Chapter 5 Solutions

Atkinson, Solutions Manual t/a Management Accounting, 6E

138

Chapter 5 Activity-Based Cost Systems

QUESTIONS

5-1 Traditional volume-based cost allocation systems that use only drivers that

vary directly with the volume of products producedsuch as direct labor dollars, direct labor hours, or machine hoursare likely to systematically distort product costs because they break the link between the cause for the

costs and the basis for assignment of the costs to the individual products. Costs

may vary not only with respect to volume of production, but also, for example,

with batch-related activities (e.g., changeovers, setups, and inspection of the

first item of production run) and the number of products (e.g., scheduling

materials receipts and improving products). Also, cost distortions tend to be

greater with greater differences between relative proportions of indirect

resources used by cost objects because traditional cost assignments based on

volume-related measures do not accurately reflect these differences.

5-2 Volume-based traditional product costing systems that use only drivers that

vary directly with the volume of products producedsuch as direct labor dollars, direct labor hours, or machine hoursare most likely to distort product costs under the following two conditions: (1) Indirect and support

expenses are high, especially when they exceed the cost of the allocation base

itself (such as direct labor cost); and (2) Product diversity is high: the plant

produces both high-volume and low-volume products, standard and custom

products, and complex and simple products. The combination of these two

conditions will magnify the distortions that arise because volume-based

product costing systems do not accurately reflect differences in non-volume-

related resource usage across products or other cost objects.

Activity-based costing systems provide more accurate costs when these two

conditions hold by creating more accurate links between the causes of indirect

and support costs and the bases for assignment of the costs to cost objects. For

example, costs may vary not only with respect to volume of production, but

Chapter 5: Activity-Based Cost Systems

139

also activities such as changeovers, setups, and inspection of the first item of

production run, which are not done in proportion to the number of units

produced. Moreover, some costs vary with the number of different products

(e.g., scheduling materials receipts and improving products).

5-3 Yes, traditional costing systems are more likely to overcost high-volume

products because all indirect and support costs are assigned to products in

proportion to the number of production units (through volume-based cost

drivers), and the low-volume products are likely to require higher indirect and

support costs per unit. The high-volume products essentially cross-subsidize

the low-volume products in the sense that indirect and support costs are

assigned uniformly in proportion to volume.

5-4 Companies producing a varied and complex mix of products require many

more resources to support their highly varied mix, and therefore have higher

costs. Examples of the greater resources required include a much larger

production support staff to schedule machine and production runs; perform

changeovers and setups between production runs; inspect items at the

beginning of each production run; move materials; ship and expedite orders;

develop new and improve existing products; negotiate with vendors; schedule

materials receipts; order, receive, and inspect incoming materials and parts;

and update and maintain the much larger computer-based information system.

5-5 A significant change in resource costs triggers an update of the capacity cost

rates. A significant and permanent change in operations, such as the efficiency

with which an activity is performed, triggers an update of the unit time

estimate. If new activities become part of operations, the time to perform the

activity will be estimated and then multiplied by the appropriate capacity cost

rate to determine the cost of the activity.

5-6 The two sets of parameters that must be estimated in time-driven activity-

based costing are 1) the capacity cost rate for each type of indirect resource;

that is, the unit cost of supplying capacity for each department or process,

based on practical capacity, and 2) the consumption of capacity, which is an

estimate of how much of a resources capacity (such as time or space) is used by the activities performed to produce the various products, services, or

customers.

To compute a capacity cost rate, first identify all costs incurred to supply that

resource (such as a machine, an indirect production employee, the computer

system, factory space, a warehouse, or a truck). Then, identify the capacity

supplied by that resource. The capacity would be the hours of work provided


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by the machine or production employee, or the space provided by the

warehouse or truck. For most resources (people, equipment, and machines),

capacity is measured by the time supplied. The resources capacity cost rate is calculated by dividing its cost by the capacity it supplies, usually expressed as

a cost per hour or cost per minute. For warehouses, production space, and

trucks, the capacity cost rate would be measured by cost per square foot (or

square meter) of usable space. For computer memory, the resource capacity

cost rate would be the cost per megabyte or gigabyte.

5-7 Managers use the information on activity costs to identify opportunities for

operational improvements and reductions in operations costs, decisions about

product mix and pricing, and targeted customer segments. An example of an

operational change is requiring minimum order sizes to eliminate short,

unprofitable production runs. Another example is changing the facility layout

to reduce moves of work in progress. Product designs can be changed in order

to manufacture products with fewer parts or common parts to reduce material

handling support costs. Finally, as discussed in more detail in Chapter 6, if

activity-based cost analysis shows that full-pallet shipments are less costly per

unit than partial-pallet shipments, customers can be encouraged to receive full-

pallet shipments. Of course, customers who insist on very small order sizes or

partial-pallet shipments can be charged a price high enough to cover the extra

costs associated with such activities.

5-8 The capacity cost driver rate should reflect the underlying efficiency of the

processfor example, the cost of resources to handle each production orderand this efficiency is measured better by using the capacity of the resources

supplied (practical capacity) as the denominator when calculating capacity

cost driver rates. The numerator in a capacity cost driver rate calculation

represents the costs of supplying resource capacity to do work. The

denominator should match the numerator by representing the quantity of work

the resources can perform. Unassigned costs represent the cost of unused

capacity and should be used as feedback to managers on their supply and

demand decisions.

5-9 Immediate financial improvement may not follow even after process

improvements reduce the demand for indirect and support resources. This is

because the support costs are often committed. The organization must actively

manage the unused capacity by increasing the volume of business or reducing

the supply of unused resources.


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5-10 Service organizations are often ideally suited for activity-based costing

because virtually all of the costs for a service company are indirect and appear

to be fixed. The large component of apparently fixed costs in service

companies arises because, unlike manufacturing companies, service

companies have virtually no material coststhe prime source of short-term variable costs. Service companies must supply virtually all of their resources

in advance to provide the capacity to perform work for customers during each

period. Fluctuations during the period of demand by individual products and

customers for the activities performed by these resources do not influence

short-term spending to supply the resources.

5-11 As mentioned in 5-10, virtually all the costs for a service company are indirect

and appear to be fixed. Service companies have few or no direct materials and

many of their personnel provide indirect, not direct, support to products and

customers. Consequently, service companies do not have direct, traceable

costs to serve as convenient allocation bases.

Unlike physical products, services cannot be inventoried for future sales.

Service companies must supply virtually all their resources in advance to

provide the capacity to perform work for customers during each period, and

demand often fluctuates. For some service industries, the increase in spending

resulting from an incremental transaction or customer is essentially zero.

Therefore, service companies making decisions about products and customers

based on short-term variable costs might provide a full range of all products

and services to customers at prices near zero, leading to little recovery of the

costs of all the committed resources supplied in order to deliver services to

customers.

It can be difficult to identify and measure the outputs for a service

organization. The variation in demand for organizational resources is much

more customer-driven in service organizations than in manufacturing

organizations. A service company can determine and control the efficiency of

its internal activities, but customers determine the quantity of demands for

these operating activities. For example, customers may vary greatly in the

number of transactions and the balances in their checking accounts. Service

companies must focus on customer costs and customer profitability;

measuring revenues and costs at the customer level provides service

companies with far more relevant and useful information than at the product

level. Finally, a customer may have multiple relationships with a service

company. Therefore, the cost system should provide information that supports

determining profitability of the entire relationship with the customer.


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Customer costs and customer profitability are discussed in more detail in

Chapter 6.

5-12 Individuals may feel vulnerable facing uncertainty about what the activity-

based cost analysis may show, or they may feel threatened by the suggestion

that their work could be improved. For example, the analysis might reveal that

products or customers thought to be very profitable are actually unprofitable,

or that some processes are inefficient. Individuals may be concerned that they

will then be judged as poor managers, even though they were making

decisions that others would agree were good decisions based on the cost

system in place.

5-13 Time-driven activity-based costing has a number of advantages over

traditional activity-based costing. The advantages include (1) It is easy and

fast to build an accurate model even for large enterprises; (2) It exploits the

detailed transactions data that are available from ERP systems; (3) It drives

costs to transactions and orders with time equations that use specific

characteristics of particular orders, processes, suppliers, and customers; (4) It

provides visibility to capacity utilization and the cost of unused capacity; (5) It

enables managers to forecast future resource demands, allowing them to

budget for resource capacity on the basis of predicted order quantities and

complexity; and (6) It is easy to update the model as resource costs and

process efficiencies change.

EXERCISES

5-14 Potter Corporation should switch to activity-based costing because its current

system appears to be distorting product costs, resulting in prices of specialty

products that are too low (hence increasing their market share) and prices of

simple products that are too high (thus, lowering their market share). This, in

turn, leads to lower overall profitability as Potter pushes products that, in

reality, produce low profit margins or even lose money.

5-15 (a) The time-driven ABC model will now incorporate a capacity cost rate for

computer resources, computed as $18,000 divided by the practical capacity

computer hours per month. Usage of computer resources can be measured

in computer time per product or production run.

(b) Before the machinery energy costs were discovered, the machinery rate

was computed as $15,400 divided by 308 practical capacity hours, which

equals $50 per hour. The energy costs of $4,000 per month will be added to


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the $15,400 monthly machinery costs, for a new machinery resource cost

of $19,400 per month, leading to a higher rate per hour. The new rate is

$19,400/308 = $62.99, which can be rounded to $63 per hour for

convenience.

(c) If the company introduces a new flavor, the new flavors consumption of direct and indirect resources will need to be estimated and then multiplied

by the appropriate cost or cost rate. For example, start with the quantity of

direct materials and labor hours per gallon produced, and multiply these

amounts by the related cost per unit of direct materials and wage rate,

respectively. Next, estimate the quantity of indirect labor (for changeovers,

scheduling and product maintenance) and machine time (for production

runs and setups). These will then be multiplied by the associated capacity

cost rates of each indirect resource and added to the direct materials and

direct labor costs in order to compute the total cost of producing the new

flavor.

5-16 (a) A 10% increase in indirect labor costs will increase the indirect labor

capacity cost rate by 10% (from $35 to $38.50) and therefore will increase

the indirect labor costs assigned to products by 10%. The revised income

statement that is similar to Exhibit 5-5 will show indirect labor costs that

are 10% higher than in Exhibit 5-5, with correspondingly lower product

gross profits, as shown below. (Small differences may result if the

calculations are performed in a spreadsheet package.)

Vanilla Chocolate Strawberry

Mocha-

Almond Total

Sales $30,000 $ 24,000 $3,960 $2,800 $60,760

Direct materials $6,000 $4,800 $720 $520 $12,040

Direct labor

(including fringes) $8,750 $7,000 $1,050 $700 $17,500

Indirect labor usage $4,967 $3,581 $3,889 $4,043 $16,480

Machine usage $6,700 $5,000 $1,660 $1,640 $15,000

Gross profit (loss) $3,583 $3,619 $(3,359) $(4,103) $(260) Gross profit (loss)

as percent of sales 11.94% 15.08% 84.82% 146.54% 0.43%

(b) With the reduction in unit time for scheduling a production from four

hours per run to three hours per run, we first compute the revised indirect

labor hours per month and then multiply by the new indirect labor capacity

cost rate of $38.50 per hour.


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The revised indirect labor hours per month are calculated as follows:


Mocha-

Almond

Schedule production

runs, purchasing, etc.

(hours per run) 3 3 3 3

Changeovers (hours per

batch) 2.0 1.0 2.5 4.0

Number of employees

per changeover 3 3 3 3

Indirect labor hours per

changeover 6 3 7.5 12

Indirect labor time per

run (batch) 9 6 10.5 15

Number of production

runs 12 12 8 6

Indirect labor per run 108 72 84 90

Product-sustaining (hrs

per month) 9 9 9 9

Indirect labor hours per

month 117 81 93 99

Indirect rate per hour $38.50 $38.50 $38.50 $38.50

Indirect labor cost $4,504.50 $3,118.50 $3,580.50 $3,811.50

The new income statement shows lower indirect labor costs than in part (a)

because of the reduced scheduling time per run. (Small differences may result

if the calculations are performed in a spreadsheet package.)


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Mocha-

Almond Total

Sales $30,000 $ 24,000 $3,960 $2,800 $60,760

Direct materials $6,000 $4,800 $720 $520 $12,040

Direct labor

(including fringes) $8,750 $7,000 $1,050 $700 $17,500

Indirect labor usage $4,505 $3,119 $3,581 $3,812 $15,017

Machine usage $6,700 $5,000 $1,660 $1,640 $15,000

Gross profit (loss) $4,045 $4,081 $(3,051) $(3,872) $1,203

Gross profit (loss)

as percent of sales 13.48% 17.00% 77.05% 138.29% 1.98%

Combining direct labor and indirect labor costs, the summary income

statement showing unused capacity costs is as follows:

Totals with

Assigned

Costs

Unused

Capacity

Costs

Totals

with

Capacity

Costs

Sales $60,760 $60,760

Direct materials $12,040 $12,040

Direct labor and indirect labora $32,517 $68 $32,585

Machine usage $15,000 400 $15,400

Gross profit (loss) $1,203 $(468) $735

Gross profit (loss) as percent of

sales 1.98% 1.21% a Labor capacity cost = $4,655 7 employees = $32,585. Employees perform

direct labor and indirect labor tasks.

5-17 (a)

Hours: Hours: Cost: Cost:

Pumps Valves Rate Pumps Valves

1,500 1,800 $20 $ 30,000 $ 36,000

5,000 6,000 $30 $150,000 $180,000

200 400 $80 $ 16,000 $ 32,000

$196,000 $248,000


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(b) The cost of unused capacity, which will be expensed on the income

statement, is calculated as follows:

Hours: Cost:

Unused

Capacity

Rate

Unused

Capacity

300 $20 $ 6,000

200 $30 $ 6,000

50 $80 $ 4,000

$16,000

Total revenues $890,000

Total direct labor cost $120,000

Total direct materials cost 90,000

OH applied to pumps 196,000

OH applied to valves 248,000 $654,000

Cost of unused practical capacity 16,000

SG&A expenses 100,000

Net income $120,000

5-18 (a) Kens previous average fixed cost per meal was $3,300 600 = $5.50. With the drop in demand, the average fixed cost is now $3,300 550 = $6. If demand decreases further and Ken continues to use the same method to

determine his costs of serving a meal, the average fixed cost will

continue to increase, and Ken will want to raise his prices even more.

However, the rising prices may contribute to further declines in demand,

leading Ken into a downward (or death) spiral.

(b) Ken should use the practical capacity quantity of meals per day to

determine cost per meal in order to avoid the fluctuations described in

part (a) and to understand the cost rate at the point where the resources

used equal the practical capacity usage. If resource usage is less than

practical capacity, Ken should monitor the cost of unused capacity. He

may be able to reduce the capacity costs or to find other profitable uses

for the capacity. In this problem, one may assume the practical capacity

is 600 meals per day.


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PROBLEMS

5-19 (a) Capacity cost rate = $500,000/10,000 hours = $50 per hour.

(b) The activity-based cost associated with Division 1s customers is (0.5 1,000 + 1.0 4,000) $50 per hour

= 4,500 hours $50 per hour = $225,000.

(c) The activity-based cost associated with Division 2s customers is (0.5 200 + 0.1 400) $50 per hour

= 140 hours $50 per hour = $7,000.

(d) The change will result in (0.5 1,000 + 1.0 2,000 + 0.1 2,000) =

2,700 hours used, a reduction from the 4,500 hours in part (a). The new

activity-based cost associated with Division 1s customers is 2,700 hours $50 per hour = $135,000. The lower cost assigned to

Division 1 will not reduce Zetas costs unless Zeta also reduces the $500,000 total resource cost. This can be accomplished in the following

way; with the change in the mix of more electronic and fewer manual

transactions, 1,800 fewer hours of accounts receivable time is required.

Since the capacity of each employee is about 1,667 hours per year

(10,000 6), Zeta can operate with one fewer employee, saving the full

cost of one employee, probably at least $60,000 per year.

5-20 (a) The practical capacity per month for each packaging and shipping

employee is (8 1.25 hours) per day 20 days per month = 135 hours per month. The capacity cost rate = $4,050/135 hours = $30 per hour.

(b) Order 705, which consists of 40 items, requires packaging preparation

time of 0.25 hours plus 40 0.1 hours to bubble wrap and pack the 40

items in the carton, for a total of 4.25 hours The cost assigned to Order

705 is therefore 4.25 $30 per hour =$127.50.


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5-21 (a) With the stated change, Madison Dairy will require 8 full-time

production employees and 3 machines, as shown below.

Labor

Vanilla

Chocolate

Straw-

berry

Mocha-

Almond

Total

Number of

production runs 18 16 4 3

Handle production

run (hours/run) 2.5 2.5 2.5 2.5

Indirect labor:

handle runs 45.0 40.0 10.0 7.5 102.5

Setup time per run

(hours) 2.0 1.0 2.0 3.2

Number of

employees per

changeover 2 2 2 2

Indirect labor

hours per run 4.0 2.0 4.0 6.4

Indirect labor: total

setup hours 72.0 32.0 16.0 19.2 139.2

Indirect labor:

maintain products 8.0 8.0 8.0 8.0 32.0

Total indirect labor

hours 125.0 80.0 34.0 34.7 273.7

Volume (gallons) 15,500 13,000

1,600 1,200 31,300

Direct labor hours

per gallon 0.025 0.025 0.025 0.025

Total direct labor

hours 387.5 325.0 40.0 30.0 782.5

Total labor hours 512.5 405.0 74.0 64.7 1,056.2

Productive hours

per employee per

month 133.0

Number of

employees needed 7.9

Number of full-

time employees 8.0


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Machines Vanilla Chocolate

Straw-

Berry

Mocha-

Almond Total

Production

volume 15,500 13,000 1,600 1,200

Machine hours

per 1000 gallons 11 11 11 11

Total machine

run time (hours) 170.5 143.0 17.6 13.2 344.3

Number of

production runs 18 16 4 3

Setup time per

run (hours) 2.0 1.0 2.0 3.2

Machine setup

time (hours) 36.0 16.0 8.0 9.6 69.6

Total machine

hours 206.5 159.0 25.6 22.8 413.9

Productive

hours per month 154.0

Number of

machines

needed (rounded

up)

3.0

(b) Pro forma monthly product line income statement (total dollar amounts

are rounded):

Vanilla Chocolate

Straw-

berry

Mocha-

Almond Total

Selling price $ 2.90 $ 2.90 $ 3.40 $ 4.00 $ 2.97

Sales volume 15,500 13,000 1,600 1,200 31,300

Revenues $44,950 $ 37,700 $ 5,440 $ 4,800 $ 92,890

Direct

materials

9,300 7,800 960 780 18,840

Direct labor

(including

fringes)

13,563 11,375 1,400 1,050 27,388

Indirect labor 4,375 2,800 1,190 1,215 9,580

Machinery 10,325 7,950 1,280 1,140 20,695

Gross profit $7,387 $ 7,775 $610 $ 615 $16,387

Gross profit 16.4% 20.6% 11.2% 12.8% 17.6%


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(% of sales)

(c) The cost of the 8 production employees is 8 $4,655 = $37,240 and the

unused labor capacity cost is therefore $37,240 $27,388 $9,580 = $272. The cost of the 3 machines is 3 $7,700 = $23,100 and the

unused machine capacity cost is $23,100 $20,695 = $2,405. After incorporating the unused capacity cost, the pro forma monthly gross

profit is $16,387 $272 $2,405 = $13,710 and gross profit as a percent of sales is $13,710/$92,890 = 14.8%.

5-22 Activity-based costing provides a means to accurately trace costs to

operational processes, and these costs can be used as one of the operations

management measures in the process perspective of a Balanced Scorecard.

Activity-based costing can also provide a means to measure customer

profitability or percent of profitable customers, which many companies

include in the customer or financial perspective of their Balanced Scorecards

(this application will be discussed in Chapter 6).

5-23 The choice really depends on what short-term problems the company faces. If

it is experiencing large, rising, and difficulty-to-control indirect and support

costs, as well as a proliferation of products and customers, then an activity-

based costing system will supply valuable information to management

decisions on process improvements, product mix, pricing, and managing

customer relationships. This is because activity-based costing requires

understanding processes and their underlying activities, as well as what drives

support costs. The development of the activity-based costing model, as well as

the model itself, will help the organization identify costly and inefficient

processes. Additional potential benefits include identifying costly customers

or understanding how costly complex products are. The company can improve

inefficient processes, encourage costly customers to interact at a lower cost to

the company, revise product pricing, and find new revenue-generating uses of

freed-up capacity or attempt to reduce capacity costs.

If, however, the biggest issue the company faces is moving to a new strategy,

particularly one focused on customers and a new value proposition, then

implementing the Balanced Scorecard will be highly beneficial in

communicating the new strategy and providing a systematic mechanism for

monitoring and improving the new strategy. The Balanced Scorecard process

can greatly facilitate and speed the major change that is desired, lead to team

building and commitment to the new strategy among the executive team,


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translate the strategy to operational terms, and lead to communication of the

strategy throughout the organization.

Of course, both approaches are highly compatible with each other.

5-24 (a) Each server is available for (22 days) (24 hours per day) = 528 hours

per month. The average cost per hour is therefore $3,696/528 hours = $7

per hour. Non-peak-hour usage accounts for (20 servers) (16 hours per

day) = 320 hours per day. Peak-hour usage accounts for (80 servers)

(8 hours per day) = 640 hours per day. Moreover, the 60-server excess

capacity during non-peak hours exists because of the peak-hour need.

Therefore the cost of the excess capacity of 60 16 hours = 960 hours

should be charged to peak-hour users. Thus, the peak-usage hourly rate

is $7 (640 + 960)/640 = $11,200/640 = $17.50 per hour.

(b) As discussed in part (a), the peak-usage hours should bear the cost of

the excess capacity that exists during non-peak usage. The non-peak

hourly rate is then the average cost of $7 per hour.

5-25 (a)

Activity Percent

Assigned

Cost*

Cost

Driver

Quantity

Activity

Cost Driver

Rate**

Handle customer

orders 75% $450,000 8,000

$56.25 per

customer order

Process customer

complaints 10% $60,000 400

$150.00 per

customer complaint

Perform customer

credit checks 15% $90,000 450

$200.00 per

credit check

100% $600,000

* $600,000 times the given percentage.

** Assigned Cost divided by Cost Driver Quantity.

(b) Capacity cost rate = $600,000/10,000 = $60 per hour.

Activity

Unit

Time

(Hours) Activity Cost Driver Rate

Handle customer orders 0.75 $45 Per customer order

Process customer complaints 3.50 $210 Per customer complaint

Perform customer credit checks 3.00 $180 Per credit check


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153

(c)

Activity

Unit

Time

(Hours)

Quantity

of

Activities

Total

Hours

Cost

Assigned

Handle customer orders 0.75 8,000 6,000 $360,000

Process customer complaints 3.50 400 1,400 $84,000

Perform customer credit checks 3.00 450 1,350 $81,000

Total 8,750 $525,000

Practical capacity used = 8,750 10,000 = 87.5% Unused capacity = 10,000 8,750 hours = 1,250 hours. Unassigned cost = $600,000 $525,000 = $75,000.

Managers can try to reduce the unused capacity and its associated

expense. Alternatively, managers can try to generate new uses for the

unused capacity by introducing new products or expanding into new

markets. The cost system provides information to assist managers in

deciding whether these new uses of capacity can be handled with the

current capacity or require additional resources and spending.

(d)

Activity

Unit

Time

(Hours)

Quantity

of

Activities

Total

Hours

Cost

Assigned

Handle customer orders 0.75 8,500 6,375 $382,500

Process customer

complaints 3.50 350 1,225 $73,500

Perform customer credit

checks 3.00 500 1,500 $90,000

Total 9,100 $546,000

Practical capacity used = 9,100 10,000 = 91.0% Unused capacity = 10,000 9,100 hours = 900 hours. Unassigned cost = $600,000 $546,000 = $54,000.

(e) The costs driver rates in (a) and (b) likely differ because not all the

practical capacity of the resources supplied during the period was used

for productive work, as illustrated in parts (c) and (d). The ABC system


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in part (a) overestimated the costs of performing activities by

apportioning all customer service costs to the three activities and

therefore assigned not only the costs of resource capacity used, but also

the cost of unused resources. Determining the unit times to complete

each activity in conjunction with the time-driven ABC system in part

(b) provides clearer information about the resources needed for each

activity and about the unused capacity.

5-26 (a) The resource units would depend on the organizations facilities and resources. If the organization is self-contained with operating rooms,

recovery rooms, and radiology and pharmacy facilities, then these

resource units would be part of Riverdales activity-based cost system. Other likely resource units include personnel performing scheduling,

admissions, and record-keeping; medical personnel, such as nurses and

surgeons; equipment (such as rehabilitation equipment and examination

tables); the cost of computers used in the clinic.

(b) Capacity cost rates must be developed for each resource. Then, for each

patient, track their routing through the clinic to identify which resources

the patient uses, and how much time is spent with each resource.

Finally, sum up the costs of all the resources used by the patient as he or

she gets processed, treated, and, eventually, released by the hospital.

This will yield the total cost associated with the complete cycle of care

for this patient episode.

5-27 (Unofficial CMA Answer, adapted)

(a) 1. Manufacturing support costs include all indirect production costs

(all production costs except direct material and direct labor).

These costs cannot be practically or economically traced to end

products and, therefore, must be assigned by some allocation

methods. Typical manufacturing support costs include:

Indirect labor, e.g., lift-truck drivers wages, maintenance and inspection labor, engineering labor, scheduling, purchasing

and supervisors.

Other indirect factory costs, e.g., building maintenance, machine and tool maintenance, property taxes, property

insurance, pension costs, depreciation on plant and

equipment, rent expense, and utility expense.


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2. Companies develop manufacturing support cost driver rates to

facilitate the costing of products as they are completed and

shipped, rather than waiting until actual costs are accumulated at

the end of a fiscal period.

(b) The cost driver rate increase should not have a negative impact on Moss

Manufacturing because the increase in indirect costs was offset by a

decrease in direct labor costs.

(c) Rather than using a universal plantwide rate, Moss Manufacturing could

implement separate cost pools for different activities. Examples are as

follows:

Accumulate separate costs into departmental accounts (or other relevant pools), with one account for each production and service

department. Each department would allocate its support costs to

products on the basis that best reflects the use of these services.

Individual machines (or other more relevant allocation bases) could be treated as separate cost centers with the machine costs

collected and charged to the products using the machine(s).

(d) An activity-based costing system might benefit Moss Manufacturing

because it

measures the cost of unused resource capacity and provides more accurate resource consumption and cost information as input to decisions that increase

company profitability

costs products according to the activities involved in the production process.

5-28 (a) A call-related activity cost driver would better identify the linkage to

call center support costs. The number of calls (a transaction driver) per

product can be used because of its simplicity. The number of minutes of

calls (a duration driver) provides better linkage to call center support

costs, but it is more time-consuming to measure.


156

(b) Product X Product Y

Previous system: Allocated support costs:

5% of sales

$20,000 $5,000

Activity-based costs: $.70 per minute $4,900 $21,000

(c) Under the previous system, product managers can only reduce the

assigned call center costs by reducing sales. Under the new system,

product managers can work with other functional areas to find ways to

reduce the number of calls or to reduce the length of calls. For example,

product Ys manager can work with package designers or the marketing group to develop clearer instructions for consumers. The instructions

might include a company web address that provides answers to

frequently asked questions (based on calls to the call center).

(d) Product Ys manager is likely to resist implementation of the activity-based cost system if the manager understands the relative usage of call

center resources devoted to product Y. Call center staff may resist

implementation of activity-based costing because it will involve

tracking of staff activity. The staff may resent tracking the number of

calls or minutes of calls, and may resent the additional monitoring

because it may lead to pressure to reduce the minutes per call. The call

center staff may also fear that the desire for cost or efficiency

improvements will lead to staff reduction or to outsourcing the entire

call center.

(e) The company will need to consider the broader management issues related

to job loss if the call center activities are outsourced. As an input to that

decision, however, the company can benchmark its costs per minute to

other call centers, or compare it to the cost of outsourcing. The company

may also pursue an intermediate course of communicating the current costs

per minute and benchmarked or competitive costs, and allowing the call

center staff to improve efficiency and lower costs per minute.

5-29 (a) Manufacturing support cost driver rate

$ , ,

, ,

$ .

1 1 5 0 0 0 0 0

1 0 0 0 0 0 3 0 0 0 0 0

2 8 7 5 p e r d i r e c t l a b o r h o u r.


157

Costs Per Unit Product X21 Product Y37

Direct materials cost $120.00 $140.00

Direct labor cost 2 $(1,000,000100,000) 20.00 3 $(4,500,000300,000) 45.00

Manufacturing support cost $28.75 (100,00050,000) 57.50 $28.75 (300,000100,000) 86.25

Unit cost $197.50 $271.25

(b) Cost Cost Costs Allocated to Products

Activity Capacity

costs Driver

Quantity Driver Rate

X21

Y37

Handling $3,000,000 60,000 50 50 40,000 50 20,000

Number

of parts 2,400,000 20,000 120 120 12,000 120 8,000

Design

changes 3,300,000 3,000 1,100 1,100 2,000 1,100 1,000

Setups 2,800,000 14,000 200 200 8,000 200 6,000

Total $11,500,000 $7,240,000 $4,260,000

Costs Per Unit X21 Y37 Direct materials cost $120.00 $140.00

Direct labor cost 20.00 45.00

Manufacturing support cost $7,240,000 50,000 144.80 $4,260,000 100,000 42.60

Unit cost $284.80 $227.60

(c) Activity-based costing produces more accurate estimates of job costs

because it takes into account the cost drivers that give rise to support

costs.


158

(d) Cost-based Prices Product X21 Product Y37

Traditional costing 1.25 unit costs in part (a) $246.88 $339.06

Activity-based costing 1.25 unit costs in part (b) $356.00 $284.50

If Endo plans to continue to use cost-based pricing, it should use

activity-based costs as the basis for its markups. Note X21s current price is not even covering its manufacturing costs as determined using

activity-based costing. Conversely, Y37 may be overpriced. Endo

should consider raising X21s price and could consider lowering Y37s price if competitors are selling the same product for a lower price.

(e) The company sells half as many X21s as Y37s, but X21 has twice as many design changes and 50% more parts. These facts suggest that the

company can explore ways to reduce the number of design changes and

the number of parts. Management accountants would be involved in

developing and communicating the cost of design changes and parts

proliferation; design engineers would be directly involved in studying

different designs and trying to reduce the number of parts. In addition,

sales staff who communicate with customers could make greater efforts

to understand customer needs and convey this information to the design

engineers.

5-30 (a) Total manufacturing support costs = $1,000,000

Total direct labor hours = [5,000 2 + 40,000 1] = 50,000 Manufacturing support cost rate = $20 per direct labor hour.

(b) Deluxe Regular

Direct material $45 $30

Direct labor $20 $10

Manufacturing support $40 $20

Unit cost $105 $60


159

(c) Activity Rate Per Unit of Cost Driver

Purchase orders

$180,$300

000

600

Quality control

$250,$125

000

2,000

Production setups

$220,$1,

000

200100

Machine maintenance

$350,

,$10

000

35 000

Capacity costs Assigned to Products Activity Deluxe Regular

Purchase orders 200 $300 = $60,000 400 $300 = $120,000

Quality control 1,000 $125 = 125,000 1,000 $125 = 125,000

Production setups

100 $1,100 =

110,000

100 $1,100 =

110,000

Machine maintenance

20,000 $10 =

200,000

15,000 $10 =

150,000

Total manufacturing support costs $495,000 $505,000

Number of units 5,000 40,000

Unit manufacturing support costs $99 $12.625

Deluxe Regular

Direct material $45.000 $30.000

Direct labor $20.000 $10.000

Manufacturing support $99.000 $12.625

Unit cost $164.000 $52.625


160

(d)

Activity

Deluxe

Regular

Ratio of

Deluxe:Regular

Purchase orders 200

5 000004

,.

400

40 000001

,. 4:1

Quality control 1000

5 00002

,

,.

1000

40 0000025

,

,. 8:1

Production setups

100

5 000002

,.

100

40 00000025

,. 8:1

Machine maintenance

20 000

5 0004

,

,

15 000

40 0000375

,

,. 10.67:1

Unit costs are distorted by the old system because it assigns

manufacturing support cost to products using direct labor hours as a

base. Although the deluxe model requires twice as much labor time as

the regular model, it was not allocated adequate support cost. Analyzing

the companys capacity costs reveals that the deluxe model is very expensive to manufacture as compared to the regular model because (i)

the deluxe model requires 4 times as many purchase orders as the

regular model, (ii) the deluxe model requires 8 times as many

inspections and setups as the regular model, and (iii) the deluxe model

requires over 10 times as many machine hours as the regular model.

(e) No, the deluxe model is not as profitable as the company thinks. Under

ABC, the following profitability analysis for each product line can be

prepared:

Deluxe Regular

Selling price per unit $140.000 $80.000

Unit cost $164.000 $52.625

Gross margin per unit ($24.000) $27.375

(f) The regular model is more profitable than the deluxe model. Therefore,

marketing staff can (i) push the regular model (increase commissions on

the regular model, and/or decrease commission on the deluxe model),

and/or (ii) raise the price of the deluxe model.


161

Design engineers can try to re-engineer the deluxe product to decrease

its high demand for activity resources.

5-31 (Unofficial CMA Answer, adapted)

(a) At least four general advantages associated with activity-based costing

include the following:

Provides management with a thorough understanding of complex product costs and product profitability for improved resource

management and pricing decisions.

Provides estimates of unused capacity costs.

Highlights the interrelationships (cause and effect) of activities and identifies opportunities to reduce costs, e.g., designing

products with fewer parts to reduce the cost of the manufacturing

process.

Provides more appropriate means of charging support costs to products.

(b) 1. Using standard costs, the total contribution expected this year

from the TV board is $1,950,000, calculated as follows:

Per Unit

Totals for 65,000 Units

Revenue $150 $9,750,000

Direct material 80 5,200,000

Material support (10% of material) 8 520,000

Direct labor ($14 1.5 hours) 21 1,365,000

Variable support ($4 1.5 hours)* 6 390,000

Other mfg. support ($10 0.5 machine hour) 5 325,000

Total cost $120 $7,800,000

Unit contribution $30

Total contribution (65,000 30) $1,950,000

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


162

2. Using standard costs, the total contribution expected this year

from the PC Board is $2,360,000, calculated as follows:

Per Unit


Revenue $300 $12,000,000

Direct material 140 5,600,000

Material support (10% of material) 14 560,000

Direct labor ($14 4 hours) 56 2,240,000

Variable support ($4 4 hours)* 16 640,000

Other mfg. support ($10 1.5 machine hours) 15 600,000

Total cost $241 $9,640,000

Unit contribution $59

Total contribution (40,000 $59) $2,360,000

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

(c) Shown below are the calculations of the cost drivers which apply to

both (c)1 and (c)2.

Procurement: $400,

,$.

000

4,000 00010 per par t

Production scheduling: $220,

,$2.

000

110 00000 per boa rd

Packaging and shipping: $440,

,$4.

000


Machine setups: setupper 60.1$750,278

000,446$

Hazardous waste disposal: $48,

,$3.

000

16 00000 per pou nd

Quality control: $560,

,$3.

000

160 00050 per ins pection

General supplies: $66,

,$.

000



163

Machine insertion: insertion machineper 40$.000,000,3

000,200,1$

Manual insertion: insertion manualper 00.4$

000,000,1

000,000,4$

Wave soldering: $132,

,$1.

000


1. Using activity-based costing, the total contribution expected this

year from the TV Board is $2,557,100 calculated as follows:

Per Unit


Revenue $150.00 $9,750,000

Direct material 80.00 5,200,000

Material support:

Procurement ($.10 25) 2.50 162,500

Production scheduling 2.00 130,000

Packaging and shipping 4.00 260,000

Variable support:

Machine setups ($1.60 2) 3.20 208,000

Waste disposal ($3 .02) .06 3,900

Quality control 3.50 227,500

General supplies .60 39,000

Other manufacturing support:

Machine insertion ($0.40 24) 9.60 624,000

Manual insertion 4.00 260,000

Wave soldering 1.20 78,000

Total cost $110.66 $7,192,900

Unit contribution $39.34

Total contribution (65,000 $39.34) $2,557,100


164

2. Using activity-based costing, the total contribution expected this

year from the PC Board is $1,594,000 calculated as follows:

Per

Unit

Totals for 40,000

Units Revenue $300.00 $12,000,000

Direct material 140.00 5,600,000

Material support:

Procurement ($.10 55) 5.50 220,000

Production scheduling 2.00 80,000

Packaging and shipping 4.00 160,000

Variable support:

Machine setups ($1.60 3) 4.80 192,000

Waste disposal ($3 .35) 1.05 42,000

Quality control ($3.50 2) 7.00 280,000

General supplies 0.60 24,000

Other manufacturing support:

Machine insertion ($0.40 35) 14.00 560,000

Manual insertion ($4 20) 80.00 3,200,000

Wave soldering 1.20 48,000

Total cost $260.15 $10,406,000

Unit contribution $39.85

Total contribution (40,000 $39.85) $1,594,000

(d) The analysis using standard costs shows that the unit contribution of the

PC Board is almost double that of the TV Board. On this basis, Alaires management is likely to accept the suggestion of the production

manager and concentrate promotional efforts on expanding the market

for the PC Boards. However, the analysis using activity-based costs

does not support this decision. This analysis shows that the total dollar

contribution from the TV Board exceeds that of the PC Board by almost


165

$1,000,000. As a percentage of selling price, the contribution from the

TV Board is double that of the PC Board, e.g., 26% versus 13%.

CASES

5-32 This question is designed to get students to think about the factors creating the

demand for activity-based cost systems.

(a) A traditional cost system, which assigns direct materials and direct labor

to products, and allocates factory support based on direct labor, cannot

signal the cost of component and product variety. Marketing research

may identify that consumers like to choose from a variety of options

(especially when the alternatives are available without any cost

associated with choosing; e.g., you can have any color of this or any

variety of that). In this situation, product engineers can design lots of

varieties and options. The cost system assigns cost only on the direct

labor and materials content of these options. Thus making one million

units of one steering column appears to cost the same as making

100,000 of 4 different steering columns, 10,000 each of 30 other

steering columns, and 1,000 each of 300 other columns. But making 334

steering columns in batch sizes ranging from, for example, 100 to

10,000, and designing and supporting 334 different steering columns is

much more expensive than just producing 5 or at most 40 different

columns. A traditional cost system would report that production costs of

labor and materials for the 1,000,000 steering columns is the same

whether they are produced in 5 varieties, 40 varieties, or 334 varieties.

Thus model and component proliferation is virtually impossible to stop

when companies cost products using traditional cost systems.

(b) In order to understand the cost of variety, the new cost system should

identify the cost of introducing new varieties, colors, and options. The

cost system will show the cost of setting up or changing over to make

the new variety, color and option, a cost that will be independent of the

number of units produced after the setup. Also the new cost system will

show the cost of designing and supporting each new variety, color, and

option (technically, in ABC terms, called the product-sustaining costs) that will be independent of the number of units produced. With

the more accurate understanding of the costs of resources that perform

batch and product-sustaining activities, the product engineers and

marketing managers can jointly make better decisions on whether the


166

higher cost of introducing another customized option will be

compensated with higher sales volumes and/or higher margins.

As a specific example, one of General Motors competitors examined the cost of how many wire harnesses it used in a given car model.

Currently it was producing 12 different wire harnesses, a number that

seemed optimal using its traditional cost system. The ABC systemwhich incorporated the economics of batch production and product-

sustaining expensesrevealed that the optimal number of harnesses was 5 or 6. And when the cost of stocking and servicing all the

dealerships was incorporated into the analysis, the optimal number

dropped to 2. In effect, the apparent savings in direct materials and labor

from having customized wire harnesses for individual combinations of

car options was far lower than the much higher support costs triggered

by high engineering, production support, and service resources

associated with having to produce, stock, and service 12 different wire

harnesses for a single car model.

5-33 This situation is drawn from Cott Corporation: Private Label in the 1990s. Harvard Business School Case #9-594-031.

This is a truly challenging exercise since it requires students to think about the

design of activity-based cost systems, not just the analysis of existing or

proposed systems. But, if a good discussion can be generated in the class, it

could motivate the work that will be done in the rest of the course. Students

may feel that activity-based cost systems are only necessary for large

organizations, like General Motors, Chrysler, Procter & Gamble, Coca Cola,

Hewlett Packard, or John Deere. This discussion shows how even small,

entrepreneurial ventures can benefit from knowing the cost of products,

services, and customers.

Cott executives could use a variety of different activity-based cost systems.

First, and perhaps most obvious, would be an analysis of production costs.

Cott, as any small company, would start with producing a limited set of high

volume, popular cola beverages such as regular cola and diet cola. So initially,

they would have long runs, few setups, and little product variety. Traditional

cost systems work fine in this environment. But if retailers want to use Cott as

their only private label beverage provider, they will ask Cott to provide a fuller

line of beverages, say caffeine-free and diet-caffeine free. Also, they may want

a variety of packaging: 12 oz cans, and 1 and 2 liter plastic bottles. And they

may start to request beverages beyond the cola category, such as sparkling


167

water, mineral water, new-age beverages, ginger ale, flavored soft drinks, etc.

Each new retailer that Cott signs up as a customer may also want its own

slight variation in beverage formulation (ingredients) and labeling. As Cott

begins to respond to the demand for higher variety, it will be performing many

more activities: scheduling production runs, buying more different ingredients

and packaging materials from more suppliers, setting up for each production

run, changing over packaging lines, more quality control activities (required

for each production run and each unique formulation), and more product

support activities to maintain information required for each individual SKU.

Cott will need an ABC system to understand the cost of these activities that

are driven by increased variety and be sure that these costs are covered by the

volume of business and prices received from retailers. Otherwise, its cost

structure will increase and it will either lose money on the incremental orders

or, as it attempts to raise prices, will lose much of its price advantage over the

national brands. Cott will want to understand its costs by individual SKU, to

be sure that the increased costs associated with offering and delivering

customized, low-volume SKUs do not become spread on to the basic high

volume beverages (say, regular and diet cola).

Second, Cott is customizing its product and service offering to individual

retailers. For each retailer, Cott can offer unique product formulations,

customized to the retailers specifications, design of a retailer-specific label for the beverages, and marketing, promotional, and consulting assistance to help

the retailer launch and sustain a private-label cola line. Thus Cott can incur

substantial customer-specific expenses with each new retailer. It will need to

measure all these front-end, customer-specific expenses and link them to the

revenues received, less product and customer-specific beverage costs [as

described in the previous paragraph] to determine customer profitability. An

ABC model of individual customer profitability will enable Cott to predict in

advance the volume and mix of business required to payback heavy front-end

investments in product design, package design, and consulting assistance. Ex

post, Cott will use the ABC customer profitability model to assess whether the

actual volume and mix of business, at actual prices and ABC-calculated

product costs, are generating sufficient margin to repay the front-end and

perhaps on-going customer-specific support expenses. Cott executives can use

such a model to guide their negotiations with each retailer.

Third, one of Cotts principal marketing devices with a retailer is to convince the retailers executives, (1) that Cott beverages are profitable for the retailer to sell, and (2) that Cott beverages may be even more profitable for the retailer

than national-branded beverages. This will require Cott to work with the


168

retailer to develop a retailer profitability model for the cola beverage category

(one of the highest gross volume categories in a retail grocery store). From the

retailers perspective, profit would be measured by the gross margin (net selling price less the price paid to Cott) minus retailer expenses to receive the

beverage containers in a warehouse, store and then ship them to retail outlets,

receive the shipments at the retail store, and then shelve and promote them at

the store. This requires an ABC model to be built for the retailers operating expenses, including the cost of inventory and shelf-space occupancy. This is

especially important since the national brands (Coke and Pepsi) charge the

retailer much higher prices and the retailer marks these items up less than it

might do for a private label beverage. But since the national brands are

delivered directly to individual stores and shelved by the national brands personnel, the retailer does not use its warehouse, distribution, or in-store

resources (other than shelf space) for these brands. Thus a fair comparison

requires the ABC model to cost out the extra activities related to the Cott-

supplied beverages but not required for Coke and Pepsi. But think about the

power of the outcome from such a study. Wouldnt you, as a supplier, like to be able to demonstrate to your customer that you are not just the lowest cost

supplier but the most profitable supplier in a category?

Students may also suggest other, non-cost, aspects of the Coke vs. Cott

decision. But thinking about these three ABC models: factory costs reflecting

the cost of variety and customization, customer cost and profitability reflecting

the cost of unique marketing, design, and promotional assistance, and, finally,

customers profitability structures should give students ample opportunity to reflect on the strategic use of accurate product, distribution, and customer cost

information.

5-34 This case on Gotham City is adapted from Indianapolis: Activity-Based Costing of City Services (A) and (B), Harvard Business School Case #9-196-115/ and -117. The material below reports on the Indianapolis experience.

(a) There are at least two reasons for estimating ABC costs of current

operations before contemplating a privatization decision. First, it may

turn out that the municipal workers are doing the work at a lower cost

than private sector alternatives. While this may seem fanciful, the

Indianapolis experience revealed quite a few tasks where the work could

be done by municipal workers at lower cost than by paying the lowest-

bidding private contractor. Of course, for this comparison to be on a

level playing field, the cost estimate for the municipal workers must

include not only their direct labor cost but also the cost of equipment,


169

supervision, and all resources performing support activities (since any

private company must bid to cover the costs of these resources as well).

The ABC approach provides a reasonable estimate of all direct and

indirect costs associated with performing a given activity (such as filling

potholes, picking up trash, sweeping streets, treating water and sewage,

repaving roads, and operating an airport). The Mayor of Indianapolis,

after seeing the ABC cost estimates for internal provision of these

services, announced he was more interested in competition (between the

public and private sector for the lowest cost supply of services) than in

privatization.

The second reason for the ABC approach is that should a company in

the private sector win the business, the city must then identify all the

resources that are no longer needed when the work is done by the

private contractor. Again, the city resources that should be reduced

include not only the front-line municipal workers, but also all their

equipment, supervisors, and support resources behind the front-line

worker. Otherwise, the city will pay twice for the service, first for the

contractor doing the work, and then for the people and other support

resources who now have less or no work to perform. That is why a

cross-functional, comprehensive total cost view is needed to provide

transparency about all the resources in place to support a front-line

worker.

(b) They should identify all the resource units used such as trucks,

machines, computers, and facilities. Then they need to identify all the

costs incurred to supply the resources and the capacity supplied by each

resource. A capacity cost rate (the cost of the indirect resource divided

by the capacity supplied by the resource) can then be developed for each

resource type. Estimates then need to be obtained for the amount of

each resources capacity used by different activities performed to provide services to the community.

(c) The answer to this question provides a third reason for building ABC

models before considering privatizing municipal services. Before

building an ABC cost model, workers would have no idea about the cost

of performing the work. Once they see the cost of labor, equipment,

supervision, and other support services, they can make suggestions to

lower the cost of performing the work. As a specific example, in

Indianapolis, the workers saw that there was one supervisor for every

two workers, clearly an excessive amount. They also developed


170

procedures so that a pothole could be filled with a three-person crew

rather than a five- or six-person crew, to share equipment with other

activities, to use their equipment more efficiently, and to perform other

work (such as cleaning streets) while waiting for equipment or materials

to be delivered to the site. The sum total of all these improvement

suggestions enabled the municipal workers to submit a much lower bid

than any private contractor, thereby retaining the business. This

message reinforces the point that sharing cost information with front-

line workers enables them to make suggestions for how to accomplish

the same outcomes with fewer resources, resulting in substantial

productivity improvements. Only good cost information can identify the

opportunities for the largest improvements in resource expenses.

5-35 (a) Stage 1: Allocation of S1 and S2 costs to production departments

Department P1 Department P2

Directly

traceable

costs

$480,000

$780,000

S1 1,176,000

336

120 = 420,000 1,176,000

336

216 = 756,000

S2 1,120,000

160

40 = 280,000 1,120,000

160

120 = 840,000

Total support $1,180,000 $2,376,000

DLH 80, 000 120,000

Cost driver

rate $14.75 per DLH $19.80 per DLH

Stage 2: Allocation of P1 and P2 costs to products

Product R361 Product R572

P1 $14. , $885,75 60 000 000 $14. , ,75 20 000 295 000

P2 $19. , ,80 72,000 1425 600 $19. , ,80 48 000 950 400

$2, ,310 600 $1, ,245 400


171

Product costing

Product R361 Product R572

Direct materials $8 , $4, , 500 000 000 000 $10 , , 400 000 4,000 000

Direct labor: P1 $15 , , 60 000 900 000 $15 , , 20 000 300 000

Direct labor: P2 $18 , , 72,000 1296 000 $18 , 48 000 864,000

Support $2, ,310 600 $1, ,245 400

Total cost $8, ,506 600 $6,409,400

Total units 500,000 400,000

Unit cost $17.0132 $16.0235

Sales price 19 0000. 200000.

Gross margin $1.9868 $3.9765

Gross margin % 10.4600% 19.88%

(b) Let x denote the number of hours required for each R361 setup. Then the number of hours required for each R572 setup = 1.5x.

R361 R572

Number of setups 2,000 4,000

Setup hours 2,000x 6,000x = 4,000 1.5x

(25%) (75%)


172

Number of transactions

Activity

Cost

Drivers

Traceable

Costs

Total

R361

R572

Capacity

Cost Driver Rate

P1-DLH $240,000 80,000 60,000 20,000 $3/P1 DLH

P2-DLH 360,000 120,000 72,000 48,000 $3/P2 DLH

Setup

hours 1,676,000 8,000x 2,000x 6,000x

$209.5

x/ setup hour

P1-MH 380,000 40,000 30,000 10,000 $9.50/P1 MH

P2-MH 900,000 120,000 72,000 48,000 $7.50/P2 MH

Total Support Costs

Capacity Cost

Drivers

Product R361

Product R572

P1-DLH $3 60,000 = $180,000 $3 , $60, 20 000 000

P2-DLH $3 72,000 = 216,000 $3 , , 48 000 144 000

Setup hours 2095

2000 419,000.

xx

20956 000 1257,000

., ,

xx =

P1-MH $9. , ,5 30 000 285 000 $9. , ,5 10 000 95 000

P2-MH $7. ,5 72,000 540 000 $7. , ,5 48 000 360 000

$1, ,640 000 $1, ,916 000

Alternatively,

Capacity

Cost

Total Support Costs

Drivers Product R361 Product R572

P1-DLH

60

80000 000 $240, $180,

20

80000 000 $240, $60,

P2-DLH

72

120000 000 $360, $216,

48

120000 144,000 $360,


173

Setup

hours

2,000

8 0001676 000 419,000

x

x,, ,

6 000

8 0001676 000 1257,000

,

,, , ,

x

x

P1-MH

30

40000 285 000 $380, ,

10

40000 95 000 $380, ,

P2-MH 72

120000 540 000 $900, ,

48

120000 360 000 $900, ,

$1, ,640 000 $1, ,916 000


174

Product costing

Product R361 Product R572 Direct materials $4,000,000 $4,000,000

Direct labor: P1 900,000 300,000

Direct labor: P2 1,296,000 864,000

Support costs $1,640,000 $1,916,000

Total cost $7,836,000 $7,080,000

Total units 500,000 400,000

Unit cost $15.672 $17.700

Sales price 19.000 20.000

Gross margin $3.328 $2.300

Gross margin % 17.520% 11.500%

(c) The old cost accounting system ignored the fact that a large part of

support costs is driven by setup hours. Under the old cost accounting

system, R572 was undercosted because it had disproportionally more

setup hours compared to direct labor hours. The ratio of setup hours per

unit of R361 to the setup hours per unit of R572 equals:

2 000

500 000

6 000

400 000415

,

,

,

,.

x x

Old Cost Accounting

System

ABC

System

R361 R572 R361 R572

Sales price $19.0000 $20.0000 $19.0000 $20.0000

Unit cost 17.0132 16.0235 15.6720 17.7000

Gross margin $1.9868 $3.9765 $3.3280 $2.3000

Gross margin % 10.46% 19.88% 17.52% 11.50%


175

(d) Recommendations for marketing:

1. R361 is more profitable than R572. Therefore, push R361 by increasing the commission on R361 or decreasing the

commission on R572.

2. Raise the price of R572.

Recommendations for production:

1. A large part of support costs is driven by setup hours. Therefore, re-engineer the products to decrease setup hours.

2. Offer discounts to customers for larger batch sizes to reduce the

number of setups. (This recommendation may also involve

marketing staff.)

(e) The experienced production manager is likely to have an intuitive

understanding of the higher production complexity for R572 and will

likely agree with the activity-based cost analysis. However, the sales

manager will likely want to keep sales high and has already built up

relations with R572 customers. Therefore, the sales manager will likely

oppose increasing the price of R572 since it will reduce its sales.

5-36 Sippican Corporation (A) (HBS Case 9-106-058)

Teaching Plan

This is an introductory case, and yet it introduces a powerful new approach for

building an ABC model. Considerable theory is illustrated in how we build the

Sippican time-driven ABC (TDABC) model. Also, the (B) case introduces an

important link, previously recognized but not exploited, in how to embed an

ABC model into the budgeting process, replacing line-item budgeting with an

integrated, analytic approach. The case discussion provides insight and

confidence about the feasibility of building a TDABC model, especially in the

face of resistance from finance people who claim that ABC is too complex to

implement.


176

Q: What is the competitive situation faced by Sippican?

Mature products

Declining profits

Inability to explain pricing decisions in market place high margins and little price competition in one line; continued price pressure in another

Q: Why was Knight studying Sippicans overhead costs?

The following two characteristics serve as indicators that a traditional costing

approach to overhead costs is likely providing inaccurate costs:

1. The Willie Sutton rule:1 Look for areas with large expenses in indirect and support resources, especially where such expenses

have been growing over time. Operations where almost all

expenses are direct labor and direct materials, which can

already be directly traced to individual products by traditional

costing systems, may have less need for ABC systems. In

effect, if organizational activities are all at the unit level

(virtually no batch or product-sustaining activities), then ABC

systems and traditional cost systems will likely give very

similar economic signals.

2. High Diversity rule: Look for a situation in which large variety exists in products, customers, or processes. For example,

consider a facility that produces mature and newly introduced

products, standard and custom products, high-volume and low-

volume products. For marketing and selling expenses,

companies may have a mixture of customers who order high-

volume, standard products with few special demands as well as

customers who order in small volumes, special products, and

require large quantities of pre-sales and post-sales technical

support.

1 Willie Sutton was a successful bank robber in the United States during the 1950s. Willie, who

was eventually captured at his home not far from a local police station, was asked during his initial

interrogation, Why do you rob banks? Willie replied, with the wisdom that had made him successful for many years, Thats where the money is! When developing ABC systems, we should follow Willies sage advice (but not his particular application of the insight) to focus on high cost areas where improvements in visibility and action could produce major benefits to the

organization. Applying an ABC analysis to a set of resource expenses that are below 1% of total

spending will not lead to high payoffs to the organization.


177

Observation: Products such as pumps and valves may be commodities; but

how they are produced (small lots, custom designs) and delivered (direct,

expedited) is not a commodity. These special services create a basis for

differentiation. But differentiation is a successful strategy only when the delta value created by differentiation exceeds the cost to differentiate.

Revenues (from higher prices, higher sales volumes) > Costs

Q: Should Sippican abandon its overhead cost allocation system and make

managerial decision based on contribution margin; in effect use marginal costs

rather than average costs?

(a) Sippicans executives should not abandon overhead assignment to products. The contribution margin is revenues minus variable costs.

Analysis based on unit contribution margins can be useful for short-term decisions, such as whether to accept a one-time order when operating

with excess capacity. In this case, management is concerned about

recurring sales.

Overhead cost is sizable ($654,600, which exceeds either direct labor or direct material costs)

Management will benefit by understanding the impact of variety in the use of overhead resources by individual

products.

The contribution margin approach, by definition, does not reveal the different demands that individual products make on

overhead resources (for machine time, engineering design,

setups, receiving, shipping, etc.).

Companies that cut prices based on contribution margin to get new business should be cautious about (i) competitive reactions, (ii) having

to lower prices to existing customers, and (iii) filling up capacity with

business that does not pay for capacity costs.

If a company cuts prices when near capacity, demand could increase beyond existing capacity. Consequently, the company may end up

having to supply more capacity for support resources to handle the

work, without being paid for supplying these capacity resources.

Using TDABC, only two parameters are needed for each department or process:

1. Calculate capacity cost rates for each department or process 2. Time required by products, orders, services, and customers on the

organizations capacity resources.


178

Q: Lets start building the time-driven ABC model. What are the various capacity cost rates?

(b) Capacity Cost Rates

Cost/ Days Used Paid Hrs Nonprod. Prod. Prod. Cost

Month Per Month Per Day Hours Hrs/Day Hrs/Mo Per Hr

Production and Setup Labor $3,900 20 7.5 1.5 6.0 120 $32.50

Machine Expenses $5,400 20 12.0 240 $22.50 Receiving and Production

Control $3,900 20 7.5 1.0 6.5 130 $30.00

Engineering $9,750 20 7.5 1.5 6.0 120 $81.25

Packaging and Shipping $3,900 20 7.5 1.0 6.5 130 $30.00

Hours Used

Valves* Pumps

Flow

Controllers*

Total

Hours

Production Volume 7,500 12,500 4,000 24,000

DL (Production and

Assembly) 2,850 6,250 1,600 10,700

Machine Runs 3,750 6,250 1,200 11,200

Machine Setups 100 600 2,700 3,400

Total Machine 14,600

Setup Labor 100 600 2,700 3,400

Receiving and Production

Control 25 125 281 431

Engineers 60 240 600 900

Packaging and Shipping 1,033 1,750 700 3,483

*For valves,

DL hours = 7,500 valves 0.38 DL hours per valve = 2,850

Machine run hours = 7,500 valves 0.5 machine hours per valve = 3,750

Machine setup hours and labor setup hours (from case) = 100 (= 5 20)

Receiving and production hours = 1.25 20 production runs = 25

Engineering hours (from case): 60

Packaging and shipping hours = (40 shipments 50/60) + (7,500 valves 8/60) =

1,033


179

For flow controllers:

DL hours = 4,000 0.40 =1,600

Machine run hours= 4,000 0.30 =1,200

Machine setups (from case) = = 2,700 (= 225 12)

Labor setup hours (from case) = = 2,700 (= 225 12)

Receiving and production hours = 225 1.25 = 281

Engineering (from case): 600

Packaging and shipping hours = (200 50/60) + (4,000 8/60) = 700

The figures for pumps are computed similarly.

Practical and Used Capacity

Hours

Resources Res. Avail/ Hours Hours Avail % Cap. Quant. Res. Unit Avail. Used Used Hrs Used

DL (Production and

Assembly) 90 120 10,800 10,700 100 99%

Machines (Runs and

Setup) 62 240 14,880 14,600 280 98%

Setup Labor 30 120 3,600 3,400 200 94%

Receiving and

Production Control 4 130 520 431 89* 83%

Engineers 8 120 960 900 60 94%

Packaging and

Shipping 28 130 3,640 3,483 157* 96%

*Rounded


180

Lets assign the costs of these various resources/departments to the flow controller line:

Total Time Cost Rate Cost Assigned Unit Cost (4,000)

Machine run time: 1,200 $22.50 $ 27,000 $ 6.75

Set-ups (labor) 2,700 32.50 87,750 21.94

Set-ups (machines) 2,700 22.50 60,750 15.19

Receive/Prod Ctrl 225(75/60)

281.25 30.00 8,438 2.11

Package & Ship [20050+4,0008]/60

700 30.00 21,000 5.25

Engineering 600 81.25 48,750 12.19

Total Overhead $253,688 $63.42

Direct Labor 52,000 13.00

Direct Materials 88,000 22.00

$393,688 $ 98.42

Revenues $380,000 95.00

Gross Margin $(13,688) ($ 3.42)

Hand out sheet of P&L of Sippican. Do you believe the revised P&L?


181

(c) (Small discrepancies in totals are due to calculations performed in a spreadsheet package.)

Valves

Valves:

per unit

costs Pumps

Pumps:

per unit

costs

Flow

Contr.

FCs: per

unit

costs Total

Unused

Capacity* Actual

Percent

of Sales

Units 7,500 12,500 4,000

Sales $592,500 $79.00 $875,000 $70.00

$380,00

0 $95.00 $1,847,500 $1,847,500 100%

Materials Expenses 120,000 16.00 250,000 20.00 88,000 22.00 $458,000 $458,000

DL Expenses 92,625 12.35 203,125 16.25 52,000 13.00 $347,750 $3,250 $351,000

Contribution Margin 379,875 50.65 421,875 33.75 240,000 60.00 $1,041,750 -$3,250 $1,038,500 56%

Manufacturing Overhead

Machine Expenses 84,375 11.25 140,625 11.25 27,000 6.75 $252,000 $6,300 $258,300

Setup Labor 3,250 0.43 19,500 1.56 87,750 21.94 $110,500 $6,500 $117,000

Machine Setup** 2,250 0.30 13,500 1.08 60,750 15.19 $76,500 $0 $76,500


Control 750 0.10 3,750 0.30 8,438 2.11 $12,938 $2,663 $15,600

Engineering 4,875 0.65 19,500 1.56 48,750 12.19 $73,125 $4,875 $78,000

Packaging and Shipping 31,000 4.13 52,500 4.20 21,000 5.25 $104,500 $4,700 $109,200

Total Manufacturing Overhead 126,500 16.87 249,375 19.95 253,688 63.42 $629,563 $25,038 $654,600 35%

Total costs 339,125 45.22 702,500 56.20 393,688 98.42 $1,435,313 $28,288 $1,463,600

Gross Margin 253,375 33.78 172,500 13.80 -13,688 -3.42 $412,188 -$28,288 $383,900 21%

Gross Margin/Sales % 42.8% 19.7% -3.6% 22.3% 20.8%

Selling and Administrative Exps. $350,000 19%

Operating Profit $33,900 2%

Return on Sales 1.83%

* See the following table.

**Machine Setup unused capacity is included with Machine Expenses unused capacity.

Atkinson, Solution Manual t/a Management Accounting, 4E

182

Using the capacity rates and unused capacity hours computed in part (b), the cost

of unused capacity is as follows.

Resources Available Cost of Used Hrs Cost/Hr Unused Capacity

DL (Production and

Assembly) 100.00 $32.50 $3,250

Machines (Runs and Setup) 280.00 $22.50 $6,300

Setup Labor 200.00 $32.50 $6,500


Control 88.75 $30.00 $2,663

Engineers 60.00 $81.25 $4,875

Packaging and Shipping 156.67* $30.00 $4,700

*Rounded

The following table summarizes the difference in reported product costs and

profitability with the

Documents

Chapter 5 Solutions