CHAPTER 5: ACTIVITY-BASED COSTING AND MANAGEMENT
QUESTIONS
5-1
Product costs are likely distorted when a firm uses a volume-based rate if the
plant has more than one activity in its operations and not all activities consume
overhead in the same proportion. The more diverse the product mixes of the
plant are in volume, sizes, manufacturing processes, or product complexities, the
greater the cost distortions are likely to be in using a volume-based rate.
5-2
Undercosting a product may appear to have increased the reported profit the
product earned (assuming the firm did not lower its selling price because of the
reported lower product cost). However, the increased profit is, at best, a twist in
truth. Costs of the product not charged to the product itself are borne by other
products of the firm.
Worse, undercosting a product may result in managers erroneously believing the
product to be more profitable than other products and shifting the limited
resource the firm has into manufacturing, promotion, and sales of the product
when, in fact, other products are more profitable to the firm. Severe cost
distortions may lead firms not to drop unprofitable products because the cost
data show these products are profitable.
5-3
Overcosting does not increase revenues. A firm can increase the selling price of
a product, thereby increasing the total revenue from the product only if the
market allows. Increases in the selling price of a product without experiencing
noticeable decrease in the sales quantity of the product is likely an indication that
the product was not priced properly, which might be a result of undercosting of
the product.
Furthermore, overcosting a product is likely accompanied by undercosting of the
firm’s other products and, as a result, underpricing of one or more of the firm’s
other products.
When a firm sets a high selling price that is a result of overcosting, competitors
also are likely to enter the market and take away the firm’s market share. A firm
also may drop or de-emphasize an erroneously overcosted product when it
erroneously believes the product is either unprofitable or having a low-margin.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-1
©The McGraw-Hill Companies, Inc., 2008
5-4
Activity-based costing recognizes that resources are spent on activities and the
cost of a product or service is the sum of the costs of activities performed in
manufacturing the product or providing the service.
An activity-based costing system traces costs to the activity that consumes
resources. Costs are determined based on the activities performed for cost
objects and their underlying cost drivers that consume resources. Product or
service costs determined using activity-based costing reflect costs of resources
consumed for activities performed in manufacturing products or providing
services. In contrast, a volume-based costing system uses cost allocations to
channel indirect costs to products or services. As a result, the cost of a product
or service often bears little or no relationship to activities performed in the
manufacturing of the product or service.
5-5
Based on the activities of most manufacturing firms, the general levels of cost
hierarchy of an activity-based costing system are:
Unit-level cost;
Batch-level cost;
Product-level cost; and
Facility-level cost.
5-6
In an activity-based costing system, the second-stage procedure in tracing costs
to products or services is a process by which the costs of activities or activity
pools are assigned to cost objects using one or more appropriate activity
consumption cost drivers.
5-7
All firms should use an ABC system when the benefits of such a system exceed
the costs of implementing it. It is especially beneficial to firms with product
diversity and/or process complexity.
5-8
Unit-level activities are activities performed on individual units of product or
service. The frequency of a unit-level activity varies in proportion with the units of
product manufactured or service provided.
Examples of unit-level activities are using direct materials, using direct labor
hours, inserting a component, inspecting each unit, and consuming power to run
machines.
5-9
Batch-level activities are activities performed for a group of units of products or
services rather than for each individual unit of product or service. The frequency
of batch-level activity is determined by both the size of the group and the total
number of units to be manufactured or provided.
Examples of batch-level activities are setting up machines, processing and
placing of purchase orders, scheduling production runs, inspecting products by
batch, and handling materials.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-2
©The McGraw-Hill Companies, Inc., 2008
5-10 Product-level activities are activities undertaken to support individual products or
services rather than for each individual unit of product or service or a group of
individual units of products or services.
Examples of product-level activities include product design, parts administration,
and product modification.
5-11 Facility-level activities are activities performed for the entire organization or
division to meet the required operating procedure or support the operation of the
organization or division.
Examples of facility-level activities include providing security for the facility,
maintaining general equipment and facility, plant management, plant
depreciation, and property taxes and insurance premium for facilities.
5-12 A product-costing system that uses a single volume-based cost driver is likely to
overcost high-volume products because high-volume products do not consume
support resources in proportion to their production volumes. As a result, a
product-costing system that uses a single volume-based cost driver often
overcosts high-volume products or services and undercosts low-volume products
or services.
The cross-subsidizations of low-volume products by high-volume products is
likely to lead the firm not to price its products properly. This may also decrease
the profits of the firm and reduce management’s confidence in the product cost
predictions. Poor pricing can lead a firm to promote less profitable products while
not spending sufficient resources on more profitable items.
5-13 Activity-based management is the use of an activity-based costing system to
improve operations, increase customer value, and enhance profitability.
5-14
Examples of high-value-added activities include insertion of parts, assembling of
components, machining to meet specification, reducing response time, and
reduction of defective characteristics.
5-15
Examples of low-value-added activities include moving parts between
workstations, transporting finished units to warehouse, waiting for materials or
parts to arrive, inspecting, repairing, and storing.
5-16
Service organizations such as banks, hospitals, transportation companies, law
firms, and trading companies can use activity-based costing and management in
all phases of their operations as manufacturing firms do. For example, a bank can
use ABC to calculate the cost to process a check, a hospital can use ABC to
determine costs per patient day for different kinds of patients and the cost to
admit a patient, etc.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-3
©The McGraw-Hill Companies, Inc., 2008
5-17
Opportunities afforded by customer profitability analysis are:
• Providing better services to highly profitable customers;
• Identifying and securing highly profitable customers from competitors;
• Setting prices based on the cost to serve;
• Negotiating with customers to set mutually beneficial levels of services;
• Transforming unprofitable customers into profitable ones through targeted
negotiations on price, quantity, product mix, order processing, delivery terms,
and payment arrangements;
• Identifying and conceding permanent loss customers to competitors.
.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-4
©The McGraw-Hill Companies, Inc., 2008
BRIEF EXERCISES
5-18 Total Cost per Batch = $50 + (.1 x 5,000)
= $550
Cost to produce 100,000 cans
= (50 x (100,000/5,000)) + (.1 x 100,000)
= $11,000
5-19
((30,000 x 0.2) / 60) x $10= $1,000
5-20
Cost for 50 Heads = (60 / 20) x 5 + (50 x $0.1)
= $20
Cost for 60 Heads = (60 / 20) x 5 + (60 x $0.1)
Difference = $21 – $20 = $1
= $21
5-21 (($15 x .5) + $5) x 5 cars x 5 days = $312.50 per week
5-22 Cost per computer = $1,000,000 / 5,000 = $200 per computer
$200 = (2 x (cost of one technician hour)) + (5 x $10)
Cost for technician time = $200 - $50 = $150
$150 = 2 x (cost of one technician hour)
technician hourly rate = $75 per technician hour
5-23
Materials Cost
Labor Cost
Inspection Cost
Packaging Cost
5-24
5-25
Direct Labor
Copying
Total Job Cost
= $3,000,000 / 100,000 = $30 per camera
= $500,000 / (100,000 x .5)
= $10 per camera
= $1,000,000 / (100,000 x .2)
= $50 per camera
= $500,000 / 100,000
= $5 per camera
= $8 x 5 = $40
= $0.05 x 1,000 = $50
= $50 + $40 = $90
Data Entry = $2,000,000 / 100,000 = $20 per hour
Data Analysis
= $3,000,000 / 30,000 = $100 per hour
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-5
©The McGraw-Hill Companies, Inc., 2008
5-26
5-27
Volume Based Rate = 2 x $10 = $20 overhead per mattress
Activity Based Rate:
Materials Handling = 30 x $.10
= $3 materials handling cost per mattress
Setup Cost
= $5 x 2
= $10 per mattress
Total ABC
= $3 + $10
= $13 per mattress
Overstatement
= $20 – $13 = $7 per mattress
$150 x .2 = $30 million
500,000 x 20 = 10 million
$30/10 = $3 per part
Total inspection cost:
$3 x 20 = $60 for 20 parts
$3 x 50 = $150 for 50 parts
5-28
6 x 10,000 x $.50 = $30,000
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-6
©The McGraw-Hill Companies, Inc., 2008
EXERCISES
5-29 Activity Levels (5 min)
1. Cost Hierarchy
a.
Unit-level
f.
Product-level
b.
Unit-level
g.
Facility-level
c.
Facility-level
h.
Facility-level
d.
Unit-level
i.
Batch-level
e.
Unit-level
j.
Batch-level (one bag per
customer).
2. Cost Driver
a.
Number of hamburgers
b.
Number of hours
c.
Square feet
d.
Number of hamburgers; Size of hamburgers
e.
Number of hamburgers
f.
Number of times the advertising is run
g.
Number of hours store is open
h.
Square feet
i.
Number of coupons redeemed; Number of multiple orders; Number
of hamburgers
j.
Number of customers
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-7
©The McGraw-Hill Companies, Inc., 2008
5-30 Activity Levels and Cost Drivers (5 min)
1. Activity Levels
a.
Unit-level
f.
Facility-level
b.
Batch-level
g.
Product-level
c.
Batch-level
h.
Product-level
d.
Batch-level; Product-level
i.
Unit-level; Batch-level
e.
Product-level
j.
Batch-level.
2. Cost Drivers
a. Machine hours
b. Number of setups or setup hours
c. Number of production orders
d. Number of material receipts; Number of purchase orders
e. Number of products
f. Number of machine hours
g. Number of engineering change notices; number of modifications;
Number of products
h. Number of parts; Number of products; Number of purchase
orders
i. Number of inspection hours; Number of units; Number of batches
j. Number of loads; Number of material moves; Material weights
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-8
©The McGraw-Hill Companies, Inc., 2008
5-31 Activity Levels and Cost Drivers (5 min)
1. Activity Levels
a.
Product-level
f.
Batch-level
b.
Product-level
g.
Unit-level
c.
Product-level
h.
Facility-level
d.
Product-level
i.
Product-level
e.
Batch-level
j.
Facility-level
2. Cost Drivers
a. Number of products
b. Number of products
c. Number of products
d. Number of products
e. Number of batches or setups
f. Number of batches
g. Number of units
h. Purchase costs; Replacement costs; Book values
i. Number of purchase orders; Number of products; Number of
suppliers
j. Square feet
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-9
©The McGraw-Hill Companies, Inc., 2008
5-32 Activity Levels and Cost Drivers - Service Company (15 min)
1. Output unit-level costs:
a. Salaries and wages of lab technicians
b. Equipment-related costs
$1,200,000
$ 300,000
These costs are likely to vary with the number of test-hours, which are
functions of the output units (test).
Batch-level costs:
c. setup costs
$240,000
Setup costs are incurred each time a batch of tests is setup for either
ST or PRT, regardless of the number of hours of the tests.
Product-level costs:
d. Costs of test designs
$360,000
These costs are incurred in designing ST and PRT tests, regardless
of the number of test-hours or number of batches tested.
2. As shown in the calculation below, the current costing system of
charging $70 per test-hour for overhead undercosts the soil test (ST)
and overcosts the pesticide residues test (PRT). One reason is that
ST uses more setup costs and test design costs than PRT does,
while ST has lower test hours than PRT. On average, ST tests take
longer to setup (0.85 versus 0.575 setup hour per test hour) and it is
more difficult to design the test (0.58 versus 0.21 setup hours per test
hour)
ST
PRT
Setup Hours
Test-Hours Total Per Test-Hour
10,000
8,500
0.850
20,000
11,500
Blocher,Stout,Cokins,Chen:Cost Management, 4e
0.575
5-10
Test Design Hours
Total
Per Test-Hour
5,800
0.58
4,200
0.21
©The McGraw-Hill Companies, Inc., 2008
5-32 (continued)
3.
Test hours
Salaries and Wages
Equipment-related
costs*
ST
PRT
Setup costs#
ST
PRT
Test design costs&
ST
PRT
TOTAL
*Equipment-related
costs
Test hours
Per test hour
Total
#
Setup costs:
Setup hours
Per hour
Total
&
Test design costs:
Test design hours
Per hour
Total
ST
$540,000
Per
Hour
10,000
$54.00
100,000
$10.00
102,000
$10.20
Total
PRT
Total
Per Hour TOTAL
20,000
30,000
$660,000 $33.00 $1,200,000
200,000
$10.00
138,000
$6.90
208,800 $20.88
151,200
________ ______
$950,800 $95.08 $1,149,200
7.56
$57.46
10,000
20,000
100,000
200,000
8,500
11,500
102,000
138,000
5,800
4,200
208,800
151,200
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-11
$300,000
30,000
$10
$240,000
20,000
$12.00
$360,000
10,000
$36.00
©The McGraw-Hill Companies, Inc., 2008
5-32 (continued-2)
4.
ST
Total
Per Hour
2,500
$135,000 $54.00
PRT
Total
Per Hour TOTAL
5,000
7,500
$165,000
$33.00 $300,000
Test hours
Salaries and Wages
Equipment-related costs*
ST
100,000 $40.00
PRT
200,000
#
Setup costs
ST
255,000 $102.00
PRT
$345,000
Test design costs&
ST
522,000 $208.80
PRT
_________ _______
378,000
TOTAL
$1,012,000 $404.80 $1,088,000
*Equipment-related
costs:
Test hours
Per test hour
Total
#
Setup costs:
Setup hours
Per hour
Total
&
Test design costs:
Test design hours
Per hour
Total
2,500
5,000
100,000
$240,000 $360,000
8,500
200,000
255,000
$360,000 $540,000
5,800
345,000
522,000
11,500
4,200
378,000
$40.00
$69.00
$75.60
$217.60
$300,000
7,500
$40
$600,000
20,000
$30.00
$900,000
10,000
$90.00
The cost per test-hour increased from $95.08 to $404.80 for ST and from
$57.46 to $217.60 for PRT. Platte Valley needs to reexamine the
appropriateness for using test-hours as the basis for costing. The bulk of
the cost is for setup and test-design and the direct cost related to test-hour
is only a fraction of the setup and test-design costs. A costing system
based on the direct test-hour is likely to distort the true cost of testing.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-12
©The McGraw-Hill Companies, Inc., 2008
5-33 Volume-Based Costing vs. ABC (20 minutes)
1. The volume-based cost system developed for inventory valuation is
likely to distort product cost information because the cost system:
a. is designed to value inventory in the aggregate and not related to
product cost information.
b. uses a common departmental or volume-based measure of
activity, such as direct labor hours or dollars (now a small portion
of overall production costs) to distribute manufacturing overhead
to products.
c. de-emphasizes long-term product analysis (when fixed costs
become variable costs).
d. causes managers, who are aware of distortions in the volumebased system, to make intuitive, imprecise adjustments to the
volume-based cost information without understanding the
complete impact.
2. Outlined below are the purpose and several characteristics of the
three noted cost systems.
a. Inventory Valuation
Meets external reporting requirements for aggregate balance sheet
valuation and income determination.
Provides monthly and quarterly reporting.
b. Operational Control
Evaluates operations to quickly detect problems to allow for
implementation of corrective action.
Compares costs against budget for monitoring variances.
c. Activity-based costing
Differentiates costs between high-value added and low-value-added
activities.
Costs products according to activities involved in the production
process.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-13
©The McGraw-Hill Companies, Inc., 2008
5-33 (continued)
3. The benefits that management can expect from activity-based
costing include these:
a. Leads to a more competitive position by evaluating cost drivers,
i.e., costs associated with the complexity of the transaction
rather than the production volume.
b. Streamlines production processes by reducing low-value-added
activities, e.g., reduced set-up times, optional plant layout, and
improved quality.
c. Provides management with a more thorough understanding of
product costs and product profitability for strategies and pricing
decisions.
4. The steps that a company, using a volume-based cost system, would
take to implement activity-based costing include:
a. evaluation of the existing system to assess how well the system
supports the objective of an activity-based cost system.
b. identification of the activities for which cost information is needed
with differentiation between high-value added and low-valueadded activities.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-14
©The McGraw-Hill Companies, Inc., 2008
5-34 Activity-Based Costing Hakara Company (10 min)
Cost Pools
Activity Costs
Machine setup
Materials handling
Electric power
$360,000
100,000
40,000
Cost Drivers
Overhead Rate
3,000 setup hours
$120
25,000 pounds
4
40,000 kilowatt hours
1
A
Direct materials
Direct labor
Factory overhead:
Machine setup
B
.
$40,000
$50,000
24,000
40,000
$120 x 200 =
24,000
$120 x 240 =
28,800
Materials handling
$4 x 1,000=
4,000
$4 x 3,000 =
12,000
Electric power
$1 x 2,000 =
2,000
$1 x 4,000 =
4,000
Total product costs
Production units
COST PER UNIT
Blocher,Stout,Cokins,Chen:Cost Management, 4e
÷
$94,000
$134,800
4,000
÷ 20,000
$23.50
$6.74
5-15
©The McGraw-Hill Companies, Inc., 2008
5-35 Customer Profitability Analysis: Hotels (15 min)
1. The information gathering program are a logical fit for the luxury type
hotels described here. These firms compete on their ability to attract highpaying customers to their luxury hotels. These additional services can
give the hotel a competitive edge.
2. There is a good application for activity-based costing here. The
program should be analyzed by activity (the different types of premium
services offered), and then the cost drivers of these activities should then
be identified, and traced to the cost object, which in this case is the
individual customer. It is likely that the hotel rates are sufficiently high,
that the cost of the extra services is covered by the room charges, but
those managing the program should be able to know how effective it is in
general, and for each customer. This type of information will help them
revise the program if necessary, and to better target their most profitable
customers.
3.
Some will argue there is not ethical issue with the information
gathering. Others might argue that the guest should be informed that the
information is being obtained and used throughout the hotel chain’s
system. For example, Marriott has guests fill out a form to participate, so
the program is entirely optional. Other ethical issues arise, for example, if
the hotel chain chooses to sell the information to third parties, such as
magazine publishers, retail stores, or other businesses.
This exercise is based on information obtained from the article by Avery
Johnson, “Hotels Take ‘Know Your Customer’ to New Level,” The Wall
Street Journal, February 6, 2006, p D1.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-16
©The McGraw-Hill Companies, Inc., 2008
5-36 Applications of ABC Costing in Government (20 min)
1,2. A variety of examples are possible here. For additional examples:
Gary Cokins, Activity-Based Cost Management in Government,
Management Concepts, Inc., 2001. Also, see case studies of
governmental agencies in Cost & Effect, by Robert S. Kaplan and Robin
Cooper, Harvard Business School Press, 1998, pp 245-250. Kaplan
and Cooper explain application at the U.S. Veterans Affairs Department,
the U.S. Immigration and Naturalization Service, the U.S. Internal
Revenue Service, and the City of Indianapolis.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-17
©The McGraw-Hill Companies, Inc., 2008
5-37 Activity-Based Costing in the Fashion Apparel Industry (20 min)
The ABC-costing solution follows:
(all figures in £)
Price
Total Revenue
20.525
205,250
Direct Materials
Labour and Overhead Costs
Pattern cutting
Grading
Lay planning
Sewing
Finishing
Inspection
Boxing up
Storage
Labor and Overhead (ABC-based)
Total Product Cost
Unit Product Cost
Non-manufacturing Expenses
Total Cost
33,750
22,000
19,000
18,500
21,000
14,300
6,500
3,500
7,000
111,800
145,550
14.56
31500
177,050
Net Margin for Trousers
28,200
The results suggest that the trouser line is more profitable than previously
thought (using volume-based costing). This is likely due to the common
situation in which the high-volume products are overcosted using volumebased costing.
Source of data used in the example: Andrew Hughes, “ABC/ABM: A
profitability Model for SME’s Manufacturing Clothing in the UK,” Journal of
Fashion Marketing and Management, 2005, Vol 9 Is 1, pp8-19. (SME
means small to medium size company)
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-18
©The McGraw-Hill Companies, Inc., 2008
5-38 Service Industry
GWS Hospital (10 min)
1. GWS’s ICU overhead costs for the month of June using:
a. Hospital Wide Rate Based on Nurse-Hours
Per nurse-hour:
$69,120,000 /1,152,000 =
Total ICU applied overhead costs:
$60 x 5,900 =
$60
$354,000
b. The ICU Department Wide Rate Based on Patient-Day
Total budgeted ICU overhead:
$810,000 + $422,500 + $457,500 = $1,690,000
Overhead rate per patient-day:
$1,690,000 / 845 =
$2,000
Total ICU applied overhead costs: $2,000 x 870 = $1,740,000
c. Activity Cost Driver Rates
Budgeted
Cost Pool
Beds
Budgeted
Cost
$810,000
Activity
900
Budgeted
Total
Applied
OH Rate Activity Overhead
$900.00
900
$810,000
Equipment
422,500
845
500.00
870
435,000
Personnel
457,500
6,000
76.25
5,900
449,875
Total applied overhead costs
$1,694,875
2. The first method uses a hospital-wide overhead rate, which likely
bears no relationship with the overhead activities performed in the
intensive care unit (ICU). The second method uses the patient-day
overhead rate for the ICU department. This is an improvement over
the first method. But a single patient-day cost driver may not have
direct relationships with some of the activities performed in the ICU
department. The third method is the preferred method because it
uses a cost driver for each of the cost pools that reflects the
resources consumed by activities of the cost pool.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-19
©The McGraw-Hill Companies, Inc., 2008
5-39 Product Selection (5 min)
Before deciding on which of the two products the firm should
focus, the company should review its costing system. It is likely
that Johans’ product costing system is providing misleading cost
information. The company is probably using a volume-based
product costing system, which tends to overcost the high-volume
product (Desktop Computer) and undercost the low-volume
product (Tablet Computer). When competitors can sell a product
at a price ($380) much lower than our cost for the desktop model
($550), it is likely that the costing system fails to determine
product costs properly or that the applied manufacturing process
is very inefficient.
The company should install an activity-based product costing
system. If the reported product cost indicates that the price of the
high-volume desktops is too high compared to the competitor’s
price, then the company should adjust the price accordingly.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-20
©The McGraw-Hill Companies, Inc., 2008
5-40 High-value-added and Low-value-added Activities—Radiology (5
min)
(Note to instructor: Answer may vary if students perceive a different
operation)
a. High-value-added
b. Low-value-added (Patients are likely to perceive waiting to have
low-value)
c. Low-value-added (Any need for lab work should have been
determined prior to arriving at the Radiology Department)
d. Low-value-added
e. High-value-added
f. High-value-added
g. Low-value-added
h. Low-value-added
i. High-value-added
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-21
©The McGraw-Hill Companies, Inc., 2008
5-41 High-value-added and Low-value-added Activities—Nurse (5
min)
(Note to instructor: Answer may vary if students perceive a different
operation)
a. High-value-added
f. High-value-added
b. High-value-added
g. High-value-added
c. High-value-added
h. Low-value-added
d. Low-value-added
i. High-value-added
e. Low-value-added
5-42 High-value-added and Low-value-added Activities—e-Retailing
(5 min)
(Note to instructor: Answer may vary if students perceive a different
operation)
a. Low-value-added
e. Low-value-added
b. Low-value-added
f. High-value-added
c. Low-value-added
g. Low-value-added
d. Low-value-added
h. High-value-added
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-22
©The McGraw-Hill Companies, Inc., 2008
5-43 ABC and Job-Costing (20 min)
A:
$0.15 x 30 =
$ 4.50
B:
$37 / 1.85 =
$20.00
C:
$35.50 / 5 =
$ 7.10
D:
$0.08 x 100 =
$ 8.00
Cost per board that passed the final inspection
$240.00
Rejection rate
x
Cost per completed board
50%
$120.00
Direct materials
$25.00
Direct labor
5.00
Other manufacturing overhead:
Axial insertion
$ 4.50
Hardware insertion
37.00
Hand load
35.50
Masking
8.00
85.00
Manufacturing overhead for final test (E)
$5.00
Units of cost driver for final test
10
Manufacturing overhead rate per unit of test time(F)
Blocher,Stout,Cokins,Chen:Cost Management, 4e
115.00
5-23
$0.50
©The McGraw-Hill Companies, Inc., 2008
5-44 Cost of Meal
(5 min)
Below is a suggestion for Annie’s response:
Dear Totem Pole: If these are business-related dinners, you should
talk to your accountant about deducting them from your expenses or
billing your share to the clients. If that isn’t feasible, agree to meet
these folks for cocktails, but leave before dinner, claiming you have
to be elsewhere. No other excuse is needed.
Note: This example illustrates the advantages of ABC in a familiar
situation. Put all in one check and then split the bill equally is an
example of volume-based overhead rate. Split-up the bill based on
the number of meals is like using machine hours, labor hours, or
other measures, rather than the activities themselves, to determine
costs of products or services. Products having the same total
machine hours pay for the same amount of overhead, regardless of
the differences in the amount of setup times, product design hours,
etc. these products might have used.
Having separate checks is an ABC system. Each check tracks
activities of an activity cost center. The person who engages in more
activities – drinks or eats more than others – pays a higher bill.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-24
©The McGraw-Hill Companies, Inc., 2008
5-45 Product-line Profitability, ABC (25 min)
1. Product-line profitability under the current costing system
Frozen Food Baked Goods Fresh Produce
Sales
Cost of goods sold
Gross margin
$120,000
$90,000
$158,125
105,000
67,000
110,000
$ 15,000
$23,000
$ 48,125
24,000
18,000
31,625
($ 9,000)
$ 5,000
$ 16,500
-7.50%
5.56%
10.43%
Store support (20% of Sales)
Operating income
Operating margin (OI/S)
2. Product-line profitability under ABC
Frozen Food Baked Goods Fresh Produce
Sales
Cost of goods sold
Gross margin
$120,000
$90,000
$158,125
105,000
67,000
110,000
$ 15,000
$23,000
$ 48,125
800
4,400
7,200
1,100
7,700
13,200
300
525
7,200
6,000
8,000
17,200
8,200
20,625
44,800
$ 6,800
$ 2,375
5.67%
2.64%
Store support:
Order processing
Receiving
Shelf-stocking
Customer support
Total store support cost
Operating income
Operating margin (OI/S)
$
3,325
2.10%
3. Both baked goods and fresh produce have a drop in profitability when
ABC is used. The decrease in profitability of fresh produce is most
noticeable. The profitability of fresh produce decreases from 10.43
percent of the sales revenues under the current system, the highest of
the three products, to 2.10 percent under ABC, the lowest of the three.
This is because fresh produce requires more support activities than the
other two products.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-25
©The McGraw-Hill Companies, Inc., 2008
5-46 Customer Profitability Analysis (25 minutes)
Requirement 1
Jerry Inc.
Donald Co.
Customer unit-level cost Sales returns(40x5;175x5)
Customer batch-level costs:
Order processing(5x300;30x300)
Sales returns(2x100;5x100)
Delivery(5x500;30x500)
Customer sustaining costs:
Sales calls(12x1000;4x1000)
TOTAL
$200
$875
$1,500
200
2,500
$9,000
500
15,000
12,000
$16,400
4,000
$29,375
Requirement 2
Jerry Inc.
$1,000,000
8,000
$992,000
744,000
$248,000
16,400
$231,600
Sales(5x1000x200;200x30x200)
Sales return(40x200;175x200)
Net Sales
Cost of goods sold(75%)
Gross margin(25%)
Sales support cost (from req. 1)
Operating income
Operating margin %
Blocher,Stout,Cokins,Chen:Cost Management, 4e
23.35%
5-26
Donald Co.
$1,200,000
35,000
$1,165,000
873,750
$291,250
29,375
$261,875
22.48%
©The McGraw-Hill Companies, Inc., 2008
5-47 Customer Profitability Analysis (25 min)
1. Determination of the $100.50 order-filling cost per unit
Total number of orders:
2 x 100 PCs + 10 x 4,000 SCs = 40,200
Total number of orders
Number of orders per block
40,200
÷
Total number of blocks
Cost per block
60
670
x $60,000
Total cost of order blocks
$ 40,200,000
Total number of orders
Per order order-filling cost
40,200
x $1,500
Total cost per order
+
Total order-filling cost
$100,500,000
÷
Total units sold
Order-filling cost per unit
Blocher,Stout,Cokins,Chen:Cost Management, 4e
60,300,000
1,000,000
$100.50
5-27
©The McGraw-Hill Companies, Inc., 2008
5-47 (continued)
2. Order filling cost per unit sold to PC:
Total number of orders
2
÷
Number of orders per block
Total number of blocks
60
1/30
Cost per block
x $60,000
Total block cost
$2,000
Total number of orders
2
Order-filling cost per order
x $1,500
Total cost per order
+ 3,000
Total order-filling cost
$5,000
÷ 5,000
Total units sold
Order-filling cost per unit
$1.00
Net profit per unit at $700 selling price per unit to preferred
customers:
Preferred Customer
Selling price per unit
$700.00
Manufacturing cost
Order-filling cost/unit
$600.00
+
Total cost per unit
601.00
Net Profit per unit
$ 99.00
Profit margin per unit
Blocher,Stout,Cokins,Chen:Cost Management, 4e
1.00
14.14%
5-28
©The McGraw-Hill Companies, Inc., 2008
5-47 (continued-2)
3. Order filling cost per order by SC:
$60,000
Cost per block
Number of orders per block
)
Block cost per order
Number of orders per SC
60
$1,000
x
10
Total block cost per SC
$10,000
Order-filling cost per order
Number of orders per SC
$1,500
x
10
Total cost per order
+ 15,000
Total order-filling cost
$25,000
Total units sold
)
125
Order-filling cost/unit
$200
Profitability per unit at $800 selling price per unit to SC
Selling price per unit
$800.00
Manufacturing cost
$600.00
Order-filling cost/unit
+
200.00
Total cost per unit
800.00
Net profit or loss per unit
$
Profit margin
Blocher,Stout,Cokins,Chen:Cost Management, 4e
0
0
5-29
©The McGraw-Hill Companies, Inc., 2008
PROBLEMS
5-48 Activity-Based Costing; Customer Group Cost Analysis (30
minutes)
1. First, obtain the total levels for activity cost drivers:
Product Lines
Units Produced
Direct Materials cost per unit
Total Direct Materials Cost
Number of Parts per unit
Total parts
Direct Labor Hours per unit
Total Labor hours
Machine Hours per unit
Total Machine Hours
Production Orders
Production Setups
Orders Shipped
Value
15,000
$
80
Quality
5,000
$
50
Luxury
500
$
110
Total
20,500
$
240
30
50
120
200
4
5
7
16
3
7
15
25
50
20
1,000
70
50
2,000
200
50
300
320
120
3,300
$
1,505,000
760,000
88,500
87,500
Then, obtain the activity rates:
Materials handling
Product Scheduling
Setup Labor
Automated Machinery
Finishing
Pack and Ship
Budgeted
Cost
$
349,600
160,000
216,000
1,750,000
619,500
285,000
Cost
Driver
Number of Parts
Number of Production orders
Number of setups
Machine hours
Direct labor hours
Number of orders shipped
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-30
Activity
Rate
$
0.460
500.00
1,800.00
20.00
7.00
86.364
=$349,600/760,000
=160,000/320
=216,000/120
=1,750,000/87,500
=619,500/88,500
=285,000/3,300
©The McGraw-Hill Companies, Inc., 2008
5-48 (continued)
The activity-based unit and total cost is as follows:
Direct Materials
Direct Labor
Overhead:
Materials handling
Product Scheduling
Setup Labor
Automated Machinery
Finishing
Pack and Ship
Total ABC Overhead
Unit ABC Cost
$
$
Value
80.00
48.00
$
$
Quality
50.00
60.00
Total ABC Cost
$
13.80
1.67
2.40
60.00
28.00
5.76
111.62
239.6242
$
3,594,364
2.
Direct Materials
Direct Labor
Overhead
Cost per unit
Total Cost
$
$
$
Value
80.00
48.00
152.77
280.7729
4,211,593
Blocher,Stout,Cokins,Chen:Cost Management, 4e
$
$
Luxury
110.00
84.00
$
23.00
7.00
18.00
140.00
35.00
34.55
257.55
367.5455
$
55.20
200.00
180.00
300.00
49.00
51.82
836.02
1,030.0182
$
1,837,727
$
515,009
$
$
$
Quality
50.00
60.00
190.97
300.9661
1,504,831
5-31
$
$
$
Luxury
110.00
84.00
267.35
461.3525
230,676
©The McGraw-Hill Companies, Inc., 2008
5-48 (continued)
3. The new activity rates based on practical capacity are as follows.
Materials handling
Product Scheduling
Setup Labor
Automated Machinery
Finishing
Pack and Ship
Budgeted
Cost
$ 349,600
160,000
216,000
1,750,000
619,500
285,000
$
Cost
Driver
Number of Parts
Number of Production orders
Number of setups
Machine hours
Direct labor hours
Number of orders shipped
Practical
Practical Capacity-Based
Capacity
Rates
990,000 $
0.353
800
200.00
200
1,080.00
100,000
17.50
123,900
5.00
5,000
57.00
3,380,100
Note that the rates have changed significantly from the calculations in part
1 above, because there is a significant level of unused capacity in many of
the activities. This information could be used by management to calculate
unit ABC-based costs using the practical capacity rates, and thereby
identify the cost of unused capacity. Moreover, the information about
capacity utilization can be used to help bring resource spending in line with
resource usage. As the firm plans to grow (particularly in the Luxury line),
some additional capacity will be needed, but careful planning will allow a
balance of planned future capacity needs versus current spending on
these resources, probably allowing some capacities to be reduced. The
potential for overcapacity appears to be greatest in product scheduling and
pack and ship.
4. The ABC costing shows clearly how expensive the Luxury line is to
produce. The volume-based approach fails to account for the activity
usage of the Luxury line, and undercosts it significantly. ABC allows HPI to
better understand how its costs will increase with the expected increased
production of the Luxury line, and how it will have to adapt its pricing
practices accordingly. Continued use of the volume-based approach at a
time when sales of the Luxury line are increasing would mean significantly
under-pricing the Luxury line, and undermining the profitability of the entire
firm.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-32
©The McGraw-Hill Companies, Inc., 2008
5-49 Cost Pools and Cost Drivers (20 min)
Note to instructor: The answer below is but one possible solution.
1.
Cost pool 1: Cost driver: Number of purchase orders
Receiving
$10,000
Inspection of direct materials
3,000
Purchasing
20,000
Total
$33,000
Cost pool 2: Cost driver: Number of production runs
Setup wages
$20,000
Cost pool 3: Cost driver: Machine hours
Depreciation, machine
Electrical power (machining)
Machine maintenance - labor
Machine maintenance - materials
Total
$40,000
30,000
11,000
9,000
$90,000
Cost pool 4: Cost driver: Factory space
Depreciation, building
Electrical power (factory building)
Insurance
Property taxes
Natural gas (for heating)
Custodial labor
Total
$ 50,000
6,000
20,000
15,000
8,000
51,000
$150,000
Note: However, the problem indicated that the firm uses machine
hours as the base for assigning facility-level costs. An
alternative solution is to combine cost pools 3 and 4.
Cost pool 5: Cost driver: production (in units)
Inspection of finished goods
Cost pool 6: Cost driver: engineering hours
Engineering design
Total
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-33
$7,000
$600,000
$600,000
©The McGraw-Hill Companies, Inc., 2008
5-49 (continued)
2.
Overhead Rates:
Cost pool 1: Total cost
Number of purchase orders
Cost per purchase order
$33,000
6
$5,500
Cost pool 2:
Total cost
Number of production runs
Cost per production run
$20,000
40
$500
Cost pool 3:
Total cost
Number of machine hours
Cost per machine hour
$ 90,000
100,000
$0.90
Cost pool 4:
Total cost
Number of machine hours
Cost per machine hour
$150,000
100,000
$1.50
Cost pool 5:
Total cost
Number of units
Cost per unit
$
Cost pool 6:
Total cost
Total engineering hours
Cost per engineering hour
$600,000
20,000
$30.00
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-34
7,000
100,000
$0.07
©The McGraw-Hill Companies, Inc., 2008
5-49 (continued-2)
Manufacturing overheads:
Unit level:
Cost pool 3 – Cost per machine hour
Number of machine hours
$ 0.90
x 4,250
$ 3,825
Cost pool 5 – Cost per unit
$ 0.07
Number of units
x 4,000
Batch level:
Cost pool 2 – Cost per production run
$500
Number of production runs
(4,000 units / 2,500 = 1.6) x
2
1,000
Product-level level:
Cost pool 1 – Cost per purchase order
Number of purchase orders
$5,500
x
1
5,500
$ 30
100
3,000
Cost pool 6 – Cost per engineering hour
Number of engineering hours
Facility-level level*:
Cost pool 4 – Cost per machine hour
Number of machine hours
Total manufacturing overhead
Number of units
Manufacturing overhead per unit
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-35
x
$ 1.50
x 4,250
280
6,375
$19,980
÷
4,000
$4.995
©The McGraw-Hill Companies, Inc., 2008
5-49 (continued-3)
* There are at least two alternative activity consumption drivers for
assigning facility-level cost:
Based on machine hours:
Total facility-level cost (Cost pool 4)
Number of machine hours
Cost per machine hour
$150,000
100,000
$1.50
Which is the cost driver for the answer above.
Alternatively, the firm may use number of units to assign facilitylevel cost.
Based on number of units:
Total facility-level cost (Cost pool 4)
$150,000
Units of production
100,000
Cost per unit
$1.50
Unit level:
Cost pool 3
Cost pool 5
$ 3,825
280
Batch level:
Cost pool 2
1,000
Product-level level:
Cost pool 1
Cost pool 6
5,500
3,000
Facility-level level:
Cost pool 4 – Cost per unit
Number of units
Total manufacturing overhead
Number of units
Manufacturing overhead per unit
Blocher,Stout,Cokins,Chen:Cost Management, 4e
$ 1.50
x 4,000
5-36
6,000
$ 19,605
÷
4,000
$4.90125
©The McGraw-Hill Companies, Inc., 2008
5-50 Activity-Based Costing, Value Chain Activities (25 min)
1. Prime costs
Manufacturing overheads:
Material handling
Machining
Assembly
Inspection
Total manufacturing costs
Number of units
Cost per unit
80 x $1,200 =
$ 96,000
80 x 105 x $0.45 =
80 x
3x
$51 =
80 x 105 x $2.85 =
80 x
$30 =
3,780
12,240
23,940
2,400
$138,360
÷
80
$1,729.50
2. Upstream activities
Manufacturing
Downstream activities
Full product cost per unit
$180.00
1,729.50
250.00
$2,159.50
8.33%
80.09%
11.58%
100%
Strategic implications:
(1) Knowing the full cost of a product including upstream and
downstream costs allows the firm to be aware of all costs
attributable to the product.
(2)
The amounts and proportions of upstream, manufacturing, and
downstream costs facilitate comparisons with competitors.
(3)
The company should consider ways of spending less cost in the
manufacturing activity, and more on upstream and downstream
activities in order to improve its competitive position by pursuing
the differentiation strategy in both the new product design and the
customer service.
3. The total value chain cost provides the firm a long-term perspective
of the product cost, in addition to the short term manufacturing cost.
Different industries have different cost structures. For example, firms
in the computer software industry are likely to have high upstream
costs while firms in the retailing industry tend to have high
downstream costs.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-37
©The McGraw-Hill Companies, Inc., 2008
5-51 Volume-based Costing Versus ABC (10 min)
1. Predetermined overhead rate based on machine hours
= Total budgeted overhead cost / Selected level of production activity
= ($100,000 + $80,000 + $200,000 + $100,000) / 10,000 machinehours
= $480,000 / 10,000 machine-hours
= $48.00 per machine-hour
Product
Total Manufacturing Overhead
Barrel
OH per Barrel
P5
$48.00 x 1,000 MH = $48,000
500
$96.00
G23
$48.00 x 1,000 MH = $48,000
500
$96.00
2. Overhead Rates:
Overhead
Cost Pool
Budgeted
Overhead
Level of
Cost Driver
Predetermined
Overhead Rate
Machine set-ups
$100,000
100 setups
$1,000 per setup
Material handling
80,000
8,000 barrels
$10 per barrel
Quality control
200,000
Other overheads
100,000 10,000 machine hrs
Overhead Per Barrel:
Overhead
Cost Pool
Rate
1,000 inspections
Quality control
Other overheads
$10 per MH
Manufacturing Overhead
P5
G23
Activity Overhead
Activity Overhead
Machine set-ups $1,000
Material handling
$200 per inspection
1
$ 1,000
50
$50,000
$10
500
5,000
500
5,000
$200
2
400
20
4,000
$10
1,000
10,000
1,000
10,000
Total overhead
Number of barrels
Cost per barrel
Blocher,Stout,Cokins,Chen:Cost Management, 4e
$16,400
÷
500
$ 32.80
5-38
$69,000
÷
500
$138.00
©The McGraw-Hill Companies, Inc., 2008
5-51 (continued)
j. The volume-based rate significantly undercosts the G23 product
which requires several times the amount of machine setup and
quality inspection effort relative to product P5. This means that
pricing and analysis of product line profitability will be distorted.
Strategic planning based on profitability analysis will also be
misguided as a result. Suppose, for example, that CCO, using
volume-based accounting, is asked to bid on a rather larger order for
the G23 product; it is likely to win the order because the volumebased cost is distorted – too low. The problem then is that CCO
must produce and sell this order at very low or negative profits,
because its actual costs of producing the order will be closer to the
ABC costs. Similarly, bidding for a potential order on the P5 product
will likely fail under the volume-based system, as CCOs costs are
distorted again – this time too high. CCO will lose these potentially
profitable orders.
Under volume-based costing, CCO will likely see its order mix shift to
G23 and away from P5, as competitors that use ABC costing will use
proper pricing and get the most profitable orders. The result might be
that CCO’s sales will continue to increase (lots of G23), but its
profitability will decline (G23 is not priced properly). This is a good
signal of a firm that needs ABC costing – sales up but profits down, in
this case, because of an unprofitable shift in the product mix due to
cost distortions in volume-based costing.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-39
©The McGraw-Hill Companies, Inc., 2008
5-52 Volume-based Costing Versus ABC (35 min)
1.
Product A
Product B
$294.00
(1) Target price
$279.00
(2) Manufacturing cost (1) ÷ 150% $186.00
$196.00
Prime cost
- 70.00 - 126.40
Overhead cost per unit
$116.00
$ 69.60
Number of units
x 1,000
x 5,000
Total overhead
$116,000
$348,000
2. Current Costing system
Actual selling price
Product manufacturing cost
Gross margin
Gross margin ratio
Product A
$280
186
$ 94
33.57%
Product B
$250
196
$ 54
21.6%
Product C
$199.50
$133.00
- 75.00
$ 58.00
x
500
$29,000
Product C
$300
133
$167
55.67%
Based on the current cost data, it is true that product B is the least
profitable product with a gross margin per unit of $54.00 (21.6%) and
product C is the most profitable product with a gross margin per unit of
$167.00 (55.67%). However, the validity of this conclusion is based on
the accuracy of the reported product costs.
Product costs based on the activity-based costing system
Direct materials
Direct labor
Factory overhead:
Setups (a)
Materials handling (b)
Hazardous control (c)
Quality control (d)
Utilities (e)
Total
Actual selling price
Product manufacturing cost
Gross margin
Gross margin ratio
Product A
$ 50.00
20.00
Product B
$114.40
12.00
Product C
$ 65.00
10.00
1.60
40.00
62.50
22.50
12.00
$208.60
0.80
5.00
22.50
5.25
8.40
$168.35
4.80
70.00
150.00
52.50
12.00
$364.30
$280.00
208.60
$ 71.40
25.50%
$250.00
168.35
$ 81.65
32.66%
$300.00
364.30
($64.30)
(21.43)%
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-40
©The McGraw-Hill Companies, Inc., 2008
5-52 (continued)
Notes:
(a) Setups:
Cost per setup: $8,000 / (2 + 5 + 3) =
$800 per setup
Product A = 2 x $800 = $1,600;
$1,600 /1,000 = $1.60 per unit
Product B = 5 x $800 = $4,000;
$4,000 /5,000 = $0.80 per unit
Product C = 3 x $800 = $2,400; $2,400 /500 = $4.80 per unit
(b) Materials handling:
Cost per pound = $100,000 / (400 + 250 + 350) = $100 per pound
Product A = 400 x $100 = $40,000; $40,000/1,000 = $40.00 per unit
Product B = 250 x $100 = $25,000; $25,000/5,000 = $ 5.00 per unit
Product C = 350 x $100 = $35,000; $35,000/500 = $70.00 per unit
(c) Waste and hazardous disposals:
Cost per disposal: $250,000/(25 + 45 + 30) = $2,500 per disposal
Product A = 25 x $2,500 = $ 62,500; $ 62,500/1,000 = $ 62.50/unit
Product B = 45 x $2,500 = $112,500; $112,500/5,000 = $ 22.50/unit
Product C = 30 x $2,500 = $ 75,000; $ 75,000/500 = $150.00/unit
(d) Quality inspections:
Cost per inspection = $75,000/(30 + 35 + 35) = $750 per inspection
Product A = 30 x $750 = $22,500; $22,500/1,000 = $22.50 per unit
Product B = 35 x $750 = $26,250; $26,250/5,000 = $ 5.25 per unit
Product C = 35 x $750 = $26,250; $26,250/500 = $52.50 per unit
(e) Utilities:
Cost per MH = $60,000 / (2,000 + 7,000 + 1,000) = $6.00 per MH
Product A = 2,000 x $6 = $12,000; $12,000/1,000 = $12.00 per unit
Product B = 7,000 x $6 = $42,000; $42,000/5,000 = $ 8.40 per unit
Product C = 1,000 x $6 = $ 6,000; $ 6,000/500 = $12.00 per unit
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-41
©The McGraw-Hill Companies, Inc., 2008
5-52 (continued-2)
3. Comparison of reported product costs, new target price, actual selling
price, and gross margin (loss):
Product A Product B Product C
Product costs:
1. Direct-labor based system
$186.00
$196.00
$133.00
2. Activity-based system
$208.60
$168.35
$364.30
ABC-based product costs:
Target price (150%)
Actual selling price
Difference in price
$312.90
$252.53
$546.45
$280.00
$250.00
$300.00
<$32.90> <$2.53> <$246.45>
Direct-labor based costing system
Gross margin
Gross margin ratio
$ 94
33.57%
$ 54
21.6%
$167
55.67%
Activity-based costing system:
Gross margin
Gross margin ratio
$71.40
25.50%
$81.65
32.66%
$(64.30)
<21.43%>
4. Strategic and Competitive Analysis
1. Emphasizing Product C as suggested by the current directlabor-cost based overhead costing system is likely to harm
the firm’s competitiveness. The activity-based costing
system shows that the manufacturing cost of Product C is
$364.30 per unit and, at the current selling price, the firm
suffers a $64.30 loss for each unit it manufactures and sells.
2. If the actual selling prices of products A & B are fair market
prices for these products and a markup of 150% is a
common industry practice, the firm needs to examine the
manufacturing cost of product A. The fact that the firm’s
target price, determined using 150% of the manufacturing
cost, is more than 10 percent over the fair market price of
the product suggests possible wastes and inefficiencies in
the manufacturing of product A.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-42
©The McGraw-Hill Companies, Inc., 2008
5-53 Ethics, Cost System Selection (5 min)
Unfortunately, there are a number of reasons why ABC costing systems
are studied by firms and then not adopted. In some cases the reason is to
protect a product line that is favored by top executives, even though the
ABC results show it to be unprofitable. Other times it is because a
customer that is considered critical to the firm is shown to be unprofitable
by the ABC results
In the case of Aero Dynamics, the reason has to do with an ethical
issue, that is, the use of cost allocation to improperly charge a cost-plus
customer (the federal government) for overhead costs. The management
accountant should keep the professional ethics code in mind. First, he or
she should try to persuade other ABC pilot project members and the
company controller to strongly recommend that top management adopt the
more accurate ABC method. If the company top management still would
not listen, then the management accountant should report the situation to
the company’s audit committee.
Because of the management
accountant’s responsibility for confidentiality, he or she should not report
the matter outside the firm.
(See the Institute of Management
Accountant’s Code of Ethics in Exhibit 1-4).
An interesting footnote to the case is that the Government Accounting
Office, to assist the Dept of Defense, in part due to issues of this nature,
developed in the 1970s a series of cost accounting standards. These
standards apply generally to companies contracting with the federal
government, especially the DOD. See http://www.gao.gov/casb1.htm for
the CASB website. Also, the Federal Government in 1990 created the
Federal Accounting Standards Advisory Board (www.fasab.gov) which sets
standards for financial and managerial reporting within the federal
government. The FASAB web site is an interesting place to see the
progress/continuing issues of accounting at the federal government.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-43
©The McGraw-Hill Companies, Inc., 2008
5-54
Volume-Based Costing Versus ABC (25 min)
1. Current costing system (direct-labor hour)
%
Speedy
Deluxe
Price
$475 100
$300.00
Prime Cost
180
38
110.00
Overhead
20
4
153.60
Unit gross profit
$275
58
$ 36.40
2. Multiple drivers costing system
Calculation of unit overhead costs - Deluxe:
Setups
Machine costs
Engineering
Packing
Total overhead
Number of Units
Overhead per unit
Deluxe
$ 560,000
10,000,000
1,800,000
1,000,000
$13,360,000
÷
50,000
$267.20
$2,800 x
200 =
$100 x 100,000 =
$40 x 45,000 =
$20 x 50,000 =
Calculation of unit overhead costs - Speedy:
Setups
Machine costs
Engineering
Packing
Total overhead
Number of Units
Overhead per unit
$2,800 x
100 =
$100 x 400,000 =
$40 x 120,000 =
$20 x 200,000 =
Price
Cost
Prime cost
$180.00
Overhead
267.20
Unit gross profit
Speedy
$ 280,000
40,000,000
4,800,000
4,000,000
$49,080,000
÷
400,000
$122.70
Deluxe %
$475.00 100
447.20
$27.80
Blocher,Stout,Cokins,Chen:Cost Management, 4e
94
6
5-44
%
100
37
51
12
$110.00
122.70
Speedy
$300.00
%
100
232.70
$67.30
78
22
©The McGraw-Hill Companies, Inc., 2008
5-54 (continued)
3. Using the activity-based costing, a much different picture on profitability
of the Deluxe and Speedy models emerges. The Speedy model is
actually more profitable than the Deluxe model. The revised cost data
suggests that shifting the emphasis to the Deluxe model may very well
be a mistake. The Deluxe printer is a much heavier user of overhead
resources as can be seen in the table below that compares uses of
overhead.
Overhead
Activity
Activity Consumption
Deluxe
Speedy
Setups
Machine costs
Engineering
Packing
250 units per setup
4,000 units per setup
2 MH per unit
1 MH per unit
0.9 Engr. Hr. per unit
0.3 Engr. Hr. per unit
1 unit per packing order
2 units per packing order
Supporting calculations
Activity Consumption
Deluxe
Total Per Activity Measure
Units
Setups
Machine
costs
50,000
400,000
200 250 units per setup
100,000
2 MH per unit
Engineering 45,000 0.9 Engineering
Hours per unit
Packing
50,000
Speedy
Total Per Activity Measure
100 4,000 units per setup
400,000 1 MH per unit
120,000 0.3 Engineering
hours per unit
1 unit per packing 200,000
order
2 units per packing
order
4. The ABC method is likely to provide Gorden Company a more accurate
product cost picture. It also directs the management’s attention to the
high volume, more profitable Speedy printers.
Given the low profit margin of the Deluxe, the firm may want to
investigate the feasibility of raising the price, the possibility of reducing
product cost, or both.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-45
©The McGraw-Hill Companies, Inc., 2008
5-55 Volume-Based Costing Versus ABC (10 min)
1. Predetermined overhead rates:
Budgeted Budgeted
OH Cost Cost Driver
Cost Pool
Overhead Rate
Machine depr./maint.
$135,000
27,000
$5.00 per MH
Factory depr./util./insur.
$120,000
30,000
$4.00 per MH
Product design
$504,000
42,000 $12.00 per Design hour
Materials purch./stor.
$147,000
Total overhead
$980,000 15.00% DM cost
$906,000
Total overhead for each product order:
Overhead Cost Pool
Material purchase
Men Shavers
Women Shavers
$30,000 x 15% = $4,500 $26,000 x 15% = $3,900
Product design
$12 x 15 =
180
$12 x 37.5 =
450
Machine depreciation
$5.00 x 50 =
250
$5.00 x 40 =
200
Factory depreciation
$4.00 x 50 =
200
$4.00 x 40 =
160
Total overhead cost
$4,710
$5,130
2. Overhead cost per unit:
Number of units
15,000
20,000
Overhead cost per unit
$ 0.342
$ 0.2355
3. Overhead rate: $906,000 / 3,020 = $300 per direct labor hour
4. Total overhead using volume-based overhead rate:
Men Shavers:
$300 x 24 =
$7,200
Women Shavers:
$300 x 12 =
$3,600
5. Men Shavers:
Women Shavers:
$7,200 / 15,000 =
$ 0.48
$3,600 / 20,000 =
$ 0.18
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-46
©The McGraw-Hill Companies, Inc., 2008
5-56 Resource and Activity-Based Cost Drivers (25 min)
1. The activity based cost pools are determined from the percent-of-use
information; for example, total setup cost = $157,500 = .15 x $850,000
+ .2 x $150,000.
Salaries
Supplies
Factory Expense
Inspect &
Factory Costs Setup
Assembly
Finishing
Packaging
$
850,000 $ 127,500 $
467,500 $
170,000 $
85,000
150,000
30,000
90,000
30,000
550,000
440,000
110,000
$ 1,550,000 $ 157,500 $
997,500 $
310,000 $
85,000
2. The activity rates are determined as follows:
Safe-V
Batches
Units
Finishing hours/unit
Packaging
250
60,000
0.2
0.1
Safe-T
600
72,000
0.3
0.15
Total Activity
Activity-based
Consumption Activity Costs
Rates
850 $
157,500 $
185.29
132,000
997,500
7.557
33,600
310,000
9.226
16,800
85,000
5.060
3. The per unit activity-based costs are $14.18 for Safe-V and $18.63 for
the Safe-T
Setup
Assembly
Inspect and Finish
Packaging
Materials per unit
Total Cost per unit
Activity Requirements
Activity-Based Costs/Unit
Safe-V
Safe-T
Safe-V
Safe-T
250
600 $
0.772 $
1.544
60,000
72,000
7.557
7.557
0.2
0.3
1.845
2.768
0.1
0.15
0.506
0.759
$
3.50 $
6.00
3.500
6.000
$
14.180
$
18.628
4. The activity-based information can be used by EEI to set prices and
assess the profitability of its two product lines.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-47
©The McGraw-Hill Companies, Inc., 2008
5-57 Resource and Activity-Based Cost Drivers; Continuation of 5-56
(20 min)
1. The resource consumption cost driver rates and the activity cost polls
are determined as follows. For example the activity cost pool, setup, is
$115,000 = 1 x $50,000 + 1 x $15,000 + 2,000 x $25.
Resource
Rate
$
50,000
15,000
25
Setup
Assembly
$
50,000 $ 500,000
15,000
75,000
275,000
50,000
$ 115,000 $ 850,000
Inspect &
Finishing Packaging
$ 250,000 $ 50,000
60,000
125,000
100,000
$ 435,000 $ 150,000
2. The new activity consumption rates are shown in the right column, using
the same activity drivers as before, with the new activity cost pool amounts.
Safe-V
Batches
250
Units
60,000
Finishing hours, per unit 0.2
Packaging
0.1
Total Activity
Activity-based
Safe-T
Consumption Activity Costs
Rates
600
850 $
115,000 $
135.29
72,000
132,000
850,000
6.439
0.3
33,600
435,000
12.946
0.15
16,800
150,000
8.929
3. The new ABC product costs are shown below; there is very little
change from the solution in 5-56 above.
Setup
Assembly
Inspect and Finish
Packaging
Materials per unit
Total Cost per unit
Activity Requirements
Activity-Based Costs/Unit
Safe-V
Safe-T
Safe-V
Safe-T
250
600 $
0.564 $
1.127
60,000
72,000
6.439
6.439
0.2
0.3
2.589
3.884
0.1
0.15
0.893
1.339
$
3.50 $
6.00
3.500
6.000
Blocher,Stout,Cokins,Chen:Cost Management, 4e
$
5-48
13.985
$
18.790
©The McGraw-Hill Companies, Inc., 2008
5-58 Volume-Based Costing vs. ABC (30 min)
1. Manufacture Costs – Direct-Labor Cost Based
Luxury Pendant
Total
Selling Price
Direct Materials
Ceiling Fixture
Per Unit
Total
Per Unit
$ 80,000
$70.00
20.00
$ 400,000
$40.00
10.00
Direct Labor
32,000
8.00
200,000
5.00
Overhead*
64,000
16.00
400,000
10.00
$176,000
44.00
$1,000,000
25.00
Manufacturing Cost
Gross Margin
$26.00
$15.00
* Overhead is allocated based on direct labor costs at the rate of
$2.00 per direct labor dollar
LP: $ 32,000 x $2.00 = $ 64,000
CF: $200,000 x $2.00 = $400,000
2. Overhead Costs Reported by ABC System:
Overhead rates
Overhead Costs Total Activities Overhead Rate
$160,000
10,000
$16.00
Support labor
81,200
232,000
0.35
Machine Setup
68,000
2,500
27.20
Assembly
88,550
402,500
0.22
Inspection
66,250
4,000
16.5625
Machine Operation
Total
$464,000
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-49
©The McGraw-Hill Companies, Inc., 2008
5-58 (continued-1)
Applied overheads
Luxury Pendants
Machine Operation
Support labor
Machine Setup
Ceiling Fixtures
Overhead Activities Overhead Activities Overhead
Rate
Cost
Cost
$ 16.00
1,500 $ 24,000
8,500 $136,000
0.35
32,000
11,200 200,000
70,000
27.20
1,000
Assembly
0.22
192,500
Inspection
16.5625
1,600
Total Overhead
27,200
1,500
40,800
42,350 210,000
46,200
26,500
39,750
$131,250
Manufacture Costs Report - ABC System
Luxury Pendants
Total
Per Unit
Number of units
4,000
Sales
$280,000
$70.00
Direct Materials
80,000
$20.00
Direct Labor
32,000
$ 8.00
Overhead:
Machine Operation
24,000
Support Labor
11,200
Machine Setup
27,200
Assembly
42,350
Inspection
26,500
Total Overhead
$131,250 $32.8125
Total Manufacturing Costs
$243,250 $60.8125
Gross Margin
$ 36,750
$9.1875
Gross margin ratio
13.13%
2,400
$332,750
Ceiling Fixtures
Total
Per Unit
40,000
$1,600,000
$40.00
$400,000
$10.00
$200,000
$ 5.00
136,000
70,000
40,800
46,200
39,750
$332,750 $ 8.3188
$932,750 $23.3188
$667,250 $16.6813
41.7%
3. The above profitability analysis indicates that the Luxury Pendant is not
as profitable as the vice president of marketing thinks it is.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-50
©The McGraw-Hill Companies, Inc., 2008
5-58 (continued-2)
4. Unit Cost Comparison between the current and ABC costing systems
Reported Overhead Costs
Current
ABC
Difference
$32.8125
+$16.8125
Luxury Pendants
$16.00
Ceiling Fixtures
$10.00
$ 8.3188
- $ 1.6822
According to the ABC cost data, a shift to more Luxury Pendant
units and fewer Ceiling Fixture units would be ill advised. The
apparent higher unit gross margin of the Luxury Pendants relative
to the Ceiling Fixtures indicates that the current costing system
distorted relative unit profitability.
5. Among the reasons for the difference are:
a. The current direct labor based costing system focused on only
one manufacturing activity of the entire production process. It
measures only one attribute of the individual product: the
number of direct labor hours consumed. By contrast, the ABC
system considered all activities of the manufacturing processes.
Costs were traced from activities to products based on the
product’s demand for these activities during the production
process. The allocation bases used in ABC were thus measures
of the activities performed. For Moden Lighting Inc., the ABC
systems listed not only the unit-level activities (machine
operation, support labor overhead) but also the batch-level ones
(setup, assembly, and inspection.)
b. Under the volume-based costing system, the high-volume ceiling
fixtures were overcosted and the low-volume luxury pendants
were undercosted. The source of this distortion is the choice of
a single volume-related allocation base, direct labor hours, for
tracing of costs from manufacturing to products. Using a
volume-related allocation base alone to trace costs to products
distorted reported product costs if some of the product-related
activities were not related to volume, such as the setup hours.
c. Differences in the complexity of the products also contribute to
cost distortion. Using a volume-based costing system, overhead
costs differ only when different number of units are
manufactured. Although the luxury pendants were low-volume
products, they actually consume more resources – a result not
related to volume.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-51
©The McGraw-Hill Companies, Inc., 2008
5-59 Volume-Based Costing vs. ABC (30 min)
1. Current Costing System – Direct-Labor-Hour Based
Overhead rate = Budgeted overhead / Budgeted direct labor hours
= $200,000 / (7,200 + 6,800 + 2,000)
= $200,000 / 16,000
= $ 12.50 per direct labor hour
Overhead cost allocation:
Diomycin
7,200
Homycin
6,800
Addolin
2,000
Overhead rate
$12.50
$12.50
$12.50
Total overhead
$90,000
$85,000
$25,000
Direct labor-hours
Cost per unit:
Diomycin
$205,000
Homycin
$265,000
Addolin
$258,000
250,000
234,000
263,000
Overhead:
90,000
85,000
25,000
Total Cost
$545,000
$584,000
$546,000
Packets produced
1,000,000
500,000
300,000
$0.545
$1.168
$1.820
Direct Materials
Direct Labor
Cost per capsule
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-52
©The McGraw-Hill Companies, Inc., 2008
5-59 (continued-1)
2. Overhead rates for Activity-Based Costing:
Activity
Machine setup
Budgeted
Overhead
Cost
Cost Driver
Setup hours
$ 16,000
1,600
$10.00
36,000
1,200
$30.00
46,000
1,150
$40.00
50,400
1,050
$48.00
51,600
645
$80.00
Plant management Workers
Supervision of
Direct labordirect labor
hours
Quality inspection Inspectionhours
Expediting orders Customers
serviced
Total overhead
Budgeted
Cost Driver Overhead
Volume
Rate
$200,000
Overhead Costs Assigned to Products Using Activity-Based Costing:
Diomycin
Homycin
Addolin
Driver Applied
Overhead Driver Applied Driver Applied
Volume Overhead Volume Overhead Volume Overhead
Rate
Machine setup
$10 200
$2,000 600
$6,000 800
$8,000
Plant
management
Supervision
of direct labor
Quality
inspection
Expediting
production
orders
Total
$30
200
$6,000 400
$12,000
600
$18,000
$40
200
$8,000 300
$12,000
650
$26,000
$48
150
$7,200 200
$9,600
700
$33,600
$80
45
$3,600 100
$8,000
500
$40,000
$26,800
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-53
$47,600
$125,600
©The McGraw-Hill Companies, Inc., 2008
5-59 (continued-2)
Cost per capsule under Activity-Based Costing:
Diomycin
Homycin
Addolin
$205,000.00
$265,000.00
$258,000.00
250,000.00
234,000.00
263,000.00
Overhead
26,800.00
47,600.00
125,600.00
Total Cost
$481,800.00
$546,600.00
$646,600.00
1,000,000
500,000
300,000
$0.4818
$1.0932
$2.1553
Direct Materials
Direct Labor
Packets produced
Cost per capsule
3. Comparison of Product Costs Using Current Costing and ABC Costing:
Diomycin
Homycin
Addolin
Current Costing System
Overhead
$90,000
$85,000
$25,000
Cost per capsule
$0.5450
$1.1680
$1.8200
Overhead
$26,800
$47,600
$125,600
Cost per capsule
$0.4818
$1.0932
$2.1553
Activity-Based Costing system
Analysis of the Differences
Under the current costing system, ADA applies overhead based on
direct labor hour, and high-volume products such as Diomycin
(1,000,000 capsules) are allocated relatively more overhead ($90,000)
than the low-volume products such as Addolin (300,000 capsules).
High-volume products “subsidize” low-volume products in this case.
Because of lack of detailed costing information, ADA ends up
undercosting Addolin ($1.82 under the current costing) and
overcosting Diomycin ($0.545 under the current costing).
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-54
©The McGraw-Hill Companies, Inc., 2008
5-59 (continued-3)
Activity-based costing provides ADA with more detailed and
better estimates of product costs. For example by using ABC, ADA
becomes aware that the cost of Diomycin is lower ($0.4818 per
capsule compared to $0.545 under current costing), meaning that it
can set the price of Diomycin lower and be more competitive. Also,
ABC revealed how costly Addolin is ($2.1553 per capsule compared to
$1.82 under the current costing). Thus, this opportunity would allow
ADA to properly price Addolin or if it is not profitable, stop producing.
From the schedule, activity-based costing assigns more
overhead to the lower-volume Addolin because the production of
Addolin requires more setups, inspection, supervision, formulation and
management. The current direct-labor-hours based costing system
failed to assign costs of all activities. As a result, Diomycin and
Homycin subsidized Addolin.
The production department at ADA also benefits under ABC.
ABC provides better costing information on the cost of each of the
activities and identifies cost drivers and the activities that consume
resources and raise cost. The additional information enables
production mangers to manage cost by managing activities and cost
drivers.
Adopting the ABC method is strategically important for ADA.
Because the ABC method provides ADA with a more accurate product
cost picture and directs management’s attention to the high-volume,
more profitable products, the firm can gain competitive advantages
and profits by focusing on the high-volume products.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-55
©The McGraw-Hill Companies, Inc., 2008
5-59 (continued-4)
4. Among major uses of ABC in the Pharmaceutical Industry are:
a. Strategic Use of ABC to Reduce Costs
One of the important ways companies develop competitive
advantages is to become a low-cost producer. Many companies in
the pharmaceutical industry have learned to use the information
they have gained from their costing systems to make substantial
price cuts to increase market share.
b. Use of ABC to Eliminate Low-Value-Added Costs
ABC can be used to identify and eliminate activities that add costs
but not value to the products in the pharmaceutical industry. A
company can eliminate low-value added activities and costs without
reducing quality or value. In the pharmaceutical industry, the
following activities typically do not add value to a product: storage,
moving items, and waiting for work. Analyses of activities facilitate
firms to identify low-value-added activities.
c. Use of ABC in Marketing and Distribution
In the pharmaceutical industry, ABC can be applied to marketing or
administrative activities. The cost of performing marketing services
such as distributing products through different distribution channels
can be computed and the information used in making informed
decisions. For example, some of the different channels of
distribution in the pharmaceutical industry are: grocery stores,
convenience stores, pharmacy shops, each having different
activities. The cost of alternative channels of distribution is useful
to marketing managers who make decisions about which channel to
use.
d. Use of ABC to Make Better Pricing Decisions
ABC enables managers to make better pricing decisions by
providing managers with more accurate product cost data for
pricing decisions.
e. Use of ABC to Make Better Product Mix Decisions
ABC provides a firm with more detailed and better estimation of
product costs. Thus, it allows a company the opportunity to decide
which products to make and which ones to eliminate.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-56
©The McGraw-Hill Companies, Inc., 2008
5-60 Volume-based Costing Versus ABC
Alaire Corporation (40
min)
1. a. Using the current volume-based standard costs, the total contribution
expected in 2007 by Alaire Corporation from the TV Board is
$1,950,000, calculated as follows:
Per Unit Totals for 65,000 units
Revenue
$150
$ 9,750,000
Direct materials
80
5,200,000
Direct labor ($14 x 1.5 hours)
21
1,365,000
Materials overhead (10% of material)
8
520,000
Variable overhead ($4 x 1.5 hours)*
6
390,000
Machine time overhead ($10 x .5)
5
325,000
$120
$7,800,000
$ 30
$1,950,000
Total cost
Contribution margin
* Variable overhead rate: $1,120,000 / 280,000 hours = $4 per hour.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-57
©The McGraw-Hill Companies, Inc., 2008
5-60 (continued-1)
1. b. Using traditional volume-based standard costs, the total contribution
expected in 2007 by Alaire Corporation from the PC Board is
$2,360,000, calculated as follows:
Per Unit Totals for 40,000 units
Revenue
$300
$ 12,000,000
140
5,600,000
Direct labor ($14 x 4 hours)
56
2,240,000
Materials overhead (10% of materials)
14
560,000
Variable overhead ($4 x 4 hours)*
16
640,000
Machine time overhead ($10 x 1.5)
15
600,000
Total cost
241
9,640,000
Contribution margin
$ 59
$ 2,360,000
Direct materials
* Variable overhead rate: $1,120,000 / 280,000 hours = $4 per hour.
2. Shown below are the calculations of the activity-based cost drivers,
which apply to both 2.a. and 2.b.
Procurement:
$400,000 / 4,000,000 = $0.10 per part
Production scheduling:
$220,000 / 110,000 = $2.00 per board
Packing & shipping:
$440,000 / 110,000 = $4.00 per board
Machine setups:
$446,000 / 278,750 = $1.60 per setup
Hazardous waste disposal:
Quality control:
General supplies:
$48,000 / 16,000 = $3.00 per pound
$560,000 / 160,000 = $3.50 per inspection
$66,000 / 110,000 = $0.60 per board
Machine insertion:
$1,200,000 / 3,000,000 = $0.40 per insertion
Manual insertion:
$4,000,000 / 1,000,000 = $4.00 per insertion
Wave soldering:
$132,000 / 110,000 = $1.20 per board
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-58
©The McGraw-Hill Companies, Inc., 2008
5-60 (continued-2)
a. Using activity-based costing, the total contribution expected in 2007 by
Alaire Corporation from the TV Board is $2,557,100 calculated as
follows.
Per Unit Totals for 65,000 units
$150.00
$ 9,750,000
80.00
5,200,000
Procurement ($.10 x 25)
2.50
162,500
Production scheduling
2.00
130,000
Packaging & shipping
4.00
260,000
3.20
208,000
.06
3,900
3.50
227,500
.60
39,000
Machine insertion ($.40 x 24)
9.60
624,000
Manual insertion
4.00
260,000
Wave soldering
1.20
78,000
Total cost
$110.66
$7,192,900
Contribution margin
$ 39.34
$2,557,100
Revenue
Direct materials
Materials overhead:
Variable overhead:
Machine set-ups ($1.60 x 2)
Waste disposal ($3 x .02)
Quality control
General supplies
Manufacturing overhead:
Note that the only cost that remains the same for both cost methods
is the cost of direct materials. Under the ABC method, direct labor
cost becomes part of the manufacturing manual insertion overhead
cost.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-59
©The McGraw-Hill Companies, Inc., 2008
5-60 (continued-3)
b. Using activity-based costing, the total contribution expected in 2007 by
Alaire Corporation from the PC Board is $1,594,000 calculated as
follows.
Per Unit Totals for 40,000 units
Revenue
$300.00
$ 12,000,000
140.00
5,600,000
Procurement ($.10 x 55)
5.50
220,000
Production scheduling
2.00
80,000
Packaging & shipping
4.00
160,000
Machine set-ups ($1.60 x 3)
4.80
192,000
Waste disposal ($3 x .35)
1.05
42,000
Quality control ($3.50 x 2)
7.00
280,000
.60
24,000
Machine insertion ($.40 x 35)
14.00
560,000
Manual insertion ($4 x 20)
80.00
3,200,000
1.20
48,000
`Total cost
$260.15
$10,406,000
Contribution margin
$ 39.85
$ 1,594,000
Direct materials
Materials overhead:
Variable overhead:
General supplies
Manufacturing:
Wave soldering
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-60
©The McGraw-Hill Companies, Inc., 2008
5-60 (continued-4)
3. The analysis using volume-based standard costs shows that the
unit contribution of the PC Board is almost double that of the TV
Board. On this basis, Alaire’s 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 unit dollar
contribution from each of the boards is almost equal, and the total
contribution from the TV Board exceeds that of the PC Board by
almost $1,000,000. As a percentage of selling price, the contribution
from the TV Board is double that of the PC Board, 26 percent versus
13 percent. Therefore, it may not be advisable to concentrate
promotional efforts only on expanding the market for the PC Board.
The analysis using ABC can help the company be more
competitive because it provides accurate cost information that allows
the company to make better decisions. As noted above, the ability
to correctly identify the most and least profitable products is critical to
building a successful company.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-61
©The McGraw-Hill Companies, Inc., 2008
5-61 Volume-based Costing Versus ABC (40 min)
1. a. Predetermined factory overhead rate
= $3,000,000 / $600,000
= $5 per direct-labor dollar
b. Product costs and selling prices
Product Costs
Mona Loa
Malaysian
Direct costs:
Direct materials
$4.20
$3.20
Direct labor
.30
$4.50
.30
$3.50
1.50
1.50
$6.00
$5.00
30%
30%
$7.80
$6.50
Indirect costs:
Factory overhead (0.30 x $5.00)
Total costs
Mark-up
Budgeted selling prices per pound
2. The cost per driver unit is:
Activity
Purchasing
Budgeted
Cost Driver
Cost
Purchase orders $579,000
Material handling
Setups
720,000
1,800
400
Quality control
Batches
144,000
720
200
Roasting
Roasting hours
961,000
96,100
10
Blending
Blending hours
336,000
33,600
10
Packaging
Packaging hours
260,000
26,000
10
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-62
Budgeted
Activity
1,158
Cost per
Unit
$500
©The McGraw-Hill Companies, Inc., 2008
5-61 (continued-1)
The budgeted unit costs per pound are:
Mona Loa Coffee
Direct unit costs:
Direct materials
$4.20
Direct labor
0.30 $4.50
Indirect unit costs:
Purchasing
0.02
Material handling
Quality control
Roasting
Blending
Packaging
Total unit cost
(4 orders x $500 /100,000 lbs.)
0.12
Malaysian Coffee
$3.20
0.30 $3.50
1.00
(4 orders x $500/2,000 lbs.)
2.40
(30 setups x $400/100,000 lbs.)
(12 setups x $400/2,000 lbs.)
(10 batches x $200/100,000 lbs.)
(4 batches x $200/2,000 lbs.)
(1,000 hours x $10/100,000 lbs.)
(20 hours x $10/2,000 lbs.)
0.02
0.10
0.05
(500 hrs. x $10/100,000 lbs.)
0.01
0.40
0.10
0.05
(10 hrs. x $10/2,000 lbs.)
0.01
(100 hrs. x $10/100,000 lbs.)
(2 hrs. x$10/2,000 lbs.)
$4.82
$7.46
The comparative cost numbers are:
Mona Loa
Malaysian
Requirement 1
$6.00
$5.00
Requirement 2
4.82
7.46
The ABC system in requirement 2 reports a decreased cost for the
high-volume Mona Loa and an increased cost for the low-volume
Malaysian.
The current costing system leads to cross-subsidization between the two
products.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-63
©The McGraw-Hill Companies, Inc., 2008
5-61 (continued-2)
3. Three of the indirect cost items can be classified as output-unit driven:
Malaysian Coffee
Mona Loa Coffee
Roasting
$0.10
$0.10
Blending
0.05
0.05
Packaging
0.01
0.01
Total output-unit overhead
$0.16
$0.16
The other three indirect cost items are batch-level driven:
Malaysian Coffee
Mona Loa Coffee
Purchasing
$0.02
$1.00
Material handling
0.12
2.40
Quality control
0.02
0.40
Total batch-level overhead
$0.16
$3.80
Malaysian coffee has a greater number of setups per output unit
than does Mona Loa coffee. The result is that the unit cost of the
lower-volume Malaysian coffee is much higher than that of the
higher-volume coffee, even though its cost of direct materials is
lower.
With the current costing system, the high-volume Mona Loa is
overcosted, while the low-volume Malaysian is undercosted. Pricing
of Mona Loa can be reduced to make it more competitive. In
contrast, Malaysian should be priced at a much higher level if the
strategy is to cover the current period’s cost. CBI may wish to have
lower margins with its low-volume products such as Malaysian in an
attempt to build up volume. The company can use the ABC cost
information to compare its two product costs with competitors, and
decide which product has a low cost competitive advantage. Then
the company can change its pricing and product mix strategies by
using the ABC cost information.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-64
©The McGraw-Hill Companies, Inc., 2008
5-61 (continued-3)
ABC cost data also point out that the reason for the Malaysian
Coffee to have a higher unit cost is not because of high-priced
ingredients. In fact, Malaysian Coffee has a lower cost of direct
materials than that of Mona Loa Coffee. The costs of roasting,
blending, and packaging are $0.16 per pound for both coffees. The
higher cost of Malaysian is because of the way in which it is
processed. The batch-level cost per pound is $0.16 for Mona Loa
and $3.80 for Malaysian. CBI can increase its profit margin or lower
its price on Malaysian Coffee if it can change the way in which it
handles purchasing, material handling, and quality control functions
of Malaysian coffee.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-65
©The McGraw-Hill Companies, Inc., 2008
5-62 Cost of Capacity; Continuation of 5-61 (25 min)
1. The calculation of the new activity rates and the cost of unused capacity
is determined below.
Purchasing
Materials Handling
Quality Control
Roasting
Blending
Packaging
Driver
Usage
1,158
1,800
720
96,100
33,600
26,000
Cost
579,000
720,000
144,000
961,000
336,000
260,000
$ 3,000,000
$
UsageBased
Rate
$ 500
400
200
10
10
10
Practical
Capacity
at Current Usage
Spending Percent
1,400
83%
2,400
75%
1,200
60%
100,000
96%
36,000
93%
30,000
87%
Practical
Cost of
Capacity Unused
Unused
Rate
Capacity Capacity
$ 413.57
242 $ 100,084
$ 300.00
600
180,000
$ 120.00
480
57,600
$
9.610
3,900
37,479
$
9.333
2,400
22,400
$
8.667
4,000
34,667
$ 432,230
2. The information on cost of capacity can alert management to the total
cost of unused capacity, in this case $432,230 or approximately 14% of
total overhead cost. This information can be used to identify activities
where there is extensive over-capacity, and to consider how the capacity
might be managed to reduce overall costs. For example, the calculations
in part 1 suggest there is substantial excess capacity in materials handling,
and the cost of the unused capacity is $180,000.
3. The analysis below shows the number of employees “unused” in
column 8. The analysis assumes that each employee (or machine)
contributes an equal share to the work of the activity. Note that the
materials handling activity appears to have as many as 5 unused
employees.
1
2
Driver
Usage
Cost
Purchasing
1,158 $ 579,000
Materials Handling
1,800
720,000
Quality Control
720
144,000
Roasting
96,100
961,000
Blending
33,600
336,000
Packaging
26,000
260,000
3
4
5
Capacity
Step: Number
at Current of Employees Unused
Spending
or Machines
Capacity
1,400
8
242
2,400
20
600
1,200
4
480
100,000
10
3,900
36,000
10
2,400
30,000
3
4,000
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-66
6
Cost per
Step
=(2)/(4)
$ 72,375
36,000
36,000
96,100
33,600
86,667
7
8
Step
Size
Steps
=(3)/(4) Not Used
175
1.38
120
5.00
300
1.60
10,000
0.39
3,600
0.67
10,000
0.40
©The McGraw-Hill Companies, Inc., 2008
5-63 Customer Profitability Analysis (30 Min)
1. Service cost rate per unit of activity
Estimated
Estimated
Service
Activities
Annual
Cost Driver
Annual Cost
Cost
Expense
Driver Units
Per Unit
Requisition
$3,000,000 Requisitions
300,000 $10.00
Handling
Warehouse
$1,050,000
Cartons
70,000 $15.00
Pick
$ 900,000
(PP) Lines
600,000 $ 1.50
Packing
Data Entry
$ 600,000
(PP) Lines
600,000 $ 1.00
Delivery
$10 per delivery (requisition) + $0.30 per mile
charge
2. Service Costs
Omega International
City of Albion
Requisition Handling
$3,000
$ 7,000
(300 requisitions x $10/requisition)
(700 requisitions x $10/requisition)
Warehouse Activity
750
7,500
(50 cartons x $15.00 per carton)
(500 cartons x $15.00 per carton)
Pick-Packing
1,350
3,150
(900 pick-pack lines x $1.50)
(2,100 pick-pack lines x $1.50)
Data Entry
900
2,100
(900 lines x $1.00/line)
(2,100 lines x $1.00/line)
Freight Out
3,450
8,260
($10 x 300) + ($0.30 x 5 x 300)
($10 x 700) + ($0.30 x 6 x 700)
Total Service Costs
$9,450
$28,010
3. Customer Profitability Analysis-Activity Based
Omega International
Sales
$ 80,000
City of Albion
$80,000
Product Cost
(50,000)
(48,000)
Service costs
( 9,450)
(28,010)
Gross Margin
Gross Margin %
$20,550
$ 3,990
25.69%
Blocher,Stout,Cokins,Chen:Cost Management, 4e
4.99%
5-67
©The McGraw-Hill Companies, Inc., 2008
5-63 (continued-1)
The above profitability analysis indicates that, under activitybased costing, Omega International, not City of Albion, is more
profitable to Boston Depot. The apparent higher gross margin
percentage of the City of Albion relative to the Omega
International was the result of not recognizing differences in the
service activities requested by different customers under the
firm’s existing costing system.
City of Albion is a much heavier user of services provided by
Boston Depot. Although both customers had the same total sales,
City of Albion made more desktop delivery requests in smaller
quantities and maintained more inventory by Boston Depot.
4.
The answer depends on the competitive strategy of the firm. The
gross profit margin ratios show that Omega is the better customer
of the two.
Omega does not use much of the desktop delivery service
Boston offers. Most likely Omega is a buyer of “commodity” items
and does not need the convenience of desktop delivery.
However, Boston’s pricing is likely to have incorporated the
average cost of desktop deliveries. If Omega realizes that it is
paying for services not used, it may buy the commodity it needs
elsewhere, unless Boston lowers the price to Omega.
All custom-printed business forms by different suppliers are
likely to be the same. Delayne wanted to “differentiate” its forms
from those of competitors’ by offering desktop delivery services.
In the long-run, Omega is not likely to be a customer staying with
Boston Depot. Boston Depot needs to be prepared to lower the
price to Omega.
If the firm desires to compete on a differentiation strategy it
needs to price accordingly. Boston Depot needs to raise prices to
City of Albion. If City of Albion is willing to pay a higher price for
the convenience of desktop delivery, it is the kind of customer
that Delayne wants.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-68
©The McGraw-Hill Companies, Inc., 2008
5-64 Activity-Based Costing (35-40 min)
(Miami Valley Architects, Inc. by Beth M. Chaffman, CPA and John Talbott,
CMA, Management Accounting Campus Report, Fall 1992, p.4)
1. Overhead Cost assigned to each branch under the ABC costing:
Columbus Cincinnati Dayton Total
Direct labor dollar
37.61%
31.19% 31.20% 100%
Timesheet entries
45.11%
28.57% 26.32% 100%
Vendor invoices
44.93%
37.44% 17.62% 100%
Client invoices
52.13%
39.36%
8.51% 100%
Employees
34.33%
38.81% 26.87% 100%
New hires
42.11%
21.05% 36.84% 100%
38.81% 26.87% 100%
Insurance claims filed
34.33%
Proposals
39.22%
49.02% 11.76% 100%
Contracted sales
48.07%
36.88% 15.05% 100%
Projects shipped
39.13%
49.01% 11.86% 100%
33.85% 24.62% 100%
Purchase orders
41.54%
Copies duplicated
43.48%
39.13% 17.39% 100%
Blueprints
45.24%
36.19% 18.56% 100%
Activity-based overhead allocation
Colum. Cinci. Dayton Total
Cost Driver
General administration
$153.84 $127.56 $127.60 $ 409 Direct labor dollar
Project costing
21.65
13.71
12.63
48 Timesheet entries
52.05
24.49
139 Vendor invoices
Accounts payable/receiving
62.46
Accounts receivable
24.50
18.50
4.00
47 Client invoices
Payroll/Mail sort & delivery
10.30
11.64
8.06
30 Employees
Personnel recruiting
16.00
8.00
14.00
38 New hires
Employee insurance process.
4.81
5.43
3.76
14 Insurance claims filed
Proposals
54.51
68.14
16.35
139 Proposals
Sales meetings/Sales aids
97.10
74.49
30.40
202 Contracted sales
Shipping
9.39
11.76
2.85
24 Projects shipped
Ordering
19.94
16.25
11.82
48 Purchase orders
Duplicating costs
20.00
18.00
8.00
46 Copies duplicated
Blueprinting
34.84
27.87
14.29
77 Blueprints
Total
$529.34 $453.41 $278.26 $1,261
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-69
©The McGraw-Hill Companies, Inc., 2008
5-64 (continued-1)
Calculation for general administration allocated to branches:
Total direct labor dollar: $382,413 + $317,086 + $317,188 =
$1,016,687
Allocation of general administration based on direct labor dollar:
Allocated Amount
Proportion
Columbus
$382,413 / $1,016,687 = 37.61% $409 x 37.61% = $153.84
Cincinnati
$317,086 / $1,016,687 = 31.19% $409 x 31.19% = $127.56
Dayton
$317,188 / $1,016,687 = 31.20% $409 x 31.20% = $127.60
2. Contribution of each branch:
Columbus
Sales
Dayton
Total
$1,500
$1,419
$1,067
$3,986
382
317
317
1,016
281
421
185
887
180
270
177
627
$657
$411
$388
$1,456
Less: Direct labor
Direct materials
Direct overhead
Contribution margin
Cincinnati
3. Profitability of each branch using activity-based costing:
Columbus Cincinnati Dayton
Sales
Total
$1,500
$1,419
$1,067
$3,986
Less: Direct labor
382
317
317
1,016
Direct materials
281
421
185
887
180
270
177
627
$657
$411
$388
$1,456
529
$128
453
($42)
278
$110
1,261
$195
Direct overhead
Contribution margin
Activity-based overhead
Operating income
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-70
©The McGraw-Hill Companies, Inc., 2008
5-64 (continued-2)
4. Evaluating management concerns:
Overhead costs are usually aggregated in pools and allocated to
products and other cost objects based on volume measures
such as direct labor dollars or machine hours. The cost object,
therefore, supposedly shares proportionally in those costs
necessary for its production or existence. If however, overhead
varies in accordance with variables other than volume, then
product costs and other cost objects will be erroneously
determined.
As the solution indicates, the profitability of the Cincinnati and
Dayton offices is vastly different employing direct tracing and
ABC than under the current approach. The obvious benefit to the
company is a more equitable distribution of bonuses and
resources to these locations. In addition, existing marketing
strategy may be promoting the wrong location and strategic
planning may be based on spurious assumptions concerning
relative profitability.
This case also illustrates that ABC is applicable to service
organizations as well as to manufacturing and that cost objects
can consist of projects, locations, customers, etc., as well as
products. In essence, the better information we have about the
profitability of any cost object, the better chance of keeping
organizations profitable.
However, the process of identifying activities and allocating costs
from the general ledger to the activities is a difficult, time
consuming process. Extensive interviews with functional
managers and workers are normally required. This process is
time consuming and often costly.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-71
©The McGraw-Hill Companies, Inc., 2008
5-65 Customer Profitability Analysis (30 minutes)
HS Inc. Adventix
Baldwin
Customer revenue analysis
Total sales
$600,000
$750,000
$900,000
12,000
22,500
18,000
$588,000
$727,500
$882,000
11,760
7,275
26,460
$576,240
$720,225
$855,540
Less: Sales discount
Net invoice
Less: Sales returns
Net sales
Less: Cash discounts
11,525
Finance charge
(7,530)
Net proceeds
$572,245
1
21,606 2
$698,619
$855,540
200
$ 125
$ 450
Order taking
500
250
2,500
Order processing
750
375
3,750
Sales return
600
800
2,000
Delivery
1,500
15,000
Expediting order
1,000
2,500
800
800
1,600
Total customer cost
$2,850
$4,850
$27,800
Net customer profit
$569,395
$693,769
$827,740
Customer cost analysis
Customer unit-level cost:
Sales return (restocking)3
$
Customer batch-level costs:
Customer sustaining costs:
Sales visits
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-72
©The McGraw-Hill Companies, Inc., 2008
5-65 (continued)
1
Net proceeds:
$576,240 - $11,525 =
$564,715
Savings of not having to finance working capital:
$564,715 x 2% x 20/30 =
2
Payment received on the 60th day:
$720,225 ) 2 = $360,112.50
Finance charge for 30 days
Payment received on the 90th day:
Finance charge for 60 days
$7,530
$360,112.50 x 2% =
$720,225 ) 2 = $360,112.50
$360,112.50 x 2% x 2 =
Net finance charge
3
Restocking cost:
$ 7,202
14,404
$21,606
HS Inc:
10 x 100 x 2% x $10 =
$200
Adventix:
5 x 250 x 1% x $10 =
$125
Baldwin:
50 x 30 x 3% x $10 =
$450
Customer profitability analysis helps the company become more
competitive by identifying the most profitable and least profitable
customers. This information can then be used by management to adjust
pricing policies, identify ways to reduce the cost to serve customers, and
change the customer mix for a more profitable group of customers.
Blocher,Stout,Cokins,Chen:Cost Management, 4e
5-73
©The McGraw-Hill Companies, Inc., 2008