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Atkinson, Solutions Manual t/a Management Accounting, 6E

Chapter 5 Activity-Based CostSystems

QUESTIONS

5-1 Traditional volume-based cost allocation systems that use only drivers thatvary directly with the volume of products producedsuch as direct labor dollars, direct labor hours, or machine hoursare likely to systematicallydistort product costs because they break the link between the cause for thecosts and the basis for assignment of the costs to the individual products. Costsmay vary not only with respect to volume of production, but also, for example,with batch-related activities (e.g., changeovers, setups, and inspection of thefirst item of production run and the number of products (e.g., schedulingmaterials receipts and improving products . !lso, cost distortions tend to begreater with greater differences between relative proportions of indirectresources used by cost ob"ects because traditional cost assignments based onvolume-related measures do not accurately reflect these differences.

5-2 #olume-based traditional product costing systems that use only drivers thatvary directly with the volume of products producedsuch as direct labor dollars, direct labor hours, or machine hoursare most likely to distort

product costs under the following two conditions$ (% &ndirect and supportexpenses are high, especially when they exceed the cost of the allocation baseitself (such as direct labor cost ' and ( )roduct diversity is high$ the plant

produces both high-volume and low-volume products, standard and custom products, and complex and simple products. The combination of these twoconditions will magnify the distortions that arise because volume-based

product costing systems do not accurately reflect differences in non-volume-related resource usage across products or other cost ob"ects.

!ctivity-based costing systems provide more accurate costs when these twoconditions hold by creating more accurate links between the causes of indirectand support costs and the bases for assignment of the costs to cost ob"ects. *or example, costs may vary not only with respect to volume of production, but

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also activities such as changeovers, setups, and inspection of the first item of production run, which are not done in proportion to the number of units produced. oreover, some costs vary with the number of different products(e.g., scheduling materials receipts and improving products .

5-3 /es, traditional costing systems are more likely to overcost high-volume products because all indirect and support costs are assigned to products in proportion to the number of production units (through volume-based costdrivers , and the low-volume products are likely to re0uire higher indirect andsupport costs per unit. The high-volume products essentially cross-subsidi1ethe low-volume products in the sense that indirect and support costs areassigned uniformly in proportion to volume.

5-4 Companies producing a varied and complex mix of products re0uire manymore resources to support their highly varied mix, and therefore have higher

costs. 2xamples of the greater resources re0uired include a much larger production support staff to schedule machine and production runs' performchangeovers and setups between production runs' inspect items at the

beginning of each production run' move materials' ship and expedite orders'develop new and improve existing products' negotiate with vendors' schedulematerials receipts' order, receive, and inspect incoming materials and parts'and update and maintain the much larger computer-based information system.

5-5 ! significant change in resource costs triggers an update of the capacity costrates. ! significant and permanent change in operations, such as the efficiencywith which an activity is performed, triggers an update of the unit timeestimate. &f new activities become part of operations, the time to perform theactivity will be estimated and then multiplied by the appropriate capacity costrate to determine the cost of the activity.

5-6 The two sets of parameters that must be estimated in time-driven activity- based costing are % the capacity cost rate for each type of indirect resource'that is, the unit cost of supplying capacity for each department or process,

based on practical capacity, and the consumption of capacity, which is anestimate of how much of a resource3s capacity (such as time or space is used

by the activities performed to produce the various products, services, or customers.

To compute a capacity cost rate, first identify all costs incurred to supply thatresource (such as a machine, an indirect production employee, the computer system, factory space, a warehouse, or a truck . Then, identify the capacitysupplied by that resource. The capacity would be the hours of work provided

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Chapter 5: Activity-Base Cost Systems

by the machine or production employee, or the space provided by thewarehouse or truck. *or most resources (people, e0uipment, and machines ,capacity is measured by the time supplied. The resource3s capacity cost rate iscalculated by dividing its cost by the capacity it supplies, usually expressed asa cost per hour or cost per minute. *or warehouses, production space, andtrucks, the capacity cost rate would be measured by cost per s0uare foot (or s0uare meter of usable space. *or computer memory, the resource capacitycost rate would be the cost per megabyte or gigabyte.

5-7 anagers use the information on activity costs to identify opportunities for operational improvements and reductions in operations costs, decisions about

product mix and pricing, and targeted customer segments. !n example of anoperational change is re0uiring minimum order si1es to eliminate short,unprofitable production runs. !nother example is changing the facility layoutto reduce moves of work in progress. )roduct designs can be changed in order to manufacture products with fewer parts or common parts to reduce material

handling support costs. *inally, as discussed in more detail in Chapter 5, if activity-based cost analysis shows that full-pallet shipments are less costly per unit than partial-pallet shipments, customers can be encouraged to receive full-

pallet shipments. 6f course, customers who insist on very small order si1es or partial-pallet shipments can be charged a price high enough to cover the extracosts associated with such activities.

5-8 The capacity cost driver rate should reflect the underlying efficiency of the processfor example, the cost of resources to handle each production order and this efficiency is measured better by using the capacity of the resourcessupplied (practical capacity as the denominator when calculating capacitycost driver rates. The numerator in a capacity cost driver rate calculationrepresents the costs of supplying resource capacity to do work. Thedenominator should match the numerator by representing the 0uantity of work the resources can perform. 7nassigned costs represent the cost of unusedcapacity and should be used as feedback to managers on their supply anddemand decisions.

5-9 &mmediate financial improvement may not follow even after process

improvements reduce the demand for indirect and support resources. This is because the support costs are often committed. The organi1ation must activelymanage the unused capacity by increasing the volume of business or reducingthe supply of unused resources.

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5-10 :ervice organi1ations are often ideally suited for activity-based costing because virtually all of the costs for a service company are indirect and appear to be fixed. The large component of apparently fixed costs in servicecompanies arises because, unlike manufacturing companies, servicecompanies have virtually no material coststhe prime source of short-termvariable costs. :ervice companies must supply virtually all of their resourcesin advance to provide the capacity to perform work for customers during each

period. *luctuations during the period of demand by individual products andcustomers for the activities performed by these resources do not influenceshort-term spending to supply the resources.

5-11 !s mentioned in ;-%9, virtually all the costs for a service company are indirectand appear to be fixed. :ervice companies have few or no direct materials andmany of their personnel provide indirect, not direct, support to products andcustomers. Conse0uently, service companies do not have direct, traceable

costs to serve as convenient allocation bases.

7nlike physical products, services cannot be inventoried for future sales.:ervice companies must supply virtually all their resources in advance to

provide the capacity to perform work for customers during each period, anddemand often fluctuates. *or some service industries, the increase in spendingresulting from an incremental transaction or customer is essentially 1ero.Therefore, service companies making decisions about products and customers

based on short-term variable costs might provide a full range of all productsand services to customers at prices near 1ero, leading to little recovery of thecosts of all the committed resources supplied in order to deliver services tocustomers.

&t can be difficult to identify and measure the outputs for a serviceorgani1ation. The variation in demand for organi1ational resources is muchmore customer-driven in service organi1ations than in manufacturingorgani1ations. ! service company can determine and control the efficiency of its internal activities, but customers determine the 0uantity of demands for these operating activities. *or example, customers may vary greatly in the

number of transactions and the balances in their checking accounts. :ervicecompanies must focus on customer costs and customer profitability'measuring revenues and costs at the customer level provides servicecompanies with far more relevant and useful information than at the productlevel. *inally, a customer may have multiple relationships with a servicecompany. Therefore, the cost system should provide information that supportsdetermining profitability of the entire relationship with the customer.

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Customer costs and customer profitability are discussed in more detail inChapter 5.

5-12 &ndividuals may feel vulnerable facing uncertainty about what the activity- based cost analysis may show, or they may feel threatened by the suggestionthat their work could be improved. *or example, the analysis might reveal that

products or customers thought to be very profitable are actually unprofitable,or that some processes are inefficient. &ndividuals may be concerned that theywill then be "udged as poor managers, even though they were makingdecisions that others would agree were good decisions based on the costsystem in place.

5-13 Time-driven activity-based costing has a number of advantages over traditional activity-based costing. The advantages include (% &t is easy andfast to build an accurate model even for large enterprises' ( &t exploits the

detailed transactions data that are available from 2% ,999 divided by the practical capacitycomputer hours per month. 7sage of computer resources can be measuredin computer time per product or production run.

(b =efore the machinery energy costs were discovered, the machinery ratewas computed as >%;,899 divided by 9 practical capacity hours, whiche0uals >;9 per hour. The energy costs of >8,999 per month will be added to

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the >%;,899 monthly machinery costs, for a new machinery resource costof >%4,899 per month, leading to a higher rate per hour. The new rate is>%4,899? 9 @ >5 .44, which can be rounded to >5 per hour forconvenience.

(c &f the company introduces a new flavor, the new flavor3s consumption ofdirect and indirect resources will need to be estimated and then multiplied

by the appropriate cost or cost rate. *or example, start with the 0uantity ofdirect materials and labor hours per gallon produced, and multiply theseamounts by the related cost per unit of direct materials and wage rate,respectively. Aext, estimate the 0uantity of indirect labor (for changeovers,scheduling and product maintenance and machine time (for productionruns and setups . These will then be multiplied by the associated capacitycost rates of each indirect resource and added to the direct materials anddirect labor costs in order to compute the total cost of producing the new

flavor.

5-16 (a ! %9B increase in indirect labor costs will increase the indirect labor capacity cost rate by %9B (from > ; to > .;9 and therefore will increasethe indirect labor costs assigned to products by %9B. The revised incomestatement that is similar to 2xhibit ;-; will show indirect labor costs thatare %9B higher than in 2xhibit ;-;, with correspondingly lower productgross profits, as shown below. (:mall differences may result if thecalculations are performed in a spreadsheet package.

#anilla Chocolate :trawberryocha-

!lmond Total:ales > 9,999 > 8,999 > ,459 > , 99 >59, 59Direct materials >5,999 >8, 99 > 9 >; 9 >% ,989Direct labor(including fringes > , ;9 > ,999 >%,9;9 > 99 >% ,;99&ndirect labor usage >8,45 > ,; % > , 4 >8,98 >%5,8 9achine usage >5, 99 >;,999 >%,559 >%,589 >%;,999Eross profit (loss > ,; > ,5%4 >( , ;4 >(8,%9 >( 59Eross profit (lossas percent of sales %%.48B %;.9 B + 8. B +%85.;8B +9.8 B

(b Fith the reduction in unit time for scheduling a production from four hours per run to three hours per run, we first compute the revised indirect laborhours per month and then multiply by the new indirect labor capacity costrate of > .;9 per hour.

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The revised indirect labor hours per month are calculated as follows$


!lmond:chedule productionruns, purchasing, etc.(hours per run

Changeovers (hours per batch .9 %.9 .; 8.9 Aumber of employees per changeover &ndirect labor hours perchangeover 5 .; %

&ndirect labor time perrun (batch 4 5 %9.; %;

Aumber of productionruns G % G % G G 5&ndirect labor per run %9 8 49

)roduct-sustaining (hrs per month 4 4 4 4&ndirect labor hours permonth %% % 4 44&ndirect rate per hour G > .;9 G > .;9 G > .;9 G > .;9&ndirect labor cost >8,;98.;9 > ,%% .;9 > ,; 9.;9 > , %%.;9

The new income statement shows lower indirect labor costs than in part (a because of the reduced scheduling time per run. (:mall differences may resultif the calculations are performed in a spreadsheet package.

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!lmond Total:ales > 9,999 > 8,999 > ,459 > , 99 >59, 59Direct materials >5,999 >8, 99 > 9 >; 9 >% ,989Direct labor

(including fringes > , ;9 > ,999 >%,9;9 > 99 >% ,;99&ndirect labor usage >8,;9; > ,%%4 > ,; % > , % >%;,9%achine usage >5, 99 >;,999 >%,559 >%,589 >%;,999Eross profit (loss >8,98; >8,9 % >( ,9;% >( , >%, 9Eross profit (lossas percent of sales % .8 B % .99B + .9;B +% . 4B %.4 B

Combining direct labor and indirect labor costs, the summary incomestatement showing unused capacity costs is as follows$

Totals with!ssigned

Costs

7nusedCapacity

Costs

Totalswith

CapacityCosts

:ales >59, 59 >59, 59Direct materials >% ,989 >% ,989Direct labor and indirect labor a > ,;% >5 > ,; ;achine usage >%;,999 899 >%;,899Eross profit (loss >%, 9 >(85 > ;Eross profit (loss as percent of

sales %.4 B %. %Ba Habor capacity cost @ >8,5;; G employees @ > ,; ;. 2mployees performdirect labor and indirect labor tasks.

5-17 (aIours$ Iours$ Cost$ Cost$)umps #alves 9 > 9,999 > 5,999

;,999 5,999 > 9 >%;9,999 >% 9,99999 899 > 9 > %5,999 > ,999

>%45,999 > 8 ,999

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(b The cost of unused capacity, which will be expensed on the incomestatement, is calculated as follows$

Iours$ Cost$7nused

Capacity 9 > 5,99999 > 9 > 5,999;9 > 9 > 8,999

>%5,999

Total revenues > 49,999Total direct labor cost >% 9,999Total direct materials cost 49,999

6I applied to pumps %45,9996I applied to valves 8 ,999 >5;8,999Cost of unused practical capacity %5,999:EJ! expenses %99,999

Aet income >% 9,999

5-18 (a Ken3s previous average fixed cost per meal was > , 99 599 @ >;.;9. Fiththe drop in demand, the average fixed cost is now > , 99 ;;9 @ >5. &f demand decreases further and Ken continues to use the same method to

determine his costs of serving a meal, the average fixed cost willcontinue to increase, and Ken will want to raise his prices even more.Iowever, the rising prices may contribute to further declines in demand,leading Ken into a downward (or death spiral.

(b Ken should use the practical capacity 0uantity of meals per day todetermine cost per meal in order to avoid the fluctuations described in

part (a and to understand the cost rate at the point where the resourcesused e0ual the practical capacity usage. &f resource usage is less than

practical capacity, Ken should monitor the cost of unused capacity. Ie

may be able to reduce the capacity costs or to find other profitable usesfor the capacity. &n this problem, one may assume the practical capacityis 599 meals per day.

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PROB E!S

5-19 (a Capacity cost rate @ >;99,999?%9,999 hours @ >;9 per hour.

(b The activity-based cost associated with Division %3s customers is(9.; G %,999 L %.9 G 8,999 G >;9 per hour@ 8,;99 hours G >;9 per hour @ > ;,999.

(c The activity-based cost associated with Division 3s customers is(9.; G 99 L 9.% G 899 G >;9 per hour@ %89 hours G >;9 per hour @ > ,999.

(d The change will result in (9.; G %,999 L %.9 G ,999 L 9.% G ,999 @, 99 hours used, a reduction from the 8,;99 hours in part (a . The newactivity-based cost associated with Division %3s customers is

, 99 hours G >;9 per hour @ >% ;,999. The lower cost assigned toDivision % will not reduce Meta3s costs unless Meta also reduces the>;99,999 total resource cost. This can be accomplished in the followingway' with the change in the mix of more electronic and fewer manualtransactions, %, 99 fewer hours of accounts receivable time is re0uired.:ince the capacity of each employee is about %,55 hours per year (%9,999 N 5 , Meta can operate with one fewer employee, saving the fullcost of one employee, probably at least >59,999 per year.

5-20 (a The practical capacity per month for each packaging and shippingemployee is ( O %. ; hours per day G 9 days per month @ % ; hours

per month. The capacity cost rate @ >8,9;9?% ; hours @ > 9 per hour.

(b 6rder 9;, which consists of 89 items, re0uires packaging preparationtime of 9. ; hours plus 89 G 9.% hours to bubble wrap and pack the 89items in the carton, for a total of 8. ; hours The cost assigned to 6rder 9; is therefore 8. ; G > 9 per hour @>% .;9.

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5-21 (a Fith the stated change, adison Dairy will re0uire full-time production employees and machines, as shown below.

Habor #anilla Chocolate:traw- berry

ocha-!lmond Total

Aumber of production runs % %5 8Iandle productionrun (hours?run .; .; .; .;&ndirect labor$handle runs 45.0 40.0 10.0 7.5 102.5:etup time per run(hours .9 %.9 .9 .

Aumber ofemployees perchangeover&ndirect laborhours per run 8.9 .9 8.9 5.8&ndirect labor$ totalsetup hours 72.0 32.0 16.0 19.2 139.2&ndirect labor$maintain products 8.0 8.0 8.0 8.0 32.0

Total indirect labor hours 125.0 80.0 34.0 34.7 273.7

#olume (gallons %;,;99 % ,999%,599 %, 99 %, 99

Direct labor hours per gallon 9.9 ; 9.9 ; 9.9 ; 9.9 ;Total direct laborhours 387.5 325.0 40.0 30.0 782.5Total labor hours 512.5 405.0 74.0 64.7 1,056.2)roductive hours

per employee permonth % .9

Aumber ofemployees needed .4

Aumber of full-time employees 8.0

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achines #anilla Chocolate:traw-=erry

ocha-!lmond Total

)roductionvolume %;,;99 % ,999 %,599 %, 99achine hours

per %999 gallons %% %% %% %%Total machinerun time (hours 170.5 143.0 17.6 13.2 344.3

Aumber of production runs % %5 8 :etup time perrun (hours .9 %.9 .9 .achine setuptime (hours 36.0 16.0 8.0 9.6 69.6

Total machinehours 206.5 159.0 25.6 22.8 413.9)roductivehours per month %;8.9

Aumber ofmachinesneeded (roundedup 3.0

(b )ro forma monthly product line income statement (total dollar amountsare rounded $

#anilla Chocolate:traw- berry

ocha-!lmond Total

:elling price > .49 > .49 > .89 > 8.99 > .4:ales volume %;,;99 % ,999 %,599 %, 99 %, 9988,4;9 > , 99 > ;,889 > 8, 99 > 4 , 49Directmaterials

4, 99 , 99 459 9 % , 89

Direct labor(includingfringes

% ,;5 %%, ; %,899 %,9;9 ,

&ndirect labor 8, ; , 99 %,%49 %, %; 4,; 9achinery %9, ; ,4;9 %, 9 %,%89 9,54;Eross profit > , > , ; >5%9 > 5%; >%5,Eross profit %5.8B 9.5B %%. B % . B % .5B

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(B of sales

(c The cost of the production employees is G >8,5;; @ > , 89 and theunused labor capacity cost is therefore > , 89 O > , O >4,; 9 @> . The cost of the machines is G > , 99 @ > ,%99 and theunused machine capacity cost is > ,%99 O > 9,54; @ > ,89;. !fter incorporating the unused capacity cost, the pro forma monthly gross

profit is >%5, O > O > ,89; @ >% , %9 and gross profit as a percent of sales is >% , %9?>4 , 49 @ %8. B.

5-22 !ctivity-based costing provides a means to accurately trace costs tooperational processes, and these costs can be used as one of the operationsmanagement measures in the process perspective of a =alanced :corecard.!ctivity-based costing can also provide a means to measure customer

profitability or percent of profitable customers, which many companies

include in the customer or financial perspective of their =alanced :corecards(this application will be discussed in Chapter 5 .

5-23 The choice really depends on what short-term problems the company faces. &f it is experiencing large, rising, and difficulty-to-control indirect and supportcosts, as well as a proliferation of products and customers, then an activity-

based costing system will supply valuable information to managementdecisions on process improvements, product mix, pricing, and managingcustomer relationships. This is because activity-based costing re0uiresunderstanding processes and their underlying activities, as well as what drivessupport costs. The development of the activity-based costing model, as well asthe model itself, will help the organi1ation identify costly and inefficient

processes. !dditional potential benefits include identifying costly customers or understanding how costly complex products are. The company can improveinefficient processes, encourage costly customers to interact at a lower cost tothe company, revise product pricing, and find new revenue-generating uses of freed-up capacity or attempt to reduce capacity costs.

&f, however, the biggest issue the company faces is moving to a new strategy,

particularly one focused on customers and a new value proposition, thenimplementing the =alanced :corecard will be highly beneficial incommunicating the new strategy and providing a systematic mechanism for monitoring and improving the new strategy. The =alanced :corecard processcan greatly facilitate and speed the ma"or change that is desired, lead to team

building and commitment to the new strategy among the executive team,

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translate the strategy to operational terms, and lead to communication of thestrategy throughout the organi1ation.

6f course, both approaches are highly compatible with each other.

5-24 (a 2ach server is available for ( days G ( 8 hours per day @ ; hours per month. The average cost per hour is therefore > ,545?; hours @ > per hour. Aon-peak-hour usage accounts for ( 9 servers G (%5 hours per day @ 9 hours per day. )eak-hour usage accounts for ( 9 servers G( hours per day @ 589 hours per day. oreover, the 59-server excesscapacity during non-peak hours exists because of the peak-hour need.Therefore the cost of the excess capacity of 59 G %5 hours @ 459 hoursshould be charged to peak-hour users. Thus, the peak-usage hourly rateis > G (589 L 459 ?589 @ >%%, 99?589 @ >% .;9 per hour.

(b !s discussed in part (a , the peak-usage hours should bear the cost of the excess capacity that exists during non-peak usage. The non-peak hourly rate is then the average cost of > per hour.

5-25 (a

!ctivity )ercent!ssigned

CostP

CostDriver

Quantity

!ctivityCost Driver

8;9,999 ,999

>;5. ; percustomer order

)rocess customer complaints %9B >59,999 899 >%;9.99 percustomer complaint

)erform customercredit checks %;B >49,999 8;9

> 99.99 percredit check

%99B >599,999

P >599,999 times the given percentage.PP !ssigned Cost divided by Cost Driver Quantity.

(b Capacity cost rate @ >599,999?%9,999 @ >59 per hour.

!ctivity

7nitTime(Iours !ctivity Cost Driver 8; )er customer order

)rocess customer complaints .;9 > %9 )er customer complaint

)erform customer credit checks .99 >% 9 )er credit check

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(c

!ctivity

7nitTime

(Iours

Quantityof

!ctivitiesTotalIours

Cost!ssigned

Iandle customer orders 9. ; ,999 5,999 > 59,999)rocess customer complaints .;9 899 %,899 > 8,999

)erform customer credit checks .99 8;9 %, ;9 > %,999

Total , ;9 >; ;,999

)ractical capacity used @ , ;9 %9,999 @ .;B7nused capacity @ %9,999 O , ;9 hours @ %, ;9 hours.7nassigned cost @ >599,999 O >; ;,999 @ > ;,999.

anagers can try to reduce the unused capacity and its associatedexpense. !lternatively, managers can try to generate new uses for theunused capacity by introducing new products or expanding into newmarkets. The cost system provides information to assist managers indeciding whether these new uses of capacity can be handled with thecurrent capacity or re0uire additional resources and spending.

(d

!ctivity

7nitTime

(Iours

Quantityof

!ctivities

Total

Iours

Cost

!ssignedIandle customer orders 9. ; ,;99 5, ; > ,;99

)rocess customercomplaints .;9 ;9 %, ; > ,;99

)erform customer creditchecks .99 ;99 %,;99 >49,999

Total 4,%99 >;85,999

)ractical capacity used @ 4,%99 %9,999 @ 4%.9B7nused capacity @ %9,999 O 4,%99 hours @ 499 hours.7nassigned cost @ >599,999 O >;85,999 @ >;8,999.

(e The costs driver rates in (a and (b likely differ because not all the practical capacity of the resources supplied during the period was usedfor productive work, as illustrated in parts (c and (d . The !=C system

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in part (a overestimated the costs of performing activities byapportioning all customer service costs to the three activities andtherefore assigned not only the costs of resource capacity used, but alsothe cost of unused resources. Determining the unit times to completeeach activity in con"unction with the time-driven !=C system in part (b

provides clearer information about the resources needed for eachactivity and about the unused capacity.

5-26 (a The resource units would depend on the organi1ation3s facilities andresources. &f the organi1ation is self-contained with operating rooms,recovery rooms, and radiology and pharmacy facilities, then theseresource units would be part of

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. Companies develop manufacturing support cost driver rates tofacilitate the costing of products as they are completed andshipped, rather than waiting until actual costs are accumulated atthe end of a fiscal period.

(b The cost driver rate increase should not have a negative impact on ossanufacturing because the increase in indirect costs was offset by adecrease in direct labor costs.

(c 9,999 >;,999

Activity-based costs: >. 9 per minute >8,499 > %,999

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(c 7nder the previous system, product managers can only reduce theassigned call center costs by reducing sales. 7nder the new system,

product managers can work with other functional areas to find ways toreduce the number of calls or to reduce the length of calls. *or example,

product /3s manager can work with package designers or the marketinggroup to develop clearer instructions for consumers. The instructionsmight include a company web address that provides answers tofre0uently asked 0uestions (based on calls to the call center .

(d )roduct /3s manager is likely to resist implementation of the activity- based cost system if the manager understands the relative usage of callcenter resources devoted to product /. Call center staff may resistimplementation of activity-based costing because it will involvetracking of staff activity. The staff may resent tracking the number of

calls or minutes of calls, and may resent the additional monitoring because it may lead to pressure to reduce the minutes per call. The callcenter staff may also fear that the desire for cost or efficiencyimprovements will lead to staff reduction or to outsourcing the entirecall center.

(e The company will need to consider the broader management issues relatedto "ob loss if the call center activities are outsourced. !s an input to thatdecision, however, the company can benchmark its costs per minute toother call centers, or compare it to the cost of outsourcing. The companymay also pursue an intermediate course of communicating the current costs

per minute and benchmarked or competitive costs, and allowing the callcenter staff to improve efficiency and lower costs per minute.

5-29 (a anufacturing support cost driver rate=

+ =

$ , , , ,

$ .

1 1 5 0 0 0 0 0 1 0 0 0 0 0 3 0 0 0 0 0 2 8 7 5 p e r d i r e c t l a b o r h o u r.

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Costs )er 7nit )roduct S % )roduct /Direct materials cost >% 9.99 >%89.99Direct labor cost

>(%,999,999 %99,999 9.99 >(8,;99,999 99,999 8;.99anufacturing support cost > . ; (%99,999 ;9,999 ; .;9 > . ; ( 99,999 %99,999 5. ;

7nit cost >%4 .;9 > %. ;

(b Cost Cost Costs !llocated to )roducts

!ctivity

Capacity

costs

Driver

Quantity

Driver

,999,999 59,999 ;9 ;9 89,999 ;9 9,999

Aumber of parts ,899,999 9,999 % 9 % 9 % ,999 % 9 ,999

Design changes , 99,999 ,999 %,%99 %,%99 ,999 %,%99 %,999

:etups , 99,999 %8,999 99 99 ,999 99 5,999Total >%%,;99,999 > , 89,999 >8, 59,999

Costs )er 7nit S % /Direct materials cost >% 9.99 >%89.99

Direct labor cost 9.99 8;.99

anufacturing support cost > , 89,999 ;9,999 %88. 9 >8, 59,999 %99,999 8 .59

7nit cost > 8. 9 > .59

(c !ctivity-based costing produces more accurate estimates of "ob costs because it takes into account the cost drivers that give rise to supportcosts.

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(d Cost-based )rices )roduct S % )roduct /Traditional costing

%. ; G unit costs in part (a > 85. > 4.95

!ctivity-based costing %. ; G unit costs in part (b > ;5.99 > 8.;9

&f 2ndo plans to continue to use cost-based pricing, it should useactivity-based costs as the basis for its markups. Aote S %3s current

price is not even covering its manufacturing costs as determined usingactivity-based costing. Conversely, / may be overpriced. 2ndoshould consider raising S %3s price and could consider lowering / 3s

price if competitors are selling the same product for a lower price.

(e The company sells half as many S %3s as / 3s, but S % has twice asmany design changes and ;9B more parts. These facts suggest that thecompany can explore ways to reduce the number of design changes andthe number of parts. anagement accountants would be involved indeveloping and communicating the cost of design changes and parts

proliferation' design engineers would be directly involved in studyingdifferent designs and trying to reduce the number of parts. &n addition,sales staff who communicate with customers could make greater effortsto understand customer needs and convey this information to the designengineers.

5-30 (a Total manufacturing support costs @ >%,999,999Total direct labor hours @ ;,999 L 89,999 %U @ ;9,999anufacturing support cost rate @ > 9 per direct labor hour.

(b Deluxe 8; > 9

Direct labor > 9 >%9

anufacturing support >89 > 9

7nit cost >%9; >59

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(c !ctivity %-9,

> 99999

599=

Quality control >(;9, >%(;999(,999

=

)roduction setups >((9,

>%,999

(99%99=

achine maintenance> ;9,

,>%9

999; 999

=

Capacity costs !ssigned to )roducts

!ctivity Deluxe 99 @ >59,999 899 > 99 @ >% 9,999Quality control %,999 >% ; @ % ;,999 %,999 >% ; @ % ;,999)roduction setups %99 >%,%99 @ %%9,999 %99 >%,%99 @ %%9,999achine maintenance 9,999 >%9 @ 99,999 %;,999 >%9 @ %;9,999Total manufacturing support costs >84;,999 >;9;,999

Aumber of units ;,999 89,9997nit manufacturing support costs >44 >% .5 ;

Deluxe 8;.999 > 9.999Direct labor > 9.999 >%9.999anufacturing support >44.999 >% .5 ;7nit cost >%58.999 >; .5 ;

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(d!ctivity Deluxe ; .5 ;Eross margin per unit (> 8.999 > . ;

(f The regular model is more profitable than the deluxe model. Therefore,marketing staff can (i push the regular model (increase commissions onthe regular model, and?or decrease commission on the deluxe model ,and?or (ii raise the price of the deluxe model.

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Design engineers can try to re-engineer the deluxe product to decreaseits high demand for activity resources.

5-31 (7nofficial C ! !nswer, adapted

(a !t least four general advantages associated with activity-based costinginclude the following$

R )rovides management with a thorough understanding of complex product costs and product profitability for improved resourcemanagement and pricing decisions.

R )rovides estimates of unused capacity costs.

R Iighlights the interrelationships (cause and effect of activitiesand identifies opportunities to reduce costs, e.g., designing

products with fewer parts to reduce the cost of the manufacturing process.

R )rovides more appropriate means of charging support costs to products.

(b %. 7sing standard costs, the total contribution expected this year from the T# board is >%,4;9,999, calculated as follows$

)er7nit

Totals for5;,999 7nits

%;9 >4, ;9,999Direct material 9 ;, 99,999aterial support (%9B of material ; 9,999Direct labor (>%8 %.; hours % %, 5;,999#ariable support (>8 %.; hours P 5 49,9996ther mfg. support (>%9 9.;machine hour ; ;,999Total cost >% 9 > , 99,999

7nit contribution > 9

Total contribution (5;,999 9 >%,4;9,999P #ariable support rate$ >%,% 9,999 9,999 hours @ >8 per hour.

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. 7sing standard costs, the total contribution expected this year from the )C =oard is > , 59,999, calculated as follows$

)er7nit

Totals for 89,9997nits

99 >% ,999,999

Direct material %89 ;,599,999aterial support (%9B of material %8 ;59,999Direct labor (>%8 8 hours ;5 , 89,999#ariable support (>8 8 hours P %5 589,9996ther mfg. support (>%9 %.;machine hours %; 599,999Total cost > 8% >4,589,9997nit contribution >;4

Total contribution (89,999 >;4 > , 59,999P #ariable support rate$ >%,% 9,999 9,999 hours @ >8 per hour.

(c :hown below are the calculations of the cost drivers which apply to both (c % and (c .

)rocurement$>899,

,>.

9998,999 999

%9 per par = t

)roduction scheduling$ >((9,,

>(.999%%9 999

99 per boa= rd

)ackaging and shipping$>889,

,>8.

999%%9 999

99 per boa= rd

achine setups$ setup per59.%>C;9,(C-999,885>

=

Ia1ardous waste disposal$>8-,

,

> .999

%5 999

99 per pou= nd

Quality control$>;59,

,> .

999%59 999

;9 per ins= pection

Eeneral supplies$>55,

,>.

999%%9 999

59 per boa= rd

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achine insertion$ insertionmachine per89>.999,999,999,(99,%>

=

anual insertion$ insertionmanual per99.8>999,999,%999,999,8>

=

Fave soldering$ >% (,

, >%.999

%%9 999 (9 per boa=

rd

%. 7sing activity-based costing, the total contribution expected thisyear from the T# =oard is > ,;; ,%99 calculated as follows$

)er7nit

Totals for5;,999 7nits

%;9.99 >4, ;9,999

Direct material 9.99 ;, 99,999aterial support$ )rocurement (>.%9 ; .;9 %5 ,;99 )roduction scheduling .99 % 9,999 )ackaging and shipping 8.99 59,999#ariable support$ achine setups (>%.59 . 9 9 ,999

Faste disposal (>

.9 .95 ,499 Quality control .;9 ,;99 Eeneral supplies .59 4,9996ther manufacturing support$ achine insertion (>9.89 8 4.59 5 8,999 anual insertion 8.99 59,999 Fave soldering %. 9 ,999 Total cost >%%9.55 > ,%4 ,4997nit contribution > 4. 8Total contribution (5;,999 > 4. 8 > ,;; ,%99

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. 7sing activity-based costing, the total contribution expected thisyear from the )C =oard is >%,;48,999 calculated as follows$

)er7nit

Totals for 89,9997nits

99.99 >% ,999,999Direct material %89.99 ;,599,999

aterial support$

)rocurement (>.%9 ;; ;.;9 9,999

)roduction scheduling .99 9,999

)ackaging and shipping 8.99 %59,999

#ariable support$

achine setups (>%.59 8. 9 %4 ,999

Faste disposal (> . ; %.9; 8 ,999

Quality control (> .;9 .99 9,999

Eeneral supplies 9.59 8,999

6ther manufacturing support$

achine insertion (>9.89 ; %8.99 ;59,999

anual insertion (>8 9 9.99 , 99,999

Fave soldering %. 9 8 ,999

Total cost > 59.%; >%9,895,999

7nit contribution > 4. ;

Total contribution (89,999 > 4. ; >%,;48,999

(d The analysis using standard costs shows that the unit contribution of the)C =oard is almost double that of the T# =oard. 6n this basis, !laire3smanagement is likely to accept the suggestion of the productionmanager and concentrate promotional efforts on expanding the marketfor the )C =oards. Iowever, the analysis using activity-based costsdoes not support this decision. This analysis shows that the total dollar contribution from the T# =oard exceeds that of the )C =oard by almost

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>%,999,999. !s a percentage of selling price, the contribution from theT# =oard is double that of the )C =oard, e.g., 5B versus % B.

CASES

5-32 This 0uestion is designed to get students to think about the factors creating thedemand for activity-based cost systems.

(a ! traditional cost system, which assigns direct materials and direct labor to products, and allocates factory support based on direct labor, cannotsignal the cost of component and product variety. arketing researchmay identify that consumers like to choose from a variety of options(especially when the alternatives are available without any costassociated with choosing' e.g., you can have any color of this or anyvariety of that . &n this situation, product engineers can design lots of

varieties and options. The cost system assigns cost only on the directlabor and materials content of these options. Thus making one millionunits of one steering column appears to cost the same as making%99,999 of 8 different steering columns, %9,999 each of 9 other steering columns, and %,999 each of 99 other columns. =ut making 8steering columns in batch si1es ranging from, for example, %99 to%9,999, and designing and supporting 8 different steering columns ismuch more expensive than "ust producing ; or at most 89 differentcolumns. ! traditional cost system would report that production costs of labor and materials for the %,999,999 steering columns is the samewhether they are produced in ; varieties, 89 varieties, or 8 varieties.Thus model and component proliferation is virtually impossible to stopwhen companies cost products using traditional cost systems.

(b &n order to understand the cost of variety, the new cost system shouldidentify the cost of introducing new varieties, colors, and options. Thecost system will show the cost of setting up or changing over to makethe new variety, color and option, a cost that will be independent of thenumber of units produced after the setup. !lso the new cost system will

show the cost of designing and supporting each new variety, color, andoption (technically, in !=C terms, called the Vproduct-sustainingW coststhat will be independent of the number of units produced. Fith the moreaccurate understanding of the costs of resources that perform batch and

product-sustaining activities, the product engineers and marketingmanagers can "ointly make better decisions on whether the higher cost

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water, mineral water, new-age beverages, ginger ale, flavored soft drinks, etc.2ach new retailer that Cott signs up as a customer may also want its ownslight variation in beverage formulation (ingredients and labeling. !s Cott

begins to respond to the demand for higher variety, it will be performing manymore activities$ scheduling production runs, buying more different ingredientsand packaging materials from more suppliers, setting up for each productionrun, changing over packaging lines, more 0uality control activities (re0uiredfor each production run and each uni0ue formulation , and more productsupport activities to maintain information re0uired for each individual :K7.Cott will need an !=C system to understand the cost of these activities that aredriven by increased variety and be sure that these costs are covered by thevolume of business and prices received from retailers. 6therwise, its coststructure will increase and it will either lose money on the incremental ordersor, as it attempts to raise prices, will lose much of its price advantage over thenational brands. Cott will want to understand its costs by individual :K7, to

be sure that the increased costs associated with offering and deliveringcustomi1ed, low-volume :K7s do not become spread on to the basic highvolume beverages (say, regular and diet cola .

:econd, Cott is customi1ing its product and service offering to individualretailers. *or each retailer, Cott can offer uni0ue product formulations,customi1ed to the retailer3s specifications, design of a retailer-specific label for the beverages, and marketing, promotional, and consulting assistance to helpthe retailer launch and sustain a private-label cola line. Thus Cott can incur substantial customer-specific expenses with each new retailer. &t will need tomeasure all these front-end, customer-specific expenses and link them to therevenues received, less product and customer-specific beverage costs asdescribed in the previous paragraphU to determine customer profitability. !n!=C model of individual customer profitability will enable Cott to predict inadvance the volume and mix of business re0uired to payback heavy front-endinvestments in product design, package design, and consulting assistance. 2x

post, Cott will use the !=C customer profitability model to assess whether theactual volume and mix of business, at actual prices and !=C-calculated

product costs, are generating sufficient margin to repay the front-end and

perhaps on-going customer-specific support expenses. Cott executives can usesuch a model to guide their negotiations with each retailer.

Third, one of Cott3s principal marketing devices with a retailer is to convincethe retailer3s executives, (% that Cott beverages are profitable for the retailer to sell, and ( that Cott beverages may be even more profitable for the retailer than national-branded beverages. This will re0uire Cott to work with the

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retailer to develop a retailer profitability model for the cola beverage category(one of the highest gross volume categories in a retail grocery store . *rom theretailer3s perspective, profit would be measured by the gross margin (netselling price less the price paid to Cott minus retailer expenses to receive the

beverage containers in a warehouse, store and then ship them to retail outlets,receive the shipments at the retail store, and then shelve and promote them atthe store. This re0uires an !=C model to be built for the retailer3s operatingexpenses, including the cost of inventory and shelf-space occupancy. This isespecially important since the national brands (Coke and )epsi charge theretailer much higher prices and the retailer marks these items up less than itmight do for a private label beverage. =ut since the national brands aredelivered directly to individual stores and shelved by the national brands3

personnel, the retailer does not use its warehouse, distribution, or in-storeresources (other than shelf space for these brands. Thus a fair comparisonre0uires the !=C model to cost out the extra activities related to the Cott-

supplied beverages but not re0uired for Coke and )epsi. =ut think about the power of the outcome from such a study. Fouldn3t you, as a supplier, like to be able to demonstrate to your customer that you are not "ust the lowest costsupplier but the most profitable supplier in a categoryY

:tudents may also suggest other, non-cost, aspects of the Coke vs. Cottdecision. =ut thinking about these three !=C models$ factory costs reflectingthe cost of variety and customi1ation, customer cost and profitability reflectingthe cost of uni0ue marketing, design, and promotional assistance, and, finally,customer3s profitability structures should give students ample opportunity toreflect on the strategic use of accurate product, distribution, and customer costinformation.

5-34 This case on Eotham City is adapted from V&ndianapolis$ !ctivity-=asedCosting of City :ervices (! and (= ,W Iarvard =usiness :chool Case #9-196-115 ? and -117 . The material below reports on the &ndianapolis experience.

(a There are at least two reasons for estimating !=C costs of currentoperations before contemplating a privati1ation decision. *irst, it may

turn out that the municipal workers are doing the work at a lower costthan private sector alternatives. Fhile this may seem fanciful, the&ndianapolis experience revealed 0uite a few tasks where the work could

be done by municipal workers at lower cost than by paying the lowest- bidding private contractor. 6f course, for this comparison to be on alevel playing field, the cost estimate for the municipal workers mustinclude not only their direct labor cost but also the cost of e0uipment,

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supervision, and all resources performing support activities (since any private company must bid to cover the costs of these resources as well .The !=C approach provides a reasonable estimate of all direct andindirect costs associated with performing a given activity (such as filling

potholes, picking up trash, sweeping streets, treating water and sewage,repaving roads, and operating an airport . The ayor of &ndianapolis,after seeing the !=C cost estimates for internal provision of theseservices, announced he was more interested in competition (between the

public and private sector for the lowest cost supply of services than in privati1ation.

The second reason for the !=C approach is that should a company inthe private sector win the business, the city must then identify all theresources that are no longer needed when the work is done by the

private contractor. !gain, the city resources that should be reduced

include not only the front-line municipal workers, but also all their e0uipment, supervisors, and support resources behind the front-lineworker. 6therwise, the city will pay twice for the service, first for thecontractor doing the work, and then for the people and other supportresources who now have less or no work to perform. That is why across-functional, comprehensive total cost view is needed to providetransparency about all the resources in place to support a front-lineworker.

(b They should identify all the resource units used such as trucks,machines, computers, and facilities. Then they need to identify all thecosts incurred to supply the resources and the capacity supplied by eachresource. ! capacity cost rate (the cost of the indirect resource divided

by the capacity supplied by the resource can then be developed for eachresource type. 2stimates then need to be obtained for the amount of each resource3s capacity used by different activities performed to

provide services to the community.

(c The answer to this 0uestion provides a third reason for building !=C

models before considering privati1ing municipal services. =efore building an !=C cost model, workers would have no idea about the costof performing the work. 6nce they see the cost of labor, e0uipment,supervision, and other support services, they can make suggestions tolower the cost of performing the work. !s a specific example, in&ndianapolis, the workers saw that there was one supervisor for everytwo workers, clearly an excessive amount. They also developed

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procedures so that a pothole could be filled with a three-person crewrather than a five- or six-person crew, to share e0uipment with other activities, to use their e0uipment more efficiently, and to perform other work (such as cleaning streets while waiting for e0uipment or materialsto be delivered to the site. The sum total of all these improvementsuggestions enabled the municipal workers to submit a much lower bidthan any private contractor, thereby retaining the business. This messagereinforces the point that sharing cost information with front-lineworkers enables them to make suggestions for how to accomplish thesame outcomes with fewer resources, resulting in substantial

productivity improvements. 6nly good cost information can identify theopportunities for the largest improvements in resource expenses.

5-35 (a :tage %$ !llocation of :% and : costs to production departmentsDepartment )% Department )

Directlytraceablecosts

>8 9,999 > 9,999

:%%,% 5,999 G,,5

%(9 @ 8 9,999 %,% 5,999 G ,,5

(%5 @ ;5,999

:%,% 9,999 G %59

89 @

9,999

%,% 9,999 G%59%(9

@ 89,999

Total support >%,% 9,999 > , 5,999

DHI 9, 999 % 9,999

Cost driverrate >%8. ; per DHI >%4. 9 per DHI

:tage $ !llocation of )% and ) costs to products)roduct < 5% )roduct %8. , >--;,C; 59 999 999 = >%8. , ,C; (9 999 (4; 999 =

) >%4. , ,-9 C(,999 % 8(; 599 = >%4. , ,-9 8- 999 4;9 899 =>(, ,%9 599 >%, ,(8; 899

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)roduct costing

)roduct < 5% )roduct - , >8, , =;99 999 999 999 >%9 , , =899 999 8,999 999

Direct labor$ )% >%; , , =59 999 499 999 >%; , , =(9 999 99 999

Direct labor$ ) >%- , , =C(,999 % (45 999 >%- , =8- 999 -58,999

:upport >(, ,%9 599 >%, ,(8; 899

Total cost >-, ,;95 599 >5,894,899

Total units ;99,999 899,999

7nit cost >% .9% >%5.9 ;

:ales price %4 9999. (9 9999.

Eross margin >%.4 5 > .4 5;Eross margin B %9.8599B %4. B

(b Het ! denote the number of hours re0uired for each < 5% setup. Thenthe number of hours re0uired for each

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Total :upport CostsCapacity Cost

Drivers )roduct < 5% )roduct 59,999 @ >% 9,999 > , >59, =(9 999 999

) -DHI > ,999 @ %5,999 > , , =8- 999 %88 999

:etup hours (94;

(999 8%4,999.

!

! =

(94;5 999 %(;C,999

., ,

!

! @

)%- I >4. , ,; 9 999 (-; 999 = >4. , ,; %9 999 4; 999 =

) - I >C. ,; C(,999 ;89 999 = >C. , ,; 8- 999 59 999 =

>%, ,589 999 >%, ,4%5 999

!lternatively,

CapacityCost

Total :upport Costs

Drivers )roduct < 5% )roduct (89, >%-9,

(9-9

999 999 =>(89, >59,

) -DHI C(

%(9999 999 => 59, >(%5,

8-%(9

999 %88,999 => 59,

:etup hours

(,999-999

% 5C5 999 8%4,999 !

!,, , =

5 999- 999

% 5C5 999 % (;C,999,,

, , , !

!

=

)%- I 9

89999 (-; 999 => -9, ,

%989

999 4; 999 => -9, ,

) - I C(

%(9999 ;89 999 =>499, ,

8-

%(9999 59 999 =>499, ,

>%, ,589 999 >%, ,4%5 999

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)roduct costing

)roduct < 5% )roduct 8,999,999 >8,999,999

Direct labor$ )% 499,999 99,999

Direct labor$ ) %, 45,999 58,999

:upport costs >%,589,999 >%,4%5,999

Total cost > , 5,999 > ,9 9,999

Total units ;99,999 899,999

7nit cost >%;.5 >% . 99

:ales price %4.999 9.999

Eross margin > . > . 99

Eross margin B % .; 9B %%.;99B

(c The old cost accounting system ignored the fact that a large part of support costs is driven by setup hours. 7nder the old cost accountingsystem, 9.9999

7nit cost % .9% %5.9 ; %;.5 9 % . 999

Eross margin >%.4 5 > .4 5; > . 9 > . 999

Eross margin B %9.85B %4. B % .; B %%.;9B

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(d #ecommen ations $or marketing:

%. < 5% is more profitable than

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Q$ Fhat is the competitive situation faced by :ippicanY

ature products Declining profits

&nability to explain pricing decisions in market place + high margins and little price competition in one line' continued price pressure in another

Q$ Fhy was Knight studying :ippican3s overhead costsY

The following two characteristics serve as indicators that a traditional costingapproach to overhead costs is likely providing inaccurate costs$

%. %he &illie Sutton rule $% Hook for areas with large expenses inindirect and support resources, especially where such expenses

have been growing over time. 6perations where almost allexpenses are direct labor and direct materials, which canalready be directly traced to individual products by traditionalcosting systems, may have less need for !=C systems. &neffect, if organi1ational activities are all at the unit level(virtually no batch or product-sustaining activities , then !=Csystems and traditional cost systems will likely give verysimilar economic signals.

. 'igh (iversity rule $ Hook for a situation in which large variety

exists in products, customers, or processes. *or example,consider a facility that produces mature and newly introduced products, standard and custom products, high-volume and low-volume products. *or marketing and selling expenses,companies may have a mixture of customers who order high-volume, standard products with few special demands as well ascustomers who order in small volumes, special products, andre0uire large 0uantities of pre-sales and post-sales technicalsupport.

% Fillie :utton was a successful bank robber in the 7nited :tates during the %4;9s. Fillie, whowas eventually captured at his home not far from a local police station, was asked during his initialinterrogation, VFhy do you rob banksYW Fillie replied, with the wisdom that had made himsuccessful for many years, VThat3s where the money isZW Fhen developing !=C systems, weshould follow Fillie3s sage advice (but not his particular application of the insight to focus onhigh cost areas where improvements in visibility and action could produce ma"or benefits to theorgani1ation. !pplying an !=C analysis to a set of resource expenses that are below %B of totalspending will not lead to high payoffs to the organi1ation.

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6bservation$ )roducts such as pumps and valves may be commodities' buthow they are produced (small lots, custom designs and delivered (direct,expedited is not a commodity. These special services create a basis fordifferentiation. =ut Vdifferentiation is a successful strategy only when the deltavalue created by differentiation exceeds the cost to differentiate.W

% &eve"ues '(rom !i#!er )rices, !i#!er sa$es vo$umes* + % osts

Q$ :hould :ippican abandon its overhead cost allocation system and makemanagerial decision based on contribution margin' in effect use marginal costsrather than average costsY

(a :ippican3s executives should not abandon overhead assignment to products.The contribution margin is revenues minus variable costs.

!nalysis based on unit contribution margins can be useful for short-term

decisions, such as whether to accept a one-time order when operatingwith excess capacity. &n this case, management is concerned aboutrecurring sales.

6verhead cost is si1able (>5;8,599, which exceeds either direct labor or direct material costs

anagement will benefit by understanding the impact ofvariety in the use of overhead resources by individual

products.The contribution margin approach, by definition, does not

reveal the different demands that individual products make onoverhead resources (for machine time, engineering design,setups, receiving, shipping, etc. .

Companies that cut prices based on contribution margin to get new business should be cautious about (i competitive reactions, (ii havingto lower prices to existing customers, and (iii filling up capacity with

business that does not pay for capacity costs. &f a company cuts prices when near capacity, demand could increase

beyond existing capacity. Conse0uently, the company may end uphaving to supply more capacity for support resources to handle thework, without being paid for supplying these capacity resources.

7sing TD!=C, only two parameters are needed for each department or process$

%. Calculate capacity cost rates for each department or process

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. Time re0uired by products, orders, services, and customers on theorgani1ation3s capacity resources.

Q$ Het3s start building the time-driven !=C model. Fhat are the various capacitycost ratesY

(b Capacity Cost ,499 9 .; %.; 5.9 % 9 32.50achine 2xpenses >;,899 9 % .9 89 22.50 ,499 9 .; %.9 5.; % 9 30.002ngineering >4, ;9 9 .; %.; 5.9 % 9 81.25)ackaging and :hipping > ,499 9 .; %.9 5.; % 9 30.00

Iours 7sed

#alvesP )umps*low

ControllersPTotalIours

)roduction #olume ,;99 % ,;99 8,999 8,999

DH ()roduction and!ssembly , ;9 5, ;9 %,599 %9, 99achine

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+ % +

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*or flow controllers$

DH hours @ 8,999 G 9.89 @%,599achine run hours@ 8,999 G 9. 9 @%, 99achine setups (from case @ @ , 99 (@ ; G %Habor setup hours (from case @ @ , 99 (@ ; G %

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Het3s assign the costs of these various resources?departments to the flow controllerline$

ota$ ime ost &ate ost Assi#"ed /"it ost '4,000 *achine run time$ %, 99 > .;9 > ,999 > 5. ;:et-ups (labor , 99 .;9 , ;9 %.48:et-ups (machines , 99 .;9 59, ;9 %;.%4 ; ,5 >5 .8Direct Habor ; ,999 % .99Direct aterials ,999 .99

> 4 ,5 > 4 .8

9,999 4; .99Eross argin >(% ,5 (> .8

Iand out sheet of )JH of :ippican. Do you believe the revised )JHY

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(c (:mall discrepancies in totals are due to calculations performed in a spreadsheet package.

#alves

#alves$ per unit

costs )umps

)umps$ per unit

costs*lowContr.

*Cs$ per unitcosts Total

7nusedCapacityP !ctual

)ercentof :ales

7nits ,;99 % ,;99 8,999

:ales >;4 ,;99 > 4.99 > ;,999 > 9.99> 9,99

9 >4;.99 >%, 8 ,;99 >%, 8 ,;99 %99B

aterials 2xpenses % 9,999 %5.99 ;9,999 9.99 ,999 .99 >8; ,999 >8; ,999DH 2xpenses 4 ,5 ; % . ; 9 ,% ; %5. ; ; ,999 % .99 > 8 , ;9 > , ;9 > ;%,999Contribution argin 4, ; ;9.5; 8 %, ; . ; 89,999 59.99 >%,98%, ;9 -> , ;9 >%,9 ,;99 ;5B

anufacturing 6verhead achine 2xpenses 8, ; %%. ; %89,5 ; %%. ; ,999 5. ; > ; ,999 >5, 99 > ; , 99 :etup Habor , ;9 9.8 %4,;99 %.;5 , ;9 %.48 >%%9,;99 >5,;99 >%% ,999 achine :etupPP , ;9 9. 9 % ,;99 %.9 59, ;9 %;.%4 > 5,;99 >9 > 5,;99 % ,4 > ,55 >%;,599 2ngineering 8, ; 9.5; %4,;99 %.;5 8 , ;9 % .%4 > ,% ; >8, ; > ,999 )ackaging and :hipping %,999 8.% ; ,;99 8. 9 %,999 ;. ; >%98,;99 >8, 99 >%94, 99Total anufacturing 6verhead % 5,;99 %5. 84, ; %4.4; ; ,5 5 .8 >5 4,;5 > ;,9 >5;8,599 ;BTotal costs 4,% ; 8;. 9 ,;99 ;5. 9 4 ,5 4 .8 >%,8 ;, % > , >%,85 ,599

Eross argin ; , ; . % ,;99 % . 9 -% ,5 - .8 >8% ,% -> , > ,499 %BEross argin?:ales B 8 . B %4. B - .5B . B 9. B

:elling and !dministrative 2xps. > ;9,999 %4B6perating )rofit > ,499 B

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Chapter ): Activity-Base Cost Systems

7sing the capacity rates and unused capacity hours computed in part (b , the costof unused capacity is as follows.

.;9 > , ;9achines ( .;9 >5, 99:etup Habor 99.99 > .;9 >5,;99 9.99 > ,552ngineers 59.99 > %. ; >8, ;)ackaging and :hipping %;5.5 P > 9.99 >8, 99

P

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Atkinson, Solution Manual t/a Management Accounting, )E

Traditional Cost !nalysis #alves )umps *low Controllers:elling price > 4.99 > 9.99 >4;.99

Direct labor cost >% . ; >%5. ; >% .99Direct material cost %5.99 9.99 .99anufacturing overhead at % ;B ofDH cost

. ; 9.95 8.9;

:tandard unit costs >;%. 9 >55. % >;4.9;

Eross margin > . 9 > .54 > ;.4;Eross margin (B ;B ;B B

Time-Driven !=C !nalysis #alves )umps *low Controllers:elling price > 4.99 > 9.99 >4;.99

Direct labor cost >% . ; >%5. ; >% .99Direct material cost %5.99 9.99 .99TD!=C overhead %5. %4.4; 5 .8:tandard unit costs >8;. >;5. 9 >4 .8

Eross margin > . >% . 9 (> .8Eross margin (B 8 B 9B - .5B

(d /es, the approach can be extended to service companies and much largercompanies than :ippican. The Towerton case in this chapter provides suchan example.

Time-driven activity-based costing reduced some of the barriers associatedwith developing and updating the common approach to activity-basedcosting, which assigns many resource expenses to activities based oninterviews and surveys. Aevertheless, barriers and difficulties associatedwith managing any ma"or change remain. *or example, individuals may feelvulnerable facing uncertainty about what the time-driven activity-based costanalysis may show. The analysis might reveal that products or customersthought to be very profitable are actually unprofitable, some processes are

+ % +

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inefficient, or there is substantial unused capacity. &ndividuals may beconcerned that they will then be "udged as poor managers, even though theywere making decisions that others would agree were good decisions basedon the cost system that was in place.

(e The company should reconsider its product strategy and focus on its core productsvalves and pumps. :ippican might attempt to increase marketshare in valves by offering discounts for large orders of valves. *urthermore,:ippican could reduce discounting for pumps, especially for small orders.*inally, :ippican should aggressively raise prices for flow controllers oraccept orders to produce flow controllers only when the pricing and ordersi1e indicate that they can be sold at a profit' :ippican could establish aminimum order si1e.

:ippican can also focus on improving processes. *or example, the companycould reduce setup times or schedule production of components for multiple

product orders to share components across multiple batches. Theseimprovements, in con"unction with the focus on larger orders, should lead tomany fewer production runs and shipments, allowing for the possibility of reducing capacity and related costs.

This discussion can be carried forward in the same context to include topicssuch as the =alanced :corecard and activity-based budgeting by using the

:ippican = case that follows (case ;- and the accompanying )ower)oint presentation slides.

5-37 :ippican Corporation (= (I=: Case 9-106-060 (:ee also the teaching planfor case ;- 5$ :ippican Corporation (! (I=: Case 9-106-058 and the)ower)oint presentation available to instructors.

&n :ippican (! , the company experiences declining profits and struggles tounderstand why it is encountering severe price competition on one product

line. The controller collects data that will enable development of a time-driven, activity-based cost model to explain better the different demands ofeach product line on :ippican[s indirect and support resources. !pplying thenewly estimated capacity cost rates for the resources to the productionstatistics of the three product lines produces a radically different perspectiveon product line profitability. The (! and (= cases together illustratemotivation and design of a time-driven, activity-based system, the action

+ % 8 +

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steps that emerge from a more accurate cost analysis, and a powerfulconnection between strategic planning and operational budgeting.

The following figure diagrams the connections among the =alanced:corecard and strategic planning, activity-based costing, and activity-basedoperational budgeting.

eac!i"# P$a"This case illustrates that fixed (capacity costs are typically not one big pieceof e0uipment. ost capacity costs come from having many machines andmany people. These can be ad"usted up or down based on forecasts of futurecapacity needs. :ippican currently has 5 machines, % 9 productionworkers, packaging and shipping workers, 8 receiving and productioncontrol workers, and engineers. &t is hard to argue that these are all VfixedWand not avoidable over some not very long time period. Fhile one can haveVfixedW costs with one machine and one indirect worker, 5 machines and

%59 employees do not represent a VfixedW cost. =ut how do these resourcelevels and associated costs change as production levels changeY

The company uses activity-based budgeting to translate the detailed salesand production plans into specific demands for labor and machine resources.Direct labor increases slightly, but setup labor demand drops dramatically

because of fewer production runs and reductions in setup time. :mall

+ % ; +

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reductions also occur in indirect labor and engineering time. !ctivity-based budgeting is a powerful tool for creating bottoms-up operational budgets.Iowever, it does re0uire much finer granularity in the sales forecasts and

production plan to estimate the demands for organi1ational resources, particularly those performing support functions.

(a The planned hours used can be computed based on the data providedin 2xhibit ;-% and case ;- 5 (:ippican (! $

a$ves Pum)s $oo"tro$$ers

ota$

)roduction units %9,999 % ,999 ,;99 8,;99%ime in 'ours

Total DH hours , 99 5,999 %,999 %9, 99Total machine run hours ;,999 5,999 ;9 %%, ;9achine setup hours %59 %4 8 9 Total machine hours ;,%59 5,%4 %, 9 % ,;Habor setup hours %59 %4 8 9

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(b &f :ippican can reduce its supply of resources to the estimated needs,:ippican estimated spending and profit next period are as presented inthe following statement. &f :ippican cannot reduce its supply ofresources to the minimum needed for pro"ected demand, or if :ippicanwants to preserve some protective capacity, then spending in V7nusedCapacityW will increase.

:ippican (=)ro *orma #alves )umps

*lowControllers Charged

7nusedCapacity !ctual

:ales (units %9,999 % ,999 ,;99:ales revenue > ;9,999 > 459,999 > ;,999 %,4 ;,999 >%,4 ;,999:ales percentage B 8 B %8BDH expenses > % ,;99 > %4;,999 > ,;99 > ;%,999 > ;%,999aterial

expenses %59,999 89,999 ;;,999 8;;,999 8;;,999Contributionmargin 855,;99 ; ;,999

% ,;99 %,% 4,999 %,% 4,999

5 B ;;B 5 B ;4B 9B ;4Bachine run-time expense %% ,;99 % ;,999 %5, ; 58, ; ,%9; 5 ,8 9achine set-upexpense ,599 8, 9 %9, 99 % , 9:etup labor ;, 99 5, 89 %;,599 ,989 59 , 99 8 ;,%99Total costs > 8; ,% ; > 5;%, %9 > % ,5;9 %, %,% ; > 4,45; >%, 4%,%99

Eross margin > 4 , ; > 9 ,549 > 4 , ;9 > 9 , 5; >(4,45;

> 54 ,499Eross margin B 89B B ;B ;B ;B:J! ;9,9996perating profit > 8 ,499

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level. Total gross margin increases by almost %B and operating profitincreases more than ten-fold. The huge profit increase assumes only amodest increase in unit sales and average selling prices. !lthough totalunits sold increase by only B, the company is selling more valves andfewer flow controllers. The changes in price and volume are pro"ected toincrease sales revenue by .8B. The ma"or impact on profit is due toad"usting the types of orders accepted, and reducing the supply ofresources no longer needed to handle the small unprofitable orders.

! comparison of product line profitability before and after the changesfollows.

+ % +

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:ippican (!)roduct Hine )rofitability

:ippican (=)roduct Hine )rofitability

#alves )umps *lowControllers

#alves )umps *lowControllers

)roduction ,;99 % ,;99 8,999 %9,999 % ,999 ,;99)rice > 4.99 > 9.99 > 4;.99 > ;.99 > 9.99 > %%9.99Direct labor % . ; %5. ; % .99 % . ; %5. ; % .99Direct materials %5.99 9.99 .99 %5.99 9.99 .99Contribution margin

> ;9.5; > . ; > 59.99 > 85.5; > 8 . ; > ;.99

Cont. margin B 58B 8 B 5 B 5 B ;;B 5 Banufacturingoverhead

achine expenses

%%. ; %%. ; 5. ; %%. ; %%. ; 5. ;

:etup labor 9.8 %.;5 %.48 9.; 9.; 5. 8achine setup cost

9. 9 %.9 %;.%4 9. 5 9. 5 8.

%5. > %4.4; > 5 .8 > %5. > % .9 > 5.95

Total costs 8;. ;5. 9 4 .8 8;. ;8. %.95Eross margin > . > % . 9 > ( .8 > 4. > ;. > .48E B 8 B 9B -8B 89B B ;B

+ % 4 +

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5-38 (a )ractical capacity for the personnel resources is calculated as follows$

)aidIours per Day

Aonpro-ductive

Iours per Day

)roductiveIours per

Day

Days7sed per onth

)racticalCapacityIours per

onth=rokers %.; 5.; 9 % 9!ccountanagers %.; 5.; 9 % 9*inancial)lanners %.; 5.; 9 % 9)rincipals %.; 5.; 9 % 9

Customerservicerepresen-tatives %.9 .9 9 %89

Capacity cost rates are calculated as follows$

Cost )er )erson )er

onth

)racticalCapacityIours )er

onthCapacityCost 5, % 9 > ; . %

!ccount anagers > ,4;8 % 9 > 5 .*inancial )lanners > , % 9 > 5 .4%

)rincipals > % ,4 % 9 > 44.8Customer servicerepresentatives > 8,%4 %89 > 4.48

+ %49 +

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(b ! summary table of time utili1ation appears below, and supportingcomputations appear in the subse0uent table.

Time7tili1ation(Iours a

:tock Trading

utual*und

Trading!ccount

anagement*inancial)lanning

=rokers , 5 , 98!ccountanagers ,9 9*inancial)lanners ,%;8)rincipals ,58 5 8% % 9Customerservicerepresen-tatives 8,9 5 %,99 9 % 4a Computations are shown below.

inutes of activity per month are calculated as follows and then divided by 59 to arrive at the time utili1ation in hours in the table above$

inutes of!ctivity )eronth :tock Trading

utual *undTrading

!ccountanage-ment

*inancial)lanning

ro ers Aew accounts(minutes for newaccounts opened

;4;G 59 @;, 99

;;G 59 @%;, 99

2xisting accounts(minutes fortransactions

9;, G ; @%,; 5,889

5, ; G ; @% %,5 ;

eetings withexisting accounts(minutes formeetings

; 9 G 9 @%,899

5;G 9 @%;, 99

Total minutes %,5 ,;89 %5 , ;Accou"ta"a#ers

Aew accounts(minutes for new

% ; G 89@ 8 ,999

+ %4% +

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accounts opened2xisting accounts(minutes fortransactions

;,899 G %9@ ;8,999

eetings withexisting accounts(minutes formeetings

8 9 G 59 @, 99

Total minutes % 8, 99i"a"cia$P$a""ers

Aew accounts(minutes for newaccounts opened

% 9 G 599 @,999

2xisting accounts

(minutes fortransactionseetings withexisting accounts(minutes formeetings

;54 G 49 @;%, %9

Total minutes % 4, %9Pri"ci)a$s

Aew !ccounts(minutes for newaccounts opened

;4; G %9 @;,4;9

;; G %9 @,;;9

% ; G 9 @,;99

% 9 G 59 @, 99

2xisting !ccounts(minutes fortransactions oraccounts

9;, G 9.;@ %; ,588

5, ; G 9.;@ % ,%5

;,899 G 8 @%,599

Total minutes %; ,;48 %;, % ;,%99 , 99ustomer ervice

Aew accounts(minutes for newaccounts opened

;4; G % @,%89

;; G % @,959

% ; G % @,%;9

% 9 G % @, 89

2xisting accounts(minutes for calls

8 ,599 G ; @,999

%%,8 ; G ; @; , ;

%, 9 G @4, 89

;89 G %9 @;,899

Total minutes 8;,%89 59,8 ; % , 49 , 89

+ %4 +

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(c ! summary table of &): usage during peak and non-peak hoursappears below, and sample computations appear in the subse0uent table.

&):7sage

:tock Trading

utual*und

Trading

!ccountanage-

ment*inancial)lanning TotalP

!vailable)roductive

Time

)eak 85;,4% 9, 99 45, %%, 598, % 55 , 99 Aon- peak 44, ; %9;,4 5 , % %%, 59 4,8%; 8,899

PThe small discrepancies in the totals are due to rounding in the previouscolumns.

&): usage during peak and non-peak hours is calculated bymultiplying &): per transaction by the number of transactions during

peak and non-peak hours, respectively. The computations for stock trading appear below. The other computations are similar.

Transactions)rocessed by

:ervers&): )er

Transaction

Aumber of Transactions$:tock Trading

&): for :tock Trading

)eak

Aon-

)eak )eak

Aon-

)eak 6rder placements,trades and orderclearing andsettlement activities %.8 9;, 9 8 ,89 9!ccount balancein0uiries 9.% ; ,54; , 9 ;, 9 ,Quotation re0uests 9.% ,899 % ,%99 , 89 % , %9=alance transfers 9. 9 ;,999 9 ; ,;99!ccount statement

preparation 9.4 9 4, ;9 9 5, ;

Total 549, 9;,; 9 85;,4% 44, ;

Aote$ The cost of &): usage is provided in this case but the calculationcan be assigned as an additional exercise, assuming the servers can

process ;9 &): per hour. The calculation for peak and non-peak usageis as follows$

+ %4 +

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2ach server is available for ( days G ( 8 hours per day @ ; hours per month. The average cost per hour is therefore > ,%5 ?; hours @ >5 per hour. Aon-peak-hour usage accounts for (%4 servers G (%5 hours per day @ 98 hours per day. )eak-hour usage accounts for ( 5 servers G (hours per day @ 59 hours per day. oreover, the ; -server excesscapacity during non-peak hours exists because of the peak-hour need.Therefore the cost of the excess capacity of ; G %5 hours @ 4% hoursshould be charged to peak-hour users. Thus, the peak-usage hourly rateis >5 G (59 L 4% ?59 @ >%; per hour.

The non-peak cost per &): is >5?;9 @ >9.% and the peak cost per &): is >%;?;9 @ >9. 9, as stated in the case.

(d !n income statement showing rounded costs and profits in thousands for

each of Towerton3s four product lines, as well as the cost of unusedcapacity, appears below, with sample calculations following. The smalldiscrepancies in the totals and margins are due to rounding.

(999s

:tock Trad-ing

utual*undTrad-ing

!ccountanage-ment

*inan-cial

)lan-ning

Total7sed

7nusedCapacity

Total:upplied

:ales > ,5 > %,94% > 49 >%;5 >8,9 8 >8,9 8Costs$=rokers %,8 % %8% %,;5 ( %,;5%!ccountanagers %8 %8 % %5%*inancial)lanners 9 %85 %85 9 %)rincipals 5 5 8 % 88 88 Customerservicereps. % 9 5 8 %5 %8 % 5Computerserverexpenses %; ; %5 ; 8%

Total Costs %,4; %4 4 %5 ,; 8 % 4 , 98argin > > > (% 4 > (% >%,8;9 > (% 4 >%, 9argin B B 9B -%;8B - B 5B - B B:, E J ! %, 996perating&ncome > 96peratingargin 9.;B

+ %48 +

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:tock trading sales @ > . 9 G 9;, @ > ,5 5,; 8.utual fund trading sales @ >8%.8; G 5, ; @ >%,94%,% %.!ccount management sales @ %.;B G >59,999 G %, 99?% @ >49,999.*inancial planning sales @ (% 9 G >%, 99 L ( 49?59U G >% ; @

>%;5,% .

The personnel costs are computed by multiplying the capacity cost ratesin part (a by the hours of time utili1ation in part (b .

The computer server expenses are calculated by multiplying the peak-usage &): by >9. 9 and the non-peak-usage &): by >9.% . *orexample, the computation for stock trading is (85;,4% G >9. 9 L(44, ; G>9.% @ >%;%,54 (rounded .

The costs in the Vtotal suppliedW column are computed as follows$

Cost )er %,;5%,9%9

!ccount anagers > ,4;8 % > %5%,%*inancial )lanners > , 9 > % 5,;59

)rincipals >% ,4 9 > ,459Customer servicerepresentatives > 8,%4 8 > % 5,958Computer serverexpenses > ,%5 5 > 89, 5

Total > , 9 ,; 8

The core stock trading and mutual fund trading product lines are

profitable, with mutual fund trading highly profitable. &n contrast, thenew product lines, investment account management and financial planning, are unprofitable' investment account management is highlyunprofitable, with a return on sales of +%;8B. The large differences in

profits across the product lines are due in part to the high cost of personnel (account managers and principals for account management,and financial planners for financial planning in proportion to product

+ %4; +

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line sales for the unprofitable product lines. &n addition, computer server expenses are 8%.4B of sales for account management. This percentage isfar greater than for any of the remaining product lines. (:ee the table

below.

Costs as a )ercent of 6wn )roduct Hine :ales

:tock Trading

utual*und

Trading!ccount

anagement*inancial)lanning

=rokers ; .4B % .4B 9.9B 9.9B!ccountanagers 9.9B 9.9B %;4. B 9.9B*inancial)lanners 9.9B 9.9B 9.9B 4 .5B)rincipals 4. B .8B 85. B . BCustomerservicerepresentatives 8.5B . B 5.4B .;BComputerserver expenses ;.5B .9B 8%.4B . B Total .4B 9.%B ;8. B %9 .5B

(e Towerton3s management team could specify a minimum accounting balance for investment account management and reprice its financial planning services. anagement could also consider raising prices onstock trading and placing a greater emphasis on mutual fund trading,which is its most profitable product line.

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