Activity Based Costing

Accounting 3300
Professor Richard McDermott

Traditional Costing
Systems
Product Costs
Direct labor
Direct materials
Factory Overhead

Period Costs
Administrative expense
Sales expense

Appear on the
income statement
when goods are
sold, prior to that
time they are
stored on the
balance sheet as
inventory.
Appear on the
income statement
in the period
incurred.

Traditional Costing
Systems
Product Costs
Direct labor
Direct materials
Factory Overhead

Direct labor and

direct materials are
easy to trace to
products.
The problem
comes with
factory overhead.

Traditional Costing
Systems
Typically used one rate to allocate
overhead to products.
This rate was often based on direct
labor dollars or direct labor hours.
This made sense, as direct labor was
a major cost driver in early
manufacturing plants.

Problems with Traditional

Costing Systems
Manufacturing processes and the
products they produce are now more
complex.
This results in over-costing or undercosting.
Complex products are not allocated an
adequate amount of overhead costs.
Simple products get too much.

Todays Manufacturing
Plants

Are more complex

Are often automated
Often make more than one product
Use proportionately smaller amount
of direct labor making direct labor a
poor allocation base for factory
overhead.

When the manufacturing

process is more complex:
Then multiple allocation bases
should be used to allocate
overhead expense.
In such situations, managers
need to consider using activity
based costing (ABC).

ABC Definitions
Activity based costing is an approach
for allocating overhead costs.
An activity is an event that incurs
costs.
A cost driver is any factor or activity
that has a direct cause and effect
relationship with the resources
consumed.

ABC Steps
Determine cost drivers.
Create activity cost pools.
A activity cost pool is a pool of individual
costs that all have the same cost driver.

Allocate all overhead costs to activity

pools.
Activity pools should be homogeneous
they should have the same cost driver
(such as labor hours).

ABC Steps:
Calculate an overhead rate for each
homogeneous activity cost pool:
Formula: total costs/base = rate

Allocate overhead costs to each

product consistent with the amount
of the base of each activity pool the
product uses.

Lets work an example . .

.
Assume that a company makes
widgets
Management decides to install an
ABC system

Determine Cost Drivers

Management decides that factory
overhead costs have only three cost
drivers
Direct labor hours
Machine hours
Number of purchase orders

Allocate each overhead cost in the

general ledger to one of the
activity cost pools.
Direct Labor

General Ledger
Payroll taxes

$1,000

Machine
maintenance

$500

Purchasing Dept.
labor

$4,000

Fringe benefits

$2,000

Purchasing Dept.
Supplies

$250

Equipment
depreciation

$750

Electricity

$1,250

Which overhead costs

do
Unemployment
$1,500
insurance
you think are driven by
direct labor hours?

Machine Hours

# of Purchase Orders

Allocate each overhead cost in the

general ledger to one of the
activity cost pools.
Direct Labor

General Ledger
Payroll taxes

$1,000

Machine
maintenance

$500

Purchasing Dept.
labor

$4,000

Fringe benefits

$2,000

Purchasing Dept.
Supplies

$250

Equipment
depreciation

$750

Electricity

$1,250

Unemployment
insurance

$1,500

$1,000
2,000
1,500
$4,500

Machine Hours

# of Purchase Orders

Allocate each overhead cost in the

general ledger to one of the
activity cost pools.
Direct Labor

General Ledger
Payroll taxes

$1,000

Machine
maintenance

$500

Purchasing Dept.
labor

$4,000

Fringe benefits

$2,000

Purchasing Dept.
Supplies

$250

Equipment
depreciation

$750

Electricity
Which overhead

$1,250
costs
Unemployment
$1,500
are driven by machine
insurance
hours?

$1,000
2,000
1,500
$4,500

Machine Hours
$ 500
750
1,250
$2,50
0

# of Purchase Orders

Allocate each overhead cost in the

general ledger to one of the
activity cost pools.
Direct Labor

General Ledger
Payroll taxes

$1,000

Machine
maintenance

$500

Purchasing Dept.
labor

$4,000

Fringe benefits

$2,000

Purchasing Dept.
Supplies

$250

Equipment
depreciation

$750

Electricity
And finally,

which $1,250
Unemployment
overhead costs are$1,500
insurance
driven by number of
purchase orders?

$1,000
2,000
1,500
$4,500

Machine Hours
$ 500
750
1,250
$2,50
0

# of Purchase Orders
$4,000
250
$4,250

Calculate an overhead rate for each

cost pool:
Again, the formula is:
Costs in Activity Cost
Pool/Base = rate
Assume the following
bases:
Direct labor hours = 1,000
Machine hours = 250
Purchase orders = 100
The ABC rates are:

Direct Labor
$1,000
2,000
1,500
$4,500

Machine Hours
$ 500
750
1,250
$2,50
0

# of Purchase Orders

$4,500/1,000 = $4.50 per direct

labor
hour = $10 per machine hour $4,000
$2,500/250
250
$4,250/100 = $42.50 per purchase order
$4,250

Allocate overhead using this rate to

all products consistent with how
much of each base the product uses.
The ABC rates are:
$4,500/1,000 = $4.50 per direct
labor
hour = $10 per machine hour
$2,500/250
$4,250/100 = $42.50 per purchase order

Lets assume the company makes two products,

Widget A and Widget B:
Lets also assume that each product uses the following qua
of overhead cost drivers:
Base
Direct labor
hours
Machine hours
Purchase
orders

Widget A

Widget B

Total

400
100

600
150

1,000
250

50

50

100

Notice
that
all base
units
are
accounte
d
for.

So, lets allocate overhead

to
Widget A:
Base A
Direct labor
hours

Rate

Allocated

4.50

$
1,800.00

$
400

Just like we learned in Accounting 2020, we m

the base used by the rate.

In this case, 400 hours used to make Widget

multiplied by the rate of $4.50. This gives to
applied for this activity cost pool of $1,800 t
Widget A.

Continuing the
calculation:

Lets do the same thing for the other two rates, to get the
of overhead applied to Widget A:
Widget A
Direct labor
hours

Base

Rate
$

400

4.50
$

Machine hours
Purchase
orders
Total

100

10.00
$

50

42.50

Allocated
$
1,800.00
$
1,000.00
$
2,125.00
$
4,925.00

Now lets allocate overhead

to Widget B:
Lets do the same thing for Widget B:

Widget B
Direct labor
hours
Machine hours
Purchase orders
Total

Base

Rate
$
600
4.50
150 $ 10.00
50 $ 42.50

Allocated
$
$
$
$

2,700.00
1,500.00
2,125.00
6,325.00

The original overhead to be applied was $4,500 of direct labor

driven overhead + $2,500 of machine hour driven overhead + $4
purchase order driven overhead = $11,250 total overhead to app

The actual overhead allocated was $4,925 for Widget A + $6,350

$11,250 overhead applied.

Same Problem-Traditional Method

Okay, so what if we had allocated the
overhead in this company using
traditional cost accounting
allocation?
Lets assume the base is direct labor
hours.
What would be the amount allocated
to each product?

Calculation
General Ledger
Payroll taxes

$1,000

Machine
maintenance

$500

Purchasing Dept.
labor

$4,000

Fringe benefits

$2,000

Purchasing Dept.
Supplies

$250

Equipment
depreciation

$750

Electricity

This the total

overhead we
were given, the
total amount is
$11,250 as
explained on
the previous
slide.
Total direct labor
hours are 1,000,
also given earlier.

$1,250

Base
A
Widget B
Unemployment Widget$1,500
Direct
labor
insurance
hours
400
600
Machine hours
100
150
Purchase

Total
1,000
250

Calculation
The rate would be:
OH Rate = Overhead/Direct Labor Hours
$11,250/1,000 = $11.25 per hour.

Applying overhead using this rate:

Widget A: 400 hours x $11.25 = $4,500
Widget B: 600 hours x $11.25 = $6,750
Total overhead applied = $11,250

Comparison
Widget A

Widget B

Total

Traditional
Method

$4,500

$6,750

$11,250

Activity Based
Costing

$4,925

$6,325

$11,250

-$425

$425

-0-

Difference

Which is more accurate?

ABC Costing!

Note these are total costs. To get per-unit costs ,we would d
number of units produced.

When do we use ABC

costing?
When one or more of the following
conditions are present:
Product lines differ in volume and
manufacturing complexity.
Product lines are numerous and
diverse, and they require different
degrees of support services.
Overhead costs constitute a
significant portion of total costs.

When do we use ABC

costing?
The manufacturing process or number
of products has changed significantly
for example, from labor intensive to
capital intensive automation.
Production or marketing managers are
ignoring data provided by the existing
system and are instead using
bootleged costing data or other
alternative data when pricing or
making other product decisions.

Additional Uses of ABC

Activity Based Management (ABM)
Extends the use of ABC from product
costing to a comprehensive
management tool that focuses on
reducing costs and improving processes
and decision making.

ABM
ABM classifies all activities as valueadded or non-value-added.
Value-added activities increase the
worth of a product or service to the
customer.
Example: Addition of a sun roof to an
automobile.

Non-value added activities dont.

Example: The cost of moving or storing the
product prior to sale.

The Objective of ABM . . .

To reduce or eliminate non-value
related activities (and their costs).
Attention to ABM is a part of
continuous improvement of
operations and activities.

Possible Cost Drivers

Machine hours
Direct labor hours
Number of setups
Number of products
Number of purchase orders
Number of employees
Number of square feet

Common Classification
System

Unit-level activities. Activities performed

for each unit of production.
Batch-level activities. Activities
performed for each of bath of products.
Product line activities.* Activities
performed in support of an entire
product line.
Facility-level activities. Activities required
to sustain an entire production process.
*The author calls these product costs but I call them product line costs to show
they do not increase with each unit of product produced but the addition of new
product lines. I think the authors approach is a little confusing.

Common Classification
System
This system provides a structured
way of thinking about relationship
between activities and the resources
they consume.

Facility Sustaining
Activities
Have no good cost driver
May or may not be allocated to
products depending upon the purpose
for which the information is to be used
Examples
Housekeeping
Factory yard maintenance

Manufacturing Systems
Traditional systems . . .
Are Just-in-Case.
Inventories of raw materials are maintained just
in case some items are of poor quality or key
suppliers dont delivery on time.

Are push systems.

Materials are pushed through the manufacturing
process.

Based on standard costs.

Once a standard is reached improvement stops!

Manufacturing Systems
Progressive manufacturing systems . . .
Are Just in Time.
Raw materials arrive just in time for use in
production.
Finished goods are manufactured just in time to
meet customer needs.

Use pull approach manufacturing.

Raw materials are not put into the process until
the next department requests them.

Use continuous quality improvement.

Three important elements

must exist for JIT systems
to work:

Dependable suppliers who can

deliver on short notice.
If your plant is in Buffalo Chip,
Wyoming, you are out of luck.

Three important elements

must exist for JIT systems
to work:

Multi-skilled workforce who can work

in work cells or work stations.
One worker may operate several kinds
of machines.

Unions have traditionally opposed

this.

Three important elements

must exist for JIT systems
to work:

Employees and suppliers who can

deliver on Total quality management.
The objective is no defects.

Objectives of JIT
Reduction or elimination of
inventories.
Enhanced production quality.
Reduction or elimination of rework
costs.
Production cost savings from
improved flow of goods through the
process.

Exercise 5-16
Teledor Inc.
Uses the following cost hierarchy
Unit
Batch
Product line
Facility sustaining

These
are the
cost
drivers!

Exercise 5-16
Teledor manufactures boom boxes.
They differ significantly in
complexity, etc.
The following page shows costs
incurred in 2006.

Exercise 5-16
The
Indirect labor cost $1,000,000
question
Procurement costs $500,000is: What
categorie
Indirect materials cost $250,000
s do each
of these
Machine set-up cost $600,000
costs fit
in?
Design process cost $800,000

Machine related overhead $1,100,000

Plant management $900,000

Exercise 5-16 (Classify)

Indirect labor cost $1,000,000unit

Procurement costs $500,000batch
Indirect materials cost $250,000unit
Machine set-up cost $600,000batch
Design process cost $800,000product
line
Machine related overhead $1,100,000
unit
Plant management $900,000facility
sustaining

Exercise 5-16
Consider two types of boom boxes
made by the company.
One boom box is complex to make
and is produced in many batches.
The other boom box is simple to
make and is produced in few
batches.

Exercise 5-16
Suppose the manufacturer needs the
same number of machine hours to make
each boombox, and that they allocate
overhead costs using machine hours.
Under a traditional system, how (if at all)
might the boom boxes be mis-costed?
Answer: the simple boom box would
receive too much overhead as machine
hours are not a good cost driver.

Exercise 5-16
How is the cost hierarchy helpful to
this company in managing its
business?
Using the cost hierarchy to calculate
activity-based costs can help Teledor
to identify both the costs of individual
activities and the cost of activities
demanded by individual products.

Exercise 5-17
Plymouth Test Laboratories
ABC, Cost Hierarchy, Service
Company

Exercise 5-17
Plymouth Test
Laboratories does
heat testing and
stress testing on
materials.

Exercise 5-17
Under its current simple costing
system, all operating costs
($1,200,000) are allocated to a single
overhead cost pool.
Plymouth calculates a rate for a test
hour at $15 ($1,200,000 divided by
80,000 total test hours).

Exercise 5-17
Of the two departments . . .
Heat Testing uses 50,000 test hours,
and Stress Testing uses 30,000
hours.
The controller feels there should be
separate cost structures and rates
for Heat Testing and Stress Testing.

Exercise 5-17
The controller divides Plymouths
cost into four activity cost categories.

Cost Categories
Direct labor cost of $240,000.
Heat testing $180,000.
Stress testing $60,000.

Exercise 5-17
Setup cost of $350,000 allocated to
the testing and stress testing on the
basis of seven hours required.
Heat testing 13,500 setup hours.
Stress testing 4000 setup hours.

Exercise 5-17
Design cost $210,000.
These costs are allocated on the basis
of time required to design the tests.
Heat testing requires 2,800 hrs.
Stress testing requires 1,400 hours.

Exercise 5-17
Classify each cost as unit, batch,
product line, or facility cost.

Unit Driven Costs

Direct-labor costs, $240,000
Equipment-related costs (rent,
maintenance, energy, and so on),
$400,000
Each unit is a cost driver, costs in this pool
increase proportionately with units produced.

Batch Driven Costs

Setup costs, $350,000
Each batch drives these costs-twice the number
of batches, twice the cost!

Product Line Costs

Designing the tests, $210,000.
Individual product lines drive these costs. If a
company has four product lines, it has four times
the cost.

Facility Costs
In this problem --apparently none!
There is no cost driver for facility costs. Whether
they are allocated to products or not depends on
the use to which the information will be put.
Facility costs include yard care, painting the
factory, watering the grounds, etc.activities
that are not driven by units, batches, or
products.

Exercise 5-17
Calculate the cost per test hour for
heat testing and stress testing.
Why do these numbers differ from
the $15 per test hour the company
calculated using a simple costing
system?

To calculate the cost per

test we will . . .
1. Allocate unit, batch, and product
line costs to the two products.
2. The two products in this problem
are
1. A heat testing hour, and
2. A stress testing hour.

To calculate the cost per

test we will . . .
1. Total the cost for heat testing and
stress testing, and then divide those
costs by the number of heat testing
or stress testing hours to get a rate
per hour of heat testing or stress
testing.

Some ABC costs to be

allocated are given,
others will need to be
allocatedRateusing
a
rate
Calculation
The rate for equipment related costs (a unit cost) is $400,000 total costs
divided by 80,000 hours = $5.00 per hour.
The rate for setup costs (a batch cost) is $350,000 total costs divided
by $17,500 setup hours = $20 per setup hour.
The rate for design hours (a product line cost) $210,000divided by
4,200 setup hours = $50 per design hour.
We will use all of these
rates in a moment.

Lets start the allocation

process

Lets allocate unit costs first. There are two categories, direct labor
and equipment-related costs.
Direct labor is givenwe just plug the figure.
Cost per hour is calculated by dividing total costs by total hours!
Equipment-related costs are applied using the rate we calculated on
an earlier slide.

Lets start the allocation

process

Lets allocate unit costs first. There are two categories, direct labor
and equipment-related costs.
Direct labor is givenwe just plug the figure.
Cost per hour is calculated by dividing total costs by total hours!
Equipment-related costs are applied using the rate we calculated on
an earlier slide.

Batch and product line

costs are calculated the
same way

Batch and product line

costs are calculated the
same way

The total costs for each product have now been calculated!

Exercise 5-18
Wolfston Group
Alternative allocation bases for a
professional services firm

Exercise 5-18
The Wolfston Group provides tax
advice to multinational firms.
They charge clients for (a) direct
professional time (at an hourly rate)
and (b) support services (at 30% of
the direct professional cost billed).

Exercise 5-18
The companys three professionals
and their rates per professional hour
are shown below.
Myron Wolston
Ann Brown
John Anderson

$500
120
80

Exercise 5-18
The company has just prepared the
May 2005 bills for two clients.
The hours of professional time spent
on each client are as follows:
Seattle

Tokyo

15

Anderson

22

30

Total

40

40

Wolfson
Brown

Exercise 5-18
What amount did the company
bill to Seattle and Tokyo for May
Direct Professional Time
Support Services
Amount
2005?
Rate per Number
Billed to
Client
(1)
Seattle
Wolfson
Brown
Anderson
Tokyo
Wolfson
Brown
Anderson

Hour
of Hours
(2)
(3)

Total
(4) = (2) (3)

Rate
Total
Client
(5) (6) = (4) (5) (7) = (4) + (6)

$500
120
80

15
3
22

$7,500
360
1,760

30%
30
30

$2,250
108
528

$ 9,750
468
2,288
$12,506

$500
120
80

2
8
30

$1,000
960
2,400

30%
30
30

$300
288
720

$1,300
1,248
3,120
$5,668

Exercise 5-18
Suppose support services were billed
at $50 per paraprofessional labor
hour (instead of 30% of professional
labor costs).
How would this change the amount
they build the two clients for May
2005?

Exercise 5-18
Client
(1)
Seattle
Wolfson
Brown
Anderson
Tokyo
Wolfson
Brown
Anderson

Direct Professional Time

Rate per Number
Hour
of
Total
Hours
(2)
(3)
(4) = (2)
(3)

Support Services
Amount
Rate
Billed to
per
Total
Client
Hour
(5)
(6) = (3) (7) = (4) + (6)
(5)

$500
120
80

15
3
22

$7,500
360
1,760

$50
50
50

$ 750
150
1,100

$ 8,250
510
2,860
$11,620

$500
120
80

2
8
30

$1,000
960
2,400

$50
50
50

$ 100
400
1,500

$1,100
1,360
3,900
$6,360

Exercise 5-18
The difference in billed amounts
would be:
Requirement 1

Seattle Dominion
Tokyo Enterprises

$12,506
5,668
$18,174

Requirement 2
$11,620
6,360
$17,980

Both clients use 40 hours of professional labor time.

However, Seattle Dominion uses a higher proportion of
Wolfsons time (15 hours), which is more costly. This
attracts the highest support-services charge when
allocated on the basis of direct professional labor costs.

Exercise 5-18
How would you determine whether
professional labor costs or
professional labor hours is the more
appropriate base for the company
support services?
Interviews with personnel.
Analysis of tasks undertaken for
clients.

Exercise 5-19
Automotive Products
Plantwide, department, and ABC
indirect cost rates

Exercise 5-19
Automotive Products designs and
produces automobile parts.
In 2007, actual variable manufacturing
overhead is $308,600.
The companys simple costing system
allocates variable manufacturing
overhead to its three customers based
on machine hours and prices its
contracts based on full costs.

Exercise 5-19
One of its customers has regularly
complained of being charged
noncompetitive prices, so the
companies controller realizes that it
is time to examine the consumption
of overhead resources more closely.

Exercise 5-19
He knows that there are three main
departments that consume overhead
resources.
Design
Production
Engineering

Interviews with the department

personnel yield the information on the
following slide.

Exercise 5-19
Use of cost drivers by customer
Departme
nt

Cost
driver

Design

CAD
design
hours

Engineeri
ng

Engineeri
ng hours

Productio
n

Machine
hours

Total

Variable
Manuf.
Overhead
in 2007

United
Motors

Holden
Motors

Leland
Vehicle

$39,000

110

200

80

29,600

70

60

240

240,000

120

2800

1080

$308,600

Exercise 5-19
Compute the variable manufacturing
overhead allocated to each customer
in 2007 using the simple costing
system that uses machine hours as
the allocation base.
The rate equals:
$308,600/4,000 machine hours =
$77.15 per machine hour.

Exercise 5-19
Allocation of overhead to customers
using this rate
United Motors $77.15 120 = $9,258
Holden Motors $77.15 2800 =
$216,020
Leland Vehicle $77.15 1080 =
$83,322
Total allocated $308,600

Exercise 5-19
Compute the variable manufacturing
overhead allocated to each customer
in 2007 using department-based
variable manufacturing overhead
rates.
First we need to calculate the rates.
We do that on the following slide.

Exercise 5-19
Variable
Manufactu
ring
Overhead
in 2007

Total
Driver
Units

Rate

Base

Design

$39,000

390

$100

Per CAD
hour

Production

$29,600

370

$80

Per
engineering
hour

Engineerin
g

$240,000

4,000

$60

Per machine
hour

We are placing all overhead costs into

three homogeneous pools, shown
above. We then divide the amount in
those cost pools by the total driver units
to get the rate

Exercise 5-19
Now we use the rates to apply cost
from the three overhead accounts to
products, based on the amount of
each of those overhead services
used by the individual products.

Exercise 5-19
Design-related overhead, allocated on
CAD-design hours
(110 x $100; 200 x $100; 80 x $100)

United
Motors

Holden
Motors

Leland
Motors

Total

$11,000

$ 20,000

$ 8,000

$ 39,000

110 hours of
design related
overhead used
x $100 rate
calculated on
earlier slide.

Exercise 5-19 New

Allocation System
United
Motors
Design-related overhead, allocated on
CAD-design hours
(110 x $100; 200 x $100; 80 x $100)

Holden
Motors

$11,000 $ 20,000

Leland
Vehicle

Total

$ 8,000 $ 39,000

Production-related overhead, allocated

on engineering hours
(70 x $80; 60 x $80; 240 x $80)
Engineering-related overhead, allocated
on machine hours
(120 x $60; 2,800 x $60; 1,080 x $60)
Total

5,600

4,800

19,200

29,600

7,200

168,000

64,800

240,000

$23,800 $192,800

$92,000 $308,600

Use the same process for the other overhead rate

Exercise 5-19
If the new rates are used which
customer will be most unhappy?
One way to answer that question is
to calculate the ratio between the
new rate and the old rate.

Ratio Old Rate/New Rate

United Motors: $23,800/$9,258 = 2.57

Holden Motors: $192,800/$216,020 = 0.89
Leland Motors $92,000/$83,322 = 1.10
United Motors had the greatest increase in
overhead allocation. They will probably be
the most unhappy customer with the new
allocation system.

Exercise 5-19
How will we explain the rate
increased to United Motors if they
complain?
Let us compare the usage of both the
old and the new driver units to see if
they are now being charged fairly.

Exercise 5-19
Remember, under the first allocation
system they were charged using
machine hours.
Now they are charged according to
their usage of all three cost drivers,
design, engineering, and production.

Exercise 5-19
Departmen Costs
t
Driver

United
Motors

Holden
Motors

Leland
Motors

Design

CAD
design
hours

28%

51%

21%

Engineerin
g

Engineerin
g hours

19%

16%

65%

Production Machine
3%
70%
27%
While Unitedhours
Motors was using significant amounts of
design, engineering, and production overhead, they were
only being charged (under the old system) 3% of total
overhead costs.
In other words, the single rate system was
undercharging United Motors.

Exercise 5-19 Question

How else might the company use
information available from its
department by department analysis of
variable manufacturing overhead
costs?

Exercise 5-19 Answer

Other than for pricing, AP can also use the
information from the department-based
system to examine and streamline its own
operations so that there is maximum valueadded from all indirect resources.
It might set targets over time to reduce both
the consumption of each indirect resource
and the unit costs of the resources.
The department-based system gives AP
more opportunities for targeted cost
management.

Exercise 5-19 Question

The companys managers are
wondering if they should further refine
the department by department
costing system into an ABC system by
identifying different activities within
each department.
Under what conditions would it not be
worthwhile to further refine the
department costing system into an
activity-based costing system?

Exercise 5-19 Answer

It would not be worthwhile to further refine
the cost system into an ABC system if there
wasnt much variation among contracts in the
consumption of activities within a department.
If, for example, most activities within the
design department were, in fact, driven by
CAD-design hours, then the more refined
system would be more costly and no more
accurate than the department-based cost
system.

Exercise 5-19 Answer

Even if there was sufficient variation,
considering the relative sizes of the 3
department cost pools, it may only
be cost-effective to further analyze
the engineering cost pool, which
consumes 78% ($240,000 $308,600)
of the manufacturing overhead.

Exercise 5-23
Family Supermarkets
ABC, retail product line profitability

Exercise 5-23
Family Supermarkets (FS) decides to
apply ABC analysis to three product
lines:
Baked goods
Milk and fruit juice
Frozen foods

Exercise 5-23
It identifies four activities and their
cost activity rates as:
Ordering
Delivery
Shelf stocking
Customer support

$100 per purchase order

$80 per delivery
$20 per hour
$.20 per item sold

Exercise 5-23
The revenues, cost of goods sold,
store support costs, and activity area
usage of the three product lines are
given on the following slide.

Exercise 5-23
Baked Goods Milk and Fruit
Juice

Frozen
Products

Financial data
Revenues

$57,000

$63,000

$52,000

Cost of goods sold

$38,000

$47,000

$35,000

$11,400

$14,100

$10,500

Ordering (purchase
orders)

30

25

13

Delivering
(deliveries)

98

36

28

183

166

24

15,500

20,500

7900

Store support
Activity-area
usage (cost
allocation base)

Shelf stocking
(hours)
Customer support

Exercise 5-23
Using its simple costing system, FS
allocated support cost of products at
the rate of 30% of cost of goods sold.
Use the simple costing system to
prepare a product line profitability
report for FS.

Exercise 5-23
Baked
Goods

Milk &
Fruit Juice

Frozen
Products

Total

Revenues
Costs
Cost of goods sold
Store support (30% of COGS)
Total costs
Operating income

$57,000

$63,000

$52,000 $172,000

38,000
11,400
49,400
$ 7,600

47,000
14,100
61,100
$ 1,900

35,000 120,000
10,500
36,000
45,500 156,000
$ 6,500 $ 16,000

Operating income Revenues

13.33%

3.02%

12.50%

9.30%

Old simple system

allocation is based
on 30% of COGS.
Probably not a
good cost driver.

Exercise 5-23
Use the ABC system to prepare a
product line report for FS.
For reference, lets go back and pick
up for the rates and activity usage
given in the problem.

Baked
Goods
Revenues
Costs
Cost of goods sold

$57,00
0

Milk & Frozen

Fruit Product
Juice
s
$63,000 $52,000
47,000 35,000
2,500
1,300

38,000

Total
$172,0
00
120,00
0

3,000

These first three rows are given in the

problem. No calculation needed here!

6,800

Baked
Goods
Revenues
$57,000
Costs
Cost of goods sold
38,000
Ordering ($100 30; 25; 3,000
13)

Milk & Frozen

Fruit Product
Total
Juice
s
$63,000 $52,000 $172,00
0
47,000
35,000
120,000

Okay, lets apply the first overhead rate (ordering) for

the first department (Baked Goods).
The overhead rate for Ordering is $100 (given
earlier), the number of orders used by Baked Goods is
30 (also given).
The amount of ordering overhead applied to Baked
Goods is therefore $100 x 30 = $3,000

Baked
Goods
Revenues
$57,000
Costs
Cost of goods sold
38,000
Ordering ($100 30; 25; 3,000
13)

Milk & Frozen

Fruit Product
Total
Juice
s
$63,000 $52,000 $172,00
0
47,000
35,000
2,500
1,300
120,000
6,800

Lets use the same procedure and rate for the other
two departments, then total the amount allocated.

Baked
Goods
Revenues
$57,000
Costs
38,000
Cost of goods sold
Ordering ($100 30; 25; 13)
Delivery ($80 98; 36; 28)
3,000

Milk & Frozen

Fruit Product
Total
Juice
s
$63,000 $52,000 $172,00
47,000
35,000
0
2,500
2,880

1,300 120,000
2,240
6,800

7,840
12,960

The next overhead department to allocate is Delivery. The

Multiply $80 by the number of deliveries to get the amoun

Department.

Baked
Goods
Revenues
$57,000
Costs
38,000
Cost of goods sold
Ordering ($100 30; 25; 13)
3,000
Delivery ($80 98; 36; 28)
Shelf-stocking ($20 183;
7,840
166; 24)
Customer support
3,660
($0.20 15,500; 20,500;
7,900)
3,100

Milk & Frozen

Fruit Product
Total
Juice
s
$63,000 $52,000 $172,00
47,000
35,000
0
2,500
2,880
3,320

1,300 120,000
2,240
480
6,800

4,100

1,580

12,960
7,460

Lets apply overhead for the remaining overhead cost

8,780
pools to each department using the same methodology
we just demonstrated.

Baked
Goods
Revenues
Costs
Cost of goods sold
Ordering ($100 30; 25; 13)
Delivery ($80 98; 36; 28)
Shelf-stocking ($20 183;
166; 24)
Customer support
($0.20 15,500; 20,500;
7,900)
Total costs

$57,000
38,000
3,000

Milk & Frozen

Fruit Product
Total
Juice
s
$63,000 $52,000 $172,00
0
47,000
35,000
2,500
1,300 120,000
2,880
2,240
3,320
480
6,800

7,840
3,660

4,100
59,800

1,580
40,600

12,960
7,460

3,100

Next step, calculate total55,600

costs.

8,780
156,000

Baked
Goods
Revenues
Costs
Cost of goods sold
Ordering ($100 30; 25; 13)
Delivery ($80 98; 36; 28)
Shelf-stocking ($20 183;
166; 24)
Customer support
($0.20 15,500; 20,500;
7,900)
Total costs
Operating income

$57,000
38,000
3,000

Milk & Frozen

Fruit Product
Total
Juice
s
$63,000 $52,000 $172,00
0
47,000
35,000
2,500
1,300 120,000
2,880
2,240
3,320
480
6,800

7,840
3,660
3,100
55,600
$
1,400

4,100
1,580
59,800
40,600
$ 3,200 $11,400
5.08% 21.92%

12,960
7,460
8,780

Operating income
156,000
Revenues
Finally, calculate operating income, then calculate
$
the operating margin.
16,000
2.46%
9.30%

With accurate costing, Frozen Products is shown to

be most profitable, Baked Goodsleast profitable.

Exercise 5-24
Villeagas Wholesalers (Furniture)
ABC, wholesale, customer
profitability

Exercise 5-24
The following data were collected
from last years operations.
gross sales
sales returns
number of items
amount
number of orders
regular
rush

$50,000

$30,000 $100,000

$70,000

100
$10,000

26
$5,000

60
$7,000

40
$6,000

40
10

150
50

50
10

70
30

Determine the contribution to profit from each chain last year.

Exercise 5-24
Chain
As this follows the
Gross sales
same methodology
Sale returns
as in the earlier
Net sales
problem, I dont work
Cost of goods sold (80%)
through the problem
Gross margin
step-by-step.
Customer-related costs:
Regular orders
$20 40; 150; 50; 70
Rush orders
$100 10; 50; 10; 30
Returned items
$10 100; 26; 60; 40
Catalogs and customer support
Customer related costs
Contribution (loss) margin
Contribution (loss) margin as % gross sales

1
2
3
4
$50,000 $30,000 $100,000 $70,000
10,000
5,000
7,000
6,000
40,000 25,000 93,000 64,000
32,000 20,000 74,400 51,200
8,000
5,000 18,600 12,800

800

3,000

1,000

1,400

1,000

5,000

1,000

3,000

1,000
260
600
1,000
1,000
1,000
3,800
9,260
3,600
$4,200 ($4,260) $15,000

400
1,000
5,800
$7,000

8.40% -14.20%

15.00%

10.00%

Exercise 5-24 Analysis

The analysis indicates that customers
profitability (loss) contribution varies
widely from (14.2%) to 15.0%.
Immediate attention to Chain 2 is
required which is currently showing a
loss contribution.
The chain has a disproportionate
number of both regular orders and
rush orders.

Exercise 5-24 Analysis

Villeagas should work with the
management of Chain 2 to find ways
to reduce the number of orders, while
maintaining or increasing the sales
volume.
If this is not possible, Villeagas should
consider dropping Chain 2, if it can
save the customer-related costs.

The End