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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 Bikes
Purchasing Materials ..................................... $ 20 Per Frame 1,000 Frames $ 20,000 200 Frames $ 4,000
Machine Setup ................................................ $ 2,000 Per Setup 7 Setups 14,000 15 Setups 30,000
Inspections ...................................................... $ 100 Per Hour 200 Hours 20,000 200 Hours 20,000
Operating 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 $ 215
Permit to Use
the River............... 30 50
Equipment Use ........ 160 [= ($5 X 28) + 20] 264 [= ($8 X 28) + 40]
Insurance ................. 75 127
Paying 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 Drivers
High
Rate Standard Grade Total
Direct Materials ................... $ 125,000a $ 114,000 $ 239,000
Direct Labor .......................... $ 160,000b $ 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 216,000 360,000
Number of Shipping
Orders ............................ 1,466.67e 146,667h 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 Base
High
Rate Standard Grade Total
Direct Materials ...................... $ 125,000a $ 114,000 $ 239,000
Direct Labor ............................. 160,000b 80,000 240,000
Total Overhead (Labor
Dollar Allocation).................. 3.66667c 586,667d 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 $ 5.80
Cost .................. 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.................................. 21,700e 40,300f 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 23,400g 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. Cell
Cost Driver Rate Phones Pagers
Production Setup ..................... $ 5,000a $ 60,000d $ 40,000
Material Handling and
Requisition ............................ $ 200b 14,000e 6,000
Packing and Shipping ............. $ 1.00 120,000f 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. Cell
Phones 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 Total
Revenue ....................... $ 80,000 $ 120,000 $ 200,000
Expenses:
Filing, Scheduling
and Data Entry ..... $ 333.33a 24,000d 16,000 40,000
Supplies .................... $ 18.00b 14,400e 21,600 36,000
Computer Costs ........ $ 12.50c 12,500f 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 Total
Revenue ....................... $ 80,000 $ 120,000 $ 200,000
Expenses ...................... $48a 38,400b 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 CORPORATION
Income Statement
Rate Dreamer Sleeper Total
Revenue ............................. $ 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 ............... $1,000 c 20,000g 70,000 90,000
Sales & Marketing .......... $1,875 d 46,875h 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 CORPORATION
Income Statement
Rate Dreamer Sleeper Total
Revenue ............................... $ 695,000 $ 280,000 $ 975,000
Direct Materials .................. 250,000 110,000 360,000
Direct 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. Report
The 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 Total
Revenue ............................... $ 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 96,000 160,000
Quality Control ................. $150c 90,000g 60,000 150,000
Sales & Marketing ............ $300d 30,000h 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 Total
Revenue ............................... $ 800,000 $ 720,000 $ 1,520,000
Direct Materials .................. 100,000 100,000 200,000
Direct Labor ......................... 360,000 240,000 600,000
Overhead Costs 0.78333a 282,000b 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. Report
The 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 Rate
Production 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 Eagles
Direct 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 1,000
Equipment Depreciation
and Maintenance .............. 4,800d 2,400 2,400
Quality Control ..................... 2,500e 2,500 2,500
Shipping ................................ 3,000f 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.
f$3,000 = $1.00 per unit X 3,000 units.
Solutions 3-18
3.39 continued
c. Difference between Product Costs
Here are the cost numbers generated by the traditional method:
Razors Slims Eagles
Direct Materials ...................... $ 8,000 $ 5,000 $ 4,000
Direct 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 Discrepancy
The 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 Total
Sales .................................. $ 760,000 $ 1,120,000 $ 950,000 $ 2,830,000
Direct Costs:
Direct Materials............. $ 300,000 $ 480,000 $ 400,000 $ 1,180,000
Direct 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 $ 943,200
Plant and Administra-
tion ................................. 176,000
Other 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 Total
Sales .................................. $ 760,000 $ 1,120,000 $ 950,000 $ 2,830,000
Direct Costs:
Direct Materials............. $ 300,000 $ 480,000 $ 400,000 $ 1,180,000
Direct Labor ................... 28,800 48,000 108,000 184,800
Variable Overhead:
Machine Setupa ............. 10,400 18,200 23,400 52,000
Order Processing b ......... 32,000 48,000 48,000 128,000
Warehousing c ................ 46,500 46,500 93,000 186,000
Depreciation 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 $ 943,200
Plant Administration ....... 176,000
Other 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 ................................................................................................ $ 100,000
Costs:
Parts Management .......................................... $ 3,500
Energy .............................................................. 5,000
Quality Inspections.......................................... 5,000
Long-Term Labor ............................................. 3,500
Short-Term Labor ............................................ 2,400
Setups .............................................................. 10,000
Materials .......................................................... 15,000
Depreciation..................................................... 10,000
Marketing ........................................................ 7,500
Customer Service ............................................. 2,000
Administrative ................................................. 7,000
Engineering ..................................................... 2,500
Contracts .......................................................... 3,000
Total Costs ...................................................................................... 76,400
Operating Profits ............................................................................ $ 23,600
b. Flodesk, Ltd.
Activity-Based Income Statement
for the Month Ending March 31
Sales ................................................................................................ $ 100,000
Resources Unused Resources
Used Capacity Supplied
Costs:
Parts Management ........ $ 3,000 $ 500 $ 3,500
Energy ............................ 5,000 0 5,000
Quality Inspections........ 4,500 500 5,000
Long-Term Labor ........... 2,500 1,000 3,500
Short-Term Labor .......... 2,000 400 2,400
Setups ............................ 7,000 3,000 10,000
Materials ........................ 15,000 0 15,000
Depreciation................... 6,000 4,000 10,000
Marketing ...................... 7,000 500 7,500
Customer Service ........... 1,000 1,000 2,000
Administrative ............... 5,000 2,000 7,000
Engineering ................... 2,500 0 2,500
Contracts ........................ 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 CORPORATION
Traditional Income Statement
for the Month Ending March 31
Sales ................................................................................................ $ 350,000
Costs:
Marketing ........................................................ $ 30,000
Depreciation..................................................... 40,000
Outside Contracts ............................................ 12,000
Materials .......................................................... 60,000
Setups .............................................................. 20,000
Energy .............................................................. 21,000
Parts Management .......................................... 16,000
Engineering Changes ...................................... 12,000
Short-Term Labor ............................................ 7,000
Long-Term Labor ............................................. 14,000
Administrative ................................................. 26,000
Quality Inspections.......................................... 22,000
Customer Service ............................................. 8,000
Total Costs .......................................................... 288,000
Operating Profits ............................................................................ $ 62,000
b. HALLOWAY CORPORATION
Activity-Based Income Statement
for the Month Ending March 31
Sales ................................................................................................ $ 350,000
Resources Unused Resources
Used Capacity Supplied
Costs:
Marketing ................... $ 28,000 $ 2,000 $ 30,000
Depreciation................ 24,000 16,000 40,000
Outside Contracts ....... 12,000 0 12,000
Materials ..................... 60,000 0 60,000
Setups ......................... 14,000 6,000 20,000
Energy ......................... 20,000 1,000 21,000
Parts Management ..... 15,000 1,000 16,000
Engineering Changes . 10,000 2,000 12,000
Short-Term Labor ....... 7,000 0 7,000
Long-Term Labor ........ 10,000 4,000 14,000
Administrative ............ 20,000 6,000 26,000
Quality Inspections..... 20,000 2,000 22,000
Customer 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 Estimated
Overhead Number
Cost of Cost
for 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 run
Manage Products ............ Number of
products 4,800c 4 products $1,200 per product
Machine Capacity ........... Machine hours 14,000d 10,000 hrs. $1.40 per hour
Total 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 Grape
Materials........................... $ 0.50 $ 0.50 $ 0.52 $ 0.55
Direct Labor ...................... 0.20 0.20 0.20 0.20
Fringe Benefits on DL ...... 0.08 0.08 0.08 0.08
Machine Setups ................ 0.08 0.03 0.533 1.20
Production Runs ............... 0.16 0.15 0.667 2.00
Managing Products........... 0.024 0.03 0.133 1.20
Machine 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 units
Direct Labor: $0.20 = $10,000 (given)/50,000 units
Fringe Benefits
on DL: $0.08 = $4,000 (given)/50,000 units
Machine Setups: $0.08 = ($20 rate X 200 hours)/50,000 units
Production Runs: $0.16 = ($200 rate X 40 runs)/50,000 units
Managing Production: $0.024 = $1,200 rate/50,000 units
Machine Capacity: $0.14 = ($1.40 rate X 5,000 hours)/50,000 units
c. Monthly Report on Cola Bottling Line
Diet Regular Cherry Grape Total
Sales............................ $ 75,000 $ 60,000 $ 13,950 $ 1,650 $ 150,600
Less:
Materials ................. 25,000 20,000 4,680 550 50,230
Direct Labor............. 10,000 8,000 1,800 200 20,000
Fringe Benefits
on DL ................... 4,000 3,200 720 80 8,000
Machine Setups ....... 4,000 1,200 4,800 1,200 11,200
Production Runs ...... 8,000 6,000 6,000 2,000 22,000
Managing
Production ........... 1,200 1,200 1,200 1,200 4,800
Machine 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 1,000 100,000
Unit Price ................... $1.50 $1.50 $1.55 $1.65 $1.506
Unit 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 hours
Production Runs: $8,000 = $200 rate X 40 runs
Managing Production: $1,200 rate X 1 product
Machine 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 $1.65
Unit 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 Estimated
Overhead Number
Cost of Cost
for the Driver
Activity Cost Driver Activity Units Rate
Machine Setups............ Setup labor hrs. $ 11,200 560 hours $20 per hour
Production Runs .......... Number of runs 22,000 110 runs $200 per run
Manage Products ......... Number of
products 2,000 4 products $1,200 per product
Machine 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 Grape
Materials........................... $ 0.50 $ 0.50 $ 0.52 $ 0.55
Direct Labor ...................... 0.20 0.20 0.20 0.20
Fringe Benefits on DL ...... 0.08 0.08 0.08 0.08
Machine Setups ................ 0.08 0.03 0.533 1.20
Production Runs ............... 0.16 0.15 0.667 2.00
Managing Products........... 0.024 0.03 0.133 1.20
Machine 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 Total
Per Unit Cost
Materials........................................................... $ 0.50 $ 50,000
Direct Labor ...................................................... 0.20 20,000
Fringe Benefits on DL ...................................... 0.08 8,000
Machine Setups ................................................ 0.08 8,000
Production Runs ............................................... 0.16 16,000
Managing Production ....................................... 0.024 2,400
Machine 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 Creamy
Dream Krackle Crunch
Product Costs:
Labor Hours per Unit .............. 7 3 1
Total Units Produced............... 1,000 1,000 1,000
Material Cost per Unit ............ $ 8.00 $ 2.00 $ 9.00
Direct Labor Cost per
Unit ...................................... $ 42.00 $ 18.00 $ 6.00
Labor 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 $ 9.00
Direct Labor Cost per
Unit ...................................... 42.00 18.00 6.00
Allocated Overhead per
Unit ...................................... 44.24 18.96 6.32
Product Cost ............................ $ 94.24 $ 38.96 $ 21.32
Selling Price ................................ $ 85.00 $ 55.00 $ 35.00
Gross 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 Creamy
Krackle Crunch
Direct Labor Cost per Hour .................................. $ 6.00 $ 6.00
Direct Labor Hours per Unit ................................. 3 1
Total Units Produced ............................................ 1,000 2,000
Labor Hours per Product....................................... 3,000 2,000
Total Labor Hours: 5,000
Allocation Rate per Labor Hour = Total Overhead/Total Labor Hours
= $69,500/5,000
= $13.90 per Labor Hour
Krispy Creamy
Krackle Crunch
Allocated Production Costs:
Material Cost per Unit ...................................... $ 2.00 $ 9.00
Direct Labor Cost per Unit................................ 18.00 6.00
Allocated 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 $ 35.00
Product 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. Creamy
Crunch
Direct Labor Cost per Hour ....................................................... $ 6.00
Direct Labor Hours per Unit ...................................................... 1
Total Units Produced ................................................................. 3,000
Labor Hours per Product............................................................ 3,000
Total Labor Hours: 3,000
Allocation Rate per Labor Hour = Total Overhead/Total Labor Hours
= $69,500/3,000
= $23.17 per Labor Hour
Creamy
Crunch
Allocated Production Costs:
Material Cost per Unit ................................................... $ 9.00
Direct Labor Cost per Unit............................................. 6.00
Allocated Overhead per Unit ($13.90 per
Labor Hour) ................................................................ 23.17
Product Cost ................................................................... $ 38.17
Gross Profit Margins:
Selling Price .................................................................... $ 35.00
Product 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 Creamy
Dream 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 Month
Total Machine Operating Costs: $30,000 per Month
Total 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 10
Krispy Krackle ..................... 27.3 46.7 40
Creamy Crunch.................... 9.1 40.0 50
Per
Allocated 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 Creamy
Dream Krackle Crunch
Allocated Production Costs:
Material Cost ................................. $ 8.00 $ 2.00 $ 9.00
Direct Labor ................................... 42.00 18.00 6.00
Allocated Overhead ....................... 21.07 26.70 21.73
Production Cost per Unit .............. $ 71.07 $ 46.70 $ 36.73
Selling Price ................................... $ 85.00 $ 55.00 $ 35.00
Product 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 Krispy
Dream Krackle
Direct Labor Hours per Unit ............. 7 3
Machine 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 1,000
Labor 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 Month
Total Machine Operating Costs: $30,000 per Month
Total Other Overhead: $24,500 per Month
Total Labor Hours: 17,000 per Month
Total Units Produced: 3,000 Units per Month
Total 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.
Per
Allocated Costs: Total Unit
Almond Dream (82.4% X $24,500) +
(36.4% X $30,000) + (33.3% X $15,000) .... .... = $ 36,103 $ 18.05
Krispy Krackle (17.6% X $24,500) +
(63.6% X $30,000) + (66.7% X $15,000) .... = $ 33,397 $ 33.39
Almond Krispy
Dream Krackle
Allocated Production Costs:
Material Cost ................................................... $ 8.00 $ 2.00
Direct Labor ..................................................... 42.00 18.00
Allocated Overhead ......................................... 18.05 33.39
Production Cost per Unit ................................ $ 68.05 $ 53.39
Selling Price ..................................................... $ 85.00 $ 55.00
Product 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.
Almond
Dream
Allocated Production Costs:
Material Cost ................................................... $ 8.00
Direct Labor ..................................................... 42.00
Allocated Overhead ......................................... 23.17
Production Cost per Unit ................................ $ 73.17
Selling Price ..................................................... $ 85.00
Product 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 Creamy
Dream Krackle Crunch
Units ........................................ 3,000 3,000 3,000
Costs:
Materials ............................... $ 24,000 $ 6,000 $ 27,000
Labor ..................................... 126,000 54,000 18,000
Overhead ............................... 69,500 69,500 69,500
$ 219,500 $ 129,500 $ 114,500
Revenue ................................... $ 255,000 $ 165,000 $ 105,000
Minus 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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Solutions 3-36
