2015 Budgeted Manufacturing Overhead Costs. Driver of the Activity s Costs

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1 Derinice Icecream, LLC (DI) owned and operated 14 retail ice cream stores spread throughout Florida. DI's stores sold only the highest-quality, ultra-premium ice cream. They offered 25 different ice cream flavors. Many of the DI flavors were "exotic," such as "Polynesian Fantasy," "Mango-Lemon Supreme," and "Multi-Nut Twist." But DI also sold a few traditional ice cream flavors, such as vanilla, chocolate, strawberry, and coffee. Some of the flavors were very popular, but a few of the exotic flavors sold in low volumes. Dl produced its own ice cream. Originally the ice cream was produced in the garage of the company's founder, Anatoly Derin. But the company outgrew the garage, and Anatoly had since leased a building to house eel's production activities. As DI had grown, Anatoly had been able to afford more expensive, automated manufacturing equipment that blended the flavors and packaged the liquid ice cream in preparation for freezing. DI's most significant production costs were for raw materials, particularly cream, sugar, and the special flavor ingredients, and for the acquisition, operation, and maintenance of the 'production equipment. All of DI s products were sold at the same retail price. Anatoly set the prices to yield, roughly, a markup of 100 percent on average full production costs. DI 's 2015 budget included manufacturing overhead of $ To estimate product costs, Anatoly spread this overhead cost to products based on a proportion of the direct labor used in the production process. DI's total direct labor cost for 2015 was $300,000, so Anatoly charged the overhead to products at a rate of 200 percent of direct labor costs. One day in a casual conversation, Mel Ayan, Anatoly's neighbor and a controller of a small manufacturing company, suggested that Anatoly's pricing policy was not very smart. Mel's intuition was that the costs of producing DI's various flavors were very different. She thought those differences should be reflected in the prices charged, or DI's profits would wary as the mix of products sold varied. Mel suggested that Anatoly re-estimate product costs using what she called an "activity-based" costs using what she called an activity-based cost system. Toward that end, she suggested that he identify the major activities whose costs were included in the company's overhead costs. Then he should a those costs to products based on the products' consumption of each of those activities. In response to Mel's suggestion, Anatoly prepared the information shown in Exhibit 1. EXHIBIT Budgeted Manufacturing Overhead Costs Activity Budgeted Cost ($000) Driver of the Activity s Costs Budgeted Activity Level for the Cost Driver Purchasing $ 80 Purchase orders 909 Material Handling 95 Setups 1,846 Blending 122 Blender hours 1,000 Freezing 175 Freezer hours 1,936 Packaging 110 Packaging machine hours 1,100 Quality Control 18 Batches 286 Total manufacturing overhead costs $ 600

2 Then, again following Mel s suggestion, he decided to calculate the costs of two Illustrative products as an experiment to see if Mel s new cost system idea produced any material differences. He asked Mel to take her best guess as to where he might find the most significant differences, If any existed. After Anatoly described the products to her, Mel suggested that he use Polynesian Fantasy and Vanilla as the test product examples. Exhibit 2 provides data pertinent to those two products. EXHIBIT 2 Two Product Examples 2015 Data Polynesian Fantasy Vanilla Direct material $2.00/gallon $1.80/gallon Direct labor $1.20/gallon $1.20/gallon Budgeted production -and sales 2,000 gallons 100,000 gallons Batch size 100 gallons 2,500 gallons Setups 3 per batch 3 per batch Purchase order size 50 gallons 1000 gallons Blender time 0.6 hour per 100 gallons 0.3 hour per 100 gallons Freezer time 1.0 hour per 100 gallons 1.0 hour per 100 gallons Packaging machine time 0.3 hour per 100 gallons 0.2 hour per 100 gallons Questions 1. Compute the full production cost (per gallon) of the Polynesian Fantasy and Vanilla. products using a. Anatoly's old costing method b. The new costing method suggested by Mel 2. What are the effects, if any, of changing the company s costing method?

3 Gallatin Carpet Cleaning is a small, family-owned business operating out of Bozeman, Montana. For its services, the company has always charged a flat fee per hundred square feet of carpet cleaned. The current fee is $28 per hundred square feet. However, there is some question about whether the company is actually making any money on jobs for some customers particularly those located on remote ranches that require considerable travel time. The owner s daughter, home for the summer from college, has suggested investigating this question using activity-based costing. After some discussion, a simple system consisting of four activity cost pools seemed to be adequate. The activity cost pools and their activity measures appear below: The total cost of operating the company for the year is $430,000, which includes the following costs: Resource consumption is distributed across the activities as follows: Job support consists of receiving calls from potential customers at the home office, scheduling jobs, billing, resolving issues, and so on. Required: 1. Prepare the first-stage allocation of costs to the activity cost pools. 2. Compute the activity rates for the activity cost pools. 3. The company recently completed a 5 hundred square foot carpet-cleaning job at the Flying N ranch a 75-mile round-trip journey from the company s offices in Bozeman. Compute the cost of this job using the activity-based costing system. 4. The revenue from the Flying N ranch was $140 (5 hundred square $28 per hundred square feet). Prepare a report showing the margin from this job. 5. What do you conclude concerning the profitability of the Flying N ranch job? Explain. 6. What advice would you give the president concerning pricing jobs in the future?

4 Requirement 1: A B C D E F G Cleaning Travel to Job Carpets Jobs Support Other Totals Wages 70% 20% 0% 10% 100% Cleaning supplies 100% 0% 0% 0% 100% Cleaning equipment depreciation 80% 0% 0% 20% 100% Vehicle expenses 0% 60% 0% 40% 100% Office expenses 0% 0% 45% 55% 100% President's compensation 0% 0% 40% 60% 100% Wages Cleaning supplies Cleaning equipment depreciation Vehicle expenses Office expenses President's compensation Total cost Requirement 2: Cleaning Travel to Job Carpets Jobs Support Other Totals GALLATIN CARPET CLEANING Activity Rates for Activity Cost Pools Total Activity Activity Cost Pool Total Cost Activity Rate Cleaning carpets Travel to job Job support Requirement 3: GALLATIN CARPET CLEANING Job Cost - Flying N Ranch Activity Total Activity Cost Pool Rate Activity Cost Cleaning carpets Travel to job Job support Total Requirement 4: GALLATIN CARPET CLEANING Product Margin Sales Costs: Cleaning carpets Travel to jobs Job support Product margin GALLATIN CARPET CLEANING Distribution of Resource Consumption Across Activity Cost Pools per hundred square feet per mile per job per hundred square feet per mile per job

5 Mercer Asbestos Removal Company removes potentially toxic asbestos insulation and related products from buildings. There has been a long-simmering dispute between the company s estimator and the work supervisors. The on-site supervisors claim that the estimators do not adequately distinguish between routine work such as removal of asbestos insulation around heating pipes in older homes and nonroutine work such as removing asbestos-contaminated ceiling plaster in industrial buildings. The on-site supervisors believe that nonroutine work is far more expensive than routine work and should bear higher customer charges. The estimator sums up his position in this way: My job is to measure the area to be cleared of asbestos. As directed by top management, I simply multiply the square footage by $2.50 to determine the bid price. Since our average cost is only $2.175 per square foot, that leaves enough cushion to take care of the additional costs of nonroutine work that shows up. Besides, it is difficult to know what is routine or not routine until you actually start tearing things apart. To shed light on this controversy, the company initiated an activity-based costing study of all of its costs. Data from the activity-based costing system follow: Required: 1. Perform the first-stage allocation of costs to the activity cost pools. 2. Compute the activity rates for the activity cost pools. 3. Using the activity rates you have computed, determine the total cost and the average cost per thousand square feet of each of the following jobs according to the activity-based costing system. a. A routine 1,000-square-foot asbestos removal job. b. A routine 2,000-square-foot asbestos removal job. c. A nonroutine 2,000-square-foot asbestos removal job. 4. Given the results you obtained in (3) above, do you agree with the estimator that the company s present policy for bidding on jobs is adequate?

6 Requirement 1: A B C D E F G MERCER ASBESTOS REMOVAL COMPANY First Stage Allocation Estimating Dealing with and Job Nonroutine Job Size Setup Jobs Other Totals Wages and salaries Disposal fees Equipment depreciation On-site supplies Office expenses Licensing and insurance Total cost $ - $ - $ - $ - $ - Requirement 2: MERCER ASBESTOS REMOVAL COMPANY Activity Rates for Activity Cost Pools Total Activity Activity Cost Pool Total Cost Activity Rate Job size Estimating and job setup Working on nonroutine jobs Requirement 3: MERCER ASBESTOS REMOVAL COMPANY Total and Average Cost per Thousand Square Feet (3a.) Routine job - square feet 1,000 Removing asbestos Estimating and job set-up Nonroutine job Total cost of the job Cost per thousand square feet (3b.) Routine job - square feet 2,000 Removing asbestos Estimating and job set-up Nonroutine job Total cost of the job Average cost per thousand square feet (3c.) Nonroutine job - square feet 2,000 Removing asbestos Estimating and job set-up Nonroutine job Total cost of the job Average cost per thousand square feet per thousand square feet per job per nonroutine job

7 Pixel Studio, Inc., is a small company that creates computer-generated animations for films and television. Much of the company s work consists of short commercials for television, but the company also does realistic computer animations for special effects in movies. The young founders of the company have become increasingly concerned with the economics of the business particularly since many competitors have sprung up recently in the local area. To help understand the company s cost structure, an activity-based costing system has been designed. Three major activities are carried out in the company: animation concept, animation production, and contract administration. The animation concept activity is carried out at the contract proposal stage when the company bids on projects. This is an intensive activity that involves individuals from all parts of the company in creating story boards and prototype stills to be shown to the prospective client. Once a project is accepted by the client, the animation goes into production and contract administration begins. Almost all of the work involved in animation production is done by the technical staff, whereas the administrative staff is largely responsible for contract administration. The activity cost pools and their activity measures are listed below: These activity rates include all of the company s costs, except for the costs of idle capacity and organization-sustaining costs. There are no direct labor or direct materials costs. Preliminary analysis using these activity rates has indicated that the local commercial segment of the market may be unprofitable. This segment is highly competitive. Producers of local commercials may ask three or four companies like Pixel Studio to bid, which results in an unusually low ratio of accepted contracts to bids. Furthermore, the animation sequences tend to be much shorter for local commercials than for other work. Since animation work is billed at fairly standard rates according to the running time of the completed animation, this means that the revenues from these short projects tend to be below average. Data concerning activity in the local commercial market appear below: The total sales from the 10 contracts for local commercials was $180,000. Required: 1. Determine the cost of serving the local commercial market. 2. Prepare a report showing the margin earned serving the local commercial market. (Remember, this company has no direct materials or direct labor costs.) 3. What would you recommend to management concerning the local commercial market?

8 Advanced Products Corporation has supplied the following data from its activity-based costing system: During the year, Advanced Products completed one order for a new customer, Shenzhen Enterprises. This customer did not order any other products during the year. Data concerning that order follow: Required: 1. Prepare a report showing the first-stage allocations of overhead costs to the activity cost pools. 2. Compute the activity rates for the activity cost pools. 3. Prepare a report showing the customer margin for Shenzhen Enterprises.