CHAPTER 3

ACTIVITY-BASED MANAGEMENT

Questions, Exercises, and Problems: Answers and Solutions

3.1 See text or glossary at the end of the book.

3.2 Disagree. This chapter deals with the problem of allocating indirect costs to products. Indirect costs can be the overhead costs incurred in manufacturing a good or providing a service.

3.3 Step 2 of ABC is to identify the cost drivers associated with each activity. These cost drivers can be selected based on causal relation, benefits received, or reasonableness.

3.4 Companies using a single plantwide rate for their allocation of indirect costs usually select a volume based allocation factor, such as direct labor hours, machine hours, volume of activity, or material costs.

3.5 1. Identify the activities that consume resources.

2. Identify the cost drivers of those activities.

3. Compute a cost rate per cost driver unit.

4. Allocate costs to products by multiplying the cost driver rate times the cost driver volume consumed by the product.

3.6 1. Causal relation. Allocate costs to the product that causes the cost.

2. Benefits received. Allocate costs to the product that receives the most benefit.

3. Reasonableness. Some costs cannot be linked to products based on either causality or benefits received, so they must be allocated on the basis of fairness or reasonableness.

3.7 The traditional approach uses one allocation rate to allocate indirect costs (typically based on direct-labor hours or machine hours), and therefore is simple and relatively inexpensive to implement. The activity-based costing approach uses multiple allocation rates using several different allocation bases (for example, machine setups, number of purchase orders, etc.), and therefore requires more accounting resources to implement.

3-1 Solutions

3.8 Cultures that focus on long-term results are more likely to accept activity-based costing. ABC takes time to be implemented effectively, and requires participation across the organization. Cultures that focus on short-term results are less likely to accept activity-based costing.

3.9 A cost driver is a term used in activity-based costing. It simply refers to any activity that causes a cost. It can be anything from machine hours, labor hours, or number of machine setups, to the number of parts in a product.

3.10 Activity based costing identifies cost drivers (activities that cause costs) that were not previously accounted for by the costing system. Once known, the production managers can control costs by managing these cost drivers. Furthermore, by providing marketing managers with more accurate product costs, they can make informed decisions about pricing.

3.11 False. The lesson learned from activity-based costing is that costs are a function not only of output volume, but also of other factors such as complexity. A complex multi-product operation will cost more than a simple single product operation, for example.

3.12 Low volume products often require more machine setups and purchase orders for a given level of production output because they are produced in smaller batches. Further, the low volume product adds complexity to the operation by disrupting the production flow of the high volume items. Thus, when overhead is applied based on the volume of output, high volume products are allocated relatively more overhead than low volume products, while low volume products cause more costs.

3.13 Non-value added activities are activities that could be eliminated without reducing product quality, performance, or value. Examples are,

University •litter pickup•equipment storage

Restaurant •hiring new employees•throwing out spoiled food

Bike Shop •sending incorrectly ordered parts back to suppliers

•sales returns

Solutions 3-2

3.14 Disagree. The total estimated overhead for the year is independent of cost allocation method. Different allocation methods allocate different amounts ot cost objects, but the total cost is not determined by allocation method.

3.15 Many companies have seen the proportion of direct labor costs to total product costs fall dramatically as production has been automated. When labor is such a small part of product costs, the relationship between labor costs and overhead is weak. Hence, product costs may be erroneous, especially if overhead is a large portion of product costs. Also, small errors in assigning labor to products may be magnified when overhead rates are several hundred percent of labor costs.

3.16 No. One of the benefits of activity-based costing is more accurate product cost information. This can help marketing people to price more competitively, and to expand or withdraw a product offering. Ideally, the implementation of an activity-based costing system involves marketing people, so they in turn better understand the costs they use and the system which generates the costs.

3.17 Nurses are employed in shifts of several hours, not in increments of minutes. A reduction of a few minutes for a patient generally would not affect nurse staffing.

3.18 No cost system can measure costs perfectly. For example, the allocation of overhead costs will probably vary according to the cost system and allocation base you use. Some systems measure costs using market values (e.g., measure the change in the market value of an asset used in a job); others use historical costs (e.g., conventional historical cost measures of depreciation of an asset used on a job). Some cost systems include a measure of opportunity costs of resources used on a job; others do not. In short, there are many alternative ways to measure costs, and none of them are perfect.

3.19 No. While activity-based costing may yield more detailed product cost information, it must pass a cost-benefit test. Activity-based costing requires a much more detailed breakdown of costs into activities that cause costs. This can be a complex task involving the teamwork of management, production, accounting, purchasing, marketing, and many others. A company should implement ABC only if it thinks the benefit from improved management decisions will outweigh the cost of establishing and maintaining the new cost system.

3.20 Capacity sustaining costs are essentially fixed costs unrelated to the level of service or production for the period, such as rent. These costs are likely to be indirect costs. Unit-level costs are variable costs that vary directly with the volume of production. These costs are likely easily attributable to products or services. A hierarchy of product costs can help managers to better establish the relationships between products and costs to better understand cost behavior.

3-3 Solutions

3.21 You would most expect to have unused resources in the capacity sustaining activities because they are the least changeable in the short term.

3.22 Unused resources are measured as resources supplied minus resources used.

3.23 Knowing what costs are incurred by activities and what activities are caused by decisions helps managers know how their decisions affect costs.

3.24 Most companies that adopt activity-based costing would likely add to shareholder value, as evidenced by a study of ABC in U.K. companies. Answers will vary as to how added shareholder value can be measured. One possible approach is to compare return on assets for companies that adopt ABC with return on assets for companies in the same industry that did not adopt ABC. Another measure is to compare a company’s return on assets over time after adopting ABC with the same company’s return on assets prior to adopting ABC.

Solutions 3-4

3.25 (Ciudad Juarez; activity-based costing.)

a. Mountain Bikes Racing Bikes Cost-Driver Actual Cost Costs Allocated to Actual Cost Costs Allocated

Activity Rate Driver Units Mountain Bikes Driver Units to Racing BikesPurchasing Materials............................... $ 20 Per Frame 1,000 Frames $ 20,000 200 Frames $ 4,000Machine Setup........................................ $2,000 Per Setup 7 Setups 14,000 15 Setups 30,000Inspections.............................................. $ 100 Per Hour 200 Hours 20,000 200 Hours 20,000Operating Machines................................ $ 30 Per Hour 1,500 Hours 45,000 500 Hours 15,000 Total Overhead........................................ $ 99,000 $ 69,000

Savings from Reduced Setups 6 Setups X $2,000 = $12,000 15 Setups X $2,000 = $30,000

The cost-driver rate for machine setups remains unchanged since the cost of machine setups changes proportionally to number of setups.

The total overhead is reduced by $42,000 with $30,000 of the savings in racing bikes and $12,000 of the savings in mountain bikes.

3-5 Solutions

3.25 continued.

b. Using activity-based costing revealed that machine setups were a costly activity; if the company could reduce the number of setups it could save a lot of money. The company was able to reduce the number of setups and thereby reduce the cost of setups by about 50 percent, resulting in a savings of $42,000.

Activity-based costing identifies the activities that cause costs. It allows managers to monitor those activities and control them. However, activity-based costing requires employee teamwork and increased record-keeping costs.

3.26 (Wildwater Adventures; activity-based costing.)

a. and b.

Activities Float Trips White Water Trips (3 day) (3 day)

Advertising............ $ 215 $ 215Permit to Use

the River............ 30 50Equipment Use...... 160 [= ($5 X 28) + 20] 264 [= ($8 X 28) + 40]Insurance.............. 75 127Paying Guides........ 1,200 (= $300 X 4 Guides) 1,600 (= $400 X 4 Guides)Food...................... 1,680 (= $60 X 28) 1,680 (= $60 X 28)

Total................ $ 3,360 $ 3,936

c. If the manager wants to cover her costs, she should charge $140 per customer for the 3 day float trip ($3,360/24 paying customers), and $164 per customer for the 3 day white water trip (= $3,936/24 paying customers).

Solutions 3-6

3.27 (ABC versus traditional costing.)

a. Using the Three Cost DriversHigh

Rate Standard Grade Total

Direct Materials................ $ 125,000 a $ 114,000 $ 239,000

Direct Labor...................... $ 160,000 b $ 80,000 $ 240,000

Overhead Costs:Number of Production

Runs........................... $10,000c $200,000f $100,000 $300,000 Number of Quality

Tests........................... 12,000d 144,000g 216,000360,000

Number of Shipping

Orders........................ 1,466.67e146,667h 73,333 220,000 ......................

Total Overhead................. $ 490,667 $ 389,333 $ 880,000

Total Costs........................ $ 775,667 $ 583,333 $ 1,359,000

Total Unit Cost.................. $2.42i $4.86i

aData given in the text.bData given in the text.c$10,000 per run = $300,000 in production costs/30 total runs.d$12,000 per test = $360,000 in quality costs/30 total tests.e$1,466.67 per order = $220,000 in shipping costs/150 shipping orders.f$200,000 = $10,000 per production run X 20 runs for Standard.g$144,000 = $12,000 per quality test X 12 tests for Standard.h$146,667 = $1,466.67 per order shipped X 100 orders shipped for Standard.i$2.42 = $775,667 total costs for Standard/320,000 units produced; $4.86 = $583,333 total costs for High Grade/120,000 units produced.

3-7 Solutions

3.27 continued.

b. Using Direct Labor as the Allocation BaseHigh

Rate Standard Grade Total

Direct Materials................... $125,000a $114,000 $ 239,000

Direct Labor........................ 160,000b 80,000 240,000Total Overhead (Labor

Dollar Allocation).............. 3.66667c586,667 d 293,333 880,000 Total Costs.......................... $ 871,667 $ 487,333 $ 1,359,000

Total Unit Cost.................... $2.72e $4 .06

aData given in the first table.bData given in the first table.c3.66667 = $880,000 total overhead/$240,000 total direct labor costs.d$586,667 = 3.66667 X $160,000.e$2.72 = $871,667/320,000 Standard units produced.

c. By allocating overhead on the basis of direct labor costs, the company has been understating the cost to manufacture High-Grade units and overstating the cost to manufacture Standard units. As a result, ABC shows that the Standard unit is more profitable than originally thought and the High-Grade unit is less profitable:

Traditional Costing Method ABC Standard High-Grade Standard High-Grade

Price.............. $ 3.60 $ 5.80 $ 3.60 $ 5.80Cost............... 2 .72 4 .06 2 .42 4 .86 Profit.............. $ 0 .88 $ 1 .74 $ 1 .18 $ .94

Solutions 3-8

3.28 (Activity-based costing in a nonmanufacturing environment.)

a. Using Labor Hours

Commercial Residential Total

Revenue.............................. $ 66,500a $ 143,000b $209,500

Direct Labor........................ 31,500c 58,500d 90,000

Overhead............................ 21,700 e 40,300 f 62,000 Profit................................... $ 13,300 $ 44,200 $ 57,500

a$66,500 = 3,500 hours X $19 per hour. b$143,000 = 6,500 hours X $22 per hour. c$31,500 = 3,500 hours X $9 per hour. d$58,500 = 6,500 hours X $9 per hour. e$21,700 = ($62,000/10,000 hours) X 3,500 hours. f$40,300 = ($62,000/10,000 hours) X 6,500 hours.

b. Using the Three Cost Drivers

Rate Commercial Residential Total

Revenuea...................... $ 66,500 $ 143,000 $ 209,500

Direct Labora................ $ 31,500 $ 58,500 $ 90,000 Overhead:

Office Supplies............ $133.33b $ 2,000e $ 6,000 $ 8,000

Equipment Costs......... $ 3.00c 10,500f 7,500 18,000

Garden Supplies......... $ 0.36d 23,400 g 12,600 36,000 Total Overhead............. $ 35,900 $ 26,100 $ 62,000 Profit (Loss)................... $ (900 ) $ 58,400 $ 57,500

aSee Part a. above.b$133.33 per client = $8,000/60 clients served.c$3.00 per hour = $18,000/6,000 equipment hours. d$0.36 per square yard = $36,000/100,000 square yards. e$2,000 = $133.33 X 15 commercial clients. f$10,500 = $3.00 X 3,500 equipment hours. g$23,400 = $0.36 X 65,000 square yards.

3-9 Solutions

3.28 continued.

c. From the results in Part b., commercial work is not profitable, while the residential business is making a profit. The cost driver analysis shows that commercial work, which provides only about 30 percent of the revenues, incurs 60 percent of the equipment and garden supplies overhead costs. Allocating overhead costs based on direct labor, as in Part a., implies that the commercial business incurs about 35 percent of the total overhead, whereas the cost driver analysis in Part b. shows the commercial business incurs more than one-half of the total overhead.

3.29 (ABC versus traditional costing.)

a. CellCost Driver Rate Phones PagersProduction Setup................. $5,000a $ 60,000d $ 40,000Material Handling and

Requisition........................ $ 200b 14,000e 6,000

Packing and Shipping.......... $ 1.00 120,000 f 40,000 Total Overhead................. $ 194,000 $ 86,000

a$5,000 per setup = $100,000/20 setups.b$200 per part = $20,000/100 parts. c$1.00 per unit shipped = $160,000/160,000 units shipped. d$60,000 = $5,000 X 12 setups. e$14,000 = $200 X 70 parts. f$120,000 = $1.00 X 120,000 units shipped.

b. CellPhones Pagers Total

Overhead............................ $210,000a $ 70,000 $280,000

a$210,000 = [$280,000 overhead/(60,000 hours + 20,000 hours)]) X 60,000 hours for cell phones.

c. Perhaps. Activity-based costing provides a more detailed allocation of overhead costs; however, the more detailed method is also more expensive. The ABC system should be adopted if the benefits from improved decisions exceed the additional costs required to obtain the information that results in better decisions.

Solutions 3-10

3.30 (ABC versus traditional costing.)

a. Account Rate Tax Consulting TotalRevenue.................... $80,000 $120,000 $200,000Expenses:

Filing, Scheduling

and Data Entry.... $333.33a 24,000d 16,000 40,000Supplies.................. $ 18.00b 14,400e 21,600 36,000

Computer Costs...... $ 12.50c 12,500 f 7,500 20,000 Profit......................... $ 29,100 $ 74,900 $ 104,000

a$333.33 per client = $40,000/120 clients. b$18 per hour billed = $36,000/2,000 hours billed. c$12.50 per computer hour = $20,000/1,600 hours. d$24,000 = $333.33 per client X 72 clients. e$14,400 = $18 per hour X 800 hours. f$12,500 = $12.50 per computer hour X 1,000 hours.

b. Account Rate Tax Consulting TotalRevenue.................... $ 80,000 $120,000 $200,000

Expenses................... $48a 38,400 b 57,600 96,000 Profit......................... $ 41,600 $ 62,400 $ 104,000

a2,000 hours billed = $200,000 revenue/$100 per hour. $48 per labor hour = $96,000 expenses/2,000 hours.

b$38,400 = $48 per labor hour X 800 hours of labor.

c. ABC implies that consulting is more profitable than it appears using labor-based allocation. According to labor-based allocation, tax and consulting generate a “profit” of 52% of revenue (52% = $62,400/$120,000 or $41,600/$80,000). Believing this, management might be indifferent as to which area to focus on—tax or consulting. ABC implies the profit rate for consulting is actually 62%. (62% = $74,900/$120,000.)

3.31 (When do ABC and traditional methods yield similar results?)

ABC and traditional costing systems generally yield comparable product-line overhead costs/allocations when overhead is a small portion of costs, or when cost drivers are highly correlated with the volume-related allocation base. In this case, billable labor hours were distributed 40 percent to Tax and 60 percent to Consulting. If each of the three cost drivers were also distributed 40 percent to Tax and 60 percent to Consulting, the labor-based allocation and ABC would have been identical.

3-11 Solutions

3.32 (Resources used versus resources supplied.)

Resources: Supplied – Used = Unused($6 X 500)

Energy................... $3,300 = $3,000 $ 300 (= 50 hours)

($25 X 200)Marketing.............. $6,000 = $5,000 $1,000 (= 40 sales

calls)

3.33 (Resources used versus resources supplied.)

a.

Resources: Supplied – Used = Unused($80 X 60)

Setups................... $6,600 = $4,800 $ 1,800........................... (27% unused)

($150 X 15)Administrative....... $3,000 = $2,250 $ 750

........................... (25% unused)

b. The company has more unused capacity than management wants. Management might decide to reduce personnel if there is no prospect of increasing capacity usage (e.g., from increased production).

3.34 (Benefits of activity-based costing. [CMA adapted])

If management implemented an activity-based costing system, it should expect to have a more thorough understanding of product costs. By breaking down costs into cost drivers, i.e., those activities that drive the costs, management should be able to see the relationship between product complexity, product volume, and product cost. This would be vital information for pricing decisions and profitability strategies. Management should also be able to streamline the production process by reducing those nonvalue-adding activities such as setups and travel time between stations or departments. (Management might consider running larger batches, or redesigning the plant layout.)

3.35 (Benefits of activity-based costing. [CMA adapted])

Any time one reduces direct labor and increases overhead, a labor-based overhead allocation rate will increase. Activity-based costing would help to clear her confusion by identifying the activities that drive overhead costs. For instance, she might find that the additional overhead costs come from the additional maintenance and depreciation required for the new equipment.

Solutions 3-12

3.36 (Comparative income statements and management analysis.)

a. SLEEP TIGHT CORPORATIONIncome Statement

Rate Dreamer Sleeper TotalRevenue......................... $ 695,000 $ 280,000 $ 975,000 Direct Materials.............. 250,000 110,000 360,000 Direct Labor................... 100,000 50,000 150,000 Indirect Costs:

Administration............ 0.33333a $ 33,333e $ 16,667i $ 50,000

Production Set-up........ $3,000b 30,000f 45,000 75,000

Quality Control............. $1,000c 20,000g 70,000 90,000

Sales & Marketing........ $1,875d 46,875 h 103,125 150,000 Total Indirect Costs........ $ 130,208 $ 234,792 $ 365,000 Operating Profit (Loss).... $ 214,792 $ (114,792 ) $ 100,000

a0.33333 = $50,000 administrative costs/$150,000 direct labor costs.b$3,000 = $75,000 production setup costs/25 production setups.c$1,000 = $90,000 quality control costs/90 inspections.d$1,875 = $150,000 sales and marketing costs/80 advertisements.e$33,333 = 0.33333 X $100,000 direct labor costs.f$30,000 = $3,000 per setup X 10 production runs.g$20,000 = $1,000 per inspection X 20 inspections.h$46,875 = $1,875 per advertisement X 25 advertisements.i$16,667 = (.33333 X $50,000).

3-13 Solutions

3.36 continued.

b. Activity-based costing can be used to identify activities that cause costs and to what extent those activities should be scrutinized relative to other activities. Focusing on activities can also indicate where waste occurs by identifying non-value added activities, and hence, costs that could be eliminated without detriment to the output. For example, better production methods might reduce inspections. Better planning might reduce the number of production setups.

c. SLEEP TIGHT CORPORATIONIncome Statement

Rate Dreamer Sleeper TotalRevenue.......................... $ 695,000 $ 280,000 $ 975,000Direct Materials............... 250,000 110,000 360,000Direct Labor..................... 100,000 50,000 150,000

Overhead Costs............... 2.43a 243,333 b 121,667 365,000 Operating Profit............... $ 101,667 $ (1,667 ) $ 100,000

a2.43 = $365,000 overhead costs/$150,000 direct labor costs.b$243,000 = 2.43 overhead rate X $100,000 direct labor costs.

d. ReportThe purpose of this report is to present a comparison of the profits, of our Dreamer and Sleeper product lines, using activity-based costing and the traditional method of allocating overhead based on labor costs.

Activity-based costing focuses on the activities that drive costs, recognizing that activities consume resources. ABC applies the costs of those resources to the product using the activity. With each line assigned the costs incurred by activities, the Dreamer line is the more profitable. The allocation of overhead under the traditional method is based on the amount of labor each line consumes. This may not be related to overhead. Despite requiring more setups, inspections and advertisements, the Sleeper line is assigned less overhead under the traditional method because its production is less labor intensive than the Dreamer line. Thus, under the traditional method, the Sleeper line appears to be nearly at break even, whereas it shows a large loss when ABC is used.

Activity-based costing provides more detailed and accurate information than the traditional method because it is based on the activities used to produce and sell each product. The traditional method allocates overhead costs based on direct labor usage, which may not represent the actual consumption of setups, inspections and advertisements.

Based on the profit presented under the traditional method, management could decide to discontinue the Dreamer line since it is operating at a minimal profit, and increase production of the Sleeper line. ABC implies the Dreamer line is the most profitable line.

Solutions 3-14

3.37 (Comparative income statements and management analysis.)

a. MARATHON, INC.Income Statement

Rate Court X-Trainer TotalRevenue.......................... $ 800,000 $ 720,000 $ 1,520,000 Direct Materials............... 100,000 100,000 200,000 Direct Labor..................... 360,000 240,000 600,000 Indirect Costs:

Administration 0.16667a $ 60,000e$ 40,000 $100,000

Production Setup $213.33b 64,000f 96,000160,000

Quality Control.............. $150c 90,000g 60,000 150,000

Sales & Marketing......... $300d 30,000 h 30,000 60,000 Total Indirect Costs.......... $ 244,000 $ 226,000 $ 470,000 Operating Profit.............. $ 96,000 $ 154,000 $ 250,000

a0.16667 = $100,000 administrative costs/$600,000 of direct labor costs. b$213.33 = $160,000 production setup costs/750 production runs. c$150 = $150,000 quality control costs/1,000 inspections. d$300 = $60,000 sales and marketing costs/200 advertisements. e$60,000 = 0.16667 X $360,000 direct labor costs.f$64,000 = $213.33 per setup X 300 production runs.g$90,000 = $150 per inspection X 600 inspections. h$30,000 = $300 per advertisement X 100 advertisements.

b. Activity-based costing can be used to identify activities that cause costs. For instance, management has identified three cost driving activities; production setups, quality control inspections, and advertising. Management has assigned a cost to each. If those activities can be reduced without reducing the value of the product to customers, then the company can reduce its costs. Focusing on activities can also indicate where waste occurs by identifying non-value added activities, and hence costs that could be eliminated without detriment to the output.

3-15 Solutions

3.37 continued.

c. MARATHON, INC.Income Statement

Rate Court X-Trainer TotalRevenue.......................... $800,000 $720,000 $1,520,000Direct Materials............... 100,000 100,000 200,000Direct Labor..................... 360,000 240,000 600,000

Overhead Costs 0.78333a 282,000 b 188,000 ........................ 470,000

Operating Profit............... $ 58,000 $ 192,000 $ 250,000

a0.78333 = $470,000 of overhead costs/$600,000 direct labor costs. b$282,000 = 0.78333 overhead rate X $360,000 direct labor

costs.

d. ReportThe purpose of this report is to present a comparison of the profits of our Court and X-Trainer product lines, using activity-based costing and the traditional method of allocating overhead based on labor costs.

Activity-based costing focuses on the activities that drive costs, recognizing that activities consume resources. The allocation of overhead under the traditional method is based on the amount of labor that each line consumes. This may not be related to overhead. The Court line for instance has 150 fewer setups, the most costly activity related to its production, yet is assigned more overhead because its production is more labor intensive than the X-Trainer production.

Activity-based costing provides more detailed and accurate information than the traditional method because ABC is based on the consumption of resources by production of a product line and assigns the costs according to actual usage. The traditional method allocates overhead costs based on direct labor, which may not represent the actual consumption of indirect resources by the product line’s production.

Solutions 3-16

3.38 (Resources used versus resources supplied.)

MnM Productions, Inc.Activity-Based Management Income Statement

a. Resources: Supplied – Used = Unused($5 X 5,000)

Materials........................... $25,000 = $25,000 $ 0

($1 X 3,200)Energy.............................. 3,500 = $3,200 300

($50 X 30)Setups.............................. 1,750 = $1,500...................................250

($40 X 30)Purchasing........................ 1,500 = $1,200...................................300

($50 X 30)Customer Service............. 1,600 = $1,500...................................100

($40 X 100)Long-Term Labor.............. 6,000 = $4,000................................2,000

($50 X 200)Administrative.................. 14,000 = $10,000 4,000

b. Managers should know what resources are unused so they can make better decisions regarding eliminating unused resources or utilizing them for some other purpose or product, and for decisions regarding increasing production (what impact increasing production will have on costs). For instance, the company can do two more setups without increasing costs.

c. The company is meeting management’s expectations of less than 20 percent unused capacity for materials, energy, setups and customer service, but not for long-term labor and administrative costs. Long-term labor and administrative costs tend to be in the facility sustaining category of costs that are fixed in the short run, but can be changed in the long-run. Reducing the supply of long-term labor and administrative costs might require changes in company strategy. If production and sales increase, the use of long-term labor and administration will likely increase and, holding the supply of resources constant, unused capacity will decrease.

3-17 Solutions

3.39 (ABC and predetermined overhead rates.)

a. Activity Recommended Base Allocation RateProduction Setup Number of Production $300 Per Run (= $60,000/

Runs 200 Runs)

Order Processing Number of Orders $250 Per Order (= $100,000/400 Orders)

Materials Handling Pounds of Material $2.50 Per Pound (= $40,000/16,000 Pounds)

Equipment Depreciation Machine Hours $6.00 Per Hour (= $120,000/and Maintenance 20,000 Hours)

Quality Management Number of Inspections $125 Per Inspection (= $100,000/800

Inspections)

Packing & Shipping Units Shipped $1.00 Per Unit (= $80,000/80,000 Units)

Direct Labor Hour Rate........................................... $50 Per Hour (= $500,000/10,000 Hours)

b. Razors Slims EaglesDirect Materials................... $ 8,000 $ 5,000 $ 4,000 Direct Labor........................ 8,000 6,000 3,480 Overhead Costs:

Production Setup.............. $ 600a $ 1,200 $ 3,600

Order Processing.............. 4,000b 4,000 2,000

Materials Handling............ 2,000c 1,000 1,000Equipment Depreciation

and Maintenance........... 4,800d 2,400 2,400

Quality Control.................. 2,500e 2,500 2,500

Shipping........................... 3,000 f 2,000 1,000 Total Overhead.................... $ 16,900 $ 13,100 $ 12,500 Total Cost............................ $ 32,900 $ 24,100 $ 19,980

a$600 = $300 per run X 2 runs.b$4,000 = $250 per order X 16 orders.c$2,000 = $2.50 per pound X 800 pounds.d$4,800 = $6.00 per hour X 800 hours.e$2,500 = $125 per inspection X 20 inspections.

Solutions 3-18

f$3,000 = $1.00 per unit X 3,000 units.

3.39 continued

c. Difference between Product CostsHere are the cost numbers generated by the traditional method:

Razors Slims EaglesDirect Materials................... $ 8,000 $ 5,000 $ 4,000Direct Labor........................ 8,000 6,000 3,480

Overheada......................... 20,000 15,000 8,700 Total Costs........................ $ 36,000 $ 26,000 $ 16,180

aNumber of hours X $50 per hour.

Re: Product-Cost DiscrepancyThe discrepancy between product costs is due to the manner in which overhead is assigned to the products using activity-based costing versus the traditional method of allocating overhead based on labor hours. The allocation of overhead under the traditional method is based on the amount of labor each line consumes. This may not be related to overhead resource consumption.

For instance, consider setups. Note that one setup is required for each production run. The Eagles line uses 0.012 setups per unit (= 12 setups/1,000 units produced) while the Razors line uses 0.00067 setups per unit (= 2 setups/3,000 units). The Eagles line uses 18 times as many setup resources per unit, yet is assigned only 2.3 times as much overhead on the basis of labor hours (2.3 = 400 hours for Razors/174 hours for Eagles).

Activity-based costing provides more detailed and probably more accurate information than the traditional method. ABC focuses on the activities that drive costs, recognizing that activities consume resources. The costs of those resources are then assigned to the product for which the activity is required. Thus, each line is assigned the costs that are incurred due to actual usage of resources.

3-19 Solutions

3.40 (Choosing an ABC system.)

a. FreeWheeler, Ltd.Income Statement

Featherweight Peak Raider TotalSales............................. $ 760,000 $ 1,120,000 $ 950,000 $ 2,830,000 Direct Costs:

Direct Materials.......... $300,000 $ 480,000 $400,000 $1,180,000Direct Labor................ 28,800 48,000 108,000 184,800

Variable Overheada....... 104,400 167,040 250,560 522,000 Contribution Margin...... $ 326,800 $ 424,960 $ 191,440 $ 943,200Plant and Administra-

tion............................. 176,000Other Fixed Overhead. . . 280,000 Operating Profit............. $ 487,200

aOverhead rate = $10.44 = $522,000/50,000 hours.

$104,400 = $10.44 X 10,000 hours;

$167,040 = $10.44 X 16,000 hours;

$250,560 = $10.44 X 24,000 hours.

Solutions 3-20

3.40 continued.

b. FreeWheeler, Ltd.Income Statement

Featherweight Peak Raider TotalSales............................. $ 760,000 $ 1,120,000 $ 950,000 $ 2,830,000 Direct Costs:

Direct Materials.......... $300,000 $ 480,000 $400,000 $1,180,000Direct Labor................ 28,800 48,000 108,000 184,800

Variable Overhead:

Machine Setupa.......... 10,400 18,200 23,400 52,000

Order Processingb...... 32,000 48,000 48,000 128,000

Warehousingc............. 46,500 46,500 93,000 186,000Depreciation of Ma-

chineryd.................. 16,800 26,880 40,320 84,000

Shippinge................... 4,800 19,200 48,000 72,000 Contribution Margin...... $ 320,700 $ 433,220 $ 189,280 $ 943,200Plant Administration...... 176,000Other Fixed Overhead. . . 280,000 Operating Profit............. $ 487,200

a$10,400 = $52,000/80 production runs X 16 production runs; etc.b$32,000 = $128,000/1,600 X 400; etc.c$46,500 = $186,000/800 X 200; etc.d$16,800 = $84,000/50,000 X 10,000; etc.e$4,800 = $72,000/15,000 X 1,000; etc.

c. The activity-based costing method provides a more detailed breakdown of costs. This additional information should enable management to make better decisions. For example, if management wants to reduce costs then activity-based costing will identify the activities on which management should focus its cost reducing efforts. For example, warehousing costs are high and particularly high for the Raider in view of its sales volume.

d. Some costs may have no relationship to any volume or activity base. To artificially allocate these costs would distort the accounting information used for pricing, evaluation, etc. A preferable method of handling these costs might be to require a “contribution margin” from each product that must cover a portion of unallocated costs.

3-21 Solutions

3.41 (Resources used versus resources supplied.)

a. Resources: Supplied – Used = Unused($5 X 2,500)

Materials........................... $12,500 = $12,500 $ 0

($25 X 250)Short-Term Labor.............. 7,000 = $6,250...................................750

($80 X 30)Setups.............................. 2,500 = $2,400...................................100

($60 X 75)Purchasing........................ 4,600 = $4,500...................................100

($30 X 17)Customer Service............. 650 = $510 140

($40 X 120)Marketing......................... 5,500 = $4,800...................................700

($30 X 125)Administrative.................. 3,800 = $3,750.....................................50

b. Managers should know what resources are unused so they can make better decisions regarding eliminating unused resources or utilizing them for some other purpose or product, and for decisions regarding increasing production (what impact increasing production will have on costs). For instance, management might use the information to eliminate a portion of short-term labor.

Solutions 3-22

3.42 (Activity-based reporting.)

a. Flodesk, Ltd.Traditional Income Statement

for the Month Ending March 31

Sales.................................................................................. $100,000Costs:

Parts Management.................................... $ 3,500Energy...................................................... 5,000Quality Inspections................................... 5,000Long-Term Labor...................................... 3,500Short-Term Labor...................................... 2,400Setups...................................................... 10,000Materials.................................................. 15,000Depreciation............................................. 10,000Marketing................................................. 7,500Customer Service..................................... 2,000Administrative.......................................... 7,000Engineering.............................................. 2,500Contracts.................................................. 3,000

Total Costs.......................................................................... 76,400 Operating Profits................................................................. $ 23,600

b. Flodesk, Ltd.Activity-Based Income Statementfor the Month Ending March 31

Sales.................................................................................. $100,000Resources Unused Resources

Used Capacity SuppliedCosts:

Parts Management...... $ 3,000 $ 500 $ 3,500Energy........................ 5,000 0 5,000Quality Inspections..... 4,500 500 5,000Long-Term Labor........ 2,500 1,000 3,500Short-Term Labor........ 2,000 400 2,400Setups........................ 7,000 3,000 10,000Materials.................... 15,000 0 15,000Depreciation............... 6,000 4,000 10,000Marketing................... 7,000 500 7,500Customer Service....... 1,000 1,000 2,000Administrative............ 5,000 2,000 7,000Engineering................ 2,500 0 2,500Contracts.................... 3,000 0 3,000

Total Costs.................... $ 63,500 $ 12,900 $ 76,400 Operating Profits................................................................. $ 23,600

3-23 Solutions

3.42 continued.

c. Activity-based reports differentiate between resources used and those supplied. Providing information on unused resources helps managers make better decisions to lower costs or use resources more efficiently.

Solutions 3-24

3.43 (Activity-based reporting.)

a. HALLOWAY CORPORATIONTraditional Income Statement

for the Month Ending March 31

Sales................................................................................... $350,000Costs:

Marketing................................................. $ 30,000Depreciation............................................. 40,000Outside Contracts..................................... 12,000Materials.................................................. 60,000Setups...................................................... 20,000Energy...................................................... 21,000Parts Management.................................... 16,000Engineering Changes................................ 12,000Short-Term Labor...................................... 7,000Long-Term Labor...................................... 14,000Administrative.......................................... 26,000Quality Inspections................................... 22,000Customer Service..................................... 8,000

Total Costs.................................................. 288,000 Operating Profits................................................................. $ 62,000

b. HALLOWAY CORPORATIONActivity-Based Income Statementfor the Month Ending March 31

Sales.................................................................................. $ 350,000Resources Unused Resources

Used Capacity SuppliedCosts:

Marketing................. $ 28,000 $ 2,000 $ 30,000Depreciation............ 24,000 16,000 40,000Outside Contracts. . . . 12,000 0 12,000Materials.................. 60,000 0 60,000Setups...................... 14,000 6,000 20,000Energy..................... 20,000 1,000 21,000Parts Management.. . 15,000 1,000 16,000Engineering Changes 10,000 2,000 12,000Short-Term Labor..... 7,000 0 7,000Long-Term Labor...... 10,000 4,000 14,000Administrative.......... 20,000 6,000 26,000Quality Inspections... 20,000 2,000 22,000Customer Service..... 6,000 2,000 8,000

Total Costs................. $ 246,000 $ 42,000 $ 288,000 Operating Profits................................................................. $ 62,000

3-25 Solutions

3.43 continued.

c. Activity-based reports differentiate between resources used and those supplied. Providing information on unused resources helps managers make better decisions to lower costs or use resources more efficiently.

3.44 (The Grape Cola Caper.)

a. Cost driver rates are shown in the far right column below:

Estimated EstimatedOverhead Number

Cost of Costfor the Driver

Activity Cost Driver Activity Units Rate

Machine Setups........... Setup labor hrs. $ 11,200a 560 hours $20 per hour

Production Runs........... Number of runs 22,000b 110 runs $200 per runManage Products......... Number of

products 4,800c 4 products $1,200 per product

Machine Capacity........ Machine hours 14,000 d 10,000 hrs.$1.40 per hourTotal Indirect Costs................................ $ 52,000

a$11,200 = $20,000 indirect labor X 40% X 1.4 fringe benefits.b$22,000= ($20,000 indirect labor X 50% X 1.4 fringe benefits) +

($10,000 IT costs X 80%).c$4,800= ($20,000 indirect labor X 10% X 1.4 fringe benefits) +

($10,000 IT costs X 20%).d$14,000 = $52,000 total indirect costs – $11,200 – $22,000 – $4,800.

b. Unit product costs are displayed in the chart below. Calculations are shown below the chart.

Diet Regular Cherry GrapeMaterials....................... $ 0.50 $ 0.50 $ 0.52 $ 0.55Direct Labor.................. 0.20 0.20 0.20 0.20Fringe Benefits on DL.... 0.08 0.08 0.08 0.08Machine Setups............. 0.08 0.03 0.533 1.20Production Runs............ 0.16 0.15 0.667 2.00Managing Products........ 0.024 0.03 0.133 1.20Machine Capacity.......... 0 .14 0 .14 0 .14 0 .14

Cost per Unit.............. $ 1 .184 $ 1 .13 $ 2 .273 $ 5 .37

(See following page for Calculations)

Solutions 3-26

3.44 b. continued.

Calculations: Unit costs for the Diet product are calculated below.Materials: $0.50 = $25,000 (given)/50,000 unitsDirect Labor: $0.20 = $10,000 (given)/50,000 unitsFringe Benefits on DL: $0.08 = $4,000 (given)/50,000 units

Machine Setups: $0.08 = ($20 rate X 200 hours)/50,000 unitsProduction Runs: $0.16 = ($200 rate X 40 runs)/50,000 unitsManaging Production: $0.024 = $1,200 rate/50,000 unitsMachine Capacity: $0.14 = ($1.40 rate X 5,000 hours)/50,000

units

c. Monthly Report on Cola Bottling Line

Diet Regular Cherry Grape TotalSales........................ $ 75,000 $60,000 $13,950 $ 1,650 $150,600Less:

Materials............... 25,000 20,000 4,680 550 50,230Direct Labor........... 10,000 8,000 1,800 200 20,000Fringe Benefits

on DL................. 4,000 3,200 720 80 8,000Machine Setups..... 4,000 1,200 4,800 1,200 11,200Production Runs..... 8,000 6,000 6,000 2,000 22,000Managing

Production......... 1,200 1,200 1,200 1,200 4,800Machine Capacity. . 7,000 5,600 1,260 140 14,000

Gross Margin.... . $ 15,800 $ 14,800 $ (6,510 ) $ (3,720 ) $ 20,370 Return on Sales........ 21.07% 24.67% (46.67%) (225.45%)

13.53%Volume.................... 50,000 40,000 9,000 1,000 100,000Unit Price................. $1.50 $1.50 $1.55 $1.65 $1.506Unit Cost.................. $1.184 $1.13 $2.273 $5.37 $1.302

Calculations: Total costs for the Diet product are calculated below.Materials: $25,000 (given)Direct Labor: $10,000 (given)Fringe Benefits

on DL: $4,000 (given)Machine Setups: $4,000 = $20 rate X 200 hoursProduction Runs: $8,000 = $200 rate X 40 runsManaging Production:$1,200 rate X 1 productMachine Capacity: $7,000 = $1.40 rate X 5,000 hours.

3-27 Solutions

3.44 continued.

d. Answers will vary, but should address a comparison of unit profit and cost data using the traditional approach versus activity-based costing. The data below summarize some important differences between the two approaches. These data show that the Diet and Regular products are significantly more profitable than originally thought, and the Cherry and Grape products are significantly less profitable than originally thought. As sales increase for the Cherry and Grape products, the company will see declining profits.

Diet Regular Cherry Grape ABC Trad’l. ABC Trad’l. ABC Trad’l. ABC Trad’l.

Unit Price $ 1.50 $ 1.50 $1.50 $1.50 $1.55 $1.55 $1.65 $1.65Unit Cost 1.18 1 .30 1 .13 1 .30 2 .27 1 .32 5 .37 1 .35 Unit Profit $ 0.32 $ 0 .20 $0 .37 $0 .20 ($0 .72) $0 .23 ($3 .72) $0 .30 Return on Sales 21.1% 13.3% 24 .7% 13 .3% (46 .5%) 14 .8% (225 %) 18 .2%

3.45 (The Grape Cola Caper; unused capacity.)

a. Cost driver rates are shown in the far right column below. Note that the rate for Machine capacity decreases to $0.70 if practical capacity is 20,000 hours instead of 10,000 hours (new information is in boldface type).

Estimated EstimatedOverhead Number

Cost of Costfor the Driver

Activity Cost Driver Activity Units RateMachine Setups........ Setup labor hrs. $ 11,200 560 hours $20 per hourProduction Runs........ Number of runs 22,000 110 runs $200 per runManage Products...... Number of

products 2,000 4 products $1,200 per productMachine Capacity..... Machine hours 14,000 20,000 hrs. $0.70 per hour

Unit product costs are displayed in the chart below. Calculations are the same as for Part b. of Case 3.44 except for machine capacity.

Diet Regular Cherry GrapeMaterials....................... $ 0.50 $ 0.50 $ 0.52 $ 0.55Direct Labor.................. 0.20 0.20 0.20 0.20Fringe Benefits on DL.... 0.08 0.08 0.08 0.08Machine Setups............. 0.08 0.03 0.533 1.20Production Runs............ 0.16 0.15 0.667 2.00Managing Products........ 0.024 0.03 0.133 1.20Machine Capacity.......... 0 .07 0 .07 0 .07 0 .07

Cost per Unit.............. $ 1 .114 $ 1 .06 $ 2 .203 $ 5 .30

Solutions 3-28

3.45 continued.

b. The cost of unused capacity is $7,000 (= 10,000 machine hours of unused capacity X $0.70 per hour rate). Recommendations could include increasing production of current products if demand allows, introducing new product lines, or leasing the unused capacity to other divisions or outside firms.

c. Costs for the Vanilla product are as follows:

Cost TotalPer Unit Cost

Materials.................................................. $ 0.50 $ 50,000Direct Labor.............................................. 0.20 20,000Fringe Benefits on DL................................ 0.08 8,000Machine Setups........................................ 0.08 8,000Production Runs........................................ 0.16 16,000Managing Production................................ 0.024 2,400Machine Capacity..................................... 0 .07 7,000

Total Cost per Unit................................. $ 1 .114 $ 111,400

Note that the answer above assumes that the Vanilla product is assigned all machine capacity costs. However, if this is a short run decision, machine capacity costs should be excluded from the unit costs. (That is, the machine capacity costs will be incurred in the short run regardless of whether a new product is introduced.)

3.46 (Chocolate Bars, Inc.; distortions caused by inappropriate overhead allocation bases.)

a. Almond Krispy CreamyDream Krackle Crunch

Product Costs:Labor Hours per Unit........... 7 3 1Total Units Produced........... 1,000 1,000 1,000Material Cost per Unit.......... $ 8.00 $ 2.00 $ 9.00Direct Labor Cost per

Unit................................. $42.00 $18.00 $ 6.00Labor Hours per Product...... 7,000 3,000 1,000

Total overhead = $69,500.Total Labor Hours = 11,000.Direct Labor Costs per Hour = $6.00.Allocation Rate per Labor Hour = $6.32 per Labor Hour.

3-29 Solutions

3.46 a. continued.

Costs of Products:Material Cost per Unit.......... $ 8.00 $ 2.00 $ 9.00Direct Labor Cost per

Unit................................. 42.00 18.00 6.00Allocated Overhead per

Unit................................. 44 .24 18 .96 6 .32 Product Cost........................ $ 94 .24 $ 38 .96 $ 21 .32

Selling Price........................... $ 85.00 $55.00 $35.00Gross Profit Margin................ –10.87% 29.16% 39.09%Drop Product......................... Yes No No

From the table above, we can see that the overhead allocation system used by CBI would lead them to drop Almond Dream and keep the remaining two bars, Krispy Krackle and Creamy Crunch.

b. Almond Dream has a much higher proportion of direct labor hours than Krispy Krackle or Creamy Crunch, so Almond Dream is allocated a greater share of the overhead costs.

c. Krispy CreamyKrackle Crunch

Direct Labor Cost per Hour............................ $ 6.00 $ 6.00Direct Labor Hours per Unit........................... 3 1Total Units Produced...................................... 1,000 2,000Labor Hours per Product................................ 3,000 2,000Total Labor Hours: 5,000

Allocation Rate per Labor Hour = Total Overhead/Total Labor Hours= $69,500/5,000= $13.90 per Labor Hour

Krispy CreamyKrackle Crunch

Allocated Production Costs:Material Cost per Unit................................ $ 2.00 $ 9.00Direct Labor Cost per Unit.......................... 18.00 6.00Allocated Overhead per Unit ($13.90 per

Labor Hour)............................................ 41.70 13.90 Product Cost.............................................. $ 61.70 $ 28.90

Solutions 3-30

3.46 c. continued.

Gross Profit Margins:Selling Price............................................... $ 55.00 $ 35.00Product Cost—Direct Labor Allocation

Base....................................................... –61.70 –28.90 $ (6.70 ) $ 6.10

Profit Margin Percentage............................ ($6.70)/$55 $6.10/$35= (12.2)% = 17.4%

The recommendation to management is to drop Krispy Krackle and increase production of Creamy Crunch.

d. CreamyCrunch

Direct Labor Cost per Hour.............................................. $ 6.00Direct Labor Hours per Unit............................................. 1Total Units Produced....................................................... 3,000Labor Hours per Product.................................................. 3,000Total Labor Hours: 3,000

Allocation Rate per Labor Hour = Total Overhead/Total Labor Hours= $69,500/3,000= $23.17 per Labor Hour

CreamyCrunch

Allocated Production Costs:Material Cost per Unit........................................... $ 9.00Direct Labor Cost per Unit..................................... 6.00Allocated Overhead per Unit ($13.90 per

Labor Hour)....................................................... 23.17 Product Cost......................................................... $ 38.17

Gross Profit Margins:Selling Price.......................................................... $ 35.00Product Cost—Direct Labor Allocation

Base.................................................................. –38.17 $ (3 .17)

Profit Margin Percentage....................................... ($3.17)/$35.00= (9.1)%

The recommendation to management is to drop Creamy Crunch and sell out!

3-31 Solutions

3.46 continued.

e. The policies and allocation method employed by CBI encourage poor decision making. The direct labor hours are inappropriate as an allocation base and give misleading information. The allocation method and policy to drop products with gross profit margins less than 10 percent could lead to the systematic elimination of all products. CBI is a profitable firm, in total, and misallocation of overhead can lead management to make unprofitable decisions.

3.47 (Chocolate Bars, Inc.; multiple allocation bases.)

a. Almond Krispy CreamyDream Krackle Crunch Total

Total Direct

Labor Hoursa....... 7,000 (63.6%) 3,000 (27.3%) 1,000 (9.1%) 11,000 (100%)Total Machine

Hoursa................. 2,000 (13.3%) 7,000 (46.7%) 6,000(40.0%) 15,000 (100%)Factory Space

(Sq. Ft.)................ 1,000 (10.0%) 4,000 (40.0%) 5,000(50.0%) 10,000 (100%)

aTotals equal hours per unit times 1,000 units.

Total Rent for Factory Space: $15,000 per MonthTotal Machine Operating Costs: $30,000 per MonthTotal Other Overhead: $24,500 per Month (= $69,500 –

$15,000 – $30,000)Total Units Produced/Month: 3,000 Units

Product Allocation Base:Machine Factory

Fraction: Labor (%) Hours (%) Space (%)Almond Dream................. 63.6 13.3 10Krispy Krackle.................. 27.3 46.7 40Creamy Crunch................ 9.1 40.0 50

PerAllocated Costs: Total Unit

Almond Dream (63.6% X $24,500) + (13.3% X $30,000) + (10% X $15,000). . = $21,072 $21.07

Krispy Krackle (27.3% X $24,500) + (46.7% X $30,000) + (40% X $15,000). . = 26,699 $26.70

Creamy Crunch (9.1% X $24,500) + (40% X $30,000) + (50% X $15,000)..... = 21,730 $21.73

Solutions 3-32

3.47 a. continued.

Almond Krispy CreamyDream Krackle Crunch

Allocated Production Costs:Material Cost............................ $ 8.00 $ 2.00 $ 9.00Direct Labor............................. 42.00 18.00 6.00Allocated Overhead.................. 21.07 26.70 21.73 Production Cost per Unit........... $ 71.07 $ 46.70 $ 36.73 Selling Price............................. $ 85.00 $ 55.00 $ 35.00Product Cost............................. –71.07 –46.70 –36.73 Gross Profit (Loss).................... $ 13.93 $ 8.30 $ (1.73 )Profit Margin Ratio.................... 16.4% 15.1% (4.9)%

b. Based upon the table above and the gross profit margin rule, management would recommend dropping Creamy Crunch. Two characteristics of Creamy Crunch appear to make it appear relatively unprofitable: one, the selling price is comparatively low as compared to the other two products; two, Creamy Crunch uses 50% of the factory space and thus is allocated half of the rent costs.

c. Almond KrispyDream Krackle

Direct Labor Hours per Unit.......... 7 3Machine Hours per Unit................ 2 7

Factory Space (Sq. Ft.)a............... 2,000 (33.3%) 4,000 (66.7%)Units of Output per Month............ 2,000 1,000Labor Hours Required................... 14,000 (82.4%) 3,000 (17.6%)Machine Hours Required.............. 4,000 (36.4%) 7,000 (63.6%)

aThis product mix leaves 4,000 square feet of space available.

Total Rent for Factory Space: $15,000 per MonthTotal Machine Operating Costs: $30,000 per MonthTotal Other Overhead: $24,500 per MonthTotal Labor Hours: 17,000 per MonthTotal Units Produced: 3,000 Units per MonthTotal Machine Hours: 11,000 Hours

Product Allocation Base:Machine Factory

Fraction: Labor (%) Hours (%) Space (%)Almond Dream................. 82.4 36.4 33.3 (Rounded)Krispy Krackle.................. 17.6 63.6 66.7 (Rounded)

3-33 Solutions

3.47 c. continued.

PerAllocated Costs: Total Unit

Almond Dream (82.4% X $24,500) + (36.4% X $30,000) + (33.3% X $15,000) .... = $ 36,103

$ 18.05Krispy Krackle (17.6% X $24,500) +

(63.6% X $30,000) + (66.7% X $15,000) .... = $ 33,397$ 33.39

Almond KrispyDream Krackle

Allocated Production Costs:Material Cost............................................ $ 8.00 $ 2.00Direct Labor.............................................. 42.00 18.00Allocated Overhead.................................. 18.05 33.39 Production Cost per Unit........................... $ 68.05 $ 53.39 Selling Price.............................................. $ 85.00 $ 55.00Product Cost............................................. –68.05 –53.39 Gross Profit............................................... $ 16.95 $ 1.61 Profit Margin Ratio:

Ratio = Gross Profit/Price...................... 19.9% 2.9%

Based on the gross profit margins of Almond Dream and Krispy Krackle, management should drop Krispy Krackle and continue to produce Almond Dream. Almond Dream appears to be the most profitable product. In fact, its margin ratio is only 13.9%, computed as follows:

Units Produced = 3,000.Overhead Allocation = $69,500/3,000 = $23.17.

AlmondDream

Allocated Production Costs:Material Cost............................................ $ 8.00Direct Labor.............................................. 42.00Allocated Overhead.................................. 23.17 Production Cost per Unit........................... $ 73.17 Selling Price.............................................. $ 85.00Product Cost............................................. –73.17 Gross Profit............................................... $ 11.83 Profit Margin Ratio:

Ratio = Gross Profit/Price...................... 13.9%

If we compute the gross profit for the three products at maximum production, we find Almond Dream and Krispy Krackle to be equally profitable, computed as follows:

Solutions 3-34

3.47 c. continued.

Almond Krispy CreamyDream Krackle Crunch

Units................................... 3,000 3,000 3,000 Costs:

Materials........................... $ 24,000 $ 6,000 $ 27,000Labor................................ 126,000 54,000 18,000Overhead.......................... 69,500 69,500 69,500

$ 219,500 $ 129,500 $ 114,500 Revenue.............................. $255,000 $165,000 $105,000Minus Total Costs................ 219,500 129,500 114,500 Gross Profit (Loss)............... $ 35,500 $ 35,500 $ (9,500 )

Moral: Allocated cost numbers can mislead decision makers.

3-35 Solutions

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