

6-32 (a) If the unit-related, batch-related, and product-sustaining support costs are all avoidable, then Kane will reduce costs by outsourcing the component. Facility costs may be unavoidable if the facility cannot be converted to alternative uses when the component is outsourced. (b)The cost per unit if the component is outsourced would be: Purchase price Facility-sustaining overhead Total costs Savings per unit ($73.10 – $71.40) $64.50 6.90 $71.40 $1.70

(c) Other factors relevant to the decision are the supplier’s ability to live up to expected quality and delivery standards, and the likelihood of suppliers increasing prices of components in the near future.

6-33 Premier should make the gear model G37 because it costs less to make than to buy.
Make Cost of purchase Direct material cost: $55 × 20,000 = Direct labor cost: $30 × 20,000 = Variable overhead: $25 × 20,000 = Fixed overhead $15 × 20,000 = Savings in facility-sustaining costs Relevant costs $1,100,000 600,000 500,000 300,000 — $2,500,000 — — 300,000 (113,000) $2,587,000 Buy $2,400,000

6-34
Year 1 Cash inflow: Sale of old machine Saving because old machine not repaired Salvage value of newmachine Decrease in annualoperating costs Cash outflow: Purchase of new machines Net cash inflow (outflow) ($40,000) Cumulative cash inflow (outflow) ($40,000) ($20,000) 0 $20,000 $45,000 $20,000 $20,000 $20,000 $25,000 (120,000) 0 0 0 0 20,000 $20,000 $20,000 $20,000 $40,000 20,000 $10,000 $20,000 (5,000) Year 2 Year 3 Year 4 Year 5

Joyce Printers should not replace the machines if they do not expect to use the new machines for more than four years. (See Chapter 8 for formal coverage of net present value analysis.)

6-35 The offer by Superior Compressor should not be accepted if facilitysustaining overhead costs are unavoidable.
Cost per unit Cost of purchase Variable cost: Direct material Direct labor Unit-related overhead Batch-related overhead Product-sustaining overhead Relevant cost per unit $ 80 60 26 22 8 $196 Make Buy

(b) The maximum acceptable purchase price is $213 per unit if the plant facilities are fully utilized at present and the incremental cost of adding more capacity is approximated well by the $17 per unit facility-sustaining overhead cost. 6-36 Prevention costs are incurred to ensure that companies produce products according to quality standards. Prevention costs include quality engineering, training of employees in methods designed to maintain quality, etc. Appraisal costs are related to inspecting products to make sure that they meet both internal and external customers’ requirements. Inspection of purchased parts and materials and process control monitoring are examples of appraisal costs. Internal failure cost occurs when the manufacturing process produces a defective component or product. The cost of downtime in production as a result of defects is an example of an internal failure cost. External failure costs are incurred when a customer in the field detects a problem with a product or the product fails. Examples of external failure costs include warranty costs, service calls, and product liability recalls.

6-37 Of the four quality costing categories, an external failure cost is the most damaging to the organization. The reasons are that external failure costs, such as a product liability lawsuit, can be extremely costly to the organization not only in dollars, but also in terms of corporate reputation. One key example of this is the Ford Pinto. 6-38 Estimated cost savings as a result of the quality improvement: Savings from decrease in reject rate (0.064 – 0.051) × [(494 – 63 – 225) + (386 – 89) + (70 – 16)] × 10,000 Savings from reduction in inventory carrying cost ($386,000 – $270,000) × 0.15 Total annual savings $17,400 $89,810 $72,410

6-39 Benefits from cellular manufacturing operations are estimated to be $294,500 as shown below:
Before the change Sales Costs: Direct material Direct labor Variable overhead Fixed overhead WIP inventory carrying costs Profit (378,000) (277,200) (352,800) (151,200) $100,800 (19,200) $81,600 (439,400) (354,900) (371,800) (135,200) $388,700 (12,600) $376,100 (61,400) (77,700) (19,000) 16,000 $287,900 6,600 $294,500 $1,260,000 After the change $1,690,000 Difference $430,000

6-40 A grocery store is organized using a process layout—similar foods are grouped together to make it easier for customers to find what they want. A grocery store might be reorganized into a modified cell layout. For example, someone wanting to prepare a certain meal, like lasagna, might find all the required ingredients in one place. However, this approach is likely to be costly and impractical and make stock rotation difficult.

PROBLEMS Fundamental Problems 6-41 (a) In determining the minimum prices, assumptions will need to be made about how well the event-related and customer-related costs represent resource usage. (For example, one might assume practical capacity was used to determine the costs.) Event-related costs should correspond to each catering event, while customerrelated costs should correspond to maintaining a relationship with the customer, not the number of events with the same customer. One might also assume the business-sustaining costs are committed in the short run and will not change with the addition of one more catering job. (b) Other factors in setting the price may include the price competition Carmen faces, the likely demand from this customer for future catering events, and the current demand for Carmen’s Catering.
(c)

Direct materials and direct labor, 100 meals Event-related support Customer-related support Total Cost per meal

Menu 1 $1300 100 22 $1422 $14.22

Menu 2 $1600 100 22 $1722 17.22

From a long-run perspective, Carmen’s Catering should charge a price that covers the costs above, as well as a portion of the business-sustaining costs and a contribution toward profit. From a short-run perspective, Carmen’s minimum price should cover at least the $14.22 for menu 1 and $17.22 for menu 2.

6-42

Incremental costs: Machine moving and reinstallation Incremental benefits: Increase in contribution margin ($200,000 × 0.31 = ) Savings in inventory carrying costs ($200,000 × (0.25) × 0.15 = ) Net benefit (loss) from a change in plant layout in year 1 7,500 $(30,500) 62,000 ($100,000)

The proposed change in plant layout should not be implemented because its costs are greater than its benefits, if only one year’s benefits are considered. The methods in Chapter 8 should be used to evaluate the benefits over the entire useful life of the machine.

6-43
Make Cost of purchase: $30 × 12,000 Manufacturing cost: Direct material Direct labor Unit-related support Batch-related support Product-sustaining support Facility-sustaining support Allocated corporate support Savings in rental costs Total costs
a

Buy $360,000

$132,000 108,000 48,000 60,000 24,000 24,000 60,000 0 $456,000 30,000 4,800 24,000 60,000 (20,000) $458,800

50% × 60,000 = 30,000 20% × 24,000 = 4,800

b

Based on the cost analysis above, O’Connor Company should make part BYKA4 in-house. All the costs listed above except facilitysustaining support costs and allocated corporate support costs are relevant to this decision. In deciding whether to purchase part BYKA4 from the outside supplier, factors such as the reliability of the supplier in maintaining quality and on-time delivery must be considered.

6-44

(a) Acquisition cost and depreciation expense for the existing elevator system are irrelevant. Relevant cost Acquisition cost Salvage value of existing system at present Operating costs for 6 years Salvage unit after 6 years Existing system — — (100,000) $900,000 (25,000) ________ $875,000 48,000 (100,000) ________ $723,000 New system $875,000

The decision to replace the existing elevator system with the new one will require net present value analysis that considers the time value of money. 6-45 (a) Selling price per unit Variable cost per unit Contribution margin per unit Number of units Increase in operating income $4.00 3.30 $0.70 50,000 $35,000

Genis Battery Company should accept the special order because it is operating under capacity and this order can generate $35,000 in additional operating income. (b) Unit costs can be misleading. The decision must be based on incremental costs. (c) Other customers may also demand a reduced price. Therefore, their reaction to the reduced price for the special order must also be taken into account.

6-46 (a)

Net cost saving over 4 years with new machine Cash inflow: Salvage value difference Decrease in annual operating costs (4 years × $60,000) Reduction in rework cost Cash outflow: Acquisition of new machine ($360,000 – $100,000) Net cash inflow (outflow)
a 0.05 (100,000 × 4) × $1 - 0.025 (100,000 × 4) × $1 Reduction in rework = $20,000 = $10,000 $10,000

New Machine

$ 2,000 240,000 10,000a

(260,000) ($ 8,000)

Syd Young should not replace the old machine due to net cash outflow of ($8,000). (b) The acquisition cost of the old machine is a sunk cost. (c) Other considerations: 1.Will sales increase because of lower defects with the new machine 2.What is the cost of capital used to discount future cash flows? In this case, discounting will only make the new machine appear worse. 6-47 Both the theory of constraints and activity-based costing support aspects of process improvement and improved profitability, but differ in many other respects. The theory of constraints emphasizes the short-run optimization of throughput contribution, and downplays operating costs (except direct materials) because they are viewed as difficult to alter in the short-run. Consequently, analyses of activities and cost drivers are not conducted as they are in activity-based costing. Proponents of activity-based costing take

a long-term perspective in which managers can alter capacity resources. Therefore, it is viewed as beneficial to produce accurate cost information by tying actual resources consumed to cost objects, such as products, services, channels, and customers. In

theory, the theory of constraints and activity-based costing might be used together. 6-48 (a) MCE in minutes under the traditional system equals [120/(120 + 80 + 240 + 40)] = [120/480] = 0.25. MCE under the JIT system equals [75/(75 + 20 + 60 + 5)] = [75/160]= 0.47. (b) Based on the calculations above, Walker Brothers should implement the JIT system since the manufacturing cycle efficiency is almost double that of the traditional system (0.47 vs. 0.25). 6-49 Cellular manufacturing refers to the organization of the plant into a number of cells so that within each cell, all machines required to manufacture a group of similar products are arranged in close proximity to each other. The shape of a cell is often a U shape, which allows workers convenient accessibility to required parts. The machines in a cell manufacturing layout are usually flexible and can be adjusted easily, or even automatically, to make the different products. Often the number of employees needed to produce a product can be reduced due to the new work design. The U shape also provides better “visual control” because employees can observe more directly what their co-workers are doing. Cellular manufacturing layouts reduce costs and quality problems associated with conventional manufacturing and facilities layouts. Usually production cycle time is improved with a cellular manufacturing approach. A just-in-time manufacturing system requires making a good or service only when the customer, internal or external, requires it. It is most appropriately used in repetitive manufacturing for products such as automobiles or electronic components. Just-in-time production requires a product layout with a continuous flow (no delays) once production starts. This means that there must be a substantial reduction in setup costs in order to eliminate the need to produce in batches, therefore, processing systems must be reliable. A just-in-time production system is based on the elimination of all nonvalue-added activities such as materials movement, storage, rework, and waiting times in order to reduce cost and time. It is an approach to continuous improvement and requires employee empowerment and involvement to eliminate the need to perform nonvalue-added activities. Just-intime production encompasses all facets of making the good or service,

including developing the design, acquiring the factors of production, making the good or service, delivering it to the customer, and following up after the delivery. Critical performance indicators in justin-time systems include inventory levels, which should be as low as possible; the number of failures, whether these are material, people, or machine

failures, with a goal of zero; moving with a goal of zero; and the amount of storing activities with a goal of zero. The ultimate measure of success with JIT occurs when the manufacturing cycle efficiency ratio equals 1 that is, when processing time equals total production time. The cellular manufacturing approach is not inconsistent with philosophy of JIT as cellular manufacturing also focuses continuous improvement. In fact, some JIT systems manufacturing cells to make specific components as part of finished product. Challenging Problems 6-50 Total net annual benefit from the new machine: Increase in contribution margin Decrease in inventory carrying costs Decrease in lease costs $648,000a 59,800b (410,000)c $297,800
a b

the on use the

[($56–$32) × 48,000]–[(56–$42) × 36,000] = $648,000 Inventory levels with the old machine: Raw materials Work-in-process Finished good 36,000 × $12 × 4/12 = 36,000 × $25 × 3/12 36,000 × $38 × 2/12 $144,000 225,000 228,000 $597,000

Inventory levels with the new machine Raw materials Work-in-process Finished good 48,000 × $11 × 1.5/12 48,000 × $20 × 1.5/12 48,000 × $28 × 1/12 $66,000 120,000 112,000 $298,000 Change in annual inventory carrying costs: ($298,000–597,000) × 20% = $59,800 (decrease)
c

$490,000–$900,000 = $410,000 decrease

(b) Rossman should replace its old machine with the new machine because the penalty of $280,000 for early termination of the lease is more than offset by the net annual benefit of $297,800 for each of four years with the new machine. (c) A manager evaluated on the basis of net income may not have the incentive to replace the existing machinery. As shown below, Iversen will exhibit a net loss for the first year with the new machinery because of the penalty for the early termination of the existing lease contract. Therefore, a myopic manager, with a shortterm focus, may not lease the new machinery even though it would increase Iversen’s income over the long-run. Sales:(48,000 × $56 =) Variable product cost: (48,000 × $32 =) Annual lease cost Penalty for early termination of the existing lease contract Net loss for the first year $2,688,000 (1,536,000) (900,000) (280,000) ($28,000)

6-51 (a) Impact of dropping JT484 on operating income: Reduction in contribution margin Cost savings: Utilities Supervision Maintenance Administrative Decrease in operating income (9,000) (30,000) (7,000) (30,000) $24,000 $100,000

Therefore, JT484 should not be eliminated. No, the decision to retain JT484 will only be reinforced by the sales manager’s comments. 6-52 (a)
Selling price per unit: Variable price per unit: Direct material Direct labor Overhead Commission Contribution margin per unit: $30.00 20.00 10.00 10.50 70.50 $34.50 New Product $105.00

Increase in inventory: Raw materials Work-in-process $3,600,000 × (2/12) $3,600,000 × (1/12) (2,400,000 + 1,200,000 × 0.5 × (1/12) $7,200,000 × (2/12) + 450,000 1,200,000 $2,250,000 $270,000 $600,000

Finished goods Total increase in inventory Additional costs

inventorycarrying $2,250,000 × 0.12

Incremental revenues: Increase margin in contribution $34.5 × 120,000 $4,140,000 (1,200,000)

Decrease in contribution $20 × (300,000 – 240,000) margin from cannibalization Incremental costs: Increase in fixed cost Additional inventory carrying costs New impact on profits if the new model is introduced

(2,000,000) (270,000) $670,000

(b) Yes. Introducing the new product will result in an increase of $670,000 in profits.

(c) Let Q be the breakeven point (in units) for the new product. Increase in inventory: Raw material: Work-in-process: Finished goods: 30 × Q × (2/12) 30 + (20 + 10) × 0.5 × Q × (1/12) 60 × Q × (2/12) 5.00Q 3.75Q 10.00Q 18.75Q Additional inventory carrying costs = 18.75Q × 0.12 = 2.25Q Net impact on profits: 34.5 Q – 20 × (Q/2) - 2,000,000 – 2.25 Q = 0 Q = 89,888 units 6-53 (a) Because the distinctive desserts are a source of competitive advantage, Beau should carefully consider the quality, freshness, and distinctiveness of the desserts from the outside providers, as well as the providers’ reliability in delivering the desserts. Beau will want to consider the possibility of price increases from an outside bakery. For the in-house option, Beau may have concerns about his ability to hire a suitable replacement pastry chef. If Beau hires a new pastry chef, the chef may be more responsive than the outside bakers to Beau’s customers’ tastes. Also, there would be no concern about delivery to Beau’s Bistro. (b) This question is designed to generate discussion about the tradeoffs among the options. Although the second bid is lower-cost than the first, the first bid promises continual developments of gourmet desserts; the second bid promises only traditional desserts. Inhouse pastry production is the highest-cost option. The ultimate decision should take into account not only the costs of the different options, but also the issues in part (a) and the anticipated effect on demand and revenue (for pastry and for Beau’s Bistro) under each option.

6-54 (a) The costs and benefit shown below are relevant for the outsourcing decision. All but the –$20,000 sale of office equipment are annual costs.
Costs In-house Outside Call center Call center Labor Rent Phone Other support Office equipment Outside call center $650,000 60,000 35,000 42,000 ($20,000) 700,000 $680,000

$787,000

(b) Hollenberry must consider the outside call center’s reliability and quality of service in responding to Hollenberry’s customers. Given Hollenberry’s worldwide operations, the greater number of multilingual operators available at the outside call center could be an important feature. Finally, Hollenberry must factor in the prospect of laying off employees, many of whom have worked at Hollenberry for over 20 years. (c) If the outside call center can meet Hollenberry’s expectations for reliability and quality, including better service for international customers, financial considerations point toward Hollenberry outsourcing the call center function. However, although the outsourcing decision seems financially sound, there is great potential for decreasing employee morale through layoffs. This question is designed to generate discussion about tradeoffs among the company’s stakeholders, including employees. One alternative to firing Hollenberry’s call center employees is reassigning the employees to other jobs and relying on attrition to eventually reduce employee costs to Hollenberry’s desired level. 6-55 Before the rearrangement, MCE in minutes for Whisper Voice Systems equals [70/(70 + 45 + 55 + 30)] = 70/200 = 0.35. After the rearrangement, MCE in minutes equals [30/(30 + 10 + 20 + 15)] =

30/75 = 0.40. The percentage improvement in MCE after the rearrangement is

[(0.4 – 0.35)/0.35] = .143 or 14.3%. Thus, the change exceeds Ray Brown’s requirement of a 12% improvement in MCE. 6-56 (a) The approach used at McDonalds in which customers wait in several lines is consistent with the push or conventional manufacturing approach. As one comes into McDonalds it is clear that they have been, and are building inventory in each of the specific bins that they use for, let’s say, Big Macs, fish sandwiches, regular hamburgers, etc. Having inventory at predefined levels keeps the production process going. The motivation to use the traditional production method is to sustain a certain level of inventory to reduce the time the customer has to wait for an order. Notice in McDonalds that hot lights are used to keep the sandwiches warm. One goal of this approach is that customers perceive that they can get their sandwich very quickly due to the inventory of sandwiches always on hand. On the other hand, Wendy’s uses more of a pull or JIT system. As you enter into Wendy’s, notice that you cannot really observe any sandwich inventory building up. The idea in forming one line is that each person has the perception (and often the reality) that each sandwich is made on the spot. This procedure is designed to show customers how fresh the sandwiches are. The motivation to use a just-in-time approach is to improve the quality of the food and to reduce waste by eliminating the need to throw out food that has been sitting too long. As processing time and setup costs drop, the organization can move closer to just-in-time, reducing the waste and quality problems that arise with batch production. (b) From a customer’s perspective, it does depend on what one favors. If a customer goes to a fast food restaurant, his or her goal is to get food quickly. On any particular day, the customer may be in a great hurry and wish to run in and run out of a fast food establishment. Having multiple lines at a place like McDonalds may be very appealing as far as the perception of the speed with which one can get a meal (compared to a single line at Wendy’s). On another day, perhaps having a meal made freshly on the spot, without any “warming” time under hot lights is more appealing than the speed of getting the food. Of course, one may simply like the taste of one company’s hamburgers over another’s.

From management’s perspective, apart from taste, competing in selling hamburgers may depend on other variables such as the speed with which an order is filled versus tailoring the production process to individual taste. The traditional push production process can lead to a lot more waste than the JIT system, because if a batch of hamburgers is made and demand

drops, the quality of the food deteriorates and often has to be thrown out. However, if the line at Wendy’s is very long and customers begin to get impatient, the freshness of the food may begin to lose its appeal. 6-57 There really is no one “correct way” to allocate the $2,000,000 of quality costs to the four categories. Clearly, managers hope that they can minimize quality costs as much as possible. But, in this hypothetical example, we are assuming that managers, a priori, have much more discretion than they probably do. Probably the most desirable quality cost trend would be to load costs up at the prevention stage and to incur some costs during the appraisal stage. By increasing prevention costs such as training and quality engineering and appraisal costs, such as maintenance of test equipment, process control monitoring and inspection of incoming materials, an organization can reduce other quality costs, especially those related to internal and external failure. As far as the allocation of the $2,000,000 goes, the “correct” trend is a high level of costs for prevention, followed next by lower costs for appraisal, internal failure and external failure. CASES 6-58 (a) Yes. Mike should accept Target’s offer, since it results in an overall increase in profit of $219,083 1. Contribution margin on Target sales: Selling price per bicycle Less variable costs per bicycle: Direct material Direct labor Overhead Contribution margin per bicycle Total contribution margin on 40,000 bicycles per year (40,000 × $20) $50 30 25 105 $20 $800,000 $125

2.

Contribution margin on cannibalized sales: Selling price per bicycle Less variable costs per bicycle Direct material Direct labor Overhead Commission Contribution margin per bicycle Total contribution margin on 8,000 bicycles per year (8,000 × $63.50) $48.00 30.00 25.00 18.50 121.50 $63.50 ($508,000) $185.00

3.

Inventory carrying costs: Raw material Work-in-progress Finished goods: $50 × 40,000 × (1/12) $(50 + 0.5 × (30 + 25)) 40,000 × (1.5/12) $105 × 40,000 × (0.5/12) × $166,667 $387,500 $175,000 $729,167 ($72,917) $219,083

Additional inventory for Target order Additional inventory carrying costs Net increase in profits

(b)

Strategic and other factors that need to be considered are: Reputation problems—Customers finding the same bicycle at Target may perceive the quality of Diamond’s Bicycles to be low. On the other hand, if they find that the same quality bicycles are available at Target for lower prices, then sales of “original” Diamond bicycles and

in general the price of “quality” bicycles will go down. Existing customer loyalty may go down. Long-term capacity implications—The ideal capacity is tied up now with low margin Target offer. When demand goes up, future expansion is costly. This implies that the contract with Target needs to be finalized based on long-term growth of the market. Retail distributor problems—The existing retail distributors are specialty bicycle stores. They will be annoyed when they find that Diamond sells the same bicycle at a much lower price to Target than what they are paying, and that this action enables Target to undercut the specialty stores. As a result, many of these stores may refuse to carry Diamond’s bicycles, or decide not to promote and push Diamond’s bicycles as much as before, resulting in substantial decreases in Diamond’s sales through its existing retail distribution channels. Transportation cost —Target requires Diamond to deliver the bikes to Target’s regional warehouse. Transportation costs should be factored into the analysis. 6-59 (a) Costs in the following items are relevant to Polley’s decision: 1, 2, 3, 4, 5, 7, 9, 10, and 13. Item 6 is not relevant because it is a sunk cost, and items 8, 11, and 12 are not relevant because the costs do not differ across the two options. (b) Polley is likely to consider the decreased health risks for workers with the new solvent, decreased risks of violating OSHA regulations and incurring penalties, and decreased risks of negative media coverage. Polley is also likely to consider the potential increase in demand for Kwik Clean’s services if the company markets its environmentally safer process. Polley may also try to assess whether individual customers are more sensitive to such marketing than are business customers.
(c) For operations with potential environmental pollution,

prevention can involve efforts to ensure pollution does not occur. Prevention efforts might include changing

processes, as Polley is considering. Appraisal efforts might include inspections to ensure pollution levels are within acceptable limits or workers are following prescribed procedures for dealing with pollution or hazardous wastes. Internal failures are failures (accidental spillages or leakages of hazardous wastes, or illegal levels of pollutants) that are detected and cleaned up or corrected before reaching the public. Finally, external failures are failures that are not detected, cleaned up, or corrected before reaching the public. As in the cost of quality framework for manufacturing operations, environmental pollution external failures are often the most costly to the firm. If prevention efforts are feasible, attention should be focused on prevention. Given that some pollution or hazardous wastes are generated, efforts should also be focused on appraisal, with the intent of minimizing internal failures and external failures.

Chapter 6

Cost Information for Pricing and Product Planning
QUESTIONS 7-1 The answer depends on the time frame considered. Short-run prices need only cover the costs that vary in the short run. However, in the long-run, most costs become variable. In fact, in the long-run, prices must cover both fixed and variable costs for the firm to survive. Since capacities made available for many production and support activities cannot be altered easily in the short-run, managers need to pay attention to whether surplus capacity is available for additional production or whether the available capacity limits production alternatives. In contrast, in the long-run, managers have considerably more flexibility in adjusting the capacities of activity resources to match the demand that is placed on these resources by the actual production of different products. In commodity-type businesses, prices are set by traders in the commodity markets based on industry supply and demand. Firms in commodity-type industries are price-takers, unable to influence the market prices.

7-2

7-3

7-4

The following two considerations complicate short-run product mix decisions: 1. Deciding what costs are relevant to the short-run product mix decision.

2. Recognizing that in the short-run managers may not have the flexibility to alter the capacities of some activity resources. 7-5 A firm that is one of a large number of small firms in an industry in which there is little to distinguish the products of different firms from each other is likely to be a price-taker. A price-taker firm cannot influence prices significantly by its own decisions because the prices are set by overall industry supply and demand forces, or by a large dominant firm in its industry. Firms in an industry with relatively few competing firms, and firms enjoying large market shares and exercising leadership in an industry are likely to behave as price setters or price leaders. Also, firms in industries in which products are highly customized or otherwise differentiated from each other because of special features, characteristics, or customer service, are able to set prices for their differentiated products. No. Products should be ranked by the contribution margin per unit of the constrained resource rather than by the contribution margin per unit of the product. Yes. When capacity is fixed in the short-run, the firm may need to sacrifice the production of some profitable products to make capacity available for a new order. The contribution margin on the production of profitable products sacrificed for a new order is an opportunity cost that must be considered to evaluate the profitability of the new order. When surplus capacity is not available and overtime, extra shift, subcontracting, or other means must be employed to augment the limited capacity, a short-run pricing decision must consider the additional costs of overtime wages, supervision, heating, lighting, cleaning, security, machine maintenance and engineering, along with human factors such as decline in morale.

7-6

7-7

7-8

7-9

7-10 If facility-sustaining (business-sustaining) costs do not vary with the decision alternatives, such as when there is some idle capacity, then these costs should not be considered for a short-run pricing decision. However, if facility-sustaining costs vary with the decision, such as

when heating, or lighting and security costs increase for overtime work, they must be considered for the short-run pricing decision.

7-11 Contracts for the development and production of new, customized products, including contracts with governmental agencies such as the Department of Defense, specify prices as full costs plus a markup. Prices set in regulated industries, such as electric utilities, are also based on full costs. Also, when a firm enters into a long-term contractual relation with a customer to supply a product, it will price the product based on its full costs. This is because it has flexibility in adjusting the level of commitment for all activity resources and as a result most of its costs become variable in the long-run. Finally, prices based on full costs are used as benchmark prices to guide short-run price adjustments in response to fluctuations in short-run demand conditions. 7-12 The stronger the demand, the higher will be the markup. When demand is more elastic, markup will be lower because customers are sensitive to higher prices. Finally, when competition is more intense, a firm cannot sustain a high markup. 7-13 Short-run prices fluctuate over time because of changes in demand conditions. When the demand for products is low, firms adjust their prices downward. Conversely, when the demand is high, they adjust prices upward. 7-14 Several strategic factors may affect the level of markup. A firm may choose a low markup to penetrate the market and win market share from its competitors. In contrast, a firm may employ a high markup if it employs a skimming strategy for a market segment in which some customers are willing to pay higher prices. 7-15 If long-run market prices are lower than full costs, managers may consider reengineering the product to lower costs, raising prices by further differentiating the product, or dropping these unprofitable products. 7-16 In the long-run, a firm has the flexibility to adjust most of its activity resources, and therefore, most costs are variable. Thus, full costs approximate long-run variable costs that are relevant for long-run pricing decisions.

EXERCISES 7-17 Healthy Hearth has sufficient excess capacity to handle the one-time order for 1000 meals next month. Consequently, the analysis focuses on incremental revenues and costs: Incremental revenue per meal Incremental cost per meal Incremental contribution margin per meal Number of meals Increase in operating income
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$3.50 3.00 $0.50 1,000 $ 500

7-18 This order will require machine hours. Since there is excess capacity of machine hours per month, Shorewood Shoes Company can accept this order without expanding its capacity. Therefore, Shorewood should charge at least as much as the incremental variable costs for this order. Direct material Direct labor Variable manufacturing support Additional cost of embossing the private label Minimum price to be charged for this order

$6.00 4.00 2.00 0.50 $12.5 0

Shorewood’s costs stated in the problem are average costs per pair of shoes. Shorewood should determine whether the costs are reasonably accurate for the discount store’s order. Shorewood should also consider how its regular customers might react to the lower price offered to the discount store. 7-19 (a) Superstore faces a problem of maximizing contribution margin per unit of scarce resource. Here, the scarce resource is shelf space. Superstore requires at least 24 square feet for each category. The store manager should assign additional available space to the category with the highest contribution margin per square foot, i.e.,

ice cream. After assigning at total of 100 square feet to ice cream, there is sufficient available shelf space to assign a total of 100 square feet to frozen dinners and 26 square feet to juices. The frozen vegetable receives the minimum required assignment of 24 square feet. Ice Cream Juices Selling price per unit (square-foot package) Variable costs per unit (square-foot package) Unit CM (square-foot package) Minimum required Maximum allowed Allocation to maximize total CM $12.00 $8.00 $4.00 24 100 100 $13.00 $10.00 $3.00 24 100 26 Frozen Frozen Dinners Vegetables $24.00 $20.50 $3.50 24 100 100 $9.00 $7.00 $2.00 24 100 24

(b) In setting the minimum required and maximum allowed square footage per category, the manager might consider seasonality (for example, permitting more ice cream space during the summer or more frozen vegetable space during the winter) and the effect on contribution margins of variability in costs and prices. The analysis does not take into account the rate at which products are sold within each category. 7-20
Sale price per sq. yard Variable costs per sq. yard Contribution margin per sq. yard DLH required per sq. yard Contribution margin per DLH Regular $16.00 10.00 $6.00 0.15 $40.00@ Deluxe $25.00 15.00 $10.00 0.20 $50.00@@

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@

@@

Because deluxe grade has a higher contribution margin per unit of scarce resource (DLH) than regular grade, and no more than 8,000 square yards of deluxe grade can be produced, Boyd Wood Company should produce the maximum of 8,000 square yards of deluxe grade first and then use the remaining available capacity of 3,000 DLH to produce regular grade. Therefore, the optimal production level for each product is: Deluxe: 8,000 sq. yards Regular: 20,000 sq. yards A.
.

This discussion question is motivated by recent articles on controversial strategies adopted by some nursing homes. A sample of relevant articles is listed below.

Moss, M. and Adams, C., “For Medicaid Patients, Doors Slam Closed —Citing Finances, Nursing Home Evicts the Needy”, The Wall Street Journal (April 7, 1998), B1. Adams, C. and Moss, M., “Bad News: The Business Potential of Nursing Homes Is Elusive, Vencor Finds—Bid for High-Paying Patients Brings Firm Headaches, And It Has to Regroup— Medicaid Is Welcome Now,” The Wall Street Journal (December 24, 1998), A1. McGinley, L., “Medicaid Fix: House Limits Evictions from Nursing Homes,” The Wall Street Journal (March 11, 1999), B1. McGinley, L., “Health Care: As Nursing Homes Say, ‘No,’ Hospitals Feel Pain,” The Wall Street Journal (May 26, 1999), B1. Conklin, J.C., “Ailing Sun Healthcare Group Files for U.S. Bankruptcy Court Protection,” The Wall Street Journal Europe (October 15, 1999), UK5A.

Adams, H.J., “U.S. Says Vencor Owes it $1.3 Billion Claim Based Largely on Fraud Charges,” The Courier-Journal (March 15, 2000), Louisville, KY, 1a.

(a) The nursing home situation can be viewed as similar to a product mix or customer profitability problem. With a given amount of bed and staffing capacity, a major nursing home provider sought to increase profitability by targeting private-insurance or Medicare patients, who generated higher revenue per day than Medicaid patients. The provider’s strategy was to market high-quality care to patients who could afford high prices. Unfortunately, the strategy was unsuccessful because the provider was unable to maintain the desired quality, and the provider received considerable negative publicity for its active efforts to discharge Medicaid patients, sometimes with little apparent regard for the toll it would take on the patients (see Adams and Moss (1998) and Moss and Adams (1998)). Aside from the concerns about quality of care, desirable patients were deterred by the prospect that they would be discharged from the nursing home if it became necessary to turn to Medicaid funding for their nursing home care. The nursing home provider ultimately reversed its position on Medicaid patients, but later filed for Chapter 11 bankruptcy. Largely motivated by this nursing home provider’s treatment of Medicaid patients, Congress passed legislation prohibiting nursing homes from evicting patients solely because their related reimbursements come from Medicaid. Formerly, such evictions were prohibited in only some states. Students, like nursing home administrators, may argue that it is necessary to consider the projected patient revenue in light of the cost of providing services. McGinley (May 1999) provides examples of out-of-pocket treatment costs that exceed federal reimbursements. Although some patients require very costly medications or equipment, many other patients’ reimbursements will cover the related out-of-pocket costs and contribute to covering capacity costs (Moss and Adams (1998)). (b) An employee who believes policies are unethical can approach management with his or her concerns. If management refuses to change its policy, employees

may, as described in the cited articles, choose to resign. An employee can also contact elected representatives to introduce legislation prohibiting unethical policies, and can alert consumer and industry groups, such as the AARP and the American Health Care Association, to encourage the groups to advocate investigations or new legislation.

7-22
³ L ³ L

Therefore, Berry’s operating income will increase by $160,000 if it accepts this offer. 7-23 (a) Variable cost per unit Sales (30,000 units @ $10 and 30,000 units @ $9) Variable manufacturing & selling costs (60,000 units @ $5.50) Contribution margin Fixed costs Operating income
³L Lr È ü ` À a ä q Ð

$570,000 (330,000) $240,000 (99,000) $141,000

If Ritter accepts the export order, its operating income will increase by . Although Ritter’s operating income will increase with the special order, Ritter must consider the long-run effect of displeasing its regular domestic customers by not fulfilling their demand.
³L Lr È ü ` À a ä q Ð

(b) Sales (36,000 units @ $10 and 30,000 units @ $9) Variable manufacturing & selling costs (66,000 units @ $5.50) Contributed margin Fixed costs ( = $99,000 + $25,000) Operating income

$630,000

(363,000) $267,000 124,000 $143,000

If Ritter operates the extra shift and accepts the export order, operating income will increase by $80,000. Ritter should consider whether the same quality will be achieved with new operators or existing operators working overtime (with possible fatigue). In addition, Ritter should understand whether the additional fixed costs will be incurred on a continuing basis or are avoidable when production drops back to its previous level. 7-24 (a)
³L ü L q rÀ È `a ä Ð

³L ü L q rÀ È `a ä Ð

Variable component of support costs . Fixed component of support costs . Because the fixed cost of $1,200,000 is apparently spread out over 8,000 units instead of 6,000 units

, the unit cost is reduced to $550 at the production level of 8,000 units from $600 at the production level of 6,000 units. (b) When excess capacity exists, the price offered for a special order should be at least as high as the variable cost per unit. Here, variable cost per unit is $400, as determined below:

Direct material cost Direct labor cost Variable support Unit variable cost

$125 125 150 $400

Therefore, you should recommend that Delta accept the offer from the German company. A. Given variable costs per half-gallon container of $1.50, the contribution margins are as shown below. The maximum contribution occurs at a price of $2.75. Demand 75,000 72,500 70,000 67,500 65,000 62,500 60,000 57,500 55,000 52,500 50,000 Price $2.50 2.55 2.60 2.65 2.70 2.75 2.80 2.85 2.90 2.95 3.00 Contribution Margin $75,000 $76,125 $77,000 $77,625 $78,000 $78,125 $78,000 $77,625 $77,000 $76,125 $75,000

7-26

Model

Total contribution margin before 5% price-cut

Total contribution margin after 5% price cut $27 × 3,120 = $84,240 33.5 × 4,680 = 156,780 40 × 5,200 = 208,000 27 × 4,160 = 112,320 33.5 × 4,160 = 139,360 40 × 4,160 = 166,400 53 × 5,400 = 286,200 68 × 5,400 = 367,200 83 × 10,800 = 896,400 53 × 6,480 = 343,440 68 × 7,560 = 514,080 93 × 6,480 = 602,640

Difference

B112 B116 B120 G112 G116 G120 M124 M126 M128 W124 W126 Wl 28

$30 × 3,000 = $90,000 37 × 4,500 = 166,500 44 × 5,000 = 220,000 30 × 4,000 = 120,000 37 × 4,000 = 148,000 44 × 4,000 = 176,000 58 × 5,000 = 290,000 74 × 5,000 = 370,000 90 × 10,000 = 900,000 58 × 6,000 = 348,000 74 × 7,000 = 518,000 100 × 6,000 = 600,000

($5,760) (9,720) (12,000) (7,680) (8,640) (9,600) (3,800) (2,800) (3,600) (4,560) (3,920)

³ È` L Ð Lü ä r aq À

³ È` L Ð Lü ä r aq À

The five percent price cut will result in a decrease of $69,440 in Columbia’s profits.

7-27

Product Hamburgers Chicken Sandwiches French Fries

Total sales without Total sales with Special promotion special promotion $1.09 × 20,000 = $21,800 $0.69 × 24,000 = $16,560

Difference ($5,240)

1.29 × 10,000 = $12,900 0.89 × 20,000 = $17,800

1.29 × 9,200 = $11,868 0.89 × 22,400 = $19,936

(1,032) 2,136 ($4,136)

Variable costs withoutspecial Variable costs withspecial Difference promotion promotion Hamburgers $0.51 × 20,000 = $10,200 $0.51 × 24,000 = $12,240 ($2,040) Chicken Sandwiches French Fries 0.63 × 10,000 = $6,300 0.37 × 20,000 = $7,400 0.63 × 9,200 = $5,796 0.37 × 22,400 = $8,288
³ È` L Ð L aä r ü q À

Product

504 (888)
³ È` L Ð L aä r ü q À

Incremental sales with special promotion = ($4,136) Incremental variable costs with special promotion = $2,424 Incremental contribution margin with special promotion = ($6,560) Incremental fixed costs with special promotion = $4,500 Incremental profits with special promotion = ($11,060) Therefore, Andrea should not go ahead with this special promotion. A countervailing argument is the creation of new customers who may stay with the firm and generate additional contribution margin in the future.

7-28 The lack of competitors suggests Sanders may be selling SM5 at a price competitors find unprofitable; Sanders should consider raising the price. Other actions to increase the profitability of SM5 include reducing manufacturing support costs or customer support costs. To reduce SM5’s manufacturing support costs, Sanders can explore process improvements, for example, to reduce rework, setup times or material handling. To reduce customer support costs, Sanders might improve the ordering process to reduce reprocessing or time to process an order, or implement lower-cost alternatives for ordering (for example, electronically). Sanders might reduce post-sales support costs by improving instructions provided with the product. 7-29 For auto dealer service departments, the standardized hours facilitate quoting estimates for customers and provide a defensible basis for the estimates. The service department has discretion over the hourly rate, which includes labor and support costs. From the customer’s viewpoint, the standardized hours represent a reasonable amount of time for the requested service. If the technician takes longer than estimated, the customer will not pay for the extra time. Conversely, however, if the technician takes less time than estimated, the customer will pay for the estimated rather than the actual time. PROBLEMS

7-30 (a) Differentiating revenue with respect to P, we have:

Setting

, we and

obtain,

.

Therefore, .

7-31 (a)
Sales price Direct materials Direct labor Variable support Unit contribution margin Machine hours per unit Contribution margin per machine hour

XLl $10.00 (4.00) (2.00) (2.00) $2.00 0.20 $10.00

XL2 $14.00 (4.50) (3.00) (3.00) $3.50 0.35 $10.00

XL3 $12.00 (5.00) (2.50) (2.50) $2.00 0.25 $8.00

Products XLl and XL2 should be produced first because they have a higher contribution margin per machine hour. Maximum production of these two products requires 110,000 machine hours: XL1: 200,000 units × 0.20 machine hours = 40,000 machine hours XL2: 200,000 units × 0.35 machine hours = 70,000 machine hours 110,000 machine hours Therefore, a balance of 10,000 machine hours (= 120,000 – 110,000) are available for XL3 production, which is sufficient for 40,000 units of XL3 Optimal Production Levels: XL1: 200,000 units; XL2: 200,000 units, XL3: 40,000 units (b) Under the current capacity constraint, Excel Corporation cannot meet all of XL3’s demand. If additional capacity becomes available, it can produce more units of XL3. To determine whether it is worthwhile operating overtime, Excel needs to analyze the contribution margin of XL3 when operating overtime.

Sales price Direct materials Direct labor Variable support Unit contribution margin
@ 3.75 = 2.50 × 150%

XL3 $12.00 $5.00 3.75@ 2.50 11.25 $0.75

As unit contribution margin of XL3 using overtime is positive, it is worthwhile operating overtime. 7-32 (a) DLH required per unit of

. The new order requires , so the existing capacity is adequate. Contribution margin per unit of HCD2 for the new order . Change in profit . (b)
Sales price Variable cost: HCD1 $400 HCD2 $500

Direct material Direct labor Variable support Contribution margin per unit DLH per unit

$60 80 100 240 $160 4

$75 100 125 300 $200 5

Contribution per DLH

$40 per DLH

$40 per DLH

The new order requires a total of 1,500 DLH (= 5 × 300), but only 1,000 DLH (= 15,000 – 14,000) are available. This will leave capacity short for 500 DLH (= 1,500 – 1,000). Therefore, the change in profit is

(c) If the plant is worked overtime to manufacture HCD2 for the new order, the contribution margin is negative $12.50 as shown below:
Unit Variable Cost for Overtime 1 × 75 = $75.00 1.5 × 100 = 1.5 × 125 = 150.00 187.50 $412.50 400.00 $(12.50) Change in profit during 200 × 100 = 100 × (12.50) = $20,000 regular hours (1,250) overtime hours $18,750 (Increase)

Material Labor Var. Support Total Var. Cost Sales Price Contr. Margin

7-33 (a)
Direct material Direct labor Machine operations and maintenance Supervision Materials handling Quality control Machine setups Production cost per unit

Product A $12.00 9.00 4 × 0.4 = 1.60

Product B $15.00 15.00 4 × 0.7 = 2.80

Product C $18.00 20.00 4 × 0.9 = 3.60

9 × 0.20 = 1.80 15 × 0.20 = 3.00 20 × 0.20 = 4.00 4 × 0.75 = 3.00 120 × 0.02 = 2.40 300 × 0.01 = 3.00 $32.80 5 × 0.75 = 3.75 120 × 0.02 = 2.40 300 × 0.01 = 3.00 $44.95 7 × 0.75 = 5.25 120 × 0.05 = 6.00 300 × 0.02 = 6.00 $62.85

(b) Product A Product B Product C Production cost per unit Markup, 25% Target price $32.80 $8.20 $41.00 $44.95 $11.24 $56.19 $62.85 $15.71 $78.56

(c) Direct material Direct labor 1.5 * 9 = A $12.00

Products B $15.00

C

$18.00 30.00

13.50 1.5 * 15 =

22.50 1.5 * 20 =

Machine operations and maintenance 1.3 * 1.60 = Supervision Materials handling 1.3 * 1.80 = 1.3 * 3.00 =

2.08 1.3 * 2.80 = 2.34 1.3 * 3.00 = 3.90 1.3 * 3.75 = 3.12 1.3 * 2.40 = 3.90 1.3 * 3.00 = $40.84 $10.21 $51.05 0.4 10,000 4,000

3.64 1.3 * 3.60 = 3.90 1.3 * 4.00 = 4.88 1.3 * 5.25 = 3.12 1.3 * 6.00 = 3.90 1.3 * 6.00 = $56.94 $14.23 $71.17 0.7 5,000 3,500

4.68 5.20 6.83 7.80 7.80 $80.31 $20.08 $100.38 0.9 5,000 4,500 12,000

Quality control 1.3 * 2.40 = Machine setups 1.3 * 3.00 = Production cost per unit Markup, 25% Target price Machine hours per unit Actual 1999 production Machine hours for actual production Total hours Maximum demand at 1999 prices Machine hours for maximum demand

12,000 4,800

12,000 8,400

6,000 5,400

Total hours The company’s 1999 production used all available machine hours. If the company desires to increase production and sales, costs will increase for all units as the company increases capacity through use of overtime. The 1999 sales prices were roughly equal to the company’s target prices that are designed to cover nonmanufacturing support costs and desired profit. Although the company could have sold more units at 1999 prices, using overtime will increase unit costs to amounts that exceed 1999 sales prices for two products. In making the decision on overtime production, the company will need to assess the market demand for products A, B, and C at the desired prices. 7-34 (a)
Sales price per unit Variable cost per unit Direct material Direct labor Support Contribution margin per unit Machine hours per unit Contribution margin per MH ($12) (6) (2) $12  10  = 0.10   100  $120 ($10) (2) (1) $8  10  = 0.05   200  $160 “Large” $32 “Small” $21

18,600

(b) Small stuffed animals are more profitable to make under constrained capacity than the large stuffed animals.

“Large” MH required per batch Estimated number of batches Estimated MH required 10
³È a q r Lü L Ð ` ä À ³È a q r Lü L Ð ` ä À

“Small” 10

1,500

1,250

Since total machine hour capacity is adequate to fill the estimated demand for both large and small stuffed animals, Barney should produce 15,000 and 25,000 units of large and small stuffed animals, respectively. (c) Special order: Price per unit Variable cost per unit: ($12 + 6 + 2) Contribution margin per unit $37 20 $17

“Large” Contribution margin per batch $1,200 (= 100)

“Small” 12 × $1,600 (= 200) $160

Special Order 8 × $1,700 (= 17 × 100) $170

Contribution margin per MH $120

Based on contribution margin per MH, Barney should produce the special order first, then small stuffed animals and last, other large stuffed animals.

Total available MH MH required:
³ È` Lqr L ü äÐ a À ³ È` Lqr L ü äÐ a À

3,000

500 1,250 1,250

Special order
³Èa qr LüL Ð ` ä À ³Èa qr LüL Ð ` ä À

“Small” MH available for “Large” Number of “Large” that can be produced: Unfilled demand Opportunity cost
³Èaä r LüLq À ` Ð ³Èaä r LüLq À ` Ð

12,500 2,500 $30,000

³a LÐ ÈÀ ü ` r L ä q

³a LÐ ÈÀ ü ` r L ä q

2,500 × $12 CM per unit =

(d) Yes, Barney should accept the special order because the contribution margin obtained from this order is $85,000(= 17 × 5,000) which is greater than the opportunity cost of $30,000, resulting in a net increase in profit of $55,000. (e)
Total contr. margin Special order Small Large Total contr. margin
³a L r È ü `Ð L ä q À ³a L r È ü `Ð L ä q À
LÐ ³a È ` r ü L q ä À LÐ ³a È ` r ü L q ä À LÐ ³L ür È a ` À q ä LÐ ³L ür È a ` À q ä

Without Subcontract

With Subcontract

Difference

$0
@

45,000 30,000

$435,000

$420,000 ($15,000)

@ Total available MH

3,000

MH required: Special order regular “Large” Available MH for “Small” Number of “Small” produced: in-house subcontract $1. 20,000 5,000
³ È` L q r Lü äÐ a À ³ È` L q r Lü äÐ a À

(500) (1500 ) 1,000

 15,000    × 10 =  100 

Contribution margin on sub-contracted “Small” = $21 – $22 = – Barney should produce the special order of 5,000 large stuffed dinosaurs, 12,500 other large stuffed animals and 25,000 small stuffed animals. It should not contract for 5,000 small stuffed animals unless subcontract price is less than $21 per animal. Barney should also consider qualitative factors such as the quality of subcontracted stuffed animals and the reliability of subcontract delivery schedule.

7-35 (a) In order to produce 10,000 units of standard doors and 5,000 units of deluxe doors, the following number of direct labor hours and machine hours are required: Cutting:Direct labor hours: 0.5 × 10,000 + 1 × 5,000 = 10,000 > 8,000 capacity Machine hours: 2 × 10,000 + 3 × 5,000 = 35,000 < 40,000 capacity

Assembly: Direct labor hours: 1 × 10,000 + 1.5 × 5,000 = 17,500 = 17,500 capacity Machine hours: 2 × 10,000 + 3 × 5,000 = 35,000 < 40,000 capacity Finishing: Direct labor hours: 0.5 × 10,000 + 0.5 × 5,000 = 7,500 < 8,000 capacity Machine hours: 1 × 10,000 + 1.5 × 5,000 = 17,500 > 15,000 capacity Evidently, the direct labor hour capacity in the cutting department, and the machine hour capacity in the finishing department are not adequate to meet the next month’s demand. (b)
Sales price per unit Variable cost per unit Contribution margin per unit Contribution margin per DLH in the cutting department Contribution margin per MH in the finishing department Standard $150 110 $40 $80 $40 Deluxe $200 155 $45 $45 $30

Since the standard door has a higher contribution margin per unit of both scarce resources than the deluxe door, the following production plan is recommended in order to maximize profit: Standard door: 10,000 units; Deluxe door: 3,000 units@
@ Constraints on the number of deluxe doors that can be made in each production
³üq La r Èä À ` Ð L ³üq La r Èä À ` Ð L

department: Cutting: Finishing: units

units

(c) The following alternatives may be considered: 1. Expand plant capacity, add more machines in cutting than finishing. 2. Use overtime or add a second shift. 3. Subcontract cutting.

7-36 (a) To maximize monthly commissions while working 160 hours per month, Loren should devote the maximum allowable time (90 hours) to customer group B because that group provides the largest average commission per hour of Loren’s time. Loren should next allocate the maximum of 60 hours to customer group A because that group provides the next largest average commission per hour. Finally, Loren should devote the remaining of his 160 hours to group C. Customer Group A B C Average monthly sales per customer Commission Average commission Hours per customer per monthly visit Average commission per hour Current hours Hours per month $900 $600 $200 6% 5% 4% $54 $30 $8 3 $18 60 60 1.5 $20 90 90 0.5 $16 60 10 Total: 160 hours (40 hours per week)

(b) Loren should also consider the probable future increased profitability from customers in group C, as well as likely future profitability of customers in the other groups.
³ üäÀ LaÐ È q ` Lr ³ üäÀ LaÐ È q ` Lr

7-37 (a) DLH per unit = = 25 DLH The new order requires 1000 DLH (40 × 25), so the existing capacity is adequate. Contribution margin per unit = $2000 – (375 + 500 + 625) = $500 Change in profit = 40 units × $500 contribution margin

= $20,000 increase.

(b) Item Sales price Variable cost: Direct materials Direct labor Variable support Contribution margin per unit DLH per unit Contribution per DLH $300 400 500 L8011 $2000 $375 500 625 L8033 $2500

1200 $ 800 20 $40 per DLH

1500 $1000 25 $40 per DLH

The new order requires a total of 1500 DLH (25 × 60), but there are only 1000 DLH (14,000 – 13,000) available. This will leave capacity short for 500 DLH (1500 – 1000). Therefore, the company will face an opportunity cost of $40 per DLH (both products contribute $40 per DLH). Change in profit = Total contribution margin – opportunity cost = (60 units × $500 contribution per unit) – (500 DLH × $40 contribution per DLH) = $30,000 – $20,000 = $10,000 increase (c) If the plant is worked overtime to manufacture L8033 for the special order, the contribution margin per unit during overtime work is negative $62.50, as computed below: Contribution margin per unit Computation $375.00 750.00 937.50 $2062.50 2000.00 $(62.50) 1 × $375 1.5 × $500 1.5 × $625

Item Variable costs: Direct materials Direct labor Variable support Total variable costs Sales price Contribution margin

Therefore, the change in profit from accepting the special order and working the plant overtime is a net increase of $18,750, as detailed below: Special order production Regular hours Overtime hours Total increase CHALLENGING PROBLEMS 7-38 (Unofficial CMA Answer) (a) The minimum price per blanket that Marcus Fibers, Inc. could bid without reducing the company’s net income is $24.00 calculated as follows: Raw materials (6 lb. @ $1.50/lb.) Direct labor (0.25 hr. @ $7.00/hr.) Machine time ($10.00/blanket) Variable support (0.25 hr @ $3.00/hr.) Administrative cost ($2,500 ÷ 1,000) Minimum bid price $9.00 1.75 10.00 0.75 2.50 $24.00 Change in contribution margin $20,000 (1,250) $18,750

Computation 40 × $500 20 × $(62.50)

(b) Using the full cost criterion and the maximum allowable return specified, Marcus Fibers, Inc.’s bid price per blanket would be $29.90, calculated as follows:

Relevant costs from Requirement (a) Fixed support (0.25 hr @ $8.00/hr.) Subtotal Allowable return (0.15a * $26.00) Bid price
a

$24.00 2.00 26.00 3.90 $29.90

9% ÷ (1 – tax rate of 40%)

(c)

Factors that Marcus Fibers, Inc. should consider before deciding whether to submit a bid at the maximum acceptable price of $25.00 per blanket include the following:

The company should be sure there is sufficient excess capacity to fulfill the order and that no additional investment is necessary in facilities or equipment, which would increase the fixed expense. • If the order is accepted at $25.00 per blanket, there will be a $1.00 contribution per blanket to fixed costs. However, the company should consider whether there are other jobs that would make a greater contribution. • Acceptance of the order at a low price could cause problems with current customers who might demand a similar pricing arrangement. 7-39 (a) Direct materials cost per unit Direct labor cost per unit Total variable cost per unit
³L ü L ÐÀ È `a äq r ³L ü L ÐÀ È `a äq r

$3.80 10.00 $13.80 3.20 $17.00
A17 B23 XLT

Shipping cost per unit Minimum price that Holmes could offer (b)

Selling price per unit Variable cost of the basic component Direct materials cost per unit Direct labor costs per unit Total variable costs per unit Contribution margin per unit

$75.00 $13.80 — 9.00 $22.80 $52.20 A17 $52.20 0.3 $174.00

$120.00 $13.80 6.00 20.00 $39.80 $80.20 B23 $80.20 0.8 $100.25

$160.00 $13.80 4.50 31.00 $49.30 $110.70 XLT $110.70 1.05 $105.43

(c)
Contribution margin per unit Direct labor hours per unit Contribution margin per direct labor hour

Therefore, it is optimal to make only model A17 if there is sufficient demand. Contribution margin per unit of B23 at a price of $140.00 = $100.20 Contribution margin per direct labor hour for B23 = $125.25 Therefore, the above answer does not change if the price of model B23 is $140.

7-40 Unit cost of direct materials Unit cost of direct labor Unit
³ üä À L aÐ È q ` Lr ³ üä À L aÐ È q ` Lr

$9.80 4.50 support cost 3.00

variable

manufacturing

Unit variable selling
³`Ð Lq È r üÀ a L ä ³`Ð Lq È r üÀ a L ä

and administrative

cost

1.00 $18.30 100,000 $1,830,000

Unit relevant cost of the special order Number of units Total relevant cost of the special order

Total relevant costs of the special order ($1,830,000) are compared with the total revenue of $2,500,000 to be derived from this order. Therefore, Kirby Company should accept this special order from the customer. 7-41 (a) The unit cost relevant to determining the minimum selling price for the damaged units is the incremental cost that will be incurred. Hence, the relevant unit cost is the variable selling and distribution cost of $2.00. (b) The maximum amount per unit Purex Company should pay is the amount that Purex Company saves by not making the product.

Variable manufacturing costs
³q L È ü `À a L ä Ð r ³q L È ü `À a L ä Ð r ³a L r È ü `Ð L ä q À

$120,000 10,000 30,000 $160,000 ÷ 25,000 $6.40

Fixed support
Lr ³L È ü ` À a ä q Ð

³a L r È ü `Ð L ä q À

Variable selling and distribution costs
Lr ³L È ü ` À a ä q Ð

Total cost savings Number of units Cost savings per unit

(c) The incremental cost per unit includes all variable manufacturing costs and variable selling costs. Thus, the incremental cost per unit is . The minimum acceptable price is $5.80.
³Ð L È ü ` a L ä q À r ³Ð L È ü ` a L ä q À r

(d)
Selling price per unit Variable costs per unit Contribution margin per unit Machine hours per unit Contribution margin per machine hour

Kleen $10.00 6.80 $3.20 1.0 $3.20

Shine $16.00 11.00 $5.00 2.5 $2.00

Since the contribution margin per machine hour for Kleen is greater than that for Shine, Purex Company should produce as many units of Kleen as can be sold (80,000 units) to maximize total contribution margin. The remaining 20,000 hours of machine

³L ü L q r È ` äÐ a À

³L ü L q r È ` äÐ a À

time should be used to manufacture 8,000 units Shine.

of

7-42 (a)
R361: R572: P1(Casting) 30,000 × 1.2 = 36,000 10,000 × 2 = 20,000 P2(Machining) 72,000 × 1.2 = 86,400 48,000 × 2 = 96,000 182,400

Total machine hours required = 56,000
Lr ³L È ü a ` À ä q Ð

Note:

Lr ³L È ü a ` À ä q Ð

and

.

Capacity in Casting is adequate because 56,000 < 80,000. However, capacity in machining is not adequate because 182,400 > 120,000. (b)
Selling price per unit Variable cost per unit Contribution margin per unit R361 $19.00 15.67 $3.33 R361 $3.33 R572 $20.00 17.70 $2.30 R572 $2.30 48, 000 = 0.12 400, 000 $3. 33 = 23.11 0.144 600,000 units $2. 30 = 19.17 0.12 800,000 units

(c)
Contribution margin per unit
³ È LÐ L` ä r ü qÀ a ³ È LÐ L` ä r ü qÀ a

per unit Contribution margin per P2 − MH Estimated Demand

L ` qÀ ³ üäÐ ÈL r a

Note that cannot exceed 120,000 hours. Since contribution margin per for R361 is greater than contribution margin per for R572, Crimson should first produce as many units of R361 as possible. required to produce 600,000 units of R361

L ` qÀ ³ üäÐ ÈL r a

Next, available to produce R572 = 120,000 – 86,400 = 33,600 hours. By using 33,600 be produced are , the maximum number of R572 that can

Summary: Contribution margin per for R361 = $23.11 Contribution margin per for R572 = $19.17 Optimal production level for R361 = 600,000 units Optimal production level for R572 = 280,000 units (d) First, note that Crimson does not need to operate overtime in the Casting (PI) department because there is surplus capacity. Next, the demand of R361 can be filled without using overtime. Thus, to determine whether it is worthwhile operating machining (P ) department overtime, we need to consider only R572.
2

7-43 (a)
Selling price (per batch) Less variable cost (per batch): Direct material Direct labor @ Shipment @@ Contribution margin per batch DLH required per batch Batch contribution marginper DLH

Standard ($10 × 60) = $600

Deluxe ($20 × 30) = $600

($5 × 60) = 300 144 15 $141 12 $11.75

($11 × 30) = 330 120 45 $105 10 $10.50

³ üäÀ L aÐ È q ` Lr

³ üäÀ L aÐ È q ` Lr

Since the Standard model has a higher contribution margin per unit of the scarce resource (DLH) than the Deluxe model, Orion should produce the Standard model first and use the remaining DLH to manufacture the Deluxe model. The optimal production schedule is as follows: Standard = 6,000 units; Deluxe = 2,400 units Number of Deluxe model units that can be produced = 30 = 2,400 units ×

(b) Selling price (per batch) Less variable cost (per batch): Direct material
³ üL Ð L` är È aqÀ ³ üL Ð L` är È aqÀ

Deluxe (Northland’s offer) $925 (= $18.50 × 50)

550 (= $11 × 50) 180

Direct labor: Shipment: $15 × 1 Contribution margin per batch DLH required per batch Contribution margin per DLH 15 $180 15 $12

Orion should accept this offer because it offers a higher contribution margin per DLH than both the Regular and the Deluxe models. However, Orion should also consider other factors such as whether the Northlands arrangement will continue in the long-run, and how its regular customers will react to the lower price offered to Northlands.

7-44 (a)
³È LÐ L` ä r ü qÀ a

³È LÐ L` ä r ü qÀ a

Week 1 2 3 4 5 6 7 8 9 10 11 12 13 Average

v $8.1 8.1 8.1 8.1 8.1 8.1 8.1 8.1 8.1 8.1 8.1 8.1 8.1

b 500 500 500 500 500 500 500 500 500 500 500 500 500

at 8,200 8,350 8,600 8,500 8,400 8,850 8,300 8,050 8,200 8,800 8,350 7,950 8,650

Pt $12.25 12.40 14.95 14.85 14.75 15.20 12.35 12.10 12.25 15.15 12.40 12.00 15.00 13.51

PL $13.95 13.95 13.95 13.95 13.95 13.95 13.95 13.95 13.95 13.95 13.95 13.95 13.95 13.95

X 2,150 2,150 2,150 2,150 2,150 2,150 2,150 2,150 2,150 2,150 2,150 2,150 2,150

Qt 2,075 2,150 1,125 1,075 1,025 1,250 2,125 2,000 2,075 1,225 2,150 1,950 1,150

³ È aäÐ Lü Lq r ` À

³ È aäÐ Lü Lq r ` À

(b) Week 1 2 3 4 5 6 7 8 9 10 11 12 13
³ È` L Ð Lü ä r aq À

Revenue@ $25,418.75 26,660.00 16,818.75 15,963.75 15,118.75 19,000.00 26,243.75 24,200.00 25,418.75 18,558.75 26,660.00 23,400.00 17,250.00

Cost@@ $23,257.50 23,865.00 15,562.50 15,157.50 14,752.50 16,575.00 23,662.50 22,650.00 23,257.50 16,372.50 23,865.00 22,245.00 15,765.00

Profit@@@ $2,161.25 2,795.00 1,256.25 806.25 366.25 2,425.00 2,581.25 l,550.00 2,161.25 2,186.25 2,795.00 l,155.00 1,1485.00

³ È` L Ð Lü ä r aq À

@

@@

@@@ Revenue – Cost

7-45 (Unofficial CMA Answer) (a) The manufacturing support cost driver rate is $18.00 per standard direct labor hour and the standard product cost includes $9.00 of manufacturing support per pressure valve. Accordingly, the
q \ q \

standard direct labor hour per finished valve is hour ($9 ÷ $18). Therefore, 30,000 units per month would require 15,000 direct labor hours. (b) The incremental analysis of accepting the Glasgow Industries’ order of 120,000 units is presented below.
Per Unit Incremental revenue Incremental costs Variable costs Direct materials Direct labor Variable support Total variable costs 5.00 6.00 3.00 $14.00 600,000 720,000 360,000 1,680,000 $19.00 Totals for 120,000 units $2,280,000

Fixed support Supervisory and clerical costs (4 months @ $12,000) Total incremental costs Incremental profit before tax 48,000 1,728,000 $552,000

The following costs are irrelevant to the incremental analysis:
• • •

Shipping Sales Commission Fixed Manufacturing Support

(c) The minimum unit price that Sommers could accept without reducing its profits must cover variable costs plus the additional fixed costs. Variable unit costs Direct materials Direct labor Variable support Additional fixed cost ($48,000 ÷ 120,000) Minimum unit price $5.00 6.00 3.00 $14.00 0.40 $14.40

(d) Sommers Company should consider the following factors before accepting the Glasgow Industries order.

• •

The effect of the special order on Sommers’ sales at regular prices. The possibility of future sales to Glasgow Industries and the effects of participating in the international marketplace. The company’s relevant range of activity and whether the special order will cause volume to exceed this range. The impact on local, state and federal taxes. The effect on machinery or the scheduled maintenance of equipment.

• •

7-46 (Unofficial CMA Answer) (a) Bakker Industries will not be able to meet the monthly sales demand for the three products because of insufficient machine capacity in Department 1. However, there is sufficient capacity for both labor and machine hours in all other departments as shown below.
Bakker Industries Sales Demand vs. Machine and Labor Hour Capacities Departments 1 2 3 Machine hours needed (Hours * Demand) Product: 611 613 615 Total hours required Machine hours available Excess (Deficiency) Labor hours needed (Hours * Demand) Product: 611 613 615 Total hours required Labor hours available Excess (Deficiency) 1,000 400 2,000 3,400 3,700 300 1,500 800 2,000 4,300 4,500 200 1,500 — 1,000 2,500 2,750 250 500 800 1,000 2,300 2,600 300 1,000 400 2,000 3,400 3,000 (400) 500 400 2,000 2,900 3,100 200 1,000 — 1,000 2,000 2,700 700 1,000 800 1,000 2,800 3,300 500

4

(b) Bakker Industries has a scarce resource, machine hour capacity in Department 1. Therefore, the company should maximize contribution per machine hour in Department 1 in order to maximize overall profit, as calculated below.
Bakker Industries Contribution Maximization Calculation Calculation of contribution per machine hour: Product

611 Unit selling price Less variable costs Contribution per unit Machine hours in Department 1 Contribution per machine hour • $196.00 103.00 $93.00 2 $46.50

613 $123.00 73.00 $50.00 1 $50.00

615 $167.00 89.00 $78.00 2 $39.00

Use available machine capacity to maximize contribution per machine hour: Machine hours available in Department 1 Use 400 hours to produce 400 units of Product 613 3,000 400 2,600 Use 1,000 hours to produce 500 units of Product 611 1,000 1,600 Use remaining 1,600 hours to produce 800 units of Product 615 1,600

Contribution from this production schedule: Product 613 (400 × $50) Product 611 (500 × $93) Product 615 (800 × $78) Total contribution $20,000 46,500 62,400 $128,900

(c) Bakker might operate overtime, subcontract some of Department 1’s production to outside firms, or use labor from outside the community. 7-47 (Unofficial CMA Answer) In order to maximize the company’s profitability, Sportway, Inc. should purchase 9,000 tackle boxes from Maple Products, manufacture 17,500 skateboards and manufacture 1,000 tackle boxes. This combination of purchased and manufactured goods maximizes the contribution per direct labor hour available, as calculated below in Tables 1 and 2.
Table 1: Calculate unit contribution PurchasedTackleManufacturedTackle Skateboards Boxes Boxes Selling price Less: Variable costs Material Direct labor Manufacturing support* Selling & administrative cost** Contribution Direct labor hours per unit Contribution per hour 68.00 n/a n/a 4.00 $14.00 none n/a 17.00 18.75 6.25 11.00 $33.00 1.25 $26.40 12.50 7.50 2.50 3.00 $19.50 0.50 $39.00 $86.00 $86.00 $45.00

* Calculation of variable support cost per unit:

Tackle boxes: Direct labor hours Support costs/DLH Capacity Total support Total variable support Variable support per hour Variable support per box Skateboards: Direct labor hours Variable support = $7.50 ÷ $15.00 = .5 hours = $5.00 × .5 = $2.50 = $18.75 ÷ $15.00 = 1.25 hours = $12.50 ÷ 1.25 = $10.00 = 8,000 boxes × 1.25 = $10,000 hours = 10,000 hours × $10 = $100,000 = $100,000 – $50,000 = $50,000 = $50,000 ÷ 10,000 = $5.00 = $5.00 × 1.25 = $6.25

** For calculating contribution, $6.00 of fixed support cost per unit for distribution must be deducted from selling and administrative cost.

Table 2: Item Total hours Skateboards Make Boxes Buy Boxes Total Contribution

Optimal use of Sportway’s available direct labor Unit DLH Total Balance Total Quantity Contribution per Unit DLH of DLH Contribution 10,000 17,500 1,000 9,000 $19.50 33.00 14.00 0.50 1.25 — 8,750 1,250 — 1,250 — — $341,250 33,000 126,000 $500,250 264,000 $236,250

Less: Contribution for manufacturing 8,000 boxes (8,000 × $33.00) Improvement in contribution margin

7-48 (a)

Fixed costs of Process A: $36,000,000@ × 0.6 = $21,600,000 Fixed costs of Process B: $12,000,000@@ × (1.2 + 0.6) = $21,600,000 The total amount of fixed manufacturing support is common to both processes and does not change with different alternatives. Therefore, it is irrelevant to this analysis. The scarce resource is hours of capacity. The objective here is to maximize the contribution margin per hour.
@12,000,000 = 600,000 hrs _ $20 per hr. @@$36,000,000 = 600,000 hrs _ $60 per hr

Process A Output Selling price per unit Variable costs per unit: Transferred-in variable costs from Process A Direct material Direct labor Total variable costs per unit Contribution margin per unit Capacity hours per unit Contribution margin per capacity hour — 1.00 0.20 $1.20 $0.80
³ L È ü ` aL ä q Ð r À ³ L È ü ` aL ä q Ð r À

Process B Output $5.10

$2.00

1.20 1.50 0.40 $3.10 $2.00

$48.00

$40.00

Therefore, Process B output should be dropped and all facilities should be devoted to the sale of only Process A output. (b) Required contribution margin per capacity hour: Required capacity hours per unit: $48.00
³ L È ü ` aL ä q Ð r À ³ L È ü ` aL ä q Ð r À

Required contribution margin per unit : $2.40 Variable costs per unit: $3.10 Minimum required selling price of Process B output: $5.50

(c)For (a):
Process A Output Selling price per unit Variable costs per unit: Contribution margin per unit Capacity hours per unit Contribution margin per capacity hour
@$1.50 = $1.20 + 0.5 _$0.60 $.60)

Process B Output $5.10 4.00@@ $1.10 1 20 $22.00

$2.00 1.50@ $0.50 1 60 $30.00

@@$4.00 = $3.00 + .5 ($1.20 +

Therefore, the earlier answer to (a) does not change. For (b): Required contribution margin per capacity hour: Required capacity hour per unit: Required contribution margin per unit: Variable costs per unit Minimum required selling price of Product B Therefore, the earlier answer to (b) does not change. $30.00 1 20 $1.50 $4.00 $5.50

CASES 7-49 (a) Unit cost Dir. mat.: Chem. & Frag. Dir. mat.: AA 100 Dir. labor Var. mfg. support Total var. mfg. cost Total selling support Total variable cost Sales price Contr. margin per ton MH per ton Contribution margin per MH AA100 $560

AA101 $400 680 30 30 $1,140 30 $1,170 1,500 $330 6 hrs $55

AA102 $470 680 60 60 $1,270 30 $1,300 1,700 $400 8 hrs $50

60 60 $680 20 $700 940 $240 4 hrs $60

(b) AA100 has a higher contribution margin per MH than AA101 and A102. Aramis should produce AA100 up to 600 tons. Since the production of 600 tons of AA100 requires 2,400 MH (=600*4) which equals available capacity, no other products will be manufactured. Therefore, the optimal production levels are: AA100: 600 tons; AA101:0 tons; and AA102: 0 tons. (c) Opportunity cost is $60 per MH (the contribution margin per MH for AA100 production that must be sacrificed) and each ton of AA101 requires 6 MH.

Required contribution margin per ton (=$60*/6) Variable cost per ton Required minimum sales price per ton

$360 1,170 =$1,530

(d) It is worthwhile operating the plant overtime. The optimal production level is AA100: 600 tons; AA101: 100 tons; and AA102: 0 tons. Explanation: The regular capacity of 2,400 MH (before operating the plant overtime) is used to produce 600 tons of AA100. How should 600 MH of overtime be used? We know that the demand for AA100 has been filled fully. Therefore, we consider AA101 and AA102. Under overtime: Dir. mat.: Chem. & Frag. Dir. mat.: AAA100 Dir. labor Var. mfg. support Total var. mfg. cost Var. selling support Total variable cost Sales price Contr. margin per ton MH per ton Contr. margin per MH AA100 $560

AA101 $400 740 45 45 $1,230 30 $1,260 1,500 $240 6 $40

AA102 $470 740 90 90 $1,390 30 $1,420 1,700 $280 8 $35

90 90 $740 20 $760 940 $180 4 $45

Since contribution margins per MH for AA101 and AA102 are positive, it is worthwhile operating the plant overtime.

7-50 (a) Avoidable costs for 400 units of DLX: Direct material = $(80 + 20) * 400 = Direct labor = $(40 + 30) * 400 = Support: MNT@ QLC@@ Total cost 8,000 8,000 $84,000 $40,000 28,000

MNT@ Week 45: FC + VC*[450 * (2 + 1) + 430 * (3 + 2)] = $35,000 (1) Week 46: FC + VC*[450 * (2 + 1) + 450 * (3 + 2)] = $35,400 (2) Solving equations (1) and (2) simultaneously, we obtain VC = $4.00 per MH. QLC@@ Week 45: FC + VC*[450 * (0.5 + 0.5) + 430 * (1 + 1)] = $63,100 (3) Week 46: FC + VC*[450 * (0.5 + 0.5) + 450 * (1 + 1)] = $63,500 (4) Solving equations (3) and (4) simultaneously, we obtain VC = $10.00 per MH.

Since the total avoidable costs are more than the total subcontracting charges of $80,000 (=$200 * 400) under the French offer, it is profitable to accept the offer. Qualitative factors such as quality of purchased model and reliability of delivery schedule should also be considered in evaluating this offer. (b) Relevant costs include direct material costs, direct labor costs, and avoidable maintenance and inspection costs.

(c) From (a) above, we can determine the fixed costs for MNT and QLC as follows: MNT: FC = $21,000 QLC: FC = $50,000 Cost savings from capacity reduction: Expected total machine hours = 3,600 Expected total inspection hours = 1,350 MNT: $21,000 * [(3 + 2) * 400/3600] = $11,666.67 QLC: $50,000 * [(1 + 1) * 400/1350] = $29,629.63 Total cost savings: Direct material Direct labor MNT - VC MNT - FC QLC - VC QLC - FC Total cost savings $40,000.00 28,000.00 8,000.00 11,666.67 8,000.00 29,629.63 $125,296.30

It is profitable for Sweditrak to accept the long-term offer because the total cost savings are greater than the total subcontracting charges.

Chapter 7

Management Accounting and Control Systems for Strategic Purposes: Assessing Performance Over the Entire Value Chain
QUESTIONS 9-1 In the context of a management accounting and control system, control refers to the set of procedures, tools, performance measures, and systems that organizations use to guide and motivate all employees to achieve organizational objectives. 9-2 The text indicates five steps that are needed to keep the organization in control: (1) plan, which consists of developing the organization’s primary and secondary objectives and identifying the processes to accomplish them; (2) execute, which consists of implementing the plan; (3) monitor, which consists of measuring the system’s current level of performance;

(4) evaluate, which consists of comparing the system’s current level of performance to the objective to identify any variance between the system’s objective and actual performance; and (5) correct, which consists of taking any corrective action needed to return the system to being in control. 9-3 The two broad technical considerations that designers of management accounting and control systems must address are the relevancy of the information generated and the scope of the system. When addressing the relevancy of a management accounting and control system, designers should develop a system that provides information that is timely and accurate enough to be relevant and useful for decision making. The system should provide a consistent framework for the organization, in the sense that the language used and the methods of producing management accounting information do not conflict within various parts of the organization. Finally, employees should be able to use the system’s available information in a flexible manner, customized for the decisions at hand. The total life cycle costing approach is a comprehensive way for managers to understand and manage costs through a product’s design, development, manufacturing, marketing, distribution, maintenance, service, and disposal stages. The three major cycles of the total life cycle costing approach are (1) research development and engineering, (2) manufacturing, and (3) post-sale service and disposal. Committed costs are those that the organization agrees must be set aside (or committed) to cover product costs through the three major stages of the life cycle. Costs incurred are the actual costs that the organization has to pay out over the three major stages of the product life cycle. The three stages of the research development and engineering cycle are (1) using market research to assess emerging customer needs that lead to idea generation for new products, (2) product design, in which

9-4

9-5

9-6

9-7

9-8

scientists and engineers develop the technical aspects of the product, and (3) product development, in which the company creates the features critical to customer satisfaction and designs prototypes, production processes, and any special tooling required. 9-9 The post-sale service and disposal cycle is the last major cycle for the product. During this cycle, organizations have to consider both the costs involved in providing service to products as soon as they are in the hands of customers, as well as the costs of ultimately disposing of the product.

9-10 Target costing is a method of cost planning that focuses on reducing costs for products that require discrete manufacturing processes and reasonably short product life cycles. Target costing usually is used during the research development and engineering stage of the total life cycle of a product. 9-11 The two essential elements needed to arrive at a target cost are determining a target selling price and the target profit margin. The target cost is the difference between the two. 9-12 Value engineering is a process in which each component of a product is scrutinized to determine whether it is possible to reduce costs while maintaining functionality and performance. 9-13 Target costing is most applicable during the research development and engineering stage of the total life cycle of a product. 9-14 Cross-functional teams guide the target costing process. These teams may include, for example, representatives from the organization’s design engineering, manufacturing, management accounting, and marketing areas, as well as representatives from among suppliers, customers, distributors, and waste disposal. Supply chain management, which involves developing cooperative, mutually beneficial long-term relations between buyers and suppliers, plays a critical role in target costing when suppliers actively participate in resolving cost reduction problems. 9-15 Kaizen costing is a method to reduce the cost of a product through small, continuous improvements during the manufacturing stage of the total life cycle of a product.

9-16 A cost variance investigation is undertaken under Kaizen costing in order to compare actual cost reduction amounts to target Kaizen costs. Variance investigation occurs whenever this comparison is needed. 9-17 The Kaizen costing system operates outside of the standard costing system because the standard costing system is oriented to complying with Japanese financial accounting standards and not internal operations, per se.
A.

Explicit environmental costs include the direct costs of modifying technology and processes, costs of cleanup and disposal, costs of permits to operate a facility, fines levied by government agencies, and litigation fees. Implicit environmental costs often pertain to the infrastructure required to monitor environmental issues. Examples of implicit environmental costs include legal counsel, employee education and awareness, and the loss of goodwill if environmental disasters occur.

9-19 Benchmarking is a process in which organizations gather information concerning the best practices of others in order to meet or exceed the benchmark. Products, functions, processes, and strategies all can be benchmarked. 9-20 The five stages of benchmarking are (1) internal study and preliminary competitive analyses, (2) developing organizational commitment and coalescing the benchmarking team, (3) identifying benchmarking partners, (4) choosing information gathering and sharing methods, and (5) taking action to meet or exceed the benchmark. 9-21 The three broad classes of information on which firms interested in benchmarking can focus are (1) product—any type of product or service, (2) functional or process—all types of organizational activities from R&D, manufacturing to service, and (3) strategic—the variables on which the organization chooses to compete such as cost, quality, etc. Variables related to the design and functioning of the management accounting system fall under the strategic category.

9-22 The stage of the benchmarking process that is the most important for benchmarking management accounting methods is stage four, relating to information gathering and information sharing. 9-23 The two general methods are unilateral and cooperative information gathering and sharing. 9-24 The three types of information gathering and sharing under the cooperative form of benchmarking are database, indirect/third party, and group.

9-25 A “benchmarking (performance) gap” is the difference between how the organization is performing currently on a specific variable and how it desires to perform on that variable. 9-26 The mission statement becomes a basis for the organization’s accountability to those stakeholders. The notion “company’s value” is ambiguous—perhaps deliberately. It may be ambiguous because it is not expected to be taken seriously, or it may be ambiguous so that if it is taken seriously it makes no real commitment. The following interpretations might be made of “company’s value”: by customers— service, quality, and cost; by employees—competitive wages, good working conditions, and security; by shareholders—a competitive rate of return on investment; and by society—conformance to laws and progressive social activities, such as affirmative action. EXERCISES 9-27 When addressing the relevancy of a management accounting and control system, designers should develop a system that provides information that is timely and accurate enough to be relevant and useful for decision making. Information that is insufficiently accurate will lead to errors in evaluating profitability of cost objects and may lead to poor decisions. Timely information is important because the most accurate information that appears after evaluations or decisions are made is irrelevant with respect to those evaluations or decisions. The system should provide a consistent framework for the organization, in the sense that the language used and the methods of producing management accounting information do not conflict within various parts of the organization. For example, having two divisions with different costing systems makes it more difficult to understand and compare results across divisions. If one division of an organization uses activity-based costing principles and another division, especially one that is very similar in goals and function to the first, uses volume-based overhead allocation methods, the information system does not meet the consistency criterion. Finally, employees should be able to use the system’s available information in a flexible manner, customized for the decisions at hand. If the management accounting and control system cannot accommodate the specialized needs of each major user, users may develop ad hoc local

systems, which can lead to poor decisions or confusion in communications between the users and the rest of the organization. 9-28 Information technology (IT) personnel play an important role in the total life cycle of products or services that financial service firms offer. IT personnel bring expertise about feasibility or ideas for improvement in new product and service development involving technology-driven interaction with customers. IT personnel also ensure that technology-driven interaction remains as convenient and trouble-free as possible, both during the “sales” interactions with customers, and during post-sales interactions, such as maintaining accurate customer accounts and fielding inquiries or complaints. 9-29 The total life cycle costing approach differs from the traditional product costing in that it includes the research development and engineering, manufacturing, and post-sale service and disposal cycles. Traditional product costing is more narrowly focused and is concerned only with costs incurred during the manufacturing stage of the total product life cycle. 9-30 The benefits of using a total life cycle costing approach to product costing include providing managers with the “big picture” of managing costs over the research development and engineering; manufacturing; and post-sale service and disposal cycles. Such a perspective allows managers the opportunity to see how decisions made in one stage affect costs throughout the entire product life cycle. This perspective is not possible under the traditional product costing approach. 9-31 The traditional accounting focus in managing costs is on the manufacturing stage of the total life cycle of a product. The most significant problem with this focus is the traditional method ignores product costs before manufacturing (in the research development and engineering stage) as well as those that occur after manufacturing (in the post-sale and disposal stage). 9-32 Exhibit 9-2 illustrates the relationship between costs committed and costs incurred over the total life cycle of a product. The top curve, “cost committed,” shows how a very large percentage of costs (80– 85%) are assigned or committed to by an organization during the pre-

manufacturing (research development and engineering) stage of the total product life cycle. Costs continue to be committed up through the end of the life cycle, but these costs level off during the manufacturing and post-sale service and disposal stages. The bottom curve, “costs incurred,” illustrates the actual costs incurred by the organization over the various stages of the life cycle. Note that a small percentage of costs are incurred during the research

development and engineering stage, but these costs increase significantly during the manufacturing and post-sale service and disposal stages. 9-33 The disposal phase of the post-sale and disposal cycle of a product begins when the first unit of product is retired by the customer and ends when the last unit of product is retired. Disposal costs are most relevant when an organization has to eliminate any harmful effects associated with the end of a product’s life. 9-34 Target costing differs from traditional cost reduction methods through the process by which costs are determined. Under traditional cost reduction, after market research to determine customer requirements and product specification, engineers and designers determine product design, then the cost to produce the product. If the estimated cost is too high, then it may be necessary to modify the product design. The desired profit margin is found by subtracting the estimated cost from the expected selling price. Target costing begins in approximately the same way with market research to determine customer requirements and product specification. From this point on, procedures are quite different. The next step under target costing is to determine the target selling price and target product volume. Then the target profit margin is determined. The target cost is the difference between the target selling price and target profit margin. 9-35 The target costing relationship is expressed in the following equation form: C = S − P , where C is the target cost, S is the target selling price, and P is the target profit margin. This equation differs from the other two types of traditional equations relating to cost reduction in the following ways. The first traditional cost reduction method is expressed as follows: P = S − C . The desired profit margin, P, is found by subtracting the estimated cost, C, from the expected selling price, S. The second traditional approach, known as the cost-plus method, expresses the relationship among variables as S = C + P . Under cost-plus, an expected profit margin is added to the expected product cost. Price is simply the result of the sum of these two variables.

9-36 The relationship between value engineering and target costing is as follows. Once a target cost has been set, the organization must determine target costs for each component. Value engineering is used to examine each component of a product to determine whether it is possible to reduce costs while maintaining functionality and performance. 9-37 Return on sales is the most widely used profitability measure to develop the target profit margin under target costing. 9-38 Some of the potential problems in implementing a target costing system from a behavioral point of view are: (a) conflicts that arise between parties involved in the target costing process, (e.g., the conflict that arises between suppliers and the target costing organization when too much pressure is placed on suppliers to cut their costs), and (b) burnout among employees. 9-39 Exhibit 9-7 illustrates the comparison between Kaizen costing and standard costing. The major differences are the overriding concepts of cost reduction and continuous improvement in manufacturing; revision of cost reduction targets monthly; the use of cost variance analysis to compare target costs versus actual costs; and the assumption that workers have the best knowledge to reduce costs. Standard costing uses a cost control system concept and assumes stability in current manufacturing processes. Standards are set annually or semiannually and cost variance analysis is used to compare actual to standard costs. The assumption is that managers and engineers have the best knowledge to develop standards as they have the technical expertise. 9-40 The major differences between target costing and Kaizen costing are that target costing is focused at the research development and engineering stage of the total product life cycle, whereas Kaizen costing is aimed at the manufacturing stage. Target costing also may call for extremely large reductions in cost, while Kaizen costing, by definition, looks at smaller incremental improvements in reducing costs.

9-41 According to the Kaizen costing approach, workers have the best knowledge to reduce costs. The reason is that workers are much closer to the production process and have far more detailed knowledge and insight than engineers and managers.

9-42 Kaizen is the Japanese term for making improvements to a process through small, incremental amounts, rather than through large innovations. Kaizen costing is a method to reduce costs through small, continuous improvements. Kaizen costing is most applicable during the manufacturing stage of the total life cycle of a product. Manufacturers use target costing during the research development and engineering stage to make their most significant cost reduction gains, and use Kaizen costing during the manufacturing stage to make smaller incremental gains. The rationale for this is that trying to make enormous changes to a product during the manufacturing stage will result in enormous costs for the manufacturing organization. 9-43 If the cost of disruptions to production is greater than the savings due to Kaizen costing, then the cost savings due to Kaizen costing will not be applied. 9-44 Environmental costs include explicit costs, such as the direct costs of modifying technology and processes, costs of cleanup and disposal, costs for permits to operate a facility, fines levied by government agencies and litigation fees. Implicit environmental costs are often more closely tied to the infrastructure required to monitor environmental issues. These costs include administration and legal counsel, employee education and awareness, and the loss of goodwill if environmental disasters occur. Using traditional cost systems, environmental-related costs are often hard to pinpoint because they are usually hidden in support cost pools. To use activity-based costing to help control and reduce environmental costs, the activities that cause environmental costs must be identified. Next, the costs associated with the activities must be determined. These costs must then be assigned to the most appropriate products, distribution channels and customers. As in all types of management accounting and control systems, it is only when managers and employees become aware of how the activities in which they engage generate environmental costs that they can control and reduce them.

9-45 The key factors in identifying benchmarking partners are the size of partners, the number of partners, the relative position of partners within and across industries, and the degree of trust among partners. Choices on each of these variables will change from one benchmarking study to the next. 9-46 A manager asked to benchmark another organization’s target costing system would want information pertaining to the method by which target prices and target costs are set, supplier relations, how the organization uses value engineering, and the organizational structure and culture needed to manage the target costing process. While these are critical variables on which to gather information, target costing always has to be studied and understood in relation to the specific organization involved. PROBLEMS Fundamental Problems 9-47 The traditional focus of cost management has been only on manufacturing processes. Under this approach, pre-manufacturing costs, such as research and development, and post-manufacturing costs, such as service, are considered period costs, and companies expense them in the period incurred. Thus, these costs are in no way linked to individual products. Traditional accounting procedures and the way that many organizations have been separated by department or function (e.g., design engineering, manufacturing, marketing, logistics, installation and postal service), often lead managers to focus myopically on their own department’s costs. In particular, for the manufacturing function, defining product costs as those solely related to the manufacturing process ignores many costs associated with the entire life cycle cost of a product. Understanding the total life cycle costs (TLCC) of a product or service, or the product costs incurred before, during, and after the manufacturing cycle is critical, as decision makers can more completely analyze and understand what creates product costs. For example, if a company can reduce a product’s design and development costs at the pre-manufacturing stage, it also is possible to reduce all other subsequent product-related (downstream) costs such

as manufacturing and service-related costs. A TLCC system provides information for managers to understand and manage costs through a product’s design, development, manufacturing, marketing, distribution,

maintenance, service, and disposal stages. The total life approach is also known as managing costs “from the cradle to the grave.” 9-48 Deron Grimes is shortsighted. The manufacturing cycle of the total life cycle costing approach is only one of three major stages of the product life cycle concept. The other life cycle concepts are research development and engineering, and post-sale service and disposal. While each concept is useful within its respective functional area, from a total life cycle costing (TLCC) perspective, it is important to integrate the concepts and to understand them in their entirety. Such integration allows managers to see the big picture and to manage whole-life product costs in a comprehensive fashion. For example, poor decisions in the research development and engineering stage may lead to much higher costs in the manufacturing and post-sale service stages. Thus, it is in Deron’s best interest to understand what is occurring in the research development and engineering stage. In order for managers at Deron’s company to fully adopt the TLCC view, it will probably be necessary to break down what are called “functional silos.” Functional silos are traditional parts of organizations that are often thought (by those in them) to be selfcontained. Breaking these down often means reorganizing the company into cross-functional teams who share a vision of integration across their previous functions. Another critical aspect to understanding the importance of the TLCC perspective is management education. The company should consider educational programs in which their managers can learn about the benefits of the TLCC perspective. 9-49 The target cost for a Calcutron calculator is computed as follows: $37,500,000 Target Sales (500,000 pens × $75) 5,625,000 Less: Target Profit (15% × $75/calculator × 500,000 calculators) Target Cost for 500,000 calculators $31,875,000 Unit target cost ($31,875,000/500,000 calculators) $ 63.75

9-50 To compute the return on sales for Bill Mann, it is necessary to determine Bill’s profit margin: Sales (300,000 units × $500) Less: Expenses = Profit Margin (ROS × Sales) $150,000,000 90,000,000 $60,000,000

ROS × $150,000,000 = $60,000,000, so ROS = 40%. Thus, Bill Mann has not met the company-wide return-on-sales target of 45%. Assuming Bill’s initial target costs and target sales prices were consistent with the company-wide return-on-sales target, Bill should explain the causes for below-target performance. Potential problem areas include manufacturing costs and misestimation of customer demand for the products’ functionality at the target prices. Evaluating whether Bill has done a good or poor job will involve determining the extent to which Bill could control cost, and evaluating Bill’s judgment in setting prices. 9-51 Some studies of target costing in Japan indicate that there are potential problems in implementing the system, especially if focusing on meeting the target cost diverts attention away from other elements of overall company goals. Three of these potential problems are: (1) Conflicts can arise between various parties involved in the target costing process. First, companies can put excessive pressure on subcontractors/suppliers to conform to the schedule and to reduce their costs. This can lead to alienation and/or failure of the subcontractor. Second, design engineers become very upset when other parts of the organization are not as cost conscious as they are. Since they work very hard to squeeze pennies out of the cost of a product, they think that other parts of the organization (administration, marketing, distribution) should also be as cost conscious. Often this is not the case. To overcome this problem, pressure can be reduced on subcontractors/suppliers by giving them reasonable grace periods over which cost reduction must occur. Simply demanding cost

reduction immediately will exacerbate the conflict. The issue of design engineers also can be addressed by making other parts of the organization as cost

conscious. Adopting a total life cycle costing approach will help the organization to this end. (2) Employees in many Japanese companies working under target costing goals experience burnout due to the pressure to meet the target cost. Burnout is particularly evident for design engineers. This issue can be addressed by making target-costing goals tight, but attainable. Often organizations make the mistake of setting impossible goals. Design engineers also often fear that if they make the target, in the next period, the target will be “ratcheted up” and made even more difficult to achieve. Thus, they may consciously try to make sure that they do not achieve the target unless their jobs rest on it. The organization has to be careful not to burn out employees, and design engineers in particular, as they are extremely valuable to the organization. Burnout is probably the biggest issue related to the success or failure of target costing in Japan. (3) While the target cost may be met, there may be increased development time because of repeated value engineering cycles to reduce costs, which ultimately can lead to the product being late getting to market. For some types of products, being six months late to market may be far more costly than having small cost overruns. This is a very serious problem for the organization. Clearly, there is a tradeoff between continuing to reduce target costs and being very late to market. However, on average, many months of lost sales will have a much more detrimental effect on the organization than whether target costs are met. Thus, the organization has to take a reasonable approach to target costing and not lose sight of the ultimate goal of selling the product and increasing market share. 9-52 There are some similarities between traditional cost reduction and target costing, but the differences are more striking. Both the traditional costing method and target costing begin with market research into customer requirements followed by product specification. Under traditional cost reduction, companies engage in product design and engineering, and obtain prices from suppliers.

Product cost at this stage is not a significant factor for product design. After the engineers and designers have determined product design, they estimate product cost and if the estimated cost is too high, then product design may have to change. The desired profit margin is found by subtracting the estimated cost from the expected selling price. Profit margin is the result of the difference between the expected selling price and the estimated production cost. Under another traditional method, cost-plus, the expected profit margin is added to the expected product cost and selling price is the result of the sum of these two variables. Under target costing, after market research to determine customer requirements and product specification, the process is quite different. The next step, determining a target selling price and target product volume, depends on the company’s perceived value of the product to the customer. The target profit margin results from a long-run profit analysis, often based on return on sales (net income/sales). The target cost is the difference between the target selling price and the target profit margin. Once the target cost is set, the company must determine target costs for each component. The value engineering process includes examination of each component of a product to determine whether it is possible to reduce costs while maintaining functionality and performance. In some cases, product design might change, materials used in production might need replacing, or manufacturing processes might require being redesigned. Suppliers also play a critical role in making target costing work. If manufacturers with market power decide that there is a need to reduce the cost of specific components, they will pressure suppliers to find ways to reduce costs. 9-53 (a) The biggest problem with Kaizen costing is similar to the one that faces target costing, and that is the system places enormous pressure on employees to reduce every conceivable cost. The results of this pressure are internal conflicts among various parties and a great deal of employee burnout. (b) To address the problem, some Japanese automobile companies use a grace period in manufacturing just before a new model is introduced. This period, called a cost sustainment period, provides

employees with the opportunity to learn any new procedures before the company imposes Kaizen and target costs on them. Another solution relates to the kinds of penalties that employees face as a result of not attaining cost targets. In Japan, for those employees with lifetime employment, there is virtually no chance of losing one’s job, however, there are “social penalties” such as loss of face, letting down the company, etc., associated with not achieving targets. In the United States the threat of job loss is much more salient. The last thing that U.S. managers would want to do is to threaten job loss to those who did not achieve targets. This would simply

exacerbate the problem. In the final analysis, Kaizen costing has to be understood as a tool for change, but not as a hammer. 9-54 Bringing in outside consultants to implement a target costing system can be effective, but costly. Consultants often have a great deal of knowledge that they can bring to an organization and in this sense the organization does not have to “start from scratch.” A downside of using consultants is that, in some instances, consultants want to use an existing template for implementing a new method, such as target costing. The template is often designed generically and is meant to be superimposed on any organization. Some organizations object to this and want a more tailored approach, especially if they are in an industry in which the consultants have not worked at all. Consultants may agree to tailor the approach, but the cost of implementation of a target costing system will increase significantly. A second downside is that many organizational members may not be involved with implementing the changes. Thus, they may simply rely on what the consultants do. If organizational members do not understand what the consultants have done or how the system works, then the system will likely fail after the consultants leave. A second approach is for organizational members to develop a target costing system internally with little or no assistance from outside consultants. This approach can be satisfying, but it can be costly and time-consuming, especially if the organization has little experience in implementing these types of systems. The positive side of this is that organizational members may get more of a “buy-in” to the new method because they have to understand it well to convince others of the need to implement it. Once organizational members know that they can develop these systems themselves, they may be more confident in the future regarding the implementation of other organizational innovations. The third approach, known as benchmarking, requires that organizational members first understand their current cost reduction methods and then look externally to the best target costing systems of other organizations for guidance on change. Benchmarking is often highly cost-effective since organizations can save time and money avoiding the mistakes that other companies have made or by avoiding reinventing a process or method that other companies have already

developed and tested. Benchmarking allows organizations to gain insights on target costing from others, but at the same time to assume responsibility for the changes. In this way, organizational members feel like they have ownership of the changes and this can lead to developing more confidence about future changes and improvements to their management accounting system. 9-55 The answer to this question is very similar to the solution for 9-52 but it is more detailed. The process involved in traditional cost reduction as practiced in the United States is significantly different from target costing. The traditional costing method begins with market research into customer requirements followed by product specification. Then, companies engage in product design and engineering, and they obtain prices from suppliers. Traditionally, at this stage, product cost is not a significant factor for product design. After the engineers and designers have determined product design, they estimate product cost (Ct ) , where the t subscript indicates numbers derived under traditional thinking. If the estimated cost is considered to be too high, then it might be necessary to modify product design. In order to find the desired profit margin ( Pt ) , it is necessary to subtract the estimated cost from the expected selling price ( St ) . The profit margin is the result of the difference between the expected selling price and the estimated production cost. This relationship in the traditional system is expressed as: Pt = St − Ct . Another widely used traditional approach is the cost-plus method. Under cost-plus, an expected profit margin Pcp is added to the expected product cost Ccp where the subscript cp indicates numbers derived under cost-plus thinking. Selling price Scp, then, is simply the result of the sum of these two variables. In equation form, this relationship for the cost-plus approach is: Scp = Ccp + Pcp . As in the first traditional method described above, product designers do not attempt to achieve a particular cost target. Under target costing, both the sequence of steps and way of thinking about determining product costs differ significantly from traditional costing. The first two steps, market research to determine customer requirements and product specification, are similar to traditional

costing. After these initial steps, the process is quite different. The next step, determining a target selling price ( Stc ) and target product volume, depends on the company’s perceived value of the product to the customer. The target profit margin ( Ptc ) results from a long-run profit analysis, often based on return on sales (net income/sales). Return on sales is the most widely used measure, as it can be linked most closely to profitability for each product. The target cost

(Ctc ) is the difference between the target selling price and the target profit margin. Note that the tc subscript indicates numbers derived under the target costing approach. This relationship for the target costing approach is shown in the following equation: Ctc = Stc − Ptc . Once the target cost is set, the company must determine target costs for each component. The value engineering process includes examination of each component of a product to determine whether it is possible to reduce costs while maintaining functionality and performance. In some cases, product design might change, materials used in production might need replacing, or manufacturing processes might require redesign. For example, a product design change might involve using fewer parts or reducing specialty parts if the company can use more common components. Several iterations of value engineering usually are required before it is possible to determine the final target cost. Suppliers also play a critical role in making target costing work. If manufacturers with market power decide that there is a need to reduce the cost of specific components, they will pressure suppliers to find ways to reduce costs. Companies such as Toyota and Nissan might, in some cases, offer incentive plans to suppliers who come up with the best cost reduction ideas. 9-56 (a) In theory there is no reason to assume that target costing, or at least parts of it, cannot be applied to service organizations. However, the method was developed for products requiring discrete manufacturing processes and short product life cycles. In a bank, products (or services, depending on how you look at it) would include checking accounts, savings accounts, all types of loans, etc. The bank could follow the steps outlined in Exhibit 9-4 and do market research to determine customer requirements and product specification. Customer requirements would include the desired interest rate on a checking account, the level of attention needed to open these accounts, the choices for colors and designs on checks, etc. Next, the “target selling price” or the cost to the customer of opening and maintaining the checking account would be determined as well as the target volume or the number of checking accounts that the company desires to service. The target profit margin would have to be determined based on calculations related to the amount of income earned from customer accounts. The

target cost then would be the difference between the target selling price and the target profit margin.

(b)

The following approach can be used. Using the five-stage benchmarking model below, the instructor may wish to select various approaches beginning with the choice of variables in Stage 3 and continuing into Stage 4 for different members of the class and then have them compare the plans that they devise. For instance, in Stage 3 you might ask some students to devise a plan for benchmarking organizations within the banking industry and for those outside of banking. Some might be asked to benchmark with many partners and some with few. For Stage 4 the methods of information gathering and sharing can be varied. Some students can be assigned the unilateral form of benchmarking, while others can be assigned one of the three forms of cooperative benchmarking. What are the implications of each? Also, students need to determine the performance measures that they will use and a time frame over which the study will occur. This can be a very interesting and informative exercise for students. Stage 1: Internal study and preliminary competitive analyses Preliminary internal and external competitive analyses Determining key areas for study Determining scope and significance of the study Stage 2: Developing long-term commitment to the benchmarking project Gaining senior management support Developing a clear set of objectives Empowering employees to make change Coalescing the benchmarking team Using an experienced coordinator Training employees Stage 3: Identifying benchmarking partners Size of partners Number of partners Relative position within and across industries Degree of trust among partners

Stage 4: Information gathering and sharing methods Type of benchmarking information: Product Functional (Process) Strategic (includes management accounting methods) Method of information collection: Unilateral Cooperative: Database Indirect/third party Group Determining performance measures Determining the benchmarking performance gap in relation to performance measures Stage 5: Taking action to meet or exceed the benchmark Making comparisons of performance measures Challenging Problems 9-57 The Kaizen costing system differs from a traditional standard costing system. Under the traditional standard costing system, the typical goal is to meet the cost standard while avoiding unfavorable variances. With Kaizen costing, the goal is to achieve cost reduction targets. Further, variance analysis under a standard cost system usually compares actual to standard costs, while under Kaizen costing, variance analysis compares target Kaizen costs with actual cost reduction amounts. Kaizen costing, then, operates outside of the standard costing system, in part because standard costing systems in Japan are oriented towards complying with financial accounting standards. Another key difference between standard and Kaizen costing has to do with the assumptions about who has the best knowledge to improve processes and reduce costs. Traditional standard costing assumes

that engineers and managers know best since they have the technical expertise. Thus they determine procedures that workers are required to perform according to pre-set standards and procedures. Under Kaizen costing, workers are assumed

to have superior knowledge about how to improve processes since they actually work with manufacturing processes to produce products. Thus, one of the central goals of Kaizen costing is to give workers the responsibility to improve processes and reduce costs. Thus, the standard costing system and the Kaizen costing system are used for very different purposes. The standard costing system is used for financial reporting purposes while the Kaizen costing system is used for cost management. The systems do coexist, although many believe that there is really no need for both systems, especially if the financial reporting system was modified to accommodate Kaizen costing. 9-58 (a) The Kaizen costing system differs quite significantly from a traditional standard costing system and there are few similarities. Under the traditional standard costing system, the typical goal is to meet the cost standard while avoiding unfavorable variances. With Kaizen costing, the goal is to achieve cost reduction targets. Variance analysis under a standard cost system compares actual to standard costs, while under Kaizen costing, variance analysis is used to compare target Kaizen costs with actual cost reduction amounts. Kaizen costing is not really part of the standard costing system because, in Japan, standard costing systems are used primarily for compliance financial accounting standards and financial reporting purposes. Another difference between standard and Kaizen costing is that, under traditional standard costing, engineers and managers are assumed to have the best information about how to reduce costs since they design and manage processes. However, under Kaizen costing, workers are assumed to have superior knowledge about how to improve processes since they actually work with manufacturing processes to produce products, and one of the central goals of Kaizen costing is to give workers the responsibility to improve processes and reduce costs. (b) Kaizen costing can be adapted in the United States in those companies that (1) see the benefits of the costing method, (2) have a willingness to change their existing thinking about the role of standard costing versus Kaizen costing, and (3) will rely more on

the input of workers and managers to improve processes and reduce costs. As in the adoption of all management innovations, being open to significant cultural change is

what will allow U.S. organizations to embrace and be successful with Kaizen costing. 9-59 The first thing that the student should do is determine what definition to follow regarding who the “best” student is. The definition could vary depending on whether “best” was defined as the one who consistently scores the highest on exams, or perhaps, the one who seemed to provide the most intelligent answers to questions in class, etc. The latter definition is the one that may be the most desirable in the long run (as a good test taker may not always be a successful decision maker), but also the hardest to try to emulate, as there may be a level of innate intelligence that cannot be “learned.” In order to do the exercise, let’s use the definition of best as the one who scores the highest on exams and assume that the student is trying to benchmark the study habits of the best student. The student should ask the best student questions like the following: 1. What procedures do you go through when you study? a. What methods do you use to take and review notes? b. What methods do you use to remember details? c. How many times do you read assigned materials? d. Do you do extra assignments that are not required? e. Do you study alone or with friends? f. Do you have any “secrets” to studying? g. How do you organize your notes? 2. Where do you study? (At home, in the library, etc.) 3. How do you decide what times of day are most effective for studying? 4. What mix of leisure and work activities do you have? 5. How many hours a day do you devote to each subject? 6. Do you make good use of an instructor’s office hours? 7. How do you review for an upcoming exam? 8. What tips do you have for taking the actual exam? Implementing some or all of these changes will take time especially if the other students’ habits are very different from what the student currently does. One suggestion is to start by implementing one or two suggestions at a time and to gradually implement more once the initial suggestions have been mastered. The implementation will probably fail if the student tries to simultaneously change on all dimensions.

Obviously, this exercise is designed to illustrate to the student how difficult personal change is and this should be a nice lead in how complex organizational change is. 9-60 The instructor should: 1. Make sure that students have done their homework what the organization that they are going into produces and any other important background information. 2. Make sure that students have read the material in the text on benchmarking and understand the five stages of benchmarking, which are: Stage 1: Internal study and preliminary competitive analyses Preliminary internal and external competitive analyses Determining key areas for study Determining the scope and significance of the study Stage 2: Developing long-term commitment to the benchmarking project Gaining senior management support Developing a clear set of objectives Empowering employees to make change Coalescing the benchmarking team Using an experienced coordinator Training employees Stage 3: Identifying benchmarking partners Size of partners Number of partners Relative position within and across industries Degree of trust among partners Stage 4: Information gathering and sharing methods

Type of benchmarking information: Product Functional (process) Strategic (includes management accounting methods) Method of information collection: Unilateral Cooperative: Database Indirect/third party Group Determining performance measures Determining the benchmarking performance gap in relation to performance measures Stage 5: Taking action to meet or exceed the benchmark Making comparisons of performance measures 3. In relation to the five stages listed above, ask students to determine a series of structured and unstructured interview questions for which they would like answers. Students should also be instructed to write down their observations of the facility and the people involved in the benchmarking project. Developing good questions and recording direct observations will help students write their report. 4. The instructor might also ask students what criteria they will use to decide whether benchmarking was successful. For a short exercise like this, students will probably have to rely on what their interviewees tell them. It is unlikely that the organization will volunteer to show them actual company data to illustrate the effects of such a change. Discussing the need to rely on what interviewees say should lead naturally to discussing how one goes about determining the effects of management accounting methods on organizations. Such a discussion could include the difficulty in getting proprietary company records, how to design good

interviews, and the role of direct observation in trying to assess how well an organizational change has been implemented.

CASES
9-61 (a) Direct costs (material plus labor) Unit-level support Batch-level support Product-level support Facility-level support Total support Total machine hours Number of units Plantwide rate: Total support ÷ machine hours Pricing using plantwide rate Direct costs (material plus labor) $ 9,000,000 $ 4,000,000 Applied support: $4.13 per machine hour 41,250,000 24,750,000 Total costs $50,250,000 $28,750,000 Number of units 100,000,000 40,000,000 Cost per unit using plantwide rate $0.50 $0.72 (b) Direct costs (material plus labor) Unit-level support Batch-level support Product-level support Facility-level support Total support Total costs Number of units Cost per unit using ABC Per unit Product X Product Y X Y $ 9,000,000 $ 4,000,000 $0.09 $0.10 $ 2,000,000 15,000,000 5,000,000 1,000,000 $23,000,000 $ 1,000,000 20,000,000 20,000,000 2,000,000 $43,000,000 0.02 0.15 0.05 0.01 $0.23 0.03 0.50 0.50 0.05 $1.08 Product X Product Y $ 9,000,000 $ 4,000,000 Plantwide Rate

2,000,000 1,000,000 15,000,000 20,000,000 5,000,000 20,000,000 1,000,000 2,000,000 $23,000,000 $43,000,000 $66,000,000 10,000,000 6,000,000 16,000,000 100,000,000 40,000,000 $4.13

$32,000,000 $47,000,000 100,000,000 40,000,000 $0.32 $1.18

(c)As shown in part (b), product Y’s support costs per unit are higher in each support category than product X’s. Although some of the cost differences per unit may result from special features that contribute to product Y’s superiority, some of product Y’s higher costs clearly result from generation of hazardous wastes that product X does not generate. Costs can be disaggregated further to highlight the costs associated with hazardous wastes as input to the decision on whether to seek a process that reduces or eliminates hazardous wastes. (d) Cost per unit using plantwide rate Price, 1.5 × cost Cost per unit using ABC Price, 1.5 × cost Product X Product Y $0.50 $0.72 $0.75 $1.08 $0.32 $0.48 $1.18 $1.76

Of the two costing systems here, the activity-based costing system more accurately assigns costs of resource usage to the two products. The cost system based on a plantwide rate results in product X essentially subsidizing product Y. Product Y’s price under this system does not even cover the product’s reported activity-based costing costs. Consequently, the company should evaluate a price increase or ways to decrease product-related costs. The company can use the activity-based costing driver rates as a starting point for potential manufacturing cost reductions. Also, as stated in part (c), the company may be able to reduce product Y’s costs by using a process that reduces or eliminates hazardous wastes. Product X’s price could be reduced and still generate a profit. In making such a decision, the company would evaluate expected changes in demand (if any) if product X’s price were reduced. 9-62 (a) Pat Polley has listed or expressed concern about a number of explicit and implicit environmental costs. Explicit environmental costs include: The net cost of purchasing and installing the new equipment Cost of removing the old equipment

Insurance for the equipment and the workers Storage and disposal costs for hazardous wastes

Legal fees related to hazardous waste liabilities Risk of OSHA fines Risk of liability due to accidental leakage Implicit environmental costs include: Negative media coverage that will reduce demand (b) Other environmental costs include: Training workers on handling hazardous wastes Monitoring hazardous wastes Filing reports on hazardous wastes Possible productivity problems because of poor worker morale due to hazardous work environment Poor worker health or increased absenteeism because of exposure to hazardous wastes Risk of liability due to increasingly stringent laws Cost for permits related to hazardous waste (c) Kwik Clean faces a variety of environmental costs, including storage and disposal costs for hazardous wastes, legal fees, training costs, insurance, permit costs, and monitoring costs. Using traditional cost systems, environmental-related costs are often hard to pinpoint because they are usually hidden in support cost pools, often one general support cost pool. Activity-based costing can help control and reduce environmental costs because it identifies process activities, including activities that cause environmental costs. Next, the costs associated with the activities are determined. These costs are then assigned to the most appropriate products or services. Awareness of how Kwik Clean’s activities generate environmental costs, as well as awareness of the magnitude of the costs, establish a starting point for controlling and reducing them.

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