5–1 “Undercosting a product increases the profit from the product and benefits

the firm.” Do you agree? Why?

Undercosting a product may appear to have increased the reported profit the product earned
(assuming the firm did not lower its selling price because of the reported lower product cost).
However, the increased profit is, at best, a twist in truth. Costs of the product not charged to
the product itself are borne by other products of the firm.
 
Worse, undercosting a product may result in managers erroneously believing the product to be
more profitable than other products and shifting the limited resource the firm has into
manufacturing, promotion, and sales of the product when, in fact, other products are
more profitable to the firm. Severe cost distortions may lead firms not to drop unprofitable
products because the cost data show these products are profitable.

5–2 Firms sell products with high costs at high prices. High selling prices
increase revenues and profits. Why then should managers worry about product
overcosting?

Overcosting does not increase revenues. A firm can increase the selling price of a product,
thereby increasing the total revenue from the product only if the market allows. Increases in
the selling price of a product without experiencing noticeable decrease in the sales quantity
of the product is likely an indication that the product was not priced properly, which might be
a result of undercosting of the product.
 
Furthermore, overcosting a product is likely accompanied by undercosting of the firm’s other
products and, as a result, underpricing of one or more of the firm’s other products.
 
When a firm sets a high selling price that is a result of overcosting, competitors also are
likely to enter the market and take away the firm’s market share. A firm also may drop or de-
emphasize an erroneously overcosted product when it erroneously believe the product is
either unprofitable or having a low-margin.

5–3 Explain why a costing system that uses a volume based rate is likely to
produce distorted product costs.

Product costs are likely distorted when a firm uses a volume-based rate if the plant has more
than one activity in its operations and not all activities consume overhead in the same
proportion. The more diverse the product mixes of the plant are in volume, sizes,
manufacturing processes, or product complexities, the greater the cost distortions are likely
to be in using a volume-based rate.

5–4 What is activity-based costing, and how can it improve an organization’s

costing system?

Activity-based costing recognizes that resources are spent on activities and the cost of a
product or service is the sum of the costs of activities performed in manufacturing the product
or providing the service.
 
An activity-based costing system traces costs to the activity that consume resources. Costs
are determined based on the activities performed for cost objects and their underlying cost
drivers that consume resources. Product or service costs determined using an activity-based
costing reflect costs of resources consumed for activities performed in manufacturing products
or providing services. In contrast, a volume-based costing system uses cost allocations to
channel indirect costs to products or services. As a result, the cost of a product or service
often bears little or no relationship to activities performed in the manufacturing of the product
 Activity-based costing recognizes that resources are spent on activities and the cost of a
product or service is the sum of the costs of activities performed in manufacturing the product
or providing the service.
 
An activity-based costing system traces costs to the activity that consume resources. Costs
are determined based on the activities performed for cost objects and their underlying cost
drivers that consume resources. Product or service costs determined using an activity-based
costing reflect costs of resources consumed for activities performed in manufacturing products
or providing services. In contrast, a volume-based costing system uses cost allocations to
channel indirect costs to products or services. As a result, the cost of a product or service
often bears little or no relationship to activities performed in the manufacturing of the product
or service.

5–5 Describe general levels of cost hierarchy in activity-based costing systems.

Based on the activities of most manufacturing firms, the general levels of cost hierarchy of an
activity-based costing system are:
Unit-level cost;
Batch-level cost;
Product-sustaining cost; and
Facility-sustaining cost.

5–6 What is the second-stage procedure in tracing costs to products when using
an activity-based costing system?

In an activity-based costing system, the second-stage procedure in tracing costs to products

or services is a process by which the costs of activities or activity pools are assigned to cost
objects using one or more appropriate activity consumption cost drivers.

5–7 What type of company needs an activity-based costing system?

All firms should use ABC system when the benefits of such a system exceed the costs of
implementing it. It is especially beneficial to firms with product diversity and/or process
complexity.

5–8 What are unit-level activities? Give two examples of unit-level activities.

Unit-level activities are activities performed on individual units of product or service. The
frequency of a unit-level activity varies in proportion with the units of product manufactured or
service provided.
 
Examples of unit-level activities are using direct materials, using direct labor hours, inserting a
component, inspecting each unit, and consuming power to run machines.

5–9 What are batch-level activities? Give two examples of batch-level activities.

Batch-level activities are activities performed for a group of units of products or services rather
than for each individual unit of product or service. The frequency of batch-level activity is
determined by both the size of the group and the total number of units to be manufactured or
provided.
 
Examples of batch-level activities are setting up machine, processing and placing of purchase
orders, scheduling production runs, inspecting products by batch, and handling materials.
 Batch-level activities are activities performed for a group of units of products or services rather
than for each individual unit of product or service. The frequency of batch-level activity is
determined by both the size of the group and the total number of units to be manufactured or
provided.
 
Examples of batch-level activities are setting up machine, processing and placing of purchase
orders, scheduling production runs, inspecting products by batch, and handling materials.

5–10 What are product-level activities? Give two examples of product-level

activities.

Production sustaining activities are activities undertaken to support individual products or

services rather than for each individual unit of product or service or a group of individual units
of products or services.

Examples of product-sustaining activities include product design, parts administration, and

product modification.

5–11 What are facility-level activities? Give two examples of facility-level

activities.

Facility-sustaining activities are activities performed for the entire organization or division to
meet the required operating procedure or support the operation of the organization or division.
 
Examples of facility-sustaining activities include providing security for the facility, maintaining
general equipment and facility, plant management, plant depreciation, and property taxes and
insurance premium for facilities.

5–12 Why do product-costing systems using a single, volume-based cost driver

tend to overcost high-volume products? Will there be any undesirable strategic
effects from such product cost distortion?

A product-costing system that uses a single volume-based cost driver is likely to overcost
high-volume products because high-volume products do not consume support resources in
proportion to their production volumes. As a result, a product-costing system that uses a single
volume-based cost driver often overcosts high-volume products or services and undercosts
low-volume products or services.
 
The cross-subsidizations of low-volume products by high-volume products is likely to lead the
firm not to price its products properly and poor management planning and control of the firm’s
resources. This may also decrease the profits of the firm and reduce management’s
confidence in the product cost predictions. Poor pricing can lead a firm to promote less
profitable products while not spending sufficient resources on more profitable items.

5–13 What is activity-based management?

Activity-based management is the uses of an activity-based costing database to improve

operations, increase customer values, and enhance profitability.
5–14 How can activity-based costing and management be used in service
organizations?

Service organizations such as banks, hospitals, transportation companies, law firms, and
trading companies can use activity-based costing and management in all phases of their
operations as manufacturing firms do. For example, a bank can use ABC to calculate the cost
to process check, a hospital can use ABC to determine costs per patient day for different kinds
of patients and the cost to admit a patient, etc.

5–15 Identify opportunities afforded by performing a customer profitability

analysis.

Opportunities afforded by performing customer profitability analysis are:

Providing better services to highly profitable customers;
Identifying and securing highly profitable customers from competitors;
Setting prices based on the cost to serve;
Negotiating with customers to set mutually beneficial levels of services;
Transforming unprofitable customers into profitable ones through targeted negotiations on
price, quantity, product mix, order processing, delivery terms, and payment arrangements;
Identifying and conceding permanent loss customers to competitors.
5-16 Tasty Beverage Co. produces soft drinks, specializing in fruit drinks. They
produce 5,000 cans of product per batch. Setup cost for each batch is $50 and
each drink costs $0.10 to produce. What is the total cost per batch? How much
would it cost to fill an order for 100,000 cans?

5-16 Total Cost per Batch = $50 + ($0.10 × 5,000) = $550

Cost to produce 100,000 cans
= ($50 × (100,000 ÷ 5,000)) + ($0.10 × 100,000)
= $11,000

5-17 Montross Lumber processes wood to be shipped to construction

companies. In order to keep their products uniform, they conduct inspections on
20% of the boards produced. Inspections cost the company $10 per hour and it
takes 1 minute to inspect each board. How much would it cost to fill an order for
30,000 boards?

5-17 ((30,000 × 0.2) ÷ 60) × $10= $1,000

5-18 Orange Inc. grows cabbage. Each package shipped out contains 20
vegetables. It costs Orange $5 to put together each package and $0.10 to clean
and process each vegetable. If they are discussing an order for 50 heads of
cabbage, how much higher is the cost of producing 60 heads, considering
package size?

5-18 Cost for 50 Heads = (50 ÷ 20; rounded up to 3 packages) × $5 +

(50 × $0.10) = $20
Cost for 60 Heads = (60 ÷ 20) × $5 + (60 × $0.10) = $21
Difference = $21 – $20 = $1

5-19 Williams Performance Co. manufactures sports cars. After making a sale,
the salesperson sends the car to be detailed before the customer takes it home.
Detailing the car takes 30 minutes at a cost of $15 per hour for direct labor and $5
per car for materials. If the average salesperson sells 5 cars per day, what is the
average cost per week for detailing cars?

5-19 (($15×.5 + $5) × 5 cars × 5 days = $312.50 per week

5-20 Stackhouse Computing produces high performance desktop computers.

Annual CGS data shows that the company spent $1,000,000 for 5,000 computers
produced, and each computer requires 2 technician hours and 5 hours of direct
labor. Direct labor is paid $10 per hour by the company. What is the cost of 1
technician hour?

5-20 Cost per computer = $1,000,000 ÷ 5,000 = $200 per computer

$200 = (2 × (cost of one technician hour)) + (5 × $10)
Cost for technician time = $200 - $50 = $150
$150 = 2 × (cost of one technician hour)
technician hourly rate = $75 per technician hour
 5-20 Cost per computer = $1,000,000 ÷ 5,000 = $200 per computer
$200 = (2 × (cost of one technician hour)) + (5 × $10)
Cost for technician time = $200 - $50 = $150
$150 = 2 × (cost of one technician hour)
technician hourly rate = $75 per technician hour

5-21 Haywood Printing is processing a job with the following activity rates:

Activity Cost Driver Driver Rate

Direct Labor Number of Hours $8
Copying Number of Copies $0.05
 
If this job requires 5 hours for the 1,000 copies, what is the activity based cost
of the job?

5-21
Direct Labor = $8 × 5 = $40
Copying = $0.05 × 1,000 = $50
Total Job Cost = $50 + $40 = $90

5-22 Locke Data Processing reported expenses of $5,000,000 for indirect labor,
of which $3,000,000 was for data analysis, and $2,000,000 was for data entry.
Locke recorded 30,000 hours of data analysis and 100,000 hours of data entry.
What are the activity based rates for each area of direct labor?

5-22 Data Analysis = $3,000,000 ÷ 30,000 = $100 per hour

Data Entry = $2,000,000 ÷ 100,000 = $20 per hour

5-23
The materials handling charge for ABC corp is $.50 per pound of finished
product. What is the materials handling charge for a job that produced 10,000
units and the weight of each product was 6 pounds?

5-23
6 pounds × 10,000 units × $.50 per unit = $30,000
 sess the strategic issues facing Laurent and the strategic role of ABC for Laurent, we first
at its strategy, and in particular its marketing and manufacturing strategies.

is Laurent’s Competitive Strategy?

Laurent has built its business on differentiation, in the large grocery chain market. The
saving bagging they developed differentiated them and gave them a competitive
ntage. As other manufacturers are catching up in this segment, Laurent is moving to the
sale segment of the market, also with a differentiation strategybased on product variety.
wholesale segment is expected to require higher product variety and smaller lot sizes.
ver, the manufacturing operations of Laurent follow a cost leadership strategy, to keep costs
because of the falling margins associated with increasing competition in Laurent’s major
ent, the large grocery segment, and because of the related increase in excess
facturing capacity. In effect, the manufacturing operations have a strategy which is not
stent with the firm’s overall strategy.
 
What are the implications of the marketing initiatives undertaken by Laurent?
The new marketing focus, involving increased product variety (and smaller customer order
, is not well supported by the manufacturing capabilities, which have been built upon a cost
rship (large order sizes, low variety).
 
ABC has an important role to play for Laurent. Because of the increased product variety as
ult of the new marketing initiative, the firm will need accurate cost information for pricing and
oduct and customer profitability analysis. A looming question, will the company be able to
the demands of the new customers profitably? Will the company be able to increase price
ver the cost of adding the additional complexity (smaller batches, more colors,..)?
 Required
Determine the net margin for trousers using ABC costing and comment on the
difference in comparison to the volume-based calculations.

Solution (20 min)

The ABC-costing solution follows:

(all figures in £)
Units 10,000
Price 20.525
Total Revenue 205,250

Direct Materials 33,750

Labour and Overhead Costs
Pattern cutting 22,000
Grading 19,000
Lay planning 18,500
Sewing 21,000
Finishing 14,300
Inspection 6,500
Boxing up 3,500
Storage 7,000
Labour and Overhead (ABC-based) 111,800
Total Product Cost 145,550
Unit Product Cost 14.56

Non-manufacturing Expenses 31,500

Total Cost 177,050

Net Margin for Trousers 28,200

The results suggest that the trouser line is more profitable than previously thought
(using volume-based costing). This is likely due to the common situation in which the
high-volume products are overcosted using volume-based costing.
 
The Real World Focus Box entitled “Who Uses ABC and Why?” notes that France and
the U.S. are countries in which ABC tends to have wide use, in contrast to a lower rate
of adoption in the U.K. and Germany.
Source of data used in the example: Andrew Hughes, “ABC/ABM: A profitability Model
for SME’s Manufacturing Clothing in the UK,” Journal of Fashion Marketing and
Management, 2005, Vol 9 Is 1, pp8-19. (SME means small to medium size company)
 Hierarchy
evel
el
evel
el
el
-level
evel
evel
vel
vel (if one bag per customer).

Driver

of hamburgers
of hours
feet
of hamburgers; Size of hamburgers
of hamburgers
of time the advertising is run
of hours store is open
feet
of coupon redeemed; Number of multiple orders; Number of
gers
mber of customers
vels
vel f. Facility-level
evel g. Product-level
evel h. Product-level
evel; Product-level i. Unit-level; Batch-level
ct-level j. Batch-level.

rs
ours
setups or setup hours
production orders
material receipts; Number of purchase orders
products
machine hours
engineering change notices; number of modifications; Number of

parts; Number of products; Number of purchase orders

inspection hours; Number of units; Number of batches
loads; Number of material moves; Material weights
Required
1. Use activity-based costing to calculate the unit cost for each product.
2. Comment on management's belief that the ABC system will generate an
overhead allocation that is more accurate than the system currently used.

Solution (25 min)

Cost Pools Activity Costs Cost Driver Units Overhead Rate

Machine Setup $360,000 4,000 ###
Materials Handling $100,000 20,000 $5.00
Electric Power $40,000 40,000 $1.00

Cost Assignment:
A B
DM $42,000 $54,000
DL $24,000 $40,000
Overhead:
Machine Setup $18,000 $21,600
Mat. Handling $5,000 $15,000
Power $2,000 $4,000
Total Product Cost $91,000 $134,600
Units Produced 4,000 20,000
Cost per Unit $22.75 $6.73

2. While one could safely say that the ABC system provides an
improved assignment of the overhead costs to the two products, the
term “accuracy” tends to be regarded as a measure of how close the
numbers are to some accepted target, but the target value is not
known. It must be remembered that allocations are needed because
direct assignment of cost to products is not possible and that all
allocations are dependent upon subjective management decisions.
The new costs reflect the decisions made with regard to the number of
cost pools, the actual assignment of costs to those cost pools, and the
selection of the cost drivers for each cost pool. If, for example,
number of setups rather than number of setup hours was used to
assign overhead from the machine setup pool, the cost of each
product may have been different, thereby making it difficult to say that
any ABC system is entirely accurate. The resulting values can only be
evaluated with respect to those generated under some other system.
Required
Fill in the unknowns identified as A through F.

Solution (15 min)

A. $6.00 =$.20 × 30
B. 18.5 =$37 ÷ $2
C. $7.10 =$35.5 ÷ 5
D. $12.00 =$.12 × 100
E. $0.60 =$6 ÷ 10
 (Note to instructor: Answer may vary if students perceive a different operation)
a. High-value-added f. High-value-added
b. High-value-added g. High-value-added
c. High-value-added h. Low-value-added
d. Low-value-added i. High-value-added
e. Low-value-added
1,2.
 
Some of the examples are noted in the text, including the U.S. Postal Service, the U.S.
Patent Office, and the U.S. Army. Others include the U.S. Coast Guard, the US.
National Security Agency (ABC used to better understand the cost of its mission
support services), the U.S. Mint (pressure from top management to better understand
the organization’s cost structure and cost behavior), and the U.S. National Institute of
Health (ABC is used to determine more accurately the cost of providing its services
including building and space acquisition, property management, and research program
support).
 
 
A variety of examples are possible here. For additional examples: Gary Cokins,
Activity-Based Cost Management in Government, Management Concepts, Inc., 2001.
Also, see case studies of governmental agencies in Cost & Effect, by Robert S.
Kaplan and Robin Cooper, Harvard Business School Press, 1998, pp. 245-250.
Kaplan and Cooper explain application at the U.S. Veterans Affairs Department, the
U.S. Immigration and Naturalization Service, the U.S. Internal Revenue Service, and
the City of Indianapolis.
 Required
Prepare a product-line profitability report for SFS under the current costing system.
Prepare a product-line profitability report for SFS using the new information the controller provides.
What new insights does the ABC system in requirement 2 privde to SFS managers?
Comment on the impact of using the expected consumption versus the practicial capacity of the
driver quantity when cumputing activity-cost rates.

Solution (25 min)

1. Prepare a product-line profitability report for SFS under the current costing system.
Frozen Food Baked Goods Fresh Produce
Sales $120,000 $91,000 $158,175
Cost of Goods Sold $105,000 $67,000 $110,000
Gross Margin $15,000 $24,000 $48,175
Store Support $24,000 $18,200 $31,635 $73,835
Operating Income -$9,000 $5,800 $16,540
Operating Margin -7.50% 6.37% 10.46%

2. Prepare a product-line profitability report for SFS using the new information the controller provides.

Frozen Food Baked Goods Fresh Produce

Sales $120,000 $91,000 $158,175
Cost of Goods Sold $105,000 $67,000 $110,000
Gross Margin $15,000 $24,000 $48,175
Store Support:
Order processing $800 $3,600 $8,000
Receiving $1,320 $6,050 $13,200
Shelf-stocking $366 $419 $7,320
Customer Support $6,300 $8,400 $18,060
TOTAL $8,786 $18,469 $46,580 $73,835
Operating Income $6,214 $5,531 $1,595
Operating Margin 5.18% 6.08% 1.01%

3. What new insights does the ABC system in requirement 2 provide to SFS managers?

Both baked goods and fresh produces drop in profitability when ABC is used. The
decrease in profitability of fresh produce is most noticeable. The profitability of
fresh produce decreases from 10.46 percent of the sales revenues under the
current system, the highest of the three products, to 1.01 percent under ABC, the
lowest of the three. This is because fresh produce requires more support activities
than the other two products.

4.
The rates come from dividing the total dollar amount in a cost pool by the activity driver
quantity for each cost pool. The issue that management faces is deciding whether to
use the expected consumption quantity of the activity driver or the practical capacity
level of the activity driver, regardless of consumption. It is not clear from the information
provided whether management used the expected consumption rates or practical
capacity levels. Consider the activity called order processing; the driver consumption
was 10 + 45 + 100 = 155 purchase orders. When computing the driver rate of
$80/purchase order the controller may have used one of the two following formulas:
 
Cost of order processing ÷ 155
Or
Cost of order processing ÷ practical capacity
 
Since practical capacity will be greater than or equal to expected consumption, the
driver rate would be lowest when using practical capacity. Also, the rates would vary as
expected consumption changed, but practical capacity is likely to remain fairly stable,
making the driver rates more stable.
Harish estimates activity-cost rates for each activity as follows:

Order Processing $140 per purchase order

Receiving $180 per delivery
Customer Support $18 per hour

Required
Prepare a product-line profitability report for SPF under the current costing system.
Prepare a product-line profitability report for SPF using the ABC information the controller
provides.
What new insights does the ABC system in requirement 2 provide to the SPF managers?

Solution (25 min)

1. The information-gathering programs are a logical fit for the luxury type hotels described
here. These firms compete on their ability to attract high-paying customers to their luxury
hotels. These additional services can give the hotel a competitive edge. It is much more
common now to see hotels with loyalty programs, where membership in the program
triggers room upgrades, free coffee, and other benefits. Hilton and Hyatt are among those
that have these programs; they are called Hilton HHonors, and Hyatt Gold Passport,
respectively.
 
2. There is a good application for activity-based costing here. The program should be
analyzed by activity (the different types of premium services offered), and then the cost
drivers of these activities should then be identified, and traced to the cost object, which in
this case is the individual customer. It is likely that the hotel rates are sufficiently high, that
the cost of the extra services is covered by the room charges, but those managing the
program should be able to know how effective it is in general, and for each customer.
This type of information will help them revise the program if necessary, and to better target
their most profitable customers.

3. Some will argue there is no ethical issue with the information gathering. Others might
argue that the guest should be informed that the information is being obtained and used
throughout the hotel chain’s system. For example, Marriott has guests fill out a form to
participate, so the program is entirely optional. Other ethical issues arise, for example, if
the hotel chain chooses to sell the information to third parties, such as magazine
publishers, retail stores, or other businesses.
 
This exercise is based on information obtained from the article by Avery Johnson,
“Hotels Take ‘Know Your Customer’ to New Level,” The Wall Street Journal,
February 6, 2006, p D1.
 Required
Classify activity costs into cost categories and compute the total cost for Colleen Compa
service Jerry Inc. and Kate Co.
Compare the profitability of these two customers (ignore cost of funds).

Solution (25 min)

1. Classify activity costs into cost categories and compute the total cost for Colleen Compa
Jerry Inc. and Kate Co.
Jerry Inc. Kate Co.
Customer Unit Level Costs:
Sales return $200 $875
Customer Batch Level Costs:
Order processing $1,500 $9,000
Sales return $200 $500
Delivery $2,500 $15,000
Customer Sustaining Costs:
Sales calls $12,000 $4,000
TOTAL $16,400 $29,375

2. Compare the profitability of these two customers (ignore cost of funds).

Jerry Inc. Kate Co.

Sales $1,000,000 $1,200,000
Sales Return $8,000 $35,000
Net Sales $992,000 $1,165,000
Cost of goods sold $744,000 $873,750
Gross margin $248,000 $291,250
Sales support costs $16,400 $29,375
Operating Income $231,600 $261,875

Operating Margin % 23.35% 22.48%

 Required
Demonstrate how Garner arrives at the $100.50 order-filling cost per unit.
What would be the amount of loss (profit) per unit if Garner sells to Cheap at $700 per unit?
What is the amount of loss (profit) per unit at the $800 selling price per unit for units sold to SC?

Solution (25 min)

1. Demonstrate how Garner arrives at the $100.50 order-filling cost per unit.

Determination of the $100.50 order-filling cost per unit

Total number of orders: 2 x 100 PCs + 10 x 4,000 SCs = 40,200

Total number of orders 40,200

Number of orders per block 60
Total number of blocks 670
Cost per block $60,000
Total cost of order-blocks $40,200,000
Total number of orders 40,200
Per order order-filling cost $1,500
Total cost per order $60,300,000
Total order-filling cost $100,500,000
Total units sold 1,000,000
Order-filling cost per unit $100.50

2. What would be the amount of loss (profit) per unit if Garner sells to Cheap at $700 per unit?

Profit Margin per Unit Sold

Order filling cost per unit sold to PC

Total number of orders per year 2
Number of orders per block 60
Total number of blocks 30
Cost per block $60,000
Total block cost $2,000
Total number of orders 2
Order-filling cost per order $1,500
Total cost per order $3,000
Total order-filling cost $5,000
Total units per order ¸ 5,000
Order-filling cost per unit $1.00

Net profit per unit at $700 selling price per unit to preferred customers:

Preferred Customer
Selling price per unit $700
Manufacturing cost $600
Order-filling cost/unit $1
Total cost per unit $601
Net Profit per unit $99

Profit margin % 14.14%

3. What is the amount of loss (profit) per unit at the $800 selling price per unit for units sold to SC?

Profit Margin per Unit Sold to SC

Order-Filling Cost/unit:
Cost per block $60,000
Number of orders per block 60
Block cost per order $1,000
Number of orders per SC per year 10
Total block cost per SC $10,000
Order-filling cost per order $1,500
Number of orders per SC 10
Total cost per order $15,000
Total order-filling cost $25,000
Order size (no. of units) 125
Order-filling cost/unit $200

Profitability per unit at $800 selling price per unit to SC:

Selling price per unit $800
Manufacturing cost $600
Order-filling cost/unit $200
Total cost per unit $800
Net profit or loss per unit $0

Profit margin % 0.00%

r guides or tips for successful implementation are noted in the text,
ome are listed below:

se a type of context where ABC is likely to succeed, such as a

ion where there is product variety and operating complexity, so that
BC analysis provides significantly useful information
the initial design system; use a simple prototype and build the
m gradually
 

ional Sources: Dan Swenson and Douglas Barney, “ABC/M: Which

panies Have Success?” The Journal of Corporate Accounting &
nce, March/April 2001, pp. 35-44. See also, Douglas T. Hicks,
d Decisions Require Good Models: Developing Activity-Based
ions that Work for Decision Makers,” Cost Management, March/April
, pp. 32-40, and Michael D. Shields and Michael A. McEwen,
ementing Activity-Based Costing Systems Successfully,” Cost
agement, Winter, 1996, pp15-22.
 Required
Compute the total manufacturing costs and the unit costs of the 80 units just completed using ABC
costing.
In addition to the manufacturing costs, the firm has determined that the total cost of upstream activities
including research and development and product design is $180 per unit. The total cost of downstream
activities, such as distribution, marketing, and customer service is $250 per unit. Compute the full
product cost per unit, including upstream, manufacturing, and downstream activities. What are strategic
implications of this new cost result?
Explain to Hoover Company the usefulness of calculating the total value-chain cost and of knowing costs
of different value-creating activities.

Solution

1. Manufacturing cost (total, and per unit):

Prime manufacturing cost (80 x$1,250) = $100,000

Manufacturing overhead:
Materials handling (80 × 105 × $0.50) = $4,200
Machining (80 × 3 × $51.00) = $12,240
Assembly (80 × 105 × $2.85) = $23,940
Inspection (80 x $30.00) = $2,400
Total Manufacturing Cost = $142,780
Number of units = 80
Manufacturing cost per unit = $1,784.75

2. Computation of full cost:

Upstream activity costs = $180.00 8.13%

Manufacturing costs = $1,784.75 80.58%
Downstream activity costs = $250.00 11.29%
Full Product Cost per Unit = $2,214.75 100.00%

(1) Knowing the full cost of a product including upstream and downstream costs allows the
firm to be aware of all costs attributable to the product.
(2) The amounts and proportions of upstream, manufacturing, and downstream costs
facilitate comparisons with competitors.
(3) The company should consider ways of spending less cost in the manufacturing activity,
and more on upstream and downstream activities in order to improve its competitive
position by pursuing the differentiation strategy in both the new product design and the
customer service.
 
3. The total value chain cost provides the firm a long-term perspective of the product cost, in
addition to the short term manufacturing cost. Different industries have different cost
structures. For example, firms in the information technology industries are likely to have high
upstream costs while firms in the retailing industry tend to have high downstream costs.
 Required
Determine the amount of the cost pool for each of the four activities.
Determine the activity-based rates for assigning factory overhead costs to the two products.
Determine the activity-based total cost for each of the products.
What is the strategic role of the information obtained in part 3?
The quantities of resource consumption cost drivers used were based on rough estimates. Under what
conditions would you recommend that more accurate cost driver data be collected?

Solution (30 min)

1. The activity-based cost pools are determined from the percent-of-use information; for example, total setup cost
$157,500 = (0.15 x $850,000) + (0.20 x $150,000).

Inspect &
Factory Costs Setup Assembly Finishing Packaging
Salaries $ 850,000 $ 127,500 $ 467,500 $ 170,000 $ 85,000
Supplies $ 150,000 $ 30,000 $ 90,000 $ 30,000 $ -
Factory Expense $ 550,000 $ - $ 440,000 $ 110,000 $ -
$ 1,550,000 $ 157,500 $ 997,500 $ 310,000 $ 85,000

2. The activity rates are determined as follows:

Total
Activity Activity-based
Safe-V Safe-T Consumption Activity Costs Rates
Batches 250 600 850 $157,500 $ 185.29
Units 60,000 72,000 132,000 $997,500 $ 7.56
Finishing hours, per unit 0.2 0.3 33,600 $310,000 $ 9.23
Packaging 0.1 0.15 16,800 $85,000 $ 5.06

3. The per-unit activity-based costs are $14.18 for Safe-V and $18.63 for the Safe-T product:

Activity Requirements Activity-Based Costs/Unit

Safe-V Safe-T Safe-V Safe-T
Setup 250 600 $ 0.77 $ 1.54
Assembly 60,000 72,000 $ 7.56 $ 7.56
Inspect and Finish 0.2 0.3 $ 1.85 $ 2.77
Packaging 0.1 0.15 $ 0.51 $ 0.76
Materials per unit $3.50 $6.00 3.500 $ 6.000
Total Cost per Unit $ 14.180 $ 18.628

4. The activity-based information can be used by EEI to set prices and to assess the profitability of its two product lines.

5. The collection of more accurate cost driver data can only be justified when the cost of data collection and analysis is less
than the expected benefit. Management would have to decide whether they think their decisions would change based on
the more accurate data. If not, then the extra effort and cost associated with collecting the new data would not be justified.
In this situation, for example, an employee might not be assigned to a single job function. If the employee primarily does
assembly but occasionally does inspections, a rough estimate of the time spent on each activity might be the most cost
effective way to collect the cost driver data. The alternative might be to have the employee log the time spent on each
activity and then the data in that log would have to be analyzed to determine the actual amount of time spent on each
activity. The decision management faces is whether the data is worth the extra collection effort.
 Required

Determine the unit cost for each of the three products and the total production cost of each of the three
product lines using ABC.
Determine the unit production cost for each of the three products using LFI’s current volume-based
approach.
The activity usage data given in the problem reflects current usage of the various cost drivers to manufacture
the firm's product lines. Suppose you are given the following information regarding the firm’s practical
capacity for each of these activities, as follows:

Cost Driver Practical Capacity

Number of Parts 990,000
No. of production orders 880
No. of setups 200
Machine hours 100,000
DLHs 123,900
No. of orders shipped 5,000

Comment on how you would use this additional information for costing the firm’s products and assisting in
strategic planning.
4. Compare the two approaches and discuss the strategic and competitive issues of using each of the
two methods.

Solution

1. First, obtain the total levels for the activity cost drivers, as follows:

Product Lines Value Quality Luxury Total

Units Produced 15,000 5,000 500 20,500
Direct Materials cost per unit $80 $50 $110
Total Direct Materials Cost
Number of Parts per unit 30 50 120
Total parts
Direct Labor Hours per unit 4 5 7
Total Labor hours
Machine Hours per unit 3 7 15
Total Machine Hours
Production Orders 50 70 200 320
Production Setups 20 50 50 120
Orders Shipped 1,000 2,000 300 3,300
Price $650 $900 $1,200

Next, obtain the activity rates, as follows:

Budgeted Cost Cost Driver Activity Rate

Materials handling $349,600 Number of Parts $0.46 =$349,600 ÷ 760,000
Product Scheduling $160,000 Number of Production orders $500.00 =160,000 ÷ 320
Setup Labor $216,000 Number of setups $1,800.00 =216,000 ÷ 120
Automated Machinery $1,750,000 Machine hours $20.00 =1,750,000 ÷ 87500
Finishing $619,500 Direct labor hours $7.00 =619,500 ÷ 88,500
Pack and Ship $290,400 Number of orders shipped $88.00 =290,400 ÷ 3,300

Direct Labor Rate $12.00

Finally, determine ABC unit and total costs, as follows:

Value Quality Luxury

Direct Materials $80.00 $50.00 $110.00
Direct Labor $48.00 $60.00 $84.00
Overhead:
Materials handling $13.80 $23.00 $55.20
Product Scheduling $1.67 $7.00 $200.00
Setup Labor $2.40 $18.00 $180.00
Automated Machinery $60.00 $140.00 $300.00
Finishing $28.00 $35.00 $49.00
Pack and Ship $5.87 $35.20 $52.80
Total ABC Overhead $111.74 $258.20 $837.00
Unit ABC Cost $239.74 $368.20 $1,031.00
Total ABC Cost $3,596,100 $1,841,000 $515,500

2. Volume-based Costing Results

Rate for Direct Labor Hours $38.25

Value Quality Luxury

Direct Materials $80.00 $50.00 $110.00
Direct Labor $48.00 $60.00 $84.00
Overhead $153.00 $191.25 $267.75
Cost per unit $281.00 $301.25 $461.75
Total Cost $4,215,000 $1,506,250 $230,875

3. Activity rates based on practical capacity:

Practical
Budgeted Cost Cost Driver Capacity Practical Capacity-Based Rates
Materials handling $ 349,600 Number of Parts 990,000 $ 0.35
Product Scheduling 160,000 Number of Production orders 800 200.00
Setup Labor 216,000 Number of setups 200 1,080.00
Automated Machinery 1,750,000 Machine hours 100,000 17.50
Finishing 619,500 Direct labor hours 123,900 5.00
Pack and Ship 290,400 Number of orders shipped 5,000 58.08
$ 3,385,500

Note that the rates have changed significantly from the calculations in part 1 above, because there is a significant level
of unused capacity in many of the activities. This information could be used by management to calculate unit ABC-based
costs using the practical capacity rates, and thereby identify the cost of unused capacity. Moreover, the information
about capacity utilization can be used to help bring resource spending in line with resource usage. As the firm plans to
grow (particularly in the Luxury group), some additional capacity will be needed, but careful planning will allow a balance
of planned future capacity needs versus current spending on these resources, probably allowing some capacities to be
reduced. The potential for overcapacity appears to be greatest in product scheduling and pack and ship.
 
4. The ABC costing shows clearly how expensive the Luxury group is to produce. The volume-based approach fails to
account for the activity usage of the Luxury line, and undercosts it significantly. ABC allows LFI to better understand how
its costs will increase with the expected increased production of the Luxury line, and how it will have to adapt its pricing
practices accordingly. Continued use of the volume-based approach at a time when sales of the Luxury line are
increasing would mean significantly underpricing the Luxury line, and undermining the profitability of the entire firm.
Based on current prices and sales units, the Value, Quality and Luxury lines have sales values and gross margins as
shown below. All three customer groups are profitable under ABC costing, but the Luxury group is only marginally
profitable.
Solution (35 min)

1. Determine the amount of overhead cost per unit and the total overhead for each of the products.

Product A Product B Product C

Materials $50.00 $114.40 $65.00
Labor $20.00 $12.00 $10.00
Overhead* $116.00 $69.60 $58.00
Total Cost $186.00 $196.00 $133.00
*overhead is applied based on direct labor dollars so the rate is:
$5.80/ Direct labor dollar = $493,000÷($20×1,000+$12×5,000+$10×500)
$116 = 5.8×20; $69.60 = 5.8×12; $58 =5.8×10

2. Is Product B the least profitable and Product C the most profitable under both the current and the ABC costing
systems?

CURRENT COSTING SYSTEM

Product A Product B Product C
Actual Selling Price $280.00 $250.00 $300.00
Product Manufacturing Cost $186.00 $196.00 $133.00
Gross Margin $94.00 $54.00 $167.00
Gross Margin Ratio 33.57% 21.60% 55.67%

Based on the current cost data, product B is the least profitable product with a gross
margin per unit of $54.00 (21.6%) and product C is the most profitable product with
a gross margin per unit of $167.00 (55.67%).

ACTIVITY-BASED COSTING SYSTEM

Cost per Transaction
Setup $800.00
Materials Handling $100.00
Hazardous Control $2,500.00
Quality Control $750.00
Utilities $6.00

(calculate on per unit basis) Product A Product B Product C

Direct Materials 50.00 114.40 65.00
Direct Labor 20.00 12.00 10.00
Factory Overhead:
Setups (a) 1.60 0.80 4.80
Materials Handling (b) 40.00 5.00 70.00
Hazardous Control (c) 62.50 22.50 150.00
Quality Control (d) 22.50 5.25 52.50
Utilities (e) 12.00 8.40 12.00
TOTAL 208.60 168.35 364.30

Actual Selling Price 280.00 250.00 300.00

Product Manufacturing Cost 208.60 168.35 364.30
Gross Margin 71.40 81.65 (64.30)
Gross Margin Percentage 0.26 0.33 (0.21)

Notes:
(a) Setups:
Cost per setup: $8,000 ÷ (2 + 5 + 3) = $800 per setup
Product A = 2 × $800 = $1,600; $1,600 ÷1,000 = $1.60 per unit
Product B = 5 × $800 = $4,000; $4,000 ÷5,000 = $0.80 per unit
Product C = 3 × $800 = $2,400; $2,400 ÷500 = $4.80 per unit
 
(b) Materials handling:
Cost per pound = $100,000 ÷ (400 + 250 + 350) = $100 per pound
Product A = 400 × $100 = $40,000; $40,000÷1,000 = $40.00 per unit
Product B = 250 × $100 = $25,000; $25,000÷5,000 = $ 5.00 per unit Product C =
350 × $100 = $35,000; $35,000÷500 = $70.00 per unit
 
(c) Waste and hazardous disposals:
Cost per disposal: $250,000÷(25 + 45 + 30) = $2,500 per disposal
Product A = 25 × $2,500 = $ 62,500; $ 62,500÷1,000 = $ 62.50/unit
Product B = 45 × $2,500 = $112,500; $112,500÷5,000 = $ 22.50/unit
Product C = 30 × $2,500 = $ 75,000; $ 75,000÷500 = $150.00/unit
 
(d) Quality inspections:
Cost per inspection = $75,000÷(30 + 35 + 35) = $750 per inspection
Product A = 30 × $750 = $22,500; $22,500÷1,000 = $22.50 per unit
Product B = 35 × $750 = $26,250; $26,250÷5,000 = $ 5.25 per unit Product C = 35
× $750 = $26,250; $26,250÷500 = $52.50 per unit
 
(e) Utilities:
Cost per MH = $60,000 ÷ (2,000 + 7,000 + 1,000) = $6.00 per MH
Product A = 2,000 × $6 = $12,000; $12,000÷1,000 = $12.00 per unit
Product B = 7,000 × $6 = $42,000; $42,000÷5,000 = $ 8.40 per unit
Product C = 1,000 × $6 = $ 6,000; $ 6,000÷500 = $12.00 per unit

3. What is the new target price for each product based on 150 percent of the new costs under the ABC system?
Compare this price with the actual selling price.

Product A Product B Product C

Product Costs:
Direct-labor system $186.00 $196.00 $133.00
Activity system $208.60 $168.35 $364.30

ABC- based product costs:

Target price $312.90 $252.53 $546.45
Actual selling price $280.00 $250.00 $300.00
Difference in price -32.90 -2.52 -246.45

Direct-labor system:
Gross Margin $94.00 $54.00 $167.00
Gross Margin ratio 33.57% 21.60% 55.67%

ABC system:
Gross Margin $71.40 $81.65 -$64.30
Gross Margin ratio 25.50% 32.66% -21.43%

4. Comment on the result. As a manager of West Chemical, describe what actions you would take based on
the information provided by the activity-based unit costs.

1. Emphasizing Product C as suggested by the current direct-labor-cost based overhead

costing system is likely to lead to the demise of the firm. The activity-based costing system
shows that the manufacturing cost of Product C is $364.30 per unit and, at the current selling
price, the firm suffers a $64.30 loss for each unit it manufactures and sells.
 
2. If the actual selling prices of products A & B are fair market prices for these products and a
markup of 150% is a common industry practice, the firm needs to examine the
manufacturing cost of product A. The fact that the firm’s target price, determined using
150% of the manufacturing cost, is more than 10 percent over the fair market price of the
product suggests possible wastes and inefficiencies in the manufacturing of product A.
 Required
What overhead costs should be assigned to each branch based on ABC concepts?
What is the contribution of each branch before subtracting the results obtained in requirement 1?
What is the profitability of each branch office using ABC?
Evaluate the concerns of management regarding the volume-based cost technique currently used.

Solution (35-40 min)

(See "Miami Valley Architects, Inc.," by Beth M. Chaffman, CPA and John Talbott, CMA, Management Accounting
Campus Report, Fall 1992, p. 4.)

1. Overhead Cost Assigned to Each Branch Under ABC:

Cost Driver Columbus Cincinnati Dayton Total

Direct labor cost 37.61% 31.19% 31.20% 100.00%

Timesheet entries 45.11% 28.57% 26.32% 100.00%
Vendor Invoices 44.93% 37.44% 17.62% 100.00%
Client invoices 52.13% 39.36% 8.51% 100.00%
Employees 34.33% 38.81% 26.87% 100.00%
New hires 42.11% 21.05% 36.84% 100.00%
Insurance claims filed 34.33% 38.81% 26.87% 100.00%
Proposals 39.22% 49.02% 11.76% 100.00%
Contracted sales 48.07% 36.88% 15.05% 100.00%
Projects shipped 39.13% 49.01% 11.86% 100.00%
Purchase orders 41.54% 33.85% 24.62% 100.00%
Copies duplicated 43.48% 39.13% 17.39% 100.00%
Blueprints 45.24% 36.19% 18.56% 100.00%

Activity-based Overhead Allocation

(in thousands)
Cost Driver Columbus Cincinnati Dayton Total

General administration Direct labor cost $153.82 $127.56 $127.60 $409

Project costing Timesheet entries $21.65 $13.71 $12.63 $48
Accounts payable/receiving Vendor Invoices $62.46 $52.05 $24.49 $139
Accounts receivable Client invoices $24.50 $18.50 $4.00 $47
Payroll/Mail sort and delivery Employees $10.30 $11.64 $8.06 $30
Personnel recruiting New hires $16.00 $8.00 $14.00 $38
Employee insurance processing Insurance claims file $4.81 $5.43 $3.76 $14
Proposals Proposals $54.51 $68.14 $16.35 $139
Sales meetings/Sales aids Contracted sales $97.10 $74.49 $30.40 $202
Shipping Projects shipped $9.39 $11.76 $2.85 $24
Ordering Purchase orders $19.94 $16.25 $11.82 $48
Duplicating costs Copies duplicated $20.00 $18.00 $8.00 $46
Blueprinting Blueprints $34.84 $27.87 $14.29 $77
TOTAL $529.32 $453.40 $278.25 $1,261

Calculation for general administration expenses allocated to branches:

Total direct labor dollars = $382,413 + $317,086 + $317,188 = $1,016,687
Allocation of gen admin expenses is based on relative direct labor costs. For example, DL % for Columbus
= $382,413 ÷ $1,016,687 = 37.61% × $409 = $153.84.

2. Contribution of each branch:

Contribution of Each Branch

(in thousands)
Columbus Cincinnati Dayton Total
Sales $1,500 $1,419 $1,067 $3,986
Less: Direct labor $382 $317 $317 $1,016
Direct materials $281 $421 $185 $887
Direct overhead $180 $270 $177 $627
Contribution margin $657 $411 $388 $1,456

3. Profitability of each branch, under ABC:

Profitability of Each Branch Based on Activity-based Costing

(in thousands)
Columbus Cincinnati Dayton Total
Sales $1,500 $1,419 $1,067 $3,986
Less: Direct labor $382 $317 $317 $1,016
Direct materials $281 $421 $185 $887
Direct overhead $180 $270 $177 $627
Contribution margin $657 $411 $388 $1,456
Activity-based overhead $529 $453 $278 $1,261
Operating income $128 ($42) $110 $195

4. Evaluating management concerns:

Overhead costs are usually aggregated in pools and allocated to products and other cost objects
based on volume measures such as direct labor dollars or machine hours. The cost object, therefore,
supposedly shares proportionally in those costs necessary for its production or existence. If however,
overhead varies in accordance with variables other than volume, then product costs and other cost
objects will be erroneously determined.
As the solution indicates, the profitability of the Cincinnati and Dayton offices is vastly different
employing direct tracing and ABC than under the current approach. The obvious benefit to the
company is a more equitable distribution of bonuses and resources to these locations. In addition,
existing marketing strategy may be promoting the wrong location and strategic planning may be
based on spurious assumptions concerning relative profitability.
This case also illustrates that ABC is applicable to service organizations as well as to manufacturing
and that cost objects can consist of projects, locations, customers, etc., as well as products. In
essence, the better information we have about the profitability of any cost object, the better chance of
keeping organizations profitable.
However, the process of identifying activities and allocating costs from the general ledger to the
 Required
Using Coffee Bean, Inc.’s current product costing system:
Determine the company’s predetermined overhead rate using DL cost as the single cost driver.
Determine the full product costs and selling prices of one pound of Mona Loa coffee and one pound of Malaysian coffee.
Using an ABC approach, develop a new product cost for one pound of Mona Loa coffee and one pound of Malaysian
coffee. Allocate all overhead costs to the 100,000 pounds of Mona Loa and the 2,000 pounds of Malaysian. Compare the
results with those in requirement 1.
What are the implications of the ABC system with respect to CBI’s pricing and product-mix strategies? How does ABC add
to CBI’s competitive advantage?

Solution (40 min)

Using Coffee Bean, Inc.'s current product costing system, determine the company's predetermined overhead rate using direct labor
cost as the single cost driver and then determine the full product costs and selling prices of one pound of Mona Loa coffee and one
pound of Malaysian coffee.

Predetermined overhead rate using direct-labor $5.00

Product costs and selling prices:

Mona Loa Malaysian

Direct Costs:
Direct Materials $4.20 $3.20
Direct Labor $0.30 $0.30
Indirect Costs:
Factory Overhead $1.50 $1.50
TOTAL Costs $6.00 $5.00
Mark-up 30% 30%
Selling Price $7.80 $6.50

Using an activity-based costing approach, develop a new product cost for one pound of Mona Loa coffee and one pound of Malaysian
coffee. Allocate all overhead costs to the 100,000 pounds of Mona Loa and the 2,000 pounds of Malaysian. Compare the results with
those in requirement 1.

Cost-driver rates:

Activity Cost Driver Budgeted Activity Budgeted Cost Cost per Unit
Purchasing Purchase orders 1,158 $579,000 $500
Materials handling Setups 1,800 $720,000 $400
Quality control Batches 720 $144,000 $200
Roasting Roasting-hours 96,100 $961,000 $10
Blending Blending-hours 33,600 $336,000 $10
Packaging Packaging-hours 26,000 $260,000 $10

The budgeted unit costs per pound are:

Per Unit Mona Loa Malaysian

Direct Costs:
Direct Materials $4.20 $3.20
Direct Labor $0.30 $0.30
TOTAL Direct Costs $4.50 $3.50
Indirect Costs:
Purchasing $0.02 $1.00
Materials handling $0.12 $2.40
Quality control $0.02 $0.40
Roasting $0.10 $0.10
Blending $0.05 $0.05
Packaging $0.01 $0.01
TOTAL Indirect Costs $0.32 $3.96
TOTAL Costs $4.82 $7.46
Mark-up 30% 30%
Selling Price $6.27 $9.70

Comparative cost numbers:

Mona Loa Malaysian
Requirement 1 $6.00 $5.00
Requirement 2 $4.82 $7.46

The ABC system in Requirement 2 reports a decreased cost for the high-volume Mona Loa and an increased cost
for the low-volume Malaysian. The current cost system leads to cross-subsidization between the two
products.

What are the implications of the activity-based costing system with respect to CBI's pricing and product mix strategies? How does
ABC add to CBI's competitive advantage?

Three of the indirect cost items can be classified as output-unit driven:

Mona Loa Coffee Malaysian Coffee
Roasting $0.10 $0.10
Blending 0.05 0.05
Packaging 0.01 0.01
Total output-unit overhead $0.16 $0.16
 
The other three indirect cost items are batch-level driven:
Mona Loa Coffee Malaysian Coffee
Purchasing $0.02 $1.00
Material handling 0.12 2.40
Quality control 0.02 0.40
Total batch-level overhead $0.16 $3.80
 
Malaysian coffee has a greater number of setups per output unit than does Mona Loa coffee. The result is
that the unit cost of the lower-volume Malaysian coffee is much higher than that of the higher-volume coffee,
even though its cost of direct materials is lower.
With the current costing system, the high-volume Mona Loa is overcosted, while the low-volume
Malaysian is undercosted. Pricing of Mona Loa can be reduced to make it more competitive. In contrast,
Malaysian should be priced at a much higher level if the strategy is to cover the current period’s cost. CBI
may wish to have lower margins with its low-volume products such as Malaysian in an attempt to build up
volume. The company can use the ABC cost information to compare its two product costs with competitors,
and decide which product has a low cost competitive advantage. Then the company can change its pricing
and product mix strategies by using the ABC cost information.
ABC cost data also point out that the reason for the Malaysian Coffee to have a higher unit cost is not
because of high-priced ingredients. In fact, Malaysian Coffee has a lower cost of direct materials than that of
Mona Loa Coffee. The costs of roasting, blending, and packaging are $0.16 per pound for both coffees. The
higher cost of Malaysian is because of the way in which it is processed. The batch-level cost per pound is
$0.16 for Mona Loa and $3.80 for Malaysian. CBI can increase its profit margin or lower its price on
Malaysian Coffee if it can change the way in which it handles purchasing, material handling, and quality
control functions of Malaysian coffee.
 Required
Determine the activity rates based on practical capacity and the cost of unused capacity for each activity.
Explain the role of the information you developed for part (1) above.
Assume the same information used in parts (1) and (2) above, but now assume also that the costs in the purchasing
activity consists entirely of the cost of 8 employees; the cost in materials handling consists entirely of the cost of 20
employees; the cost of quality control consists entirely of the cost of 4 employees; the cost of roasting and blending
consists entirely of the cost of machines--10 roasting machines and 10 blending machines; and the cost of packaging
consists entirely of the cost of three employees. Based on this additional information, what can you now advise
management about the utilization of capacity?

Solution (25 min)

1. The calculation of the new activity rates and the cost of unused capacity is determined as follows:

Usage Practical Capacity Practical Cost of

Budgeted Budgeted Based at current Capacity Unused Unused
Activity Activity Cost Rate spending Usage % Rate Capacity Capacity
Purchasing 1,158 $579,000 $500 1,400 83% $413.57 242 $100,084
Materials handling 1,800 $720,000 $400 2,400 75% $300.00 600 $180,000
Quality control 720 $144,000 $200 1,200 60% $120.00 480 $57,600
Roasting 96,100 $961,000 $10 100,000 96% $9.61 3,900 $37,479
Blending 33,600 $336,000 $10 36,000 93% $9.33 2,400 $22,400
Packaging 26,000 $260,000 $10 30,000 87% $8.67 4,000 $34,667
$3,000,000 $432,230

2. The information on cost of capacity can alert management to the total cost of unused capacity, in this case $432,230 or
approximately 14% of total overhead cost. This information can be used to identify activities where there is extensive over-
capacity, and to consider how the capacity might be managed to reduce overall costs. For example, the calculations in part 1
suggest there is substantial excess capacity in materials handling, and the cost of the unused capacity is $180,000.
 
3. The analysis below shows the number of employees “unused” in column 8. The analysis assumes that each employee (or
machine) contributes an equal share to the work of the activity. Note that the materials handling activity appears to have as
many as 5 unused employees.

1 2 3 4 5 6 7 8
Capacity Step: Number of Cost per Step
Driver at Current Employees or Unused Step Size Steps
Usage Cost Spending Machines Capacity =(2)÷(4) =(3)÷(4) Not Used
Purchasing 1,158 $ 579,000 1,400 8 242 $ 72,375 175 1.38
Materials Handling 1,800 720,000 2,400 20 600 36,000 120 5.00
Quality Control 720 144,000 1,200 4 480 36,000 300 1.60
Roasting 96,100 961,000 100,000 10 3,900 96,100 10,000 0.39
Blending 33,000 336,000 36,000 10 3,000 33,600 3,600 0.83
Packaging 26,000 260,000 30,000 3 4,000 86,667 10,000 0.40
ately, there are a number of reasons why ABC costing systems are studied by firms and
adopted. In some cases the reason is to protect a product line that is favored by top
es, even though the ABC results show it to be unprofitable. Other times it is because a
that is considered critical to the firm is shown to be unprofitable by the ABC results
case of Aero Dynamics, the reason has to do with an ethical issue, that is, the use of
cation to improperly charge a cost-plus customer (the federal government) for overhead
he management accountant should keep the professional ethics code in mind. First, he
hould try to persuade other ABC pilot project members and the company controller to
ecommend that top management adopt the more accurate ABC method. If the company
agement still would not listen, then the management accountant should report the
to the company’s audit committee. Because of the management accountant’s
bility for confidentiality, he or she should not report the matter outside the firm. (See the
of Management Accountant’s Code of Ethics in Exhibit 1-10).

nteresting footnote to the case is that the Government Accounting Office, to assist the
of Defense, in part due to issues of this nature, developed in the 1970s a series of cost
unting standards. These standards apply generally to companies contracting with the
ral government, especially the DOD. See http://www.gao.gov/casb1.htm for the CASB
site. Also, the Federal Government in 1990 created the Federal Accounting Standards
sory Board (www.fasab.gov) which sets standards for financial and managerial reporting
n the federal government. The FASAB web site is an interesting place to see the
ress/continuing issues of accounting at the federal government.
Salaries $4,223,555
Utilities $2,387,446
Platinum Regional Bank 234,000 6.0
Healthwise Software Inc. 66,788 5.0
 company not experience an immediate financial improvement? Put another way, will National’s
resource spending necessarily decrease in response to the shift in customer demand?

7. Finally, why do most proponents of ABC (both traditional and time-driven) recommend the use of
practical capacity when calculating cost rates for planning purposes?

Solution (30 min)

1. Unlike a manufacturing company, almost all costs for a service company are indirect in
nature. Almost all of these costs are supplied in advance; short-term spending is generally
not affected by fluctuations in demand or produce/service mix. Thus, traditional accounting
practice is to view such costs as “fixed.” ABC methods (both traditional and time-driven) have
their origin in the manufacturing sector where the intent was to develop more accurate
allocations of manufacturing support costs. In a similar way, ABC systems for service
companies focus on a better allocation of indirect costs (to customers, clients, etc.).
 
2. As indicated in the text, two items need to be estimated for each department or process in
conjunction with a TDABC model: (1) the unit cost of supplying capacity for the department or
process in question (this is also referred to as the capacity cost rate), and (2) the
consumption of capacity (i.e., an estimate of how much capacity (measured, generally
speaking, in terms of time) by activities performed. As to item (1), we include total resource
spending (labor, utilities, computer systems, depreciation, etc.); this level of spending
(resource commitment) is divided by a measure of resources supplied—time, for example—
by the department or process in question. In short, we generate a cost per hour or cost per
minute for resources supplied by each department/process.
 
The capacity cost rate for the claims processing support center = $255,000 ÷ 5,000 hours =
$51.00 per hour (under the assumption that the level of practical capacity is estimated as
5,000 hours).

3. and 4.

Remote On-site
Claim information Processing Processing Total
Processing time/claim 0.50 1.00
Customer record maintenance/claim 0.20 0.20
Total time per claim 0.70 1.20
× Number of claims 1,900 2,900 4,800
Total hours needed 1,330 3,480 4,810
× Capacity cost per hour $ 51 $ 51
Budgeted support costs $ 67,830 $ 177,480 $ 245,310

5.
Remote On-site
Claim information Processing Processing Total
Processing time/claim 0.50 1.00
Customer record maintenance/claim 0.20 0.20
Total time per claim 0.70 1.20
× Number of claims 2,700 2,000 4,700
Total hours needed 1,890 2,400 4,290
× Capacity cost per hour $ 51 $ 51
Budgeted support costs $ 96,390 $ 122,400 $ 218,790
 Solution (45 min)

1. The primary issue addressed in the article is the effort to boost the total value of each of the firm’s customers.
 
2. Customer lifetime value is the estimate of how much a customer is expected to spend on a company’s products
and/or services for some designated time, less the cost of marketing to that customer. Customer referral value is
an estimate of the lifetime value of a customer that would not otherwise have become a customer if the referral
had not been made. A second type of customer referral value is the lifetime value of a customer that would likely
have become a customer even if the referral had not been made, and, in effect, saving the marketing costs that
would have been incurred to attract the customer in the absence of a referral.
 
The authors believe that CRV is more important for financial success because the spending of the referred
customers, as a group, can far exceed the spending of any one customer that made the referrals.
 
3. Customer referral value is more difficult to estimate because of the number of variables involved. In addition to
estimating the expected lifetime value of each referral, the number of successful referrals must also be estimated.
This entails estimating how many new customers actually become customers because of a specific person’s
referral and a determination of whether that customer would have eventually become a customer anyway.
Remember, a referred customer that would have eventually become a customer anyway only saves the marketing
costs that would have been spent to attract that customer.
 
4. The customer value matrix is a method of categorizing the organization’s customers based on their value to the
firm. Since the authors found that CLV is not a good predictor of CRV, it became necessary to capture these two
different dimensions of a customer’s value. The two-by-two customer value matrix makes this classification
scheme fairly easy. Its strategic importance becomes apparent when one considers that all organizations have
limited marketing resources. Those resources, like any other of the organization’s resources, should be used in a
manner that will help capture the most value. The matrix provides management guidance on where to focus
those limited resources.
 
5. The determination of CLV and CRV both require the ability to identify the resources directed toward the
acquisition and retention of customers. This fundamental requirement matches up with the underlying theme of
activity-based costing: that activities, like customer acquisition and retention, require resources and the cost of
those resources should be properly attached to those activities. Therefore, many of the concepts of ABC will aid
in the determination of CLV and CRV.
 Required
Use the firm’s current costing system to calculate the unit cost of each product.
Use the activity-based system to calculate the unit cost of each product.
The two cost systems provide different results; give reasons for this. Why might these differences be strategically
important to ADA Enterprises? How does ABC add to ADA’s competitive advantage?

Solution (30 min)

1. Using the firm's current costing system to calculate the unit of each product.

Overhead Rate per Direct-Labor Hour $12.50

Diomycin Homycin Addolin

Direct Labor Hours 7,200 6,800 2,000
Overhead Rate $12.50 $12.50 $12.50
Total Overhead $90,000 $85,000 $25,000

Direct Materials $205,000 $265,000 $258,000

Direct Labor $250,000 $234,000 $263,000
Overhead $90,000 $85,000 $25,000
Total Cost $545,000 $584,000 $546,000
Number of Capsules 1,000,000 500,000 300,000
Cost per Capsule $0.545 $1.168 $1.820

2. Using the activity-based cost system to calculate the unit cost of each product.
Budgeted
Budget Cost Driver Overhead
Activity Cost Driver Overhead Cost Volume Rate
Machine setup Setup hours $16,000 1,600 $10
Plant management Workers $36,000 1,200 $30
Supervision of direct labor Direct labor-hours $46,000 1,150 $40
Quality inspection Inspection-hours $50,400 1,050 $48
Expediting orders Customers served $51,600 645 $80
TOTAL OVERHEAD $200,000

Overhead costs assigned to products using ABC:

DIOMYCIN HOMYCIN ADDOLIN
Applied Driver Applied Driver Applied
Overhead Rate Driver Volume Overhead Volume Overhead Volume Overhead
Machine setup $10 200 $2,000 600 $6,000 800 $8,000
Plant management $30 200 $6,000 400 $12,000 600 $18,000
Supervision of direct labor $40 200 $8,000 300 $12,000 650 $26,000
Quality inspection $48 150 $7,200 200 $9,600 700 $33,600
Expediting orders $80 45 $3,600 100 $8,000 500 $40,000
TOTAL $26,800 $47,600 $125,600

Cost per capsule, under ABC:

Diomycin Homycin Addolin
Direct Materials $205,000 $265,000 $258,000
Direct Labor $250,000 $234,000 $263,000
Overhead $26,800 $47,600 $125,600
Total Cost $481,800 $546,600 $646,600
Number of Capsules 1,000,000 500,000 300,000
Cost per Capsule $0.482 $1.093 $2.155

3. The two cost systems provide different results; give several reasons for this. Why might these differences be strategically important to ADA
Enterprises? How does ABC add to ADA's competitive advantage?

Diomycin Homycin Addolin

Current Costing System:
Overhead $90,000 $85,000 $25,000
Cost per Capsule $0.545 $1.168 $1.820
ABC System:
Overhead $26,800 $47,600 $125,600
Cost per Capsule $0.482 $1.093 $2.155

Analysis of the Differences

Under the current costing system, ADA applies overhead based on direct labor hour, and high-volume
products such as Diomycin (1,000,000 capsules) are allocated relatively more overhead ($90,000) than
the low-volume products such as Addolin (300,000 capsules). High-volume products “subsidize” low-
volume products in this case. Because of lack of detailed costing information, ADA ends up undercosting
Addolin ($1.82 under the current costing) and overcosting Diomycin ($0.545 under the current costing).
Activity-based costing provides ADA with more detailed and better estimates of product costs. For
example by using ABC, ADA becomes aware that the cost of Diomycin is lower ($0.4818 per capsule
compared to $0.545 under current costing), meaning that it can set the price of Diomycin lower and be
more competitive. Also, ABC revealed how costly Addolin is ($2.1553 per capsule compared to $1.82
under the current costing). Thus, this opportunity would allow ADA to properly price Addolin or if it is not
profitable, stop producing.
 
From the schedule, activity-based costing assigns more overhead to the lower-volume Addolin because
the production of Addolin requires more setups, inspection, supervision, formulation and management.
The current direct-labor-hours based costing system failed to assign costs of all activities. As a result,
Diomycin and Homycin subsidized Addolin.
 
The production department at ADA also benefits under ABC. ABC provides better costing information on
the cost of each of the activities and identifies cost drivers and the activities that consume resources and
raise cost. The additional information enables production mangers to manage cost by managing
activities and cost drivers.
 
Adopting the ABC method is strategically important for ADA. Because the ABC method provides ADA
with a more accurate product cost picture and directs management’s attention to the high-volume, more
profitable products, the firm can gain competitive advantages and profits by focusing on the high-volume
products.

4. How and why may firms in the pharmaceutical industry use ABC?

Among major uses of ABC in the Pharmaceutical Industry are:

a. Strategic Use of ABC to Reduce Costs
One of the important ways companies develop competitive advantages is to become a low-cost
producer. Many companies in the pharmaceutical industry have learned to use the information they
have gained from their costing systems to make substantial price cuts to increase market share.
 
b. Use of ABC to Eliminate Low-Value-Added Costs
ABC can be used to identify and eliminate activities that add costs but not value to the products in the
pharmaceutical industry. A company can eliminate low-value added activities and costs without
reducing quality or value. In the pharmaceutical industry, the following activities typically do not add
value to a product: storage, moving items, and waiting for work. Analyses of activities facilitate firms
to identify low-value-added activities.
 
c. Use of ABC in Marketing and Distribution
In the pharmaceutical industry, ABC can be applied to marketing or administrative activities. The cost
of performing marketing services such as distributing products through different distribution
channels can be computed and the information used in making informed decisions. For example,
some of the different channels of distribution in the pharmaceutical industry are: grocery stores,
convenience stores, pharmacy shops, each having different activities. The cost of alternative
channels of distribution is useful to marketing managers who make decisions about which channel
to use.
 
d. Use of ABC to Make Better Pricing Decisions
ABC enables managers to make better pricing decisions by providing managers with more accurate
product cost data for pricing decisions.
 
e. Use of ABC to Make Better Product Mix Decisions
ABC provides a firm more detailed and better estimation of product costs. Thus, it allows a company
the opportunity to decide which products to make and which ones to eliminate.
 Solution (30 min)

1. Social and customer pressures, along with regulatory requirements have caused organizations’ environmental
costs to rise over the past few decades. Environmental cost accounting or just environmental accounting
addresses the limitations of conventional accounting methods by incorporating both direct and less obvious costs
associated with environmental sustainability.
 
 
2, Some of the obvious environmental costs include:
Materials, equipment, and labor costs that can be readily identified from the general ledger of an organization.
 
Some of the”hidden” or less obvious costs include:
Upfront costs, such a process analysis and preliminary site studies
Regulatory costs, such as paperwork preparation and data collection and storage
Back-end costs, such a facility closure related costs
Relationship costs, including relationships with customer, suppliers and investors
 
 3. Both ABC and ABM require a clear understanding of processes. Therefore, the process analysis step will help
managers better understand the scope of an environmental sustainability initiative. Once the process is
understood, the resources required to execute the process can be more readily identified. Once the resources
are identified, the ABC methodology allows for the assignment of costs of activities to the various sustainability
efforts, which would be the cost objects. Starting on page 758 of the article, the authors provide a more detailed
description of the approach.