5-54

West Chemical Company produces three products. The firm sets the target price of each
product at 150% of the product's total manufacturing cost. Recognizing that the firm was
able to sell Product C at a much higher price than the target price of the product and lost
money on Product B, To Watson, CEO, wants to promote Product C much more
aggressively and phase out Product B. He believes that the information suggests that
Product C has the greatest potential among the firm's three products since the actual
selling price of Product C was almost 50 percent higher than the target price while the
firm was forced to sell Product B at a price below the target price. Both the budgeted and
actual factory overhead for 2010 are $493,000. The actual units sold for each product also
are the same as the budgeted units. The firm uses direct labor dollars to estimate
manufacturing overhead costs. The direct materials and direct labor costs per unit for
each product are:
Target selling price (% of total mfg. cost) =
Budgeted factory overhead =
Actual factory overhead incurred =

150%
$493,000
$493,000

Actual operating results for 2007 are as follows

Product
Sales Quantity
Target Price
A
1,000
$279.00
B
5,000
$294.00
C
500
$199.50

Actual Price
$280.00
$250.00
$300.00

Difference
$1.00
($44.00)
$100.50

The direct labor and direct materials cost per unit are as follows:
Direct Materials
Direct labor
Total prime cost

Product A
$50.00
$20.00
$70.00

Product B
$114.40
$12.00
$126.40

Product C
$65.00
$10.00
$75.00

The controller notes that not all of the products consume factory overhead costs similarly.
Upon further investigation, she identified the following overhead consumption data for
2007:

Number of setups
Weight of direct materials (pounds)
Waste and hazardous disposals
Quality inspections
Utilities (machine hours)
TOTAL

Product
A
2
400
25
30
2,000

Product
B
5
250
45
35
7,000

Product
C
3
350
30
35
1,000

Total
Overhead
$8,000
$100,000
$250,000
$75,000
$60,000
$493,000

Required
1. Determine the manufacturing cost per unit for each of the products using the
volume-based method.
2. What is the least profitable and the most profitable product under both the current
and the ABC costing systems?
3. What is the new target price for each product based on 150 percent of the new
costs under the ABC system? Compare this price with the actual selling price.
4. Comment on the result. As a manager of West Chemical, describe what actions
you would take based on the information provided by the activity-based unit
costs.

5-58
Superior Door Company (SDC) manufactures and sells two main product lines, exterior
doors and interior doors. Its products are sold through industry and wholesale suppliers.
SDC is known for their quality and value, and are often priced lower than competing
brands. During a recent executive meeting, Jerry Rhodes, the vice president of
marketing, made three observations: First, the price of the interior door (ID), a highvolume product for the firm, is often higher than that of competitors products. Second,
SDC has been struggling to maintain its market share of ID. Third, the firm has sold
approximately the same number of units of external doors (ED), a high margin product,
despite a 7.5 percent increase in price. Noting that the profit margin per unit of ED is
higher than that of ID, Rhodes has suggested that SDC should push for producing and
selling of ED. Regina Jones, the plant manager, objected to this strategy because the
manufacturing processes of ED were much more complicated than those for ID. The total
manufacturing costs would increase substantially if SDC shifted its product line to
emphasize ED.
Joseph Higgins, the vice president of finance, observes that SDC uses a direct labor costbased system to determine the amount of manufacturing overhead for all of its products.
Selected operating data for the year 2010 follow:

Product
ED
ID

Units Sold
5,000
50,000

Cost per Unit

Direct
Direct
Materials
Labor
$40
$30

Selling
Price per
Unit
$24
$150
$12
$80

Joseph also has collected the following data on activity cost pools and their cost
drivers:B101
Cost Pools/Activities
Machine operation
Support labor overhead
Machine setup
Assembly
Inspection

Cost Drivers
Machine-hours
Direct labor costs
Setup hours
Number of operators
Inspection hours

Estimated Overhead Costs and Activity Consumption Information

Activity Cost Pool

Machine operation
Support labor overhead
Machine setup
Assembly
Inspection
Total

Activity Consumption Levels

Total
Overhead
Activity
ED
$200,000
10,000
2,500
$150,800
$720,000 $120,000
$82,500
2,500
1,200
$140,875
402,500
192,500
$66,250
4,000
1,800
$640,425

ID
7,500
$600,000
1,300
210,000
2,200

Joseph explained why these cost drivers were appropriate:

The overhead costs for machine operation had nothing to do with the direct labor-hours.
These costs were more likely to vary with the number of machine-hours.
The support labor included allowances for benefits, break periods and costs related to
the supervising and engineering staff. This overhead was indirect to the products but was
related to the direct labor costs.
The setup overhead was generated by changing the job to be run and should be related
to the setup hours rather than the direct labor-hours.
The assembly overheads related to costs incurred to the number of cutting, trimming,
and sanding operators. Therefore, the correct cost driver should be the number of
operators.
The inspection overhead arose from checking the finished goods. The higher the
number of finished units, the higher the inspection overhead costs. The appropriate cost
driver should be the number of hours spent on the inspection.
Required
1. Using the current costing system, which uses direct labor costs as the basis to
determine overhead costs, calculate the unit manufacturing costs of the two
products.
2. Using the activity-based costing (ABC) system, calculate the unit manufacturing
costs of the two products.
3. Under ABC, is the exterior door line as profitable as the vice-president of
marketing thinks it is under the existing costing system?
4. Evaluate the marketing vice-presidents suggestion to shift the sales mix in favor
of exterior doors.
5. Give at least two reasons for the difference between the results for the two
different costing systems.

Chapter 5

5-54 Volume-based Costing Versus ABC

1.
Product A
Product B Product C
Materials
$50.00
$114.40
$65.00
Labor
20.00
12.00
10.00
Overhead*
116.00
69.60
58.00
Total Cost
$186.00
$ 196.00
$133.00
*overhead is applied based on direct labor dollars so the rate is:
$5.80/ Direct labor dollar = $493,000/($20x1,000+$12x5,000+$10x500)
$116 = 5.8x20; $69.60 = 5.8x12; $58 =5.8x10
2. Current Costing system
Actual selling price
Product manufacturing cost
Gross margin
Gross margin ratio

Product A
$280
186
$ 94
33.57%

Product B
$250
196
$ 54
21.6%

Product C
$300
133
$167
55.67%

Based on the current cost data, 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%).
Product costs based on the activity-based costing system
Product A Product B
Product C
Direct materials
$ 50.00
$114.40
$ 65.00
Direct labor
20.00
12.00
10.00
Factory overhead:
Setups (a)
1.60
0.80
4.80
(b)
Materials handling
40.00
5.00
70.00
(c)
Hazardous control
62.50
22.50
150.00
(d)
Quality control
22.50
5.25
52.50
(e)
Utilities
12.00
8.40
12.00
Total Factory overhead
$138.60
$41.95
$289.30
Total Cost
$208.60
$168.35
$364.30
Actual selling price
Product manufacturing cost
Gross margin
Gross margin ratio

$280.00
208.60
$ 71.40
25.50%

$250.00
168.35
$ 81.65
32.66%

$300.00
364.30
($64.30)
(21.43)%

Chapter 5

5-54 (continued -1)

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

Chapter 5

5-54 (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
$280.00
$32.90

Direct-labor based costing system

Gross margin
Gross margin ratio

$ 94
33.57%

$ 54
21.6%

$167
55.67%

Activity-based costing system:

Gross margin
Gross margin ratio

$71.40
25.50%

$81.65
32.66%

$(64.30)
(21.43%)

$252.53
$250.00
$ 2.52

$546.45
$300.00
$246.45

4. Strategic and Competitive Analysis

1. Emphasizing Product C as suggested by the current directlabor-cost based overhead costing system is likely to harm
the firms competitiveness. The activity-based costing
system shows that the manufacturing cost of Product C is
$364.30 per unit and, at the current selling price, the firm
suffers a $64.30 loss for each unit it manufactures and sells.
2. If the actual selling prices of products A & B are fair market
prices for these products and a markup of 150% is a
common industry practice, the firm needs to examine the
manufacturing cost of product A. The fact that the 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 waste and inefficiency in the
manufacturing of product A.

Chapter 5

5-58 Volume-Based Costing vs. ABC

1. Manufacturing Costs Volume Based
Basic Data
Exterior Door
Interior Door
Activities
Machine operation
Support labor overhead
Machine setup
Assembly
Inspection
Total

Units
Sold
5,000
50,000

Materials
$40
$30

Labor
$24
$12

Activity Cost Driver

Machine-hours
Direct labor costs
Setup hours
Number of parts
Inspection hours

Using the Volume Based Method

Overhead allocated on the basis of direct labor cost
Exterior Door
Interior Door

$200,000
$150,800
$82,500
$140,875
$66,250
$640,425

Selling Price
$150
$80
Total Activity Exterior Door Interior Door
10,000
2,500
7,500
$ 720,000 $
120,000 $ 600,000
2,500
1,200
1,300
402,500
192,500
210,000
4,000
1,800
2,200

0.889 =$640,425/$720,000
Total
Per Unit
$ 106,738 $
21.35
533,688
10.67

2. Activity Rates and Costs Using ABC:

Using the Activity-based Method
Activity
Rate
Machine operation
$20.0000
Support labor overhead
$0.2094
Machine setup
$33.0000
Assembly
$0.3500
Inspection
$16.5625

Activity Cost Driver

Machine-hours
Direct labor costs
Setup hours
Number of parts
Inspection hours

Exterior Door
Activities
Overhead
2,500
$50,000
120,000
$25,133
1,200
$39,600
192,500
$67,375
1,800
$29,813
$211,921

Interior Door
Activities
Overhead
7,500
$150,000
600,000
$125,667
1,300
$42,900
210,000
$73,500
2,200
$36,438
$428,504

Chapter 5

5-58 (continued-1)
Total
Number of units
Sales
Direct materials
Direct Labor
Overhead
Machine Operation
Support Labor
Machine Setup
Assembly
Inspection
Total Overhead
Total Manufacturing Costs
Gross Margin
Gross Margin Percent

Exterior Door
Interior Door
Per Unit
Total
Per Unit
5,000
50,000
750,000 $
150.00
4,000,000 $
80.00
200,000
40.00
1,500,000
30.00
120,000
24.00
600,000
12.00

50,000.00
25,133.33
39,600.00
67,375.00
29,812.50
211,920.83
531,920.83
$ 218,079.17 $
29.08%

42.38

150,000.00
125,666.67
42,900.00
73,500.00
36,437.50
428,504.17

106.38
43.62

2,528,504.17
$ 1,471,495.83

8.57

50.57
29.43
36.79%

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

Chapter 5

5-58 (continued-2)
4. Unit Cost Comparison of overhead costs between the current and
ABC costing systems
Cost Comparison of Overhead costs per unit
Volume-based
Activity Based
Difference (ABC-VB)

$
$

Ext. Doors
21.35
42.38
21.04

Int. Doors
10.67
8.57
$
(2.10)

According to the ABC cost data, a shift to more Exterior Door

units and fewer Interior Door units would be ill advised. The
apparent higher unit gross margin of the Exterior Doors relative to
the Interior Doors indicates that the current costing system
distorted relative unit profitability.
5. Among the reasons for the difference are:
a. The current direct labor based costing system focused on only
one manufacturing activity of the entire production process. It
measures only one attribute of the individual product: the
number of direct labor hours consumed. By contrast, the ABC
system considered all activities of the manufacturing processes.
Costs were traced from activities to products based on the
products demand for these activities during the production
process. The allocation bases used in ABC were thus measures
of the activities performed. For Superior Door Company, 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 interior
doors were overcosted and the low-volume exterior doors were
undercosted. The source of this distortion is the choice of a
single volume-related allocation base, direct labor cost, for
tracing of costs from manufacturing to products. Using a volumerelated 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 exterior doors were low-volume
products, they actually consume more resources a result not
related to volume.
6