Exercise 5-25 Activity Levels and Cost Drivers

Shroeder Machine Shop has the following activities:

 
a. Machine operation f. Machine maintenance
b. Machine setup g. Product improvement
c. Production scheduling h. Parts administration
d. Materials receiving i. Final inspection
e. Research and development j. Materials handling

Required

1. Classify each of the activities as a unit-level, batch-level, product-level, or facility-level

activity.

2. Identify a proper cost driver for each activity in requirement 1.

Activity Levels
a. Unit-level f. Facility-level
b. Batch-level g. Product-level
c. Batch-level h. Product-level
d. Batch-level i. Unit-level; Batch-level
e. Product-level j. Batch-level.
 

Cost Drivers
Machine hours
Number of setups or setup hours
Number of production orders
Number of material receipts; Number of purchase orders
Number of products
Number of machine hours
Number of engineering change notices; number of modifications; Number of
products
Number of parts; Number of products; Number of purchase orders
Number of inspection hours; Number of units; Number of batches
Number of loads; Number of material moves; Material weights
 
Exercise 5-26 Activity Levels and Cost Drivers
Steve's Slop Shop, a small hamburger shop, has identified the resources used in its operations:

a. Bread f. Advertising for Triple-Burger special

b. Hourly help g. Salary for the store managers
c. Store rent h. Utilities
d. Ground beef i. $1-off-coupon for the second order
e. Catsup j. Bags

Required

1. Classify its costs as unit-level, batch-level, product-level, or facility-level costs.

2. Suggest a proper driver for each of the above items.

1. Cost Hierarchy
a. Unit-level
Unit-level
Facility-level
Unit-level
Unit-level
Product-level
Facility-level
Facility-level
Batch-level
Batch-level (if one bag per customer).
 

2. Cost Driver
 
Number of hamburgers
Number of hours
Square feet
Number of hamburgers; Size of hamburgers
Number of hamburgers
Number of time the advertising is run
Number of hours store is open
Square feet
Number of coupon redeemed
j. Number of customers
Number of coupon redeemed
j. Number of customers
Exercise 5-28 Activity Based Costing
Hakara Company has been using direct labor costs as the basis for assigning
overhead to its products. Under this allocation system product A has been
assigned overhead of $10.80 per unit while produce B has been assigned $3.60
per unit. Management feels that an ABC system will provide a more accurate
allocation of the overhead costs and collected the following cost pool and cost
driver information:

Cost Pools Activity Costs Cost Driver Driver Consumption

Machine Setup $360,000 Setup hours 4,000
Materials Handling $100,000 Pounds of materials 20,000
Electric Power $40,000 Kilowatt-hours 40,000
The following cost information pertains to the production of two of its Products, A
and B

A B
No. of units produced 4,000 20,000
DM Cost ($) $42,000 $54,000
DL Cost ($) $24,000 $40,000
No. of Setup Hours 400 200
Lbs. of materials used 1,000 3,000
Kwh (electricity) 2,000 4,000
Required
1. Use activity-based costing to calculate the unit cost for each product.
2. Comment on management's belief that the ABC system will generate an
overhead allocation that is more accurate than the system currently used.

Cost Pools Activity Costs Cost Driver Units Overhead Rate

Machine Setup $360,000 4,000 $90.00
Materials Handling $100,000 20,000 $5.00
Electric Power $40,000 40,000 $1.00

Cost Assignment:
A B
DM $42,000 $54,000
DL $24,000 $40,000
Overhead:
Machine Setup $36,000 $18,000
 Mat. Handling $5,000 $15,000
Power $2,000 $4,000
Total Product Cost $109,000 $131,000
Units Produced 4,000 20,000

DM per unit $10.50 $2.70

DL per unit $6.00 $2.00
OH per unit $10.75 $1.85
Cost per Unit $27.25 $6.55

2. While one could safely assume that the ABC system provides an
improved, more detailed assignment of the overhead costs to the two
products, the term “accuracy” tends to be regarded as a measure of
how close the numbers are to some accepted target, but the target
value is not known. It must be remembered that allocations are
needed because direct assignment of cost to products is not possible
and that all allocations are dependent upon subjective management
decisions. The new costs reflect the decisions made with regard to
the number of cost pools, the actual assignment of costs to those cost
pools, and the selection of the cost drivers for each cost pool. If, for
example, number of setups rather than number of setup hours was
used to assign overhead from the machine setup pool, the cost of
each product may have been different, thereby making it difficult to
say that any ABC system is entirely accurate. The resulting values
can only be evaluated with respect to those generated under some
other system.
Exercise 5-29 ABC and Job-Costing; Working with Unknowns
North Company designs and manufactures machines that facilitate DNA sequencing. Depending on the
intended purpose of each machine and its functions, each machine is likely to be unique. The job-order
costing system in its Norfolk plant has five activity cost pools, in addition to direct materials and direct
labor. Job TPY–2306 requires 1,000 printed-circuit boards. The cost per board that passes the final
inspection is $240. On average, only 50 percent of the completed units pass the final inspection. The
prime costs per completed board are direct materials $25 and direct labor $5. Information pertaining to
manufacturing overheads for printed-circuit boards follows:

Unit of Cost
Driver per Factory OH
Activity Cost Pool Cost Driver Activity Driver Path Board per Board
Axial insertion Number of axial insertions $0.20 30 A
Hardware insertion Number of hardware insertio $2.00 B $37.00
Hand load Boothroyd time C 5 $35.50
Masking Number of points masked $0.12 100 D
Final test Test time E 10 $6.00

Required
Fill in the unknowns identified as A through F.

A. $6.00 =$.20 × 30
B. 18.5 =$37 ÷ $2
C. $7.10 =$35.5 ÷ 5
D. $12.00 =$.12 × 100
E. $0.60 =$6 ÷ 10
Exercise 5-33 Customer Profitability Analysis

Studemeir Paint & Floors (SPF) has experienced net operating losses in its Other Flooring Products line
during the last few periods. SPF’s management team thinks that the store will improve its profitability if
they discontinue the Other Flooring Products line. The operating results from the most recent period are:

Paint & Paint Other Flooring

Supplies Carpet Products
Sales $295,000 $214,900 $167,900
Cost of goods sold $165,000 $150,000 $135,250
SPF estimates that store support expenses are approximately 24 percent of revenues.
Harish Rana, SPF’s controller, states that not every sales dollar requires or uses the same
amount of store support activities. He conducts a preliminary investigation and his results and
analysis are as follows:

Paint & Paint Other Flooring

Supplies Carpet Products
Order Processing (# of 425 150 100
purchase orders)
Receiving (# of deliveries) 50 120 60
Customer support (hours 0.50 8.00 0.75
required per sale)
each purchase order represents a sale

Harish estimates activity-cost rates for each activity as follows:

Order Processing $140 per purchase order

Receiving $180 per delivery
Customer Support $18 per hour

Required
Prepare a product-line profitability report for SPF under the current costing system.
Prepare a product-line profitability report for SPF using the ABC information the controller
provides.
What new insights does the ABC system in requirement 2 provide to the SPF managers?

1. Product line profitability report for SPF under the current costing system.

Paint & Paint Supplies Carpet Other Flooring Products

Sales $295,000 $214,900 $167,900
Cost of goods sold $165,000 $150,000 $135,250
Gross Margin $130,000 $64,900 $32,650
Store Support (24% $70,800 $51,576 $40,296
of revenue)
Operating Income $59,200 $13,324 ($7,646)
Operating Margin 20.07% 6.20% -4.55%

2. Product line profitability under ABC.

Paint & Paint Supplies Carpet Other Flooring Products

Sales $295,000 $214,900 $167,900
Cost of goods sold $165,000 $150,000 $135,250
Gross Margin $130,000 $64,900 $32,650
Store Support:
Order Processing $59,500 $21,000 $14,000
Receiving $9,000 $21,600 $10,800
Customer Support $3,825 $21,600 $1,350.00
Total Store Support $72,325 $64,200 $26,150
Operating Income $57,675 $700 $6,500
Operating Margin 19.55% 0.33% 3.87%

3. Paint & Paint supplies have little change in operating profit. Carpet and Other Flooring
Products, however, have significant changes. This is important because it indicates that the
current costing system does not provide an accurate reflection of store support. It is also
interesting that the Other Flooring Products are more profitable than Carpet under the ABC
system. This is because Carpet requires much more store support than Paint & Paint Supplies
and Other Flooring Products. The level of customer support needed for each carpet sale could
potentially be reduced, but that might lower customer satisfaction. If customers truly value the
support associated with buying carpet, management might consider charging more for carpeting.
Exercise 5-36 Customer Profitability Analysis
Garner Industries manufactures precision tools. The firm uses an activity-based costing system. CEO Deb
Garner is very proud of the accuracy of the system in determining product costs. She noticed that since the
installment of the ABC system 10 years earlier the firm had become much more competitive in all aspects of
the business and earned an increasing amount of profits every year.
In the last two years the firm sold 1 million units to 4,100 customers each year. The manufacturing cost is
$600 per unit. In addition, Garner has determined that the order-filling cost is $100.50 per unit. The $784.56
selling price per unit includes 12 percent markup to cover administrative costs and profits.
The order-filling cost per unit is determined based on the firm’s costs for order-filling activities. Order filling
capacity can be added in blocks of 60 orders. Each block costs $60,000. In addition, the firm incurs $1,500
order-filling costs per order.
Garner serves two types of customers designated as PC (Preferred Customer) and SC (Small Customer).
Each of the 100 PCs buys, on average, 5,000 units in two orders. The firm also sells 500,000 units to 4,000
SCs. On average each SC buys 125 units in 10 orders. Ed Cheap, a buyer for one PC, complains about the
high price he is paying. Cheap claims that he has been offered a price of $700 per unit and threatens to take
his business elsewhere. Garner does not give in because the $700 price Cheap demands is below her cost.
Besides, she has recently raised the price to SC to $800 per unit and experienced no decline in orders.

Sales experience, last two years:

Units sold 1,000,000
# customers 4,100
Manufacturing cost/unit $600.00
Order-Filling Costs/Unit $100.50
Selling price per unit $784.56
Markup % 12%
Order-Filling Capacity Units 60 orders
Cost per Capacity Unit (Block) $60,000
Additional Order-Filling Cost per Order $1,500
Customer Profiles:
#PC (preferred customers) 100
#SC (small customers) 4,000
Order size:
PC 5,000
SC 125
No. orders per year:
PC 2
SC 10
Possible Selling Prices per Unit:
Alternative 1 $700.00
Alternative 2 $800.00

Required
Demonstrate how Garner arrives at the $100.50 order-filling cost per unit.
What would be the amount of loss (profit) per unit if Garner sells to Cheap at $700 per unit?
What is the amount of loss (profit) per unit at the $800 selling price per unit for units sold to SC?

1. Demonstrate how Garner arrives at the $100.50 order-filling cost per unit.
 Determination of the $100.50 order-filling cost per unit

Total number of orders: 2 x 100 PCs + 10 x 4,000 SCs = 40,200

Total number of orders 40,200

Number of orders per block 60
Total number of blocks 670
Cost per block $60,000
Total cost of order-blocks $40,200,000
Total number of orders 40,200
Per order order-filling cost $1,500
Total cost per order $60,300,000
Total order-filling cost $100,500,000
Total units sold 1,000,000
Order-filling cost per unit $100.50

2. What would be the amount of loss (profit) per unit if Garner sells to Cheap at $700 per unit?

Profit Margin per Unit Sold

Order filling cost per unit sold to PC

Total number of orders per year 2
Number of orders per block 60
Total number of blocks 30
Cost per block $60,000
Total block cost $2,000
Total number of orders 2
Order-filling cost per order $1,500
Total cost per order $3,000
Total order-filling cost $5,000
Total units per order ¸ 5,000
Order-filling cost per unit $1.00

Net profit per unit at $700 selling price per unit to preferred customers:

Preferred Customer
Selling price per unit $700
Manufacturing cost $600
Order-filling cost/unit $1
Total cost per unit $601
Net Profit per unit $99

Profit margin % 14.14%

3. What is the amount of loss (profit) per unit at the $800 selling price per unit for units sold to SC?

Profit Margin per Unit Sold to SC

Order-Filling Cost/unit:
Cost per block $60,000
Number of orders per block 60
Block cost per order $1,000
Number of orders per SC per year 10
Total block cost per SC $10,000
Order-filling cost per order $1,500
Number of orders per SC 10
Total cost per order $15,000
Total order-filling cost $25,000
Order size (no. of units) 125
Order-filling cost/unit $200

Profitability per unit at $800 selling price per unit to SC:

Selling price per unit $800
Manufacturing cost $600
Order-filling cost/unit $200
Total cost per unit $800
Net profit or loss per unit $0

Profit margin % 0.00%

Problem 5-38 Activity-Based Costing, Value Chain Analysis

Drilling Company uses activity-based costing and provides this information:

Manufacturing Activity Cost Driver Overhead Rate

Materials handling Number of parts $0.60
Machinery Number of machine-hours 51.00
Assembly Number of parts 2.85
Inspection Number of finished units 30.00

Drilling has just completed 80 units of a component for a customer. Each unit required 105 parts and 3
machine-hours. The prime cost is $1,200 per finished unit. All other manufacturing costs are classified as
manufacturing overhead.

Customer order specifics:

Number of units = 80
No. of parts/unit produced = 100
No. of mhr/unit produced = 3
Prime cost (DM + DL)/unit = $1,300

Upstream cost (e.g., R&D)/unit = $180

Downstream cost/unit = $300

Required

Compute the total manufacturing costs and the unit costs of the 80 units just completed using ABC
costing.
In addition to the manufacturing costs, the firm has determined that the total cost of upstream activities
including research and development and product design is $180 per unit. The total cost of downstream
activities, such as distribution, marketing, and customer service is $300 per unit. Compute the full product
cost per unit, including upstream, manufacturing, and downstream activities. What are strategic
implications of this new cost result?
Explain to Drilling Company the usefulness of calculating the total value-chain cost and of knowing costs
of different value-creating activities.

Solution

1. Manufacturing cost (total, and per unit):

Prime manufacturing cost (80 x$1,300) = $104,000

Manufacturing overhead:
Materials handling (80 × 100 × $0.60) = $4,800
Machining (80 × 3 × $51.00) = $12,240
Assembly (80 × 100 × $2.85) = $22,800
Inspection (80 x $30.00) = $2,400
Total Manufacturing Cost = $146,240
Number of units = 80
Manufacturing cost per unit = $1,828.00

2. Computation of full cost:

Upstream activity costs = $180.00 7.80%

Manufacturing costs = $1,828.00 79.20%
Downstream activity costs = $300.00 13.00%
Full Product Cost per Unit = $2,308.00 100.00%

(1) Knowing the full cost of a product including upstream and downstream costs allows the
firm to be aware of all costs attributable to the product.
(2) The amounts and proportions of upstream, manufacturing, and downstream costs
facilitate comparisons with competitors.
(3) The company should consider ways of spending less cost in the manufacturing activity,
and more on upstream and downstream activities in order to improve its competitive
position by pursuing the differentiation strategy in both the new product design and the
customer service.
 
3. The total value chain cost provides the firm a long-term perspective of the product cost, in
addition to the short term manufacturing cost. Different industries have different cost
structures. For example, firms in the information technology industries are likely to have high
upstream costs while firms in the retailing industry tend to have high downstream costs.
Problem 5-41 Volume-Based Costing Versus ABC
Eastern Chemical Company produces three products. The firm sets the target price of each product at 150% of the
product's total manufacturing cost. Recognizing that the firm was able to sell Product C at a much higher price
than the target price of the product and lost money on Product B, To Watson, CEO, wants to promote Product C
much more aggressively and phase out Product B. He believes that the information suggests that Product C has
the greatest potential among the firm's three products since the actual selling price of Product C was almost 50
percent higher than the target price while the firm was forced to sell Product B at a price below the target price.
Both the budgeted and actual factory overhead for 2013 are $493,000. The actual units sold for each product also
are the same as the budgeted units. The firm uses direct labor dollars to estimate manufacturing overhead costs.
The direct materials and direct labor costs per unit for each product are:

Target selling price (% of total mfg. cost) = 150%

Budgeted factory overhead = $508,000
Actual factory overhead incurred = $508,000

Actual operating results for the year are as follows:

Product Sales Quantity Target Price Actual Price Difference

A 1,000 $285.00 $286.00 $1.00 $190.00 190 285.00
B 5,000 $297.60 $255.60 ($42.00) $198.40 198.4 297.60
C 500 $202.50 $310.00 $107.50 $135.00 135 202.50

The direct labor and direct materials cost per unit are as follows:

Product A Product B Product C

Direct Materials $50.00 $114.40 $65.00
Direct labor $20.00 $12.00 $10.00
Total prime cost $70.00 $126.40 $75.00

The controller notes that not all of the products consume factory overhead costs similarly. Upon further investigation, she
identified the following overhead consumption data for the year:

Product A Product B Product C Total Overhead

Number of setups 2 5 3 $9,000
Weight of direct materials (pounds) 400 250 350 $110,000
Waste and hazardous disposals 25 45 30 $250,000
Quality inspections 30 35 35 $75,000
Utilities (machine hours) 2,000 7,000 1,000 $66,000
TOTAL $510,000

Required
Determine the manufacturing cost per unit for each of the products using the volume-based method.
What is the least profitable and the most profitable product under both the current and the ABC costing systems?
What is the new target price for each product based on 150 percent of the new costs under the ABC system?
Compare this price with the actual selling price.
Comment on the result. As a manager of Eastern Chemical, describe what actions you would take based on the
information provided by the activity-based unit costs.

1. Determine the amount of overhead cost per unit and the total overhead for each of the products.

Product A Product B Product C

Materials $50.00 $114.40 $65.00
Labor $20.00 $12.00 $10.00
Overhead* $120.00 $72.00 $60.00
Total Cost $190.00 $198.40 $135.00
*overhead is applied based on direct labor dollars so the rate is:
$6.00 per direct labor dollar = $510,000÷($20×1,000+$12×5,000+$10×500)
$120 = 6×20; $72 = 6×12; $60 =6×10
2. Is Product B the least profitable and Product C the most profitable under both the current and the ABC costing
systems?

CURRENT COSTING SYSTEM

Product A Product B Product C
Actual Selling Price $286.00 $255.60 $310.00
Product Manufacturing Cost $190.00 $198.40 $135.00
Gross Margin $96.00 $57.20 $175.00
Gross Margin Ratio 33.57% 22.38% 56.45%

Based on the current cost data, product B is the least profitable product with a gross
margin per unit of $57.20 (22.38%) and product C is the most profitable product
with a gross margin per unit of $175.00 (56.45%).

ACTIVITY-BASED COSTING SYSTEM

Cost per Transaction
Setup $900.00
Materials Handling $110.00
Hazardous Control $2,500.00
Quality Control $750.00
Utilities $6.60

(calculate on per unit basis) Product A Product B Product C

Direct Materials 50.00 114.40 65.00
Direct Labor 20.00 12.00 10.00
Factory Overhead:
Setups (a) 1.80 0.90 5.40
Materials Handling (b) 44.00 5.50 77.00
Hazardous Control (c) 62.50 22.50 150.00
Quality Control (d) 22.50 5.25 52.50
Utilities (e) 13.20 9.24 13.20
TOTAL 214.00 169.79 373.10

Actual Selling Price 286.00 255.60 310.00

Product Manufacturing Cost 214.00 169.79 373.10
Gross Margin 72.00 85.81 (63.10)
Gross Margin Percentage 25.17% 33.57% -20.35%

Notes:
(a) Setups:
Cost per setup: $9,000 ÷ (2 + 5 + 4) = $900 per setup
Product A = 2 × $900 = $1,800; $1,800 ÷1,000 = $1.80 per unit
Product B = 5 × $900 = $4,500; $4,500 ÷5,000 = $0.90 per unit
Product C = 3 × $900 = $2,700; $2,700 ÷500 = $5.40 per unit
 
(b) Materials handling:
Cost per pound = $110,000 ÷ (400 + 250 + 350) = $110 per pound
Product A = 400 × $110 = $44,000; $44,000÷1,000 = $44.00 per unit
Product B = 250 × $110 = $27,500; $27,500÷5,000 = $ 5.50 per unit
Product C = 350 × $110 = $38,500; $38,500÷500 = $77.00 per unit
 
(c) Waste and hazardous disposals:
Cost per disposal: $250,000÷(25 + 45 + 30) = $2,500 per disposal
Product A = 25 × $2,500 = $ 62,500; $ 62,500÷1,000 = $ 62.50/unit
Product B = 45 × $2,500 = $112,500; $112,500÷5,000 = $ 22.50/unit
Product C = 30 × $2,500 = $ 75,000; $ 75,000÷500 = $150.00/unit
 
(d) Quality inspections:
Cost per inspection = $75,000÷(30 + 35 + 35) = $750 per inspection
Product A = 30 × $750 = $22,500; $22,500÷1,000 = $22.50 per unit
Product B = 35 × $750 = $26,250; $26,250÷5,000 = $ 5.25 per unit
Product C = 35 × $750 = $26,250; $26,250÷500 = $52.50 per unit
 
(e) Utilities:
Cost per MH = $66,000 ÷ (2,000 + 7,000 + 1,000) = $6.60 per MH
Product A = 2,000 × $6.6 = $13,200; $13,200÷1,000 = $13.20 per unit
Product B = 7,000 × $6.6 = $46,200; $46,200÷5,000 = $ 9.24 per unit
Product C = 1,000 × $6.6 = $ 6,600; $ 6,600÷500 = $13.20 per unit
  
(e) Utilities:
Cost per MH = $66,000 ÷ (2,000 + 7,000 + 1,000) = $6.60 per MH
Product A = 2,000 × $6.6 = $13,200; $13,200÷1,000 = $13.20 per unit
Product B = 7,000 × $6.6 = $46,200; $46,200÷5,000 = $ 9.24 per unit
Product C = 1,000 × $6.6 = $ 6,600; $ 6,600÷500 = $13.20 per unit

3. What is the new target price for each product based on 150 percent of the new costs under the ABC system?
Compare this price with the actual selling price.

Product A Product B Product C

Product Costs:
Direct-labor system $190.00 $198.40 $135.00
Activity system $214.00 $169.79 $373.10

ABC- based product costs:

Target price $321.00 $254.69 $559.65
Actual selling price $286.00 $255.60 $310.00
Difference in price -35.00 0.91 -249.65

Direct-labor system:
Gross Margin $96.00 $57.20 $175.00
Gross Margin ratio 33.57% 22.38% 56.45%

ABC system:
Gross Margin $72.00 $85.81 -$63.10
Gross Margin ratio 25.17% 33.57% -20.35%

4. Comment on the result. As a manager of Eastern Chemical, describe what actions you would take based on
the information provided by the activity-based unit costs.

1. Emphasizing Product C as suggested by the current direct-labor-cost based overhead

costing system is likely to lead to the demise of the firm. The activity-based costing system
shows that the manufacturing cost of Product C is $373.10 per unit and, at the current selling
price, the firm suffers a $63.10 loss for each unit it manufactures and sells.
 
2. If the actual selling prices of products A & B are fair market prices for these products and a
markup of 150% is a common industry practice, the firm needs to examine the
manufacturing cost of product A. The fact that the firm’s target price, determined using
150% of the manufacturing cost, is more than 10 percent over the fair market price of the
product suggests possible wastes and inefficiencies in the manufacturing of product A.
Problem 5-44 Activity-Based Costing

Miami Valley Architects, Inc., provides a wide range of engineering and architectural consulting services
through its three branch offices in Columbus, Cincinnati, and Dayton, OH. The company allocates
resources and bonuses to the three branches based on the net income of the period. The results of the
firm’s performance for the year 2013 (in thousands) follows:

Columbus Cincinnati Dayton Total

Sales $1,500 $1,419 $1,067 $3,986
Less: Direct labor $382 $317 $317 $1,016
Direct Materials $281 $421 $185 $887
Overhead $710 $589 $589 $1,888
Net Income $127 $92 -$24 $195
Prod OH Rate = $1.859
Miami Valley accumulates overhead items in one overhead pool and allocates it to the branches based on
direct labor dollars. For 2013, this predetermined overhead rate was $1.859 for every direct labor dollar
incurred by an office. The overhead pool includes rent, depreciation, and taxes, regardless of which office
incurred the expense. Some branch managers complain that the overhead allocation method forces them to
absorb a portion of the overhead incurred by the other offices.
Management is concerned with the 2013 operating results. During a review of overhead expenses,
management noticed that many overhead items were clearly not correlated to the movement in direct labor
dollars as previously assumed. Management decided that applying overhead based on activity-based costing
and direct tracing wherever possible should provide a more accurate picture of the profitability of each
branch.
An analysis of the overhead revealed that the following dollars for rent, utilities, depreciation, and taxes
could be traced directly to the office that incurred the overhead ($ in thousands):

Columbus Cincinnati Dayton Total

Direct Overhead $180 $270 $177 $627

Activity pools and their corresponding cost drivers were determined from the accounting records and staff
surveys as follows:

(values in thousands)

General administration $409

Project costing $48
Accounts payable/receiving $139
Accounts receivable $47
Payroll/Mail sort and delivery $30
Personnel recruiting $38
Employee insurance processing $14
Proposals $139
Sales meetings/Sales aids $202
Shipping $24
Ordering $48
 Duplicating costs $46
Blueprinting $77

Volume of Cost Drivers by Location

Cost Driver Columbus Cincinnati Dayton

Direct labor cost $382,413 $317,086 $317,188

Timesheet entries 6,000 3,800 3,500
Vendor Invoices 1,020 850 400
Client invoices 588 444 96
Employees 23 26 18
New hires 8 4 7
Insurance claims filed 230 260 180
Proposals 200 250 60
Contracted sales 1,824,439 1,399,617 571,208
Projects shipped 99 124 30
Purchase orders 135 110 80
Copies duplicated 162,500 146,250 65,000
Blueprints 39,000 31,200 16,000

Required
What overhead costs should be assigned to each branch based on ABC concepts?
What is the contribution of each branch before subtracting the results obtained in requirement 1?
What is the profitability of each branch office using ABC?
Evaluate the concerns of management regarding the volume-based cost technique currently used.

(See "Miami Valley Architects, Inc.," by Beth M. Chaffman, CPA and John Talbott, CMA, Management Accounting
Campus Report, Fall 1992, p. 4.)

1. Overhead Cost Assigned to Each Branch Under ABC:

Cost Driver Columbus Cincinnati Dayton Total

Direct labor cost 37.61% 31.19% 31.20% 100.00%

Timesheet entries 45.11% 28.57% 26.32% 100.00%
Vendor Invoices 44.93% 37.44% 17.62% 100.00%
Client invoices 52.13% 39.36% 8.51% 100.00%
Employees 34.33% 38.81% 26.87% 100.00%
New hires 42.11% 21.05% 36.84% 100.00%
Insurance claims filed 34.33% 38.81% 26.87% 100.00%
Proposals 39.22% 49.02% 11.76% 100.00%
Contracted sales 48.07% 36.88% 15.05% 100.00%
Projects shipped 39.13% 49.01% 11.86% 100.00%
Purchase orders 41.54% 33.85% 24.62% 100.00%
Copies duplicated 43.48% 39.13% 17.39% 100.00%
Blueprints 45.24% 36.19% 18.56% 100.00%

Activity-based Overhead Allocation

 (in thousands)
Cost Driver Columbus Cincinnati Dayton Total

General administration Direct labor cost $153.82 $127.56 $127.60 $409

Project costing Timesheet entries $21.65 $13.71 $12.63 $48
Accounts payable/receiving Vendor Invoices $62.46 $52.05 $24.49 $139
Accounts receivable Client invoices $24.50 $18.50 $4.00 $47
Payroll/Mail sort and delivery Employees $10.30 $11.64 $8.06 $30
Personnel recruiting New hires $16.00 $8.00 $14.00 $38
Employee insurance processing Insurance claims file $4.81 $5.43 $3.76 $14
Proposals Proposals $54.51 $68.14 $16.35 $139
Sales meetings/Sales aids Contracted sales $97.10 $74.49 $30.40 $202
Shipping Projects shipped $9.39 $11.76 $2.85 $24
Ordering Purchase orders $19.94 $16.25 $11.82 $48
Duplicating costs Copies duplicated $20.00 $18.00 $8.00 $46
Blueprinting Blueprints $34.84 $27.87 $14.29 $77
TOTAL $529.32 $453.40 $278.25 $1,261

Calculation for general administration expenses allocated to branches:

Total direct labor dollars = $382,413 + $317,086 + $317,188 = $1,016,687
Allocation of gen admin expenses is based on relative direct labor costs. For example, DL % for Columbus
= $382,413 ÷ $1,016,687 = 37.61% × $409 = $153.84.

2. Contribution of each branch:

Contribution of Each Branch

(in thousands)
Columbus Cincinnati Dayton Total
Sales $1,500 $1,419 $1,067 $3,986
Less: Direct labor $382 $317 $317 $1,016
Direct materials $281 $421 $185 $887
Direct overhead $180 $270 $177 $627
Contribution margin $657 $411 $388 $1,456

3. Profitability of each branch, under ABC:

Profitability of Each Branch Based on Activity-based Costing

(in thousands)
Columbus Cincinnati Dayton Total
Sales $1,500 $1,419 $1,067 $3,986
Less: Direct labor $382 $317 $317 $1,016
Direct materials $281 $421 $185 $887
Direct overhead $180 $270 $177 $627
Contribution margin $657 $411 $388 $1,456
Activity-based overhead $529 $453 $278 $1,261
Operating income $128 ($42) $110 $195

4. Evaluating management concerns:

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