5.7: Chapter 4- Exercises

Questions

➢ A company’s performance measure is the number of customer complaints. Why would the company measure the number of customer complaints?

➢ A company’s performance measure is the percentage of time that machines are not working. Why would the company measure the percentage of time that the machines are not working?

➢ What is the difference between activity-based costing and activity-based management?

➢ Activity-based costing methods use four steps in computing a product’s cost. What are these steps?

➢ “Activity-based costing is great for manufacturing plants, but does not really address the needs of the service sector.” Do you agree with this statement? Explain.

➢ What is a cost driver? Give three examples.

➢ The vice president of marketing wonders how products can cost less under one cost system than under another. How would you respond to her question “Are not costs cut-and-dried?”

➢ A drawback to activity-based costing is that it requires more record-keeping and extensive teamwork between all departments. What are the potential benefits of a more detailed product cost system?

➢ Give three criteria for choosing cost drivers for allocating costs to products.

➢ “Activity-based costing is for accountants and production managers. I plan to be a marketing specialist so ABC will not help me.” Do you agree with this statement? Explain.

➢ Observe the workings of a food service or coffee house. What activities are being performed? Give examples of some cost drivers that cause the cost of those activities. (For example, cooking food is an activity; the number of meals could be a cost driver for the cooking activity.)

➢ Observe the workings of a bank, credit union, or savings and loan institution. What activities are being performed? Give examples of some cost drivers that cause the cost of those activities. (For example, opening checking accounts is an activity; the number of accounts opened could be a cost driver for the opening accounts activity.)

➢ Activity-based costing assigns costs to activities that consume resources and to the products based on each product’s use of activities. What is a benefit of this approach compared to a traditional approach that allocates costs to products based on the machine-hours used to produce the product?

Exercises

Exercise A Quality Sound Corporation produces two types of compact discs (CDs), one is to install on touring bicycles and the other is a high-grade product for home and car use. The touring bicycles’ CDs are designed for durability rather than accurate sound reproduction. The company only recently began producing the high-grade disc. Management believes the accounting system may not be accurately allocating costs to products.

Management asked you to investigate the cost allocation problem. You found that manufacturing overhead is currently assigned based on the direct labor costs in the products. For your investigation, you are using data from last year. Last year’s manufacturing overhead was $440,000 based on production of 320,000 touring bicycle CDs and 100,000 high-grade CDs. Direct labor and direct materials costs were as follows:

	Touring bicycle	High grade	Total
Direct labor	$180,000	$60,000	$240,000
Materials	120,000	112,000	232,000

Management believes three activities cause overhead costs. The cost drivers and related costs for your analysis are as follows:

		Activity	Level
Cost drivers	Cost assigned	Touring bicycle	High grade	Total
Number of production runs	$200,000	40	10	50
Quality tests performed	180,000	12	18	30
Shipping orders processed	60,000	100	50	150
Total overhead	$440,000

1. How much of the overhead would be assigned to each product if the three cost drivers are used to allocate overhead? What would be the cost per unit (including materials, labor, and overhead) for each product if overhead is assigned to products using the three cost drivers?
2. How much of the overhead would be assigned to each product if direct labor costs had been used as the basis for allocating overhead to each product? What would be the cost per unit (including materials, labor, and overhead) for each product if overhead is allocated to products using direct labor cost as the allocation base?

Exercise E Landscape, Inc., is a lawn and garden service. The company originally specialized in serving small residential clients; recently it has started contracting for work on larger office building grounds.

Employees worked a total of 10,000 hours last year, 6,500 on residential jobs and 3,500 on commercial jobs. Wages amounted to $10 per hour for all work done. Materials used are included in overhead and called supplies. All overhead is allocated on the basis of labor-hours worked, which is also the basis for customer charges. Landscape, Inc., can charge $30 per hour for residential work but, because of greater competition for commercial accounts, only $20 per hour for commercial work.

1. Using labor-hours as the basis for allocating overhead, what was the gross margin (revenues minus labor and overhead expense) for (1) commercial and (2) residential service? Assume overhead was $50,000.
2. Overhead consists of transportation, lawn mowing and landscaping equipment costs, depreciation on equipment, supplies, fuels, and maintenance. These costs can be traced to the following activities:

			Activity	Level
Activity	Cost driver	Cost	Commercial	Residential
Transportation	Clients served	$10,000	15	45
Equipment costs:
Fuel, maintenance, depreciation	Equipment hours	25,000	3,000	2,000
Supplies	Square yards serviced per year	15,000	100,000	50,000
Total overhead		$50,000

Recalculate gross margin for commercial and residential services based on these cost driver bases.

1. Would you advise Landscape, Inc., to drop either the residential or commercial service based on your analysis? Explain.

Problems

Problem A C & W Corporation manufactures travel clocks and watches. Overhead costs are currently allocated using direct labor-hours, but the controller has recommended using an activity-based costing system based on the following data:

			Activity	Level
Activity	Cost driver	Cost	Travel clocks	Watches
Production setup	Setups	$100,000	20	30
Material handling and requisition	Parts	30,000	24	36
Packaging and shipping	Units shipped	60,000	80,000	120,000
Total overhead		$190,000

1. Compute the amount of total overhead allocated to each of the products under activity-based costing.
2. Compute the amount of total overhead allocated to each product using labor-hours as the allocation base. Assume labor-hours required to assemble each unit are .5 per travel clock and 1.0 per watch, and that 80,000 travel clocks and 120,000 watches were produced.
3. Should the company follow the controller’s recommendations?

Problem B Sunshield Company makes three types of sunglasses: Nerds, Stars, and Fashions. Sunshield presently allocates overhead to products using a rate based on direct labor-hours. A consultant recommended that Sunshield switch to activity-based costing. Management decided to give ABC a try and identified the following activities, cost drivers, and costs for a typical year for each activity center. Use this information to compute the overhead rates for each cost driver.

Activity	Recommended cost driver	Costs	Cost driver units
Production setup	Production runs	$ 30,000	100
Order processing	Orders	50,000	200
Materials handling	Pounds of materials used	20,000	8,000
Equipment depreciation and maintenance	Machine-hours	60,000	10,000
Quality management	Inspections	50,000	40
Packing and shipping	Units shipped	40,000	20,000
Total overhead		$250,000

In addition, there are 2,500 direct labor-hours in a typical year.

Assume the following activities occurred in February of 2011:

	Nerds	Stars	Fashions
Units produced	1,000	500	400
Direct materials costs	$4,000	$2,500	$2,000
Direct labor-hours	100	100	89
Orders	8	8	4
Production runs	2	4	8
Pounds of material	400	200	200
Machine-hours	500	300	300
Inspections	2	2	2
Units shipped	1,000	500	300

Direct labor costs are $15 per hour.

1. Compute an overhead allocation rate (1) for each of the cost drivers recommended by the consultant and (2) for direct labor.
2. Management wants to compare the product costs using ABC and the traditional method for the month of February. Compute the production costs for each product for February using direct labor-hours as the allocation base. (Note: Production costs are direct materials, direct labor, and overhead.)
3. To derive product costs under ABC, compute the production costs for each product for February using the cost drivers recommended by the consultant.
4. Management has seen your numbers and wants to know how you account for the discrepancy between the product costs using direct labor-hours as the allocation base and using activity-based costing. Write a brief response to management.

Problem C Filmworks Photography offers two types of services, student portraits and family portraits. Last year, Filmworks had the following costs and revenues:

	FilmworksPhotography
	Income statement
	Deluxe	Family	Total
Revenue	$180,000	$200,000	$380,000
Direct materials	25,000	25,000	50,000
Direct labor	90,000	60,000	150,000
Indirect costs:
Administration	——-	———-	25,000
Production setup	——-	———-	50,000
Quality control	——-	———-	25,000
Marketing	——-	———-	20,000
Operating profit			$60,000

Filmworks Photography currently uses labor costs to allocate all overhead, but management is considering implementing an activity-based costing system. After interviewing the sales and production staff, management decides to allocate administrative costs on the basis of direct labor costs and to use the following bases to allocate the remaining overhead:

		Cost driver	Units
Activity	Cost driver	Student	Family
Production setup	Photo sessions	150	250
Quality control	Customer inspections	300	200
Marketing	Advertisements	60	40

1. Complete the income statement using these activity bases.
2. Write a report describing how management might use activity-based costing to reduce costs.
3. Restate the income statement for Filmworks Photography using direct labor costs as the only overhead allocation base.
4. Write a report to management stating why product line profits differ using activity-based costing compared to the traditional approach. Indicate whether the activity-based costing method provides more accurate information and why (if you believe it does provide more accurate information). Indicate in your report how the use of labor-based overhead allocation could result in Filmworks Photography management making suboptimal decisions.

Alternate problems

Alternate problem A The manager of Rafting Excursions uses activity-based costing to compute the costs of her raft trips. Each raft holds six paying customers and a guide. She offers two types of raft trips, a three-day float trip for beginners, and a three-day white-water trip for seasoned rafters. The breakdown of costs is as follows:

Activities (with cost drivers)	Costs per float trip	Costs per white-water trip
Advertising (trips)	$430	$430
Permit to use the river (trips)	60	100
Equipment use (trips, people)	40 + 10 per person	80 + $16 per person
Insurance (trips)	150	300
Paying guide (trips, guides)	600 per guide	800 per guide
Food (people)	120 per person	120 per person

1. Compute the cost of a 28-person (including guides) float trip with four rafts and four guides.
2. Compute the cost of a 28-person (including guides) white-water trip with four rafts and four guides.
3. How much should the manager charge each customer if she wants to cover her costs?

Alternate problem B Shoe Express, Inc., manufactures two types of shoes, B-Ball and Marathon. The B-Ball shoe has a complex design that uses gel-filled compartments to provide support. The Marathon shoe is simpler to manufacture and uses conventional foam padding. Last year, Shoe Express had the following revenues and costs:

	Shoe Express, Inc.
	Income Statement
	B-Ball	Marathon	Total
Revenue	$390,000	$368,000	$758,000
Direct materials	110,000	100,000	210,000
Direct labor	80,000	40,000	120,000
Indirect costs:
Administration	——–	———	40,000
Production setup	———	———	90,000
	———	———
Quality control	———	———	60,000
Advertising	———-	———	120,000
Net income before taxes			$118,000

Shoe Express currently uses labor costs to allocate all overhead, but management is considering implementing an activity-based costing system. After interviewing the sales and production staff, management decides to allocate administrative costs on the basis of direct labor costs, but to use the following bases to allocate the remaining overhead:

		Activity	Level
Activity	Cost drivers	B-ball	Marathon
Production setup	Production runs	20	20
Quality control	Inspections	40	20
Advertising	Advertisements	12	48

1. Complete the income statement using these activity bases.
2. Write a brief report indicating how management could use activity-based costing to reduce costs.
3. Restate the income statement for Shoe Express, Inc., using direct labor costs as the only overhead allocation base.
4. Write a report to management stating why product line profits differ using activity-based costing compared to the traditional approach. Indicate whether the activity-based costing method provides more accurate information and why (if you believe it does provide more accurate information). Indicate in your report how the use of labor-based overhead allocation could result in Shoe Express management making suboptimal decisions.

Beyond the numbers—Critical thinking

Business decision case A Many companies recognize that their cost systems are inadequate for today’s global market. Managers in companies selling multiple products are making important product decisions based on distorted cost information.

Write a short paper describing the benefits management should expect from implementing activity-based costing.

Business decision case B A company that makes Halloween costumes is considering using just-in-time purchasing and production methods. Write a short paper describing the problems this company might face in using just-in-time.

Business decision case C Managers at Texas Instruments developed these four cost-of-quality categories: prevention costs, appraisal costs, internal failure costs, and external failure costs. Give an example of a cost for each of these four categories. Would minimizing the sum of these four costs assure high-quality products? Why or why not? Write a short paper summarizing your analysis.

Group project D The chapter listed the following six important points to remember about activity-based costing. Following each point are the comments of a cynic in italics. After forming six groups, discuss one of these points in each group. How would you respond to the cynic’s comments? (It is okay to agree; even cynics have good points to make.) Choose one group member to report your group’s response to the class.

• The allocation of indirect costs is at least somewhat arbitrary, even using sophisticated accounting methods. (“This means no method gives you a true cost; all are arbitrary. So why go to the trouble of implementing ABC?”)
• Activity-based costing provides more detailed measures of costs than traditional allocation methods. (“Who needs more detail? Life is already too complicated“.)
• Activity-based costing can help marketing people by providing more accurate product cost numbers for decisions about pricing and which unprofitable products the company should eliminate. (“Why should accountants want to help marketing people?”)
• Production also benefits because activity-based costing provides better information about the cost of each activity. In practice, ABC helps managers identify cost causing activities. To manage costs, production managers learn to manage the activities that cause costs. (“If production people know their jobs, they do not need help from accountants“.)
• Activity-based costing provides more information about product costs than traditional methods but requires more record-keeping. Managers must decide whether the benefits of improved decisions justify the additional record-keeping cost. (“ABC sounds like a lot of work. Why bother?“)
• Installing activity-based costing requires teamwork among accountants, production managers, marketing managers, and other nonaccounting people. (“You will never get these people to work together. Accountants and marketing people? You have got to be kidding!”)

Group project E Form a group of three or four students and assume you are hired as business consultants for each of the cases below. Respond to each of the comments made in case 1 and case 2. Your response should assume you are talking directly to the CEO. State whether you agree or disagree with the statement and justify your response. (Hint: Consider the potential costs and benefits associated with each case.)

Case 1 Your group is meeting with the CEO of a relatively small company that produces one model of bicycles. After lengthy discussion regarding the company’s costing system, the CEO makes the following statement: “From what I have seen at other companies lately, activity-based costing is the wave of the future. Everyone, including us, should drop existing cost systems and adopt ABC!”

Case 2 Your group is meeting with the CEO of a relatively large company that produces hundreds of expensive custom computers. After lengthy discussion regarding the company’s costing system, the CEO makes the following statement: “From what I have seen at other companies lately, activity-based costing is the wave of the future. Everyone, including us, should drop existing cost systems and adopt ABC!”

Group project F In teams of two or three, interview the manager of a retail (or wholesale) store such as a music store, an automobile parts store, or the parts department of an appliance dealership. Ask the manager how items are ordered to replace those sold. For example, does he or she order based on observing inventory levels or place an order each time a customer buys an item? Does he or she appear to use just-in-time inventory? Write a memorandum to the instructor summarizing the results of the interview. Information contained in the memo should include:

Date:

To:

From:

Subject:

Content of the memo must include the name and title of the person interviewed, name of the company, date of the interview, and the results of the interview.

Group project G In teams of two or three, observe an organization of your choice—wholesale, retail, or service. Give examples of warning and diagnostic signals the organization uses. How could it use control charts, Pareto charts, and cause-and-effect analysis?

Using the Internet—A view of the real world

The Malcolm Baldrige National Quality Award is awarded to companies meeting certain quality standards and criteria. This award is issued annually by the National Institute of Standards and Technology (NIST). Visit the following website:

http://www.baldrige.nist.gov

Click on “Criteria and their Impact”. What criteria are used as a basis for making awards to applicants? Click on “Winners Showcase”. Who were the most recent winners of the Baldrige Award? What products or services do these companies provide?

Based on the results of the previous Internet project, perform an Internet search to find at least one recent Baldrige Award winning company. Does the company provide information on the Internet about being the recipient of the award? If so, write a report summarizing this information. If not, search for a recent award winner that does provide this information, and write a report summarizing the information provided.

1. [1]“Texas Instruments: Cost of Quality (A)” (Boston: Harvard Business School, Case 9-189-029).

1. [2]Based on R. S. Kaplan and D. P. Norton, “Using the Balanced Scorecard as a Strategic Management System,” Harvard Business Review, January-February 1996.