Predetermined Indirect Cost Rate Estimated Volume of the Allocation Base

3.1 Predetermined Indirect Cost Rate Estimated Volume of the Allocation Base

5. Apply activity-based management and costing to marketing. Activity-based costing identifies the marketing activities needed to service each customer or order more appropriately. The variability in marketing costs across customer types and distribution channels requires attention by the costing system. Activity-based costing also supports activity-based management by encouraging the elimination of accounts with high processing costs.

6. Use the cost hierarchy to organize cost information for decision making. Allocating all costs to units is misleading if some costs do not vary with the volume of units. To deal with this, management can set up a hierarchy of costs—capacity, product, customer-sustaining,

batch, and unit—and focus on the costs in the applicable category.

7. Distinguish between resources used and resources supplied, and measure unused resource capacity. Resources used for an activity are measured by the cost driver rate times the cost driver volume. Resources supplied to an activity are the expenditures for the activity. Differences between resource supply and resource usage (unused resource capacity) generally occur because managers have committed to supply a certain level of resources before using them. Activity-based management involves looking for ways to reduce unused capacity.

8. Explain the difficulties of implementing advanced cost-management systems. Accountants cannot implement activity-based costing without becoming familiar with the operations of the company. Accountants become part of a team with management and people from production, engineering, marketing, and other parts of the company who all work to identify the activities that drive the company’s costs. One cause of difficulty in implementing activity-based costing is the failure to get influential people in the organization to buy into the process.

Key Terms and Concepts

Activity-based costing (ABC) Department allocation method Activity-based management (ABM)

Plantwide allocation method Activity center

Resources supplied

Cost driver

Resources used

Cost hierarchy

Unused capacity

Cost pool

Value chain

Solutions to Self-Study Problems 95

S olutions to S elf-Study Problems

S U G G E S T E D S O L U T I O N T O P R O B L E M 3 . 1 F O R S E L F - S T U DY

Mountain Bikes

Racing Bikes

Actual

Costs Allocated

Actual

Costs Allocated

Cost Driver

to Mountain

Cost Driver

to Racing

Activity Rate

Purchasing $20 per

materials frame Machine setups

per setup Inspections

inspection hour

Running $30 per

machines hour Total cost allocated to each product:

The costs of producing 600 mountain bikes and 200 racing bikes are as follows:

Direct Materials ........................................................................

$ 60,000 ($100 each)

$ 40,000 ($200 each)

Direct Labor ..............................................................................

$ 60,000 (see above)

$ 90,000 (see above)

Unit Costs Mountain

Direct Materials ..............................................................................................

Direct Labor ....................................................................................................

b $100 ¼ total allocation to products divided by number of units produced ¼ $60,000/600 units. $450 ¼ total allocation to products divided by number of units produced ¼ $90,000/200 units.

S U G G E S T E D S O L U T I O N T O P R O B L E M 3 . 2 F O R S E L F - S T U DY Activity

Category

1. Piecework labor ..............................................................................................

Unit

2. Long-term lease on building .......................................................................

Capacity-sustaining

3. Energy to run machines ...............................................................................

Unit

4. Engineering drawings for a product ..........................................................

Product-sustaining

5. Purchase order ................................................................................................

Batch

6. Movement of materials for products in production ...............................

Batch

7. Change order to meet new customer specifications .............................

Customer-sustaining

96 Chapter 3 Activity-Based Management

Que stions , Exercis e s , Problems , and Ca s e s

REVIEWQUESTIONS

1. Review the meaning of the concepts and terms given in Key Terms and Concepts.

2. ‘‘Activity-based costing is great for manufacturing plants, but it doesn’t really address the needs of the service sector.’’ Do you agree? Explain.

3. If step 1 of ABC is to identify activities that consume resources, what is step 2?

4. What basis or cost driver does a company using a single plantwide rate typically select for the allocation of indirect costs?

5. What are the four basic steps required for activity-based costing?

6. Give the criterion for choosing cost drivers for allocating costs to products.

7. Why is the traditional approach to indirect cost allocation less expensive to implement than the activity-based costing approach?

C R I T I C A L A N A LY S I S A N D D I S C U S S I O N Q U E S T I O N S

8. What types of cultures most likely support implementing ABC? What types would not support ABC implementation?

9. What exactly is a cost driver? Give three examples.

10. Activity-based costing requires more record keeping and extensive teamwork among all departments. What are the potential benefits of a more detailed product cost system?

11. ‘‘One of the lessons learned from activity-based costing is that all costs are really a function of volume.’’ True, false, or uncertain? Explain.

12. Allocating overhead based on the volume of output, such as direct labor hours or machine hours, seems fair and equitable. Why, then, do many people claim that high-volume products ‘‘subsidize’’ low-volume products?

13. Give examples of two non–value-added activities that may be found in each of the following organizations: (1) a university, (2) a restaurant, and (3) a bicycle repair shop.

14. ‘‘The total estimated overhead for the year will differ depending on whether you use department allocation or activity-based costing.’’ Do you agree? Explain.

15. Many companies have experienced great technological change resulting in potential for erroneous product cost figures, assuming traditional labor-based cost drivers are used to allocate overhead to products. What is that technological change?

16. ‘‘Activity-based costing is for accountants and production managers. I plan to be a marketing specialist, so ABC won’t help me.’’ Do you agree with this statement? Explain.

17. Refer to the Managerial Application ‘‘Resources Used versus Resources Supplied in Health Care.’’ If the new anesthesia reduces the number of minutes a patient stays in the recovery room after surgery, why wouldn’t nursing costs necessarily be reduced proportional to the reduction in the number of minutes the patient stays in the recovery room?

18. Martha Clark, the vice-president of marketing, wonders how products can cost less under one cost system than under another: ‘‘Aren’t costs cut-and-dried?’’ How would you respond?

19. According to a recent publication, ‘‘Activity-based costing is the wave of the future. Everyone should drop their existing cost systems and adopt ABC!’’ Do you agree? Explain.

20. What is the difference between a capacity-sustaining cost and a unit-level cost? How can managers use a hierarchy of overhead costs like the one presented in Exhibit 3.9?

21. Of the four categories of costs in the hierarchy, which one would you most expect to have unused resources? Why?

22. How are the unused resources measured?

23. How does activity-based management use the hierarchy of costs?

24. Would you expect companies that adopt ABC to add value to shareholders? How would you measure such added value?

Questions, Exercises, Problems, and Cases 97

EXERCISES Solutions to even-numbered exercises are at the end of the chapter.

25. Activity-based costing. Jake Miille has just joined the Ciudad Juarez factory (text example) as the new production manager. He was pleased to see the company uses activity-based costing. Miille believes he can reduce production costs if he reduces the number of machine setups. He has spent the past month working with purchasing and sales to better coordinate raw material arrivals and the anticipated demand for the company’s products. In March, he plans to produce 1,000 mountain bikes and 200 racing bikes. Miille believes that with his efficient production scheduling he can reduce the number of setups for both mountain and racing bikes by about 50 percent.

a. Refer to Exhibit 3.5. Compute the amount of overhead allocated to each product line— mountain bikes and racing bikes—assuming annual setups are reduced by approxi- mately 50 percent. Assume the number of machine setups in March is seven setups for mountain bikes and 15 setups for racing bikes. Assume the overhead costs of setting up machines decrease proportionately with the reduction in the number of setups; thus, the setup rate remains at $2,000 per setup. All other overhead costs will remain the same.

b. What information did activity-based costing provide that enabled Jake Miille to pursue reducing overhead costs? In general, what are the advantages of activity-based costing over the traditional volume-based allocation methods? What are the disadvantages?

26. Activity-based costing. Keaton Hoffman, the manager of Wildwater Adventurers uses activity- based costing to compute the costs of his raft trips. Each raft holds six paying customers and a guide. The company offers two types of raft trips—three-day float trips for beginners and three- day whitewater trips for seasoned rafters. The breakdown of the costs is as follows:

Activities (with cost drivers)

Float Trip Costs

Whitewater Trip Costs

Advertising (trips) .............................

$215 per trip

$215 per trip

Permit to Use the River (trips) ......

30 per trip

50 per trip

Equipment Use (trips, people) .......

20 per trip þ $5 per person

40 per trip þ $8 per person

(including guides)

(including guides)

Insurance (trips) ................................

75 per trip

127 per trip

Paying Guides (trips, guides) .........

300 per trip per guide

400 per trip per guide

Food (people) .....................................

60 per person

60 per person

(including guides)

(including guides)

a. Compute the cost of a four-raft, 28-person (including four guides) float trip.

b. Compute the cost of a four-raft, 28-person (including four guides) whitewater trip.

c. Recommend a minimum price per customer to the manager if she wants to cover her costs.

27. ABC versus traditional costing. EyePod Corporation produces two types of compact discs: standard and high-grade. The standard CDs are used primarily in computer drives and are designed for data storage rather than accurate sound reproduction. The company only recently began producing the higher-quality, high-grade model to enter the lucrative music- recording market. Since the new product was introduced, profits have seen only a modest increase. Management expected a significant profit increase related to rapidly growing sales of the high-grade discs. Management believes the accounting system may not be accurately allocating costs to products.

Management has asked you to investigate the cost allocation problem. You find that manufacturing overhead is currently assigned to products based on the direct labor costs in the products. Last year’s manufacturing overhead was $880,000, based on production of 320,000 standard CDs and 120,000 high-grade CDs. Selling prices last year averaged $3.60 per standard disc and $5.80 per high-grade disc. Direct labor and direct materials costs for last year were as follows:

Direct Labor .........................................................................................

Direct Materials ...................................................................................

98 Chapter 3 Activity-Based Management

Management believes the following three activities cause overhead costs. The cost drivers and related costs are as follows:

Activity Level

Standard High-Grade Total Number of Production Runs ......................................

Costs Assigned

20 10 30 Quality Tests Performed ..............................................

12 18 30 Shipping Orders Processed ........................................

50 150 Total Overhead ...........................................................

a. How much of the overhead will be assigned to each product if the three cost drivers are used to allocate overhead? What would be the cost per unit produced for each product?

b. How much of the overhead would have been assigned to each product if direct labor cost had been used to allocate overhead? What would have been the total cost per unit produced for each product?

c. How might the results explain why profits did not increase as much as management expected?

28. Activity-based costing in a nonmanufacturing environment. Plantcare, Inc., is a garden care service. The company originally specialized in serving residential clients but has recently started contracting for work with larger commercial clients. Ms. Plantcare, the owner, is considering reducing residential services and increasing commercial lawn care.

Five field employees worked a total of 10,000 hours last year—6,500 on residential jobs and 3,500 on commercial jobs. Wages were $9 per hour for all work done. Direct materials used were minimal and are included in overhead. All overhead is allocated on the basis of labor hours worked, which is also the basis for customer charges. Because of greater competition for commercial accounts, Ms. Plantcare can charge $22 per hour for residential work, but only $19 per hour for commercial work.

a. If overhead for the year was $62,000, what were the profits of commercial and residential service using labor hours as the allocation base?

b. Overhead consists of office supplies, garden supplies, and depreciation and maintenance on equipment. These costs can be traced to the following activities:

Activity Level Activity

Commercial Residential Office Supplies

Cost Driver

Cost

15 45 Equipment Depreciation

Number of Clients Served

3,500 2,500 and Maintenance

Equipment Hours

Garden Supplies

Area Covered (computed as number of

square yards of garden times number of times garden is serviced per year)

Total Overhead ............................................................................................

Recalculate profits for commercial and residential services based on these activity bases.

c. What recommendations do you have for management?

29. ABC versus traditional costing. Motorola Corporation manufactures cell phones and pagers in a particular factory. Assume that overhead costs are currently allocated using direct labor hours, but the controller has recommended an activity-based costing system using the following data:

Activity Level Activity

Cell Phones Pagers Production Setup

Cost Driver

Cost

12 8 Material Handling and Requisition

Number of Setups

70 30 Packaging and Shipping

Number of Parts

120,000 40,000 Total Overhead ..........................................................................................

Number of Units Shipped

a. Compute the amount of overhead allocated to each of the products under activity-based

Questions, Exercises, Problems, and Cases 99

b. Compute the amount of overhead to be allocated to each product using labor hours as the allocation base. Assume 60,000 labor hours were used to assemble cell phones and 20,000 labor hours were used to assemble pagers.

c. Should the company adopt an ABC system?

30. ABC versus traditional costing. Danny Whelan provides consulting and tax preparation services to his clients. He charges a fee of $100 per hour for each service. His revenues and expenses for the year are shown in the following income statement:

Expenses: Filing, scheduling, and data entry ..............................................

Computer costs .................................................................................

Danny has kept records of the following data for cost allocation purposes:

Activity Level

Expenses

Cost Driver

Tax Preparation

Consulting

Filing, scheduling, and data entry

Number of Clients

Supplies

Number of Hours Billed

Computer costs

Computer Hours

a. Complete the income statement using these three cost drivers.

b. Recompute the income statements using hours billed as the only allocation base.

c. How might Danny’s decisions be altered if he were to use only hours billed to allocate expenses?

31. When do ABC and traditional methods yield similar results? Refer to Exercise 30. In general, under what circumstances would the two allocation methods in parts a. and b. result in similar profit results?

32. Resources used versus resources supplied. Information about two activities for the Condor Corporation follows:

Cost Driver Rate

Cost Driver Volume

Resources Used Energy .........................................................................................

6 500 machine hours

Marketing ...................................................................................

25 200 sales calls

Resources Supplied Energy .........................................................................................

Compute unused capacity for energy and marketing.

33. Resources used versus resources supplied. Here is information about resources for College Prep Inc., which produces various publications for new college students:

Cost Driver Rate

Cost Driver Volume

Resources Used Setups ..................................................................

Resources Supplied Setups ..................................................................

Administrative ...................................................

100 Chapter 3 Activity-Based Management

a. Compute unused capacity for these items.

b. Management wants no more than 20 percent of total costs to be incurred for unused

capacity. How well is College Prep doing?

PROBLEMS

34. Benefits of activity-based costing (adapted from the CMA exam). Many companies recognize that their cost systems are inadequate for today’s global market. Managers in companies selling multiple products are making important product decisions based on distorted cost information. Most systems of the past were designed to focus on inventory valuation. If management should decide to implement an activity-based costing system, what benefits should they expect?

35. Benefits of activity-based costing (adapted from the CMA exam). Enviro, Inc. has just completed a major change in the method it uses to inspect its products. Previously 12 inspectors examined the product after each major process. The salaries of these inspectors were charged as direct labor to the operation or job. In an effort to improve efficiency, the Enviro production manager recently bought a computerized quality control system consist- ing of a microcomputer, 30 video cameras, peripheral hardware, and software. The cameras are placed at key points in the production process, taking pictures of the product and comparing these pictures with a known ‘‘good’’ image supplied by a quality control engineer. This new system allowed Enviro to replace the 12 quality control inspectors with just two quality control engineers.

The president of the company was confused. She was told that the production process was now more efficient, yet she noticed a large increase in the factory overhead rate. The computation of the rate before and after automation is as follows:

Before After

Budgeted Overhead .......................................................................................

Budgeted Direct Labor ..................................................................................

Budgeted Overhead Rate ..............................................................................

How might an activity-based costing system benefit Enviro, Inc. and clear up the president’s confusion?

36. Comparative income statements and management analysis. Sleep Tight Corporation manufactures two types of mattresses, Dreamer and Sleeper. Dreamer has a complex design that uses gel-filled compartments to provide support. Sleeper is simpler to manu- facture and uses conventional padding. Last year, Sleep Tight had the following revenues and costs:

Dreamer

Sleeper Total

Direct Materials ......................................................................

Direct Labor ............................................................................

Indirect Costs: ........................................................................

Production Setup ................................................................

Quality Control ....................................................................

Sales and Marketing ...........................................................

Operating Profit .....................................................................

Sleep Tight currently uses labor costs to allocate all overhead, but management is considering implementing an activity-based costing system. After interviewing the sales and

Questions, Exercises, Problems, and Cases 101

production staff, management decides to allocate administrative costs on the basis of direct labor costs but to use the following bases to allocate the remaining overhead:

Activity Level

Activity

Cost Driver

Dreamer

Sleeper

Production Setup

Number of Production Runs

10 15

Quality Control

Number of Inspections

20 70

Sales and Marketing

Number of Advertisements

25 55

a. Complete the income statement using the activity bases above.

b. Write a brief report indicating how management could use activity-based costing to reduce costs.

c. Restate the income statement for Sleep Tight using direct labor costs as the only overhead allocation base.

d. Write a report to management stating why product-line profits differ using activity- based costing compared with the traditional approach. Indicate whether activity-based costing provides more accurate information and why (if you believe it does provide more accurate information). Indicate in your report how the use of labor-based overhead allocation could result in Sleep Tight management making suboptimal decisions.

37. Comparative income statements and management analysis. Marathon, Inc., manufac- tures two types of shoes: X-Trainer and Court. Last year, Marathon had the following costs and revenues:

MARATHON, INC. Income Statement For the Year Ended December 31, XXXX

Direct Materials ........................................................................

Direct Labor ..............................................................................

Indirect Costs: Administration .......................................................................

100,000

Production Setup ..................................................................

160,000

Quality Control ......................................................................

150,000

Sales and Marketing .............................................................

60,000

Operating Profit .......................................................................

$ 250,000

Marathon, Inc., currently uses labor costs to allocate all overhead, but management is considering implementing an activity-based costing system. After interviewing the sales and production staff, management decides to allocate administrative costs on the basis of direct labor costs but to use the following cost drivers to allocate the remaining overhead:

Activity Level

Activity

Cost Driver

Court

X-Trainer

Production Setup

Number of Production Runs

300

450

Quality Control

Number of Inspections

600

400

Sales and Marketing

Number of Advertisements

100

100

a. Complete the income statement using the cost drivers above.

b. Write a report indicating how management might use activity-based costing to reduce costs.

Questions, Exercises, Problems, and Cases 103

The company estimated 10,000 labor hours would be worked in Year 2. Assume the following activities occurred in February of Year 2:

Number of Units Produced ...............................................................

Direct Materials Costs ........................................................................

Direct Labor Hours .............................................................................

Number of Production Runs .............................................................

Number of Orders ................................................................................

Pounds of Material Used ...................................................................

Machine Hours .....................................................................................

Number of Inspections ......................................................................

Units Shipped ......................................................................................

Direct labor costs are $20 per hour ................................................

a. Compute an overhead allocation rate for each of the cost drivers recommended by the consultant and for direct labor.

b. Compute the production costs for each product for February using the cost drivers recommended by the consultant.

c. Management has seen your numbers and wants to know how you account for the discrepancy between the product costs using only direct labor hours as the allocation base and using activity-based costing. Write a brief response to management, including calculation of product costs using direct labor hours to allocate overhead.

40. Choosing an ABC system. FreeWheeler, Ltd., manufactures three bicycle models: a racing bike, a mountain bike, and a children’s model. The racing model is made of a titanium- aluminum alloy and is called the Featherweight. The mountain bike is called the Peak and is made of aluminum. The steel-framed children’s bike is called the Raider. Because of the different materials used, production processes differ significantly among models in terms of machine types and time requirements. However, once parts are produced, assembly time per unit required for each type of bike is similar. For this reason, FreeWheeler, Ltd., had adopted the practice of allocating overhead on the basis of machine hours. Last year, the company produced 2,000 Featherweights, 4,000 Peaks, and 10,000 Raiders and had the following revenues and expenses:

FREEWHEELER, LTD. Income Statement For the Year Ended December 31, XXXX

Direct Costs Direct Materials ............................

Direct Labor ..................................

Variable Overhead Machine Setup ..............................

Order Processing ..........................

Warehousing Costs .......................

Depreciation of Machines ..........

Contribution Margin ....................

Fixed Overhead Plant Administration ...................

Other Fixed Overhead .................

Operating Profit ..............................

104 Chapter 3 Activity-Based Management

The CFO of FreeWheeler had heard about activity-based costing and hired a consultant to recommend cost allocation bases. The consultant recommended the following:

Activity Level

Activity

Cost Driver

Featherweight Peak Raider

Machine Setup

Number of Production Runs

16 28 36

Order Processing

Number of Sales Orders Received

400

600 600

Warehousing Costs

Number of Units Held in Inventory

Machine Hours

Number of Units Shipped

1,000

4,000 10,000

The consultant found no basis for allocating the plant administration and other fixed overhead costs and recommended that these not be applied to products.

a. Using machine hours to allocate variable overhead, complete the income statement for

FreeWheeler. Do not attempt to allocate fixed overhead.

b. Complete the income statement using the cost drivers recommended by the consultant.

c. How might activity-based costing result in better decisions by FreeWheeler management?

d. After hearing the consultant’s recommendations, the CFO decided to adopt activity- based costing but expressed concern about not allocating some of the overhead (administration and other fixed overhead) to the products. In the CFO’s view, ‘‘Products have to bear a fair share of all overhead or we won’t be covering all our costs.’’ How would you respond to this comment?

41. Resources used versus resources supplied. Selected information about resources for Jones

Juice is as follows:

Cost Driver Rate

Cost Driver Volume

Resources Used Materials ....................................................................................

5 2,500

Short-term Labor ......................................................................

Customer Service ......................................................................

Resources Supplied Materials ....................................................................................

$12,500

Short-term Labor ......................................................................

Customer Service ......................................................................

a. Compute unused capacity for these items.

b. Write a short report stating why managers should know the difference between resources used and resources supplied. Give examples of how managers could use information about resources used and resources supplied.

42. Activity-based reporting. Flodesk, Ltd., manufactures desk lamps and floor lamps. Infor-

mation regarding resources for the month of March follows:

Resources Used

Resources Supplied

Parts Management ...................................................................

Quality Inspections .................................................................

4,500

5,000

106 Chapter 3 Activity-Based Management

EXHIBIT 3.10

Monthly Report on Cola Bottling Line

Diet

Regular

Cherry Grape Total

Less: Materials .................................................................

Direct labor ............................................................

Fringe benefits on direct labor .........................

Indirect costs @ 260% of direct labor ...........

Gross margin ..........................................................

Return on sales a ..................................................

Unit price .................................................................

Unit cost ..................................................................

a Return on sales before considering selling, general, and administrative expenses.

(These people worked in the Human Resources Department.) And some people wanted to install a new computer system. (It should be obvious who these people were.)

Rockness listened patiently. When all participants had made their cases, Rockness said, ‘‘We made money when we were a smaller, simpler company. We have grown, added new product lines, and added new products to old product lines. Now we are going downhill. What’s wrong with this picture?’’

Rockness continued, ‘‘Here, look at this report. This is last month’s report on the cola bottling line. What do you see here?’’ He handed copies of the report in Exhibit 3.10 to the people in his office.

Rockness asked, ‘‘Do you see any problems here? Should we drop any of these products? Should we reprice any of these products?’’ The room was silent for a moment, then everybody started talking at once. Nobody could see any problems based on the data in the report, but all made suggestions to Rockness ranging from ‘‘add another cola product’’ to ‘‘cut costs across the board’’ to ‘‘we need a new computer system so that managers can get this information more quickly.’’ A not-so-patient Rockness stopped the discussion abruptly and adjourned the meeting.

He then turned to the quietest person in the room—his son, Rocky—and said, ‘‘I am suspicious of these cost data, Rocky. Here we are assigning indirect costs to these products using a 260 percent rate. I really wonder whether that rate is accurate for all products. I want you to dig into the indirect cost data, figure out what drives those costs, and see whether you can give me more accurate cost numbers for these products.’’

‘‘Will do, Dad.’’ Rocky first went to the accounting records to get a breakdown of indirect costs. Here is

what he found:

Indirect labor ................................................................................................................................................. $20,000 Fringe benefits on indirect labor .............................................................................................................

8,000 Information technology ...............................................................................................................................

10,000 Machinery depreciation ...............................................................................................................................

8,000 Machinery maintenance ...............................................................................................................................

4,000 Energy ..............................................................................................................................................................

2,000 Total ..................................................................................................................................................................

Questions, Exercises, Problems, and Cases 107

Then, he began a series of interviews with department heads to see how to assign these costs to cost pools. He found that one-half of indirect labor was for scheduling or for handling production runs, including purchasing, preparing the production run, releasing materials for the production run, and performing a first-time inspection of the run. Another

40 percent of indirect labor was used to set up machinery to produce a particular product. The time to set up the products varied. The remaining 10 percent of indirect labor was spent maintaining records for each of the four products, monitoring the supply of raw materials required for each product, and improving the production processes for each product.

Interviews with people in the Information Technology Department indicated that $10,000 was allocated to the cola bottling line. Eighty percent of this $10,000 information technology cost was for scheduling production runs. Twenty percent of the cost was for record keeping for each of the four products.

Fringe benefits were 40 percent of labor costs. The rest of the overhead was used to supply machine capacity of 10,000 hours of productive time. Rocky then found the following cost driver volumes from interviews with production personnel.

Setups: 560 person hours doing setups Production runs: 110 production runs Number of products: 4 products Machine-hour capacity: 10,000 hours

Diet cola used 200 setup hours, 40 production runs, and 5,000 machine-hours to produce 50,000 units. Regular cola used 60 setup hours, 30 production runs, and 4,000 machine- hours to produce 40,000 units. Cherry cola used 240 setup hours, 30 production runs, and 900 machine-hours to produce 9,000 units. Grape cola used 60 setup hours, 10 production runs, and 100 machine-hours to produce 1,000 units. Rocky learned that production people had difficulty getting the taste just right for the Cherry and Grape cola, so Cherry and Grape cola required more time per setup than either Diet or Regular cola did.

a. Compute cost driver rates for each of the four cost drivers.

b. Compute unit costs for each product: Diet, Regular, Cherry, and Grape colas.

c. Prepare a report like the one in Exhibit 3.10 but with your revised indirect cost numbers for each product.

d. Prepare a memorandum to (Howard) Rockness recommending what to do.

45. The Grape cola caper: unused capacity. Assume that all facts in Case 44 still hold except that the practical capacity of the machinery was 20,000 hours instead of 10,000 hours.

a. Recompute the unit costs for each product: Diet, Regular, Cherry, and Grape colas.

b. What is the cost of unused capacity? What do you recommend that Rockness Bottling do with this unused capacity?

c. Now assume that Rockness considers producing a fifth product: Vanilla cola. Because Vanilla cola is in high demand in the Rockness Bottling’s market, assume that it would use 10,000 hours of machine time to make 100,000 units. (Recall that the machine capacity in this case is 20,000 hours, while Diet, Regular, Cherry, and Grape consume only 10,000 hours.) Vanilla cola’s per-unit costs would be identical to those of Diet cola except for the machine usage costs. What would be the cost of Vanilla cola? Calculate on a per-unit basis, then in total.

46. Distortions caused by inappropriate overhead allocation base. 9 Chocolate Bars, Inc. (CBI) manufactures creamy deluxe chocolate candy bars. The firm has developed three distinct products: Almond Dream, Krispy Krackle, and Creamy Crunch.

CBI is profitable, but management is quite concerned about the profitability of each product and the product costing methods currently employed. In particular, management questions whether the overhead allocation base of direct labor-hours accurately reflects the costs incurred during the production process of each product.

9 Copyright Ed Deakin 1992. Used by permission.

108 Chapter 3 Activity-Based Management

In reviewing cost reports with the marketing manager, cost accountant Steve Hoffman notices that Creamy Crunch appears exceptionally profitable while Almond Dream appears to be produced at a loss. This surprises both Steve and the manager, and after much discussion, they are convinced that the cost accounting system is at fault and that Almond Dream is performing very well at the current market price.

Steve decides to hire Jean Sharpe, a management consultant, to study the firm’s cost system over the next month and present her findings and recommendations to senior management. Her objective is to identify and demonstrate how the cost accounting system might be distorting the firm’s product costs.

Jean begins her study by gathering information and documenting the existing cost accounting system. It is rather simplistic, using a single overhead allocation base, direct labor-hours, to calculate and apply overhead rates to all products. The rate is calculated by summing variable and fixed overhead costs and then dividing the result by the number of direct labor-hours. The product cost is determined by multiplying the number of direct labor-hours required to manufacture the product by the overhead rate and adding this amount to the direct labor and direct material costs.

CBI engages in two distinct production processes for each product. Process 1 is labor intensive, using a high proportion of direct materials and labor. Process 2 uses special packing equipment that wraps each individual candy bar and then packs it into a box of 24 bars. The boxes are then packaged into cases of six boxes. Special packing equipment is used on all three products and has a monthly capacity of 3,000 boxes, each containing 144 candy bars.

To illustrate the source of the distortions to senior management, Jean collects the cost data for the three products, Almond Dream, Krispy Krackle, and Creamy Crunch (see Exhibit 3.11).

CBI recently adopted a general policy of discontinuing all products whose gross profit margin ([Gross margin/Selling price] comparing the selling prices to the firm’s costs and then calculating the gross margin percentages, Jean could determine which products, under the current cost system, should be dropped. The current selling prices of Almond Dream, Krispy Krackle, and Creamy Crunch are $85, $55, and $35 per case, respectively.

a. Complete Exhibit 3.11 under the current cost system and determine which product(s), if

any, should be dropped.