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CHAPTER 5: ACTIVITY-BASED COSTING AND MANAGEMENT

QUESTIONS
5-1

Product costs are likely being distorted when a firm uses a plantwide or
departmental overhead rate if the plant or department engages in more than one
activity in its operations and not all activities consume overhead in the same
proportion. The more diverse the product mixes of the plant or department are in
volume, sizes, manufacturing processes, or product complexities the plant or
department, the worse cost distortions are likely to be in using a plantwide or
departmental overhead rate to assign overhead costs to cost objects.

5-2

Undercosting a product may appear to have increased the reported profit the
product earned (assuming the firm did not lower its selling price because of the
reported lower product cost). However, the increased profit is, at best, a twist in
truth. Costs of the product not charged to the product itself are borne by other
products of the firm.
Worse, undercosting a product may result in managers erroneously believing the
product to be more profitable than other products and shifting the limited
resource the firm has into manufacturing, promotion, and sales of the product
when, in fact, other products are more profitable to the firm. Severe cost
distortions may lead firms not to drop unprofitable products because the cost data
show these products are profitable.

5-3

Overcosting does not increase revenues. A firm can increase the selling price of
a product, thereby increaseing the total revenue from the product only if the
market allows. Increases in the selling price of a product without experiencing
noticeable decrease in the sales quantity of the product is likely an indication
that the product was not priced properly, which might be a result of undercosting
of the product.
Furthermore, overcosting a product is likely accompanied by undercosting of
the firms other products and, as a result, underpricing of one or more of the
firms other products.
When a firm sets a high selling price that is a result of overcosting, competitors
also are likely to enter the market and take away the firms market share. A firm
also may drop or de-emphasize an erroneously overcosted product when it
erroneously believe the product is either unprofitable or having a low-margin.

Solutions Manual

5- 1

5-4

Activity-based costing recognizes that resources are spent on activities and the
cost of a product or service is the sum of the costs of activities performed in
manufacturing the product or providing the service.
Activity-based costing system traces costs to the activity that consume resources.
Costs are determined based on the activities performed for cost objects and their
underlying cost drivers that consume resources. Product or service costs
determined using an activity-based costing reflect costs of resources consumed
for activities performed in manufacturing products or providing services. In
contrast, a volume-based costing system uses cost allocations to channel indirect
costs to products or services. As a result, the cost of a product or service often
bears little or no relationship to activities performed in the manufacturing of the
product or service.

5-5

Based on the activities of most manufacturing firms, the general levels of cost
hierarchy of an activity-based costing system are:
Unit-level cost;
Batch-level cost;
Product-sustaining cost; and
Facility-sustaining cost.

5-6

In an activity-based costing system, the second-stage procedure in tracing costs


to products or services is a process by which the costs of activities or activity
pools are assigned to cost objects using one or more appropriate activity
consumption cost drivers.

5-7

All firms should use ABC system when the benefits of such a system exceed the
costs of implementing it. It is especially beneficial to firms with product diversity
and/or process complexity.

5-8

Unit-level activities are activities performed on individual units of product or


service. The frequency of a unit-level activity varies in proportion with the units of
product manufactured or service provided.
Examples of unit-level activities are using direct materials, using direct labor
hours, inserting a component, inspecting each unit, and consuming power to run
machines.

5-9

Batch-level activities are activities performed for a group of units of products or


services rather than for each individual unit of product or service. The frequency
of batch-level activity is determined by both the size of the group and the total
number of units to be manufactured or provided.
Examples of batch-level activities are setting up machine, processing and placing
of purchase orders, scheduling production runs, inspecting products by batch,
and handling materials.

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5-10

Production sustaining activities are activities undertaken to support individual


products or services rather than for each individual unit of product or service or a
group of individual units of products or services.
Examples of product-sustaining activities
administration, and product modification.

5-11

include

product

design, parts

Facility-sustaining activities are activities performed for the entire organization or


division to meet the required operating procedure or support the operation of the
organization or division.
Examples of facility-sustaining activities include providing security for the facility,
maintaining general equipment and facility, plant management, plant
depreciation, and property taxes and insurance premium for facilities.

5-12 A product-costing system that uses a single volume-based cost driver is likely to
overcost high-volume products because high-volume products do not consume
support resources in proportion to their production volumes. As a result, a
product-costing system that uses a single volume-based cost driver often
overcosts high-volume products or services and undercosts low-volume products
or services.
The subsidizations low-volume products by high-volume products is likely to lead
the firm not to price its products properly and poor management planning and
control of the firms resources. This may also decrease the profits of the firm and
reduce managements confidence in the product cost predictions. Poor pricing
can lead a firm to promote less profitable products while not spending sufficient
resources on more profitable items.
5-13 Activity-based management is the uses of an activity-based costing database to
improve operations, increase customer values, and enhance profitability.
5.14

Examples of high-value-added activities include insertion of parts, assembling of


components, machining to meet specification, reducing response time, and
reduction of defective characteristics.

5.15

Examples of low-value-added activities include moving parts between


workstations, transporting finished units to warehouse, waiting for materials or
parts to arrive, inspecting, repairing, and storing.

5.16

Service organizations such as banks, hospitals, transportation companies, law


firms, and trading companies can use activity-based costing and management in
all phases of their operations as manufacturing firms do. For example, a bank can
use ABC to calculate the cost to process check, a hospital can use ABC to
determine costs per patient day for different kinds of patients and the cost to
admit a patient, etc.
Opportunities afforded by customer profitability analysis are:
Providing better services to highly profitable customers;

5.17

Solutions Manual

5- 3

Identifying and securing highly profitable customers from competitors;


Setting prices based on the cost to serve;
Negotiating with customers to set mutually beneficial levels of services;
Transforming unprofitable customers into profitable ones through targeted
negotiations on price, quantity, product mix, order processing, delivery terms,
and payment arrangements;
Identifying and conceding permanent loss customers to competitors.
5-18 Important factors in conducting customer revenues analyses include:
price discounting,
sales terms,
sales returns and allowances, and

time-lengths customer accounts remain outstanding.


5-19 General customer costs categories are:
Customer unit-level cost resources consumed for each unit sold. Examples
are sales commission for each unit sold and shipping cost per unit when the
freight term is FOB destination and the freight charge is based on the number
of units shipped.
Customer batch-level costs resources consumed each time a sale occurs.
Examples include order-processing costs and invoicing costs.
Customer-sustaining costs resources consumed to service a customer
regardless of the number of units or batches sold. Examples are salespersons
travel costs to visit customers, monthly statements processing costs, and late
payment collection costs.
Distribution-channel costs resources consumed in each distribution channel
the firm uses to serve customers. Examples are operating costs of regional
warehouses serving major customers and centralized distribution centers
serving small retail outlets.
Sales-sustaining costs resources consumed to sustain sales and service
activities that cannot be traced to individual unit, batch, customer, or
distribution-channel. Examples are general corporate expenditures for sales
activities and salary, fringe benefits, and bonus of the general sales manager.

Blocher, Chen, Cokins, Lin: Cost Management, 3e

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EXERCISES
5-20 Activity Levels (5 min)
1. Cost Hierarchy

f.

Product-sustaining

a.

Unit-level

g.

Facility-sustaining

b.

Unit-level

h.

Facility-sustaining

c.

Facility-sustaining

i.

Batch-level

d.

Unit-level

j.

Batch-level (one bag per

e.

Unit-level

customer).

2. Cost Driver
a.

Number of hamburgers

b.

Number of hours

c.

Square feet

d.

Number of hamburgers; Size of hamburgers

e.

Number of hamburgers

f.

Number of time the advertising is run

g.

Number of hours store is open

h.

Square feet

i.

Number of coupon redeemed; Number of multiple orders; Number of


hamburgers

j.

Number of customers

Solutions Manual

5- 5

5-21 Activity Levels and Cost Drivers (5 min)


1. Activity Levels
a. Unit-level

f. Facility-sustaining

b. Batch-level

g. Product-sustaining

c. Batch-level

h. Product-sustaining

d. Batch-level; Product-

i. Unit-level; Batch-level

sustaining

j. Batch-level

e. Product-sustaining
2. Cost Drivers
a. Machine hours
b. Number of setups or setup hours
c. Number of production orders
d. Number of material receipts; Number of purchase orders
e. Number of products
f. Number of machine hours
g. Number of engineering change notices; number of modifications;
Number of products
h. Number of parts; Number of products; Number of purchase orders
i. Number of inspection hours; Number of units; Number of batches
j. Number of loads; Number of material moves; Material weights

5-22 Activity Levels and Cost Drivers (5 min)


1. Activity Levels
a. Product-sustaining

f.

Batch-level

b. Product-sustaining

g. Unit-level

c. Product-sustaining

h. Facility-sustaining

d. Product-sustaining

i.

Product-sustaining

e. Batch-level

j.

Facility-sustaining

2. Cost Drivers
a. Number of products
b. Number of products
c. Number of products
d. Number of products
e. Number of batches or setups
f. Number of batches
g. Number of units
h. Purchase costs; Replacement costs; Book values
i. Number of purchase orders; Number of products; Number of suppliers
j. Square feet

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5-23 Activity Levels and Cost Drivers - Service Company (15 min)
1. Output unit-level costs:
a. Salaries and wages of lab technicians
b. Equipment-related costs

$1,200,000
$ 300,000

These costs are likely to vary with the number of test-hours, which are
functions of the output units (test).
Batch-level costs:
c. Setup costs
$240,000
Setup costs are incurred each time a batch of tests is setup for either ST or
PRT, regardless of the number of hours of the tests.
Product-sustaining costs: d. Costs of test designs
$360,000
These costs are incurred in designing ST and PRT tests, regardless of the
number of test-hours or number of batches tested.
2. As shown in the calculation below, the current costing system of charging
$70 per test-hour for overhead undercosts soil test (ST) and overcosts
pesticide residues test (PRT). One reason is that ST uses more setup costs
and test design costs than PRT does, while ST has lower test hours than
PRT. On average, ST tests take longer to setup (0.85 versus 0.575 setup
hour per test hour) and it is more difficult to design the test (0.58 versus
0.21 setup hour per test hour)

ST
PRT

Test-Hour
10,000
20,000

Setup Hour
Total
Per Test-Hour
8,500
0.850
11,500

0.575

Test Design Hour


Total
Per Test-Hour
5,800
0.58
4,200

0.21

5-23 (Continued)
3.

Test hour
Salaries and Wages
Equipment-related
costs*
ST
PRT
Setup costs#
ST
PRT
Test design costs&
ST
PRT
TOTAL
*Equipment-related
costs
Test hours
Per test hour
Total
#
Setup costs:
Setup hours
Per hour
Total
&
Test design costs:
Test design hours
Per hour
Total

ST
Total Per Hour
10,000
$540,000 $54.00
100,000
102,000
208,800
________
$950,800

PRT
Total
Per Hour TOTAL
20,000
30,000
$660,000 $33.00 $1,200,000

$10.00
200,000

$10.00

138,000

$6.90

$20.88
______
151,200
$95.08 $1,149,200

7.56
$57.46

$10.20

10,000

20,000

100,000

200,000

8,500

11,500

102,000

138,000

5,800

4,200

208,800

151,200

Blocher, Chen, Corkin, Lin: Cost Management

5-6

$300,000
30,000
$10
$240,000
20,000
$12.00
$360,000
10,000
$36.00

The McGraw-Hill Companies, Inc., 2005

5-23 (Continued-2)
4.
ST
Total
Per Hour
2,500
$135,000 $54.00

PRT
Total
Per Hour TOTAL
5,000
7,500
$165,000
$33.00 $300,000

Test hour
Salaries and Wages
Equipment-related costs*
ST
100,000 $40.00
PRT
200,000
#
Setup costs
ST
255,000 $102.00
PRT
$345,000
&
Test design costs
ST
522,000 $208.80
PRT
_________ _______
378,000
TOTAL
$1,012,000 $404.80 $1,088,000
*Equipment-related costs:
Test hours
Per test hour
Total
#
Setup costs:
Setup hours
Per hour
Total
&
Test design costs:
Test design hours
Per hour
Total

2,500

5,000

100,000
$240,000 $360,000
8,500

200,000

255,000
$360,000 $540,000
5,800

345,000

522,000

11,500

4,200

$40.00
$69.00
$75.60
$217.60
$300,000
7,500
$40
$600,000
20,000
$30.00
$900,000
10,000
$90.00

378,000

The cost per test-hour increased from $95.08 to $404.80 for ST and from $57.46
to $217.60 for PRT. Platte Valley needs to reexamine the appropriateness for
using test-hour as the basis for costing. The bulk of the cost is for setup and testdesign and the direct cost related to test-hour is only a fraction of the setup and
test-design costs. A costing system based on the direct test-hour is likely to
distort the true cost of testing.

5-24 Volume-Based Costing vs. ABC (20 minutes)


1. The volume-based cost system developed for inventory valuation is likely
to distort product cost information because the cost system:
a. is designed to value inventory in the aggregate and not related to
product cost information.
b. uses a common departmental or plantwide measure of activity, such
as direct labor hours or dollars (now a small portion of overall
production costs) to distribute manufacturing overhead to products.
c. de-emphasizes long-term product analysis (when fixed cost become
variable costs).
d. causes managers, who are aware of distortions in the volume-based
system, to make intuitive, imprecise adjustments to the volume-based
cost information without understanding the complete impact.
2. Outlined below are the purpose and several characteristics of the three
noted cost systems.
a. Inventory Valuation
Meets external reporting requirements for aggregate balance sheet
valuation and income determination.
Provides monthly and quarterly reporting.
b. Operational Control
Evaluates operations to quickly detect problems to allow implementation
of corrective action.
Compares costs against budget for monitoring variances.
c. Activity-based costing
Differentiates costs between high-value added and low-value-added
activities.
Costs products according to activities involved in the production process.

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5-24 (Continued)
3. The benefits that management can expect from activity-based costing
include these:
a. Leads to a more competitive position by evaluating cost drivers, i.e.,
costs associated with the complexity of the transaction rather than the
production volume.
b. Streamlines production processes by reducing low-value-added
activities, e.g., reduced set-up times, optional plant layout, and
improved quality.
c. Provides management with a more thorough understanding of product
costs and product profitability for strategies and pricing decisions.
4. The steps that a company, using a volume-based cost system, would take
to implement activity-based costing include:
a. evaluation of the existing system to assess how well the system
supports the objective of an activity-based cost system.
b. identification of the activities for which cost information is needed with
differentiation between value added and low-value-added activities.
(CMA 6/90, Part IV No. 5)

5-25 Activity-Based Costing Hakara Company (10 min)


Cost Pools

Activity Costs

Machine setup

$360,000

Cost Drivers

Overhead Rate

3,000 setup hours

$120

Materials handling 100,000

25,000 pounds

Electric power

40,000 kilowatt hours

40,000
A

Direct materials

$40,000

Direct labor
Factory overhead:
Machine setup

$50,000

24,000
$120 x 200 =

24,000

.
40,000

$120 x 240 =

28,800

Materials handling

$4 x 1,000= 4,000

$4 x 3,000 =

12,000

Electric power

$1 x 2,000 =

$1 x 4,000 =

4,000

2,000

Total product costs

$94,000

$134,800

Production units

20,000

COST PER UNIT

Blocher, Chen, Corkin, Lin: Cost Management

4,000

$23.50

5-6

$6.74

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5-26 Service Industry GWS Hospital (10 min)


1.GWSs ICU overhead costs for the month of June using:
a. Hospital Wide Rate Based on Nurse-Hours
Per nurse-hour:

$69,120,000 /1,152,000 =

Total ICU applied overhead costs:

$60 x 5,900 =

$60
$354,000

b. The ICU Department Wide Rate Based on Patient-Day


Total budgeted ICU overhead:
$810,000 + $422,500 + $457,500 = $1,690,000
Overhead rate per patient-day:
$1,690,000 / 845 =

$2,000

Total ICU applied overhead costs: $2,000 x 870 = $1,740,000


c. Activity Cost Driver Rates
Budgeted
Cost Pool
Beds

Budgeted
Cost
$810,000

Activity
900

Budgeted
OH Rate
$900.00

Total
Applied
Activity Overhead
900
$810,000

Equipment

422,500

845

500.00

870

435,000

Personnel

457,500

6,000

76.25

5,900

449,875

Total applied overhead costs

$1,694,875

2. The first method uses a hospital-wide overhead rate, which likely bears
no relationship with the overhead activities performed in the intensive
care unit (ICU). The second method uses the patient-day overhead rate
for the ICU department. This is an improvement over the first method.
But a single patient-day cost driver may not have direct relationships with
some of the activities performed in the ICU department. The third method
is the preferred method because it uses a cost driver for each of the cost
pools that reflects the resources consumed by activities of the cost pool.

5-27 PRODUCT SELECTION (5 min)


Before deciding on which of the two products the firm should focus,
the company should review its costing system. It is likely that Johans
product costing system is providing misleading cost information. The
company is probably using a volume-based product costing system,
which tends to overcost the high-volume product (Desktop Computer)
and undercost the low-volume product (Tablet Computer). When
competitors can sell a product at a price ($380) much lower than our
cost ($660), it is likely that Johans costing system fails to determine
product costs properly or that applied manufacturing process is very
inefficient.
The company should install an activity-based product costing system.
If the reported product cost indicates that the price of the high-volume
desktops is too high compared to the competitors price, then the
company should adjust the price accordingly.

Blocher, Chen, Corkin, Lin: Cost Management

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5-28 High-value-added and Low-value-added ActivitiesRadiology (5 min)


(Note to instructor: Answer may vary if students perceive a different
operation)
a. High-value-added
b. Low-value-added (Patients are likely to perceive waiting to have lowvalue
c. Low-value-added (Any need for lab work should have been determined
prior to arriving at the Radiology Department)
d. Low-value-added
e. High-value-added
f. High-value-added
g. Low-value-added
h. Low-value-added
i. High-value-added

5-29 High-value-added and Low-value-added ActivitiesNurse (5 min)


(Note to instructor: Answer may vary if students perceive a different
operation)
a. High-value-added

f. High-value-added

b. High-value-added

g. High-value-added

c. High-value-added

h. Low-value-added

d. Low-value-added

i. High-value-added

e. Low-value-added

5-30 High-value-added and Low-value-added Activitiese-Retailing (5 min)


(Note to instructor: Answer may vary if students perceive a different
operation)
a. Low-value-added

e. Low-value-added

b. Low-value-added

f. High-value -added

c. Low-value-added

g. Low-value-added

d. Low-value-added

h. High-value -added

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5-31 PLANTWIDE OR DEPARTMENTAL OVERHEAD RATE (20 min)


Requirement 1
Client
B&J Cream
Partner
Senior Consultant
Consultant
Total for professional time
Support activities (40%)
Total billed
Mini Mart
Partner
Senior Consultant
Consultant
Total for professional time
Support activities (40%)
Total billed

# of Hours Hourly Rate Total Amount Billed


50
30
20
100

$800
$400
$200

$40,000
12,000
4,000
$56,000
22,400
$78,400

10
30
60
100

$800
$400
$200

$8,000
12,000
12,000
$32,000
12,800
$44,800

5-31 (Continued)
Requirement 2
Client
# of Hours Hourly Rate Total Amount Billed
B&J Cream
Partner
50
$800
$40,000
Senior Consultant
30
$400
12,000
Consultant
20
$200
4,000
Total for professional time
100
$56,000
Support activities ($60 per hour)
6,000
Total billed
$62,000
Mini Mart
Partner
10
Senior Consultant
30
Consultant
60
Total for professional time
100
Support activities ($60 per hour)
Total billed

$800
$400
$200

$8,000
12,000
12,000
$32,000
6,000
$38,000

3. Charging 40 percent of the professional time billed as in requirement 1


assumes that a professional at a higher rank with higher salaries and
wages demands more support activities or services of support staff.
Charging a flat rate per professional hour for support activities as in
requirement 2 assumes that the amount of support activity is a function
of number of professional hours spent on the project.
The most fair system is to charge clients for the actual support
activities. The amount of support activities such as research, phone
calls, copying, faxing, and emailing is likely to differ for different clients.
However, this system requires MPA to install a tracking system for
support activities. Unless MPA can justify the additional time and cost
based on the benefit from the new system, it is unlikely MPA will change
its billing system.

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5.32 PLANTWIDE OVERHEAD RATE (20 min)


1.
Budget Data
Machine Hours Total Overhead
10,000
$3,600,000

Department
Engineering
Precision tooling

30,000

1,800,000

Molding and fabrication

120,000

2,400,000

Total

160,000

$7,800,000

Plantwide overhead rate:


$7,800,000 160,000 = $48.75 per Machine Hour
2. & 3.
Answer for 2
Customer
Dellway Computer
Leland Motors
PH Company
Total

Answer for 3

Machine
Total
Number
Hour
Overhead
of Unit
4,000 $ 195,000 500,000
8,000
390,000
40,000
148,000
7,215,000 200,000
160,000 $7,800,000

Overhead
Per Unit
$ 0.390
9.750
36.075

5.33 DEPARTMENTAL OVERHEAD RATE (20 min)


1.

Department Rates
Department

Budgeted
Activity
Cost

Cost Driver

Overhead
2.
Rate

Engineering

Engineering hours

30,000 $ 3,600,000

$120.00

Precision Tooling

Direct Labor hours

96,000 $ 1,800,000

$18.75

120,000 $ 2,400,000

$20.00

Molding & Fabrication Machine hours


Total

$7,800,000
Total manufacturing overhead for each of the three customers:

Customer
Engineering
Dellway
24,000 x $120 =
Computer
$2,880,000
Leland
2,400 x $120 =
Motors
$288,000
PH
3,600 x $120 =
Company
$432,000
Total

Activity Hours
Total
Direct Labor
Machine
Overhead
2,000 x $18.75 =
3,000 x $20 =
$37,500
$60,000 $2,977,500
84,000 x $18.75 =
6,000 x $20 =
$1,575,000
$120,000 $1,983,000
10,000 x $18.75 = 111,000 x $20 =
$187,500
$2,220,000 $2,839,500

$3,600,000

$1,800,000

$2,400,000 $7,800,000

3. Manufacturing overhead per unit:


Customer
Dellway Computer

Total Overhead

Number of Unit

Overhead Per Unit

$2,977,500

500,000

$ 5.9550

Leland Motors

1,983,000

40,000

49.5750

PH Company

2,839,500

200,000

14.1975

Total

$7,800,000

Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

5-33 (Continued)
4. Summary of results:
Customer
Dellway Computer
Leland Motors
PH Company

Plantwide Rate
Total
Per Unit
$195,000
$0.3900
$390,000
9.7500
$7,215,000
36.0750
$7,800,000

Department Rates
Total
Per Unit
$2,977,500
$5.9550
1,983,000
49.5750
2,839,500
14.1975
$7,800,000

Dellway Computer is a heavy user of Flexmetals engineering hours and


uses almost next to nothing of machine hours. When Flexmetal uses
machine hours to calculate charges for overhead, the overhead cost per unit
manufactured for Dellway Computer is only $0.39. In effect, other customers
subsidize Dellway Computer when the firm uses machine hours to allocate
manufacturing overhead.
The subsidization is evident in the manufacturing overhead charged to
Leland Motors. The manufacturing of products for Leland requires mostly
direct labor hours and very few machine hours. As a result the
manufacturing overheads charged to the work for Leland Motors based on
the plantwide rate of $9.75 per machine hour while the overhead rate based
on departmental rates is $49.575 per unit.

5-34 ABC and Job-Costing (10 min)


A:

$0.15 x 30 =

$ 4.50

B:

$37 1.85 =

$20.00

C:

$35.50 5 =

$ 7.10

D:

$0.08 x 100 =

$ 8.00

Cost per board that passed the final inspection

$240.00

Rejection rate

Cost per completed board

50%
$120.00

Direct materials

$25.00

Direct labor

5.00

Other manufacturing overhead:


Axial insertion

$ 4.50

Hardware insertion37.00
Hand load

35.50

Masking

8.00

85.00

115.00

Manufacturing overhead for final test (E)

Units of cost driver for final test


Manufacturing overhead rate per unit of test time(F)

Blocher, Chen, Corkin, Lin: Cost Management

$5.00

5-6

10
$0.50

The McGraw-Hill Companies, Inc., 2005

5.35COST OF MEAL-PLANTWIDE (5 min)


Below is Annies response:
Dear Totem Pole: If these are business-related dinners, you should talk to
your accountant about deducting them from your expenses or billing your
share to the clients. If that isnt feasible, agree to meet these folks for
cocktails, but beg off before dinner, claiming you have to be elsewhere. No
other excuse is needed.
Note: This example illustrates the advantages of ABC in a familiar
situation. Put all in one check and then split the bill equally is an example
of plantwide overhead rate. Split-up the bill based on the number of meals
is like using machine hours, labor hours, or other measures, rather than
the activities themselves, to determine costs of products or services.
Products having the same total machine hours pay for the same amount of
overheads, regardless of the differences in the amount of setup times,
product design hours, etc. these products might have used.
Having separate checks is an ABC system. Each check tracks
activities of an activity cost center. The person engages in more activities
drinks or eats more than others pays a higher bill.

5-36 PRODUCT-LINE PROFITABILITY, ABC (20 min)


1. Product-line profitability under the current costing system
Frozen Food Baked Goods Fresh Produce
Sales

$120,000

$90,000

$158,125

105,000

67,000

110,000

$ 15,000

$23,000

$ 48,125

24,000

18,000

31,625

($ 9,000)

$ 5,000

$ 16,500

-7.50%

5.56%

10.43%

Cost of goods sold


Gross margin
Store support (20% of Sales)
Operating income
Operating margin (OI/S)

2. Product-line profitability under ABC


Frozen Food Baked Goods
Sales

$120,000

$90,000

$158,125

105,000

67,000

110,000

$ 15,000

$23,000

$ 48,125

800

4,400

7,200

1,100

7,700

13,200

300

525

7,200

6,000

8,000

17,200

8,200

20,625

44,800

$ 6,800

$ 2,375

5.67%

2.64%

Cost of goods sold


Gross margin

Fresh Produce

Store support:
Order processing
Receiving
Shelf-stocking
Customer support
Total store support cost
Operating income
Operating margin (OI/S)

3,325
2.10%

3. Both baked goods and fresh produces drop in profitability when ABC is used.
The decrease in profitability of fresh produce is most noticeable. The
profitability of fresh produce decreases from 10.43 percent of the sales
revenues under the current system, the highest of the three products, to 2.10
percent under ABC, the lowest of the three. This is because fresh produce
requires more support activities than the other two products.

Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

5-37 CUSTOMER REVENUE ANALYSIS (5 minutes)


Total sales
Less: Sales discounts
Net invoice
Less: Sales return and Allowance
Net sales
Less: Cash discount
Net proceeds on the 15th day
Less: Finance charge (1.5%/month)
Net proceeds on the 30th day
Net proceeds as percentage of sales
*$693,475.20 x 1.5% x = $5,201.06

TS

CS

$800,000.00

$880,000

96,000.00

132,000

$704,000.00

$748,000

3,520.00

5,610

$700,480.00

$742,390

7,004.80
$693,475.20
5,201.06*
$698,676.26

$742,390

87.33%

84.36%

5-38 CUSTOMER COST ANALYSIS (15 minutes)

Requirement 1
Jerry Inc.

Donald Co.

Customer unit-level cost Sales return


Customer batch-level costs:
Order processing
Sales return
Delivery
Customer sustaining costs:
Sales calls

$200

$875

$1,500
200
2,500

$9,000
500
15,000

12,000

4,000

$16,400

$29,375

Jerry Inc.
$1,000,000
8,000
$992,000
744,000
$248,000
16,400
$231,600

Donald Co.
$1,200,000
35,000
$1,165,000
873,750
$291,250
29,375
$261,875

23.35%

22.48%

TOTAL
Requirement 2
Sales
Sales return
Net Sales
Cost of goods sold
Gross margin
Sales support cost
Operating income
Operating margin %

Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

5.39 CUSTOMER PROFITABILITY (20 min)


1. Determination of the $100.50 order-filling cost per unit
Total number of orders:
Total number of orders
Number of orders per block
Total number of blocks
Cost per block
Total cost of order blocks
Total number of orders
Per order order-filling cost
Total cost per order
Total order-filling cost
Total units sold
Order-filling cost per unit

2 x 100 PCs + 10 x 4,000 SCs = 40,200


40,200

60
670
x $60,000
$ 40,200,000
40,200
x $1,500
+

60,300,000
$100,500,000

1,000,000
$100.50

5-39 (Contd)
2. Order filling cost per unit sold to PC:
Total number of orders
Number of orders per block
Total number of blocks
Cost per block
Total block cost
Total number of orders
Order-filling cost per order
Total cost per order
Total order-filling cost
Total units sold
Order-filling cost per unit

2
60
1/30
x $60,000
$2,000
2
x $1,500
+ 3,000
$5,000
5,000
$1.00

Net profit per unit at $700 selling price per unit to preferred customers:
Selling price per unit
Manufacturing cost
Order-filling cost/unit
Total cost per unit
Net Profit per unit

Preferred Customer
$700.00
$600.00
+
1.00
601.00
$ 99.00

Profit margin per unit

14.14%

Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

5-39 (Contd-2)
3. Order filling cost per order by SC:
Cost per block
Number of orders per block

$60,000

Block cost per order


Number of orders per SC

60
$1,000

10

Total block cost per SC

$10,000

Order-filling cost per order


Number of orders per SC

$1,500
x

10

Total cost per order

+ 15,000

Total order-filling cost

$25,000

Total units sold

125

Order-filling cost/unit

$200

Profitability per unit at $800 selling price per unit to SC


Selling price per unit

$800.00

Manufacturing cost
Order-filling cost/unit
Total cost per unit
Net profit or loss per unit
Profit margin

$600.00
+

200.00
800.00
$

0
0

PROBLEMS
5-40 Cost Pools and Cost Drivers (15 min)
Note to instructor: The answer below is but one possible solution.
1.
Cost pool 1: Cost driver: Number of purchase orders
Receiving
$10,000
Inspection of direct materials
3,000
Purchasing
20,000
Total
$33,000
Cost pool 2: Cost driver: Number of production runs
Setup wages

$20,000

Cost pool 3: Cost driver: Machine hours


Depreciation, machine
Electrical power (machining)
Machine maintenance - labor
Machine maintenance - materials
Total

$40,000
30,000
11,000
9,000
$90,000

Cost pool 4: Cost driver: Factory space


Depreciation, building
Electrical power (factory building)
Insurance
Property taxes
Natural gas (for heating)
Custodial labor
Total

$ 50,000
6,000
20,000
15,000
8,000
51,000
$150,000

Note: However, the problem indicated that the firm uses machine hours as
the base for assigning facility-sustaining costs. An alternative
solution is to combine cost pools 3 and 4.
Cost pool 5: Cost driver: production (in units)
Inspection of finished goods
Cost pool 6: Cost driver: engineering hours
Engineering design
Total

Blocher, Chen, Corkin, Lin: Cost Management

5-6

$7,000
$600,000
$600,000

The McGraw-Hill Companies, Inc., 2005

5-40 (Contd)
2.

Overhead Rates:
Cost pool 1:
Total cost
Number of purchase orders
Cost per purchase order
Total cost
Number of production runs
Cost per production run

$33,000

6
$5,500

Cost pool 2:

$20,000

40
$500

Cost pool 3:

$ 90,000
100,000
$0.90

Cost pool 4:

$150,000
100,000
$1.50

Cost pool 5:

$ 7,000
100,000

Cost pool 6:

$600,000
20,000
$30.00

Total cost
Number of machine hours
Cost per machine hour
Total cost
Number of machine hours
Cost per machine hour
Total cost
Number of units
Cost per unit $0.07
Total cost
Total engineering hours
Cost per engineering hour

5-40 (Contd-2)
Manufacturing overheads:
Unit level:
Cost pool 3 Cost per machine hour
Number of machine hours

$ 0.90
x 4,250

$ 3,825

Cost pool 5 Cost per unit


$ 0.07
Number of units
x 4,000
Batch level:
Cost pool 2 Cost per production run
$500
Number of production runs
(4,000 units 2,500 = 1.6) x
2

1,000

Product-sustaining level:
Cost pool 1 Cost per purchase order
Number of purchase orders

$5,500
x
1

5,500

$ 30
100

3,000

Cost pool 6 Cost per engineering hour


Number of engineering hours
Facility-sustaining level*:
Cost pool 4 Cost per machine hour
Number of machine hours
Total manufacturing overhead
Number of units
Manufacturing overhead per unit

Blocher, Chen, Corkin, Lin: Cost Management

5-6

$ 1.50
x 4,250

280

6,375
$19,980

4,000
$4.995

The McGraw-Hill Companies, Inc., 2005

5-40 (Contd-3)
* There are at least two alternative activity consumption drivers for
assigning facility-sustaining cost:
Based on machine hours:
Total facility-sustaining cost (Cost pool 4)
Number of machine hours
Cost per machine hour

$150,000
100,000
$1.50

Which is the cost driver for the answer above.


Alternatively, the firm may use number of units to assign facilitysustaining cost.
Based on number of units:
Total facility-sustaining cost (Cost pool 4)
$150,000
Units of production
100,000
Cost per unit $1.50
Unit level:
Cost pool 3
Cost pool 5

$ 3,825
280

Batch level:
Cost pool 2

1,000

Product-sustaining level:
Cost pool 1
Cost pool 6

5,500
3,000

Facility-sustaining level:
Cost pool 4 Cost per unit
Number of units
x 4,000
Total manufacturing overhead
Number of units
Manufacturing overhead per unit

$ 1.50
6,000

$ 19,605

4,000
$4.90125

5-41 Volume-Based Costing Versus ABC (10 min)


1. Plantwide rate based on direct labor-hours
Total Budgeted Overhead Cost
$50,000 + $100,000 + $3,250 + $30,000 =$183,250

Budgeted direct labor hours

5,000

Overhead rate per direct labor-hour

$36.65

Number of direct labor-hours for this order

400

Overhead applied to the order

$14,660

2. Activity-based costing
Overhead Rates:
Quality control

$50,000

100 = $500.00 per inspection

Machine operation $100,000 40,000 =


Purchasing
Other OH cost

$3,250

$2.50 per MH

25 = $130.00 per PO

$30,000 5,000 =

$6.00 per DLH

Overhead applied to the order:


Quality control
Machine operation
Purchasing
Other OH cost

$500.00 x

5=

$2,500

$2.50 x 1,400 =

3,500

$130.00 x

1=

130

$6.00 x

400 =

2,400

Total overhead assigned

$8,530

Number of boxes
Overhead per box

500
$17.06

3. Using a single application rate for a firm with product diversity is likely to
distort product costs. Using a costing system with multiple rates based on
cost drivers that reflect the underlying activities can provide a better cost
determination.

Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

5-42 Activity-Based Costing, Value Chain Activities (15 min)


1. Prime costs
Manufacturing overheads:
Material handling
Machining
Assembly
Inspection
Total manufacturing costs
Number of units
Cost per unit
2. Upstream activities
Manufacturing
Downstream activities
Full product cost per unit

80 x $1,200 =

$ 96,000

80 x 105 x $0.45 =
80 x
3x
$51 =
80 x 105 x $2.85 =
80 x $30 =

3,780
12,240
23,940
2,400
$138,360

80
$1,729.50

$180.00
1,729.50
250.00
$2,159.50

8.33%
80.09%
11.58%
100%

Strategic implications:
(1) Knowing the full cost of a product including upstream and downstream
costs allows the firm to be aware of all costs attributable to the product.
(2)

The amounts and proportions of upstream, manufacturing, and


downstream costs facilitate comparisons with competitors.

(3)

The company should consider ways of spending less cost in the


manufacturing activity, and more on upstream and downstream
activities in order to improve its competitive position by pursuing the
differentiation strategy in both the new product design and the customer
service.

3. The total value chain cost provides the firm a long-term perspective of the
product cost, in addition to the short term manufacturing cost. Different
industries have different cost structures. For example, firms in the
computer software industry are likely to have high upstream costs while
firms in the retailing industry tend to have high downstream costs.

5-43 Volume-based Costing Versus ABC (10 min)


1. Predetermined overhead rate based on machine hours
= Total budgeted overhead cost / Selected level of production activity
= ($100,000 + $80,00 + $200,000 + $100,000) / 10,000 machine-hours
= $480,000 / 10,000 machine-hours
= $48.00 per machine-hour
Product

Total Manufacturing Overhead

Barrel

OH per Barrel

P5

$48.00 x 1,000 MH = $48,000

500

$96.00

G23

$48.00 x 1,000 MH = $48,000

500

$96.00

2. Overhead Rates:
Overhead
Cost Pool

Budgeted
Overhead

Level of
Cost Driver

Predetermined
Overhead Rate

Machine set-ups

$100,000

100 setups

$1,000 per setup

Material handling

80,000

8,000 barrels

$10 per barrel

Quality control

200,000

Other overheads

100,000 10,000 machine hrs

Overhead Per Barrel:


Overhead
Cost Pool

Rate

1,000 inspections

Quality control
Other overheads

$10 per MH

Manufacturing Overhead
P5
G23
Activity Overhead
Activity Overhead

Machine set-ups $1,000


Material handling

$200 per inspection

$ 1,000

50

$50,000

$10

500

5,000

500

5,000

$200

400

20

4,000

$10

1,000

10,000

1,000

10,000

Total overhead

$16,400

Number of barrels
Cost per barrel

500
$ 32.80

$69,000

500
$138.00

5-44 Volume-based Costing Versus ABC (35 min)


Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

1.

Product A
(1) Target price
$279.00
(2) Manufacturing cost (1) 150% $186.00
Prime cost
- 70.00
Overhead cost per unit
$116.00
Number of units
x 1,000
Total overhead
$116,000

Product B
$294.00
$196.00
- 126.40
$ 69.60
x 5,000
$348,000

2. Current Costing system

Product A Product B
Actual selling price
$280
$250
Product manufacturing cost
186
196
Gross margin
$ 94
$ 54
Gross margin ratio
33.57%
21.6%

Product C
$199.50
$133.00
- 75.00
$ 58.00
x
500
$29,000

Product C
$300
133
$167
55.67%

Based on the current cost data, it is true that product B is the least profitable
product with a gross margin per unit of $54.00 (21.6%) and product C is the
most profitable product with a gross margin per unit of $167.00 (55.67%).
However, the validity of this conclusion is based on the accuracy of the
reported product costs.
Product costs based on the activity-based costing system
Direct materials
Direct labor
Factory overhead:
Setups (a)
Materials handling (b)
Hazardous control (c)
Quality control (d)
Utilities (e)
Total

Product A
$ 50.00
20.00
1.60
40.00
62.50
22.50
12.00
$208.60

Actual selling price


$280.00
Product manufacturing cost
208.60
Gross margin
$ 71.40
Gross margin ratio
25.50%

Product B
$114.40
12.00

Product C
$ 65.00
10.00

0.80
5.00
22.50
5.25
8.40
$168.35

4.80
70.00
150.00
52.50
12.00
$364.30

$250.00
168.35
$ 81.65
32.66%

$300.00
364.30
($64.30)
(21.43)%

5-44 (Continued)
Notes:
(a) Setups:
Cost per setup: $8,000 (2 + 5 + 3) =
$800 per setup
Product A = 2 x $800 = $1,600;
$1,600 1,000 = $1.60 per unit
Product B = 5 x $800 = $4,000;
$4,000 5,000 = $0.80 per unit
Product C = 3 x $800 = $2,400;
$2,400 500 = $4.80 per unit
(b) Materials handling:
Cost per pound = $100,000 (400 + 250 + 350) = $100 per pound
Product A = 400 x $100 = $40,000;
$40,000 1,000 = $40.00 per unit
Product B = 250 x $100 = $25,000; $25,000 5,000 = $ 5.00 per unit
Product C = 350 x $100 = $35,000; $35,000 500 = $70.00 per unit
(c) Waste and hazardous disposals:
Cost per disposal: $250,000 (25 + 45 + 30) = $2,500 per disposal
Product A = 25 x $2,500 = $ 62,500; $ 62,500 1,000 = $ 62.50/unit
Product B = 45 x $2,500 = $112,500; $112,500 5,000 = $ 22.50/unit
Product C = 30 x $2,500 = $ 75,000; $ 75,000 500 = $150.00/unit
(d) Quality inspections:
Cost per inspection = $75,000 (30 + 35 + 35) = $750 per inspection
Product A = 30 x $750 = $22,500; $22,500 1,000 = $22.50 per unit
Product B = 35 x $750 = $26,250; $26,250 5,000 = $ 5.25 per unit Product
C = 35 x $750 = $26,250;
$26,250 500 = $52.50 per unit
(e) Utilities:
Cost per MH = $60,000 (2,000 + 7,000 + 1,000) = $6.00 per MH
Product A = 2,000 x $6 = $12,000; $12,000 1,000 = $12.00 per unit
Product B = 7,000 x $6 = $42,000; $42,000 5,000 = $ 8.40 per unit
Product C = 1,000 x $6 = $ 6,000; $ 6,000 500 = $12.00 per unit

Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

5-44 (Continued-2)
3. Comparison of reported product costs, new target price, actual selling price,
and gross margin (loss):
Product A Product B Product C
Product costs:
1. Direct-labor based system
$186.00
$196.00
$133.00
2. Activity-based system
$208.60
$168.35
$364.30
ABC-based product costs:
Target price (150%)
Actual selling price
Difference in price

$312.90
$252.53
$280.00
$250.00
<$32.90> <$2.52>

Direct-labor based costing system


Gross margin
$ 94
Gross margin ratio
Activity-based costing system:
Gross margin
Gross margin ratio

33.57%
$71.40
25.50%

$ 54
21.6%
$81.65
32.66%

$546.45
$300.00
<$246.45>
$167
55.67%
$(64.30)
<21.43%>

4. Comment
1. Emphasizing Product C as suggested by the current direct-laborcost based overhead costing system is likely to lead to the demise
of the firm. The activity-based costing system shows that the
manufacturing cost of Product C is $364.30 per unit and, at the
current selling price, the firm suffers a $64.30 loss for each unit it
manufactures and sells.
2. If the actual selling prices of products A & B are fair market prices
for these products and a markup of 150% is a common industry
practice, the firm needs to examine the manufacturing cost of
product A. The fact that the firms target price, determined using
150% of the manufacturing cost, is more than 10 percent over the
fair market price of the product suggests possible wastes and
inefficiencies in the manufacturing of product A.

5-45 Volume-Based Costing Versus ABC (35 min)


1. Crrent costing system

Elite
5,000

Standard
20,000

Junior
50,000

Sales (Actual price)


Cost of goods sold
Gross margin

$180.00
97.50
$ 82.50

$150.00
75.00
$ 75.00

$110.00
47.50
$ 62.50

Gross margin ratio

45.83%

50%

56.82%

Total gross margin

$412,500

$1,500,000

$3,125,000

Sales units

Based on the gross margin per unit determined using the current
volume-based product costing system, Elite Box Radio is the most
profitable product ($82.50 per unit), followed by Standard model ($75
per unit). Junior model is the least profitable of the three ($62.50 per
unit).
2. Multiple drivers costing system
Elite
Selling price (actual)

Standard

Junior

$180.00

$150.00

$110.00

Direct materials

22.50

15.00

7.50

Direct labor

15.00

12.00

8.00

100.80

10.50

2.52

b) Quality control

31.70

15.85

9.51

c) Machinery

12.80

10.50

5.40

d) Materials handling

15.00

10.00

5.00

$197.80

$ 73.85

$ 37.93

-$ 17.80

$ 76.15

$ 72.07

-9.89%

50.77%

65.52%

Cost of goods sold

Factory overhead*
a) Engineering

Total cost
Gross margin
Gross margin ratio
5-45 (Continued)
Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

*Note:
a) Engineering
Factory overhead per engineering hour:
$840,000 (900 + 375 +2 25) =
$560.00
Elite:
(900 x $560) 5,000 =
$100.80
Standard:
(375 x $560) 20,000 =
$ 10.50
Junior:
(225 x $560) 50,000 =
$ 2.52
b) Quality Control
Factory overhead per quality inspection hour:
$951,000 (5,000 + 10,000 +15,000) =
$31.70
Elite:
( 5,000 x $31.70) 5,000 =
Standard:
(10,000 x $31.70) 20,000 =
Junior:
(15,000 x $31.70) 50,000 =

$31.70
$15.85
$ 9.51

c) Machinery
Factory overhead per machine hour:
$544,000 (640 +2,100 + 2,700) =
Elite:
( 640 x $100) 5,000 =
Standard:
(2,100 x $100) 20,000 =
Junior:
(2,700 x $100) 50,000 =

$12.80
$10.50
$ 5.40

$100

d) Materials handling
Total direct materials cost:
Elite
$22.50 per unit x 5,000 units =
Standard
$15.00 per unit x 20,000 units =
Junior
$ 7.50 per unit x 50,000 units =
Total direct materials cost
Factory overhead per dollar of direct materials:
$525,000 787,500 =
$0.6667
Elite:
$112,500 x $0.6667 5,000 =
Standard:
$300,000 x $0.6667 20,000 =
Junior:
$375,000 x $0.6667 50,000 =

$112,500
300,000
375,000
$787,500

$15.00
$10.00
$ 5.00

5-45 (Continued-2)
3. Comparison of reported product costs:
Costing System
Elite
Standard Junior
Volume-based (direct labor cost)
$ 97.50
$75.00 $47.50
Activity-based costing
197.80
73.85
37.93
Difference in cost
-$100.30
$ 1.15 $ 9.57
Elite consumes more of engineering hours and Quality Control
activities. These two activities are not directly related to direct
labor hours. Therefore, under the activity-based costing system,
Elite has a much higher unit cost than the volume-based direct
labor costing system for factory overhead.
Costing System
Target price
Actual price
Gross margin (Volume-based)
Gross margin (ABC)

Elite
$195.00
$180.00
$82.50
-$17.80

Standard
Junior
$150.00 $95.00
$150.00 $110.00
$75.00 $62.50
$76.15 $72.07

Although Addison already has to sell Elite at a price below its


target price, the cost based on the manufacturing activities show
that the firm is actually suffering a loss on each unit of Elite it
sells. On the other hand, Junior is actually more profitable than
the firmrealizes.
The firm should focus on Junior and Standard models and leave
Elite, perhaps, to elite companies.

Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

5-46 Ethics, Cost System Selection (5 min)


The management accountant should keep the professional ethics
code in mind. First, he or she should try to persuade other ABC
pilot project members and the company controller to strongly
recommend the top management to adopt the more accurate ABC
method. If the companys top management still would not change
the costing system, then the management accountant should
report the situation to the companys audit committee.

5-47

Volume-Based Costing Versus ABC (15 min)

1. Current costing system (direct-labor hour)


Deluxe
%
Speedy
%
Price
$475 100
$300.00
100
Prime Cost
180
38
110.00 37
Overhead
20
4
153.60
51
Unit gross profit
$275
58
$ 36.40
12
2. Multiple drivers costing system
Calculation of unit overhead costs - Deluxe:
Setups
$2,800 x
200 =
Machine costs
$100 x 100,000 =
Engineering
$40 x 45,000 =
Packing
$20 x 50,000 =
Total overhead
Number of Units

Overhead per unit


Calculation of unit overhead costs - Speedy:
Setups
Machine costs
Engineering
Packing
Total overhead
Number of Units
Overhead per unit

$2,800 x
100 =
$100 x 400,000 =
$40 x 120,000 =
$20 x 200,000 =

Deluxe
$ 560,000
10,000,000
1,800,000
1,000,000
$13,360,000
50,000
$267.20
Speedy
$ 280,000
40,000,000
4,800,000
4,000,000
$49,080,000

400,000
$122.70

Deluxe %
$475.00100

Price
Cost
Prime cost
$180.00
Overhead
267.20
447.20 94
Unit gross profit
$27.80
6

Blocher, Chen, Corkin, Lin: Cost Management

5-6

$110.00
122.70

Speedy
$300.00

%
100

232.70
$67.30

78
22

The McGraw-Hill Companies, Inc., 2005

5-47 (Contd)
3. Using the activity-based costing, a much different picture on profitability of the
Deluxe and Speedy models emerges. The Speedy model is actually more
profitable than the Deluxe model. The revised cost data suggests that shifting
the emphasis to the Deluxe model may very well be a mistake. The Deluxe
printer is a much heavier user of overhead resources as can be seen in the
table below that compares uses of overhead.
Overhead
Activity

Activity Consumption
Deluxe
Speedy

Setups
Machine costs
Engineering
Packing

250 units per setup

4,000 units per setup

2 MH per unit

1 MH per unit

0.9 Engr. Hr. per unit


1 unit per packing order

0.3 Engr. Hr. per unit


2 units per packing order

Supporting calculations
Activity Consumption

Total
Units
Setups
Machine
costs

Deluxe
Per Activity Measure

50,000

400,000

200 250 units per setup


100,000

2 MH per unit

Engineering 45,000 0.9 Engineering


Hours per unit
Packing

50,000

Total

Speedy
Per Activity Measure

100 4,000 units per setup


400,000 1 MH per unit
120,000 0.3 Engineering
hours per unit

1 unit per packing 200,000


order

2 units per packing


order

4. The ABC method is likely to provide Gordon Company a more accurate


product cost picture. It also directs the managements attention to the high
volume, more profitable Speedy printers.
Given the low profit margin of the Deluxe, the firm may want to investigate
the feasibility of raising the price, the possibility of reducing product cost, or
both.

5.48 Volume-Based Costing Versus ABC (10 min)


1. Predetermined overhead rates:
Budgeted Budgeted
OH Cost Cost Driver

Cost Pool

Overhead Rate

Machine depr./maint.

$135,000

27,000

$5.00 per MH

Factory depr./util./insur.

$120,000

30,000

$4.00 per MH

Product design

$504,000

42,000 $12.00 per Design hour

Materials purch./stor.

$147,000

Total overhead

$980,000 15.00% DM cost

$906,000

Total overhead for each product order:


Overhead Cost Pool
Material purchase

Men Shavers
$30,000 x 15% =$4,500

Product design

Women Shavers
$26,000 x 15% = $3,900

$12 x 15 =180

$12 x 37.5 =

450

Machine depreciation

$5.00 x 50 =

250

$5.00 x 40 =

200

Factory depreciation

$4.00 x 50 =

200

$4.00 x 40 =

160

Total overhead cost

$5,130

$4,710

2. Overhead cost per unit:


Number of units

15,000

20,000

Overhead cost per unit

$ 0.342

$ 0.2355

3. Overhead rate: $906,000 / 3,020 = $300 per direct labor hour


4. Total overhead using plantwide overhead rate:
Men Shavers:

$300 x 24 =

$7,200

Women Shavers:

$300 x 12 =

$3,600

5. Men Shavers:
Women Shavers:

$7,200 / 15,000 =

$ 0.48

$3,600 / 20,000 =

$ 0.18

5.49 volume-Based Costing Versus ABC (20 min)


1. Current costing system based on direct labor hours
Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

Direct materials cost

Job 101
$ 45,300

Direct labor cost

16,800

Indirect manufacturing cost 420 x $120 =


Total manufacturing cost

Job 102
$ 5,700
1,400

50,400 35 x $120 =

4,200

$112,500

Number of units

$11,300

450

Unit manufacturing cost per job


2.
Direct materials cost
Direct labor cost

20

$ 250

$ 565

Job 101
$ 45,300

Job 102
$5,700

16,800

1,400

Indirect Manufacturing cost:


Material handling

1,500 x $.70 =

1,050

600 x $.70 =

420

80,000 x $.35 =

28,000

15,000 x $.35 =

5,250

750 x $15 =

11,250

70 x $15 =

1,050

Grinding

1,500 x $.60 =

900

600 x $.60 =

360

Shipping

1 x $2,180 =

2,180

1 x $2,180 =

2,180

Lathe work
Milling

Total overhead

43,380

Total manufacturing cost


Number of units
Unit manufacturing cost per job
3.

9,260

$105,480

$16,360

450

20

$234.40

Number of units

$ 818
Job 101
450

Job 102
20

Unit cost with the existing costing system $250.00

$565

Unit cost with activity-based system

$818

$234.40

5-49 (Continued)
The cost per unit of Job 102 increased 44.8% [($818 - $565) / $565 ] while
the cost per unit of Job 101 decreased 6.24% [($234.40 - 250) / $250 ],
when using ABC instead of a single cost pool with a single allocation base.
A common finding after implementing an activity-based accounting system
is that the costs of low-volume products increased and the costs of highvolume products decreased. Similar results are found in requirements 1
and 2 for Auer Corporation.
4. Among factors that contribute to the differences in the product cost figures
computed in requirements 1 and 2 are:
(a) the jobs differ in the way they use each of five activity areas, and
(b) the activities differ in their indirect cost application base (the direct labor
hour is not the only cost allocation base).
5. Adopting the ABC method is strategically important for the Auer
Corporation. The ABC method provides the Auer Corporation a more
accurate product cost picture, and directs the managements attention to
the high-volume more profitable jobs. If management can find ways to
continuously improve the high-volume jobs product design or
manufacturing process, the company will sustain its competitive advantage.

Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

5.50 Volume-Based Costing vs. ABC (30 min)


1. Manufacture Costs Direct-Labor Cost Based
Luxury Pendant
Total
Selling Price
Direct Materials

Ceiling Fixture

Per Unit

Total

Per Unit

$ 80,000

$70.00
20.00

$ 400,000

$40.00
10.00

Direct Labor

32,000

8.00

200,000

5.00

Overhead*

64,000

16.00

400,000

10.00

$176,000

44.00

$1,000,000

25.00

Manufacturing Cost
Gross Margin

$26.00

$15.00

* Overhead is allocated based on direct labor costs at the rate of $2.00


per direct labor dollar
LP: $ 32,000 x $2.00 = $ 64,000
CF: $200,000 x $2.00 = $400,000
2. Overhead Costs Reported by ABC System:
Overhead rates
Overhead Costs Total Activities
Machine Operation
Support labor

Overhead Rate

$160,000
81,200

10,000
232,000

$16.00
0.35

Machine Setup

68,000

2,500

27.20

Assembly

88,550

402,500

0.22

Inspection

66,250

4,000

16.5625

Total

$464,000

5-50 (Continued-1)
Applied overheads
Luxury Pendants

Machine Operation
Support labor
Machine Setup

Ceiling Fixtures

Overhead Activities Overhead Activities Overhead


Rate
Cost
Cost
$ 16.00
1,500 $ 24,000
8,500 $136,000
0.35
32,000
11,200 200,000
70,000
27.20

1,000

27,200

1,500

40,800

Assembly

0.22

192,500

42,350

210,000

46,200

Inspection

16.5625

1,600

26,500

2,400

39,750

Total Overhead

$131,250

Manufacture Costs Report - ABC System


Luxury Pendants
Total
Per Unit
Number of units
4,000
Sales
$280,000
$70.00
Direct Materials
80,000
$20.00
Direct Labor
32,000
$ 8.00
Overhead:
Machine Operation
24,000
Support Labor
11,200
Machine Setup
27,200
Assembly
42,350
Inspection
26,500
Total Overhead
$131,250 $32.8125
Total Manufacturing Costs
$243,250 $60.8125
Gross Margin
$ 36,750
$9.1875
Gross margin ratio
13.13%

$332,750

Ceiling Fixtures
Total
Per Unit
40,000
$1,600,000
$40.00
$400,000
$10.00
$200,000
$ 5.00
136,000
70,000
40,800
46,200
39,750
$332,750 $ 8.3188
$932,750 $23.3188
$667,250 $16.6813
41.7%

3. The above profitability analysis indicates that the Luxury Pendant is not as
profitable as the vice president of marketing thinks it is.

Blocher, Chen, Corkin, Lin: Cost Management

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The McGraw-Hill Companies, Inc., 2005

5-50 (Continued-2)
4. Unit Cost Comparison between the current and ABC costing systems
Reported Overhead Costs
Current
ABC
Difference
Luxury Pendants
$16.00
$32.8125
+$16.8125
Ceiling Fixtures

$10.00

$ 8.3188

- $ 1.6822

According to the ABC cost data, a shift to more Luxury Pendant units
and fewer Ceiling Fixture units would be ill advised. The apparent
higher unit gross margin of the Luxury Pendants relative to the Ceiling
Fixtures that the current costing system reports was a result of
inaccurate overhead applications, which distorted relative unit
profitability.
5. Among the reasons for the different costs reported between the
current direct labor based and the ABC systems are:
a. The current direct labor based costing system focused on only one
manufacturing activity of the entire production process. It measures
only one attribute of the individual product: the number of direct labor
hours consumed. By contrast, the ABC system considered all
activities of the manufacturing processes. Costs were traced from
activities to products based on the products demand for these
activities during the production process. The allocation bases used in
ABC were thus measures of the activities performed. For Modern
Lighting Inc., the ABC systems listed not only the unit-level activities
(machine operation, support labor overhead) but also the batch-level
ones (setup, assembly, and inspection.)
b. Under the volume-based costing system, the high-volume ceiling
fixtures were overcosted and the low-volume luxury pendants were
undercosted. The source of this distortion is the choice of a single
volume-related allocation base, direct labor hours, for tracing of costs
from manufacturing to products. Using a volume-related allocation
base alone to trace costs to products distorted reported product costs
if some of the product-related activities were not related to volume,
such as the setup hours.
c. Differences in the complexity of the products also contribute to cost
distortion. Using a volume-based costing system, overhead costs
differ only when different number of units are manufactured. Although
the luxury pendants were low-volume products, they actually consume
more resources a result not related to volume.

5-51 Volume-Based Costing vs. ABC (30 min)


1. Current Costing System Direct-Labor-Hour Based
Overhead rate = Budgeted overhead / Budgeted direct labor hours
= $200,000 / (7,200 + 6,800 + 2,000)
= $200,000 / 16,000
= $ 12.50 per direct labor hour
Overhead cost allocation:
Diomycin
7,200

Homycin
6,800

Addolin
2,000

Overhead rate

$12.50

$12.50

$12.50

Total overhead

$90,000

$85,000

$25,000

Diomycin
$205,000

Homycin
$265,000

Addolin
$258,000

250,000

234,000

263,000

Overhead:

90,000

85,000

25,000

Total Cost

$545,000

$584,000

$546,000

Packets produced

1,000,000

500,000

300,000

$0.545

$1.168

$1.820

Direct labor-hours

Cost per unit:


Direct Materials
Direct Labor

Cost per capsule

Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

5-51 (Continued-1)
2. Overhead rates for Activity-Based Costing:

Activity
Machine setup

Cost Driver
Setup hours

Budgeted
Budgeted
Overhead Cost Driver Overhead
Cost
Volume
Rate
$ 16,000
1,600 $10.00

Plant management Workers

36,000

Supervision of
Direct labordirect labor
hours
Quality inspection Inspectionhours
Expediting orders Customers
serviced
Total overhead

1,200

$30.00

1,150

$40.00

50,400

1,050

$48.00

51,600

645

$80.00

46,000

$200,000

Overhead Costs Assigned to Products Using Activity-Based Costing:


Diomycin
Homycin
Addolin
Driver
Overhead Driver Applied Driver Applied
Applied
Volume
Volume
Volume
Rate
Overhead
Overhead
Overhead
Machine setup
$10 200
$2,000 600
$6,000 800
$8,000
Plant
management
Supervision of
direct labor
Quality
inspection
Expediting
production
orders
Total

$30

200

$6,000

400

$12,000

600

$18,000

$40

200

$8,000

300

$12,000

650

$26,000

$48

150

$7,200

200

$9,600

700

$33,600

$80

45

$3,600

100

$8,000

500

$40,000

$26,800

$47,600

$125,600

5-51 (Continued-2)
Cost per capsule under Activity-Based Costing:
Direct Materials
Direct Labor
Overhead
Total Cost
Packets produced
Cost per capsule

Diomycin
Homycin
Addolin
$205,000.00 $265,000.00 $258,000.00
250,000.00
234,000.00
263,000.00
26,800.00
47,600.00
125,600.00
$481,800.00 $546,600.00 $646,600.00
1,000,000
500,000
300,000
$0.4818
$1.0932
$2.1553

3. Comparison of Product Costs Using Current Costing and ABC Costing:


Current Costing System
Overhead
Cost per capsule
Activity-Based Costing system
Overhead
Cost per capsule

Diomycin

Homycin

Addolin

$90,000
$0.5450

$85,000
$1.1680

$25,000
$1.8200

$26,800
$0.4818

$47,600
$1.0932

$125,600
$2.1553

Analysis of the Differences


Under the current costing system, ADA applies overhead based on direct
labor hour, and high-volume products such as Diomycin (1,000,000
capsules) are allocated relatively more overhead ($90,000) than the lowvolume products such as Addolin (300,000 capsules). High-volume products
subsidize low-volume products in this case. Because of lack of detailed
costing information, ADA ends up undercosting Addolin ($1.82 under the
current costing) and overcosting Diomycin ($0.545 under the current
costing).

5-51 (Continued-3)
Activity-based costing provides ADA with more detailed and better
estimates of product costs. For example by using ABC, ADA becomes
aware that the cost of Diomycin is lower ($0.4818 per capsule compared to
$0.545 under current costing), meaning that it can set the price of Diomycin
lower and be more competitive. Also, ABC revealed how costly Addolin is
Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

($2.1553 per capsule compared to $1.82 under the current costing). Thus,
this opportunity would allow ADA to properly price Addolin or if it is not
profitable, stop producing.
From the schedule, activity-based costing assigns more overheads to
the lower-volume Addolin because the production of Addolin requires more
setups, inspection, supervision, formulation and management. The current
direct-labor-hours based costing system failed to assign costs of all
activities. As a result, Diomycin and Homycin subsidized Addolin.
The production department at ADA also benefits under ABC. ABC
provides better costing information on the cost of each of the activities and
identifies cost drivers and the activities that consume resources and raise
cost. The additional information enables production mangers to manage
cost by managing activities and cost drivers.
Adopting the ABC method is strategically important for ADA. Because
the ABC method provides ADA with a more accurate product cost picture
and directs managements attention to the high-volume, more profitable
products, the firm can gain competitive advantages and profits by focusing
on the high-volume products.

5-51 (Continued-4)
4. Among major uses of ABC in the Pharmaceutical Industry are:
a. Strategic Use of ABC to Reduce Costs
One of the important ways companies develop competitive advantages is
to become a low-cost producer. Many companies in the pharmaceutical
industry have learned to use the information they have gained from their
costing systems to make substantial price cuts to increase market share.
b. Use of ABC to Eliminate Low-Value-Added Costs
ABC can be used to identify and eliminate activities that add costs but
not value to the products in the pharmaceutical industry. A company can
eliminate low-value added activities and costs without reducing quality or
value. In the pharmaceutical industry, the following activities typically do
not add value to a product: storage, moving items, and waiting for work.
Analyses of activities facilitate firms to identify low-value-added activities.
c. Use of ABC in Marketing and Distribution
In the pharmaceutical industry, ABC can be applied to marketing or
administrative activities. The cost of performing marketing services such
as distributing products through different distribution channels can be
computed and the information used in making informed decisions. For
example, some of the different channels of distribution in the
pharmaceutical industry are: grocery stores, convenience stores,
pharmacy shops, each having different activities. The cost of alternative
channels of distribution is useful to marketing managers who make
decisions about which channel to use.
d. Use of ABC to Make Better Pricing Decisions
ABC enables managers to make better pricing decisions by providing
managers with more accurate product cost data for pricing decisions.
e. Use of ABC to Make Better Product Mix Decisions
ABC provides a firm more detailed and better estimation of product costs.
Thus, it allows a company the opportunity to decide which products to
make and which ones to eliminate.

Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

5-52 Volume-based Costing Versus ABC Alaire Corporation (40 min)


(CMA Exam Part 3, Question 3; 6/92)
1. General advantages associated with activity-based costing include:
a. Provides management with a more thorough understanding of
complex product costs and product profitability for improved resource
management and pricing decisions.
b. Allows management to be aware of values of activities so that lowvalue-added activities can be controlled or eliminated, thus
streamlining production processes.
c. Highlights the interrelationship (cause and effect) of activities that
facilitate identifications of opportunities to reduce costs such as
designing products with fewer parts to reduce the cost of
manufacturing.
d. Provides more appropriate means of charging overhead costs to
products.
2. a. Using the current volume-based standard costs, the total contribution
expected in 2007 by Alaire Corporation from the TV Board is $1,950,000,
calculated as follows:
Per Unit Totals for 65,000 units
Revenue

$150

$ 9,750,000

Direct materials

80

5,200,000

Direct labor ($14 x 1.5 hours)

21

1,365,000

Materials overhead (10% of material)

520,000

Variable overhead ($4 x 1.5 hours)*

390,000

Machine time overhead ($10 x .5)

325,000

$120

$7,800,000

$ 30

$1,950,000

Total cost
Contribution margin

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

5-52 (Continued-1)
2. b. Using traditional volume-based standard costs, the total contribution
expected in 2007 by Alaire Corporation from the PC Board is $2,360,000,
calculated as follows.
Per Unit Totals for 40,000 units
Revenue

$300

$ 12,000,000

140

5,600,000

Direct labor ($14 x 4 hours)

56

2,240,000

Materials overhead (10% of materials)

14

560,000

Variable overhead ($4 x 4 hours)*

16

640,000

Machine time overhead ($10 x 1.5)

15

600,000

Total cost

241

9,640,000

Contribution margin

$ 59

$ 2,360,000

Direct materials

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


3. Shown below are the calculations of the activity-based cost drivers, which
apply to both 3.a. and 3.b.
Procurement:

$400,000 / 4,000,000 = $0.10 per part

Production scheduling:

$220,000 / 110,000 = $2.00 per board

Packing & shipping:

$440,000 / 110,000 = $4.00 per board

Machine setups:

$446,000 / 278,750 = $1.60 per setup

Hazardous waste disposal:


Quality control:
General supplies:

$48,000 / 16,000 = $3.00 per pound


$560,000 / 160,000 = $3.50 per inspection
$66,000 / 110,000 = $0.60 per board

Machine insertion:

$1,200,000 / 3,000,000 = $0.40 per insertion

Manual insertion:

$4,000,000 / 1,000,000 = $4.00 per insertion

Wave soldering:

$132,000 / 110,000 = $1.20 per board

5-52 (Continued-2)
Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

a. Using activity-based costing, the total contribution expected in 2007 by Alaire


Corporation from the TV Board is $2,557,100 calculated as follows.
Per Unit Totals for 65,000 units
Revenue
Direct materials

$150.00

$ 9,750,000

80.00

5,200,000

Procurement ($.10 x 25)

2.50

162,500

Production scheduling

2.00

130,000

Packaging & shipping

4.00

260,000

3.20

208,000

Materials overhead:

Variable overhead:
Machine set-ups ($1.60 x 2)
Waste disposal ($3 x .02)
Quality control

.06

3,900
3.50

227,500

.60

39,000

Machine insertion ($.40 x 24)

9.60

624,000

Manual insertion

4.00

260,000

Wave soldering

1.20

78,000

$110.66

$7,192,900

$ 39.34

$2,557,100

General supplies
Manufacturing overhead:

Total cost
Contribution margin

Note that the only cost that remains the same for both cost methods is the
cost of direct materials. Under the ABC method, direct labor cost becomes
part of the manufacturing manual insertion overhead cost.

5-52 (Continued-3)
b. Using activity-based costing, the total contribution expected in 2007 by Alaire
Corporation from the PC Board is $1,594,000 calculated as follows.
Per Unit Totals for 40,000 units
Revenue

$300.00

$ 12,000,000

140.00

5,600,000

Procurement ($.10 x 55)

5.50

220,000

Production scheduling

2.00

80,000

Packaging & shipping

4.00

160,000

Machine set-ups ($1.60 x 3)

4.80

192,000

Waste disposal ($3 x .35)

1.05

42,000

Quality control ($3.50 x 2)

7.00

280,000

.60

24,000

Machine insertion ($.40 x 35)

14.00

560,000

Manual insertion ($4 x 20)

80.00

3,200,000

1.20

48,000

`Total cost

$260.15

$10,406,000

Contribution margin

$ 39.85

$ 1,594,000

Direct materials
Materials overhead:

Variable overhead:

General supplies
Manufacturing:

Wave soldering

Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

5-52 (Continued-4)
4. The analysis using volume-based standard costs shows that the unit
contribution of the PC Board is almost double that of the TV Board. On
this basis, Alaires management is likely to accept the suggestion of the
production manager and concentrate promotional efforts on expanding
the market for the PC Boards.
However, the analysis using activity-based costs does not support
this decision. This analysis shows that the unit dollar contribution from
each of the boards is almost equal, and the total contribution from the
TV Board exceeds that of the PC Board by almost $1,000,000. As a
percentage of selling price, the contribution from the TV Board is double
that of the PC Board, 26 percent versus 13 percent. Therefore, it may
not be advisable to concentrate promotional efforts only on expanding
the market for the PC Board.

5-53 Volume-based Costing Versus ABC (40 min)


(CMA Exam Part 3, Question 6: 12/93)
1. a. Predetermined factory overhead rate
b. Product costs and selling prices

= $3,000,000 / $600,000

= $5 per direct-labor dollar

Product Costs

Mona Loa

Malaysian

Direct costs:
Direct materials

$4.20

$3.20

Direct labor

.30
$4.50

.30
$3.50

1.50

1.50

Indirect costs:
Factory overhead (0.30 x $5.00)
Total costs
Mark-up
Budgeted selling prices per pound
2. The cost per driver unit is:
Activity
Purchasing

Budgeted
Cost Driver
Cost
Purchase orders $579,000

$6.00

$5.00

30%

30%

$7.80

$6.50

Budgeted
Activity
1,158

Cost per
Unit
$500

Material handling

Setups

720,000

1,800

400

Quality control

Batches

144,000

720

200

Roasting

Roasting hours

961,000

96,100

10

Blending

Blending hours

336,000

33,600

10

Packaging

Packaging hours

260,000

26,000

10

Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

5-53 (Continued-1)
The budgeted unit costs per pound are:
Mona Loa Coffee
Malaysian Coffee
Direct unit costs:
Direct materials
$4.20
$3.20
Direct labor
0.30 $4.50
0.30 $3.50
Indirect unit costs:
Purchasing
0.02
1.00
(4 orders x $500 /100,000 lbs.)
(4 orders x $500/2,000 lbs.)
Material handling
0.12
2.40
(30 setups x $400/100,000 lbs.)
(12 setups x $400/2,000 lbs.)
Quality control
0.02
0.40
(10 batches x $200/100,000 lbs.)
(4 batches x $200/2,000 lbs.)
Roasting
0.10
0.10
(1,000 hours x $10/100,000 lbs.)
(20 hours x $10/2,000 lbs.)
Blending
0.05
0.05
(500 hrs. x $10/100,000 lbs.)
(10 hrs. x $10/2,000 lbs.)
Packaging
0.01
0.01
(100 hrs. x $10/100,000 lbs.)
(2 hrs. x$10/2,000 lbs.)
Total unit cost
$4.82
$7.46
The comparative cost numbers are:
Mona Loa

Malaysian

Requirement 1

$6.00

$5.00

Requirement 2

4.82

7.46

The ABC system in requirement 2 reports a decreased cost for the highvolume Mona Loa and an increased cost for the low-volume Malaysian.
The current costing system leads to cross-subsidization between the two
products.

5-53 (Continued-2)
3. Three of the indirect cost items can be classified as output-unit driven:
Mona Loa Coffee
Malaysian Coffee
Roasting
$0.10
$0.10
Blending
0.05
0.05
Packaging
0.01
0.01
Total output-unit overhead
$0.16
$0.16
The other three indirect cost items are batch-level driven:
Mona Loa Coffee
Malaysian Coffee
Purchasing
$0.02
$1.00
Material handling
0.12
2.40
Quality control
0.02
0.40
Total batch-level overhead
$0.16
$3.80
Malaysian coffee has a greater number of setups per output unit than
does Mona Loa coffee. The result is that the unit cost of the lowervolume Malaysian coffee is much higher than that of the higher-volume
coffee, even though its cost of direct materials is lower.
With the current costing system, the high-volume Mona Loa is
overcosted, while the low-volume Malaysian is undercosted. Pricing of
Mona Loa can be reduced to make it more competitive. In contrast,
Malaysian should be priced at a much higher level if the strategy is to
cover the current periods cost. CBI may wish to have lower margins with
its low-volume products such as Malaysian in an attempt to build up
volume. The company can use the ABC cost information to compare its
two product costs with competitors, and decide which product has a low
cost competitive advantage. Then the company can change its pricing
and product mix strategies by using the ABC cost information.
ABC cost data also point out that the reason for the Malaysian
Coffee to have a higher unit cost is not because of high-priced
ingredients. In fact, Malaysian Coffee has a lower cost of direct materials
than that of Mona Loa Coffee. The costs of roasting, blending, and
packaging are $0.16 per pound for both coffees. The higher cost of
Malaysian is because of the way in which it is processed. The batch-level
cost per pound is $0.16 for Mona Loa and $3.80 for Malaysian. CBI can
increase its profit margin or lower its price on Malaysian Coffee if it can
change the way in which it handles purchasing, material handling, and
quality control functions of Malaysian coffee.

Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

5-54 Customer Profitability Analysis (30 Min)


1. Service cost rate per unit of activity
Estimated
Estimated
Service
Activities
Annual
Cost Driver
Annual Cost
Cost
Expense
Driver Units
Per Unit
Requisition
Handling
$3,000,000 Requisitions
300,000 $10.00
Warehouse
$1,050,000
Cartons
70,000 $15.00
Pick
Packing
$ 900,000
(PP) Lines
600,000 $ 1.50
Data Entry
$ 600,000
(PP) Lines
600,000 $ 1.00
Delivery
$10 per delivery (requisition) + $0.30 per mile
charge
2. Service Costs

Omega International

City of Albion

Requisition Handling
$3,000
$ 7,000
(300 requisitions x $10/requisition)
(700 requisitions x $10/requisition)
Warehouse Activity
750
7,500
(50 cartons x $15.00 per carton)
(500 cartons x $15.00 per carton)
Pick-Packing
1,350
3,150
(900 pick-pack lines x $1.50)
(2,100 pick-pack lines x $1.50)
Data Entry
900
2,100
(900 lines x $1.00/line)
(2,100 lines x $1.00/line)
Freight Out
3,450
8,260
($10 x 300) + ($0.30 x 5 x 300)
($10 x 700) + ($0.30 x 6 x 700)
Total Service Costs
$9,450
$28,010
3. Customer Profitability Analysis-Activity Based
Omega International
Sales

$ 80,000

City of Albion
$80,000

Product Cost

(50,000)

(48,000)

Service costs

( 9,450)

(28,010)

Gross Margin
Gross Margin %

$20,550
25.69%

$ 3,990
4.99%

5-54 (Continued-1)
The above profitability analysis indicates that, under activity-based
costing, Omega International, not City of Albion, is more profitable to
Boston Depot. The apparent higher gross margin percentage of the
City of Albion relative to the Omega International was the result of not
recognizing differences in the service activities requested by different
customers under the firms existing costing system.
City of Albion is a much heavier user of services provided by
Boston Depot. Although both customers had the same total sales, City
of Albion made more desktop delivery requests in smaller quantities
and maintained more inventory by Boston Depot.
4.

The answer depends on the competitive strategy of the firm. The gross
profit margin ratios show that Omega is the better customer of the two.
Omega does not use much of the desktop delivery service Boston
offers. Most likely Omega is a buyer of commodity items and does not
need the convenience of desktop delivery. However, Bostons pricing is
likely to have incorporated the average cost of desktop deliveries. If
Omega realizes that it is paying for services not used, it may buy the
commodity it needs elsewhere, unless Boston lowers the price to
Omega.
All custom-printed business forms by different suppliers are likely
to be the same. Delayne wanted to differentiate its forms from those
of competitors by offering desktop delivery services. In the long-run,
Omega is not likely to be a customer staying with Boston Depot.
Boston Depot needs to be prepared to lower the price to Omega.
If the firm desires to compete on a differentiation strategy it needs
to price accordingly. Boston Depot needs to raise prices to City of
Albion. If City of Albion is willing to pay a higher price for the
convenience of desktop delivery, it is the kind of customer that Delayne
wants.

Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

5-55 Activity-Based Costing (35-40 min)


(Miami Valley Architects, Inc. by Beth M. Chaffman, CPA and John Talbott, CMA,
Management Accounting Campus Report, Fall 1992, p.4)
1. Overhead Cost assigned to each branch under the ABC costing:
Columbus Cincinnati Dayton Total
Direct labor dollar
37.61%
31.19% 31.20% 100%
Timesheet entries
45.11%
28.57% 26.32% 100%
Vendor invoices
44.93%
37.44% 17.62% 100%
Client invoices
52.13%
39.36%
8.51% 100%
Employees
34.33%
38.81% 26.87% 100%
New hires
42.11%
21.05% 36.84% 100%
Insurance claims filed
34.33%
38.81% 26.87% 100%
Proposals
39.22%
49.02% 11.76% 100%
Contracted sales
48.07%
36.88% 15.05% 100%
Projects shipped
39.13%
49.01% 11.86% 100%
Purchase orders
41.54%
33.85% 24.62% 100%
Copies duplicated
43.48%
39.13% 17.39% 100%
Blueprints
45.24%
36.19% 18.56% 100%
Activity-based overhead allocation
Colum. Cinci. Dayton Total
Cost Driver
General administration
$153.84 $127.56 $127.60 $ 409Direct labor dollar
Project costing
21.65
13.71
12.63
48Timesheet entries
Accounts payable/receiving
62.46
52.05
24.49
139Vendor invoices
Accounts receivable
24.50
18.50
4.00
47Client invoices
Payroll/Mail sort & delivery
10.30
11.64
8.06
30Employees
Personnel recruiting
16.00
8.00
14.00
38New hires
Employee insurance process.
4.81
5.43
3.76
14Insurance claims filed
Proposals
54.51
68.14
16.35
139Proposals
Sales meetings/Sales aids
97.10
74.49
30.40
202Contracted sales
Shipping
9.39
11.76
2.85
24Projects shipped
Ordering
19.94
16.25
11.82
48Purchase orders
Duplicating costs
20.00
18.00
8.00
46Copies duplicated
Blueprinting
34.84
27.87
14.29
77Blueprints
Total
$529.34 $453.41 $278.26 $1,261

5-55 (Continued-1)
Calculation for general administration allocated to branches:
Total direct labor dollar: $382,413 + $317,086 + $317,188 = $1,016,687
Allocation of general administration based on direct labor dollar:
Proportion

Allocated Amount

Columbus

$382,413 / $1,016,687 = 37.61%

$409 x 37.61% = $153.84

Cincinnati

$317,086 / $1,016,687 = 31.19% $409 x 31.19% = $127.56

Dayton

$317,188 / $1,016,687 = 31.20% $409 x 31.20% = $127.60

2. Contribution of each branch:


Columbus
Sales

Cincinnati

Dayton

Total

$1,500

$1,419

$1,067

$3,986

382

317

317

1,016

281

421

185

887

180

270

177

627

$657

$411

$388

$1,456

Less: Direct labor


Direct materials
Direct overhead
Contribution margin

3. Profitability of each branch using activity-based costing:


Columbus Cincinnati
Sales

Dayton

Total

$1,500

$1,419

$1,067

$3,986

Less: Direct labor

382

317

317

1,016

Direct materials

281

421

185

887

180

270

177

627

$657

$411

$388

$1,456

529
$128

453
($42)

278
$110

1,261
$195

Direct overhead
Contribution margin
Activity-based overhead
Operating income
5-55 (Continued-2)
Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

4. Evaluating management concerns:


Overhead costs are usually aggregated in pools and allocated to
products and other cost objects based on volume measures such as
direct labor dollars or machine hours. The cost object, therefore,
supposedly shares proportionally in those costs necessary for its
production or existence. If however, overhead varies in accordance
with variables other than volume, then product costs and other cost
objects will be erroneously determined.
As the solution indicates, the profitability of the Cincinnati and Dayton
offices is vastly different employing direct tracing and ABC than under
the current approach. The obvious benefit to the company is a more
equitable distribution of bonuses and resources to these locations. In
addition, existing marketing strategy may be promoting the wrong
location and strategic planning may be based on spurious
assumptions concerning relative profitability.
This case also illustrates that ABC is applicable to service
organizations as well as to manufacturing and that cost objects can
consist of projects, locations, customers, etc., as well as products. In
essence, the better information we have about the profitability of any
cost object, the better chance of keeping organizations profitable.
However, the process of identifying activities and allocating costs from
the general ledger to the activities is a difficult, time consuming
process. Extensive interviews with functional managers and workers
are normally required. This process is time consuming and often
costly.

5.56 Customer Profitability Analysis (30 minutes)


HS Inc. Adventix

Baldwin

Customer revenue analysis


Total sales
Less: Sales discount
Net invoice
Less: Sales returns
Net sales

$600,000

$750,000

$900,000

12,000

22,500

18,000

$588,000

$727,500

$882,000

11,760

7,275

26,460

$576,240

$720,225

$855,540

Less: Cash discounts

11,525

Finance charge

(7,530)

Net proceeds

$572,245

21,606

$698,619

$855,540

200

$ 125

$ 450

Order taking

500

250

2,500

Order processing

750

375

3,750

Sales return

600

800

2,000

Delivery

1,500

15,000

Expediting order

1,000

2,500

800

800

1,600

Total customer cost

$2,850

$4,850

$27,800

Net customer profit

$569,395

$693,769

$827,740

Customer cost analysis


Customer unit-level cost:
Sales return (restocking)3

Customer batch-level costs:

Customer sustaining costs:


Sales visits

Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005

5-56 (Continued)
1

Net proceeds:

$576,240 - $11,525 =

$564,715

Savings of not having to finance working capital:


$564,715 x 2% x 20/30 =
2

Payment received on the 60th day:

Finance charge for 30 days


Payment received on the 90th day:

Finance charge for 60 days

$7,530

$720,225 2 = $360,112.50

$360,112.50 x 2% =
$720,225 2 = $360,112.50

$360,112.50 x 2% x 2 =

Net finance charge


3

Restocking cost:

$ 7,202
14,404
$21,606

HS Inc:

10 x 100 x 2% x $10 =

$200

Adventix:

5 x 250 x 1% x $10 =

$125

Baldwin:

50 x 30 x 3% x $10 =

$450

5-57 A Team Project Assignment, Activity Analysis


Answer will be different for each team depending on the project selected by each
team.

Blocher, Chen, Corkin, Lin: Cost Management

5-6

The McGraw-Hill Companies, Inc., 2005