CHAPTER FOUR

ACTIVITY-BASED COSTING AND MANAGEMENT

4-1 Benefits of ABC

The Brazos Mill does not need ABC because it makes a single product. No matter how complex the
process, how many ingredients, how many processes, all of the costs of the mill relate to the one product--flour.
The River City Bakery is a perfect candidate for ABC. It makes a wide range of products that are highly
diverse. It makes them in very different quantities. It uses a variety of materials and processes.
Some students think that ABC should be applied in any circumstances.

4-2 Cost Analysis

Levi Strauss probably did an ABC analysis looking at costs driven by the number of orders a store made,
the dollar amount of each store’s orders, and by the number of stores the company services. Some costs of
servicing a single order are as high for a small customer's order as they are for a large customer's. Small orders
are relatively more costly than large orders and small customers probably place a good many orders (as opposed to
ordering all year's worth of product at once).
Simply having a customer generates costs related to recordkeeping, credit-checking, and other services.

4-3 Cost Drivers

One driver is probably the total base of customers, regardless of when they bought the packages, but recent
sales probably are the key driver because buyers who have had the software for shorter time periods are more
likely to require assistance.

4-4 Costs and Activities

Zydeco's narrower product line reduces costs generally regarded as fixed, because they do not change
with volume. Such costs nonetheless increase or decrease with significant changes in activities. Zydeco's
operations are less diverse and less complex than those of its competitors, so its costs are lower. Zydeco probably
does not deal with as many suppliers, keep as many records, engage in as many transactions, use as much space,
or employ as many people as its competitors. Therefore, Zydeco’s breakeven point should be lower than it’s
competitors.

4-1
4-5 Costs of Complexity

Complexity drives costs because it makes operations less smooth and requires more people to accomplish
tasks. Companies that make or sell a variety of products incur some costs simply because of the complexity of
their operations. For instance, they must stock parts for more products, and must change machinery over from one
product to another. They might need several sizes of cartons for shipping. They must schedule production and
coordinate much more material and in-process flow than a single-product operation.

4-6 Quality Costs

External failure costs are the hardest to estimate because so much of the cost is the opportunity cost of
lost sales because of your defects. The other categories contain recorded costs and some involve allocations that
generate disagreement, but not to the degree of external failure costs.

4-7 Classifying Quality Costs

1. Prevention, though some of the cost is not quality-related.

2. Prevention, though again some of the cost does not relate to quality.
3. Prevention.
4. Internal failure.
5. Prevention, though some is not quality-related.
6. External failure.
7. Some relates to external failure, but some is related to color, size, and customer whim.

4-8 Basic Allocation (5 minutes)

1. $67,500 to residential, $112,500 to commercial

Residential Commercial Total

Allocated overhead, 6/16, 10/16 $67,500 $112,500 $180,000

2.
Residential Commercial Totals
Revenues $100,000 $300,000 $400,000
Labor costs (60,000) (100,000) (160,000)
Overhead costs (67,500) (112,500) (180,000)
Income (loss) ($27,500) $ 87,500 $ 60,000

4-9 ABC Estimates (Extension of 4-6) (15 minutes)

1.

Cost Pool Cost in Pool Cost Driver Rate

Maintenance $ 75,000 25,000 $3/hour
Scheduling and transport 45,000 5,000 $9/hour
General 60,000 $160,000 $0.375/hour
Total $180,000

2.
Residential Commercial Totals

4-2
Revenues $100,000 $300,000 $400,000
Labor costs 60,000 100,000 160,000
Overhead costs:
Maintenance, $3 x 5,000, 20,000 15,000 60,000 75,000 Scheduling, transport at $9/hour
9,000 36,000 45,000 General at $0.375/labor dollar 22,500 37,500 60,000
Total costs 106,500 233,500 340,000
Income ($ 6,500) $ 66,500 $ 60,000

3. Residential work still appears to be unprofitable in the long term. Roberts might think about raising prices to
residential customers, making explicit charges for travel time, or dropping the residential business over time. In
this situation, the conclusions one might reach do not differ between a single-driver analysis and an ABC analysis,
but the numbers do differ.

Another reasonable suggestion is to leave the general overhead unassigned, though we are told that it is
driven by labor cost. That labor cost does drive all of the general overhead is doubtful.

4-10 Basic Allocations (15 minutes)

1. 110,000 hours, (10 x 10,000) + (20 x 500)

2. $6/hour, $660,000/110,000

3.
Doodler Sketcher
Material cost $ 20 $ 45
Assembly labor at $20/hour 200 400
Overhead at $6/assembly hour 60 120
Total cost $280 $565

4.
Doodler Sketcher
Revenue $320 $950
Cost 280 565
Profit $ 40 $385

4-11 ABC Estimates (Extension of 4-10) (15 minutes)

1.
Setups Testing Assembly
Total cost in pool $140,000 $190,000 $330,000
Activity 350 4,750 110,000
Rate $400 $40 $3

4-3
2.
Doodler Sketcher
Material cost $ 20 $ 45
Assembly labor at $20/ hour 200 400
Overhead:
Setup-related, $400 x 1/100 4
$400 x 1/2 200

Testing-related, $40 x 0.20 8

$40 x 5.5 220
Assembly labor-related 30 60
Total cost $262 $925

3.
Doodler Sketcher
Revenue $320 $950
Cost 262 925
Profit $ 58 $ 25

4. The costs of the two workstations differ considerably under the two approaches. The ABC approach better
captures the consumption of resources, especially setups and testing, than does the simple, one-driver approach.
The profitability of the two products changes as well, with the Doodler now seeming more profitable, while the
Sketcher is just barely profitable.

4-12 Basic Allocations (5 minutes)

1. $18, $3,600,000/200,000

2. $0.45, $3,600,000/$8,000,000

3. $50,400, 2,800 x $18

$63,900, $142,000 x $0.45

The amounts differ because Barron used relatively high-salaried people. The actual average salary was $50.71 per
hour ($142,000/2,800) on work done for Barron, compared to the $40 average ($8,000,000/200,000).

Barron might argue that overhead costs are more likely to be driven by hours than by dollars. Why should a
$70/hour consultant generate more overhead cost than a $30/hour one? The argument is reasonable, as far as it
goes.

4-13 ABC Estimates (Extension of 4-12) (15 minutes)

1. Market Product
Research Promotion Feasibility
Annual overhead $800,000 $1,800,000 $1,000,000
Annual billable hours 100,000 60,000 40,000
Rate $8 $30 $25

2. $21,700
Market Product
Research Promotion Feasibility Total
Billable hours 1,800 800 200 2,800
Overhead cost $14,400 $24,000 $5,000 $43,400

4-4
3. The method given here makes more sense because clients pay for the actual resources they consume. Barron
used relatively more of the low-overhead market research services than of the higher-overhead promotion and
product feasibility services. You might wish to point out that, over time, charging based on hours or dollars
without reference to the specific services (the approach used in 4-12) could influence the kinds of business the
firm receives. Because users of market research services are overcharged, they will gravitate toward other firms,
while users of promotion and product feasibility services will move toward Erffmeyer and Sutton.

4-14 Quality Costs (15 minutes)

1. If no inspection is made:
8%  1,000 units  $300 = $24,000 external failure costs

If inspection is made:
1,000 units  $10 inspection cost = $10,000 appraisal cost
8%  95%  1,000 units  $50 repair cost = $3,800 internal failure cost
8%  5%  1,000 units  $300 = $1,200 external failure cost

2. No inspection: $24,000
Inspect: $10,000 + 3,800 + 1,200 = $15,000

Acme should institute the additional inspection.

4-15 Classifying Quality Costs (10 minutes)

Prevention
Quality training $ 65,000

Appraisal
Incoming materials inspection $120,000
Product inspection 150,000
Total $270,000

Internal failure
Rework $650,000
Scrap 375,000
Total $1,025,000

External failure
Product warranty $950,000

4-16 ABC for Shipping Department (20-25 minutes)

1. The rate per dollar of orders is $0.1043, $1,252,000/$12,000,000

Supermarkets Convenience Stores

Shipping cost, $0.1043 x $9,000,000 $938,700
$0.1043 x $3,000,000 $312,900

The total allocated is $1,251,600, $400 off because of rounding.

2. Amount Amount of
Cost Pool/Driver in Pool Activity Rate

4-5
 Dollar volume of orders $492,000 $12,000,000 $0.04100
Number of customers 360,000 560 642.86
Number of orders 160,000 1,360 117.65
Number of stocks 240,000 6,400 37.50
Total shipping costs $1,252,000

Supermarkets Convenience Stores

Dollar volume of orders at $0.041 $369,000 $123,000

Number of customers at $643 102,880 257,200
Number of orders at $118 51,920 108,560
Number of stocks at $37.50 150,000 90,000
Totals $673,800 $578,760

The ABC costs total $1,252,560 because of rounding. Students need reminding that precision is not the issue
here, no one will make a different decision based on $560 out of hundreds of thousands. The assignment also
states that this analysis is rough and preliminary, so striving for computational accuracy is not useful.

3. The results are quite different. Convenience stores use considerable amounts of resources that are not driven
by dollar volume and so are undercosted using the single driver. It should prove worthwhile to extend and refine
the analysis.

4-17 Cost Drivers (20 minutes)

Note to the Instructor: Good students will give a wide variety of answers here and will be able to justify
most of them. One point to make is that drivers do not come up and introduce themselves: accountants and other
managers must seek them out.

Machine maintenance Machine hours

Wages of workers who reset machinery when Number of production runs
products change
Costs of inspecting incoming materials and Number of incoming shipments
components
Costs of keeping records on workers--how much Number of employees
they produce, what they earn
Costs of inspecting finished products Production in units
Costs to rework defective units Production in units, if
defectives run a fairly
constant relationship to
output
Building maintenance Space in factory
Personnel department costs, including Number of employees
payroll processing costs
Purchasing department costs, including Number of vendors,
soliciting bids from vendors Number of parts stocked
preparing, reviewing, and auditing
purchase orders
Customer billing Number of customers

Some of these are arguable, and you might wish to discuss the conditions under which a different driver, listed
or not, is appropriate. For instance, machine maintenance might depend partly on the number of runs because
setting and tearing down generates additional wear-and-tear. Or, the costs of recordkeeping might be driven
partly by the types of workers, whether salaried or on wages. Time-keeping for workers subject to overtime pay is

4-6
costlier than for salaried employees.

The number of purchase orders probably drives some costs in the purchasing department. A more important
driver in some purchasing departments is the complexity or uniqueness of orders. That is, the department might
spend a lot of time obtaining and evaluating bids on major, unique items. This is characteristic of university
purchasing departments.

4-18 Activity-Based Cost Analysis (15-20 minutes)

Regression output from Excel including both units produced and number of products appears below.

SUMMARY OUTPUT

Regression Statistics
Multiple R 0.933578
R Square 0.871567
Adjusted R Square 0.820194
Standard Error 3,933.513
Observations 8

  Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept (25,580.10) 55,835.90 -0.458 0.666 (169,110.63) 117,950.43
Units Produced 0.2348 0.1942 1.209 0.281 (0.2644) 0.7340
Number of Products 101.4761 17.8851 5.674 0.002 55.5010 147.4513

It is clear from the output that Units Produced is not a statistically significant variable since the 95% confidence
interval includes a value of zero. Therefore, the regression should be performed using only Number of Products as
the x-variable.

4-7
SUMMARY OUTPUT

Regression Statistics
Multiple R 0.913248
R Square 0.834021
Adjusted R Square 0.806358
Standard Error 4,082.05
Observations 8

  Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 41,454.58 6,837.10 6.063 0.001 24,724.80 58,184.36
Number of Products 92.3155 16.8127 5.491 0.002 51.1764 133.4547

The output shows that the quarterly fixed costs are about $41,455 and that there is a variable component of
$92.32 per product. The variable component is most likely step-variable. Using quarterly data helps to make the
point that some costs respond slowly to changes in activity.

The measures of fit are good. About 83.4% of the variation in cost is associated with changes in the number of
products. The standard error of the estimate is 4,082, so that 68% of the observations should be within $4,082 of
the predicted value and 95% within $8,160. The variable Number of Products has a 95% confidence interval
ranging from 51.17 to 133.45. Since this range does not include zero, the variable is statistically significant. We
can conclude that the number of products is a cost driver in the production scheduling department.

The major conclusion about cost reduction is that reducing the number of products will reduce these costs. It
might be possible to achieve some reductions by standardizing products.

4-19 Product Line Report (25 minutes)

1. Paper Products Detergents Total

Sales $2,000,000 $1,200,000 $3,200,000
Variable costs:
Cost of goods sold* 1,400,000 720,000 2,120,000
Commissions at 10% 200,000 120,000 320,000
Total variable costs 1,600,000 840,000 2,440,000
Contribution margin 400,000 360,000 760,000
Line sustaining costs 110,000 150,000 260,000
Product line margin $ 290,000 $ 210,000 500,000
Company sustaining costs 350,000
Profit $ 150,000

* 70% of sales and 60% of sales

4-8
2. Paper products
Paper Products Detergents

Current contribution margin $400,000 $360,000

10% increase $ 40,000 $ 36,000
Less promotion cost 30,000 30,000
Increase in profit $ 10,000 $ 6,000

3. Detergent
Paper Products Detergents
Sales after increase $2,200,000 $1,320,000
Cost of goods sold* 1,540,000 792,000
Commissions at 12% 264,000 158,400
Total variable costs 1,804,000 950,400
Contribution margin $ 396,000 $ 369,600
Original contribution margin 400,000 360,000
Increase (decrease) in profit ($ 4,000) $ 9,600

* $1,400,000 x 110%; $720,000 x 110%

Note to the Instructor: Some students will try to solve by dealing only with changes, as they could in
requirement 2. Most of these students will reach an incorrect answer because of failure to recognize that the new
commission rate applies to all sales, not just to the increased sales.

Paper Products Detergents

Sales increase $200,000 $120,000 times contribution margin percentage,
30% - 12%; 40% - 12% 18% 28% Contribution from sales increase
$ 36,000 $ 33,600 Additional commissions on existing sales
$2,000,000 x 2%; $1,200,000 x 2% 40,000 24,000 Increase (decrease) in profit
($ 4,000) $ 9,600

4. This format shows how each line is performing and also makes CVP analysis easier because the contribution
margin percentage is readily calculated from the report. A report showing only the combined results does not
permit you to make decisions about individual lines, only about the business as a whole (e.g., increase volume of
both lines by the same percentage).

Note to the Instructor: One purpose of this assignment is to show how profitability and changes in it depend on
both volume and contribution margin. The answer to requirement 2 must be either paper products or neither line,
because a 10% increase in volume will increase total contribution margin of that product line by 10%, and paper
products have a higher total contribution margin than detergents. The question is then whether the increase in
contribution margin is greater than the increase in fixed costs.

In requirement 3, the problem is more subtle because not only is volume increasing but the contribution margin
percentage is decreasing by two percentage points. It is therefore not so clear that one line will do better than the
other, much less whether changing either commission will be profitable. The schedule below shows the effects in
a different way.

4-9
 Paper Products Detergents
Original contribution margin percentage:
$400,000/$2,000,000; $360,000/$1,200,000 20% 30%
Less two points increased commission 18% 28%
Times new volume $2,200,000 $1,320,000
Equals new total contribution margin $ 396,000 $ 369,600

In general, reducing contribution margin percentage (by dropping prices, increasing variable costs such as
commissions) to increase volume is not profitable for low contribution margin products. It might be profitable for
high contribution margin products but not necessarily.

4-20 Quality Costs (10-15 minutes)

1.
Prevention
Employee training $ 50,000
Product design 250,000
Vendor certification 80,000
Total $380,000

Appraisal
Inspection of outgoing shipments $ 70,000
Salaries of laboratory personnel 150,000
Inspection of incoming shipments 40,000
Total $260,000

Internal failure
Rework of defective units $ 40,000

External failure
Salaries of customer service personnel, 40% $ 80,000

Some alternatives are possible. Some employee training might relate to quality inspection, an appraisal cost.
Customer service personnel salaries are included above at 40%, the percentage of time spent fixing products.
Some of the remaining 60% of those salaries might be prevention costs if service representatives take customer
recommendations back to designers.

2. The point of this question is that opportunity costs of lost sales from external failure are not recorded, nor are
internal costs of lost output from time spent making and reworking defective product.

Note to the Instructor: You might wish to introduce the question of allocating indirect costs. Some of the
costs above are salaries only, but the company incurs costs to support the laboratory and the customer service
representatives, as well as other quality-related activities. The rework costs might be labor only, or include
applied overhead as well.

4-10
4-21 Quality Costs in a Law Firm (15 minutes)

Activity Quality CostCategory

1. Bad debt write-offs External failure
2. Billing or payroll errors Internal failure
3. Computer downtime Internal failure
4. Employee turnover Internal failure
5. Frequent budget revisions Internal failure
6. Overstaffing Internal failure
7. Overtime Internal failure
8. Unplanned revision of documents Internal failure
9. Premiums for malpractice insurance External failure
10. Review time by partners Appraisal
11. Revising or recopying of documents to correct errors Internal failure
12. Settlements paid out by the firm External failure
13. Time devoted to addressing client complaints External failure
14. Time spent defending lawsuits filed by other parties External failure
15. Travel to continuing legal education Prevention
16. Underutilization of office equipment Internal failure
17. Unproductive meeting time Internal failure

Note to Instructor Notice that most of the activities are either internal failure or external failure.

4-22 ABC, Value-Chain (15 minutes)

The ABC rate for order-filling is $1,460 per order.

Order-filling costs $2,000,000

Number of orders 1,370 ((12 x 10) + (25 x 50))
Cost per order $ 1,460

Income statements reflecting the order-filling costs and dropping the other selling and administrative expenses
appear below.

Typical Typical
Large Customer Small Customer

Number per order 40,000 1,600

Number of orders annually 12 25
Total annual volume 480,000 40,000

Revenue $1,680,000 $140,000

Variable manufacturing costs 672,000 56,000
Variable manufacturing margin 1,008,000 84,000
Fixed manufacturing costs 288,000 24,000
Manufacturing margin 720,000 60,000
Order-filling at $1,460 per order 17,520 36,500
Profit $ 702,480 $ 23,500

Large customers are paying for more costs than they are generating. The small customers are not as profitable as
originally calculated, at least over a reasonable period of time. The company could consider several approaches.
The mention of value-chain in the title gives one suggestion. Kawishiwi could propose measures to its small
customers that would reduce Kawishiwi's costs. Such measures might include asking the small customers to order
less frequently, or to pay more. One way to do so is to charge declining per-unit amounts as order size increases,
or to institute a flat charge per order, no matter the size.

4-11
Large customers should get a price reduction, else they might find another supplier more willing to accommodate
them.

4-23 ABC for a Distributor (25 minutes)

1. Rates

Expense Amount Driver Rate

Delivery $60,000 500 $ 120

Stocking 30,000 15,000 2
Recordkeeping 40,000 2,000 20
Other 50,000 $600,000 8.33% rounded

Supermarkets Convenience Stores

Sales
$500,000 $100,000
Cost of sales 300,000 50,000
Gross profit 200,000 50,000
Operating expenses
Delivery
48,000 12,000
Stocking 8,000 22,000
Recordkeeping 16,000 24,000
Other 41,650 8,350
Total operating expenses 113,650 66,350
Profit $ 86,350 ($16,350)

Several recommendations are possible. One is to phase out convenience stores over time. Another is to charge
convenience store customers separately for the activities that consume resources. The company must make a
strategic decision whether to continue doing business with convenience stores and if so, how to recover the costs.

4-24 Cost Drivers, Activity-Based Analysis (20 minutes)

Regression output from Excel follows.

SUMMARY OUTPUT
Regression Statistics
Multiple R 0.925124
R Square 0.855855
Adjusted R Square 0.831831
Standard Error 2,899.44
Observations 8.00

  Coefficients Standard Error t Stat P-value Lower 95% Upper 95%

Intercept 64,436.48 7,638.00 8.436 0.000 45,746.96 83,125.99
Number of Parts 3.8448 0.6442 5.969 0.001 2.2686 5.4210

The output says that quarterly fixed costs are about $64,436 and that there is a variable component of $3.845

4-12
per part. The facts of the situation suggest that the variable component is step-variable. We used quarterly data to
highlight the point that some costs respond slowly to changes in activity.

The measures of fit are good. About 85.6% of the variation in cost is associated with changes in the number of
parts. The standard error of the estimate is $2,899, so that 68% of the observations should be within $2,899 of the
predicted value, 95% within $5,798. The variable Number of Parts has a 95% confidence interval ranging from
2.27 to 5.42. Since this range does not include zero, the variable is statistically significant. We can conclude that
the number of parts being used is an important driver of purchasing department costs.

The major recommendation for cost reduction is to standardize parts among the products. This might be
accomplished by stressing the use of common, standard parts in new products, perhaps through charges for using
non-standard parts.

4-25 Categorizing Quality Costs (15 minutes)

Internal External
Prevention Appraisal Failure Failure
Design analysis X
Design engineering X
Equipment repair/maintenance X
Liability claims X
Manufacturing inspection X
Manufacturing process/engineering X X X X
Marketing X
Product acceptance X
Quality engineering X
Quality scrap X
Quality testing X
Quality training X
Receiving inspection X
Returned merchandise cost X
Repair X
Rework X
Travel X

Note to Instructor There may be minor differences in which category any specific cost is placed. Some experts
consider receiving inspection to be a prevention cost while others consider it an appraisal cost. Likewise,
manufacturing and process engineering expenditures may be for any of the categories.

4-26 ABC for Receiving Department (20 minutes)

1. The rate is $0.0814, $700,000/$8,600,000.

Line A Line B Line C Receiving costs at $0.0814 $366,300
$179,080 $154,660

Total cost allocated is $40 off from rounding.

2.
Amount of Amount of
Cost Driver Cost in Pool Activity Rate

Total manufacturing costs $440,000 $8,600,000 $ 0.051

Number of shipments received 180,000 1,400 129.00
Number of orders requiring inspection 80,000 240 333.00

4-13
 $700,000
The rates are rounded.

Line A Line B Line C

Total manufacturing costs at $0.051 $229,500 $112,200 $ 96,900

Number of shipments received at $129 56,760 41,280 82,560
Orders requiring inspection at $333 3,333 8,325 68,265
Totals $289,593 $161,805 $247,725

Again, the totals are off because of rounding, but this should not be a concern because the analysis is preliminary.

3. Line C costs increase considerably, while B's drop some and A's decrease considerably. Line C uses more
resources than do the other lines. Allocations based on total manufacturing costs do not capture this resource use.

We cannot tell whether it would be desirable to do a full-blown ABC study because we do not know whether
total costs would be significantly different. That is, we do not know whether receiving costs are material. If they
are, the company should pursue ABC because the product lines consume quite different amounts of receiving
department resources.

4-27 Product Line Income Statements (35 minutes)

1. The first step is to find the number of each product sold.

Saws: 4,000 ($500,000 x 40%)/$50
Drills: 7,500 ($500,000 x 30%)/$20
Sanders: 3,750 ($500,000 x 30%)/$40

Mifflan Tool Company

Income Statement for January 20X8
Total Saws Drills Sanders
Sales $500,000 $200,000 $150,000 $150,000
Cost of sales (1) 307,500 120,000 112,500 75,000
Gross profit 192,500 80,000 37,500 75,000
Shipping and delivery (2) 23,000 8,000 7,500 7,500
Contribution margin 169,500 $ 72,000 $ 30,000 $ 67,500
Fixed costs (3) 140,000
Income before taxes $ 29,500

(1) Saws = 4,000 x $30

Drills = 7,500 x $15
Sanders = 3,750 x $20
(2) Saws = 4,000 x $2
Drills = 7,500 x $1
Sanders = 3,750 x $2
(3) Rent, salaries, and other expenses of $40,000, $70,000, and $30,000

2. At the expected mix the sales of each product would have been as follows:

Saws: 3,000 ($500,000 x 30%)/$50

Drills: 5,000 ($500,000 x 20%)/$20
Sanders: 6,250 ($500,000 x 50%)/$40

Mifflan Tool Company

Expected Income Statement for January 20X8

4-14
 Total Saws Drills Sanders

Sales $500,000 $150,000 $100,000 $250,000

Cost of sales 290,000 90,000 75,000 125,000
Gross profit 210,000 60,000 25,000 125,000
Shipping and delivery 23,500 6,000 5,000 12,500
Contribution margin 186,500 $ 54,000 $ 20,000 $112,500
Fixed costs 140,000
Income before taxes $ 46,500

3.

Expected Percentages: Total Saws Drills Sanders

Selling price $50.00 $20.00 $40.00
Cost of sales 30.00 15.00 20.00
Gross profit $20.00 $ 5.00 $20.00
Gross profit percentage 40% 25% 50%
Mix percentage 30% 20% 50%
Weighted average 42% 12% 5% 25%

Gross margin, above $20.00 $ 5.00 $20.00

Less shipping and delivery 2.00 1.00 2.00
Contribution margin $18.00 $ 4.00 $18.00
Contribution margin percentage 36% 20% 45%
Weighted average 37.3% 10.8% 4.0% 22.5%

Actual Percentages:
Total Saws Drills Sanders
Gross profit percentage 40% 25% 50%
Actual sales mix 40% 30% 30%
Weighted average 38.5% 16% 7.5% 15%
Contribution margin percentage 36% 20% 45%
Weighted average 33.9% 14.4% 6.0% 13.5%

The effect of the change in mix was to reduce the gross margin percentage to 38.5% from 42%, 3.5 percentage
points. This resulted in a $17,500 drop in gross margin ($500,000 x 3.5%). The percentage of shipping and
delivery expenses dropped from 4.7% ($23,500/$500,000) to 4.6% ($23,000/$500,000). This 0.1% decrease
gained an additional $500 of contribution margin and profit.

Some students will deal only with the change in the WACM (37.3% expected versus 33.9% actual), a drop of
3.4 percentage points, giving the $17,000 profit shortfall ($500,000 x 3.4%). Whether or not variable costs are
discussed individually, the president can be told that the shift in mix was unfavorable because the lowest margin
product, drills, increased its share and the highest margin product, sanders, reduced its share.

4-28 Product Line Reporting, Activity Analysis (35 minutes)

Kelly Company
Product-line Income Statement for April 20X7 (000s)
Sport
Suits Clothes Accessories Total
Sales (1) $240.0 $400.0 $160.0 $800.0 Variable costs:
Cost of sales (2) 192.0 300.0 80.0 572.0
Commissions (3) 14.4 24.0 9.6 48.0
Total variable costs 206.4 324.0 89.6 620.0 Contribution margin 33.6 76.0
70.4 180.0 Product-line sustaining costs (4) 12.0 8.0 5.2 25.2 Short-term margin
21.6 68.0 65.2 154.8

4-15
Direct committed fixed costs (5) 6.0 8.8 6.0 20.8 Long-term margin $ 15.6 $ 59.2
$ 59.2 134.0 Facility-sustaining costs:
Salaries ($71.4 - $25.2) 46.2
Rent 21.4
Shipping and delivery 15.2
Insurance 14.0
Total company-sustaining costs 96.8
Income $ 37.2

(1) $800,000 times sales mix percentages of 30%, 50%, and 20%
(2) Sales dollars times variable cost percentages of 80%, 75%, and 50%
(3) Sales dollars times 6%
(4) Salaries for managers and directly associated personnel, as given.
(5) Given

Note to the Instructor: Some discussion points regarding the income statement follow.

Statements about profitability of departments assume independence among the departments. It is likely in this
case that sales in other departments would be adversely affected if one were dropped. Students will understand
this point even though it has not yet been explicitly introduced.
Suits have relatively low margins compared to the other lines, and we might ask whether this is normal.
Students, especially marketing majors, might be aware that trade associations publish information that would help
to determine whether the suit department is well below those of competitors. If there is reason to believe that the
performance is poor, the manager of the suit department should have to explain the relatively lackluster
performance.

4-29 ABC for a Distributor (35 minutes)

1. A B C D E
Sales $400,000 $440,000 $660,000 $800,000 $1,400,000
Gross profit 192,000 202,400 277,200 296,000 476,000
Order costs 82,600 48,750 39,600 29,400 25,500
Delivery costs 70,000 62,500 45,000 30,000 37,500
Stocking costs 13,440 20,000 17,280 33,600 45,600
Total costs 166,040 131,250 101,880 93,000 108,600
Margin $ 25,960 $ 71,150 $175,320 $203,000 $ 367,400

Order costs, $240 per order plus $5.00 per item ordered.
Customer A = ($240 x 140) + ($5.00 x 140 x 70) = $82,600

Delivery costs, $500 x number of deliveries.

Customer A $500 x 140 = $70,000

Shelf-stocking costs, $0.16 x deliveries x total units per order.

Customer A = $0.16 x 140 x 600 = $13,440

2. You might wish to point out that the controller allocated $600,002 in costs to the customers, while the ABC
estimates are $600,770, a slight difference that is likely to occur anytime. The picture is quite different under the
ABC analysis. Customer A had appeared quite profitable under the controller’s analysis because of its high gross
profit percentage, but its relatively higher servicing costs reduced its apparent profitability considerably under the
ABC analysis. Customers C and D had appeared almost equally profitable under the controller’s analysis, but a
sharp difference opens up under the ABC analysis. Customer E’s profitability jumped nearly 50% under the ABC
analysis.

The reasons for the changes lie in the demands that the various customers place on Western’s resources.
The smaller customers use relatively more resources because they order and receive deliveries more often.

4-16
4-30 Line of Business Reporting (60 minutes)

Riparian Company
Quarterly Income Statement
Total Product A Product B Product C

Sales $1,300,000 $500,000 $400,000 $400,000

Variable costs:
Manufacturing 820,000 300,000(60%) 280,000(70%) 240,000(60%)
Selling 31,000 15,000 (3%) 8,000(2%) 8,000 (2%)
Total variable costs 851,000 315,000 288,000 248,000
Contribution margin 449,000 185,000 112,000 152,000
Product sustaining (1) 180,000 42,000 52,000 86,000
Product margin $ 269,000 $143,000 $ 60,000 $ 66,000
Company sustaining costs:
Manufacturing (2) 50,000
Selling (3) 34,000
Administrative 52,000
Total 136,000
Income $ 133,000

(1) $40,000 avoidable, 30%, 30%, 40% to products, plus $140,000 product-sustaining manufacturing costs,
$30,000, $40,000, $70,000
(2) Total fixed manufacturing cost of $190,000 less $140,000 product sustaining
(3) Total selling expense of $105,000 less $31,000 variable less $40,000 avoidable, direct selling costs.

4-17
2. Riparian Company
Quarterly Income Statement

Total Domestic Foreign

Sales $1,300,000 $1,000,000 $300,000

Variable costs:
Manufacturing 820,000 630,000 (A) 190,000 (A)
Selling 31,000 24,000 (B) 7,000 (B)
Total variable costs 851,000 654,000 197,000
Contribution margin 449,000 346,000 103,000
Market sustaining costs (1) 184,000 126,000 (C) 58,000 (C)
Market margin 265,000 $ 220,000 $ 45,000
Company sustaining costs
Manufacturing 80,000
Administrative 52,000
Total 132,000
Income $ 133,000

(1) Selling costs of $36,000 and $38,000 (see below) plus $90,000 and $20,000 manufacturing costs

Schedule A--Variable Manufacturing Costs

(1) (2) (3) (4) (5) (6) (7)
Variable Variable Variable
Cost Domestic Cost Foreign Cost Total
Product Ratio Sales (2) x (3) Sales (2) x (5) (4) + (6)

A 60% $400,000 $240,000 $100,000 $ 60,000 $300,000

B 70% 300,000 210,000 100,000 70,000 280,000
C 60% 300,000 180,000 100,000 60,000 240,000
Totals $630,000 $190,000 $820,000

Schedule B--Variable Selling Expenses

A 3% $400,000 $12,000 $100,000 $3,000 $15,000

B 2% 300,000 6,000 100,000 2,000 8,000
C 2% 300,000 6,000 100,000 2,000 8,000
Totals $24,000 $7,000 $31,000

Schedule C--Fixed Selling Costs by Market

Domestic Foreign
Total selling costs $60,000 $45,000
Variable (Schedule B) 24,000 7,000
Fixed $36,000 $38,000

4-18
3. The change would produce an increase in profit of $2,200 per quarter.

Sales Contribution Additional

Product Increase Margin Percentage Contribution Margin

A $ 80,000 37 (100 - 60 - 3) $29,600

B 80,000 28 (100 - 70 - 2) 22,400
C 40,000 38 (100 - 60 - 2) 15,200
Totals $200,000 $67,200
Lost short-term margin--foreign market
(see Requirement 2) ($103,000 – 38,000) 65,000
Net increase $ 2,200

4. At least $166,000. Product C provides product margin of $136,000 per quarter and additional costs of $30,000
would be incurred.

4-31 Determining Variable Costs of Products--Activity-Based Analysis (25 minutes)

1. Product 816 uses 0.50 DLH ($8/$16) and product 389 uses 1.0 DLH ($16/$16).

Amount of Driver Variable Overhead Cost

Product 816 Product 389 Rates Product 816 Product 389

DLH 0.5 1 $4.00 $ 2.00 $ 4.00

MH 0.5 0.2 $20.00 10.00 4.00
Parts 120 185 $0.07 8.40 12.95 Processing time 10 5 $4.00 40.00
20.00
Total variable overhead $60.40 $40.95
Materials 15.00 13.00
Direct labor 8.00 16.00
Total variable cost $83.40 $69.95

2.

Overhead 0.5 1 $50.00 $25.00 $50.00 Materials 15.00

13.00
Direct labor 8.00 16.00
Total variable cost $48.00 $79.00

3. We do not wish to focus attention too much on the specific differences between the costs, but rather on the
general point that establishing cost pools might benefit the company through better information about the
consumption of resources. The cost of product 816 is higher using the multiple pools, while that of product 389 is
lower. The reason is the relative uses of the cost drivers. You might wish to show how the costs might change for
products with, say, large numbers of parts or longer processing time.

4-19
4-32 Segmented Income Statements for a Distributor, Activity Analysis, Ethics (25 minutes)

1.
Total Eastern Southern Western

Sales $2,896.0 $589.0 $752.0 $1,555.0 Variable costs:

Cost of sales (1) 1,231.9 200.3 300.8 730.8
Selling expenses (2) 429.1 82.5 97.8 248.8 Total variable costs 1,661.0 282.8
398.6 979.6 Contribution margin 1,235.0 306.2 353.4 575.4 District-sustaining costs
Selling expenses (3) 514.0 152.0 155.0 207.0
Administrative expenses (4) 40.0 9.0 12.0 19.0 Total district-sustaining 554.0 161.0
167.0 226.0 District margin $ 681.0 $145.2 $186.4 $ 349.4 Company-sustaining costs (5)
307.9
Income $ 373.1

(1) As originally given

(2) Sales multiplied by variable cost percentages: $589 x .14; $752 x .13; $1,555 x .16.
(3) Given
(4) Given
(5) Total costs less costs accounted for above
Selling Costs Administrative Costs

Total in problem $1,026.0 $265.0

Variable costs (429.1) 0
District-sustaining costs (514.0) (40.0)
Company-sustaining costs $ 82.9 $225.0
Total company sustaining costs = $307.9, $82.9 + $225

2. The memorandum could make the following points.

The new income statements rearrange costs but do not change them. Notice that income for the company
remains the same at $373.1 thousand. The new statements reflect the use of resources, or activities, for each
region. Our previous income statements assumed that sales was the only cost driver. The new format does not
attempt to allocate common costs to the regions.

The district margins are the best bases for evaluating the regions. These margins include all costs incurred to
sustain the segments. The margin indicates how much the region contributes to covering company sustaining
costs and providing a profit. Using the district margins, all territories appear to be doing well. We need time to
assess performance in the new territories. The opening of these territories should also affect the Western territory,
because costs that were formerly incurred only for the benefit of the West now are common to all three territories.
Examples include corporate overhead costs and some data processing costs. A comparison of the income
statement above with ones similarly prepared for previous periods would help us to see how the Western territory
has been progressing.

The new territories have sizable district margins and their contribution margin percentages are even higher than
that of the established Western territory. This higher return could be related to the product lines that we are
selling. Taylor might be selling more of the high-margin lines in the new territories, as the lower cost of sales
ratios in the new territories suggest.

The new statements should allow you to make better decisions and evaluations because they highlight
contribution margin and segment margin for each region.

3. The following points are relevant for the memorandum.

Regardless of how we prepare segmented income statements, we could have ethical issues with the allocations
and assignments of costs to regions.

4-20
 The IMA objectivity standard requires that we communicate information fairly and objectively and disclose all
relevant information. The competence standard requires that we maintain professional competence and employ it
in developing reports. Taken together, these Standards require us to be sure that (1) we have reflected the costs of
activities in a fair and reasonable way, (2) we have not favored any region over another in assigning costs, and (3)
we have reflected the most relevant information in appropriate ways.

4-33 Segmented Income Statements--Costs of Activities, Ethics (30 minutes)

1.
Sporting
Total Goods Housewares Hardware

Sales $3,337.0 $650.0 $921.0 $1,766.0 Variable costs:

Cost of sales (1) 1,094.8 182.0 294.7 618.1
Selling expenses (2) 58.6 13.0 13.8 31.8
Administrative expenses (3) 47.6 5.9 6.4 35.3 Total variable costs 1,201.0 200.9
314.9 685.2 Contribution margin 2,136.0 449.1 606.1 1,080.8 Product-line sustaining
costs
Cost of sales 496.0 158.0 141.0 197.0
Selling expenses 276.0 56.0 87.0 133.0
Administrative expenses 78.0 13.0 22.0 43.0 Total line sustaining costs 850.0 227.0
250.0 373.0 Product margin $1,286.0 $222.1 $356.1 $ 707.8 Company sustaining costs
(4) 1,180.0
Income $ 106.0

(1) Sales x percentage variable cost, $650 x 28%; $921 x 32%, $1,766 x 35% (2) Sales x percentage variable
cost, $650 x 2%; $921 x 1.5%, $1,766 x 1.8% (3) Sales x percentage variable cost, $650 x .9%; $921 x .7%,
$1,766 x 2%
(4) Costs remaining after others accounted for
Administrative
Cost of Sales Selling Costs Costs
Total in problem $1,928.8 $787.6 $514.6
Variable costs (1,094.8) ( 58.6) ( 47.6)
Line-sustaining costs ( 496.0) (276.0) ( 78.0)
Company-sustaining costs $ 338.0 $453.0 $389.0

Total company sustaining costs are $1,180, $338 + $453 + $389

4-21
2.
To: Controller
From: Student
Date: Today
Subj: Alternative income statements

I recommend that we adopt the new form of segmented income statement.

The new income statement isolates costs by behavior, which gives you and other managers better information
for planning and for decisions about issues such as which segments to emphasize. The contribution margin
percentages (69.1% for sporting goods, 65.8% for housewares, and 61.2% for hardware) are more helpful in
evaluating the segments and in deciding which ones we might promote or downplay than are return on sales
percentages. For instance, the 65.8% for housewares tells us that we would not be smart to ignore it, as the
original income statement suggested.

The product margins shown on the new statement show the contributions each line makes to covering common
costs and providing a profit. Again, we see that the housewares line makes a significant contribution. These
margins are more helpful than the gross margin or income figures on the original statement. Evaluating the
profitability of segments should center on their margins without allocated common costs. We will then be better
able than before to assess the effects of dropping segments or replacing them.

The new statement provides more relevant information for virtually any decision that you and other managers
wish to make. The contribution margin percentages are valuable for any decision involving changes in volumes,
prices, or variable costs. The product margins are helpful in assessing how well each line is doing.

3. The managers can expect that the accountants will prepare objective reports in a competent way. The IMA
objectivity standard requires that we communicate information fairly and objectively and disclose all relevant
information. The competence standard requires that we maintain professional competence and employ it in
developing reports. Taken together, these Standards require us to be sure that (1) we have reflected the costs of
activities in a fair and reasonable way, (2) we have not favored any region over another in assigning costs, and (3)
we have reflected the most relevant information in appropriate ways.

4-22