CHAPTER 4 ACTIVITY-BASED PRODUCT COSTING

QUESTIONS FOR WRITING AND DISCUSSION

1. Unit costs provide essential information needed for inventory valuation and preparation of income statements. Knowing unit costs is also critical for many decisions such as bidding decisions and accept-orreject special order decisions. 2. Cost measurement is determining the dollar amounts associated with resources used in production. Cost assignment is associating the dollar amounts, once measured, with units produced. An actual overhead rate is rarely used be- cause of problems with accuracy and timeli- ness. Waiting until the end of the year to en- sure accuracy is rejected because of the need to have timely information. Timeliness of information based on actual overhead costs runs into difficulty (accuracy problems) because overhead is incurred nonuniformly and because production also may be non- uniform. For plantwide rates, overhead is first collected in a plantwide pool, using direct tracing. Next, an overhead rate is computed and used to assign overhead to products. First stage: Overhead is assigned to production department pools using direct tracing, driver tracing, and allocation. Second stage: Individual departmental rates are used to assign overhead to products as they pass through the departments. Departmental rates would be chosen over plantwide rates whenever some departments are more overhead intensive than others and if certain products spend more time in some departments than they do in others. sent a significant proportion of total overhead costs. 8. Low-volume products may consume nonunit-level overhead activities in much greater proportions than indicated by a unitlevel cost driver and vice versa for highvolume products. If so, then the low-volume products will receive too little overhead and the high-volume products too much. If some products are undercosted and oth- ers are overcosted, a firm can make a num- ber of competitively bad decisions. For ex- ample, the firm might select the wrong product mix or submit distorted bids. Nonunit-level overhead activities are those overhead activities that are not highly correlated with production volume measures. Examples include setups, material handling, and inspection. Nonunit-level cost drivers are causal factors factors that explain the consumption of nonunit-level overhead. Examples include setup hours, number of moves, and hours of inspection. Product diversity is present whenever products have different consumption ratios for different overhead activities. An overhead consumption ratio measures the proportion of an overhead activity con- sumed by a product. Departmental rates typically use unit-level cost drivers. If products consume nonunitlevel overhead activities in different proportions than those of unit-level measures, then it is possible for departmental rates to move even further away from the true consumption ratios, since the departmental unit-level ratios usually differ from the one used at the plant level. Agree. Prime costs can be assigned using direct tracing and so do not cause cost dis- tortions. Overhead costs, however, are not directly attributable and can cause distor- tions. For example, using unit-level activity drivers to trace nonunit-level overhead costs would cause distortions.

9.

3.

10.

4.

5.

11.

12.

6.

13.

7. Plantwide overhead rates assign overhead to products in proportion to the amount of the unit-level cost driver used. If the products consume some overhead activities in different proportions than those assigned by the unit-level cost driver, then cost distortions can occur (the product diversity factor). These distortions can be significant if the nonunit-level overhead costs repre-

14.

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15.

Activity-based product costing is an overhead costing approach that first assigns costs to activities and then to products. The assignment is made possible through the identification of activities, their costs, and the use of cost drivers. An activity dictionary is a list of activities accompanied by information that describes each activity (called attributes) A primary activity is consumed by the final cost objects such as products and custom- ers, whereas secondary activities are con- sumed by other activities (ultimately con- sumed by primary activities). Costs are assigned using direct tracing and resource drivers. Unit-level activities are those that occur each time a product is produced. Batch-level activities are those that are performed each time a 20.

batch of products is produced. Product-level or sustaining activities are those that are performed as needed to support the various products produced by a company. Facilitylevel activities are those that sustain a factorys general manufacturing process Rates can be reduced by building a system that approximates the cost assignments of a fully specified ABC system. One way to do this is by using only the most expensive ac- tivities to assign costs. If the most expensive activities represent a large percentage of the total costs, then most of the costs are as- signed using a causeand-effect relation- ship, thus creating a good level of accuracy while reducing the complexity of the ABC system.

16.

17.

18. 19.

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EXERCISES 41
1. $27,000,000/90,000 = $300 per direct labor hour (DLH) 2. $300 91,000 = $27,300,000 3. Applied overhead Actual overhead Overrapplied overhead $ 27,300,000 27,200,000 $ 100,000

4. Predetermined rates allow the calculation of unit costs and avoid the problems of nonuniform overhead incurrence and nonuniform production associated with actual overhead rates. Unit cost information is needed throughout the year for a variety of managerial purposes.

42
1. Predetermined overhead rate = $4,500,000/600,000 = $7.50 per DLH 2. Applied overhead = $7.50 585,000 = $4,387,500 3. Applied overhead Actual overhead Underapplied overhead Unit cost: Prime costs Overhead costs Total Units Unit cost $ 4,387,500 4,466,250 $ (78,750)

4.

6,750,000 4,387,500 $ 11,137,500 750,000 $ 14.85

43
1. Predetermined overhead rate = $4,500,000/187,500 = $24 per machine hour (MHr) 2. Applied overhead = $24 187,875 = $4,509,000

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43
3.

Concluded
Applied overhead Actual overhead Overapplied overhead $ 4,509,000 4,466,250 $ 42,750

4. Unit cost: Prime costs Overhead costs Total Units Unit cost *Rounded

6,750,000 4,509,000 $ 11,259,000 750,000 $ 15.01*

5. Gandars needs to determine what causes its overhead. Is it primarily labor driven (e.g., composed predominantly of fringe benefits, indirect labor, and personnel costs), or is it machine oriented (e.g., composed of depreciation on machinery, utilities, and maintenance)? It is impossible for a decision to be made on the basis of the information given in this exercise.

44
1. Units produced Prime costs Overhead costs Unit cost: Prime Overhead Total Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total 400,000 160,000 80,000 560,000 1,200,000 $8,000,000 $3,200,000 $1,600,000 $11,200,000 $24,000,000 $3,200,000 $2,400,000 $3,600,000 $2,800,000 $12,000,000 $20 8 $28 $20 15 $35 $20 45 $65 $20 5 $25 $20 10 $30

2. Actual costing can produce wide swings in the overhead cost per unit. The cause appears to be nonuniform incurrence of overhead and nonuniform production (seasonal production is a possibility). 3. First, calculate a predetermined rate: OH rate = $11,640,000/1,200,000 = $9.70 per unit This rate is used to assign overhead to the product throughout the year. Since the driver is units produced, $9.70 would be assigned to each unit.
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Adding this to the actual prime costs produces a unit cost under normal costing: Unit cost = $9.70 + $20.00 = $29.70

This cost is close to the actual annual cost of $30.00. 45

1. Inspection hours Setup hours Machine hours Number of moves
a. c. b.

Total inspection hours = 200 (40+160); 40/200 for Scented and 160/200 for Regular Total Setup hours = 100 (50+50); 50/100 for Scented and 50/100 for Regular

Scented Cards a 0.20 b 0.50 c 0.25 d 0.75

Regular Cards a 0.80 b 0.50 c 0.75 d 0.25

Total Machine hours = 800 (200+600); 200/800 for Scented and 600/800 for Regular d. Total Number of moves = 300 (225+75); 225/300 for Scented and 75/300 for Regular

2. The consumption ratios vary significantly from driver to driver. Using, for example, only machine hours to assign the overhead may create accuracy problems. Both setup hours and number of moves have markedly different con- sumption ratios.

46
1. Rates: Inspecting products: $2,000/200 = $10 per inspection hour Setting up equipment: $2,500/100 = $25 per setup hour Machining: $4,000/800 = $5 per machine hour Moving materials: $900/300 = $3.00 per move Note: The denominator is the total driver amount (sum of the demand of the two products). 2.

Rate = Cost/hours
Inspection hours = Cost/Rate = $2,000/$20 = 100 inspection hours

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47
1. Predetermined rates: Drilling Department: Rate = $600,000/280,000 = $2.14* per MHr Assembly Department: Rate = $392,000/200,000 = $1.96 per DLH *Rounded 2. Applied overhead: Drilling Department: $2.14 288,000 = $616,320 Assembly Department: $1.96 196,000 = $384,160 Overhead variances: Actual overhead Applied overhead Overhead variance 3. Drilling $602,000 616,320 $ (14,320) over Assembly $ 412,000 384,160 $ 27,840 under Total $ 1,014,000 1,000,480 $13,520 under

Unit overhead cost = [($2.14 4,000) + ($1.96 1,600)]/8,000 = $11,696/8,000 = $1.46* *Rounded

48
1. Activity rates: Machining = $632,000/300,000 = $2.11* per MHr Inspection = $360,000/12,000 = $30 per inspection hour *Rounded 2. Unit overhead cost = [($2.11 4,000) + ($30 800)]/8,000 = $32,440/8,000 = $4.055

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49
1. Yes. Because direct materials and direct labor are directly traceable to each product, their cost assignment should be accurate. 2. The consumption ratios for each (using machine hours and setup hours as the activity drivers) are as follows:

Machining Setups 3. Elegant: Fina:

Elegant 0.10 0.50

Fina 0.90 (500/5,000 and 4,500/5,000) 0.50 (100/200 and 100/200)

(1.75 $9,000)/3,000 = $5.25 per briefcase (1.75 $3,000)/3,000 = $1.75 per briefcase

Note: Overhead rate = $21,000/$12,000 = $1.75 per direct labor dollar (or 175 percent of direct labor cost). There are more machine and setup costs assigned to Elegant than Fina. This is clearly a distortion because the production of Fina is automated and uses the machine resources much more than the handcrafted Elegant. In fact, the consumption ratio for machining is 0.10 and 0.90 (using machine hours as the measure of usage). Thus, Fina uses 9 times the machining resources as Elegant. Setup costs are similarly distorted. The products use an equal number of setup hours. Yet if direct labor dollars are used, then the Elegant briefcase receives three times more machining costs than the Fina briefcase. 4. Products tend to make different demands on overhead activities and this should be reflected in overhead cost assignments. Usually this means the use of both unit and nonunit-level activity drivers. In this example, there is a unitlevel activity (machining) and a nonunit-level activity (setting up equipment).

Machine rate: $18,000/5,000 = $3.60 per machine hour Setup rate: $3,000/200 = $15 per setup hour Costs assigned to each product: Machining: $3.60 500 $3.60 4,500 Setups: $15 100 Total Units Unit overhead cost Elegant $ 1,800 Fina $16,200 1,500 $ 3,300 3,000 $ 1.10
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1,500 $17,700 3,000 $ 5.90

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410
1. Normal Treating patients: $4.00 5,000 $4.00 20,000 Providing hygienic care: $5.00 5,000 $5.00 11,000 Responding to requests: $2.00 30,000 $2.00 50,000 Monitoring patients: $0.75 20,000 $0.75 180,000 Cost Assigned $ 20,000 $ 80,000 25,000 55,000 60,000 100,000 15,000 $120,000 135,000 $370,000 Intensive

2. Nursing cost per patient day: $120,000/10,000 $370,000/8,000 Normal $12.00 Intensive $46.25

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411
Activity dictionary: Activity Name Providing nursing care Supervising nurses Feeding patients Laundering bedding and clothes Providing physical therapy Monitoring patients Activity Description Satisfying patient needs Coordinating nursing activities Providing meals to patients Cleaning and delivering clothes and bedding Therapy treatments directed by physician Using equipment to monitor patient conditions Primary/ Secondary Primary Secondary Primary Primary Activity Driver Nursing hours Number of nurses Number of meals Pounds of laundry

Primary

Hours of therapy

Primary

Monitoring hours

4-12
1. Resource Equipment Fuel Operating Labor* Total Unloading $ 12,000 2,400 1,000 48,000 $ 63,400 Counting Inspecting $ 800 30,000 $ 30,000 500 42,000 $ 43,300

*(0.40 $120,000; 0.25 $120,000; 0.35 $120,000)

2. Direct tracing and driver tracing are used. When the resource is used only by one activity, then direct tracing is possible. When the activities are shared, as in the case of labor, then resource drivers must be used.

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413
1. Unit-level activities: Batch-level activities: Product-level activities: Facility-level activities: Machining Setups and packing Receiving None

2.

Activity rates: (1) Machining: $80,000/40,000 = $2 per MHr (2) Setups: $32,000/400 = $80 per setup (3) Receiving: $18,000/600 = $30 per receiving order (4) Packing: $48,000/3,200 = $15 per packing order Overhead assignment: Infantry Activity 1: Activity 2: Activity 3: Activity 4: Total $2 20,000 = $ 40,000 $80 300 = 24,000 $30 200 = 6,000 $15 2,400 = 36,000 $106,000

Special forces Activity 1: $2 20,000 = $ 40,000 Activity 2: $80 100 = 8,000 Activity 3: $30 400 = 12,000 Activity 4: $15 800 = Total 12,000 $ 72,000

Combining Activities 2 and 4 produces a new pooled rate: ($32,000 + $48,000)/400 = $ 200 per setup Overhead assignment: Infantry Activity 1: $2 20,000 = $ 40,000 Activity 2*: $200 300 = 60,000 Activity 3: $30 200 = 6,000 Total $106,000 *Combined activities 2 and 4

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Special forces Activity 1: $2 20,000 = $ 40,000 Activity 2: $200 100 = 20,000 Activity 3: $30 400 = 12,000 Total $ 72,000 The assignments are the same and this happens because the consumption ratios of activities 2 and 4 are identical. Thus, rate reduction can occur by combining all activities with identical rates. 3. The two most expensive activities are the first and the combined 2 and 4 activities. Each has $80,000 of cost. Thus if the cost of activity 3 is allocated in proportion to the cost, each of the expensive activities would receive 50% of the $18,000 or $9,000. This yields the following pool rates: Activity (pool 1) 1: ($80,000 + $9,000)/40,000 = $2.225 per machine hour Activities 2 and 4 (pool 2): ($80,000 + $9,000)/400 = $222.50 per setup Overhead assignment: Infantry Pool 1: $2.225 20,000 = $ 44,500 Pool 2: $222.50 300 = 66,750 Total $111,250 Special forces Pool 1: $2.225 20,000 = $ 44,500 Pool 2: $222.5 100 = 22,250 Total $ 66,750 4. Infantry: ($111,250 - $106,000)/$106,000 = .05 (rounded) Special forces = ($66,750 - $72,000)/$72,000 = -.07 (rounded) The error is less than 10% for both products. Using machine hours would have produce a rate of $178,000/40,000 = $4.45 per Mhr and an assignment of $89,000 to each product ($4.45 20,000). The error for the plantwide rate would be Infantry: ($89,000 - $106,000)/106,000 = 0.16 (rounded) Special forces = ($89,000 - $72,000)/$72,000 = 0.24 (rounded) Thus, the plantwide rate produces product costing errors that are more than three times the magnitude of the approximately relevant ABC assignments. Clearly, the approximation produces a more reasonable and useful outcome and is less complex than the full ABC system.
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414
1. Cost of labor (0.40 $50,000) Forklift (direct tracing) Total cost of receiving $20,000 10,000 $30,000

2. Activity rates: Receiving: $30,000/60,000 = $0.50 per part Setup: $60,000/300 = $200 per setup Grinding: $90,000/18,000 = $5 per MHr Inspecting: $20,000/2,000 = $10 per inspection Subassembly A Overhead: Setup: $200 150 $200 150 Inspecting: $10 1,500 $10 500 Grinding: $5 7,200 $5 10,800 Receiving: $0.50 20,000 $0.50 40,000 Total costs assigned 3. $ 30,000 $ 30,000 15,000 5,000 36,000 54,000 10,000 $ 91,000 20,000 $ 109,000 Subassembly B

Setup pool: $60,000 + [($60,000/$150,000) $50,000] = $80,000 Grinding pool: $90,000 + [($90,000/$150,000) $50,000] = $120,000 Pool rates: Setup = $80,000/300 = $266.67/setup Grinding = $120,000/18,000 = $6.67/ Mhr

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Approximating assignment: Subassembly A Setup: $266.67 150 $266.67 150 Grinding: $6.67 7,200 $6.67 10,800 Total costs assigned 4. $40,000 $ 40,000 48,024 $88,024 72,036 $ 112,036 Subassembly B

Error (Subassembly A) = ($91,000 - $88,024)/$91,000 = 0.033 Error (Subassembly B) = ($109,000 - $112,036)/$109,000 = - 0.028 The error is small and so the approach may be desirable as it reduces the complexity and size of the system, making it more likely to be accepted by management.

415
1. 2. Unit-level: Batch-level: Testing products, inserting dies Setting up batches, handling wafer lots, purchasing materials, receiving materials

3.

Product-level: Developing test programs, making probe cards, engineering design, paying suppliers Facility-level: Providing utilities, providing space

4.

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PROBLEMS 416
1. Plantwide rate = $1,320,000/440,000 = $3.00 per DLH Overhead cost per unit: Model A: $3.00 140,000/30,000 = $14.00 Model B: $3.00 300,000/300,000 = $3.00 2. Calculation of activity rates: Activity Setup Inspection Machining Maintenance Overhead assignment: Model A Setups $3,600 40 $3,600 60 Inspections $140 800 $140 1,200 Machining $1.454 20,000 $1.454 200,000 Maintenance $3.60 10,000 $3.60 90,000 Total overhead Units produced Overhead per unit 3. Departmental rates: Overhead cost per unit: Model A: [($4.66 10,000) + ($1.20 130,000)]/30,000 = $6.76 Model B: [($4.66 170,000) + ($1.20 270,000)]/300,000 = $3.72
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Driver Prod. runs Insp. hours Mach. Hours Maint. hours

Activity Rate $360,000/100 = $3,600 per run $280,000/2,000 = $140 per hour $320,000/220,000 = $1.454 per hr $360,000/100,000 =$3.60 per hr Model B

$ 144,000 $ 216,000 112,000 168,000 29,080 290,800 36,000 ----$ 321,080 30,000 $ 10.70

324,000 $ 998,800 300,000 $ 3.33

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4. A common justification is that of using machine hours for machine-intensive departments and labor hours for labor-intensive departments. Using activitybased costs as the standard, we can say that departmental rates decreased the accuracy of the overhead cost assignment (over the plantwide rate) for both products. Looking at Department 1, this departments costs are as- signed at a 17:1 ratio which overcosts B and undercosts A in a big way. This raises some doubt about the conventional wisdom regarding departmental rates.

417
1. Cost before addition of duffel bags: $60,000/100,000 = $0.60 per unit The assignment is accurate because all costs belong to one product. 2. Activity-based cost assignment: Stage 1: Activity rate = $120,000/80,000 = $1.50 per transaction Stage 2: Overhead applied: Backpacks: Duffel bags: $1.50 40,000* = $60,000 $1.50 40,000 = $60,000

*80,000 transactions/2 = 40,000 (number of transactions had doubled) Unit cost: Backpacks: Duffel bags: 3. $60,000/100,000 = $0.60 per unit $60,000/25,000 = $2.40 per unit

Product cost assignment: Overhead rates: Patterns: Finishing: $48,000/10,000 = $4.80 per direct labor hour $72,000/20,000 = $3.60 per direct labor hour

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417

Concluded

Unit cost computation: Backpacks Patterns: $4.80 0.1 $4.80 0.4 Finishing: $3.60 0.2 $3.60 0.8 Total per unit $0.48 $1.92 0.72 $1.20 2.88 $4.80 Duffel Bags

4. This problem allows us to see what the accounting cost per unit should be by providing the ability to calculate the cost with and without the duffel bags. With this perspective, it becomes easy to see the benefits of the activitybased approach over those of the functional-based approach. The activitybased ap- proach provides the same cost per unit as the single-product setting. The functional-based approach used transactions to allocate accounting costs to each producing department, and this allocation probably reflects quite well the consumption of accounting costs by each producing department. The problem is the second-stage allocation. Direct labor hours do not capture the con- sumption pattern of the individual products as they pass through the depart- ments. The distortion occurs, not in using transactions to assign accounting costs to departments, but in using direct labor hours to assign these costs to the two products. In a single-product environment, ABC offers no improvement in productcosting accuracy. However, even in a single-product environment, it may be possible to increase the accuracy of cost assignments to other cost objects such as customers.

418
1. Unit-level costs ($120 20,000) Batch-level costs ($80,000 20) Product-level costs ($80,000 10) Facility-level ($20 20,000) Total cost $ 2,400,000 1,600,000 800,000 400,000 $ 5,200,000

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resold, copied, or distributed without the prior consent of the publisher.

2.

Unit-level costs ($120 30,000) Batch-level costs ($80,000 20) Product-level costs ($80,000 10) Facility-level costs Total cost

$ 3,600,000 1,600,000 800,000 400,000 $ 6,400,000

The unit-based costs increase because these costs vary with the number of units produced. Because the batches and engineering orders did not change, the batch-level costs and product-level costs remain the same, behaving as fixed costs with respect to the unit-based driver. The facility-level costs are fixed costs and do not vary with any driver. 3. Unit-level costs ($120 30,000) Batch-level costs ($80,000 30) Product-level costs ($80,000 12) Facility-level costs Total cost $ 3,600,000 2,400,000 960,000 400,000 $ 7,360,000

Batch-level costs increase as the number of batches changes, and the costs of engineering support change as the number of orders change. Thus, batches and orders increased, increasing the total cost of the model. 4. Classifying costs by category allows their behavior to be better understood. This, in turn, creates the ability to better manage costs and make decisions. 419 1. Labor and gasoline are driver tracing. Labor (0.75 $180,000) Gasoline ($4.50 6,000 moves) Depreciation Total cost 2. Plantwide rate = $660,000/20,000 = $33 per DLH Unit cost: Prime costs Overhead: $33 10,000/40,000 $33 10,000/20,000 Basic $160.00 8.25 $168.25 16.50 $336.50 Deluxe $320.00 $ 135,000 Time = Resource driver 27,000 Moves = Resource driver 18,000 Direct tracing $180,000

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419
3.

Continued

Activity rates: Maintenance Engineering hour Material handling Setting up Purchasing requisition Receiving Paying suppliers Providing space $114,000/4,000 = $28.50 per maint. hour $120,000/6,000 = $20 per eng. $180,000/6,000 = $30 per move $ 96,000/80 = $1,200 per move $ 60,000/300 = $200 per $ 40,000/750 = $53.33 per order $ 30,000/750 = $40 per invoice $ 20,000/10,000 = $2.00 per machine hour

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419 Continued Unit cost: Basic Prime costs Overhead: Maintenance $28.50 1,000 $28.50 3,000 Engineering $20 1,500 $20 4,500 Material Handling $30 1,200 $30 4,800 Setting up $1,200 16 $1,200 64 Purchasing $200 100 $200 200 Receiving $53.33 250 $53.33 500 Paying Suppliers $40 250 $40 500 Providing space $2 5,000 $2 5,000 Total Units produced Unit cost (ABC) Unit cost (traditional) $6,400,000 Deluxe $6,400,000

28,500 85,500 30,000 90,000 36,000 144,000 19,200 76,800 20,000 40,000 13,333 26,665 10,000 20,000 10,000 $ 6,567,033 40,000 $ 164.18 $ 168.25 10,000 $6,892,965 20,000 $ 344.65 $ 336.50

The ABC costs are more accurate (better tracing closer representation of actual resource consumption). This shows that the basic model was over- costed and the deluxe model undercosted when the plantwide overhead rate was used.

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419 Continued 4. Consumption ratios: Maint. Eng. Mat. H. Setups Purch. Receiving Pay. Sup Space Basic Delux 0.25 0.75 0.25 0.75 0.20 0.80 0.20 0.80 0.33 0.67 0.33 0.67 0.33 0.67 0.50 0.50

5.

When products consume activities in the same proportion, the activities with the same proportions can be combined into one pool. This is so because the pooled costs will be assigned in the same proportion as the individual activity costs. Using these consumption ratios as a guide, we create four pools, reducing the number of rates from 8 to 4. Pool 1: Maintenance Engineering Total Maintenance hours Pool rate $114,000 120,000 $234,000 4,000 $ 58.50

Note: Engineering hours could also be used as a driver. The activities are grouped together because they have the same consumption ratios: (0.25, 0.75). Pool 2: Material handling Setting up Total Number of moves Pool rate $180,000 96,000 $276,000 6,000 $ 46

Note: Material handling and setups have the same consumption ratios: (0.20, 0.80). The number of setups could also be used as the pool driver.

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419 Concluded Pool 4: Purchasing Receiving Paying suppliers Total Orders processed Pool rate $ 60,000 40,000 30,000 $130,000 750 $ 173.33

Note: The three activities are all product-level activities and have the same consumption ratios: (0.33, 0.67) Pool 5: Providing space Machine hours Pool rate $ 20,000 10,000 $ 2

Note: This is the only facility-level activity.

420
1. Activity classification: Unit-level: Batch-level: Product-level: Facility-level: Machining Material handling, setups, inspection, and receiving Maintenance and engineering None

2. Pool 1, consumption ratios: (0.5, 0.5): Machining $ 90,000 Activity driver 100,000 MHr Pool rate $ 0.90 per MHr Pool 2, consumption ratios: (0.75, 0.25): Setups $ 96,000 Inspection 60,000 Total $ 156,000 Activity driver 80 setups* Pool rate $ 1,950 per setup *Inspection hours could also be used.

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420

Concluded

Pool 3, consumption ratios: (0.33, 0.67):

Material handling Receiving Total Activity driver Pool rate $ 120,000 30,000 $ 150,000 6,000 material moves $ 25 per move

Pool 4, consumption ratios: (0.67, 0.33): Engineering $ 100,000 Maintenance 80,000 Total $ 180,000 Activity driver 6,000 maintenance hours* Pool rate $ 30 per maintenance hour *Number of engineering hours could also be used. 3. Computation of unit overhead costs: Small Clock Unit-level activities: Pool 1: $0.90 50,000 $0.90 50,000 Batch-level activities: Pool 2: $1,950 60 $1,950 20 Pool 3: $25 2,000 $25 4,000 Product-level activities: Pool 4: $30 4,000 $30 2,000 Total overhead costs Units produced Overhead cost per unit 120,000 $ 332,000 100,000 $ 3.32 60,000 $ 244,000 200,000 $ 1.22 117,000 39,000 50,000 100,000 $ 45,000 $ 45,000

Large Clock

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421 1. The total cost of care is $1,950,000 plus a $50,000 share of the cost of supervision [(25/150) $300,000]. The cost of supervision is computed as follows: Salary of supervisor (direct) Salary of secretary (direct) Capital costs (direct) Assistants (3 0.75 $48,000) Total $ 70,000 22,000 100,000 108,000 $ 300,000

Thus, the cost per patient day is computed as follows: $2,000,000/10,000 = $200 per patient day (The total cost of care divided by patient days.) Notice that every maternity patient regardless of type would pay the daily rate of $200. 2. First, the cost of the secondary activity (supervision) must be assigned to the primary activities (various nursing care activities) that consume it (the driver is the number of nurses): Maternity nursing care assignment: (25/150) $300,000 = $50,000 Thus, the total cost of nursing care is $950,000 + $50,000 = $1,000,000. Next, calculate the activity rates for the two primary activities: Occupancy and feeding: Nursing care: $1,000,000/10,000 = $100 per patient day $1,000,000/50,000 = $20 per nursing hour

Finally, the cost per patient day type can be computed: Patient Normal Cesarean Complications Daily Rate* $150 225 500

*($100 7,000) + ($20 17,500)/7,000 ($100 2,000) + ($20 12,500)/2,000 ($100 1,000) + ($20 20,000)/1,000 This example illustrates that activity-based costing can produce significant product costing improvements in service organizations that experience prod- uct diversity.

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421 3.

Concluded

The Laundry Department cost would increase the total cost of the Maternity Department by $100,000 [(200,000/1,000,000) $500,000]. This would increase the cost per patient day by $10 ($100,000/10,000). The activity approach would need more detailed information specifically, the amount of pounds of laun- dry caused by each patient type. The activity approach will increase the accu- racy of the cost assignment if patient types produce a disproportionate share of laundry. For example, if patients with complications produce 40 percent of the pounds with only 10 percent of the patient days, then the $10 charge per day is not a fair assignment.

422 1. Activity rates: Testing products Purchasing materials Machining Receiving = $252,000/300 = $840 per setup = $36,000/1,800 = $20 per order = $252,000/21,000 = $12 per machine hour = $60,000/2,500 = $24 per receiving hour Model A Testing products: $840 200 $840 100 Purchasing materials: $20 600 $20 1,200 Machining: $12 12,000 $12 9,000 Receiving: $24 750 $24 1,750 Total OH assigned $168,000 $ 84,000 12,000 24,000 144,000 108,000 18,000 $342,000 42,000 $258,000 Model B

Overhead cost assignment:

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2.

New cost pools: Testing products: $252,000 + [($252,000/$504,000) $96,000] = $300,000 Machining: $252,000 + [($252,000/$504,000) $96,000] = $300,000 New activity rates: Testing products: $300,000/300 = $1,000 per setup Machining: $300,000/21,000 = $14.29 per hour Model A Model B

Testing products: $1,000 200 $1,000 100 Machining: $14.29 12,000 $14.29 9,000 Total OH assigned 3. Percentage error: Model A: ($371,480 $342,000)/$342,000 = 0.086 (8.6%) Model B: ($228,610 $258,000)/$258,000 = 0.114 (11.4%) The error is not bad and is certainly not in the range that is often seen when comparing a plantwide rate assignment with the ABC costs. For example, if Model A is expected to use 30% of the direct labor hours, then it would receive a plantwide assignment of $180,000, producing an error of more than 47%an error almost six times greater than the approximately relevant as- signment. In this type of situation, it may be better to go with two drivers to gain acceptance and get reasonably close to the more accurate ABC cost. It also avoids the data collection costs of the bigger system. $200,000 $100,000 171,480 $371,480 128,610 $228,610

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resold, copied, or distributed without the prior consent of the publisher.

423 1. Overhead rate = $6,990,000/272,500 = $25.65 per DLH* Overhead assignment: X-12: $25.65 250,000/1,000,000 = $6.41* S-15: $25.65 22,500/200,000 = $2.89* *Rounded numbers used throughout Unit gross margin: Price Cost Gross margin X-12 $ 15.93 10.68* $ 5.25 S-15 $ 12.00 6.02** $ 5.98

*Prime costs + Overhead = ($4.27 + $6.41) **Prime costs + Overhead = ($3.13 + $2.89) 2. Pools Setup Machine Receiving Engineering Material handling Driver Runs Machine hrs. Orders Engineering hrs. Moves Pool Rate $240,000/300 = $800 per run $1,750,000/185,000 = $9.46/per MHr $2,100,000/1,400 = $1,500/per order $2,000,000/10,000 = $200/per eng. hour $900,000/900 = $1,000/per move

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423

Continued X-12 S-15

Overhead assignment: Setup costs: $800 100 $800 200 Machine costs: $9.46 125,000 $9.46 60,000 Receiving costs: $1,500 400 $1,500 1,000 Engineering costs: $200 5,000 $200 5,000 Material-handling costs: $1,000 500 $1,000 400 Total overhead costs Units produced Overhead cost per kg Prime cost per kg Unit cost Selling price Less unit cost Unit gross margin $ 80,000 $ 1,182,500 567,600 600,000 1,500,000 1,000,000 1,000,000 500,000 $ 3,362,500 1,000,000 $ 3.36 4.27 $ 7.63 $ $ 15.93 7.63 8.30 400,000 $ 3,627,600 200,000 $ 18.14 3.13 $ 21.27 $ $ 12.00 21.27 (9.27) 160,000

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423 3.

Concluded

No. The cost of making X-12 is $7.63, much less than the amount indicated by functional-based costing. The company can compete by lowering its price on the high-volume product. The $10 price offered by competitors is not out of line. The concern about selling below cost is unfounded.

4. The $12 price of compound S-15 is well below its cost of production. This explains why Pearson has no competition and why customers are willing to pay $15, a price that is probably still way below competitors quotes. 5. The price of X-12 should be lowered to a competitive level and the price of S-15 increased so that a reasonable return is being earned.

424 1. Welding Machining Setups Total $2,000,000 1,000,000 400,000 $3,400,000

Percentage of total activity costs = $3,400,000/$4,000,000= 85%. 2. Allocation: ($2,000,000/$3,400,000) $600,000 = $352,941 ($1,000,000/$3,400,000) $600,000 = $176,471 ($400,000/$3,400,000) $600,000 = $70,588 Cost pools: Welding = $2,000,000 + $352,941 = $2,352,941 Machining = $1,000,000 + $176,471 = $1,176,471 Setups = $400,000 + $70,588 = $470,588 Activity rates: Rate 1: Welding = $2,352,941/4,000 = $588 per welding hour Rate 2: Machining = $1,176,471/10,000 = $118 per machine hour Rate 3: Setups = $470,588/100 = $4,706 per batch
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Overhead assignment: Subassembly A Rate 1: $588 1,600 welding hours $588 2,400 welding hours Rate 2: $118 3,000 machine hours $118 7,000 machine hours Rate 3: $4,706 45 batches $4,706 55 batches Total overhead costs Units produced Overhead per unit 3. Percentage error:

Subassembly B $ 940,800 $1,411,200 354,000 826,000 211,770 $1,506,570 1,500 $ 1,004 258,830 $2,496,030 3,000 $ 832

Error (Subassembly A) = ($1,004 $1,108)/$1,108 = 0.094 (9.4%) Error (Subassembly B) = ($832 $779)/$779 = 0.068 (6.8%) The error is at most 10%. The simplification is simple and easy to implement. Most of the costs (85%) are assigned accurately. Only three rates are used to assign the costs, representing a significant reduction in complexity.

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MANAGERIAL DECISION CASES 425 1. Shipping and warehousing costs are currently assigned using tons of paper produced, a unit-based measure. Many of these costs, however, are not driven by quantity produced. Many products have special handling and shipping requirements involving extra costs. These costs should not be assigned to those products that are shipped directly to customers. 2. The new method proposes assigning the costs of shipping and warehousing separately for the low-volume products. To do so requires three cost assignments: receiving, shipping, and carrying. The cost drivers for each cost are tons processed, items shipped, and tons sold. Pool rate, receiving costs: Receiving cost/Tons processed Pool rate, shipping costs: Shipping cost per shipping item = $1,100,000/56,000 tons = $19.64 per ton processed* = $2,300,000/190,000 = $12.11 per shipping item*

Pool rate, carrying cost (an opportunity cost): Carrying cost per year (LLHC) = 25 $1,665 0.16 = $6,660 Carrying cost per ton sold = $6,660/10 = $666 Shipping and warehousing cost per ton sold: Receiving $ 19.64 Shipping ($12.11 7) 84.77 Carrying Total *Rounded 666.00 $770.41

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3. Profit analysis:
Revised profit per ton (LLHC): Selling price Less manufacturing cost Gross profit Less shipping and warehousing Loss Original profit per ton: Selling price Less manufacturing costs Gross profit Less shipping and warehousing Profit

$2,400.00 1,665.00 $ 735.00 770.41 $ (35.41) $2,400.00 1,665.00 $ 735.00 30.00 $ 705.00

The revised profit, reflecting a more accurate assignment of shipping and warehousing costs, presents a much different picture of LLHC. The product is, in reality, losing money for the company. Its earlier apparent profitability was attributable to a subsidy being received from the high-volume products (by spreading the special shipping and handling costs over all products, using tons produced as the cost driver). The same effect is also true for the other low-volume products. Essentially, the system is understating the han- dling costs for low-volume products and overstating the cost for highvolume products. 4. The decision to drop some high-volume products and emphasize low-volume products could clearly be erroneous. As LLHC has demonstrated, its apparent profitability is attributable to distorted cost assignments. A significant change in the image of LLHC was achieved by simply improving the accuracy of shipping and handling costs. Further improvements in accuracy in the overhead assignments may cause the view of LLHC to deteriorate even more. Conversely, the profitability of high-volume products may improve signifi- cantly with increased costing accuracy. This example underscores the impor- tance of having accurate and reliable accounting information. The accounting system must bear the responsibility of providing reliable information. 5. Ryans strategy changed because his information concerning the individual products changed. Apparently, the accounting system was undercosting the low-volume products and overcosting the high-volume products. Once better information was available, Ryan was able to respond better to competitive conditions.

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426 1. Disagree. Chuck is expressing an uninformed opinion. He has not spent the effort to find out exactly what activity-based management and costing are attempting to do; therefore, he has no real ability to offer any constructive criticism of the possible benefits of these two approaches. 2. and 3. At first glance, it may seem strange to even ask if Chucks behavior is unethical. After all, what is unethical about expressing an opinion, albeit uninformed? While offering uninformed opinions or recommendations may be of little consequence in many settings, a serious issue arises when a persons expertise is relied upon by others to make decisions or take actions that could be wrong or harmful to themselves or their organizations. This very well may be the case for Chucks setting, and his behavior may be labeled professionally unethical. Chucks lack of knowledge about activity-based systems is a signal of his failure to maintain his professional competence. Standard I-1 of the IMA Statement of Ethical Professional Practice indicates that management ac- countants have a responsibility to continually develop their knowledge and skills. Failure to do so is unethical. RESEARCH ASSIGNMENT 427 Answers will vary.

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