Cost Management

Session 4 & 5 - Activity Based Costing

Solutions to Problem 5-55 & Self study problems

Problem 5-55 (page 251)

Generaladvantagesassociatedwithactivitybasedcostingincludethe
following:
1.

Providesmanagementwithamorethoroughunderstandingofcomplex
productcostsandproductprofitabilityforimprovedresource
managementandpricingdecisions.

2.

Allowsmanagementtofocusonvalueaddedandnonvalueadded
activities,sothatnonvalueaddedactivitiescanbecontrolledor
eliminated,thusstreamliningproductionprocesses.

3.

Highlightstherelationshipbetweenactivitiesandidentifiesopportunities
toreducecosts (i.e.,designingproductswithfewerpartsinorderto
reducethecostofthemanufacturingprocess).

4.

Providesamoreappropriatemeansofchargingoverheadcoststo
products.

Problem 5-55 (Continued)

2.Usingunitcostdata,thetotalcontributionmarginexpectedfromtheHDboardiscalculated
asfollows:
Totalfor
HDBoard
Revenue
Direct material
Material-handling charge (10% of material)
Direct labor ($14 per hr. *4 hr.)
Variable overhead ($4 per hr*4 hr.)*
Machine time ($10 per hr. *1.5 hr.)
Total cost
Unit contribution margin
Total contribution margin ($67*40,000)
Variable OH rate (1120,000/280,000)

PerUnit
$
330
$
160
16
56
16
15
$
263
$
67

40,000Units
$ 13,200,000
$ 6,400,000
$
640,000
$ 2,240,000
$
640,000
$
600,000

$ 2,680,000
4

Usingunitcostdata,thetotalcontributionmarginexpectedfromtheSDboardiscalculatedas
follows:
Totalfor
SDBoard
Revenue
Directmaterial
Materialhandlingcharge
Directlabor($14perhr.*1.5hr.)
Variableoverhead($4perhr.*1.5hr.)*
Machinetime($10perhr.*.5hr.)
Totalcost
Unitcontributionmargin
Totalcontributionmargin($28*65,000)

PerUnit
170
100
10
21
6
5
142
28

65,000Units
11,050,000
6,500,000
650,000
1,365,000
390,000
325,000
3

1,820,000

Problem 5-55 (Continued)

3. The pool rates, which apply to both the HD board and the SD board,
are calculated as follows:

PoolRatesforActivityBasedCosting
Procurement
$400,000
4,000,000 $0.10
Productionscheduling
220,000
110,000 $2.00
Packagingandshipping
440,000
110,000 $4.00
Machinesetup
446,000
278,750 $1.60
Hazardouswastedisposal
48,000
8,000 $6.00
Qualitycontrol
560,000
160,000 $3.50
Generalsupplies
66,000
110,000 $0.60
Machineinsertion
1,200,000
3,000,000 $0.40
Manualinsertion
4,000,000
1,000,000 $4.00
Wavesoldering
132,000
110,000 $1.20

perpart
perboard
perboard
persetup
perlb.
perinspection
perboard
perpart
perpart
perboard

Problem 5-55 (Continued)

Using activity-based costing, the total contribution margin expected from the HD board is
$1,994,000, calculated as follows:
HDBoard
Rate
Revenue
Directmaterial
Procurement
0.10
Productionscheduling
2.00
Packagingandshipping
4.00
Machinesetup
1.60
Hazardouswastedisposal 6.00
Qualitycontrol
3.50
Generalsupplies
0.60
Machineinsertion
0.40
Manualinsertion
4.00
Wavesoldering
1.20
Totalcost
Unitcontributionmargin
Totalcontributionmargin

Activity PerUnit
$330
$160
55 5.50
2.00
4.00
3 4.80
0.175 1.05
2 7.00
0.600
35 14.00
20 80.00
1.20
$280.15
$49.85

Totalfor
40,000Units
$13,200,000
$6,400,000
$220,000
$80,000
$160,000
$192,000
$42,000
$280,000
$24,000
$560,000
$3,200,000
$48,000
$11,206,000
$1,994,000
5

Problem 5-55 (Continued)

Using activity-based costing, the total contribution margin expected from the SD
board is $2,557,100, calculated as follows:

SDBoard
Revenue
Directmaterial
Procurement
Productionscheduling
Packagingandshipping
Machinesetup
Hazardouswastedisposal
Qualitycontrol
Generalsupplies
Machineinsertion
Manualinsertion
Wavesoldering
Totalcost
Unitcontributionmargin
Totalcontributionmargin

Rate

0.10
2.00
4.00
1.60
6.00
3.50
0.60
0.40
4.00
1.20

Activity PerUnit
$170
$100
25 2.50
2.00
4.00
2 3.20
0.01 0.06
1 3.50
0.600
24 9.60
1 4.00
1.20
$130.66
$39.34

Totalfor65,000
Units
$11,050,000
$6,500,000
$162,500
$130,000
$260,000
$208,000
$3,900
$227,500
$39,000
$624,000
$260,000
$78,000
$8,492,900
$2,557,100

Problem 5-55 (Continued)

Answer4
Theanalysisusingthepreviouslyreportedcostsshowsthattheunit
contributionoftheHDboard($67)isalmostdoublethatoftheSD
board($28).Onthisbasis,managementislikelytoacceptthe
suggestionoftheproductionmanagerandconcentratepromotional
effortsonexpandingthemarketfortheHDboards.
However,theanalysisusingactivitybasedcostingdoesnotsupport
thisdecision.Thisanalysisshowsthattheunitdollarcontribution
fromeachoftheboardsisnotextremelydifferent,andthetotal
contributionfromtheSDboardexceedsthatoftheHDboardby
almost$563,000.
Asapercentageofsellingprice,thecontributionfromtheSD
boardismuchhigherthanthatoftheHDboard(23.14percent
versus15.10percent).
7

Session 4 & 5 - Activity Based Costing

Self study problems : 5-47, 5-69, 5-66, 5-67

5-47
1.

The predetermined overhead rate is calculated as follows:

Predetermined overhead rate
= Budgeted manufacturing overhead/budgeted direct-labor hours
= $1,224,000/102,000* = $12 per hour

*Direct labor, budgeted hours:

REG: 5,000 units 9 hours
ADV: 4,000 units 11 hours
GMT: 1,000 units 13 hours
Total direct-labor hours

45,000 hours
44,000 hours
13,000 hours
102,000 hours

5-47

Activity-based-costing analysis:

Activity

Activity Cost
Pool

Cost
Driver

Machine
Related

$310,500 Machine
Hours

Material
Hand.

Cost Driver
Quantity

Pool Rate

115,000

$ 2.70

52,500 Prod.
Runs

100

525.00

Purch.

75,000 Purch.
Orders

300

250.00

Setup

85,000 Prod.
Runs

100

850.00

27,500 Inspect.
Hours

1,100

25.00

Ship.

66,000 Ship.

1,100

60.00

Eng.

32,500

650

50.00

115,000

5.00

Inspect.

Hours
Fac.

Grand
Total

575,000 Machine
Hours

$1,224,000

Product Line
REG
ADV
GMT
Total
REG
ADV
GMT
Total
REG
ADV
GMT
Total
REG
ADV
GMT
Total
REG
ADV
GMT
Total
REG
ADV
GMT
Total
REG
ADV
GMT
Total
REG
ADV
GMT
Total
Grand Total

Cost Driver
Quantity for Activity Cost for
Product Line
Product Line
50,000
48,000
17,000
115,000
40
40
20
100
100
96
104
300
40
40
20
100
400
400
300
1,100
500
400
200
1,100
250
200
200
650
50,000
48,000
17,000
115,000

$135,000
129,600
45,900
$310,500
$ 21,000
21,000
10,500
$ 52,500
$ 25,000
24,000
26,000
$ 75,000
$ 34,000
34,000
17,000
$ 85,000
$ 10,000
10,000
7,500
$ 27,500
$ 30,000
24,000
12,000
$ 66,000
$ 12,500
10,000
10,000
$ 32,500
$250,000
240,000
85,000
$575,000
$1,224,000

Product Line
Prod.
Volume

Activity Cost
per Unit of
Product

5,000
4,000
1,000

$27.00
32.40
45.90

5,000
4,000
1,000

4.20
5.25
10.50

5,000
4,000
1,000

5.00
6.00
26.00

5,000
4,000
1,000

6.80
8.50
17.00

5,000
4,000
1,000

2.00
2.50
7.50

5,000
4,000
1,000

6.00
6.00
12.00

5,000
4,000
1,000

2.50
2.50
10.00

5,000
4,000
1,000

50.00
60.00
85.00

10

3. Calculation of new product costs under ABC

REG

ADV

GMT

Direct material

$134.00

$156.00

$208.00

Direct labor (not including

set-up time)

171.00 (9 hr. @ $19)

209.00 (11 hr. @ $19)

247.00 (13 hr.@ $19)

Total direct costs per unit

$305.00

$365.00

$455.00

Manufacturing overhead (based on ABC):

Machine-related

$ 27.00

$ 32.40

$ 45.90

Material Handling

4.20

5.25

10.50

Purchasing

5.00

6.00

26.00

Setup

6.80

8.50

17.00

Quality assurance

2.00

2.50

7.50

Packing/shipping

6.00

6.00

12.00

Engineering design

2.50

2.50

10.00

50.00

60.00

85.00

Total ABC overhead

cost per unit

$103.50

$123.15

$213.90

Total product cost per unit

$408.50

$488.15

$668.90

Facility

11

4. Comparison of costs and target prices under two alternative product-costing systems:
Reported unit overhead cost:
Traditional, volume-based costing system
Activity-based costing system
Reported unit product cost (direct material, direct labor
and overhead):
Traditional, volume-based costing system
Activity-based costing system
Sales price data:
Original target price (130% of product cost based on
traditional, volume-based costing system)
New target price (130% of product cost based activitybased costing system)
Actual current selling price

REG

ADV

GMT

$108.00

$132.00

$156.00

103.50

123.15

213.90

413.00
408.50

497.00
488.15

611.00
668.90

536.90

646.10

794.30

531.05

634.60

869.57

525.00

628.00

800.00

5. The REG and ADV products were overcosted by the traditional system, and the GMT
product was undercosted by the traditional system

Reported unit product cost:

Traditional, volume-based costing system

$413.00

$497.00

$611.00

Activity-based costing system

408.50
Cost distortion:
REG and ADV overcosted by traditional system $ 4.50
GMT undercosted by traditional system

488.15

668.90

8.85
($ 57.90)

12

5-69
2.Productcostsbasedonactivitybasedcostingsystem:
Direct material
Direct labor
Machinery depreciation and maintenancea
Engineering, inspection and
repair of defectsb
Purchasing, receiving, shipping, and
material handlingc
Factory depreciation, taxes, insurance,
and miscellaneous overhead costsd
Total
I:
Depreciation, machinery
Maintenance, machinery
Total
Standard:
Deluxe:
Heavy-Duty:

Standard
Model

Deluxe
Model

Heavy-Duty
Model

$10.00 $ 25.00
10.00
20.00
32.00 208.00

$ 42.00
20.00
75.20

17.04

43.50

34.08

15.28

52.00

29.25

12.50
89.25
$96.82 $437.75

25.59
$226.12

aPool

($1,600,000 40%)
($1,600,000 13%)
($1,600,000 47%)

$1,480,000
120,000
$1,600,000
20,000 =
1,000 =
10,000 =

$32.00
$208.00
$75.20

13

5-69

bPool

II:
Engineering
Inspection and repair of defects

Total
Standard:
Deluxe:
Heavy-Duty:

$350,000

($725,000 47%)
($725,000 6%)
($725,000 47%)

375,000
$725,000
20,000 =
1,000 =
10,000 =

$17.04
$43.50
$34.08

cPool

III:
Purchasing, receiving, and shipping
Material handling
Total
Standard:
Deluxe:
Heavy-Duty:

$250,000
400,000
$650,000

($650,000 47%)
($650,000 8%)
($650,000 45%)

20,000 =
1,000 =
10,000 =

$15.28
$52.00
$29.25

dPool

IV:
Depreciation, taxes, and insurance for factory
Miscellaneous manufacturing overhead
Total
Standard:
Deluxe:
Heavy-Duty:

($595,000 42%)
($595,000 15%)
($595,000 43%)

$300,000
295,000
$595,000

20,000 =
1,000 =
10,000 =

$12.50
$89.25
$25.59

14

5-69
1.

StandardModel

DeluxeModel HeavyDutyModel

Productcostsbasedon
traditional,volume
basedcostingsystem
110%

$105.00

$215.00

$232.00

110%

110%

110%

Targetprice

$115.50

$236.50

$255.20

3.

StandardModel

DeluxeModel HeavyDutyModel

Productcostsbasedon
activitybasedcosting
system
110%

$ 96.82

$437.75

$226.12

110%

110%

110%

NewTargetprice

$106.50

$481.53

$248.73

The new target price of the standard model, $106.50, is lower than the current actual selling
price, $110.
15

4.Memorandum
Date:Today
To:PresidentMorelliElectricMotorCorporation
From:IIMStudent
Subject:Productcosting

5-69

Basedonthecostdatafromourtraditional,volumebasedproductcostingsystem,
ourstandardmodelisnotveryprofitable.Itsreportedactualcontributionmarginis
only$5($110 $105).However,thevalidityofthisconclusiondependsonthe
accuracyoftheproductcostsreportedbyourproductcostingsystem.Our
competitorsaresellingmotorslikeourstandardmodelfor$106.Thispricesuggests
thattheirproductcostissubstantiallybelowourpreviouslyreportedcostof$105.

Ournewactivitybasedcostingsystemrevealsseriousproductcostdistortions
stemmingfromouroldcostingsystem.Thenewcostingsystemshowsthatthe
standardmodelcostsonly$96.82,whichimpliesatargetpriceof$106.50.Thisprice
islowerthanourcurrentactualsellingpriceandconsistentwiththepriceour
competitorsarecharging.

Incontrast,ournewproductcostingsystemrevealsthatthedeluxemodel'sproduct
costis$437.75insteadofthepreviouslyreportedcostof$215.Thenewproductcost
suggestsatargetpriceof$481.53forthedeluxemodel,ratherthan$236.50,which
wasourprevioustargetpriceforthedeluxemodel.
16

5-69

Thecompanyshouldadoptandmaintaintheactivitybasedcostingsystem.Theprice
ofthestandardmodelshouldbeloweredtothe$106.Loweringthepriceshould
enablethefirmtoregainitscompetitivepositioninthemarketforthestandard
model.Furtherpricecutsshouldbeconsideredifmarketingstudiesindicatesucha
movewillincreasedemand.
Thepriceofthedeluxemodelshouldbesetnearthetargetpriceof$481.53.Ifthe
deluxemodeldoesnotsellatthisprice,managementshouldconsiderdiscontinuing
theproductline.Inputfromthemarketingstaffshouldbesoughtbeforesuchan
actionistaken.Animportantconsiderationistheextenttowhichsalesinthestandard
modelandheavydutymodelmarketsdependonthefirm'sofferingacomplete
productline.
Aslightpricereductionshouldbeconsideredfortheheavydutymodel(from$255.20
downto$248.73).However,theproductcostdistortionfromtheoldcostingsystem
didnotaffectthismodelasseriouslyasitdidtheothertwo.

17

5- 66
1. Customer-profitability analysis:

Krondor
Computing

Feist
Cables

Sales revenue
Cost of goods sold
Gross margin
Selling and administrative costs:
General selling costs
General administrative costs
Customer-related costs:
Sales activity ($500*visits)
Order taking ($100 * orders)
Special handling ($50* units handled)
Special shipping($1000* shipments)
Total selling and administrative costs

$200,000
90,000
$110,000

$123,800
62,000
$ 61,800

$ 24,000
19,000

$ 19,000
15,000

8,000
3,000
40,000
9,000
$103,000

6,000
4,000
30,000
10,000
$ 84,000

Operating income

7,000

$ (22,200)
18

5-67
1. Customer-profitability profile (supporting details in the table following the profile):
Cumulative Operating Income as a
Percentage of Total Operating Income
120%
110%
100%
90%

Supporting details for

customer-profitability profile

80%

Cumulative
Customer
Operating Operating
a
Number
Customer
Profit
Profit
(1)
Nettwerk Telecom
$93,000
$ 93,000
(2)
Hillpert Service Associates
71,000
164,000
(3)
Hossfeld Computer Company
60,000
224,000
(4)
Lindenstrasse Computing Company 42,000
266,000
b
7,000
273,000
(5)
Krondor Computing
(6)
The Bavaria Group
6,000
279,000
(7)
Tele-Install, GmbH
(18,000)
261,000
(22,200)
238,800
(8)
Feist Cablesc

70%
60%
50%
40%
30%
20%

Cumulative
Operating Profit as
a Percentage of
Operating Income
39%
69%
94%
111%
114%
117%
109%
100%

10%
0%
1
aCustomer

numbers are ranked by operating income.

bFrom solution to preceding problem.
cFrom solution to preceding problem.

Customers*

19

5-67

4.Memorandum
Date:Today
To:I.Sellit,VicePresidentforMarketing
From:IIMStudent
Subject:Customerprofitabilityprofile
Theattachedcustomerprofitabilityprofileshowsthattwoofour
customerrelationshipsareunprofitable(TeleInstall,GmbHandFeist
Cables).
Astheprofileshows,overhalfofouroperatingincomeisgenerated
byourtwomostprofitablecustomers,and94percentofour
operatingprofitisgeneratedbyourthreemostprofitablecustomers.
Withoutourtwounprofitablecustomers,ouroperatingincome
wouldbe17%higher.
Anactivitybasedcostinganalysisofcustomerrelatedcostsprovided
thedataforthecustomerprofitabilityanalysisportrayedinthe
profile.
20

Thank You

21