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

Chapter 5 Activity-Based Cost Systems

QUESTIONS 5-1

Traditional volume-based cost allocation systems that use only drivers that vary directly with the volume of products produced—such as direct labor dollars, direct labor hours, or machine hours—are likely to systematically distort product costs because they break the link between the cause for the costs and the basis for assignment of the costs to the individual products. Costs may vary not only with respect to volume of production, but also, for example, with batch-related activities (e.g., changeovers, setups, and inspection of the first item of production run) and the number of products (e.g., scheduling materials receipts and improving products). Also, cost distortions tend to be greater with greater differences between relative proportions of indirect resources used by cost objects because traditional cost assignments based on volume-related measures do not accurately reflect these differences.

5-2

Volume-based traditional product costing systems that use only drivers that vary directly with the volume of products produced—such as direct labor dollars, direct labor hours, or machine hours—are most likely to distort product costs under the following two conditions: (1) Indirect and support expenses are high, especially when they exceed the cost of the allocation base itself (such as direct labor cost); and (2) Product diversity is high: the plant produces both high-volume and low-volume products, standard and custom products, and complex and simple products. The combination of these two conditions will magnify the distortions that arise because volume-based product costing systems do not accurately reflect differences in non-volumerelated resource usage across products or other cost objects. Activity-based costing systems provide more accurate costs when these two conditions hold by creating more accurate links between the causes of indirect and support costs and the bases for assignment of the costs to cost objects. For example, costs may vary not only with respect to volume of production, but

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also activities such as changeovers, setups, and inspection of the first item of production run, which are not done in proportion to the number of units produced. Moreover, some costs vary with the number of different products (e.g., scheduling materials receipts and improving products). 5-3

Yes, traditional costing systems are more likely to overcost high-volume products because all indirect and support costs are assigned to products in proportion to the number of production units (through volume-based cost drivers), and the low-volume products are likely to require higher indirect and support costs per unit. The high-volume products essentially cross-subsidize the low-volume products in the sense that indirect and support costs are assigned uniformly in proportion to volume.

5-4

Companies producing a varied and complex mix of products require many more resources to support their highly varied mix, and therefore have higher costs. Examples of the greater resources required include a much larger production support staff to schedule machine and production runs; perform changeovers and setups between production runs; inspect items at the beginning of each production run; move materials; ship and expedite orders; develop new and improve existing products; negotiate with vendors; schedule materials receipts; order, receive, and inspect incoming materials and parts; and update and maintain the much larger computer-based information system.

5-5

A significant change in resource costs triggers an update of the capacity cost rates. A significant and permanent change in operations, such as the efficiency with which an activity is performed, triggers an update of the unit time estimate. If new activities become part of operations, the time to perform the activity will be estimated and then multiplied by the appropriate capacity cost rate to determine the cost of the activity. The two sets of parameters that must be estimated in time-driven activitybased costing are 1) the capacity cost rate for each type of indirect resource; that is, the unit cost of supplying capacity for each department or process, based on practical capacity, and 2) the consumption of capacity, which is an estimate of how much of a resource’s capacity (such as time or space) is used by the activities performed to produce the various products, services, or customers.

5-6

To compute a capacity cost rate, first identify all costs incurred to supply that resource (such as a machine, an indirect production employee, the computer system, factory space, a warehouse, or a truck). Then, identify the capacity supplied by that resource. The capacity would be the hours of work provided –139–

Chapter 5: Activity-Based Cost Systems

5-7

by the machine or production employee, or the space provided by the warehouse or truck. For most resources (people, equipment, and machines), capacity is measured by the time supplied. The resource’s capacity cost rate is calculated by dividing its cost by the capacity it supplies, usually expressed as a cost per hour or cost per minute. For warehouses, production space, and trucks, the capacity cost rate would be measured by cost per square foot (or square meter) of usable space. For computer memory, the resource capacity cost rate would be the cost per megabyte or gigabyte. Managers use the information on activity costs to identify opportunities for operational improvements and reductions in operations costs, decisions about product mix and pricing, and targeted customer segments. An example of an operational change is requiring minimum order sizes to eliminate short, unprofitable production runs. Another example is changing the facility layout to reduce moves of work in progress. Product designs can be changed in order to manufacture products with fewer parts or common parts to reduce material handling support costs. Finally, as discussed in more detail in Chapter 6, if activity-based cost analysis shows that full-pallet shipments are less costly per unit than partial-pallet shipments, customers can be encouraged to receive fullpallet shipments. Of course, customers who insist on very small order sizes or partial-pallet shipments can be charged a price high enough to cover the extra costs associated with such activities.

5-8

The capacity cost driver rate should reflect the underlying efficiency of the process—for example, the cost of resources to handle each production order— and this efficiency is measured better by using the capacity of the resources supplied (practical capacity) as the denominator when calculating capacity cost driver rates. The numerator in a capacity cost driver rate calculation represents the costs of supplying resource capacity to do work. The denominator should match the numerator by representing the quantity of work the resources can perform. Unassigned costs represent the cost of unused capacity and should be used as feedback to managers on their supply and demand decisions.

5-9

Immediate financial improvement may not follow even after process improvements reduce the demand for indirect and support resources. This is because the support costs are often committed. The organization must actively manage the unused capacity by increasing the volume of business or reducing the supply of unused resources.

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5-10 Service organizations are often ideally suited for activity-based costing because virtually all of the costs for a service company are indirect and appear to be fixed. The large component of apparently fixed costs in service companies arises because, unlike manufacturing companies, service companies have virtually no material costs—the prime source of short-term variable costs. Service companies must supply virtually all of their resources in advance to provide the capacity to perform work for customers during each period. Fluctuations during the period of demand by individual products and customers for the activities performed by these resources do not influence short-term spending to supply the resources. 5-11 As mentioned in 5-10, virtually all the costs for a service company are indirect and appear to be fixed. Service companies have few or no direct materials and many of their personnel provide indirect, not direct, support to products and customers. Consequently, service companies do not have direct, traceable costs to serve as convenient allocation bases. Unlike physical products, services cannot be inventoried for future sales. Service companies must supply virtually all their resources in advance to provide the capacity to perform work for customers during each period, and demand often fluctuates. For some service industries, the increase in spending resulting from an incremental transaction or customer is essentially zero. Therefore, service companies making decisions about products and customers based on short-term variable costs might provide a full range of all products and services to customers at prices near zero, leading to little recovery of the costs of all the committed resources supplied in order to deliver services to customers. It can be difficult to identify and measure the outputs for a service organization. The variation in demand for organizational resources is much more customer-driven in service organizations than in manufacturing organizations. A service company can determine and control the efficiency of its internal activities, but customers determine the quantity of demands for these operating activities. For example, customers may vary greatly in the number of transactions and the balances in their checking accounts. Service companies must focus on customer costs and customer profitability; measuring revenues and costs at the customer level provides service companies with far more relevant and useful information than at the product level. Finally, a customer may have multiple relationships with a service company. Therefore, the cost system should provide information that supports determining profitability of the entire relationship with the customer. –141–

Chapter 5: Activity-Based Cost Systems

Customer costs and customer profitability are discussed in more detail in Chapter 6. 5-12 Individuals may feel vulnerable facing uncertainty about what the activitybased cost analysis may show, or they may feel threatened by the suggestion that their work could be improved. For example, the analysis might reveal that products or customers thought to be very profitable are actually unprofitable, or that some processes are inefficient. Individuals may be concerned that they will then be judged as poor managers, even though they were making decisions that others would agree were good decisions based on the cost system in place. 5-13 Time-driven activity-based costing has a number of advantages over traditional activity-based costing. The advantages include (1) It is easy and fast to build an accurate model even for large enterprises; (2) It exploits the detailed transactions data that are available from ERP systems; (3) It drives costs to transactions and orders with time equations that use specific characteristics of particular orders, processes, suppliers, and customers; (4) It provides visibility to capacity utilization and the cost of unused capacity; (5) It enables managers to forecast future resource demands, allowing them to budget for resource capacity on the basis of predicted order quantities and complexity; and (6) It is easy to update the model as resource costs and process efficiencies change. EXERCISES 5-14 Potter Corporation should switch to activity-based costing because its current system appears to be distorting product costs, resulting in prices of specialty products that are too low (hence increasing their market share) and prices of simple products that are too high (thus, lowering their market share). This, in turn, leads to lower overall profitability as Potter pushes products that, in reality, produce low profit margins or even lose money. 5-15 (a) The time-driven ABC model will now incorporate a capacity cost rate for computer resources, computed as $18,000 divided by the practical capacity computer hours per month. Usage of computer resources can be measured in computer time per product or production run. (b) Before the machinery energy costs were discovered, the machinery rate was computed as $15,400 divided by 308 practical capacity hours, which equals $50 per hour. The energy costs of $4,000 per month will be added to –142–

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

the $15,400 monthly machinery costs, for a new machinery resource cost of $19,400 per month, leading to a higher rate per hour. The new rate is $19,400/308 = $62.99, which can be rounded to $63 per hour for convenience. (c) If the company introduces a new flavor, the new flavor’s consumption of direct and indirect resources will need to be estimated and then multiplied by the appropriate cost or cost rate. For example, start with the quantity of direct materials and labor hours per gallon produced, and multiply these amounts by the related cost per unit of direct materials and wage rate, respectively. Next, estimate the quantity of indirect labor (for changeovers, scheduling and product maintenance) and machine time (for production runs and setups). These will then be multiplied by the associated capacity cost rates of each indirect resource and added to the direct materials and direct labor costs in order to compute the total cost of producing the new flavor. 5-16 (a) A 10% increase in indirect labor costs will increase the indirect labor capacity cost rate by 10% (from $35 to $38.50) and therefore will increase the indirect labor costs assigned to products by 10%. The revised income statement that is similar to Exhibit 5-5 will show indirect labor costs that are 10% higher than in Exhibit 5-5, with correspondingly lower product gross profits, as shown below. (Small differences may result if the calculations are performed in a spreadsheet package.)

Sales Direct materials Direct labor (including fringes) Indirect labor usage Machine usage Gross profit (loss) Gross profit (loss) as percent of sales

Vanilla Chocolate Strawberry $30,00 0 $ 24,000 $3,960 $6,000 $4,800 $720

MochaAlmond

Total

$2,800 $520

$60,760 $12,040

$8,750 $4,967 $6,700 $3,583

$7,000 $3,581 $5,000 $3,619

$1,050 $3,889 $1,660 $(3,359)

$700 $4,043 $1,640 $(4,103)

$17,500 $16,480 $15,000 $(260)

11.94%

15.08%

–84.82%

–146.54%

–0.43%

(b) With the reduction in unit time for scheduling a production from four hours per run to three hours per run, we first compute the revised indirect labor hours per month and then multiply by the new indirect labor capacity cost rate of $38.50 per hour.

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Chapter 5: Activity-Based Cost Systems

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

Schedule production runs, purchasing, etc. (hours per run) Changeovers (hours per batch) Number of employees per changeover Indirect labor hours per changeover Indirect labor time per run (batch) Number of production runs Indirect labor per run Product-sustaining (hrs per month) Indirect labor hours per month Indirect rate per hour Indirect labor cost

Vanilla

Chocolate

Strawberry

MochaAlmond

3

3

3

3

2.0

1.0

2.5

4.0

3

3

3

3

6

3

7.5

12

9

6

10.5

15

× 12 108

× 12 72

×8 84

×6 90

9

9

9

9

117 × $38.50 $4,504.50

81 × $38.50 $3,118.50

93 99 × $38.50 × $38.50 $3,580.50 $3,811.50

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

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

Sales Direct materials Direct labor (including fringes) Indirect labor usage Machine usage Gross profit (loss) Gross profit (loss) as percent of sales

Vanilla Chocolate Strawberry $30,00 0 $ 24,000 $3,960 $6,000 $4,800 $720

MochaAlmond

Total

$2,800 $520

$60,760 $12,040

$8,750 $4,505 $6,700 $4,045

$7,000 $3,119 $5,000 $4,081

$1,050 $3,581 $1,660 $(3,051)

$700 $3,812 $1,640 $(3,872)

$17,500 $15,017 $15,000 $1,203

13.48%

17.00%

–77.05%

–138.29%

1.98%

Combining direct labor and indirect labor costs, the summary income statement showing unused capacity costs is as follows: Totals with Unused Assigned Capacity Costs Costs $60,760 $12,040 $32,517 $68 $15,000 400 $1,203 $(468)

Totals with Capacity Costs $60,760 $12,040 $32,585 $15,400 $735

Sales Direct materials Direct labor and indirect labora Machine usage Gross profit (loss) Gross profit (loss) as percent of sales 1.98% 1.21% a Labor capacity cost = $4,655 × 7 employees = $32,585. Employees perform direct labor and indirect labor tasks. 5-17 (a) Hours: Pumps 1,500 5,000 200

Hours: Valves 1,800 6,000 400

Rate $20 $30 $80

Cost: Pumps $ 30,000 $150,000 $ 16,000 $196,000

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Cost: Valves $ 36,000 $180,000 $ 32,000 $248,000

Chapter 5: Activity-Based Cost Systems

(b)

The cost of unused capacity, which will be expensed on the income statement, is calculated as follows: Hours: Unused Capacity Rate 300 $20 200 $30 50 $80

Cost: Unused Capacity $ 6,000 $ 6,000 $ 4,000 $16,000

Total revenues Total direct labor cost Total direct materials cost OH applied to pumps OH applied to valves Cost of unused practical capacity SG&A expenses Net income

$890,000 $120,000 90,000 196,000 248,000

$654,000 16,000 100,000 $120,000

5-18 (a)

Ken’s previous average fixed cost per meal was $3,300 600 = $5.50. With the drop in demand, the average fixed cost is now $3,300 550 = $6. If demand decreases further and Ken continues to use the same method to determine his costs of serving a meal, the average fixed cost will continue to increase, and Ken will want to raise his prices even more. However, the rising prices may contribute to further declines in demand, leading Ken into a downward (or death) spiral.

(b)

Ken should use the practical capacity quantity of meals per day to determine cost per meal in order to avoid the fluctuations described in part (a) and to understand the cost rate at the point where the resources used equal the practical capacity usage. If resource usage is less than practical capacity, Ken should monitor the cost of unused capacity. He may be able to reduce the capacity costs or to find other profitable uses for the capacity. In this problem, one may assume the practical capacity is 600 meals per day.

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

PROBLEMS 5-19 (a)

Capacity cost rate = $500,000/10,000 hours = $50 per hour.

(b)

The activi...