Hallmark Inc.: Activity-Based Costing
The Business Situation
Mr. Obama, president of Hallmark Inc., created the Wall Décor unit of Hallmark Inc. three years ago to
increase the company’s revenue and profits. Unfortunately, even though Wall Décor’s revenues have
grown quickly, Hallmark appears to be losing money on Wall Décor. Mr. Obama has hired you to provide
consulting services to Wall Décor’s management. Your assignment is to make Wall Décor a profitable
business unit.
Your first step is to talk with the Wall Décor work force. From your conversations with store managers you
learn that the individual Hallmark stores are very happy with the Wall Décor arrangement. The stores are
generating additional sales revenue from the sale of unframed and framed prints. They are especially
enthusiastic about this revenue source because the online nature of the product enables them to generate
revenue without the additional cost of carrying inventory. Wall Décor sells unframed and framed prints
to each store at product cost plus 20%. A 20% markup on products is a standard policy of all Hallmark
intercompany transactions. Each store is allowed to add an additional markup to the unframed and
framed print items according to market pressures. That is, the selling price charged by each store for
unframed and framed prints is determined by each store manager. This policy ensures competitive pricing
in the respective store locations, an important business issue because of the intense mall competition.
While the store managers are generally happy with the Wall Décor products, they have noted a significant
difference in the sales performance of the unframed prints and the framed prints. They find it difficult to
sell unframed prints at a competitive price. The price competition in the malls is very intense. On average,
stores find that the profits on unframed prints are very low because the cost for unframed prints charged
by Wall Décor to the Hallmark stores is only slightly below what competing stores charge their customers
for unframed prints. As a result, the profit margin on unframed prints is very low, and the overall profit
earned is small, even with the large volume of prints sold. In contrast, stores make a very good profit on
framed prints and still beat the nearest competitor’s price by about 15%. That is, the mall competitors
cannot meet at a competitive price the quality of framed prints provided by the Hallmark stores. As a
result, store managers advertise the lowest prices in town for high-quality framed prints. One store
manager referred to Wall Décor’s computer on the counter as a “cash machine” for framed prints and a
“lemonade stand” for unframed prints.
In a conversation with the production manager, you learned that she believes that the relative profitability
of framed and unframed prints is distorted because of improper product costing. She feels that the costs
provided by the company’s traditional job order costing system are inaccurate. From the very beginning,
she has carefully managed production and distribution costs. She explains” Wall Décor is essentially giving
away expensive framed and it seems that it is charging the stores too much for unframed prints.” In her
office she shows you her own product costing system which supports her point of view.
Your tour in the Information Technology department provided you more insight why Wall décor is
encountering financial problems. You discovered that to keep the Website working it needs computer
servers and several computer professionals. Two separate activities are happening in the area. First,
purchasing and IT professionals are spending many hours in managing the thousands of prints, frame and
matting materials. Their tasks include selecting the prints and the types of framing materials to sell. They
also must upload, manage and download prints and framing materials in and off the Website. The IT staff
tells you that much of their time is spent in framing and matting of materials. Only a highly skilled IT
professional can properly scan a print and load it up to the site so that it graphically represents what the
print will look like when properly matted and framed.
In addition, you discover that a different team of IT professional is dedicated to optimizing the operating
performance of the Website. These costs are classified as manufacturing overhead because a substantial
amount of work is required to keep the site integrated with purchasing and production and to safeguard
Wall Décor’s online assets. Most time- consuming is the effort to develop and maintain the site so that
customers can view its prints as they would appear either unframed or framed or matted.
A discussion with IT professional suggests that the time spent on developing and maintaining the site for
the unframed prints is considerably less than the required for the framed prints and in particular for the
framed and matted prints. Developing and maintain a site for the unframed prints is relatively straight
forward. It becomes more complicated when the site must allow the customer to view every possible
combination of print with every type of steel frame, and immensely more complicated when one
considers all the possible wood frames and different matting colors. More time of IT professionals ate
needed to present the over 1,000 different framing and matting options.
Based on your preliminary findings, you have decided that the company’s ability to measure and evaluate
the profitability of individual products would be improved if the company employed an ACTIVITY BASED
COSTING system. As a first step in this effort, you compiled a list of cost, activities and values. Your work
consisted of taking the manufacturing overhead cost of P375,200.00 and allocating the cost to activities
presented on schedules shown below
DIFFERENT ACTIVITIES OF THE COMPANY
ACTIVITY
COST DRIVER
ESTIMATED
OVERHEAD
EXPECTED USE OF
COST DRIVER
1
Picking prints
Number of prints
30,600.00
2
Inventory, selection
and management
No. of component
per print
Print -1
Print/ frame- 2
Print/mat/frame 3
91,700.00
No. of prints cap.
No. of prints cap.
total
25,800.00
103,200.00
129,000.00
Unframed prints: 100,000 print capacity
Framed and/or matted prints: 25,000 prints
(16,000 steel and 9,000 wood)
No. of component
at capacity
123,900.00
Print/frame (16000 x 2) = 32,000 comps.
Print/Mat/Frame ( 9000x3) = 27,000 comps
total = 59,000 components at capacity
3
4
Website
Optimization
Unframed
Framed
Framing and
Matting
Cost ( equipment,
insurance, rent and
supervisory labor)
Unframed=
80,000 prints
Steel Framed = 15,000 prints
Wood Framed=
7,000 prints
Total =
102,000 prints
Print: 80000 components
Print/frame (15000x2)= 30,000 components
Print/mat/frame (7000x3)= 21,000 comp.
TOTAL=
131,000 components
In the Website Optimization activity, the total overhead cost is expected to be 129,000. It was difficult to
identify the cost driver that directly related to Website optimization to the products. In order to reflect
that the majority of the time spent related to the framed prints, the cost of the Website optimization must
be split to unframed prints and framed prints. Based on the discussion with the IT professionals, you
determined that they spent roughly 1/5 of their time is associated with the unframed prints and the
remaining time is for the framed prints even though the number of framed prints sold is substantially less
than the number of the unframed prints. As a consequence, the cost associated with the Website
Optimization is allocated at P25,800 for unframed prints and P103,200 for framed prints. You
contemplated having three categories (unframed, Steel framed and wood framed with matting), but
chose not to add this additional refinement.
Once the P129,000 of the Website Optimization was allocated across the two broad product categories,
the number of prints at operating capacity was used as the cost driver. Note that the operating capacity
was used instead of the expected units because the employees are salaried. If a fixed cost is allocated
using a value that varies from period to period (like expected sales), then the cost per unit a base that
does not vary as much, such as the operating capacity. The advantage of using the operating capacity as
the base is that it keeps the fixed cost per unit stable over time. The same reason was adopted in the final
activity wherein you chose to base the cost driver on levels of operating capacity, rather than at expected
sales level.
The above transactions are further summarized in a schedule below
TOTAL OVERHEAD COSTS AND COST DRIVERS USED PER PRODUCT
Activity
1
Picking
prints
2
Inventory,
select. &
mgt.
3
Website
Cost Driver
Number of
prints
No. of
component
No. of prints
cap.
4
Framing and
Matting
at capacity
Wood framed
No matting
with matting
TOTAL
Overhead
Cost
80,000.00
15,000.00
7,000.00
102,000.00
30,600.00
80,000.00
30,000.00
21,000.00
131,000.00
91,700.00
100,000.00
25,800.00
100,000.00
Optimization
No. of
component
Steel
framed
Unframed
NA
16,000.00
9,000.00
25,000.00
103,200.00
32,000.00
27,000.00
59,000.00
123,900.00
TOTAL
375,200.00
Instructions: Answer the following questions
1. Identify two reasons why an activity based costing system may be appropriate for Wall décor.
2. Compute the activity based overhead rates for each of the 4 activities
3. Using the data below (based on Predetermined manufacturing overhead rate of .28 computed
in the old and traditional costing method) and the above activity based overhead rates, compute
the product cost of the unframed print, steel framed no matting and wood framed with matting.
Print
Direct material
Print
Frame and glass
Matting
Direct labor
Picking
Matting and framing
Manufacturing overhead
(0.28 X $12, $16, $20)
Total product cost
Steel-Framed Print,
No Matting
Wood-Framed Print,
with Matting
$12.00
$16.00
4.00
$20.00
6.00
4.00
2.00
2.00
7.00
2.00
10.50
4.48
$33.48
5.60
$48.10
3.36
$17.36
4. Compare the product cost computed under the traditional costing system and activity based
costing system. Analyze and evaluate the differences and cite the potential implication to the
company.
5. Explain why overhead cost related to Website Optimization was first divided on to categories
(unframed prints and framed prints) and then allocated based on the number of prints.
6. When allocating the cost of the Website optimization, the decision was made initially allocate the
cost across two categories (unframed prints and framed prints) rather than three categories
(unframed prints, steel framed no matting and wood framed with matting). Discuss the pros and
cons of splitting the cost between two categories rather than three categories.
7. Discuss the implications of using the operating capacity as the cost driver rather than the expected
units sold when allocating fixed overhead costs.
8. (a) Allocate the overhead to the three product categories (unframed prints, steel framed no
matting and wood framed with matting), assuming that the estimate of the expected units sold is
correct and the actual amount of overhead incurred equaled the estimated amount of P375,200.
(b) calculate the total amount of the overhead allocated. Explain why the total overhead of
P375,200 was not allocated, even though the estimate of sales was correct. What are the
implication of this for management?