Atkinson, Solutions Manual t/a Management Accounting, 6E
Chapter 5
Activity-Based Cost
Systems
QUESTIONS
5-1
Traditional volume-based cost allocation systems that use only drivers that
vary directly with the volume of products produced—such as direct labor
dollars, direct labor hours, or machine hours—are likely to systematically
distort product costs because they break the link between the cause for the
costs and the basis for assignment of the costs to the individual products. Costs
may vary not only with respect to volume of production, but also, for example,
with batch-related activities (e.g., changeovers, setups, and inspection of the
first item of production run) and the number of products (e.g., scheduling
materials receipts and improving products). Also, cost distortions tend to be
greater with greater differences between relative proportions of indirect
resources used by cost objects because traditional cost assignments based on
volume-related measures do not accurately reflect these differences.
5-2
Volume-based traditional product costing systems that use only drivers that
vary directly with the volume of products produced—such as direct labor
dollars, direct labor hours, or machine hours—are most likely to distort
product costs under the following two conditions: (1) Indirect and support
expenses are high, especially when they exceed the cost of the allocation base
itself (such as direct labor cost); and (2) Product diversity is high: the plant
produces both high-volume and low-volume products, standard and custom
products, and complex and simple products. The combination of these two
conditions will magnify the distortions that arise because volume-based
product costing systems do not accurately reflect differences in non-volumerelated resource usage across products or other cost objects.
Activity-based costing systems provide more accurate costs when these two
conditions hold by creating more accurate links between the causes of indirect
and support costs and the bases for assignment of the costs to cost objects. For
example, costs may vary not only with respect to volume of production, but
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Chapter 5: Activity-Based Cost Systems
also activities such as changeovers, setups, and inspection of the first item of
production run, which are not done in proportion to the number of units
produced. Moreover, some costs vary with the number of different products
(e.g., scheduling materials receipts and improving products).
5-3
Yes, traditional costing systems are more likely to overcost high-volume
products because all indirect and support costs are assigned to products in
proportion to the number of production units (through volume-based cost
drivers), and the low-volume products are likely to require higher indirect and
support costs per unit. The high-volume products essentially cross-subsidize
the low-volume products in the sense that indirect and support costs are
assigned uniformly in proportion to volume.
5-4
Companies producing a varied and complex mix of products require many
more resources to support their highly varied mix, and therefore have higher
costs. Examples of the greater resources required include a much larger
production support staff to schedule machine and production runs; perform
changeovers and setups between production runs; inspect items at the
beginning of each production run; move materials; ship and expedite orders;
develop new and improve existing products; negotiate with vendors; schedule
materials receipts; order, receive, and inspect incoming materials and parts;
and update and maintain the much larger computer-based information system.
5-5
A significant change in resource costs triggers an update of the capacity cost
rates. A significant and permanent change in operations, such as the efficiency
with which an activity is performed, triggers an update of the unit time
estimate. If new activities become part of operations, the time to perform the
activity will be estimated and then multiplied by the appropriate capacity cost
rate to determine the cost of the activity.
The two sets of parameters that must be estimated in time-driven activitybased costing are 1) the capacity cost rate for each type of indirect resource;
that is, the unit cost of supplying capacity for each department or process,
based on practical capacity, and 2) the consumption of capacity, which is an
estimate of how much of a resource’s capacity (such as time or space) is used
by the activities performed to produce the various products, services, or
customers.
5-6
To compute a capacity cost rate, first identify all costs incurred to supply that
resource (such as a machine, an indirect production employee, the computer
system, factory space, a warehouse, or a truck). Then, identify the capacity
supplied by that resource. The capacity would be the hours of work provided
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Atkinson, Solutions Manual t/a Management Accounting, 6E
5-7
by the machine or production employee, or the space provided by the
warehouse or truck. For most resources (people, equipment, and machines),
capacity is measured by the time supplied. The resource’s capacity cost rate is
calculated by dividing its cost by the capacity it supplies, usually expressed as
a cost per hour or cost per minute. For warehouses, production space, and
trucks, the capacity cost rate would be measured by cost per square foot (or
square meter) of usable space. For computer memory, the resource capacity
cost rate would be the cost per megabyte or gigabyte.
Managers use the information on activity costs to identify opportunities for
operational improvements and reductions in operations costs, decisions about
product mix and pricing, and targeted customer segments. An example of an
operational change is requiring minimum order sizes to eliminate short,
unprofitable production runs. Another example is changing the facility layout
to reduce moves of work in progress. Product designs can be changed in order
to manufacture products with fewer parts or common parts to reduce material
handling support costs. Finally, as discussed in more detail in Chapter 6, if
activity-based cost analysis shows that full-pallet shipments are less costly per
unit than partial-pallet shipments, customers can be encouraged to receive fullpallet shipments. Of course, customers who insist on very small order sizes or
partial-pallet shipments can be charged a price high enough to cover the extra
costs associated with such activities.
5-8
The capacity cost driver rate should reflect the underlying efficiency of the
process—for example, the cost of resources to handle each production order—
and this efficiency is measured better by using the capacity of the resources
supplied (practical capacity) as the denominator when calculating capacity
cost driver rates. The numerator in a capacity cost driver rate calculation
represents the costs of supplying resource capacity to do work. The
denominator should match the numerator by representing the quantity of work
the resources can perform. Unassigned costs represent the cost of unused
capacity and should be used as feedback to managers on their supply and
demand decisions.
5-9
Immediate financial improvement may not follow even after process
improvements reduce the demand for indirect and support resources. This is
because the support costs are often committed. The organization must actively
manage the unused capacity by increasing the volume of business or reducing
the supply of unused resources.
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Chapter 5: Activity-Based Cost Systems
5-10 Service organizations are often ideally suited for activity-based costing
because virtually all of the costs for a service company are indirect and appear
to be fixed. The large component of apparently fixed costs in service
companies arises because, unlike manufacturing companies, service
companies have virtually no material costs—the prime source of short-term
variable costs. Service companies must supply virtually all of their resources
in advance to provide the capacity to perform work for customers during each
period. Fluctuations during the period of demand by individual products and
customers for the activities performed by these resources do not influence
short-term spending to supply the resources.
5-11 As mentioned in 5-10, virtually all the costs for a service company are indirect
and appear to be fixed. Service companies have few or no direct materials and
many of their personnel provide indirect, not direct, support to products and
customers. Consequently, service companies do not have direct, traceable
costs to serve as convenient allocation bases.
Unlike physical products, services cannot be inventoried for future sales.
Service companies must supply virtually all their resources in advance to
provide the capacity to perform work for customers during each period, and
demand often fluctuates. For some service industries, the increase in spending
resulting from an incremental transaction or customer is essentially zero.
Therefore, service companies making decisions about products and customers
based on short-term variable costs might provide a full range of all products
and services to customers at prices near zero, leading to little recovery of the
costs of all the committed resources supplied in order to deliver services to
customers.
It can be difficult to identify and measure the outputs for a service
organization. The variation in demand for organizational resources is much
more customer-driven in service organizations than in manufacturing
organizations. A service company can determine and control the efficiency of
its internal activities, but customers determine the quantity of demands for
these operating activities. For example, customers may vary greatly in the
number of transactions and the balances in their checking accounts. Service
companies must focus on customer costs and customer profitability;
measuring revenues and costs at the customer level provides service
companies with far more relevant and useful information than at the product
level. Finally, a customer may have multiple relationships with a service
company. Therefore, the cost system should provide information that supports
determining profitability of the entire relationship with the customer.
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Atkinson, Solutions Manual t/a Management Accounting, 6E
Customer costs and customer profitability are discussed in more detail in
Chapter 6.
5-12 Individuals may feel vulnerable facing uncertainty about what the activitybased cost analysis may show, or they may feel threatened by the suggestion
that their work could be improved. For example, the analysis might reveal that
products or customers thought to be very profitable are actually unprofitable,
or that some processes are inefficient. Individuals may be concerned that they
will then be judged as poor managers, even though they were making
decisions that others would agree were good decisions based on the cost
system in place.
5-13 Time-driven activity-based costing has a number of advantages over
traditional activity-based costing. The advantages include (1) It is easy and
fast to build an accurate model even for large enterprises; (2) It exploits the
detailed transactions data that are available from ERP systems; (3) It drives
costs to transactions and orders with time equations that use specific
characteristics of particular orders, processes, suppliers, and customers; (4) It
provides visibility to capacity utilization and the cost of unused capacity; (5) It
enables managers to forecast future resource demands, allowing them to
budget for resource capacity on the basis of predicted order quantities and
complexity; and (6) It is easy to update the model as resource costs and
process efficiencies change.
EXERCISES
5-14 Potter Corporation should switch to activity-based costing because its current
system appears to be distorting product costs, resulting in prices of specialty
products that are too low (hence increasing their market share) and prices of
simple products that are too high (thus, lowering their market share). This, in
turn, leads to lower overall profitability as Potter pushes products that, in
reality, produce low profit margins or even lose money.
5-15 (a) The time-driven ABC model will now incorporate a capacity cost rate for
computer resources, computed as $18,000 divided by the practical capacity
computer hours per month. Usage of computer resources can be measured
in computer time per product or production run.
(b) Before the machinery energy costs were discovered, the machinery rate
was computed as $15,400 divided by 308 practical capacity hours, which
equals $50 per hour. The energy costs of $4,000 per month will be added to
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Chapter 5: Activity-Based Cost Systems
the $15,400 monthly machinery costs, for a new machinery resource cost
of $19,400 per month, leading to a higher rate per hour. The new rate is
$19,400/308 = $62.99, which can be rounded to $63 per hour for
convenience.
(c) If the company introduces a new flavor, the new flavor’s consumption of
direct and indirect resources will need to be estimated and then multiplied
by the appropriate cost or cost rate. For example, start with the quantity of
direct materials and labor hours per gallon produced, and multiply these
amounts by the related cost per unit of direct materials and wage rate,
respectively. Next, estimate the quantity of indirect labor (for changeovers,
scheduling and product maintenance) and machine time (for production
runs and setups). These will then be multiplied by the associated capacity
cost rates of each indirect resource and added to the direct materials and
direct labor costs in order to compute the total cost of producing the new
flavor.
5-16 (a) A 10% increase in indirect labor costs will increase the indirect labor
capacity cost rate by 10% (from $35 to $38.50) and therefore will increase
the indirect labor costs assigned to products by 10%. The revised income
statement that is similar to Exhibit 5-5 will show indirect labor costs that
are 10% higher than in Exhibit 5-5, with correspondingly lower product
gross profits, as shown below. (Small differences may result if the
calculations are performed in a spreadsheet package.)
Sales
Direct materials
Direct labor
(including fringes)
Indirect labor usage
Machine usage
Gross profit (loss)
Gross profit (loss)
as percent of sales
Vanilla Chocolate Strawberry
$30,000 $ 24,000
$3,960
$6,000
$4,800
$720
MochaAlmond
$2,800
$520
Total
$60,760
$12,040
$8,750
$4,967
$6,700
$3,583
$7,000
$3,581
$5,000
$3,619
$1,050
$3,889
$1,660
$(3,359)
$700
$4,043
$1,640
$(4,103)
$17,500
$16,480
$15,000
$(260)
11.94%
15.08%
–84.82%
–146.54%
–0.43%
(b) With the reduction in unit time for scheduling a production from four
hours per run to three hours per run, we first compute the revised indirect
labor hours per month and then multiply by the new indirect labor capacity
cost rate of $38.50 per hour.
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Atkinson, Solutions Manual t/a Management Accounting, 6E
The revised indirect labor hours per month are calculated as follows:
Schedule production
runs, purchasing, etc.
(hours per run)
Changeovers (hours per
batch)
Number of employees
per changeover
Indirect labor hours per
changeover
Indirect labor time per
run (batch)
Number of production
runs
Indirect labor per run
Product-sustaining (hrs
per month)
Indirect labor hours per
month
Indirect rate per hour
Indirect labor cost
Vanilla
Chocolate
Strawberry
MochaAlmond
3
3
3
3
2.0
1.0
2.5
4.0
3
3
3
3
6
3
7.5
12
9
6
10.5
15
× 12
108
× 12
72
×8
84
×6
90
9
9
9
9
117
× $38.50
$4,504.50
81
× $38.50
$3,118.50
93
99
× $38.50 × $38.50
$3,580.50 $3,811.50
The new income statement shows lower indirect labor costs than in part (a)
because of the reduced scheduling time per run. (Small differences may result
if the calculations are performed in a spreadsheet package.)
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Chapter 5: Activity-Based Cost Systems
Sales
Direct materials
Direct labor
(including fringes)
Indirect labor usage
Machine usage
Gross profit (loss)
Gross profit (loss)
as percent of sales
Vanilla Chocolate Strawberry
$30,000 $ 24,000
$3,960
$6,000
$4,800
$720
MochaAlmond
$2,800
$520
Total
$60,760
$12,040
$8,750
$4,505
$6,700
$4,045
$7,000
$3,119
$5,000
$4,081
$1,050
$3,581
$1,660
$(3,051)
$700
$3,812
$1,640
$(3,872)
$17,500
$15,017
$15,000
$1,203
13.48%
17.00%
–77.05%
–138.29%
1.98%
Combining direct labor and indirect labor costs, the summary income
statement showing unused capacity costs is as follows:
Totals with Unused
Assigned Capacity
Costs
Costs
$60,760
$12,040
$32,517
$68
$15,000
400
$1,203
$(468)
Totals
with
Capacity
Costs
$60,760
$12,040
$32,585
$15,400
$735
Sales
Direct materials
Direct labor and indirect labora
Machine usage
Gross profit (loss)
Gross profit (loss) as percent of
sales
1.98%
1.21%
a
Labor capacity cost = $4,655 × 7 employees = $32,585. Employees perform
direct labor and indirect labor tasks.
5-17 (a)
Hours:
Pumps
1,500
5,000
200
Hours:
Valves
1,800
6,000
400
Rate
$20
$30
$80
Cost:
Pumps
$ 30,000
$150,000
$ 16,000
$196,000
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Cost:
Valves
$ 36,000
$180,000
$ 32,000
$248,000
Atkinson, Solutions Manual t/a Management Accounting, 6E
(b)
The cost of unused capacity, which will be expensed on the income
statement, is calculated as follows:
Hours:
Unused
Capacity Rate
300 $20
200 $30
50 $80
Cost:
Unused
Capacity
$ 6,000
$ 6,000
$ 4,000
$16,000
Total revenues
Total direct labor cost
Total direct materials cost
OH applied to pumps
OH applied to valves
Cost of unused practical capacity
SG&A expenses
Net income
$890,000
$120,000
90,000
196,000
248,000
$654,000
16,000
100,000
$120,000
5-18 (a)
Ken’s previous average fixed cost per meal was $3,300  600 = $5.50. With
the drop in demand, the average fixed cost is now $3,300  550 = $6. If
demand decreases further and Ken continues to use the same method to
determine his costs of serving a meal, the average fixed cost will
continue to increase, and Ken will want to raise his prices even more.
However, the rising prices may contribute to further declines in demand,
leading Ken into a downward (or death) spiral.
(b)
Ken should use the practical capacity quantity of meals per day to
determine cost per meal in order to avoid the fluctuations described in
part (a) and to understand the cost rate at the point where the resources
used equal the practical capacity usage. If resource usage is less than
practical capacity, Ken should monitor the cost of unused capacity. He
may be able to reduce the capacity costs or to find other profitable uses
for the capacity. In this problem, one may assume the practical capacity
is 600 meals per day.
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Chapter 5: Activity-Based Cost Systems
PROBLEMS
5-19 (a)
Capacity cost rate = $500,000/10,000 hours = $50 per hour.
(b)
The activity-based cost associated with Division 1’s customers is
(0.5 × 1,000 + 1.0 × 4,000) × $50 per hour
= 4,500 hours × $50 per hour = $225,000.
(c)
The activity-based cost associated with Division 2’s customers is
(0.5 × 200 + 0.1 × 400) × $50 per hour
= 140 hours × $50 per hour = $7,000.
(d)
The change will result in (0.5 × 1,000 + 1.0 × 2,000 + 0.1 × 2,000) =
2,700 hours used, a reduction from the 4,500 hours in part (a). The new
activity-based cost associated with Division 1’s customers is
2,700 hours × $50 per hour = $135,000. The lower cost assigned to
Division 1 will not reduce Zeta’s costs unless Zeta also reduces the
$500,000 total resource cost. This can be accomplished in the following
way; with the change in the mix of more electronic and fewer manual
transactions, 1,800 fewer hours of accounts receivable time is required.
Since the capacity of each employee is about 1,667 hours per year
(10,000 ÷ 6), Zeta can operate with one fewer employee, saving the full
cost of one employee, probably at least $60,000 per year.
5-20 (a)
The practical capacity per month for each packaging and shipping
employee is (8 − 1.25 hours) per day × 20 days per month = 135 hours
per month. The capacity cost rate = $4,050/135 hours = $30 per hour.
(b)
Order 705, which consists of 40 items, requires packaging preparation
time of 0.25 hours plus 40 × 0.1 hours to bubble wrap and pack the 40
items in the carton, for a total of 4.25 hours The cost assigned to Order
705 is therefore 4.25 × $30 per hour =$127.50.
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Atkinson, Solutions Manual t/a Management Accounting, 6E
5-21 (a)
With the stated change, Madison Dairy will require 8 full-time
production employees and 3 machines, as shown below.
Labor
Number of
production runs
Handle production
run (hours/run)
Indirect labor:
handle runs
Setup time per run
(hours)
Number of
employees per
changeover
Indirect labor
hours per run
Indirect labor: total
setup hours
Indirect labor:
maintain products
Total indirect labor
hours
Volume (gallons)
Direct labor hours
per gallon
Total direct labor
hours
Total labor hours
Productive hours
per employee per
month
Number of
employees needed
Number of fulltime employees
Straw- MochaVanilla Chocolate berry Almond
Total
18
16
4
3
2.5
2.5
2.5
2.5
45.0
40.0
10.0
7.5
2.0
1.0
2.0
3.2
2
2
2
2
4.0
2.0
4.0
6.4
72.0
32.0
16.0
19.2
139.2
8.0
8.0
8.0
8.0
32.0
125.0
80.0
34.0
34.7
273.7
15,500
13,000
1,600
1,200
31,300
0.025
0.025
0.025
0.025
387.5
512.5
325.0
405.0
40.0
74.0
102.5
30.0
782.5
64.7 1,056.2
133.0
7.9
8.0
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Chapter 5: Activity-Based Cost Systems
Machines
Production
volume
Machine hours
per 1000 gallons
Total machine
run time (hours)
Number of
production runs
Setup time per
run (hours)
Machine setup
time (hours)
Total machine
hours
Productive
hours per month
Number of
machines
needed (rounded
up)
(b)
Vanilla
Straw- MochaChocolate Berry Almond
Total
15,500
13,000
1,600
1,200
11
11
11
11
170.5
143.0
17.6
13.2
18
16
4
3
2.0
1.0
2.0
3.2
36.0
16.0
8.0
9.6
69.6
206.5
159.0
25.6
22.8
413.9
344.3
154.0
3.0
Pro forma monthly product line income statement (total dollar amounts
are rounded):
Selling price
Sales volume
Revenues
Direct
materials
Direct labor
(including
fringes)
Indirect labor
Machinery
Gross profit
Gross profit
Vanilla
$ 2.90
15,500
$44,950
Chocolate
$ 2.90
13,000
$ 37,700
Strawberry
$ 3.40
1,600
$ 5,440
9,300
7,800
960
780
18,840
13,563
4,375
10,325
$7,387
16.4%
11,375
2,800
7,950
$ 7,775
20.6%
1,400
1,190
1,280
$610
11.2%
1,050
1,215
1,140
$ 615
12.8%
27,388
9,580
20,695
$16,387
17.6%
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MochaAlmond
Total
$ 4.00
$ 2.97
1,200
31,300
$ 4,800 $ 92,890
Atkinson, Solutions Manual t/a Management Accounting, 6E
(% of sales)
(c)
The cost of the 8 production employees is 8 × $4,655 = $37,240 and the
unused labor capacity cost is therefore $37,240 − $27,388 − $9,580 =
$272. The cost of the 3 machines is 3 × $7,700 = $23,100 and the
unused machine capacity cost is $23,100 − $20,695 = $2,405. After
incorporating the unused capacity cost, the pro forma monthly gross
profit is $16,387 − $272 − $2,405 = $13,710 and gross profit as a
percent of sales is $13,710/$92,890 = 14.8%.
5-22 Activity-based costing provides a means to accurately trace costs to
operational processes, and these costs can be used as one of the operations
management measures in the process perspective of a Balanced Scorecard.
Activity-based costing can also provide a means to measure customer
profitability or percent of profitable customers, which many companies
include in the customer or financial perspective of their Balanced Scorecards
(this application will be discussed in Chapter 6).
5-23 The choice really depends on what short-term problems the company faces. If
it is experiencing large, rising, and difficulty-to-control indirect and support
costs, as well as a proliferation of products and customers, then an activitybased costing system will supply valuable information to management
decisions on process improvements, product mix, pricing, and managing
customer relationships. This is because activity-based costing requires
understanding processes and their underlying activities, as well as what drives
support costs. The development of the activity-based costing model, as well as
the model itself, will help the organization identify costly and inefficient
processes. Additional potential benefits include identifying costly customers
or understanding how costly complex products are. The company can improve
inefficient processes, encourage costly customers to interact at a lower cost to
the company, revise product pricing, and find new revenue-generating uses of
freed-up capacity or attempt to reduce capacity costs.
If, however, the biggest issue the company faces is moving to a new strategy,
particularly one focused on customers and a new value proposition, then
implementing the Balanced Scorecard will be highly beneficial in
communicating the new strategy and providing a systematic mechanism for
monitoring and improving the new strategy. The Balanced Scorecard process
can greatly facilitate and speed the major change that is desired, lead to team
building and commitment to the new strategy among the executive team,
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Chapter 5: Activity-Based Cost Systems
translate the strategy to operational terms, and lead to communication of the
strategy throughout the organization.
Of course, both approaches are highly compatible with each other.
5-24 (a)
Each server is available for (22 days) × (24 hours per day) = 528 hours
per month. The average cost per hour is therefore $3,696/528 hours = $7
per hour. Non-peak-hour usage accounts for (20 servers) × (16 hours per
day) = 320 hours per day. Peak-hour usage accounts for (80 servers) ×
(8 hours per day) = 640 hours per day. Moreover, the 60-server excess
capacity during non-peak hours exists because of the peak-hour need.
Therefore the cost of the excess capacity of 60 × 16 hours = 960 hours
should be charged to peak-hour users. Thus, the peak-usage hourly rate
is $7 × (640 + 960)/640 = $11,200/640 = $17.50 per hour.
(b)
As discussed in part (a), the peak-usage hours should bear the cost of
the excess capacity that exists during non-peak usage. The non-peak
hourly rate is then the average cost of $7 per hour.
5-25 (a)
Activity
Handle customer
orders
Process customer
complaints
Perform customer
credit checks
Percent
75%
10%
15%
100%
Cost
Assigned Driver
Cost* Quantity
Activity
Cost Driver
Rate**
$56.25 per
8,000 customer order
$450,000
$150.00 per
400 customer complaint
$60,000
$200.00 per
450 credit check
$90,000
$600,000
* $600,000 times the given percentage.
** Assigned Cost divided by Cost Driver Quantity.
(b)
Capacity cost rate = $600,000/10,000 = $60 per hour.
Unit
Time
Activity
(Hours)
Activity Cost Driver Rate
Handle customer orders
0.75
$45 Per customer order
Process customer complaints
3.50
$210 Per customer complaint
Perform customer credit checks
3.00
$180 Per credit check
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Atkinson, Solutions Manual t/a Management Accounting, 6E
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Chapter 5: Activity-Based Cost Systems
(c)
Unit
Time
(Hours)
0.75
Activity
Handle customer orders
Quantity
of
Activities
8,000
Total
Cost
Hours Assigned
6,000 $360,000
Process customer complaints
3.50
400
1,400
$84,000
Perform customer credit checks
3.00
450
1,350
$81,000
8,750
$525,000
Total
Practical capacity used = 8,750  10,000 = 87.5%
Unused capacity = 10,000 − 8,750 hours = 1,250 hours.
Unassigned cost = $600,000 − $525,000 = $75,000.
Managers can try to reduce the unused capacity and its associated
expense. Alternatively, managers can try to generate new uses for the
unused capacity by introducing new products or expanding into new
markets. The cost system provides information to assist managers in
deciding whether these new uses of capacity can be handled with the
current capacity or require additional resources and spending.
(d)
Activity
Handle customer orders
Unit
Time
(Hours)
0.75
Quantity
of
Total
Activities Hours
8,500
6,375
Cost
Assigned
$382,500
Process customer
complaints
3.50
350
1,225
$73,500
Perform customer credit
checks
3.00
500
1,500
$90,000
9,100
$546,000
Total
Practical capacity used = 9,100  10,000 = 91.0%
Unused capacity = 10,000 − 9,100 hours = 900 hours.
Unassigned cost = $600,000 − $546,000 = $54,000.
(e)
The costs driver rates in (a) and (b) likely differ because not all the
practical capacity of the resources supplied during the period was used
for productive work, as illustrated in parts (c) and (d). The ABC system
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Atkinson, Solutions Manual t/a Management Accounting, 6E
in part (a) overestimated the costs of performing activities by
apportioning all customer service costs to the three activities and
therefore assigned not only the costs of resource capacity used, but also
the cost of unused resources. Determining the unit times to complete
each activity in conjunction with the time-driven ABC system in part
(b) provides clearer information about the resources needed for each
activity and about the unused capacity.
5-26 (a)
The resource units would depend on the organization’s facilities and
resources. If the organization is self-contained with operating rooms,
recovery rooms, and radiology and pharmacy facilities, then these
resource units would be part of Riverdale’s activity-based cost system.
Other likely resource units include personnel performing scheduling,
admissions, and record-keeping; medical personnel, such as nurses and
surgeons; equipment (such as rehabilitation equipment and examination
tables); the cost of computers used in the clinic.
(b)
Capacity cost rates must be developed for each resource. Then, for each
patient, track their routing through the clinic to identify which resources
the patient uses, and how much time is spent with each resource.
Finally, sum up the costs of all the resources used by the patient as he or
she gets processed, treated, and, eventually, released by the hospital.
This will yield the total cost associated with the complete cycle of care
for this patient episode.
5-27 (Unofficial CMA Answer, adapted)
(a) 1.
Manufacturing support costs include all indirect production costs
(all production costs except direct material and direct labor).
These costs cannot be practically or economically traced to end
products and, therefore, must be assigned by some allocation
methods. Typical manufacturing support costs include:
•
Indirect labor, e.g., lift-truck driver’s wages, maintenance and
inspection labor, engineering labor, scheduling, purchasing
and supervisors.
•
Other indirect factory costs, e.g., building maintenance,
machine and tool maintenance, property taxes, property
insurance, pension costs, depreciation on plant and
equipment, rent expense, and utility expense.
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Chapter 5: Activity-Based Cost Systems
2.
(b)
(c)
Companies develop manufacturing support cost driver rates to
facilitate the costing of products as they are completed and
shipped, rather than waiting until actual costs are accumulated at
the end of a fiscal period.
The cost driver rate increase should not have a negative impact on Moss
Manufacturing because the increase in indirect costs was offset by a
decrease in direct labor costs.
Rather than using a universal plantwide rate, Moss Manufacturing could
implement separate cost pools for different activities. Examples are as
follows:
(d)
•
Accumulate separate costs into departmental accounts (or other
relevant pools), with one account for each production and service
department. Each department would allocate its support costs to
products on the basis that best reflects the use of these services.
•
Individual machines (or other more relevant allocation bases)
could be treated as separate cost centers with the machine costs
collected and charged to the products using the machine(s).
An activity-based costing system might benefit Moss Manufacturing
because it
•
measures the cost of unused resource capacity and provides more accurate
resource consumption and cost information as input to decisions that increase
company profitability
•
5-28 (a)
costs products according to the activities involved in the
production process.
A call-related activity cost driver would better identify the linkage to
call center support costs. The number of calls (a transaction driver) per
product can be used because of its simplicity. The number of minutes of
calls (a duration driver) provides better linkage to call center support
costs, but it is more time-consuming to measure.
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Atkinson, Solutions Manual t/a Management Accounting, 6E
(b)
Previous system: Allocated support costs:
5% of sales
Activity-based costs: $.70 per minute
Product X
$20,000
Product Y
$5,000
$4,900
$21,000
(c)
Under the previous system, product managers can only reduce the
assigned call center costs by reducing sales. Under the new system,
product managers can work with other functional areas to find ways to
reduce the number of calls or to reduce the length of calls. For example,
product Y’s manager can work with package designers or the marketing
group to develop clearer instructions for consumers. The instructions
might include a company web address that provides answers to
frequently asked questions (based on calls to the call center).
(d)
Product Y’s manager is likely to resist implementation of the activitybased cost system if the manager understands the relative usage of call
center resources devoted to product Y. Call center staff may resist
implementation of activity-based costing because it will involve
tracking of staff activity. The staff may resent tracking the number of
calls or minutes of calls, and may resent the additional monitoring
because it may lead to pressure to reduce the minutes per call. The call
center staff may also fear that the desire for cost or efficiency
improvements will lead to staff reduction or to outsourcing the entire
call center.
(e)
The company will need to consider the broader management issues related
to job loss if the call center activities are outsourced. As an input to that
decision, however, the company can benchmark its costs per minute to
other call centers, or compare it to the cost of outsourcing. The company
may also pursue an intermediate course of communicating the current costs
per minute and benchmarked or competitive costs, and allowing the call
center staff to improve efficiency and lower costs per minute.
5-29 (a)
Manufacturing support cost driver rate
$11,500, 000

100, 000  300, 000
 $28. 75 per direct labor hour.
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Chapter 5: Activity-Based Cost Systems
Costs Per Unit
Product X21
Direct materials cost
$120.00
Direct labor cost
2  $(1,000,000100,000)
20.00
3  $(4,500,000300,000)
Manufacturing support cost
$28.75  (100,00050,000)
57.50
$28.75  (300,000100,000)
Unit cost
(b)
$197.50
Cost
Cost
Capacity
Driver Driver
Activity
costs
Quantity Rate
Handling $3,000,000 60,000
50
Number
of parts
2,400,000
20,000
Design
changes
3,300,000
3,000
2,800,000
$11,500,000
14,000
Setups
Total
Costs Per Unit
Direct materials cost
Direct labor cost
Manufacturing support cost
$7,240,000  50,000
$4,260,000  100,000
Unit cost
(c)
120
Product Y37
$140.00
45.00
86.25
$271.25
Costs Allocated to Products
X21
50  40,000
Y37
50  20,000
120  12,000
120  8,000
1,100 1,100  2,000 1,100  1,000
200
200  8,000
$7,240,000
X21
$120.00
Y37
$140.00
20.00
45.00
200  6,000
$4,260,000
144.80
42.60
$284.80
$227.60
Activity-based costing produces more accurate estimates of job costs
because it takes into account the cost drivers that give rise to support
costs.
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Atkinson, Solutions Manual t/a Management Accounting, 6E
(d)
Cost-based Prices
Traditional costing
1.25 × unit costs in part (a)
Activity-based costing
1.25 × unit costs in part (b)
Product X21
Product Y37
$246.88
$339.06
$356.00
$284.50
If Endo plans to continue to use cost-based pricing, it should use
activity-based costs as the basis for its markups. Note X21’s current
price is not even covering its manufacturing costs as determined using
activity-based costing. Conversely, Y37 may be overpriced. Endo
should consider raising X21’s price and could consider lowering Y37’s
price if competitors are selling the same product for a lower price.
(e)
5-30 (a)
The company sells half as many X21’s as Y37’s, but X21 has twice as
many design changes and 50% more parts. These facts suggest that the
company can explore ways to reduce the number of design changes and
the number of parts. Management accountants would be involved in
developing and communicating the cost of design changes and parts
proliferation; design engineers would be directly involved in studying
different designs and trying to reduce the number of parts. In addition,
sales staff who communicate with customers could make greater efforts
to understand customer needs and convey this information to the design
engineers.
Total manufacturing support costs = $1,000,000
Total direct labor hours = [5,000  2 + 40,000  1] = 50,000
Manufacturing support cost rate = $20 per direct labor hour.
(b)
Deluxe
$45
Regular
$30
Direct labor
$20
$10
Manufacturing support
$40
$20
$105
$60
Direct material
Unit cost
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Chapter 5: Activity-Based Cost Systems
(c)
Activity
Rate Per Unit of Cost Driver
$180,000
 $300
600
$250,000
 $125
2,000
Purchase orders
Quality control
$220,000
 $1,100
200
$350,000
 $10
35,000
Production setups
Machine maintenance
Activity
Purchase orders
Capacity costs Assigned to Products
Deluxe
Regular
200  $300 = $60,000 400  $300 = $120,000
1,000  $125 = 125,000 1,000  $125 = 125,000
Quality control
Production
setups
100  $1,100 = 110,000 100  $1,100 = 110,000
Machine
maintenance
20,000  $10 = 200,000 15,000 $10 = 150,000
Total manufacturing support costs $495,000
$505,000
Number of units
5,000
40,000
Unit manufacturing support costs
$99
$12.625
Deluxe
$45.000
$20.000
$99.000
$164.000
Direct material
Direct labor
Manufacturing support
Unit cost
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Regular
$30.000
$10.000
$12.625
$52.625
Atkinson, Solutions Manual t/a Management Accounting, 6E
(d)
Activity
Ratio of
Deluxe:Regular
Deluxe
200
 0.04
5,000
Regular
400
 0.01
40,000
Quality control
1,000
 0.2
5,000
1,000
 0.025
40,000
Production setups
100
 0.02
5,000
100
 0.0025
40,000
8:1
20,000
4
5,000
15,000
 0.375
40,000
10.67:1
Purchase orders
Machine maintenance
4:1
8:1
Unit costs are distorted by the old system because it assigns
manufacturing support cost to products using direct labor hours as a
base. Although the deluxe model requires twice as much labor time as
the regular model, it was not allocated adequate support cost. Analyzing
the company’s capacity costs reveals that the deluxe model is very
expensive to manufacture as compared to the regular model because (i)
the deluxe model requires 4 times as many purchase orders as the
regular model, (ii) the deluxe model requires 8 times as many
inspections and setups as the regular model, and (iii) the deluxe model
requires over 10 times as many machine hours as the regular model.
(e)
No, the deluxe model is not as profitable as the company thinks. Under
ABC, the following profitability analysis for each product line can be
prepared:
Selling price per unit
Unit cost
Gross margin per unit
(f)
Deluxe
$140.000
$164.000
($24.000)
Regular
$80.000
$52.625
$27.375
The regular model is more profitable than the deluxe model. Therefore,
marketing staff can (i) push the regular model (increase commissions on
the regular model, and/or decrease commission on the deluxe model),
and/or (ii) raise the price of the deluxe model.
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Chapter 5: Activity-Based Cost Systems
Design engineers can try to re-engineer the deluxe product to decrease
its high demand for activity resources.
5-31 (Unofficial CMA Answer, adapted)
(a)
(b)
At least four general advantages associated with activity-based costing
include the following:
•
Provides management with a thorough understanding of complex
product costs and product profitability for improved resource
management and pricing decisions.
•
Provides estimates of unused capacity costs.
•
Highlights the interrelationships (cause and effect) of activities
and identifies opportunities to reduce costs, e.g., designing
products with fewer parts to reduce the cost of the manufacturing
process.
•
Provides more appropriate means of charging support costs to
products.
1.
Using standard costs, the total contribution expected this year
from the TV board is $1,950,000, calculated as follows:
Revenue
Direct material
Material support (10% of material)
Direct labor ($14  1.5 hours)
Variable support ($4  1.5 hours)*
Other mfg. support ($10  0.5
machine hour)
Total cost
Unit contribution
Total contribution (65,000  30)
*
Per
Unit
$150
80
8
21
6
Totals for
65,000 Units
$9,750,000
5,200,000
520,000
1,365,000
390,000
5
$120
$30
325,000
$7,800,000
$1,950,000
Variable support rate: $1,120,000  280,000 hours = $4 per hour.
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Atkinson, Solutions Manual t/a Management Accounting, 6E
2.
Using standard costs, the total contribution expected this year
from the PC Board is $2,360,000, calculated as follows:
Revenue
Direct material
Material support (10% of material)
Direct labor ($14  4 hours)
Variable support ($4  4 hours)*
Other mfg. support ($10  1.5
machine hours)
Total cost
Unit contribution
Total contribution (40,000  $59)
*
(c)
Per
Unit
$300
140
14
56
16
Totals for 40,000
Units
$12,000,000
5,600,000
560,000
2,240,000
640,000
15
$241
$59
600,000
$9,640,000
$2,360,000
Variable support rate: $1,120,000  280,000 hours = $4 per hour.
Shown below are the calculations of the cost drivers which apply to
both (c)1 and (c)2.
Procurement:
$400,000
 $.10 per part
4,000,000
Production scheduling:
$220,000
 $2.00 per board
110,000
Packaging and shipping:
$440,000
 $4.00 per board
110,000
Machine setups:
$446,000
 $1.60 per setup
278,750
Hazardous waste disposal:
$48,000
 $3.00 per pound
16,000
Quality control:
$560,000
 $3.50 per inspection
160,000
General supplies:
$66,000
 $.60 per board
110,000
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Chapter 5: Activity-Based Cost Systems
Machine insertion:
$1,200,000
 $.40 per machine insertion
3,000,000
Manual insertion:
$4,000,000
 $4.00 per manual insertion
1,000,000
Wave soldering:
$132,000
 $1.20 per board
110,000
1.
Using activity-based costing, the total contribution expected this
year from the TV Board is $2,557,100 calculated as follows:
Revenue
Direct material
Material support:
Procurement ($.10  25)
Production scheduling
Packaging and shipping
Variable support:
Machine setups ($1.60  2)
Waste disposal ($3  .02)
Quality control
General supplies
Other manufacturing support:
Machine insertion ($0.40  24)
Manual insertion
Wave soldering
Total cost
Unit contribution
Total contribution (65,000  $39.34)
–163–
Per
Unit
$150.00
80.00
Totals for
65,000 Units
$9,750,000
5,200,000
2.50
2.00
4.00
162,500
130,000
260,000
3.20
.06
3.50
.60
208,000
3,900
227,500
39,000
9.60
4.00
1.20
$110.66
$39.34
624,000
260,000
78,000
$7,192,900
$2,557,100
Atkinson, Solutions Manual t/a Management Accounting, 6E
2.
Using activity-based costing, the total contribution expected this
year from the PC Board is $1,594,000 calculated as follows:
Per
Totals for 40,000
Unit
Units
$300.00 $12,000,000
Revenue
Direct material
140.00
5,600,000
Procurement ($.10 55)
5.50
220,000
Production scheduling
2.00
80,000
Packaging and shipping
4.00
160,000
Machine setups ($1.60  3)
4.80
192,000
Waste disposal ($3  .35)
1.05
42,000
Quality control ($3.50  2)
7.00
280,000
General supplies
0.60
24,000
Machine insertion ($0.40  35)
14.00
560,000
Manual insertion ($4  20)
80.00
3,200,000
1.20
48,000
$260.15
$10,406,000
Material support:
Variable support:
Other manufacturing support:
Wave soldering
Total cost
Unit contribution
$39.85
Total contribution (40,000  $39.85)
(d)
$1,594,000
The analysis using standard costs shows that the unit contribution of the
PC Board is almost double that of the TV Board. On this basis, 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 total dollar
contribution from the TV Board exceeds that of the PC Board by almost
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Chapter 5: Activity-Based Cost Systems
$1,000,000. As a percentage of selling price, the contribution from the
TV Board is double that of the PC Board, e.g., 26% versus 13%.
CASES
5-32 This question is designed to get students to think about the factors creating the
demand for activity-based cost systems.
(a)
A traditional cost system, which assigns direct materials and direct labor
to products, and allocates factory support based on direct labor, cannot
signal the cost of component and product variety. Marketing research
may identify that consumers like to choose from a variety of options
(especially when the alternatives are available without any cost
associated with choosing; e.g., you can have any color of this or any
variety of that). In this situation, product engineers can design lots of
varieties and options. The cost system assigns cost only on the direct
labor and materials content of these options. Thus making one million
units of one steering column appears to cost the same as making
100,000 of 4 different steering columns, 10,000 each of 30 other
steering columns, and 1,000 each of 300 other columns. But making 334
steering columns in batch sizes ranging from, for example, 100 to
10,000, and designing and supporting 334 different steering columns is
much more expensive than just producing 5 or at most 40 different
columns. A traditional cost system would report that production costs of
labor and materials for the 1,000,000 steering columns is the same
whether they are produced in 5 varieties, 40 varieties, or 334 varieties.
Thus model and component proliferation is virtually impossible to stop
when companies cost products using traditional cost systems.
(b)
In order to understand the cost of variety, the new cost system should
identify the cost of introducing new varieties, colors, and options. The
cost system will show the cost of setting up or changing over to make
the new variety, color and option, a cost that will be independent of the
number of units produced after the setup. Also the new cost system will
show the cost of designing and supporting each new variety, color, and
option (technically, in ABC terms, called the “product-sustaining”
costs) that will be independent of the number of units produced. With
the more accurate understanding of the costs of resources that perform
batch and product-sustaining activities, the product engineers and
marketing managers can jointly make better decisions on whether the
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Atkinson, Solutions Manual t/a Management Accounting, 6E
higher cost of introducing another customized option will be
compensated with higher sales volumes and/or higher margins.
As a specific example, one of General Motors’ competitors examined
the cost of how many wire harnesses it used in a given car model.
Currently it was producing 12 different wire harnesses, a number that
seemed optimal using its traditional cost system. The ABC system—
which incorporated the economics of batch production and productsustaining expenses—revealed that the optimal number of harnesses
was 5 or 6. And when the cost of stocking and servicing all the
dealerships was incorporated into the analysis, the optimal number
dropped to 2. In effect, the apparent savings in direct materials and labor
from having customized wire harnesses for individual combinations of
car options was far lower than the much higher support costs triggered
by high engineering, production support, and service resources
associated with having to produce, stock, and service 12 different wire
harnesses for a single car model.
5-33 This situation is drawn from “Cott Corporation: Private Label in the 1990s.”
Harvard Business School Case #9-594-031.
This is a truly challenging exercise since it requires students to think about the
design of activity-based cost systems, not just the analysis of existing or
proposed systems. But, if a good discussion can be generated in the class, it
could motivate the work that will be done in the rest of the course. Students
may feel that activity-based cost systems are only necessary for large
organizations, like General Motors, Chrysler, Procter & Gamble, Coca Cola,
Hewlett Packard, or John Deere. This discussion shows how even small,
entrepreneurial ventures can benefit from knowing the cost of products,
services, and customers.
Cott executives could use a variety of different activity-based cost systems.
First, and perhaps most obvious, would be an analysis of production costs.
Cott, as any small company, would start with producing a limited set of high
volume, popular cola beverages such as regular cola and diet cola. So initially,
they would have long runs, few setups, and little product variety. Traditional
cost systems work fine in this environment. But if retailers want to use Cott as
their only private label beverage provider, they will ask Cott to provide a fuller
line of beverages, say caffeine-free and diet-caffeine free. Also, they may want
a variety of packaging: 12 oz cans, and 1 and 2 liter plastic bottles. And they
may start to request beverages beyond the cola category, such as sparkling
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Chapter 5: Activity-Based Cost Systems
water, mineral water, new-age beverages, ginger ale, flavored soft drinks, etc.
Each new retailer that Cott signs up as a customer may also want its own
slight variation in beverage formulation (ingredients) and labeling. As Cott
begins to respond to the demand for higher variety, it will be performing many
more activities: scheduling production runs, buying more different ingredients
and packaging materials from more suppliers, setting up for each production
run, changing over packaging lines, more quality control activities (required
for each production run and each unique formulation), and more product
support activities to maintain information required for each individual SKU.
Cott will need an ABC system to understand the cost of these activities that
are driven by increased variety and be sure that these costs are covered by the
volume of business and prices received from retailers. Otherwise, its cost
structure will increase and it will either lose money on the incremental orders
or, as it attempts to raise prices, will lose much of its price advantage over the
national brands. Cott will want to understand its costs by individual SKU, to
be sure that the increased costs associated with offering and delivering
customized, low-volume SKUs do not become spread on to the basic high
volume beverages (say, regular and diet cola).
Second, Cott is customizing its product and service offering to individual
retailers. For each retailer, Cott can offer unique product formulations,
customized to the retailer’s specifications, design of a retailer-specific label for
the beverages, and marketing, promotional, and consulting assistance to help
the retailer launch and sustain a private-label cola line. Thus Cott can incur
substantial customer-specific expenses with each new retailer. It will need to
measure all these front-end, customer-specific expenses and link them to the
revenues received, less product and customer-specific beverage costs [as
described in the previous paragraph] to determine customer profitability. An
ABC model of individual customer profitability will enable Cott to predict in
advance the volume and mix of business required to payback heavy front-end
investments in product design, package design, and consulting assistance. Ex
post, Cott will use the ABC customer profitability model to assess whether the
actual volume and mix of business, at actual prices and ABC-calculated
product costs, are generating sufficient margin to repay the front-end and
perhaps on-going customer-specific support expenses. Cott executives can use
such a model to guide their negotiations with each retailer.
Third, one of Cott’s principal marketing devices with a retailer is to convince
the retailer’s executives, (1) that Cott beverages are profitable for the retailer
to sell, and (2) that Cott beverages may be even more profitable for the retailer
than national-branded beverages. This will require Cott to work with the
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Atkinson, Solutions Manual t/a Management Accounting, 6E
retailer to develop a retailer profitability model for the cola beverage category
(one of the highest gross volume categories in a retail grocery store). From the
retailer’s perspective, profit would be measured by the gross margin (net
selling price less the price paid to Cott) minus retailer expenses to receive the
beverage containers in a warehouse, store and then ship them to retail outlets,
receive the shipments at the retail store, and then shelve and promote them at
the store. This requires an ABC model to be built for the retailer’s operating
expenses, including the cost of inventory and shelf-space occupancy. This is
especially important since the national brands (Coke and Pepsi) charge the
retailer much higher prices and the retailer marks these items up less than it
might do for a private label beverage. But since the national brands are
delivered directly to individual stores and shelved by the national brands’
personnel, the retailer does not use its warehouse, distribution, or in-store
resources (other than shelf space) for these brands. Thus a fair comparison
requires the ABC model to cost out the extra activities related to the Cottsupplied beverages but not required for Coke and Pepsi. But think about the
power of the outcome from such a study. Wouldn’t you, as a supplier, like to
be able to demonstrate to your customer that you are not just the lowest cost
supplier but the most profitable supplier in a category?
Students may also suggest other, non-cost, aspects of the Coke vs. Cott
decision. But thinking about these three ABC models: factory costs reflecting
the cost of variety and customization, customer cost and profitability reflecting
the cost of unique marketing, design, and promotional assistance, and, finally,
customer’s profitability structures should give students ample opportunity to
reflect on the strategic use of accurate product, distribution, and customer cost
information.
5-34 This case on Gotham City is adapted from “Indianapolis: Activity-Based
Costing of City Services (A) and (B),” Harvard Business School Case #9-196115/ and -117. The material below reports on the Indianapolis experience.
(a)
There are at least two reasons for estimating ABC costs of current
operations before contemplating a privatization decision. First, it may
turn out that the municipal workers are doing the work at a lower cost
than private sector alternatives. While this may seem fanciful, the
Indianapolis experience revealed quite a few tasks where the work could
be done by municipal workers at lower cost than by paying the lowestbidding private contractor. Of course, for this comparison to be on a
level playing field, the cost estimate for the municipal workers must
include not only their direct labor cost but also the cost of equipment,
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Chapter 5: Activity-Based Cost Systems
supervision, and all resources performing support activities (since any
private company must bid to cover the costs of these resources as well).
The ABC approach provides a reasonable estimate of all direct and
indirect costs associated with performing a given activity (such as filling
potholes, picking up trash, sweeping streets, treating water and sewage,
repaving roads, and operating an airport). The Mayor of Indianapolis,
after seeing the ABC cost estimates for internal provision of these
services, announced he was more interested in competition (between the
public and private sector for the lowest cost supply of services) than in
privatization.
The second reason for the ABC approach is that should a company in
the private sector win the business, the city must then identify all the
resources that are no longer needed when the work is done by the
private contractor. Again, the city resources that should be reduced
include not only the front-line municipal workers, but also all their
equipment, supervisors, and support resources behind the front-line
worker. Otherwise, the city will pay twice for the service, first for the
contractor doing the work, and then for the people and other support
resources who now have less or no work to perform. That is why a
cross-functional, comprehensive total cost view is needed to provide
transparency about all the resources in place to support a front-line
worker.
(b)
They should identify all the resource units used such as trucks,
machines, computers, and facilities. Then they need to identify all the
costs incurred to supply the resources and the capacity supplied by each
resource. A capacity cost rate (the cost of the indirect resource divided
by the capacity supplied by the resource) can then be developed for each
resource type. Estimates then need to be obtained for the amount of
each resource’s capacity used by different activities performed to
provide services to the community.
(c)
The answer to this question provides a third reason for building ABC
models before considering privatizing municipal services. Before
building an ABC cost model, workers would have no idea about the cost
of performing the work. Once they see the cost of labor, equipment,
supervision, and other support services, they can make suggestions to
lower the cost of performing the work. As a specific example, in
Indianapolis, the workers saw that there was one supervisor for every
two workers, clearly an excessive amount. They also developed
–169–
Atkinson, Solutions Manual t/a Management Accounting, 6E
procedures so that a pothole could be filled with a three-person crew
rather than a five- or six-person crew, to share equipment with other
activities, to use their equipment more efficiently, and to perform other
work (such as cleaning streets) while waiting for equipment or materials
to be delivered to the site. The sum total of all these improvement
suggestions enabled the municipal workers to submit a much lower bid
than any private contractor, thereby retaining the business. This
message reinforces the point that sharing cost information with frontline workers enables them to make suggestions for how to accomplish
the same outcomes with fewer resources, resulting in substantial
productivity improvements. Only good cost information can identify the
opportunities for the largest improvements in resource expenses.
5-35 (a)
Stage 1: Allocation of S1 and S2 costs to production departments
Department P1
Department P2
Directly
traceable
$480,000
$780,000
costs
216
120
1,176,000
×
=
420,000
1,176,000
×
= 756,000
S1
336
336
S2
Total support
1,120,000 ×
40
= 280,000
160
P1
P2
120
= 840,000
160
$1,180,000
$2,376,000
80, 000
120,000
$14.75 per DLH
$19.80 per DLH
DLH
Cost driver
rate
1,120,000 ×
Stage 2: Allocation of P1 and P2 costs to products
Product R361
Product R572
$14.75  60,000  $885,000
$14.75  20,000  295,000
$19.80  72,000  1,425,600
$2,310,600
–170–
$19.80  48,000  950,400
$1,245,400
Chapter 5: Activity-Based Cost Systems
Product costing
Direct materials
Product R361
$8  500,000  $4,000,000
Product R572
$10  400,000  4,000,000
Direct labor: P1
$15  60,000  900,000
$15  20,000  300,000
Direct labor: P2
$18  72,000  1,296,000
$18  48,000  864,000
Support
$2,310,600
$1,245,400
Total cost
$8,506,600
$6,409,400
500,000
400,000
$17.0132
$16.0235
Sales price
19.0000
20.0000
Gross margin
$1.9868
$3.9765
10.4600%
19.88%
Total units
Unit cost
Gross margin %
(b)
Let x denote the number of hours required for each R361 setup. Then
the number of hours required for each R572 setup = 1.5x.
R361
Number of setups
2,000
Setup hours
2,000x
(25%)
–171–
R572
4,000
6,000x = 4,000  1.5x
(75%)
Atkinson, Solutions Manual t/a Management Accounting, 6E
Number of transactions
Activity
Cost Traceable
Drivers
Costs
Total
P1-DLH $240,000 80,000
R361
60,000
Capacity
R572
Cost Driver Rate
20,000 $3/P1 DLH
P2-DLH
72,000
48,000 $3/P2 DLH
Setup
hours
360,000 120,000
1,676,000
6,000x
$209.5
/ setup hour
x
8,000x
2,000x
P1-MH
380,000 40,000
30,000
10,000 $9.50/P1 MH
P2-MH
900,000 120,000
72,000
48,000 $7.50/P2 MH
Total Support Costs
Capacity Cost
Drivers
Product R361
Product R572
P1-DLH
$3  60,000 = $180,000
$3  20,000  $60,000
P2-DLH
$3  72,000 = 216,000
$3  48,000  144,000
209.5
209.5
 2000x  419,000
 6,000x = 1,257,000
x
x
$9.5  30,000  285,000
$9.5  10,000  95,000
Setup hours
P1-MH
P2-MH
$7.5  72,000  540,000
$7.5  48,000  360,000
$1,640,000
$1,916,000
Alternatively,
Capacity
Cost
Drivers
P1-DLH
P2-DLH
Total Support Costs
Product R361
60
 $240,000  $180,000
80
72
 $360,000  $216,000
120
–172–
Product R572
20
 $240,000  $60,000
80
48
 $360,000  144,000
120
Chapter 5: Activity-Based Cost Systems
Setup
hours
P1-MH
P2-MH
2,000x
6,000x
 1,676,000  419,000
 1,676,000  1,257,000
8,000x
8,000x
30
 $380,000  285,000
40
72
 $900,000  540,000
120
$1,640,000
–173–
10
 $380,000  95,000
40
48
 $900,000  360,000
120
$1,916,000
Atkinson, Solutions Manual t/a Management Accounting, 6E
Product costing
Direct materials
Product R361
$4,000,000
Product R572
$4,000,000
Direct labor: P1
900,000
300,000
Direct labor: P2
1,296,000
864,000
Support costs
$1,640,000
$1,916,000
Total cost
$7,836,000
$7,080,000
Total units
500,000
400,000
Unit cost
$15.672
$17.700
Sales price
19.000
20.000
Gross margin
$3.328
$2.300
17.520%
11.500%
Gross margin %
(c)
The old cost accounting system ignored the fact that a large part of
support costs is driven by setup hours. Under the old cost accounting
system, R572 was undercosted because it had disproportionally more
setup hours compared to direct labor hours. The ratio of setup hours per
unit of R361 to the setup hours per unit of R572 equals:
2,000x
6,000x

 4.15
500,000 400,000
Sales price
Old Cost Accounting
System
R361
R572
$19.0000
$20.0000
ABC
System
R361
$19.0000
R572
$20.0000
Unit cost
17.0132
16.0235
15.6720
17.7000
Gross margin
$1.9868
$3.9765
$3.3280
$2.3000
Gross margin %
10.46%
–174–
19.88%
17.52%
11.50%
Chapter 5: Activity-Based Cost Systems
(d)
Recommendations for marketing:
1.
R361 is more profitable than R572. Therefore, push R361 by
increasing the commission on R361 or decreasing the
commission on R572.
2.
Raise the price of R572.
Recommendations for production:
(e)
1.
A large part of support costs is driven by setup hours. Therefore,
re-engineer the products to decrease setup hours.
2.
Offer discounts to customers for larger batch sizes to reduce the
number of setups. (This recommendation may also involve
marketing staff.)
The experienced production manager is likely to have an intuitive
understanding of the higher production complexity for R572 and will
likely agree with the activity-based cost analysis. However, the sales
manager will likely want to keep sales high and has already built up
relations with R572 customers. Therefore, the sales manager will likely
oppose increasing the price of R572 since it will reduce its sales.
5-36 Sippican Corporation (A) (HBS Case 9-106-058)
Teaching Plan
This is an introductory case, and yet it introduces a powerful new approach for
building an ABC model. Considerable theory is illustrated in how we build the
Sippican time-driven ABC (TDABC) model. Also, the (B) case introduces an
important link, previously recognized but not exploited, in how to embed an
ABC model into the budgeting process, replacing line-item budgeting with an
integrated, analytic approach. The case discussion provides insight and
confidence about the feasibility of building a TDABC model, especially in the
face of resistance from finance people who claim that ABC is too complex to
implement.
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Atkinson, Solutions Manual t/a Management Accounting, 6E
Q:
What is the competitive situation faced by Sippican?
 Mature products
 Declining profits
 Inability to explain pricing decisions in market place – high margins and little
price competition in one line; continued price pressure in another
Q:
Why was Knight studying Sippican’s overhead costs?
The following two characteristics serve as indicators that a traditional costing
approach to overhead costs is likely providing inaccurate costs:
1. The Willie Sutton rule:1 Look for areas with large expenses in
indirect and support resources, especially where such expenses
have been growing over time. Operations where almost all
expenses are direct labor and direct materials, which can
already be directly traced to individual products by traditional
costing systems, may have less need for ABC systems. In
effect, if organizational activities are all at the unit level
(virtually no batch or product-sustaining activities), then ABC
systems and traditional cost systems will likely give very
similar economic signals.
2. High Diversity rule: Look for a situation in which large variety
exists in products, customers, or processes. For example,
consider a facility that produces mature and newly introduced
products, standard and custom products, high-volume and lowvolume products. For marketing and selling expenses,
companies may have a mixture of customers who order highvolume, standard products with few special demands as well as
customers who order in small volumes, special products, and
require large quantities of pre-sales and post-sales technical
support.
Willie Sutton was a successful bank robber in the United States during the 1950s. Willie, who
was eventually captured at his home not far from a local police station, was asked during his initial
interrogation, “Why do you rob banks?” Willie replied, with the wisdom that had made him
successful for many years, “That’s where the money is!” When developing ABC systems, we
should follow Willie’s sage advice (but not his particular application of the insight) to focus on
high cost areas where improvements in visibility and action could produce major benefits to the
organization. Applying an ABC analysis to a set of resource expenses that are below 1% of total
spending will not lead to high payoffs to the organization.
1
–176–
Chapter 5: Activity-Based Cost Systems
Observation: Products such as pumps and valves may be commodities; but
how they are produced (small lots, custom designs) and delivered (direct,
expedited) is not a commodity. These special services create a basis for
differentiation. But “differentiation is a successful strategy only when the delta
value created by differentiation exceeds the cost to differentiate.”
∆ Revenues (from higher prices, higher sales volumes) > ∆ Costs
Q:
Should Sippican abandon its overhead cost allocation system and make
managerial decision based on contribution margin; in effect use marginal costs
rather than average costs?
(a) Sippican’s executives should not abandon overhead assignment to products.
The contribution margin is revenues minus variable costs.
 Analysis based on unit contribution margins can be useful for short-term
decisions, such as whether to accept a one-time order when operating
with excess capacity. In this case, management is concerned about
recurring sales.
 Overhead cost is sizable ($654,600, which exceeds either direct labor or
direct material costs)
 Management will benefit by understanding the impact of
variety in the use of overhead resources by individual
products.
 The contribution margin approach, by definition, does not
reveal the different demands that individual products make on
overhead resources (for machine time, engineering design,
setups, receiving, shipping, etc.).
 Companies that cut prices based on contribution margin to get new
business should be cautious about (i) competitive reactions, (ii) having
to lower prices to existing customers, and (iii) filling up capacity with
business that does not pay for capacity costs.
 If a company cuts prices when near capacity, demand could increase
beyond existing capacity. Consequently, the company may end up
having to supply more capacity for support resources to handle the
work, without being paid for supplying these capacity resources.
Using TDABC, only two parameters are needed for each department or process:
1. Calculate capacity cost rates for each department or process
2. Time required by products, orders, services, and customers on the
organization’s capacity resources.
–177–
Atkinson, Solutions Manual t/a Management Accounting, 6E
Q:
Let’s start building the time-driven ABC model. What are the various capacity
cost rates?
(b) Capacity Cost Rates
Cost/
Month
Production and Setup Labor
Machine Expenses
Receiving and Production
Control
Engineering
Packaging and Shipping
Days Used Paid Hrs Nonprod. Prod.
Prod.
Cost
Per Month Per Day Hours
Hrs/Day Hrs/Mo Per Hr
$3,900
$5,400
20
20
7.5
1.5
6.0
12.0
120
240
$32.50
$22.50
$3,900
$9,750
$3,900
20
20
20
7.5
7.5
7.5
1.0
1.5
1.0
6.5
6.0
6.5
130
120
130
$30.00
$81.25
$30.00
Hours Used
Production Volume
DL (Production and
Assembly)
Machine Runs
Machine Setups
Total Machine
Setup Labor
Receiving and Production
Control
Engineers
Packaging and Shipping
Valves*
7,500
Flow
Pumps Controllers*
12,500
4,000
Total
Hours
24,000
2,850
3,750
100
6,250
6,250
600
1,600
1,200
2,700
100
600
2,700
10,700
11,200
3,400
14,600
3,400
25
60
1,033
125
240
1,750
281
600
700
431
900
3,483
*For valves,
DL hours = 7,500 valves × 0.38 DL hours per valve = 2,850
Machine run hours = 7,500 valves × 0.5 machine hours per valve = 3,750
Machine setup hours and labor setup hours (from case) = 100 (= 5 × 20)
Receiving and production hours = 1.25 × 20 production runs = 25
Engineering hours (from case): 60
Packaging and shipping hours = (40 shipments × 50/60) + (7,500 valves × 8/60) =
1,033
–178–
Chapter 5: Activity-Based Cost Systems
For flow controllers:
DL hours = 4,000 × 0.40 =1,600
Machine run hours= 4,000 × 0.30 =1,200
Machine setups (from case) = = 2,700 (= 225 × 12)
Labor setup hours (from case) = = 2,700 (= 225 × 12)
Receiving and production hours = 225 × 1.25 = 281
Engineering (from case): 600
Packaging and shipping hours = (200× 50/60) + (4,000 × 8/60) = 700
The figures for pumps are computed similarly.
Practical and Used Capacity
Resources
DL (Production and
Assembly)
Machines (Runs and
Setup)
Setup Labor
Receiving and
Production Control
Engineers
Packaging and
Shipping
*Rounded
Hours
Avail/
Res. Unit
Res.
Quant.
Hours
Avail.
Hours
Used
Avail − % Cap.
Used Hrs Used
90
120
10,800 10,700
100
99%
62
30
240
120
14,880 14,600
3,600 3,400
280
200
98%
94%
4
8
130
120
520
960
431
900
89*
60
83%
94%
28
130
3,640
3,483
157*
96%
–179–
Atkinson, Solutions Manual t/a Management Accounting, 6E
Let’s assign the costs of these various resources/departments to the flow controller
line:
Total Time
Cost Rate Cost Assigned Unit Cost (4,000)
Machine run time: 1,200
$22.50
$ 27,000
$ 6.75
Set-ups (labor)
2,700
32.50
87,750
21.94
Set-ups (machines) 2,700
22.50
60,750
15.19
Receive/Prod Ctrl 225×(75/60)
281.25
30.00
8,438
2.11
Package & Ship [200×50+4,000×8]/60
700
30.00
21,000
5.25
Engineering
600
81.25
48,750
12.19
Total Overhead
$253,688
$63.42
Direct Labor
52,000
13.00
Direct Materials
88,000
22.00
$393,688
$ 98.42
Revenues
Gross Margin
$380,000
$(13,688)
95.00
($ 3.42)
Hand out sheet of P&L of Sippican. Do you believe the revised P&L?
–180–
Chapter 5: Activity-Based Cost Systems
(c) (Small discrepancies in totals are due to calculations performed in a spreadsheet package.)
Valves:
per unit
costs
Pumps:
per unit
costs
Units
Valves
7,500
Sales
$592,500
$79.00
$875,000
$70.00
Flow
Contr.
4,000
$380,00
0
120,000
92,625
379,875
16.00
12.35
50.65
250,000
203,125
421,875
20.00
16.25
33.75
84,375
3,250
2,250
11.25
0.43
0.30
140,625
19,500
13,500
750
4,875
31,000
126,500
339,125
0.10
0.65
4.13
16.87
45.22
253,375
42.8%
33.78
Materials Expenses
DL Expenses
Contribution Margin
Manufacturing Overhead
Machine Expenses
Setup Labor
Machine Setup**
Receiving and Production
Control
Engineering
Packaging and Shipping
Total Manufacturing Overhead
Total costs
Gross Margin
Gross Margin/Sales %
Selling and Administrative Exps.
Operating Profit
Return on Sales
Pumps
12,500
FCs: per
unit
costs
Total
$95.00
$1,847,500
88,000
52,000
240,000
22.00
13.00
60.00
$458,000
$347,750
$1,041,750
11.25
1.56
1.08
27,000
87,750
60,750
6.75
21.94
15.19
3,750
19,500
52,500
249,375
702,500
0.30
1.56
4.20
19.95
56.20
8,438
48,750
21,000
253,688
393,688
172,500
19.7%
13.80
-13,688
-3.6%
* See the following table.
**Machine Setup unused capacity is included with Machine Expenses unused capacity.
–181–
Unused
Capacity*
Actual
Percent
of Sales
$1,847,500
100%
$3,250
-$3,250
$458,000
$351,000
$1,038,500
56%
$252,000
$110,500
$76,500
$6,300
$6,500
$0
$258,300
$117,000
$76,500
2.11
12.19
5.25
63.42
98.42
$12,938
$73,125
$104,500
$629,563
$1,435,313
$2,663
$4,875
$4,700
$25,038
$28,288
$15,600
$78,000
$109,200
$654,600
$1,463,600
-3.42
$412,188
22.3%
-$28,288
$383,900
20.8%
$350,000
$33,900
1.83%
35%
21%
19%
2%
Atkinson, Solution Manual t/a Management Accounting, 4E
Using the capacity rates and unused capacity hours computed in part (b), the cost
of unused capacity is as follows.
Resources
DL (Production and
Assembly)
Machines (Runs and Setup)
Setup Labor
Receiving and Production
Control
Engineers
Packaging and Shipping
*Rounded
Available −
Used Hrs
Cost/Hr
Cost of
Unused Capacity
100.00
280.00
200.00
$32.50
$22.50
$32.50
$3,250
$6,300
$6,500
88.75
60.00
156.67*
$30.00
$81.25
$30.00
$2,663
$4,875
$4,700
The following table summarizes the difference in reported product costs and
profitability with the traditional cost system that Sippican used previously, and
the time-driven activity-based costing (TDABC). The difference lies in the
assigned manufacturing overhead costs. The traditional method assigns
manufacturing overhead at 185% of direct labor cost, which results in pumps
receiving the greatest overhead per unit, flow controllers the next highest
overhead per unit, and valves the least. Based on the more accurate TDABC
assignment of machine and support expenses, management can see that valves
are even more profitable than they thought; pumps, while not earning the
targeted 35% gross margin, are still strong profit contributors, and flow
controllers – previously thought to be the most profitable product line – actually
lose money because of the high costs of setups, engineering, and shipping. Most
of the engineering work was for the customized flow controllers requested by
customers.
– 182 –
Chapter 4: Activity-Based Cost Systems
Traditional Cost Analysis
Selling price
Valves
$79.00
Pumps
Flow Controllers
$70.00
$95.00
Direct labor cost
Direct material cost
Manufacturing overhead at 185% of
DL cost
$12.35
16.00
22.85
$16.25
20.00
30.06
$13.00
22.00
24.05
Standard unit costs
$51.20
$66.31
$59.05
Gross margin
Gross margin (%)
$27.80
35%
$3.69
5%
$35.95
38%
Time-Driven ABC Analysis
Selling price
Valves
$79.00
Pumps
Flow Controllers
$70.00
$95.00
Direct labor cost
Direct material cost
TDABC overhead
Standard unit costs
$12.35
16.00
16.87
$45.22
$16.25
20.00
19.95
$56.20
$13.00
22.00
63.42
$98.42
Gross margin
Gross margin (%)
$33.78
43%
$13.80
20%
($3.42)
-3.6%
(d)
Yes, the approach can be extended to service companies and much larger
companies than Sippican. The Towerton case in this chapter provides such
an example.
Time-driven activity-based costing reduced some of the barriers associated
with developing and updating the common approach to activity-based
costing, which assigns many resource expenses to activities based on
interviews and surveys. Nevertheless, barriers and difficulties associated
with managing any major change remain. For example, individuals may feel
vulnerable facing uncertainty about what the time-driven activity-based cost
analysis may show. The analysis might reveal that products or customers
– 183 –
Atkinson, Solution Manual t/a Management Accounting, 4E
thought to be very profitable are actually unprofitable, some processes are
inefficient, or there is substantial unused capacity. Individuals may be
concerned that they will then be judged as poor managers, even though they
were making decisions that others would agree were good decisions based
on the cost system that was in place.
(e) The company should reconsider its product strategy and focus on its core
products—valves and pumps. Sippican might attempt to increase market
share in valves by offering discounts for large orders of valves. Furthermore,
Sippican could reduce discounting for pumps, especially for small orders.
Finally, Sippican should aggressively raise prices for flow controllers or
accept orders to produce flow controllers only when the pricing and order
size indicate that they can be sold at a profit; Sippican could establish a
minimum order size.
Sippican can also focus on improving processes. For example, the company
could reduce setup times or schedule production of components for multiple
product orders to share components across multiple batches. These
improvements, in conjunction with the focus on larger orders, should lead to
many fewer production runs and shipments, allowing for the possibility of
reducing capacity and related costs.
This discussion can be carried forward in the same context to include topics
such as the Balanced Scorecard and activity-based budgeting by using the
Sippican B case that follows (case 5-37) and the accompanying PowerPoint
presentation slides.
5-37 Sippican Corporation (B) (HBS Case 9-106-060) (See also the teaching plan
for case 5-36: Sippican Corporation (A) (HBS Case 9-106-058) and the
PowerPoint presentation available to instructors.)
In Sippican (A), the company experiences declining profits and struggles to
understand why it is encountering severe price competition on one product
line. The controller collects data that will enable development of a timedriven, activity-based cost model to explain better the different demands of
each product line on Sippican's indirect and support resources. Applying the
newly estimated capacity cost rates for the resources to the production
statistics of the three product lines produces a radically different perspective
on product line profitability. The (A) and (B) cases together illustrate
– 184 –
Chapter 4: Activity-Based Cost Systems
motivation and design of a time-driven, activity-based system, the action
steps that emerge from a more accurate cost analysis, and a powerful
connection between strategic planning and operational budgeting.
The following figure diagrams the connections among the Balanced
Scorecard and strategic planning, activity-based costing, and activity-based
operational budgeting.
A new integrated approach links strategic planning with operational
budgeting.
SWOT
Activity-Based
Costing
Product and
Customer
Profitability
5 Forces
Model
Develop
Strategy and
Strategy Map
BSC
• Objectives
• Measures
• Targets
• Revenue Growth & Mix
• Productivity and Process
Improvements
Select
Strategic
Initiatives
Strategic Initiative
Expense Budget
Develop Sales
Forecasts
ActivityBased
Budgeting
Propose
Production &
Sales Plans
Resource Plan
Initiative
Management
•
•
•
People
Capital
Support
Budget and
Pro Forma
P&L
Process
Management
Teaching Plan
This case illustrates that fixed (capacity) costs are typically not one big piece
of equipment. Most capacity costs come from having many machines and
many people. These can be adjusted up or down based on forecasts of future
capacity needs. Sippican currently has 62 machines, 120 production
workers, 28 packaging and shipping workers, 4 receiving and production
control workers, and 8 engineers. It is hard to argue that these are all “fixed”
and not avoidable over some not very long time period. While one can have
“fixed” costs with one machine and one indirect worker, 62 machines and
160 employees do not represent a “fixed” cost. But how do these resource
levels and associated costs change as production levels change?
The company uses activity-based budgeting to translate the detailed sales
and production plans into specific demands for labor and machine resources.
Direct labor increases slightly, but setup labor demand drops dramatically
– 185 –
Atkinson, Solution Manual t/a Management Accounting, 4E
because of fewer production runs and reductions in setup time. Small
reductions also occur in indirect labor and engineering time. Activity-based
budgeting is a powerful tool for creating bottoms-up operational budgets.
However, it does require much finer granularity in the sales forecasts and
production plan to estimate the demands for organizational resources,
particularly those performing support functions.
(a)
The planned hours used can be computed based on the data provided
in Exhibit 5-12 and case 5-36 (Sippican (A)):
Valves
Production units
Pumps
10,000
12,000
Time in Hours
3,800
6,000
5,000
6,000
160
192
5,160
6,192
160
192
50
50
Flow
Controllers
2,500
Total
24,500
Total DL hours
1,000 10,800
Total machine run hours
750 11,750
Machine setup hours
480
832
Total machine hours
1,230 12,582
Labor setup hours
480
832
Receiving and
62.5
163
production controla
Engineering hours
60
240
400
700
Packaging and shippingb
1,367
1,658
417
3,442
a
Receiving and Production Control Time Equation:
Valves: 1.25 × 40 production runs = 50 hours; Pumps: 1.25 × 40 = 50 hours
Flow Controllers: 1.25 × 50 production runs = 62.5 hours
b
Packaging and Shipping Time Equation:
Valves: [40 × 50 + 10,000 × 8]/60 = 82,000/60 = 1,367 hours
Pumps: [70 × 50 + 12,000 × 8]/60 = 99,500/60 = 1,658 hours
Flow Controllers: [100 × 50 + 2,500 × 8]/60 = 25,000/60 =417 hours
The units of each resource type needed to meet projected demand
follow (see the Sippican (A) solutions for hours available per resource
unit).
Resources Needed
Direct labor
Setup labor
Machines
Receiving and production
control
Packaging and shipping
Hours Hrs. Avail. per #FTEs
Needed Resource Unit Needed
10,800
120
90.00
832
120
6.93
12,582
240
52.43
163
3,442
– 186 –
130
130
1.25
26.48
Actual
90
7
53
2
27
Chapter 4: Activity-Based Cost Systems
Engineers
(b)
120
5.83
6
If Sippican can reduce its supply of resources to the estimated needs,
Sippican estimated spending and profit next period are as presented in
the following statement. If Sippican cannot reduce its supply of
resources to the minimum needed for projected demand, or if Sippican
wants to preserve some protective capacity, then spending in “Unused
Capacity” will increase.
Sippican (B)
Pro Forma
Sales (units)
Sales revenue
Sales percentage
DL expenses
Material
expenses
Contribution
margin
Machine runtime expense
Machine set-up
expense
Setup labor
Receiving and
production
control
Engineering
Package & ship
Manufacturing
overhead
Total costs
Gross margin
Gross margin %
S&A
Operating profit
Return on sales
(c)
700
Valves
10,000
$ 750,000
38%
$ 123,500
Flow
Pumps
Controllers
12,000
2,500
$ 960,000
$ 275,000
48%
14%
$ 195,000
$ 32,500
Charged
Unused
Capacity
Actual
1,985,000
$1,985,000
$ 351,000
$ 351,000
160,000
240,000
55,000
455,000
455,000
466,500
62%
525,000
55%
187,500
68%
1,179,000
59%
0%
1,179,000
59%
112,500
135,000
16,875
264,375
3,105
267,480
3,600
5,200
4,320
6,240
10,800
15,600
18,720
27,040
260
27,300
1,500
4,875
41,000
1,500
19,500
49,750
1,875
32,500
12,500
4,875
56,875
103,250
2,925
1,625
2,050
7,800
58,500
105,300
168,675
$ 452,175
$ 297,825
40%
216,310
$ 651,310
$ 308,690
32%
90,150
$ 177,650
$ 97,350
35%
475,135
1,281,135
$ 703,865
35%
9,965
$ 9,965
$(9,965)
$ 485,100
$1,291,100
$ 693,900
35%
350,000
$ 343,900
17.3%
If Sippican can reduce the supply of support labor and machines to
budgeted levels, the company will earn a 35% gross margin percent (of
sales) and a 17.3% return on sales, a considerable improvement from the
21% gross margin percent and 2% return on sales of recent experience.
All products now have projected gross margins around the targeted 35%
– 187 –
Atkinson, Solution Manual t/a Management Accounting, 4E
level. Total gross margin increases by almost 81% and operating profit
increases more than ten-fold. The huge profit increase assumes only a
modest increase in unit sales and average selling prices. Although total
units sold increase by only 2%, the company is selling more valves and
fewer flow controllers. The changes in price and volume are projected to
increase sales revenue by 7.4%. The major impact on profit is due to
adjusting the types of orders accepted, and reducing the supply of
resources no longer needed to handle the small unprofitable orders.
A comparison of product line profitability before and after the changes
follows.
– 188 –
Chapter 4: Activity-Based Cost Systems
Sippican (A)
Product Line Profitability
Valves Pumps
Flow
Controllers
7,500 12,500
4,000
$ 79.00 $ 70.00
$ 95.00
12.35
16.25
13.00
16.00
20.00
22.00
$ 50.65 $ 33.75
$ 60.00
Production
Price
Direct labor
Direct materials
Contribution
margin
Cont. margin %
64%
48%
Manufacturing
overhead
Machine
11.25
11.25
expenses
Setup labor
0.43
1.56
Machine setup
0.30
1.08
cost
Receiving and
0.10
0.30
production
control
Engineering
0.65
1.56
Package &
4.13
4.20
ship
Total
$ 16.87 $ 19.95
manufacturing
overhead
Total costs
45.22
56.20
Gross margin
$ 33.78 $ 13.80
GM %
43%
20%
Sippican (B)
Product Line Profitability
Valves Pumps
Flow
Controllers
10,000
12,000
2,500
$ 75.00 $ 80.00
$ 110.00
12.35
16.25
13.00
16.00
20.00
22.00
$ 46.65 $ 43.75
$ 75.00
63%
62%
55%
68%
6.75
11.25
11.25
6.75
21.94
15.19
0.52
0.36
0.52
0.36
6.24
4.32
2.11
0.15
0.13
0.75
12.19
5.25
0.49
4.10
1.63
4.15
13.00
5.00
$ 63.42
$ 16.87
$ 18.03
$ 36.06
98.42
$ (3.42)
-4%
45.22
$ 29.78
40%
54.28
$ 25.72
32%
71.06
$ 38.94
35%
– 189 –
Atkinson, Solution Manual t/a Management Accounting, 4E
5-38 (a)
Practical capacity for the personnel resources is calculated as follows:
Brokers
Account
Managers
Financial
Planners
Principals
Customer
service
representatives
Paid
Hours
per
Day
8
Nonpro- Productive
ductive
Hours per
Hours per
Day
Day
1.5
6.5
Days
Used
per
Month
20
Practical
Capacity
Hours per
Month
130
8
1.5
6.5
20
130
8
8
1.5
1.5
6.5
6.5
20
20
130
130
8
1.0
7.0
20
140
Capacity cost rates are calculated as follows:
Cost Per
Person Per
Month
Practical
Capacity
Hours Per
Month
Capacity
Cost Rate
Brokers
$ 6,787
130
$ 52.21
Account Managers
Financial Planners
$ 8,954
$ 8,828
130
130
$ 68.88
$ 67.91
Principals
Customer service
representatives
$ 12,932
130
$ 99.48
$ 4,192
140
$ 29.94
– 190 –
Chapter 4: Activity-Based Cost Systems
(b)
A summary table of time utilization appears below, and supporting
computations appear in the subsequent table.
Time
Mutual
Utilization
Stock
Fund
Account
Financial
a
(Hours)
Trading Trading Management Planning
Brokers
27,226
2,704
Account
Managers
2,080
Financial
Planners
2,154
Principals
2,643
262
418
130
Customer
service
representatives
4,086
1,007
207
129
a
Computations are shown below.
Minutes of activity per month are calculated as follows and then divided
by 60 to arrive at the time utilization in hours in the table above:
Minutes of
Activity Per
Month
Brokers
New accounts
(minutes for new
accounts opened)
Existing accounts
(minutes for
transactions)
Meetings with
existing accounts
(minutes for
meetings)
Total minutes
Account
Managers
New accounts
(minutes for new
Stock Trading
Mutual Fund
Trading
595× 60 =
35,700
255× 60 =
15,300
305,288 × 5 =
1,526,440
26,325 × 5 =
131,625
3570 × 20 =
71,400
1,633,540
765× 20 =
15,300
162,225
Account
Management
175 × 240
= 42,000
– 191 –
Financial
Planning
Atkinson, Solution Manual t/a Management Accounting, 4E
accounts opened)
Existing accounts
(minutes for
transactions)
Meetings with
existing accounts
(minutes for
meetings)
Total minutes
Financial
Planners
New accounts
(minutes for new
accounts opened)
Existing accounts
(minutes for
transactions)
Meetings with
existing accounts
(minutes for
meetings)
Total minutes
Principals
New Accounts
(minutes for new
accounts opened)
Existing Accounts
(minutes for
transactions or
accounts)
Total minutes
Customer Service
New accounts
(minutes for new
accounts opened)
Existing accounts
(minutes for calls)
Total minutes
5,400 × 10
= 54,000
480 × 60 =
28,800
124,800
130 × 600 =
78,000
569 × 90 =
51,210
129,210
595 × 10 =
5,950
255 × 10 =
2,550
175 × 20 =
3,500
130 × 60 =
7,800
305,288 × 0.5
= 152,644
158,594
26,325 × 0.5
= 13,163
15,713
5,400 × 4 =
21,600
25,100
7,800
595 × 12 =
7,140
47,600 × 5 =
238,000
245,140
255 × 12 =
3,060
11,475 × 5 =
57,375
60,435
175 × 18 =
3,150
1,320 × 7 =
9,240
12,390
130 × 18 =
2,340
540 × 10 =
5,400
7,740
– 192 –
Chapter 4: Activity-Based Cost Systems
(c)
A summary table of MIPS usage during peak and non-peak hours
appears below, and sample computations appear in the subsequent table.
MIPS
Usage
Stock
Trading
Mutual
Fund
Trading
Account
Management
Financial
Planning
Peak
Nonpeak
465,913
30,200
96,783
11,823
604,718
668,800
99,358 105,986
72,212
11,860
289,415
334,400
Total*
Available
Productive
Time
*The small discrepancies in the totals are due to rounding in the previous
columns.
MIPS usage during peak and non-peak hours is calculated by
multiplying MIPS per transaction by the number of transactions during
peak and non-peak hours, respectively. The computations for stock
trading appear below. The other computations are similar.
Transactions
Processed by
Servers
Number of
Transactions:
Stock Trading
MIPS Per
Transaction
Peak
Order placements,
trades and order
clearing and
settlement activities
Account balance
inquiries
Quotation requests
Balance transfers
Account statement
preparation
Total
MIPS for Stock
Trading
NonPeak
Peak
NonPeak
1.4
305,288
0
427,403
0
0.1
0.1
0.7
52,695
332,400
0
23,730
177,100
75,000
5,270
33,240
0
2,373
17,710
52,500
0.9
0
690,383
29,750
305,580
0
465,913
26,775
99,358
Note: The cost of MIPS usage is provided in this case but the calculation
can be assigned as an additional exercise, assuming the servers can
process 50 MIPS per hour. The calculation for peak and non-peak usage
is as follows:
– 193 –
Atkinson, Solution Manual t/a Management Accounting, 4E
Each server is available for (22 days) × (24 hours per day) = 528 hours
per month. The average cost per hour is therefore $3,168/528 hours = $6
per hour. Non-peak-hour usage accounts for (19 servers) × (16 hours per
day) = 304 hours per day. Peak-hour usage accounts for (76 servers) × (8
hours per day) = 608 hours per day. Moreover, the 57-server excess
capacity during non-peak hours exists because of the peak-hour need.
Therefore the cost of the excess capacity of 57 × 16 hours = 912 hours
should be charged to peak-hour users. Thus, the peak-usage hourly rate
is $6 × (608 + 912)/608 = $15 per hour.
The non-peak cost per MIPS is $6/50 = $0.12 and the peak cost per
MIPS is $15/50 = $0.30, as stated in the case.
(d)
An income statement showing rounded costs and profits in thousands for
each of Towerton’s four product lines, as well as the cost of unused
capacity, appears below, with sample calculations following. The small
discrepancies in the totals and margins are due to rounding.
(000s)
Sales
Costs:
Brokers
Account
Managers
Financial
Planners
Principals
Customer
service
reps.
Computer
server
expenses
Total Costs
Margin
Margin %
S, G & A
Operating
Income
Operating
Margin
Stock
Trading
$2,687
Mutual
Fund
Trading
$ 1,091
1,421
141
Account
Manage
-ment
$ 90
Financial
Planning
$156
143
Total
Used
$4,024
Unused
Capacity
Total
Supplied
$4,024
1,563
(2)
1,561
143
18
161
263
26
0
42
146
13
146
344
30
44
177
388
122
30
6
4
163
14
176
152
1,958
22
219
38
229
5
168
216
2,574
25
129
241
2,704
$ 728
27%
$ 872
80%
$ (139)
-154%
$ (12)
-8%
$1,450
36%
$ (129)
-3%
$1,320
33%
1,300
$20
0.5%
– 194 –
Chapter 4: Activity-Based Cost Systems
Stock trading sales = $8.80 × 305,288 = $2,686,534.
Mutual fund trading sales = $41.45 × 26,325 = $1,091,171.
Account management sales = 1.5% × $60,000 × 1,200/12 = $90,000.
Financial planning sales = (130 × $1,200) + ([90/60] × $125) =
$156,188.
The personnel costs are computed by multiplying the capacity cost rates
in part (a) by the hours of time utilization in part (b).
The computer server expenses are calculated by multiplying the peakusage MIPS by $0.30 and the non-peak-usage MIPS by $0.12. For
example, the computation for stock trading is (465,913 × $0.30) +
(99,358 ×$0.12) = $151,697 (rounded).
The costs in the “total supplied” column are computed as follows:
Cost Per
Resource
Month
Number of
Resources
Brokers
$ 6,787
230
$1,561,010
Account Managers
Financial Planners
$ 8,954
$ 8,828
18
20
$ 161,172
$ 176,560
Principals
Customer service
representatives
Computer server
expenses
Total
$12,932
30
$ 387,960
$ 4,192
42
$ 176,064
$ 3,168
76
$ 240,768
$2,703,534
Total Cost
The core stock trading and mutual fund trading product lines are
profitable, with mutual fund trading highly profitable. In contrast, the
new product lines, investment account management and financial
planning, are unprofitable; investment account management is highly
unprofitable, with a return on sales of –154%. The large differences in
profits across the product lines are due in part to the high cost of
personnel (account managers and principals for account management,
and financial planners for financial planning) in proportion to product
– 195 –
Atkinson, Solution Manual t/a Management Accounting, 4E
line sales for the unprofitable product lines. In addition, computer server
expenses are 41.9% of sales for account management. This percentage is
far greater than for any of the remaining product lines. (See the table
below.)
Costs as a Percent of Own Product Line Sales
Stock
Trading
Brokers
Account
Managers
Financial
Planners
Principals
Customer
service
representatives
Computer
server expenses
Total
(e)
Mutual
Fund
Trading
Account
Management
Financial
Planning
52.9%
12.9%
0.0%
0.0%
0.0%
0.0%
159.2%
0.0%
0.0%
9.8%
0.0%
2.4%
0.0%
46.2%
93.6%
8.3%
4.6%
2.8%
6.9%
2.5%
5.6%
72.9%
2.0%
20.1%
41.9%
254.2%
3.2%
107.6%
Towerton’s management team could specify a minimum accounting
balance for investment account management and reprice its financial
planning services. Management could also consider raising prices on
stock trading and placing a greater emphasis on mutual fund trading,
which is its most profitable product line.
– 196 –