Week 7: ACTIVITY-BASED COSTING

QUESTION 1

Wipeout Enterprises produces exercise equipment. One of its plants produces two versions of a small
bike for children: a basic model and a custom model. The custom model has a fancy frame, a plush seat,
and some electronic gadgets. At the beginning of the year, the following data were provided/estimated
for this plant:

Plant Overhead Costs:

Item Description Cost ($)

Maintenance 84,000
Process setups 96,000
Goods receival officers 40,000
Engineering support 120,000
Purchasing clerks 60,000
Materials handling 120,000
Factory rent & leases 20,000
Accounts payable dept 30,000

In addition, the following details relating to each of the product models were projected:

Basic Model Custom Model

Expected production quantity (units) 20,000 10,000
Selling price - per unit $90 $180
Prime costs (direct materials & direct labour) – per unit $40 $80

Machine hours 5,000 5,000

Direct labour hours 10,000 10,000

Other data:
Number of deliveries received & placed into inventory 250 500
Number of batch-run set-ups 20 80
Engineering support (hours provided) 1,500 4,500
Number of purchase requisitions made (& subsequent orders placed) 100 200
Maintenance workers (hours) 1,000 3,000
Number of suppliers invoices processed & paid 250 500
Number of material movements for production runs (eg by fork-lifts etc) 2000 8000

Required:

1. Calculate the cost per unit of each model using the traditional approach, by assigning overhead
costs using a plant-wide rate. Use a volume based measure (eg direct labour hours) for this
purpose.

2. Calculate the cost per unit of each model using activity-based costing principles (note: to
reduce calculation complexity, use homogenous overhead cost pools where appropriate). Assign
facility (infrastructure) level costs to cost objects on the basis of machine hours for this
purpose.

Compare and comment upon the methods & costs obtained in 1 and 2 above.
[Question 1 (above) has been adapted from Hansen, D.R., and Mowen, M.M. Cost Management: Accounting & Control, South-Western
College Publishing, Cincinnati, Ohio, 1995, p.330, 8-10]
Activity Cost Overview Diagram

Traditional Method

MOH
Application
Rate 570000/ 20000 = 28.5per labour hour
For basic 28.5 *0.5 = 14.25 per unit
For custom 28.5 *1 = 28.5

Item Description Basic Model Custom Model

Prime Cost 40 80
MOH per unit 14.25 28.5

Total Cost
Number of Units
Cost Per Unit 54.25 108.8
Selling Price 90 180
Profit Per Unit 35.75 71.5
Activity Based Costing Method (total 570000)
Pool 1

Item Description Cost Total Cost Allocation Base Allocation Rate

Goods receival officers 40,000 130000 No of purchases = 130000/300=433.33

Purchasing clerks 60,000 200+100 = 300 per purchase =
433.33/200=2.16 per
Accounts payable dept 30,000 unit

Pool 2

Item Description Cost Total Cost Allocation Base Allocation Rate

Maintenance 84,000 204000 Maintncec worker hours 204000/4000= $51
= 1000 +3000 =4000 per hour
Engineering support 120,000

Pool 3

Item Description Cost Total Cost Allocation Base Allocation Rate

Process setups 96,000 216000 N OF BATCHES = 20 $2160 per batch
Materials handling 120,000 +80 = 100

Pool 4

Item Description Cost Total Cost Allocation Base Allocation Rate

Factory rent & leases 20,000 20000 Machine hrs = $2 per machine hour
5000+5000 =10000

Cost Allocation

Item Description Basic Model Custom Model

Prime cost 40*20000=800000 80*10000=800000
Pool 1 (433.33 per purch) 433.33*100=43333 433.33*200= 8667
Pool 2 (52 per maintenance w hr) 51 *1000= 51000 51 *3000= 153000
Pool 3 (2160 per batch) 2160 * 20 = 43200 2160 * 80 = 172800
Pool 4 (2 per machine hr) 2*5000 =10000 2 *5000 = 10000

Total Cost 947533 1222467

Number of Units 20000 10000
Cost Per Unit 47.37 $122.25
Revenue Per unit 90 180
Profit Per Unit 42.36 57.75
Recommendations: increase the margin for the custom model by increasing the selling price (180 -> 200) or
decrease the cost.

QUESTION 2

Tim and Lisa operate TLs Take-Away Coffee Bar located in a central city shopping centre, catering for busy,
“on-the-run” people who don’t want to be held up. The business offers flat-whites, which sell for $2.50 as well as
three extremely popular exotic types (Latin, Mediterranean, and Continental) which sell for $2.70 (the 20c higher
is to cover the cost of special additives).

The coffee bar sells about 10,000 cups per month, but is concerned about operating costs (particularly labour) and
profitability, as it appears to be making only a very modest profit even though Tim, Lisa and staff are “run off their
feet” all day. The flat-whites (which have their own machines) are simple to make, but the exotic types (which use
the basic coffee, milk and sugar, but also have special additives) require their machines to be specially set-up and
then cleaned-out more regularly. They also require a number of special ingredient stock items to be ordered,
received, accounted and paid for. Tim and Lisa have engaged a business consultant to investigate why they are not
trading more profitably because they feel they can do no more than they are at present to be efficient and
profitable. They feel their prices are very reasonable and are loathe to put them up. The overall average cost per
cup of coffee is $2.42 [i.e. $24,161 (below) ÷ 10,000 cups], so the profit margin on each cup is very slim.

Ingredients:
Coffee (DM) $3,230
Milk (DM) 995
Additives (for the exotic coffees only) 1,010
(DM)
Sugar (DM) 206
Labour:
Coffee machine set-up costs 2,570
Coffee machine cleaning-up costs 3,360
Stock ordering & receiving costs 1,320
Stock moving, recording & control costs 1,550
Invoice processing & paying costs 1,140
Coffee preparation & serving costs (DL) 3,700
General cleaning 900
Other:
Electricity for the coffee machines 420
Rent & Insurances 2,000
Equipment depreciation (based on usage) 900
Display advertising & signage 860
Total costs 24,161

The consultant noted and recorded the following details about the coffee bar’s operations for the month under
review:
Flat Whites Exotic Types
Sales (cups) 4,900 5,100
Coffee machines set-ups 40 240
Stock orders & receivals 4 36
Stock movements 30 270
Coffee machines cleaning-ups 40 240
Supplier invoices processed and 8 72
paid
Signage & displays 4 12

Required:
1. Using the information above prepare an ABC analysis of the cost per cup of the flat-whites and the
exotics. (Note: you have to choose a basis for allocating any facility-level costs).
2. Comment on your findings. What recommendation(s) can you make?
Activity Based Costing

Pool 1

Item Description Cost Total Cost Allocation Base Allocation Rate

Coffee (DM) $3,230
Milk (DM) 995
Sugar (DM) 206 8131 Cups 4900+5100 = 10000 8131/1000=0.8131 per cup
Coffee preparation & 3,700
serving costs (DL)

Pool 2

Item Description Cost Total Cost Allocation Base Allocation Rate

Coffee machine set-up 2,570 5930 Setups 240+40 =280 21.1785 per setup
costs
Coffee machine cleaning- 3,360
up costs

Pool 3

Item Description Cost Total Cost Allocation Base Allocation Rate

Stock ordering & receiving 1,320 4010 Stock orders and 100.25
costs receivals 4+36 = 40
Stock moving, recording & 1,550
control costs
Invoice processing & 1,140
paying costs

Pool 4

Item Description Cost Total Cost Allocation Base Allocation Rate

Display advertising & 860 860 Signage and displays 860/16 = 53.75
signage 4+12= 16

Pool 5
Item Description Cost Total Cost Allocation Base Allocation Rate
General cleaning 900 4220 Units 4900+5100 = 10000 0.422
Electricity for the coffee 420
machines
Rent & Insurances 2,000
Equipment depreciation 900
(based on usage)

Cost Allocation

Item Description Flat Whites Exotic Varieties

Pool 1 (0.8131) 0.8131*4900 = 3984.19 0.8131*5100= 4146.81
Additives (for the exotic coffees xxx 1,010
only) (DM)
Pool 2 (21.1785) 40*21.1785=847 21.1785*240 = 5083
Pool 3 100.24 *4 = 401 100.24*36 =3609
Pool 4 4*53.75 = 215 12*53.75 = 645
Pool 5 4900*0.422= 2068 5100*0.422= 2152

Total Cost 7515 16646

Number of Units 4900 5100
Cost Per Unit 1.53 3.26
Revenue Per unit 2.50 2.70
Profit Per Unit 0.97 -0.56

Recommendations: to increase the price of the exotic coffee, should be greater than 3.26 (higher than
cost).