CHAPTER 14
DISCUSSION QUESTIONS
Q14-1. Compared to traditional costing, ABC is a
more thorough application of cost traceabil-
ity. Traditional costing traces only direct
material and direct tabor to output; ABC rec-
ognizes that many other costs are traceable,
if not to output, then to other cost objects
called activities.
Q14-2. The role of activities in assigning costs to
products, using ABC, is to serve as the link
between products and costs: activities are
required to produce output, and it is the
activities that consume resources, thus
causing costs to be incurred. This differs
from traditional costing in which output is
assumed to cause costs.
Q14-3. Examples of significant, costly activities in
manufacturing are setting up, changing
designs, receiving materials, requisitioning
materials, moving materials and products,
ordering from vendors, and inspecting.
Q14-4. The two circumstances that must be present
for a traditional costing system to report dis-
torted product costs are a complex cost
structure and a diverse product line.
Q14-5. A complex cost structure is present if a sig-
nificant part of overhead cost is not related
to the volume of output.
Q14-6. A diverse product line is one in which differ-
ent products consume different mixes of vol-
ume-related and nonvolume-related costs.
Q14-7. The four levels of costs and drivers in ABC
are the unit level, the batch level, the prod-
uct level, and the plant level.
Q14-8. If a product consumes 10% of all unit-level
activities and 30% of all batch-level activi-
ties, traditional costing will under-report its
cost by assigning 10% of all overhead costs
to the product, including 10% of batch-level
costs, when 30% of batch-level costs should
be assigned to the product.
Q14-9. When both low-volume and high-volume prod-
ucts are produced in a company using tradi-
tional costing, the low-volume product is likely
to have its cost distorted by a larger percent-
age than the high-volume product. The low-
volume product’s cost is generally distorted
14-1
downward by traditional costing, and the high-
volume product’s cost is distorted upward.
Q14-10. In assigning plant-level costs to products,
ABC offers little or no advantage over tradi-
tional costing.
Q14-11. The difference between CM and ABC is pri-
marily explained by the fact that ABC is a
long-run decision-making technique, while
CM is short-run analysis.
Q14-12. If a product is discontinued, the costs
reported for that product by ABC will not
necessarily be avoided, because ABC only
measures how resources are consumed by
products, not how spending will be affected
by discontinuing a product. Avoiding a cost
requires that less be spent on some
resource(s), and ABC does not predict
changes in spending. (This is also true of
traditional absorption costing.)
Q14-13. The relationship between ABC and ABM is
that ABM uses information obtained from
ABC to make improvements in the firm.
Q14-14. The area of ABM that follows directly from
ABC’s revision of product costs is the strate-
gic realignment of the firm’s pricing structure
and product line, permitting the firm to retain
or regain high-volume business in spite of
pricing pressure, and prompting manage-
ment to reexamine the roles of some low-vol-
ume products.
Q14-15. The high costs of some activities, especially
non-value-added activities, can focus atten-
tion on the need to reduce or eliminate them.
Q14-16. ABC can lead to improved decisions in
designing a product because ABC tells the
cost of each activity required in producing
the product. This information permits design-
ers to make design decisions more accu-
rately, so that the most cost-effective design
can be selected.
Q14-17. The link between ABC and TQM is that ABC
reveals the costs of each activity, including
those that do not add value, and TQM seeks
to reduce or eliminate non-value-added activ-
ities. Thus, ABC can focus attention in a TQM
effort and can prioritize TQM’s improvements.
14-2 Chapter 14

EXERCISES

E14-1 (a) B
(b) U
(c) U
(d) B—because no finished goods inventory is maintained, each batch is
shipped immediately; therefore, shipments are most likely a batch-level
driver.
(e) P
(f) U
(g) P—where large materials inventories are maintained, purchase orders are
not issued for each batch to be produced; instead, a withdrawal will be
made from inventory for each batch. Purchase orders are then identifiable
with the total annual requirements, which makes it a product-level driver,
i.e., it is traceable no farther than to products. If a purchased item is used
in several products, its purchase orders are at the level of the product
family or product line, which are even higher levels.
(h) U
(i) U
(j) B

E 14-2 (a) U
(b) B
(c) U
(d) U
(e) U
(f) B
(g) P
(h) P

E14-3 The existing system allocated 1,500/30,000 = 5% of all overhead to Product #1

last year; but #1 accounted for only 30/1,000 = 3% of batch-level activity. So, with
respect to batch-level costs only, the existing system overstated #1’s cost last
year by a total of:

(5% – 3%) × $100,000 = $2,000 overstatement

E14-4 The existing system allocated $15,000/$3,000,000 = 0.5% of materials-related

overhead to Product AA last year, but AA accounted for only 40/40,000 = 0.1% of
materials-related activity. So, with respect to materials-related overhead only, the
existing system overstated AA’s cost last year by a total of:

(0.5% – 0.1%) × $1,200,000 = $4,800 overstatement

Chapter 14 14-3

E14-5 The existing system allocated only 600/50,000 = 1.2% of all overhead to Product
RK last year; but Product RK accounted for 132/6,000 = 2.2% of design change
activity last year. Therefore, with respect to design change costs only, the exist-
ing system understated RK’s cost last year by a total of:

(2.2% – 1.2%) × $2,000,000 = $20,000 understatement

E14-6 The existing system allocated $40,000/$200,000 = 20% of all overhead to Product
BB last year; but BB accounted for only 6/200 = 3% of the activity of maintaining
supplies of purchased subassemblies last year. Therefore, with respect to the
cost of maintaining supplies of purchased subassemblies only, the existing sys-
tem overstated BB’s cost last year by a total of:

(20% – 3%) × $50,000 = $8,500 overstatement

E14-7
(1) $126 of overhead cost will be allocated to a unit of #456, calculated as follows:
$1, 400, 000
× 90 machine hours = $12, 600;
10, 000 machine hours
$12, 600
= $126 per unit
100 units of Product # 456

(2) $554 of overhead cost will be allocated to a unit of #456, calculated as follows:
$300, 000
× 6 setups = $15, 000 of batch − level cost;
120 setups
$35,000 of
$500, 000
× 280 design hours = product-level cost;
4, 000 design hours
$5,400 of unit-
$200, 000 + $400, 000 and plant-level cost.
× 90 machine hours =
10, 000 machine hours

Therefore, the overhead allocated to a unit of Product #456 is:

($15,000 + $35,000 + $5,400)/100 units = $55,400/100 units = $554 per unit

14-4 Chapter 14

E14-8 Because the traditional system uses machine hours as the only allocation base,
Product #456 is allocated 90/10,000 = 0.9% of all overhead. The activity data indi-
cate #456 should be assigned 6/120 = 5% of batch-level costs, 280/4,000 = 7% of
product-level costs, and 0.9% of all other overhead. The reconciliation is:

Per
Total Unit
Cost of #456 from traditional system, as
calculated in part (1) of E14-7 ..................... $12,600 $126
Adjustments for.
Understatement of batch-level
costs, $300,000 × (5% – 0.9%)................. $12,300
Understatement of product-level
costs, $500,000 × (7% – 0.9%)................. 30,500
Total adjustments ......................................... $42,800 428
Cost of #456 from ABC system, as
calculated in part (2) of E14-7 .................... $55,400 $554

E14-9
(1) $140 of overhead cost will be allocated to a unit of #456, calculated as follows:
$1, 400, 000
× 200 DL hours = $14, 000;
20, 000 DL hours
$14, 000
= $140 per unit
100 units of Product # 456
(2) $740 of overhead cost will be allocated to a unit of #456, calculated as follows:

$300, 000
× 30 setuphours = $18, 000 of batch-level costt;
500 setup hours

$500, 000 $50,000 of product-level

× 4 design changes =
40 design hours cost;

$200, 000 + $400, 000 200 direct labor $6,000 of unit-

× =
20, 000 DL hours hours and plant-level cost.

Therefore, the overhead allocated to a unit of Product #456 is:

($18,000 + $50,000 + $6,000)/100 units = $74,000/100 units = $740 per unit

Chapter 14 14-5

E14-10 Because the traditional system uses direct labor hours as the only allocation
base, Product #456 is allocated 200/20,000 = 1% of all overhead. The activity
data indicate #456 should be assigned 30/500 = 6% of batch-level costs, 4/40 =
10% of product-level costs, and 1% of all other overhead. The reconciliation is:

Per
Total Unit
Cost of #456 from traditional system, as
calculated in part (1) of E14-9 ..................... $14,000 $140
Adjustments for:
Understatement of batch-level
costs, $300,000 × (6% – 1%).................... $15,000
Understatement of product-level
costs, $500,000 × (10% – 1%).................. 45,000
Total adjustments ........................................ $60,000 600
Cost of #456 from ABC system, as
calculated in part (2) of E14-9 ..................... $74,000 $740

E14-11 Activities g, u, y, and dd are the only ones that definitely add value. Activity
k is questionable, because a single deburring after drilling should be suffi-
cient to remove all burrs. The first deburring, k, is probably performed to
make it easier and safer for workers to handle the product in the interim. If
the need for so much handling can be eliminated (perhaps through auto-
mated material-handling equipment), then k could be eliminated with no loss
of value to the customer and perhaps with a net savings to the company, so
k is arguably a non-value-added activity.
14-6 Chapter 14

PROBLEMS

P14-1
(1) The overhead rates in the existing costing system are $23 per machine hour, and
$14 per direct labor hour, calculated as follows:
$92, 000 of machine-related overhead
= $23 per machine hour
4, 000 machine hours

$280, 000 of remaining overhead costs

= $14 per direct labor hour
20, 000 DLH

(2) Making only the changes suggested by the study, the structure of the ABC sys-
tem would be:

Pool Driver
machine operation ..................... machine hours
setup and material handling ..... setups
other materials-related overhead purchase orders
all remaining overhead .............. direct labor hours

The study did not suggest any change for machine operation cost, nor for the
“other overhead” category.

(3) The ABC system’s overhead rates (driver rates) are $16.25 per machine hour, $57
per setup, $50 per purchase order, and $10.75 per direct labor hour, calculated
as follows:

$65, 000 of machine operation overhead

= $16.25 per machine hour
4, 000 machine hours

$27, 000 of machine-setup overhead +

$30, 000 of materials handling overhead
= $57 per setup
1, 000 setups

$35, 000 of otherr materials-related cost

= $50 per purchase orde
er
700 purchase orders

$215, 000 of "other overhead"

= $10.75 per direct labor hour
20, 000 DLH
Chapter 14 14-7

P14-2

(1) The three overhead rates in the existing costing system are $17.50 per machine
hour, $.96 per direct material dollar, and $1.25 per direct labor dollar, calculated
as follows:
$700,000 of machine-related overhead
= $17.50 per machine hour
40,000 machine hours

$960,000 of materials-
related overhead 96% of direct material cost or
=
00 of direct
$1,000,00 $.96 per direct material dollar
material cost

$2,500,000 of other
overhead cost 125% of direct labor cost or
= $1.25 per direct labor dollar
$2,000,000 of
direct labor cost

(2) Making only the changes suggested by the study, the structure of the ABC sys-
tem would be:

Pool Driver
machine operation ..................... machine hours
setup and material handling ..... setups
materials administration............ purchase orders
freight-in ...................................... material pounds
all remaining overhead .............. direct labor cost

The study did not suggest any change for machine operation cost, nor for the
“all remaining overhead” category.

(3) The ABC system’s overhead rates are $12.50 per machine hour, $1,020 per setup,
$50 per purchase order, $.75 per pound of materials, and $1.25 per direct labor
dollar, calculated as follows:

$500, 000 of machine-

operation overhead
= $12.50 per machine hour
40, 000 machine hours

$200, 000 of machine-setup overhead +

$310, 000 of materials handling overhead
= $1, 020 per setup
500 setups

$500,000 of materials
administration overhead
= $50 per purchase order
10, 000 purchase orders
14-8 Chapter 14

P14-2 (Concluded)

$150,000 of freight-in
= $.75 per pound off materials
200,000 pounds of materials

$2,500,000 of other
overhead cost
= 125% of direct labor cost or
$2,000,000 of $1.25 per direct labor dollar
direct labor cost

P14-3
(1) DRAPER COMPANY
Product Costs from Existing Costing System

Overhead rate: $4,500,000 of overhead divided by $3,000,000 of direct labor cost =

150% of direct labor cost

Standard Custom Total

Direct material ................................................ $ 882,000 $ 12,500 $ 894,500
Direct labor ................................................ 2,910,000 90,000 3,000,000
Overhead:
150% × $2,910,000 ........................................... 4,365,000
150% × $90,000 ................................................ 135,000 4,500,000
Total cost ................................................ $8,157,000 $237,500 $8,394,500
Units produced ................................................ ÷ 73,500 ÷ 125
Cost per unit ................................................ $ 110.98 $ 1,900
Chapter 14 14-9

P14-3 (Continued)

(2) DRAPER COMPANY

Product Costs from Activity Based Costing System

Overhead rates:
$300,000 setup-related costs divided by 60 setups = $5,000 per setup
$900,000 design-related costs divided by 15,000 design hours = $60 per design hour
$3,300,000 other overhead divided by $3,000,000 DL cost = 110% of direct labor cost

Standard Custom Total

Direct material...................................................... $ 882,000 $ 12,500 $ 894,500
Direct labor........................................................... 2,910,000 90,000 3,000,000
Overhead:
$5,000 × 30 setups ............................................ 150,000
$5,000 × 30 setups ............................................ 150,000 300,000
$60 × 12,000 design hrs.................................... 720,000
$60 × 3,000 design hrs...................................... 180,000 900,000
110% × $2,910,000 ............................................. 3,201,000
110% × $90,000 .................................................. 99,000 3,300,000
Total cost .............................................................. $7,863,000 $531,500 $8,394,500
Units produced .................................................... ÷ 73,500 ÷ 125
Cost per unit ........................................................ $ 106.98 $ 4,252

(3) Because the existing system used direct labor cost as the only allocation base
and Custom consumed $90,000/$3,000,000 = 3% of direct labor cost, the exist-
ing system allocated 3% of all overhead to Custom. The activity information
indicates Custom consumed 30/60 = 50% of setup-related activity and
3,000/15,000 = 20% of design-related activity, so the reconciliation is as follows:

Per
Total Unit
Cost of Custom from traditional system,
as calculated in requirement (1) ................. $237,500 $1,900
Adjustments for:
Understatement of setup-related
costs, $300,000 × (50% – 3%).................. $141,000
Understatement of design-related
costs, $900,000 × (20% – 3%).................. 153,000
Total adjustments ......................................... 294,000 2,352
Cost of Custom from ABC system, as
calculated in requirement (2) ...................... $531,500 $4,252

P14-3 (Concluded)
14-10 Chapter 14

(4) The only costs handled differently by the two costing systems were the $300,000
of setup-related costs and $900,000 of design-related costs, for a total of
$1,200,000; this represents only 27% of the total overhead of $4,500,000.

The change in the costing system caused the reported cost of Custom to change
from $237,500 to $531,500, which is an increase of 124%.

P14-4

(1) SHAUTON COMPANY

Product Costs from Existing Costing System

Overhead rate: $1,200,000 of overhead divided by 30,000 direct labor

hours = $40 per direct labor hour

Fancy Plain Total

Direct material...................................................... $ 60,000 $ 160,000 $ 220,000
Direct Labor ......................................................... 28,000 272,000 300,000
Overhead:
$40 × 2,800 DLH ............................................... 112,000
$40 × 27,200 DLH ............................................. 1,088,000 1,200,000
Total cost .............................................................. $200,000 $1,520,000 $1,720,000
Units produced .................................................... ÷ 200 ÷ 16,000
Cost per unit ........................................................ $ 1,000 $ 95
Chapter 14 14-11

P14-4 (Continued)

(2) SHAUTON COMPANY

Product Costs from Activity Based Costing System

Overhead rates:
$135,000 setup-related costs divided by 90 setups = $1,500 per setup
$240,000 design-related costs divided by 8,000 design hours = $30 per design hour
$825,000 other overhead divided by 30,000 direct labor hours = $27.50 per direct labor
hour
Fancy Plain Total
Direct material...................................................... $ 60,000 $ 160,000 $ 220,000
Direct labor........................................................... 28,000 272,000 300,000
Overhead:
$1,500 × 45 setups .................................. 67,500
$1,500 × 45 setups .................................. 67,500 135,000
$30 × 3,000 design hrs ........................... 90,000
$30 × 5,000 design hrs ........................... 150,000 240,000
$27.50 × 2,800 DLH ................................. 77,000
$27.50 × 27,200 DLH ............................... 748,000 825,000
Total cost .............................................................. $322,500 $1,397,500 $1,720,000
Units produced .................................................... ÷ 200 ÷ 16,000
Cost per unit ........................................................ $1,612.50 $ 87.34

(3) Because the existing system used direct labor hours as the only allocation base
and Fancy consumed 2,800/30,000 = 9 1/3% of direct labor hours, the existing
system allocated 9 1/3% of all overhead to Fancy. The activity information indi-
cates Fancy consumed 45/90 = 50% of setup-related activity and 3,000/8,000 =
37.5% of design-related activity, so the reconciliation is as follows:

Per
Total Unit
Cost of Fancy from traditional system,
calculated in requirement (1) ...................... $200,000 $1,000.00
Adjustments for:
Understatement of setup costs,
$135,000 × (50% – 9 1/3%) ........................... $54,900
Understatement of design costs,
$240,000 × (37.5% – 9 1/3%) ........................ 67,600
Total adjustments ......................................... 122,500 612.50
Cost of Fancy from ABC system, as
calculated in requirement (2) ...................... $322,500 $1,612.50
14-12 Chapter 14

P14-4 (Concluded)

(4) The only costs handled differently by the two costing systems were the $135,000
of setup-related costs and $240,000 of design-related costs, for a total of
$375,000; this represents only 31.25% of the total overhead of $1,200,000.

The change in the costing system caused the reported cost of Fancy to change
from $200,000 to $322,500, which is an increase of 61.25%.

P14-5

(1) TUNNEY COMPANY

Product Costs from Existing Costing System

Overhead rate: $1,000,000 of overhead divided by 50,000 direct

labor hours = $20 per direct labor hour

Normal Enhanced Super Total

Direct material .......... $ 60,000 $ 20,000 $ 5,000 $ 85,000
Direct labor ............... 300,000 35,000 5,000 340,000
Overhead:
$20 × 45,000 DLH.. 900,000
$20 × 4,500 DLH.... 90,000
$20 × 500 DLH....... 10,000 1,000,000
Total cost................... $1,260,000 $145,000 $20,000 $1,425,000
Units produced ......... ÷ 30,000 ÷ 1,000 ÷ 50
Cost per unit ............. $ 42 $ 145 $ 400
Chapter 14 14-13

P14-5 (Concluded)

(2) TUNNEY COMPANY

Product Costs from Activity Based Costing System

Overhead rates:
$400,000 batch-level overhead divided by 500 requisitions = $800 per requisition
$600,000 other overhead divided by 50,000 direct labor hours = $12 per direct labor hour

Normal Enhanced Super Total

Direct material .......... $ 60,000 $ 20,000 $ 5,000 $ 85,000
Direct labor ............... 300,000 35,000 5,000 340,000
Overhead:
$800 × 150 req ...... 120,000
$800 × 200 req ...... 160,000
$800 × 150 req ...... 120,000 400,000
$12 × 45,000 DLH.. 540,000
$12 × 4,500 DLH.... 54,000
$12 × 500 DLH....... 6,000 600,000
Total cost................... $1,020,000 $269,000 $136,000 $1,425,000
Units produced ......... ÷ 30,000 ÷ 1,000 ÷ 50
Cost per unit ............. $ 34 $ 269 $ 2,720

(3) Because the existing system used direct labor hours as the only allocation
base and Super consumed 500/50,000 = 1% of direct labor hours, the existing
system allocated 1% of all overhead to Super. The activity information indi-
cates Super consumed 150/500 = 30% of batch-level activity, so the reconcilia-
tion is as follows:

Per
Total Unit

Cost of Super from traditional system,

as calculated in requirement (1).............................. $ 20,000 $ 400
Adjustment for understatement of batch-
level costs, $400,000 × (30% – 1%) ......................... 116,000 2,320
Cost of Super from ABC system, as
calculated in requirement (2)................................... $136,000 $2,720

(4) The only costs handled differently by the two costing systems were the $400,000
of batch-level costs, which represents only 40% of the total overhead of
$1,000,000.
The change in the costing system caused the reported cost of Super to
change from $20,000 to $136,000, which is an increase of 580%.
14-14 Chapter 14

P14-6

(1) TEKSIZE COMPANY

Product Costs from Existing Costing System

Overhead rate: $1,500,000 of overhead divided by 50,000 direct labor

hours = $30 per direct labor hour

Regular Large Total

Direct material ....................................... $ 10,000 $ 40,000 $ 50,000
Direct labor ............................................ 120,000 480,000 600,000
Overhead:
$30 × 10,000 DLH .............................. 300,000
$30 × 40,000 DLH .............................. 1,200,000 1,500,000
Total cost ............................................... $430,000 $1,720,000 $2,150,000
Units produced ...................................... ÷ 10,000 ÷ 10,000
Cost per unit .......................................... $ 43 $ 172

(2) TEKSIZE COMPANY

Product Costs from Activity Based Costing System

Overhead rates: $515,000 setup-related costs divided by 103 setups

= $5,000 per setup
$985,000 other overhead divided by 50,000 direct labor
hours = $19.70 per DLH

Regular Large Total

Direct material ....................................... $ 10,000 $ 40,000 $ 50,000
Direct labor ............................................ 120,000 480,000 600,000
Overhead:
$5,000 × 51 setups ............................ 255,000
$5,000 × 52 setups ............................ 260,000 515,000
$19.70 × 10,000 DLH ......................... 197,000
$19.70 × 40,000 DLH ......................... 788,000 985,000
Total cost ............................................... $582,000 $1,568,000 $2,150,000
Units produced ...................................... ÷ 10,000 ÷ 10,000
Cost per unit .......................................... $ 58.20 $ 156.80
Chapter 14 14-15

P14-6 (Concluded)

(3) Because the existing system used direct labor hours as the only allocation base
and Regular consumed 10,000/50,000 = 20% of direct labor hours, the existing
system allocated 20% of all overhead to Regular. The activity information indi-
cates Regular consumed 51/103 = 49.51456% of setup-related activity, so the rec-
onciliation is as follows:

Per
Total Unit
Cost of Regular from traditional
system, as calculated in requirement (1) ............... $430,000 $43.00
Adjustment for understatement of setup-
related costs, $515,000 × (49.51456% – 20%)......... 152,000 15.20
Cost of Regular from ABC system, as
calculated in requirement (2)................................... $582,000 $58.20

(4) Yes, Teksize Company does have a diverse product line in the sense in which the
term is used in ABC. The fact that the two products have the same annual unit
volumes does not matter, because the existing cost system does not use units
as the allocation base. Regular represents only 20% of direct labor hours but
nearly 50% of setup-related costs, while Large has a very different mix, so a
diverse product line is present in Teksize Company.
14-16 Chapter 14

CASES

C14-1

(1) DALLAS DIVISION

Product Costs from Existing Costing System

Overhead rate: $800,000 of overhead divided by 20,000 direct

labor hours = $40 per direct labor hour

#321 #333
Direct material............................................................... $ 6,000 $ 150
Direct labor.................................................................... 30,000 600
Overhead:
$40 × 7,200 DLH ........................................................ 288,000
$40 × 120 DLH ........................................................... 4,800
Total cost ...................................................................... $324,000 $5,550
Units produced ............................................................. ÷ 2,400 ÷ 6
Cost per unit ................................................................. $ 135 $ 925

(2)
DALLAS DIVISION
Product Costs from Activity Based Costing System

Overhead rates:
$240,000 batch-level costs divided by 1,600 setups = $150 per setup
$200,000 product-level costs divided by 2,000 design hours = $100 per design hour
$360,000 other overhead divided by 20,000 direct labor hours = $18 per DLH

#321 #333
Direct material............................................................... $ 6,000 $ 150
Direct labor.................................................................... 30,000 600
Overhead:
$150 × 40 setups....................................................... 6,000
$150 × 4 setups......................................................... 600
$100 × 320 design hrs .............................................. 32,000
$100 × 200 design hrs .............................................. 20,000
$18 × 7,200 DLH ........................................................ 129,600
$18 × 120 DLH ........................................................... 2,160
Total cost ...................................................................... $203,600 $ 23,510
Units produced ............................................................. ÷ 2,400 ÷ 6
Cost per unit ................................................................. $ 84.83 $3,918.33
Chapter 14 14-17

C14-1 (Continued)

#321 #333
(3) Usual selling price............................................... $150 $1,500
Product cost......................................................... 135 925
Gross margin ....................................................... $ 15 $ 575
Percent of sales ................................................... 10% 38%

#321 #333
(4) Usual selling price............................................... $150.00 $ 1,500.00
Product cost......................................................... 84.83 3,918.33
Gross margin (loss)............................................. $ 65.17 $(2,418.33)
Percent of sales ................................................... 43% (161%)

(5) The ABC system shows that the relative profitabilities of the two products are
the reverse of what is shown by the existing system: the existing system shows
a very modest gross margin of 10% on #321, which is probably not enough to
cover its marketing and administrative costs, while showing a respectable 38%
gross margin on #333. In contrast, the ABC system shows a 43% gross margin
on #321 and a substantial loss on #333. The low-volume product appears to be
the more profitable of the two under the existing system, but appears to be a
money loser under ABC; the high-volume product appears weak under the exist-
ing system, but highly profitable under ABC.

(6) Based on the results of the ABC study, Dallas division management should con-
sider meeting the competitor’s prices on #321; this pricing strategy can be prof-
itable in the long run and should avoid loss of market share. The strategy for
#333 is not as clear. Customers are not likely to accept the 200% price increase
needed to make #333 reasonably profitable, and Dallas could lose some cus-
tomers who also buy large amounts of #321, if management discontinues #333
or increases its price too much. Management should consider several possibili-
ties for low-volume products such as #333:
(a) Reduce batch- and product-level costs enough to become an efficient pro-
ducer of low-volume products. This may require creation of a small job-
shop environment in a portion of the plant (or in another facility) where
low-volume products could be made more efficiently. The case indicates
the existing plant was designed to produce long runs efficiently, which
may explain the high batch- and product-level costs.
14-18 Chapter 14

C14-1 (Concluded)

(b) Reduce the number of products by designing a new one that can be substi-
tuted for several low-volume, unprofitable products that can then be discon-
tinued; this essentially exchanges several low-volume products for one of
much higher volume, with substantial batch- and product-level savings.
(c) Convince one of the current buyers of the low-volume products to become
a distributor of several such products; buying them from Dallas in larger
quantities, maintaining small inventories, and selling them to other cus-
tomers. This can reduce Dallas’ batch-level costs and marketing costs, but
it risks the loss of customers who like to buy the full line from one supplier.
(d) Raise prices gradually until all products are reasonably priced. This does
not mean all products must show profits. (It is acceptable for a good cus-
tomer to occasionally buy a money-losing product.) Rather, it means that
the company should not continue making a money-losing product without
a good reason. It is not acceptable to have a customer who buys only the
money-losing products, nor for the company to continue making a money-
losing product that no “good customers” are buying.
(e) In addition to the usual per-unit prices, charge a lump-sum amount per
order for any small order of a low-volume product. This charge could be
set at a level to cover estimated batch- and product-level costs.

C14-2

(1) WARRENTON DIVISION

Product Costs from OPICS

Overhead rate: $1,930,000 of overhead divided by 25,000 direct

labor hours = $77.20 per DLH

#33 #44
Direct material............................................................... $15,000 $120,000
Direct labor.................................................................... 6,000 60,000
Overhead:
$77.20 × 450 DLH ...................................................... 34,740
$77.20 × 6,000 DLH ................................................... 463,200
Total cost ...................................................................... $55,740 $643,200
Units produced ............................................................. ÷ 100 ÷ 2,000

Cost per unit ................................................................. $557.40 $ 321.60

Chapter 14 14-19

C14-2 (Continued)

(2) WARRENTON DIVISION

Product Costs from TPICS

Overhead rates:
$340,000 machine-related costs divided by 20,000 machine hours = $17 per MH
$330,000 materials-related costs divided by $1,320,000 direct material cost = 25% of
direct material cost
$360,000 + $900,000 of remaining costs divided by 25,000 direct labor hours = $50.40
per direct labor hour

#33 #44
Direct material............................................................... $15,000 $120,000
Direct labor.................................................................... 6,000 60,000
Overhead:
$17 × 300 MH............................................................. 5,100
$17 × 3,000 MH.......................................................... 51,000
25% × $15,000 ........................................................... 3,750
25% × $120,000 ......................................................... 30,000
$50.40 × 450 DLH ...................................................... 22,680
$50.40 × 6,000 DLH ................................................... 302,400
Total cost ...................................................................... $52,530 $563,400
Units produced ............................................................. ÷ 100 ÷ 2,000
Cost per unit ................................................................ $525.30 $ 281.70

(3) TPICS is not an ABC system because all the allocation bases are at the unit level.
The changes management made do show many of the attributes typically associ-
ated with a change to ABC: the increase in the number of overhead cost pools, the
attempt to create homogeneous cost pools, and the use of three distinct allocation
bases. These changes show an attempt was made to capture differences among
the demands placed on resources by the different products. But because there are
no batch- or product-level drivers used, the system cannot capture the demands
placed on batch- and product-level activities, i.e., it is not an ABC system.
14-20 Chapter 14

C14-2 (Continued)

(4) WARRENTON DIVISION

Product Costs from Proposed New Costing System

Overhead rates:
$100,000 troubleshooting costs + $140,000 machine setup costs divided by 3,000
setup hours = $80 per setup hour
$135,000 material handling costs divided by 15,000 loads = $9 per load
$195,000 materials administration costs divided by 10,000 vendor orders = $19.50 per
vendor order
$260,000 engineering design costs divided by 4,000 design hours = $65 per design
hour
$200,000 machine operation costs + $900,000 other overhead divided by 20,000
machine hours = $55 per machine hour

#33 #44
Direct material............................................................... $15,000 $120,000
Direct labor.................................................................... 6,000 60,000
Overhead:
$80 × 300 setup hrs .................................................. 24,000
$80 × 400 setup hrs .................................................. 32,000
$9 × 20 loads ............................................................. 180
$9 × 60 loads ............................................................. 540
$19.50 × 90 orders .................................................... 1,755
$19.50 × 150 orders .................................................. 2,925
$65 × 280 design hrs ................................................ 18,200
$65 × 300 design hrs ................................................ 19,500
$55 × 300 MH............................................................. 16,500
$55 × 3,000 MH.......................................................... 165,000
Total cost ...................................................................... $81,635 $399,965
Units produced ............................................................. ÷ 100 ÷ 2,000
Cost per unit ................................................................. $816.35 $ 199.98

(5) The proposed new costing system is an ABC system because it uses cost driv-
ers that include non-unit-level drivers. The unit-level driver is machine hours, the
batch-level drivers are setup hours and loads handled, and the product-level
driver is design hours. Vendor orders could be either a batch- or product-level
driver, depending on whether orders are placed for each batch; the case does
not tell whether this is so.
(6) For the low-volume product, #33, the proposed ABC system shows a substan-
tially higher cost than did either of the other two systems. This is the general
result when ABC is implemented and compared with traditional systems. At the
usual selling price of $800, the ABC system says this product is a money loser.
Equally, or perhaps more importantly, the proposed ABC system shows that the
high-volume product can be priced very competitively.
Chapter 14 14-21

C14-2 (Concluded)

(7) Based on the results of the ABC study, Warrenton’s management should con-
sider meeting the competitor’s prices on #44; this pricing strategy can be prof-
itable in the long run and should avoid loss of market share. The strategy for #33
is not as clear. Some customers may not accept the price increase needed to
make #33 reasonably profitable, and Warrenton could lose some customers who
also buy large amounts of #44 if management discontinues #33 or hikes its price
too much. Management should consider several possibilities for low-volume
products such as #33:
(a) Reduce batch- and product-level costs enough to become an efficient pro-
ducer of low-volume products. This may require creation of a small job-shop
environment in a portion of the plant (or in another facility), where low-volume
products could be made more efficiently.
(b) Reduce the number of products by designing a new product that can be sub-
stituted for several low-volume, unprofitable products that can then be dis-
continued; this essentially exchanges several low-volume products for one
of much higher volume, with substantial batch- and product-level savings.
(c) Convince one of the current buyers of the low-volume products to become
a distributor of several such products; buying them from Warrenton in larger
quantities, maintaining small inventories, and selling them to other cus-
tomers. This can reduce Warrenton’s batch-level and marketing costs, but it
risks the loss of customers who like to buy the full line from one supplier.
(d) Raise prices gradually until all products are reasonably priced. This does not
mean all products must show profits. (It is acceptable for a good customer
to occasionally buy a money-losing product.) Rather, it means that the com-
pany should not continue making a money-losing product without a good
reason. It is not acceptable to have a customer who buys only the money-
losing products, nor for the company to continue making a money-losing
product that no “good customers” are buying.
(e) In addition to the usual sales price, charge a lump-sum amount per order for
any small order of a low-volume product. This charge could be set at a level
to cover estimated batch- and product-level costs.