XLSX
XLSX
XLSX
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.
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.
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?
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.
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.
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.
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.
5-18 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?
5-19 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?
5-21 Haywood Printing is processing a job with the following activity rates:
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?
5-23
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.
(all figures in £)
Units 10,000
Price 20.525
Total Revenue 205,250
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
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.
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.
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.
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:
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?
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).
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
1. Demonstrate how Garner arrives at the $100.50 order-filling cost per unit.
2. What would be the amount of loss (profit) per unit if Garner sells to Cheap at $700 per unit?
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
3. What is the amount of loss (profit) per unit at the $800 selling price per unit for units 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
Solution
(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?
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
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:
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:
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:
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.
2. Is Product B the least profitable and Product C the most profitable under both the current and the ABC costing
systems?
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%).
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.
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.
(See "Miami Valley Architects, Inc.," by Beth M. Chaffman, CPA and John Talbott, CMA, Management Accounting
Campus Report, Fall 1992, p. 4.)
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?
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.
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 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?
1. The calculation of the new activity rates and the cost of unused capacity is determined as follows:
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?
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?
1. Using the firm's current costing system to calculate the unit of each product.
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
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?
4. How and why may firms in the pharmaceutical industry use ABC?
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.