Comparison with Functional-Based Costing
Department 1 Department 2
Model A 10,000 130,000
Model B 170,000 270,000
Compute the overhead cost per unit for each product using departmental rates.
4. Using the activity-based product costs as the standard, comment on the ability of departmental rates to improve the accuracy of product costing. (Did the departmental rates do better than the plantwide rate?)
Wilson Company produces lawn mowers. One of its plants produces two versions of mowers: a basic model and a deluxe model. The deluxe model has a sturdier frame, a higher horsepower engine, a wider blade, and mulching capability. At the begin- ning of the year, the following data were prepared for this plant:
Basic Model Deluxe Model
Expected quantity 40,000 20,000
Selling price $180 $360
Prime costs $160 $320
Machine hours 5,000 5,000
Direct labor hours 10,000 10,000
Engineering support (hours) 1,500 4,500
Receiving (orders processed) 250 500
Material handling (number of moves) 1,200 4,800
Purchasing (number of requisitions) 100 200
Maintenance (hours used) 1,000 3,000
Paying suppliers (invoices processed) 250 500
Setting up equipment (number of setups) 16 64
Additionally, the following overhead activity costs are reported:
Maintaining equipment $114,000
Engineering support 120,000
Material handling ?
Setting up equipment 96,000
Purchasing materials 60,000
Receiving goods 40,000
Paying suppliers 30,000
Providing space 20,000
Total $ ?
Facility-level costs are allocated in proportion to machine hours (provides a measure of time the facility is used by each product). Material handling uses three inputs:
two forklifts, gasoline to operate the forklift, and three operators. The three opera- tors are paid a salary of $60,000 each. The operators spend 25 percent of their time on the receiving activity and 75 percent on moving goods (material handling).
Gasoline costs $4.50 per move. Depreciation amounts to $9,000 per forklift per year.
Required
1. Calculate the cost of the material-handling activity. Label the cost assignments as driver tracing and direct tracing. Identify the resource drivers.
2. Calculate the cost per unit for each product using direct labor hours to assign all overhead costs.
3. Calculate activity rates and assign costs to each product. Calculate a unit cost for each product and compare these costs with those calculated in Requirement 2.
4. Calculate consumption ratios for each activity.
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Production-Based Costing versus Activity-Based Costing; Assigning Costs to Activities;
Resource Drivers LO3, LO4
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5. Explain how the consumption ratios calculated in Requirement 4 can be used to reduce the number of rates. Calculate the rates that would apply under this approach.
Dulce Sound Company produces several different models of a compact disc player system. The company has recently adopted an ABC system. The unit cost expected for the deluxe model, Model FRX, follows:
Unit-level costs (includes materials and labor) $120
Batch-level costs 80
Product-level costs 40
Facility-level costs 20
Total unit cost $260
The unit cost is based on an expected volume of 20,000 units. These units will be produced in 20 equal batches. The product-level costs are all from engineering sup- port. The product-level costs are driven by engineering orders. The $40 cost assign- ment is based on 10 orders. Facility-level costs are allocated on the basis of direct labor hours (one hour per unit produced).
Required
1. Calculate the total manufacturing cost to produce 20,000 units of the deluxe model. Present the total cost for each activity category.
2. Now assume that the company has revised its forecast for the deluxe model and expects to produce 30,000 units. A decision was made to handle the increased production by increasing batch size to 1,500 units. The increased production will not require an increase in engineering support. Calculate the total cost to produce the 30,000 units of the deluxe model. Present the total cost for each activity category. Explain the outcome.
3. Assume that the revised forecast of 30,000 units is made. Now, however, the decision is made to handle the extra production by increasing the number of batches from 20 to 30. Also, the sale of the extra 10,000 units is possible only if an engineering modification is made. This increases the expected engineering orders from 10 to 12. Explain why the costs changed from those predicted in Requirement 2.
4. Discuss the value of classifying and reporting costs by activity category.
Trinity Clinic has identified three activities for daily maternity care: occupancy and feeding, nursing, and nursing supervision. The nursing supervisor oversees 150 nurses, 25 of whom are maternity nurses (the other nurses are located in other care areas such as the emergency room and intensive care). The nursing supervisor has three assistants, a secretary, several offices, computers, phones, and furniture. The three assistants spend 75 percent of their time on the supervising activity and 25 percent of their time as surgical nurses. They each receive a salary of $48,000. The nursing supervisor has a salary of $70,000. She spends 100 percent of her time supervising. The secretary receives a salary of $22,000 per year. Other costs directly traceable to the supervisory activity (depreciation, utilities, phone, etc.) average
$100,000 per year.
Daily care output is measured as “patient days.” The clinic has traditionally assigned the cost of daily care by using a daily rate (a rate per patient day). There are actually different kinds of daily care, and rates are structured to reflect these differ- ences. For example, a higher daily rate is charged for an intensive care unit than for a maternity care unit. Within units, however, the daily rates are the same for all patients. Under the traditional, functional approach, the daily rate is computed by dividing the annual costs of occupancy and feeding, nursing, and a share of supervi- sion by the unit’s capacity expressed in patient days. The cost of supervision is
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ABC Costing and Cost Behavior LO4, LO5
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Activity-Costing;
Assigning Resource Costs; Primary and Secondary Activities LO3, LO4
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assigned to each care area based on the number of nurses. A single driver (patient days) is used to assign the costs of daily care to each patient.
A pilot study has revealed that the demands for nursing care vary within the maternity unit, depending on the severity of a patient’s case. Specifically, demand for nursing services per day increases with severity. Assume that within the maternity unit there are three levels of increasing severity: normal patients, cesarean patients, and patients with complications. The pilot study provided the following activity and cost information:
Activity Annual Cost Activity Driver Annual Quantity
Occupancy and feeding $1,000,000 Patient days 10,000
Nursing care (maternity) 950,000 Hours of nursing care 50,000
Nursing supervision ? Number of nurses 150
The pilot study also revealed the following information concerning the three types of patients and their annual demands:
Patient Days Nursing Hours
Patient Type Demanded Demanded
Normal 7,000 17,500
Cesarean 2,000 12,500
Complications 1,000 20,000
Total 10,000 50,000
Required
1. Calculate the cost per patient day using a functional-based approach.
2. Calculate the cost per patient day using an activity-based approach.
3. The hospital processes 1,000,000 pounds of laundry per year. The cost for the laundering activity is $500,000 per year. In a functional-based costing system, the cost of the Laundry Department is assigned to each user department in pro- portion to the pounds of laundry produced. Typically, maternity produces 200,000 pounds per year. How much would this change the cost per patient day calculated in Requirement 1? Now describe what information you would need to modify the calculation made in Requirement 2. Under what conditions would this activity calculation provide a more accurate cost assignment?
Mendoza Company has recently decided to convert from conventional product cost- ing to an activity-based system. The company produces two types of clocks: small and large. The clocks are produced in batches. Information concerning these two products follows:
Small Clock Large Clock
Quantity produced 100,000 200,000
Direct labor hours 100,000 100,000
Material handling (number of moves) 2,000 4,000
Engineering (hours) 10,000 5,000
Receiving (number of orders processed) 250 500
Setups 60 20
Maintenance (hours used) 4,000 2,000
Machining (machine hours) 50,000 50,000
Inspection (number of hours) 3,000 1,000
Additionally, the following overhead costs are reported for the activities associated with the two products:
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Reducing Number of Rates Using Consumption Ratios; Activity- Based Costing LO4, LO5
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Material handling $120,000
Maintenance equipment 80,000
Machining 90,000
Engineering 100,000
Receiving* 30,000
Setups 96,000
Inspection 60,000
*Materials are ordered and received each time a batch is produced
Required
1. Classify activities as unit-level, batch-level, product-level, and facility-level.
2. Reduce the rates by grouping all activities with identical consumption ratios into homogeneous cost pools. Select an activity driver for each cost pool, and com- pute a pool rate.
3. Using the pool rates calculated in Requirement 2, assign all overhead costs to the two products, and compute the overhead cost per unit for each.
Pearson Manufacturing is engaged in the production of chemicals for industrial use.
One plant specializes in the production of chemicals used in the copper industry.
Two compounds are produced: compound X-12 and compound S-15. Compound X- 12 was originally developed by Pearson’s chemists and played a key role in copper extraction from low-grade ore. The patent for X-12 has expired, and competition in this market has intensified dramatically. Compound X-12 produced the highest vol- ume of activity and for many years was the only chemical compound produced by the plant. Five years ago, S-15 was added. Compound S-15 was more difficult to manufacture and required special handling and setups. For the first three years after the addition of the new product, profits increased. In the last two years, however, the plant has faced intense competition, and its sales of X-12 have dropped. In fact, the plant showed a small loss in the most recent reporting period. The plant manager is convinced that competing producers have been guilty of selling X-12 below the cost to produce it—perhaps with the objective of expanding their market shares. The fol- lowing conversation between Diane Woolridge, plant manager, and Rick Dixon, divi- sional marketing manager, reflects the concerns of the division about the future of the plant and its products.
Rick:You know, Diane, the divisional manager is very concerned about the plant’s trend. He indicated that in this budgetary environment, we can’t afford to carry plants that don’t show a profit. We shut one down just last month because it couldn’t handle the competition.
Diane:Rick, our compound X-12 has a reputation for quality and value—we have a very pure product. It has been a mainstay for years. I don’t understand what’s happening.
Rick:I just received a call from one of our major customers concerning X-12. He said that a sales representative from another firm had offered the chemical at $10 per kilogram—about $6 less than what we ask. It’s hard to compete with a price like that. Perhaps the plant is simply obsolete.
Diane:No. I don’t agree. We have good technology. I think that we are efficient.
And it’s costing a little more than $10 to produce X-12. I don’t see how these com- panies can afford to sell it so cheaply. I’m not convinced that we should meet the price. Perhaps we should emphasize producing and selling more of S-15. Our mar- gin is high on this product, and we have virtually no competition for it. We just recently raised the price per kilogram, and our customers didn’t blink an eye.
Rick:You may be right. I think we can increase the price even more and not lose busi- ness. I called a few customers to see how they would react to a 25 percent increase in price, and they all said that they would still purchase the same quantity as before.
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Product Costing Accuracy; Corporate Strategy; Activity- Based Costing LO3, LO4, LO5
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Diane:It sounds promising. However, before we make a major commitment to S- 15, I think we had better explore other possible explanations. The market potential is much less than that for X-12. I want to know how our production costs compare to our competitors. Perhaps we could be more efficient and find a way to earn our normal return on X-12. Besides, my production people hate producing S-15. It’s very difficult to produce.
After meeting with Rick, Diane requested an investigation of the production costs and comparative efficiency. Independent consultants were hired. After a three- month assessment, the consulting group provided the following information on the plant’s production activities and costs associated with the two products:
X-12 S-15
Production (kilograms) 1,000,000 200,000
Selling price $15.93 $12.00
Overhead per unit* $6.41 $2.89
Prime cost per kilogram $4.27 $3.13
Number of production runs 100 200
Receiving orders 400 1,000
Machine hours 125,000 60,000
Direct labor hours 250,000 22,500
Engineering hours 5,000 5,000
Material handling (number of moves) 500 400
*Calculated using a plantwide rate based on direct labor hours, which is the current way of assigning the plant’s overhead to its products.
The consulting group recommended switching the overhead assignment to an activity-based approach. It maintained that activity-based costing assignment is more accurate and will provide better information for decision making. To facilitate this recommendation, the plant’s activities were grouped into homogeneous sets based on common consumption ratios. The costs of these pooled activities follow:
Overhead pool:*
Setup costs $ 240,000
Machine costs 1,750,000
Receiving costs 2,100,000
Engineering costs 2,000,000
Material-handling costs 900,000
Total $6,990,000
*The pools are named for the major activities found within them. All overhead costs within each pool can be assigned using a single driver (based on the major activity after which the pool is named).
Required
1. Verify the overhead cost per unit reported by the consulting group using direct labor hours to assign overhead. Compute the per-unit gross margin for each product.
2. Recompute the unit cost of each product using activity-based costing. Compute the per-unit gross margin for each product.
3. Should the company switch its emphasis from the high-volume product to the low-volume product? Comment on the validity of the plant manager’s concern that competitors are selling below the cost of producing compound X-12.
4. Explain the apparent lack of competition for S-15. Comment also on the will- ingness of customers to accept a 25 percent increase in price for this compound.
5. Describe what actions you would take based on the information provided by the activity-based unit costs.
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Ellishawk Company has identified the following overhead activities, costs, and activ- ity drivers for the coming year:
Activity Expected Activity Activity
Cost Driver Capacity
Testing products $252,000 Number of tests 300
Purchasing materials 36,000 Number of orders 1,800
Machining 252,000 Machine hours 21,000
Receiving 60,000 Receiving hours 2,500
Ellishawk produces two models of electronic game computers with the following expected activity demands:
Model A Model B
Units completed 10,000 20,000
Number of tests 200 100
Number of orders 600 1,200
Machine hours 12,000 9,000
Receiving hours 750 1,750
Required
1. Determine the total overhead assigned to each product using the four activity drivers.
2. Determine the total overhead assigned to each model using the two most expen- sive activities. The costs of the two relatively inexpensive activities are allocated to the two expensive activities in proportion to their costs.
3. Using ABC as the benchmark, calculate the percentage error and comment on the accuracy of the reduced system. Explain why this approach may be desirable.
Airepart, Inc., produces two different types of subassemblies for the aircraft industry.
Airepart produces a major component for the subassemblies in the cutting and welding department. Other parts and the manufactured component are then assem- bled in the assembly department. The activities, expected costs, and drivers associ- ated with these two manufacturing processes are as follows:
Process Activity Cost Activity Expected Driver Quantity Cutting and Welding $ 2,000,000 Welding hours 4,000
Welding Machining 1,000,000 Machine hours 10,000
Inspecting 70,000 No. of inspections 1,000 Materials
handling 52,000 No. of moves 12,000
Setups 400,000 No. of batches 100
$3,522,000
Assembly Changeover $ 28,000 Changeover hours 1,000
Rework 50,000 Rework orders 50
Testing 40,000 No. of tests 750
Materials 60,000 No. of parts 50,000
handling Engineering
support 70,000 Engineering hours 2,000
$ 248,000
Note:In the assembly process, the materials handling activity is a function of product characteristics rather than batch activity.
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Approximately Relevant ABC LO5
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Approximately Relevant ABC LO5
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Managerial Decision Cases
Sharp Paper, Inc., has three paper mills, one of which is located in Memphis, Ten- nessee. The Memphis mill produces 300 different types of coated and uncoated spe- cialty printing papers. This large variety of products was the result of a full-line mar- keting strategy adopted by Sharp’s management. Management was convinced that the value of variety more than offset the extra costs of the increased complexity.
Other overhead activities, their costs, and drivers are as follows:
Activity Cost Activity Driver Quantity
Purchasing $50,000 Purchase requisitions 500
Receiving 70,000 Receiving orders 2,000
Paying suppliers 80,000 No. of invoices 1,000
Providing space and utilities 30,000 Machine hours 10,000
$230,000
Other production information concerning the two subassemblies is also provided as follows:
Subassembly A Subassembly B
Units produced 1,500 3,000
Welding hours 1,600 2,400
Machine hours 3,000 7,000
Inspections 500 500
Moves 7,200 4,800
Batches 45 55
Changeover hours 540 460
Rework orders 5 45
Tests 500 250
Parts 40,000 10,000
Engineering hours 1,500 500
Requisitions 425 75
Receiving orders 1,800 200
Invoices 650 350
The per-unit overhead costs using the 14 activity-based drivers are $1,108 and $779 for Subassemblies A and B, respectively.
Required
1. Determine the percentage of total costs represented by the three most expensive activities.
2. Allocate the costs of all other activities to the three activities identified in Requirement 1. Allocate the other activity costs to the three activities in propor- tion to their individual activity costs. Now assign these total costs to the prod- ucts using the drivers of the three chosen activities.
3. Using the costs assigned in Requirement 1, calculate the percentage error using the ABC costs as a benchmark. Comment on the value and advantages of this ABC simplification.
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ABC; Distorted Product Costs LO3, LO4
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During 2006, the Memphis mill produced 120,000 tons of coated paper and 80,000 tons of uncoated paper. Of the 200,000 tons produced, 180,000 were sold.
Sixty products account for 80 percent of the tons sold. Thus, 240 products are classi- fied as low-volume products.
Lightweight lime hopsack in cartons (LLHC) is one of the low-volume products.
LLHC is produced in rolls, converted into sheets of paper, and then sold in cartons.
In 2006, the cost to produce and sell one ton of LLHC was as follows:
Direct materials:
Furnish (3 different pulps) . . . 2,225 pounds $ 450 Additives (11 different items) . . . 200 pounds 500 Tub size . . . 75 pounds 10 Recycled scrap paper . . . (296 pounds) (20) Total direct materials . . . $ 940 Direct labor . . . $ 450 Overhead:
Paper machine ($100 per ton 2,500 pounds) . . . . $ 125 Finishing machine ($120 per ton 2,500 pounds) . . . 150 Total overhead . . . $ 275 Shipping and warehousing . . . $ 30 Total manufacturing and selling cost . . . $1,695 Overhead is applied using a two-stage process. First, overhead is allocated to the paper and finishing machines using the direct method of allocation with carefully selected cost drivers. Second, the overhead assigned to each machine is divided by the budgeted tons of output. These rates are then multiplied by the number of pounds required to produce one good ton.
In 2008, LLHC sold for $2,400 per ton, making it one of the most profitable products. A similar examination of some of the other low-volume products revealed that they also had very respectable profit margins. Unfortunately, the performance of the high-volume products was less impressive, with many showing losses or very low profit margins. This situation led Ryan Chesser to call a meeting with his marketing vice president, Jennifer Woodruff, and his controller, Kaylin Penn.
Ryan:The above-average profitability of our low-volume specialty products and the poor profit performance of our high-volume products make me believe that we should switch our marketing emphasis to the low-volume line. Perhaps we should drop some of our high-volume products, particularly those showing a loss.
Jennifer:I’m not convinced that the solution you are proposing is the right one. I know our high-volume products are of high quality, and I am convinced that we are as efficient in our production as other firms. I think that somehow our costs are not being assigned correctly. For example, the shipping and warehousing costs are assigned by dividing these costs by the total tons of paper sold. Yet . . .
Kaylin: Jennifer, I hate to disagree, but the $30-per-ton charge for shipping and warehousing seems reasonable. I know that our method to assign these costs is iden- tical to a number of other paper companies.
Jennifer:Well, that may be true, but do these other companies have the variety of products that we have? Our low-volume products require special handling and pro- cessing, but when we assign shipping and warehousing costs, we average these spe- cial costs across our entire product line. Every ton produced in our mill passes through our mill shipping department and is either sent directly to the customer or to our distribution center and then eventually to customers. My records indicate quite clearly that virtually all the high-volume products are sent directly to cus- tomers, whereas most of the low-volume products are sent to the distribution center.
Now, all the products passing through the mill shipping department should receive