CHAPTER 5 ACTIVITY-BASED COSTING AND MANAGEMENT

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1 CHAPTER 5 ACTIVITY-BASED COSTING AND MANAGEMENT SHORT-ANSWER QUESTIONS 5-1 Cost smoothing (or traditional costing, broad averaging, peanut-butter costing ) describes a costing approach that uses one average cost allocation rate for assigning (or spreading, as in spreading peanut butter) the cost of shared resources to distinct types of cost objects when the use among the distinct types of cost objects is unequal. Cost smoothing is appropriate when either the cost objects are similar in sharing consumption of costly indirect resources, or the indirect MOH cost pool is insignificant. Cost smoothing ignores differences in the value-added provided to different cost objects that is provided by the unequal use of shared resources. The result is inaccurate costing, pricing, and predictions. The greater the variations in shared resources consumption, the more unreliable and irrelevant the cost data will be to management teams trying to make decisions that will most likely improve profitability. 5-2 Overcosting may result in competitors entering a market and taking market share for products that a company erroneously believes are low-margin or even unprofitable. Undercosting may result in companies selling products on which they are in fact losing money, when they erroneously believe them to be profitable. 5-3 Costing system refinement means making changes to a traditional costing system that reduces the use of one broad average to assign indirect costs of shared resources to cost objects. Reducing the use of one broad average is a refinement that requires increasing the number of indirect MOH cost pools from one to several. Three guidelines for refinement are 1. Classify as many of the total costs as direct costs as is economically feasible. 2. Expand the number of indirect cost pools until each of these pools is more homogenous and less mixed in the resource costs contained in the pool. 3. Use the cause-and-effect criterion, when possible, to identify the cost-driver for each new, homogeneous indirect-cost pool. 5-4 An activity-based costing (ABC) approach is a refinement to a costing system that defines the cost object as an activity. The same support activity can be done in many business functions in the value chain. The cost of these activities is the activity cost pool or numerator. The activity cost driver is the denominator which when divided into the activity cost pool equals activity cost driver rate. The activity cost driver may be a measure of benefit (such as purchase orders completed in a timely way) or a measure of input such as quality control hours consumed. What is essential is that change in the 159

2 Instructor s Resource Manual for Cost Accounting, Seventh Canadian Edition quantity of the activity cost driver explains most of the change in the total value of the activity cost pool. 5-5 Four levels of a cost hierarchy are (i) Output unit-level costs: costs of activities performed on each unit of a distinct type of output (ii) Batch-level costs: costs of activities related to a group of distinct units of homogeneous outputs. A batch may be 1,000 identical units of one distinct type of output that are distinguished from another batch of 1,000 identical units of a different distinct type of output in some meaningful and costly way. (iii) Product-sustaining or service-sustaining costs: costs of activities undertaken to support distinct types of products or services regardless of the number of units or batches in which the types of products or services are produced. (iv) Facility-sustaining costs: costs of intangible (unmeasurable) activities that cannot be traced to distinct types of units, batches, products, or services but support the organization as a whole. 5-6 It is important to classify costs into a cost hierarchy because costs saved at the facilities level can generate savings for all business functions in the value-chain. By identifying the level at which an activity is shared, the scope of potential savings is also identified. For example a unit-level cost saving will not affect a facility-sustaining cost. In practical terms, reducing the cost of a direct material input for a specific type of output cannot reduce the salary of the director of IT services. 5-7 An ABC system defines activities as the cost objects. The costs of these activities are accumulated throughout the hierarchy to compute the costs of products, and services, and so on. Simple costing systems have one or a few indirect cost pools that ignore the inaccuracies induced when there are many types of resource costs in one cost pool. ABC systems have multiple indirect cost pools, one for each type of resource used. An ABC approach uses the quantity of activity cost drivers as the allocation base or denominator for each indirect cost pool. A traditional cost system typically uses a quantity of a direct input as the cost allocation base. The ABC approach classifies as many indirect costs as direct costs as possible. This improves the management team s understanding of cause and effect relationships and the accuracy of costing. 5-8 Four decisions for which ABC information is useful are 1. pricing and product mix decisions, 2. cost reduction and process improvement decisions, 160

3 Chapter 5: Activity-Based Costing and Management 3. product design decisions, and 4. decisions for planning and managing activities. 5-9 No. Department indirect-cost rates are similar to activity-cost rates if (1) a single activity accounts for a sizable fraction of the department s costs, or (2) significant costs are incurred because of different activities within a department but each activity has the same cost-allocation base, or (3) significant costs are incurred because of different activities with different cost-allocation bases within a department but different products use resources from the different activity areas in the same proportions Tell-tale signs that indicate when ABC systems are likely to provide the most benefits are as follows: 1. Significant amounts of indirect costs are allocated using only one or two cost pools. 2. All or most indirect costs are identified as output-unit-level costs (i.e., few indirect costs are described as batch-level, product-sustaining, or facilitysustaining costs). 3. Products make diverse demands on shared resources because of differences in volume, process steps, batch size, or complexity. 4. Products that a company is well suited to make and sell show small profits, whereas products that a company is less suited to produce and sell show large profits. 5. Operations staff has significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services The main costs and limitations of ABC are the measurements necessary to implement the systems. It is hard for management teams to think about activities instead of jobs as a cost object. It is also hard for management teams to think about the scope of business functions affected by one activity and establish an activity hierarchy. Even basic ABC systems require many calculations to determine costs of products and services. Activity-cost rates often need to be updated regularly. Very detailed ABC systems are costly to operate and difficult to understand. Sometimes the allocations necessary to calculate activity costs result in activity-cost pools and quantities of costdrivers being measured with error. When measurement errors are large, activity-cost information can be misleading. A common problem is that when accruals are used, the costs in the pool lead the full consumption of the activity. This means the quantity of the activity cost driver is understated relative to the value of the activity cost pool. 161

4 Instructor s Resource Manual for Cost Accounting, Seventh Canadian Edition 5-12 No, ABC systems are appropriate for service companies such as banks, railroads, hospitals, and accounting firms, as well as for merchandising companies such as retailers and distributors No. An activity-based system should be adopted only if its expected benefits exceed its expected costs. It is not always a wise investment. If the jobs, products, or services are alike in the way they use indirect resources of a company, then a simple costing system will suffice No. Increasing the number of indirect-cost pools does not guarantee increased accuracy of product or service costs. If the existing cost pool is already homogeneous, increasing the number of cost pools will not increase accuracy. If the existing cost pool is not homogeneous, accuracy will increase only if the increased cost pools themselves increase in homogeneity when compared to the single cost pool The controller faces a difficult challenge. The benefits of a better accounting system show up in improved decisions by managers. It is important that the controller have the support of these managers when seeking increased investments in accounting systems. Statements by these managers showing how their decisions will be improved by a better accounting system are the controller s best arguments when seeking increased funding. For example, the new system will result in more accurate product costs which will influence pricing and product mix decisions. The new system can also be used to reduce product costs, which will lower selling prices. As a result, the customer will benefit from the new system. EXERCISES 5-16 (10 min.) Terminology. One common refinement to a traditional or peanut butter costing system is called an activity-based costing system (ABC). The single MOH cost pool is separated into different activity cost pools distinguished from one another by their measure of benefits provided, or the activity cost driver. Benefits provided unequally to distinct types of outputs provide value-added to customers, for which customers are willing to pay. This is the basic concept that guides the approach to cost reduction and control called activity-based management (ABM). The management team identifies and eliminates non-value added activity and its costs and reorganizes the value-added activity to minimize costs. There are four levels of activities in a cost 162

5 Chapter 5: Activity-Based Costing and Management hierarchy. From narrowest to broadest in scope they are output, batch, product (or service), and facility-sustaining cost. When a management team fails to develop a cost management system that reports faithfully the unequal benefits (and costs) of value-added activities there is a high risk of mispricing distinct types of outputs. If pricing is cost-plus then an overcosted output will be priced too high and an undercosted product will be priced too low relative to the economic value-added. The result is preventable cross-subsidization of costs of the lower-priced by the higher-priced product (20 min.) Cost hierarchy. 1. a. Indirect manufacturing labour costs of $1,500,000 support direct manufacturing labour and are output unit-level costs. Direct manufacturing labour generally increases with output units, and so will the indirect costs to support it. b. Batch-level costs are costs of activities that are related to a group of units of a product rather than each individual unit of a product. Purchase order-related costs (including costs of receiving materials and paying suppliers) of $800,000 relate to a group of units of product and are batch-level costs. c. Cost of indirect materials of $450,000 generally changes with labour-hours or machine-hours which are unit-level costs. Therefore, indirect material costs are output unit-level costs. d. Setup costs of $900,000 are batch-level costs because they relate to a group of units of product produced after the machines are set up. e. Costs of designing processes, drawing process charts, and making engineering changes for individual products, $900,000, are product-sustaining because they relate to the costs of activities undertaken to support individual products regardless of the number of units or batches in which the product is produced. f. Machine-related overhead costs (amortization and maintenance) of $1,200,000 are output unit-level costs because they change with the number of units produced. g. Plant management, plant rent, and insurance costs of $950,000 are facilitysustaining costs because the costs of these activities cannot be traced to individual products or services but support the organization as a whole. 2. The complex boom box made in many batches will use significantly more batchlevel overhead resources compared to the simple boom box that is made in a few batches. In addition, the complex boom box will use more product-sustaining overhead resources because it is complex. Because each boom box requires the same amount of machine-hours, both the simple and the complex boom box will be allocated the same amount of overhead costs per boom box if Teledor uses only machine-hours to allocate overhead costs to boom boxes. As a result, the 163

6 Instructor s Resource Manual for Cost Accounting, Seventh Canadian Edition complex boom box will be undercosted (it consumes a relatively high level of resources but is reported to have a relatively low cost) and the simple boom box will be overcosted (it consumes a relatively low level of resources but is reported to have a relatively high cost). 3. 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. Teledor can use this information to manage its business in several ways: a. Teledor can improve pricing and product mix decisions. Knowing the resources needed to manufacture and sell different types of boom boxes can help Teledor to price the different boom boxes and also identify which boom boxes are more profitable. It can then emphasize its more profitable products. b. Teledor can use information about the costs of different activities to improve processes and reduce costs of the different activities. Teledor could have a target of reducing costs of activities (setups, order processing, etc.) by, say, 3% and constantly seek to eliminate activities and costs (such as engineering changes) that its customers perceive as not adding value. c. Teledor management can identify and evaluate new designs to improve performance by analyzing how product and process designs affect activities and costs. d. Teledor can use its ABC systems and cost hierarchy information to plan and manage activities. What activities should be performed in the period and at what cost? 5-18 (20 min.) Cost hierarchy classification. Requirement 1 Classification Requirement 2 Cost Drivers a Designing new products Product-sustaining Engineering hours b Setting up machines Batch # of setups c Quality inspection Unit or Batch* # of units inspected d Moving materials Batch # of parts e Receiving raw materials Batch # of orders f Performing regular maintenance Product or Facility** Machine-hours g Updating inventory software Facility level Programmer hours * If all units are inspected this would be a unit-level activity. If products are sampled, this would likely be a batch-level activity. **If the production equipment services one product line, it would be product sustaining. If the equipment is general purpose, then it would be facility sustaining. 164

7 Chapter 5: Activity-Based Costing and Management 5-19 (15 min.) Apply the logic of an ABC cost hierarchy. 1. Rates per unit cost driver. Activity Cost Driver Rate Machining Machine-hours $450,000 (35, ,000) = $6 per machine-hour Setup Production runs $144,000 ( ) = $1,440 per production run Inspection Inspection-hours $126,000 (1, ) = $84 per inspection-hour Overhead cost per unit: Mathematical Financial Machining: $6 35,000; 40,000 $210,000 $240,000 Set up: $1,440 50; 50 72,000 72,000 Inspection: $84 1,000; ,000 42,000 Total manufacturing overhead costs 366, ,000 Divide by number of units 50, ,000 Manufacturing overhead cost per unit $ 7.32 $ Mathematical Financial Manufacturing cost per unit: Direct materials $180,000 50,000 $ 3.60 $360, ,000 $3.60 Direct manufacturing labour $60,000 50, $120, , Manufacturing overhead (from Requirement 1) Manufacturing cost per unit $10.92 $ (20 min.) Plantwide indirect cost rates. 1. Actual plantwide variable MOH rate based on machine-hours: 308,600 4,000 = $77.15 per machine-hour United Motors Holden Motors Leland Motors Total Variable manufacturing overhead, allocated based on machine-hours ($ ; $ ,800; $ ,080) $9,258 $216,020 $83,322 $308,

8 Instructor s Resource Manual for Cost Accounting, Seventh Canadian Edition 2. Department Variable MOH in Total 2015 Driver Units Rate Design $39, $100 per CAD-design hour Engineering 29, $80 per engineering hour Production 240,000 4,000 $60 per machine-hour United Motors Holden Motors Leland Motors Total Design-related overhead, allocated on CAD-design hours (110 $100; 200 $100; 80 $100) $11,000 $ 20,000 $ 8,000 $ 39,000 Engineering-related overhead, allocated on engineering hours (70 $80; 60 $80; 240 $80) 5,600 4,800 19,200 29,600 Production-related overhead, allocated on machine-hours (120 $60; 2,800 $60; 1,080 $60) 7, ,000 64, ,000 Total Variable MOH $23,800 $192,800 $92,000 $308, United Motors Holden Motors Leland Motors a. Department rates (Requirement 2) b. Plantwide rate (Requirement 1) $23,800 $ 9,258 $192,800 $216,020 $92,000 $83,322 Ratio of (a) (b) The variable manufacturing overhead allocated to United Motors increases by 157% under the department rates, the overhead allocated to Holden decreases by about 11% and the overhead allocated to Leland increases by about 10%. The three contracts differ sizably in the way they use the resources of the three departments. The percentage of total driver units in each department used by the companies is: 166

9 Chapter 5: Activity-Based Costing and Management Department Design Engineering Production Cost Driver CAD-design hours Engineering hours Machine-hours United Motors 28% 19 3 Holden Motors 51% Leland Motors 21% The United Motors contract uses only 3% of total machine-hours in 2015, yet uses 28% of CAD design-hours and 19% of engineering hours. The result is that the plantwide rate, based on machine-hours, will greatly underestimate the cost of resources used on the United Motors contract. This explains the 157% increase in indirect costs assigned to the United Motors contract when department rates are used. In contrast, the Holden Motors contract uses less of design (51%) and engineering (16%) than of machine-hours (70%). Hence, the use of department rates will report lower indirect costs for Holden Motors than does a plantwide rate. Holden Motors was probably complaining under the use of the simple system because its contract was being overcosted relative to its consumption of MOH resources. United, on the other hand, was having its contract undercosted and underpriced by the simple system. Assuming that CP is an efficient and competitive supplier, if the new department-based rates are used to price contracts, United will be unhappy. CP should explain to United how the calculation was done, and point out United s high use of design and engineering resources relative to production machine-hours. Discuss ways of reducing the consumption of those resources, if possible, and show willingness to partner with them to do so. If the price increase is going to be steep, perhaps offer to phase in the new prices. 4. Other than for pricing, CP can also use the information from the departmentbased system to examine and streamline its own operations so that there is maximum value added 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 CP more opportunities for targeted cost management. 5. It would not be worthwhile to further refine the cost system into an ABC system if there wasn t 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. Even if there were sufficient variation, considering the relative sizes of the three department cost pools, it may only be cost-effective to further 167

10 Instructor s Resource Manual for Cost Accounting, Seventh Canadian Edition analyze the production cost pool, which consumes 78% (= $240,000 $308,600) of the manufacturing overhead (25 min.) ABC, product cross-subsidization. 1. Current Costing System: Manufacturing Overhead Allocation Rate = Budgeted MOH Costs Direct Labour-Hours = $1,600,000/100,000 = $16 per DL hour Unit Costs and Selling Price: Table Top Model Floor Model Direct Materials $28.00 $34.00 Direct Labour $7.00 $14.00 Manufacturing Overhead $8.00 $16.00 Unit Cost $43.00 $64.00 Price 140%) $60.20 $ ABC Costing System: Calculation of Pool Rates: Activity Budgeted Costs Budgeted Activity Pool Rate Materials handling $450, ,000 parts $1.125 per part Setups $750, setups $1,000 per setup General factory $400, ,000 DL hours $4 per DL hour Allocation of overhead costs: Table Top Model Floor Model Materials Handling: 160,000 $1.125 $180, ,000 $1.125 $270,000 Setups: 500 $1,000 $500, $1,000 $250,000 General Factory Overhead: 20,000 DL $80,000 80,000 DL $4 $320,000 Total Overhead Allocated $760,000 $840,000 # of Units 40,000 80,000 Unit Overhead Cost $19.00 $10.50 Unit Direct Materials Cost $28.00 $34.00 Unit Direct Labour Cost $7.00 $14.00 Total Unit Cost (ABC) $54.00 $58.50 Selling Price $75.60 $

11 Chapter 5: Activity-Based Costing and Management 3. Comparison Table Top Model Floor Model Unit Cost ABC $54.00 $58.50 Unit Cost Current $43.00 $64.00 Difference in Cost +$11.00 ($5.50) Percentage Change in Cost $11/$43 = 25.6% increase ($5.5)/$64 = 8.6% decrease Unit Price ABC $75.60 $81.90 Unit Price Current $60.20 $89.60 Difference in Price $15.40 ($7.70) Percentage Change in Price $15.4/$60.2 = 25.6% increase ($7.7)/$89.6 = 8.6% decrease The lower volume product (Table Top Model) is significantly undercosted under the current system. This product currently uses twice as many setups as the higher volume Floor Model. Because it consumes less labour time per unit (0.5 hours per unit versus 1 hour per unit for the Floor Model), under the current costing system it receives proportionately less allocated manufacturing overhead when overhead is allocated based on direct labour-hours. It may be useful to compare the total allocated manufacturing overhead under the two systems: (refer also to calculations in parts 1 and 2) Table Top Model Floor Model MOH Allocated ABC $760,000 $840,000 Unit MOH OH current $8.00 $16.00 Number of Units 40,000 80,000 Total MOH Allocated $320,000 $1,280,000 Total Difference $440,000 ($440,000) Unit Difference $11.00 ($5.50) ABC systems can be costly to implement; however, in this case it is likely the benefits of the more accurate costing would outweigh the costs. 169

12 Instructor s Resource Manual for Cost Accounting, Seventh Canadian Edition 5-22 (15 min.) Explain undercosting and overcosting of services. 1. Direct Professional Time Rate Number Support Services Amount per of Billed to Client Hour Hours Total Rate per hour Total Client (1) (2) (3) (4)=(2) (3) (5) (6)=(4) (5) (7)=(4)+(6) Winnipeg Dominion Wolfson $ $12,000 30% $3,600 $ 15,600 Ku % Anderson ,112 30% 634 2,746 $18,908 Tokyo Enterprises Wolfson $800 2 $1,600 30% $480 $2,080 Ku ,152 30% 346 1,498 Anderson ,880 30% 864 3,744 $7, Direct Professional Time Support Services Rate Number Amount per of Billed to Client Hour Hours Total Rate per hour Total Client (1) (2) (3) (4)=(2) (3) (5) (6)=(3) (5) (7)=(4)+(6) Winnipeg Dominion Wolfson $ $12,000 $60 $900 $ 12,900 Ku Anderson , ,320 3,432 $16,944 Tokyo Enterprises Wolfson $800 2 $1,600 $60 $120 $1,420 Ku , ,632 Anderson , ,800 4,680 $7,732 Requirement 1 Requirement 2 Winnipeg Dominion $15,908 $16,944 Tokyo Enterprises 7,322 7,732 $23,230 $24,676 Both clients use 40 hours of professional labour time. However, Winnipeg Dominion uses a higher proportion of Wolfson s time (15 hours), which is more costly. This attracts the highest support-services charge when allocated on the basis of direct professional labour costs. 170

13 Chapter 5: Activity-Based Costing and Management 3. Assume that the Wolfson Group uses a cause-and-effect criterion when choosing the allocation base for support services. You could use several pieces of evidence to determine whether professional labour costs or hours is the driver of support-service costs: a. Interviews with personnel. For example, staff in the major cost categories in support services could be interviewed to determine whether Wolfson requires more support per hour than, say, Anderson. The professional labour costs allocation base implies that an hour of Wolfson s time requires 6.25 (= $600 $96) times more support-service dollars than does an hour of Anderson s time. b. Analysis of tasks undertaken for selected clients. For example, if computer-related costs are a sizable part of support costs, you could determine if there was a systematic relationship between the percentage involvement of professionals with high billing rates on cases and the computer resources consumed for those cases (25 min.) Contrast the logic of two cost assignment systems. 1. Total distribution costs (given), $2,636,000 Distribution cost per case under existing system Total distribution costs $2,636,000 Total cases of specialty 200,000 and regular wine shipped $13.18 per case specialty and regular wine shipped Regular Specialty Per Case Per Case Total (2) Total (4) (1) = (1) 120,000 (3) = (3) 80,000 Distribution costs $ ,000; 80,000 $1,581,600 $13.18 $1,054,400 $ a. Promotional activity distributor-level costs because these costs do not depend on the number of cases shipped or the number of batches in which the cases are shipped. An amount of $9,600 is incurred for each of Niagara s distributors. Order-handling costs batch-level costs because these costs are incurred each time a customer places an order regardless of the number of cases ordered. These costs total $360 per order. Freight distribution costs Unit-level costs because a cost of $10 is incurred on freight for each case shipped. 171

14 Instructor s Resource Manual for Cost Accounting, Seventh Canadian Edition b. Regular Specialty Per Case Per Case Total (2) Total (4) (1) = (1) 120,000 (3) = (3) 80,000 Distribution costs of freight $10 120,000 cases $1,200,000 $10.00 $10 80,000 cases $800,000 $10.00 Ordering costs $ orders/year 10 distr. 36, $ orders/year 30 distr. 216, Promotion costs $9, distributors 96, $9, distributors _ 288,000 _ 3.60 Total costs $1,332,000 $11.10 $1,304,000 $ The existing costing system uses cases shipped, a unit-level cost driver, as the only cost allocation base for distribution costs. As a result, the distribution cost per case is the same for specialty and regular wines ($13.18). In fact, specialty wines use distribution resources more intensively than regular wines: (a) Niagara spends $9,600 on promotional activity at each distributor independent of cases sold. Specialty wine distributors sell fewer cases a year than regular wine distributors. As a result the promotional cost per case of wine sold is higher for specialty wines than for regular wines. (b) Niagara s cost per order is $360 regardless of the number of cases sold in each order. Because specialty wine distributors order fewer cases per order, the ordering costs per case are higher for specialty wines than for regular wines. The existing costing system undercosts distribution costs per case for specialty wines and overcosts distribution costs per case for regular wines. Niagara s management can use the information from the ABC system to make better pricing and product mix decisions, to reduce costs by eliminating processes and activities that do not add value, to identify and evaluate new designs that reduce the activities demanded by various products, to reduce the costs of doing various activities, and to plan and manage activities. 172

15 Chapter 5: Activity-Based Costing and Management 5-24 (25 min.) Allocation of costs to activities, unused capacity. 1. Percentage of Costs Used by Each Activity Indirect Resources Academic Instruction Administration Sports Training Community Relationships 2015 Expenditures Teachers salaries and benefits 60% 20% 8% 12% $4,000,000 Principals salaries and benefits 10% 60% 5% 25% 400,000 Facilities cost 35% 15% 45% 5% 2,600,000 Office staff salaries and benefits 5% 60% 10% 25% 300,000 Sports program staff salaries and benefits 35% 10% 45% 10% 500,000 $7,800,000 Actual Resource Cost Used by Each Activity Indirect Resources Academic Instruction Administration Sports Training Community Relationships 2015 Expenditures Teachers salaries and benefits $2,400,000 $ 800,000 $ 320,000 $480,000 $4,000,000 Principals salaries and benefits 40, ,000 20, , ,000 Facilities cost 910, ,000 1,170, ,000 2,600,000 Office staff salaries and benefits 15, ,000 30,000 75, ,000 Sports program staff salaries and benefits 175,000 50, ,000 50, ,000 Total $3,540,000 $1,660,000 $1,765,000 $835,000 $7,800,000 No. of students Cost per student $7,080 $ 3,320 $3,530 $1,670 $15,600 Percent of total cost by activity 45% 21% 23% 11% 100% 173

16 Instructor s Resource Manual for Cost Accounting, Seventh Canadian Edition The overall cost of educating each student is $15,600. Of this, $7,080 (or 45%) is spent on academic instruction and $3,320 (or 21%) is spent on administration. 2. Cost of ice hockey program = $300,000 Total cost of activities w/o ice hockey program = $7,800,000 $300,000 = $7,500,000 Per student cost of educational program w/o hockey = $7,500, = $15, Net cost of ice hockey program with $1,000 fee = $300,000 (30 $1,000) = $270,000 Total cost of activities with ice hockey program fee = $7,500,000 + $270,000 = $7,770,000 Per student cost of educational program with hockey fee = $7,770, = $15,540 Charging a fee helps a bit but the net cost of the ice hockey program is still high and significantly increases the cost of educating each student. 4. Academic instruction capacity 600 students Cost of academic instruction activity (from requirement 1 calculations) $3,540,000 Cost of academic instruction per student at full utilization = $3,540, $5,900 Academic instruction resource costs used by current student population = 500 $5,900 $2,950,000 Cost of excess academic instruction capacity = $3,540,000 $2,950,000 $590,000 Most of the costs at Heights Academy are fixed in the short run. So, Smith must try to recruit more students to the school. If, in the long run, it seems like the student population is going to be stable at around 500, he should plan how some of the excess capacity can be cut back so that the fixed school capacity is better utilized; that is, he should work to reduce the cost of excess capacity. One problem with that plan is that cutting excess academic instruction capacity may eventually mean reducing the number of sections in each grade and letting teachers go, and if this involves the loss of experienced teachers, that could cause long-term damage to the school. Unrelated to the excess capacity issue, but with the aim of improving the school s economics, he should consider doing away with expensive activities like the ice hockey program which raises the cost per student substantially, even after a large fee is charged from students who choose to play the sport. 174

17 Chapter 5: Activity-Based Costing and Management 5-25 (30 min.) Special order, activity-based costing. 1. Medal Plus s operating income under the alternatives of accepting/rejecting the special order are: Without With One- One-Time- Time-Only Only Special Special Order Order Difference 9,000 Units 11,500 Units 2,500 Units Sales $1,800,000 $2,220,000 $420,000 Variable costs: Direct materials 360, , ,000 Direct manufacturing labour 405, , ,500 Batch manufacturing costs 126, , ,500 Fixed costs: Fixed manufacturing costs 325, ,000 Fixed marketing costs 224, ,000 Total costs 1,440,000 1,670, ,000 Operating income $ 360,000 $ 550,000 $ 190,000 1 Unit cost of direct materials = $360,000/9,000 = $40 per medal $40 11,500 = $460,000 2 Unit cost of direct labour = $405,000/9,000 = $45 per medal $45 11,500 = $517,500 3 Batch costs $126,000 + (25 * $700) Alternatively, we could calculate the incremental revenue and the incremental costs of the additional 2,500 units as follows: Incremental revenue $168 2,500 $420,000 Incremental direct material costs 2,500 $40 = 100,000 Incremental direct manufacturing labour costs 2,500 $45 = 112,500 Incremental batch manufacturing costs $ = 17,500 Total incremental costs 230,000 Total incremental operating income from accepting the special order $190,000 Medal Plus should accept the one-time-only special order if it has no longterm implications, because accepting the order increases Medal Plus s operating income by $190,000. If, however, accepting the special order would cause the regular customers to be dissatisfied or to demand lower prices, then Medal Plus will have to trade off the $190,000 gain from accepting the special order against the operating income it might lose from regular customers. 175

18 Instructor s Resource Manual for Cost Accounting, Seventh Canadian Edition 2. Medal Plus has a capacity of 10,000 medals. Therefore, if it accepts the special onetime order of 2,500 medals, it can sell only 7,500 medals instead of the 9,000 medals that it currently sells to existing customers. That is, by accepting the special order, Medal Plus must forgo sales of 1,500 medals to its regular customers. Alternatively, Medal Plus can reject the special order and continue to sell 9,000 medals to its regular customers. Medal Plus s operating income from selling 7,500 medals to regular customers and 2,500 medals under the one-time special order follows: Sales (7,500 $200) + (2,500 $168) $1,920,000 Direct materials (10,000 * $40) 400,000 Direct manufacturing labour (10,000 * $45) 450,000 Batch manufacturing costs** (150 $700) + (25 $700) 122,500 Fixed manufacturing costs 325,000 Fixed marketing costs 224,000 Total costs 1,521,500 Operating income $ 398,500 ** Medal Plus makes regular medals in batch sizes of 50. To produce 7,500 medals requires 150 (7,500 50) batches. Accepting the special order will result in an increase in operating income of $38,500 ($398,500 $360,000). The special order should therefore be accepted. A more direct approach would be to focus on the incremental effects the benefits of accepting the special order of 2,500 units versus the costs of selling 1,500 fewer units to regular customers. Increase in operating income from the 2,500-unit special order equals $190,000 (requirement 1). The loss in operating income from selling 1,500 fewer units to regular customers equals: Lost revenue $200 1,500 $(300,000) Savings in direct materials costs $40 1,500 60,000 Savings in direct manufacturing labour costs $45 1,500 67,500 Savings in batch manufacturing costs $ ,000 Operating income lost $ (151,500) Accepting the special order will result in an increase in operating income of $38,500 ($190,000 $151,500). The special order should therefore be accepted. 3. Medal Plus should not accept the special order. Increase in operating income by selling 2,500 units under the special order (requirement 1) $ 190,000 Operating income lost from existing customers ($11 9,000) (99,000) Net effect on operating income of accepting special order $91,000 The special order should therefore be accepted. 176

19 Chapter 5: Activity-Based Costing and Management 5-26 (30 min.) ABC, product cost cross-subsidization. 1. Direct costs Direct materials $250,000 Indirect costs Production support 1,298,000 Total costs $1,548,000 # of kilograms 1,000,000 Cost per kilogram $ Retail Potato Cuts Institutional Potato Cuts Direct costs Direct materials $225,000 $25,000 Packaging 238,000 $463,000 22,000 $47,000 Indirect costs Cleaning $ , ,000 $ ,000 18,000 Cutting $ , ,000 $ ,000 20,000 Packaging $ , ,000 $ , ,000 28,000 66,000 Total costs $1,435,000 $113,000 Kilograms produced 900, ,000 Costs per kilogram $1.594 $1.13 Note: The total costs of $1,548,000 ($1,435,000 + $113,000) are the same as those in requirement #1. This is expected, as the total costs do not change. It is the allocation basis that assigns costs differently. 3. There is much evidence of product-cost cross-subsidization. Retail Institutional Current system $1.548 $1.548 ABC system $1.594 $1.130 Assuming the ABC numbers are more accurate, retail is undercosted by approximately 3% ($1.548 $1.594 = 0.97), while institutional is overcosted by 37% ($1.548 $1.13 = 1.37). 177

20 Instructor s Resource Manual for Cost Accounting, Seventh Canadian Edition The current system assumes each product uses all the activity areas in a homogeneous way. This is not the case. Institutional sales use sizably less resources in the cutting area and the packaging area. The percentage of total costs for each cost category are: Retail Institutional Total Direct costs Direct materials 90.0% 10.0% 100.0% Packaging 91.5% 8.5% Indirect costs Cleaning % Cutting % Packaging % Units produced 90.0% 10.0% 100.0% PEI can use the revised cost information for a variety of purposes: a. Pricing/product mix decisions. The sizable drop in the reported cost of institutional potatoes makes it possible that PEI was overpricing potato products in this market. It lost the bid for a large institutional contract with a bid 30% above the winning bid. With its revised product cost dropping from $1.548 to $1.13, PEI could have bid much lower and still made a profit. An increased emphasis on the institutional market appears warranted. b. Product design decisions. ABC provides a road map as to how to reduce the costs of individual products. The relative components of costs are: Retail Institutional Direct costs Direct materials 15.7% 22.1 % Packaging 16.6% 19.5% Indirect costs Cleaning 11.3% 15.9% Cutting 18.8% 17.7% Packaging 37.6% 24.8% Total costs 100.0% 100.0% Packaging-related costs constitute 54.2% (= 16.6% +37.6%) of total costs of the retail product line. Design efforts that reduce packaging costs can have a big impact on reducing total unit costs for retail. Retail packaging requires better barrier properties, as the cuts require a longer shelf life than institutional (large quantities) cuts. Retail also has to market the cuts, which requires more expensive packaging design. The biggest problem is the smaller quantity of cuts per package in retail vs. institutional, which means more packages are required for retail. c. Process improvements. Each activity area is now highlighted as a separate cost. The three indirect cost areas are over 50% of total costs for each product, indicating the upside from improvements in the efficiency of processes in these activity areas. 178

21 Chapter 5: Activity-Based Costing and Management 5-27 (15 20 min.) ABC, wholesale, customer profitability. Chain Gross sales $50,000 $30,000 $100,000 $70,000 Sales returns 10,000 5,000 7,000 6,000 Net sales 40,000 25,000 93,000 64,000 Cost of goods sold (80%) 32,000 20,000 74,400 51,200 Gross margin 8,000 5,000 18,600 12,800 Customer-related costs: Regular orders $20 40; 150; 50; ,000 1,000 1,400 Rush orders $100 10; 50; 10; 30 1,000 5,000 1,000 3,000 Returned items $20 100; 26; 60; 40 2, , Catalogues and customer support 1,000 1,000 1,000 1,000 Customer related costs 3,800 9,260 3,600 5,800 Contribution (loss) margin $ 3,200 $ (4,520) $ 14,400 $ 6,600 Contribution (loss) margin as percentage of gross sales 6.4% (15.1%) 14.4% 9.4% The analysis indicates that customers profitability (loss) contribution varies widely. Immediate attention to Chain 2 is required which is currently showing a contribution loss. The chain has a disproportionate number of both regular orders and rush orders. Ames 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, Ames should consider dropping Chain 2, if it can save the customer-related costs. Chain 1 has a disproportionate number of sale returns. The causes of these should be investigated so that the profitability contribution of Chain 1 could be improved. 179

22 Instructor s Resource Manual for Cost Accounting, Seventh Canadian Edition 5-28 (30 min.) ABC, product line costing. 1. Manufacturing overhead activity rates: Activity Budgeted Cost Budgeted Cost Driver Activity Rate Equipment Setups $44, setups $550/setup Machine Processing $875, ,000 machine-hours $3.50/MH Quality Control $630,000 15,000 inspection hours $42/IH Packaging/Shipping $80, shipments $400/shipment 2. Unit cost of each model of phone: Family Friend Office Assistant Equipment Setup: 50/30 $550 $27,500 $16,500 Machine Processing: 30,000/220,000 $3.50 $105,000 $770,000 Quality Control: 5,000/10,000 $42 $210,000 $420,000 Packaging/Shipping: 125/75 $400 $50,000 $30,000 Total allocated overhead $392,500 $1,236,500 Number of units produced 50, ,000 Per unit overhead cost $7.85 $8.24 Direct materials $12.14 $28.64 Direct labour $10.86 $10.86 Total unit manufacturing cost $30.85 $ Current system using one overhead cost pool and direct labour cost as the activity base: Total budgeted direct labour cost: [50,000 * $10.86] + [150,000 * $10.86] = $2,172,000 Manufacturing overhead rate = Budgeted Manufacturing OH Cost Budgeted Direct Labour Cost = $1,629,000/$2,172,000 = 75% of Direct Labour Cost Family Friend Office Assistant Direct materials $12.14 $28.64 Direct labour $10.86 $10.86 MOH at 75% of direct labour $8.15 $8.15 Total unit manufacturing cost $31.15 $

23 Chapter 5: Activity-Based Costing and Management 4. Comparison of Results: Family Friend Office Assistant Total unit cost under ABC $30.85 $47.74 Total unit cost current $31.15 $47.65 Difference in dollars ($0.30) $0.09 The $0.30 cost reduction under ABC for the Family Friend model represents approximately a 1% change in the cost ($0.30/$31.15). The nine cent increase in the cost of the Office Assistant model is less than 1% change. In this case, the switch to ABC does not significantly improve product costing and the costs of the ABC system may outweigh the benefits. This would depend on the costs of implementing ABC and how competitive the market place is (30 min.) ABC, product costing at banks, cross-subsidization. 1. Robinson Skerrett Farrel Total Revenue Spread revenue on annual basis (2.5% ; $2,600, $1,200, $40,000) $ $ $1, $ 1, Monthly fee charges ($35 ; 0, 12, 0) Total revenue , , Costs Deposit/withdrawal with teller $ ; 55; Deposit/withdrawal with ATM $ ; 24; Deposit/withdrawal prearranged monthly: $0.80 0; 15; Bank cheques written $ ; 5; Foreign currency drafts $ ; 1; Inquiries $ ; 20; Total costs $1, Operating income $(321.90) $ $ $ The assumption that the Robinson and Farrel accounts exceed $2,500 every month and the Skerrett account is less than $2,500 each month means the monthly charges apply only to Skerrett. 181

24 Instructor s Resource Manual for Cost Accounting, Seventh Canadian Edition One student with a banking background noted that in this solution 100% of the spread is attributed to the borrowing side of the bank. He noted that often the spread is divided between the borrowing side and the lending side of the bank. 2. Cross-subsidization across individual Premier Accounts occurs when profits made on some accounts are offset by losses on other accounts. The aggregate profitability on the three customers is $ The Farrel account is highly profitable ($730.40), while the Robinson account is sizably unprofitable. International Trust (IT) should be very concerned about the crosssubsidization. Competition likely would understand that high-balance lowactivity type accounts (such as Farrel) are highly profitable. Offering free services to these customers is not likely to retain these accounts if other banks offer higher interest rates. Competition likely will reduce the interest rate spread IT can earn on the high-balance low-activity accounts they are able to retain. 3. Possible changes IT could make are: a. Offer higher interest rates on high-balance accounts to increase IT s competitiveness in attracting and retaining these accounts. b. Introduce charges for individual services. The ABC study reports the cost of each service. IT has to decide if it wants to price each service at cost, below cost, or above cost. If it prices above cost, it may use advertising and other means to encourage additional use of those services by customers. c. Increase the minimum balance for unlimited use of services (15-20 min.) ABC, costs of quality. 1 a. Overhead allocated using current costing system: Direct labour costs 150% = $467, % = $700, b. Overhead allocating using ABC: Activity Activity Rate Quantity Allocated Cost Materials inspection $36 per type 50 $1,800 In process testing $6 per unit produced 40,000 $240,000 Final product testing $25 per unit inspected 12,000 $300,000 Testing supplies 30% of DM cost $392,000 $117,600 Total OH allocated $659, A switch to ABC would result in this job s cost being reduced by $41,100 (= $700,500 $659,400) or 5.9% reduction in overhead costs assigned ($41,100/$700,500). This is a significant amount and job overcosting could result in lost bids on cost-plus contracts. A switch to ABC is recommended for this company. 182

25 Chapter 5: Activity-Based Costing and Management PROBLEMS 5-31 (20-30 min.) Job costing with single direct-cost category, single indirect-cost pool. 1. Pricing decisions at Wigan Associates are heavily influenced by reported cost numbers. Suppose Wigan is bidding against another firm for a client with a job similar to that of Widnes Coal. If the costing system overstates the costs of these jobs, Wigan may bid too high and fail to land the client. If the costing system understates the costs of these jobs, Wigan may bid low, land the client, and then lose money in handling the case. 2. Widnes St. Helen s Coal Glass Total Direct professional labour, $70 104; $70 96 $ 7,280 $ 6,720 $14,000 Indirect costs allocated, $ ; $ ,920 10,080 21,000 Total costs to be billed $18,200 $16,800 $35, (20 25 min.) Job costing with multiple direct-cost categories, single indirectcost pool, law firm. 1. Indirect costs = $9,000 Total professional labour-hours = 200 hours ( ) = $9, = $45/hour 2. Widnes St. Helen s Coal Glass Total Direct costs: Direct professional labour, $70 104; $70 96 $ 7,280 $ 6,720 $14,000 Research support labour 1,600 3,400 5,000 Computer time 500 1,300 1,800 Travel and allowances 600 4,400 5,000 Telephones/faxes 200 1,000 1,200 Photocopying ,000 Total direct costs 10,430 17,570 28,000 Indirect costs allocated, $35 104; $ ,640 3,360 7,000 Total costs to be billed $14,070 $20,930 $35,

26 Instructor s Resource Manual for Cost Accounting, Seventh Canadian Edition 3. Widnes St. Helen s Coal Glass Total Problem 5-31 $18,200 $16,800 $35,000 Problem ,070 20,930 35,000 The Problem 5-32 approach directly traces $14,000 of general support costs to the individual jobs. In Problem 5-31, these costs are allocated on the basis of direct professional labour-hours. The averaging assumption implicit in the Problem 5-31 approach appears incorrect for example, the St. Helen s Glass job has travel costs more than seven times higher than the Widnes Coal case, despite having lower direct professional labour-hours (30 min.) Job costing with multiple direct-cost categories, multiple indirectcost pools, law firm. Widnes St. Helen s Coal Glass Total Direct costs: Partner professional labour, $100 24; $ $ 2,400 $ 5,600 $ 8,000 Associate professional labour, $50 80; $ ,000 2,000 6,000 Research support labour 1,600 3,400 5,000 Computer time 500 1,300 1,800 Travel and allowances 600 4,400 5,000 Telephones/faxes 200 1,000 1,200 Photocopying ,000 Total direct costs 9,550 18,450 28,000 Indirect costs allocated: Indirect costs for partners, $ ; $ ,380 3,220 4,600 Indirect costs for associates, $20 80; $ , ,400 Total indirect costs 2,980 4,020 7,000 Total costs to be billed $12,530 $22,470 $35,

27 Chapter 5: Activity-Based Costing and Management Widnes St. Helen s Comparison Coal Glass Total Single direct cost/ Single indirect cost pool $18,200 $16,800 $35,000 Multiple direct costs/ Single indirect cost pool $14,070 $20,930 $35,000 Multiple direct costs/ Multiple indirect cost pools $12,530 $22,470 $35,000 The higher the percentage of costs directly traced to each case, and the greater the number of homogeneous indirect cost pools linked to the cost drivers of indirect costs, the more accurate the product cost of each individual case. The Widnes and St. Helen s cases differ in how they use resource areas of Wigan Associates: Widnes St. Helen s Coal Glass Partner professional labour 30.0% 70.0% Associate professional labour Research support labour Computer time Travel and allowances Telephones/faxes Photocopying The Widnes Coal case makes relatively low use of the higher-cost partners but relatively higher use of the lower-cost associates than does St. Helen s Glass. As a result, it also uses less of the higher indirect costs required to support partners compared to associates. The Widnes Coal case also makes relatively lower use of the support labour, computer time, travel, phones/faxes, and photocopying resource areas than does the St. Helen s Glass case (25 min.) Contrast the logic of two cost assignment systems. 1. Output unit-level costs: 1. Direct-labour costs, $288, Equipment-related costs (rent, maintenance, energy, and so on), $480,000 These costs are output unit-level costs because they are incurred on each unit of materials tested, that is, for every hour of testing. 185

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