Management Accounting Information For Decision Making And Strategy Execution 6th Edition By Anthony A Atkinson - Solution Manual

Management Accounting Information For Decision Making And Strategy Execution 6th Edition By Anthony A Atkinson – Solution Manual

 

Instant Download – Complete Test Bank With Answers

 

 

Sample Questions Are Posted Below

 

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-volume-related 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 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.

 

5-6    The two sets of parameters that must be estimated in time-driven activity-based 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.

 

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 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.

 

5-7    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 full-pallet 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.

 

 

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. Customer costs and customer profitability are discussed in more detail in Chapter 6.

 

5-12  Individuals may feel vulnerable facing uncertainty about what the activity-based 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 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.)

 

	Vanilla	Chocolate	Strawberry	Mocha-Almond	Total
Sales	$30,000	$ 24,000	$3,960	$2,800	$60,760
Direct materials	$6,000	$4,800	$720	$520	$12,040
Direct labor (including fringes)	$8,750	$7,000	$1,050	$700	$17,500
Indirect labor usage	$4,967	$3,581	$3,889	$4,043	$16,480
Machine usage	$6,700	$5,000	$1,660	$1,640	$15,000
Gross profit (loss)	$3,583	$3,619	$(3,359)	$(4,103)	$(260)
Gross profit (loss) as percent of sales	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.

 

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

 

	Vanilla	Chocolate	Strawberry	Mocha-Almond
Schedule production runs, purchasing, etc. (hours per run)	3	3	3	3
Changeovers (hours per batch)	2.0	1.0	2.5	4.0
Number of employees per changeover	3	3	3	3
Indirect labor hours per changeover	6	3	7.5	12
Indirect labor time per run (batch)	9	6	10.5	15
Number of production runs	× 12	× 12	× 8	× 6
Indirect labor per run	108	72	84	90
Product-sustaining (hrs per month)	9	9	9	9
Indirect labor hours per month	117	81	93	99
Indirect rate per hour	×  $38.50	×  $38.50	×  $38.50	×  $38.50
Indirect labor cost	$4,504.50	$3,118.50	$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.)

 

	Vanilla	Chocolate	Strawberry	Mocha-Almond	Total
Sales	$30,000	$ 24,000	$3,960	$2,800	$60,760
Direct materials	$6,000	$4,800	$720	$520	$12,040
Direct labor (including fringes)	$8,750	$7,000	$1,050	$700	$17,500
Indirect labor usage	$4,505	$3,119	$3,581	$3,812	$15,017
Machine usage	$6,700	$5,000	$1,660	$1,640	$15,000
Gross profit (loss)	$4,045	$4,081	$(3,051)	$(3,872)	$1,203
Gross profit (loss) as percent of sales	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 Assigned Costs	Unused Capacity Costs	Totals with Capacity Costs
Sales	$60,760		$60,760
Direct materials	$12,040		$12,040
Direct labor and indirect labora	$32,517	$68	$32,585
Machine usage	$15,000	400	$15,400
Gross profit (loss)	$1,203	$(468)	$735
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:	Hours:		Cost:	Cost:
Pumps	Valves	Rate	Pumps	Valves
1,500	1,800	$20	$  30,000	$  36,000
5,000	6,000	$30	$150,000	$180,000
200	400	$80	$  16,000	$  32,000
			$196,000	$248,000

(b)     The cost of unused capacity, which will be expensed on the income statement, is calculated as follows:

Hours:		Cost:
Unused Capacity	Rate	Unused Capacity
300	$20	$  6,000
200	$30	$  6,000
50	$80	$  4,000
		$16,000

Total revenues		$890,000
Total direct labor cost	$120,000
Total direct materials cost	90,000
OH applied to pumps	196,000
OH applied to valves	248,000	$654,000
Cost of unused practical capacity		16,000
SG&A expenses		100,000
Net income		$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.

PROBLEMS

5-19  (a)     Capacity cost rate = $500,000/10,000 hours = $50 per hour.

(b)     The activity-based cost associated with Division 1’s customers is

(0.5 × 1,000 + 1.0 × 4,000) × $50 per hour

= 4,500 hours × $50 per hour = $225,000.

(c)      The activity-based cost associated with Division 2’s customers is

(0.5 × 200 + 0.1 × 400) × $50 per hour

= 140 hours × $50 per hour = $7,000.

(d)     The change will result in (0.5 × 1,000 + 1.0 × 2,000 + 0.1 × 2,000) = 2,700 hours used, a reduction from the 4,500 hours in part (a). The new activity-based cost associated with Division 1’s customers is

2,700 hours × $50 per hour = $135,000. The lower cost assigned to Division 1 will not reduce Zeta’s costs unless Zeta also reduces the $500,000 total resource cost. This can be accomplished in the following way; with the change in the mix of more electronic and fewer manual transactions, 1,800 fewer hours of accounts receivable time is required. Since the capacity of each employee is about 1,667 hours per year (10,000 ÷ 6), Zeta can operate with one fewer employee, saving the full cost of one employee, probably at least $60,000 per year.

5-20  (a)     The practical capacity per month for each packaging and shipping employee is (8 − 1.25 hours) per day × 20 days per month = 135 hours per month. The capacity cost rate = $4,050/135 hours = $30 per hour.

(b)     Order 705, which consists of 40 items, requires packaging preparation time of 0.25 hours plus 40 × 0.1 hours to bubble wrap and pack the 40 items in the carton, for a total of 4.25 hours The cost assigned to Order 705 is therefore 4.25 × $30 per hour =$127.50.

 

 

5-21  (a)     With the stated change, Madison Dairy will require 8 full-time production employees and 3 machines, as shown below.

 

Labor	Vanilla	Chocolate	Straw- berry	Mocha-Almond	Total
Number of production runs	18	16	4	3
Handle production run (hours/run)	2.5	2.5	2.5	2.5
Indirect labor: handle runs	45.0	40.0	10.0	7.5	102.5
Setup time per run (hours)	2.0	1.0	2.0	3.2
Number of employees per changeover	2	2	2	2
Indirect labor hours per run	4.0	2.0	4.0	6.4
Indirect labor: total setup hours	72.0	32.0	16.0	19.2	139.2
Indirect labor: maintain products	8.0	8.0	8.0	8.0	32.0
Total indirect labor hours	125.0	80.0	34.0	34.7	273.7
Volume (gallons)	15,500	13,000	1,600	1,200	31,300
Direct labor hours per gallon	0.025	0.025	0.025	0.025
Total direct labor hours	387.5	325.0	40.0	30.0	782.5
Total labor hours	512.5	405.0	74.0	64.7	1,056.2
Productive hours per employee per month					133.0
Number of employees needed					7.9
Number of full-time employees					8.0

Machines	Vanilla	Chocolate	Straw- Berry	Mocha-Almond	Total
Production volume	15,500	13,000	1,600	1,200
Machine hours per 1000 gallons	11	11	11	11
Total machine run time (hours)	170.5	143.0	17.6	13.2	344.3
Number of production runs	18	16	4	3
Setup time per run (hours)	2.0	1.0	2.0	3.2
Machine setup time (hours)	36.0	16.0	8.0	9.6	69.6
Total machine hours	206.5	159.0	25.6	22.8	413.9
Productive hours per month					154.0
Number of machines needed (rounded up)					3.0

(b)     Pro forma monthly product line income statement (total dollar amounts are rounded):

 

	Vanilla	Chocolate	Straw-berry	Mocha-Almond	Total
Selling price	$ 2.90	$ 2.90	$  3.40	$ 4.00	$ 2.97
Sales volume	15,500	13,000	1,600	1,200	31,300
Revenues	$44,950	$ 37,700	$ 5,440	$ 4,800	$ 92,890
Direct materials	9,300	7,800	960	780	18,840
Direct labor (including fringes)	13,563	11,375	1,400	1,050	27,388
Indirect labor	4,375	2,800	1,190	1,215	9,580
Machinery	10,325	7,950	1,280	1,140	20,695
Gross profit	$7,387	$ 7,775	$610	$ 615	$16,387
Gross profit (% of sales)	16.4%	20.6%	11.2%	12.8%	17.6%

(c)      The cost of the 8 production employees is 8 × $4,655 = $37,240 and the unused labor capacity cost is therefore $37,240 − $27,388 − $9,580 = $272. The cost of the 3 machines is 3 × $7,700 = $23,100 and the unused machine capacity cost is $23,100 − $20,695 = $2,405. After incorporating the unused capacity cost, the pro forma monthly gross profit is $16,387 − $272 − $2,405 = $13,710 and gross profit as a percent of sales is $13,710/$92,890 = 14.8%.

5-22  Activity-based costing provides a means to accurately trace costs to operational processes, and these costs can be used as one of the operations management measures in the process perspective of a Balanced Scorecard. Activity-based costing can also provide a means to measure customer profitability or percent of profitable customers, which many companies include in the customer or financial perspective of their Balanced Scorecards (this application will be discussed in Chapter 6).

 

5-23  The choice really depends on what short-term problems the company faces. If it is experiencing large, rising, and difficulty-to-control indirect and support costs, as well as a proliferation of products and customers, then an activity-based costing system will supply valuable information to management decisions on process improvements, product mix, pricing, and managing customer relationships. This is because activity-based costing requires understanding processes and their underlying activities, as well as what drives support costs. The development of the activity-based costing model, as well as the model itself, will help the organization identify costly and inefficient processes. Additional potential benefits include identifying costly customers or understanding how costly complex products are. The company can improve inefficient processes, encourage costly customers to interact at a lower cost to the company, revise product pricing, and find new revenue-generating uses of freed-up capacity or attempt to reduce capacity costs.

 

If, however, the biggest issue the company faces is moving to a new strategy, particularly one focused on customers and a new value proposition, then implementing the Balanced Scorecard will be highly beneficial in communicating the new strategy and providing a systematic mechanism for monitoring and improving the new strategy. The Balanced Scorecard process can greatly facilitate and speed the major change that is desired, lead to team building and commitment to the new strategy among the executive team, translate the strategy to operational terms, and lead to communication of the strategy throughout the organization.

 

Of course, both approaches are highly compatible with each other.

 

5-24  (a)     Each server is available for (22 days) × (24 hours per day) = 528 hours per month. The average cost per hour is therefore $3,696/528 hours = $7 per hour. Non-peak-hour usage accounts for (20 servers) × (16 hours per day) = 320 hours per day. Peak-hour usage accounts for (80 servers) × (8 hours per day) = 640 hours per day. Moreover, the 60-server excess capacity during non-peak hours exists because of the peak-hour need. Therefore the cost of the excess capacity of 60 × 16 hours = 960 hours should be charged to peak-hour users. Thus, the peak-usage hourly rate is $7 × (640 + 960)/640 = $11,200/640 = $17.50 per hour.

 

(b)     As discussed in part (a), the peak-usage hours should bear the cost of the excess capacity that exists during non-peak usage. The non-peak hourly rate is then the average cost of $7 per hour.

 

5-25    (a)	Activity	Percent	Assigned Cost*	Cost Driver Quantity	Activity Cost Driver Rate**
	Handle customer orders	75%	$450,000	8,000	$56.25 per customer order
	Process customer complaints	10%	$60,000	400	$150.00 per customer complaint
	Perform customer credit checks	15%	$90,000	450	$200.00 per credit check
		100%	$600,000

 

*   $600,000 times the given percentage.

** Assigned Cost divided by Cost Driver Quantity.

 

          (b)     Capacity cost rate = $600,000/10,000 = $60 per hour.

Activity	Unit Time (Hours)	Activity Cost Driver Rate
Handle customer orders	0.75	$45	Per customer order
Process customer complaints	3.50	$210	Per customer complaint
Perform customer credit checks	3.00	$180	Per credit check

 

 

 

(c)	Activity	Unit Time (Hours)	Quantity of Activities	Total Hours	Cost Assigned
	Handle customer orders	0.75	8,000	6,000	$360,000
	Process customer complaints	3.50	400	1,400	$84,000
	Perform customer credit checks	3.00	450	1,350	$81,000
	Total			8,750	$525,000

 

Practical capacity used = 8,750 ¸ 10,000 = 87.5%

Unused capacity = 10,000 − 8,750 hours = 1,250 hours.

Unassigned cost = $600,000 − $525,000 = $75,000.

 

Managers can try to reduce the unused capacity and its associated expense. Alternatively, managers can try to generate new uses for the unused capacity by introducing new products or expanding into new markets. The cost system provides information to assist managers in deciding whether these new uses of capacity can be handled with the current capacity or require additional resources and spending.

 

(d)	Activity	Unit Time (Hours)	Quantity of Activities	Total Hours	Cost Assigned
	Handle customer orders	0.75	8,500	6,375	$382,500
	Process customer complaints	3.50	350	1,225	$73,500
	Perform customer credit checks	3.00	500	1,500	$90,000
	Total			9,100	$546,000

 

Practical capacity used = 9,100 ¸ 10,000 = 91.0%

Unused capacity = 10,000 − 9,100 hours = 900 hours.

Unassigned cost = $600,000 − $546,000 = $54,000.

 

          (e)      The costs driver rates in (a) and (b) likely differ because not all the practical capacity of the resources supplied during the period was used for productive work, as illustrated in parts (c) and (d). The ABC system in part (a) overestimated the costs of performing activities by apportioning all customer service costs to the three activities and therefore assigned not only the costs of resource capacity used, but also the cost of unused resources. Determining the unit times to complete each activity in conjunction with the time-driven ABC system in part (b) provides clearer information about the resources needed for each activity and about the unused capacity.

 

5-26  (a)     The resource units would depend on the organization’s facilities and resources. If the organization is self-contained with operating rooms, recovery rooms, and radiology and pharmacy facilities, then these resource units would be part of Riverdale’s activity-based cost system. Other likely resource units include personnel performing scheduling, admissions, and record-keeping; medical personnel, such as nurses and surgeons; equipment (such as rehabilitation equipment and examination tables); the cost of computers used in the clinic.

 

(b)     Capacity cost rates must be developed for each resource. Then, for each patient, track their routing through the clinic to identify which resources the patient uses, and how much time is spent with each resource. Finally, sum up the costs of all the resources used by the patient as he or she gets processed, treated, and, eventually, released by the hospital. This will yield the total cost associated with the complete cycle of care for this patient episode.

 

5-27  (Unofficial CMA Answer, adapted)

(a)     1.       Manufacturing support costs include all indirect production costs (all production costs except direct material and direct labor). These costs cannot be practically or economically traced to end products and, therefore, must be assigned by some allocation methods. Typical manufacturing support costs include:

 

• Indirect labor, e.g., lift-truck driver’s wages, maintenance and inspection labor, engineering labor, scheduling, purchasing and supervisors.
• Other indirect factory costs, e.g., building maintenance, machine and tool maintenance, property taxes, property insurance, pension costs, depreciation on plant and equipment, rent expense, and utility expense.

 

2. Companies develop manufacturing support cost driver rates to facilitate the costing of products as they are completed and shipped, rather than waiting until actual costs are accumulated at the end of a fiscal period.

 

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

 

(c)      Rather than using a universal plantwide rate, Moss Manufacturing could implement separate cost pools for different activities. Examples are as follows:

 

• Accumulate separate costs into departmental accounts (or other relevant pools), with one account for each production and service department. Each department would allocate its support costs to products on the basis that best reflects the use of these services.
• Individual machines (or other more relevant allocation bases) could be treated as separate cost centers with the machine costs collected and charged to the products using the machine(s).

 

(d)     An activity-based costing system might benefit Moss Manufacturing because it

 

• measures the cost of unused resource capacity and provides more accurate resource consumption and cost information as input to decisions that increase company profitability
• costs products according to the activities involved in the production process.

 

5-28  (a)     A call-related activity cost driver would better identify the linkage to call center support costs. The number of calls (a transaction driver) per product can be used because of its simplicity. The number of minutes of calls (a duration driver) provides better linkage to call center support costs, but it is more time-consuming to measure.

 

(b)		Product X	Product Y
	Previous system: Allocated support costs: 5% of sales	$20,000	$5,000
	Activity-based costs: $.70 per minute	$4,900	$21,000

 

(c)      Under the previous system, product managers can only reduce the assigned call center costs by reducing sales. Under the new system, product managers can work with other functional areas to find ways to reduce the number of calls or to reduce the length of calls. For example, product Y’s manager can work with package designers or the marketing group to develop clearer instructions for consumers. The instructions might include a company web address that provides answers to frequently asked questions (based on calls to the call center).

 

(d)     Product Y’s manager is likely to resist implementation of the activity-based cost system if the manager understands the relative usage of call center resources devoted to product Y. Call center staff may resist implementation of activity-based costing because it will involve tracking of staff activity. The staff may resent tracking the number of calls or minutes of calls, and may resent the additional monitoring because it may lead to pressure to reduce the minutes per call. The call center staff may also fear that the desire for cost or efficiency improvements will lead to staff reduction or to outsourcing the entire call center.

 

(e)      The company will need to consider the broader management issues related to job loss if the call center activities are outsourced. As an input to that decision, however, the company can benchmark its costs per minute to other call centers, or compare it to the cost of outsourcing. The company may also pursue an intermediate course of communicating the current costs per minute and benchmarked or competitive costs, and allowing the call center staff to improve efficiency and lower costs per minute.

 

5-29  (a)     Manufacturing support cost driver rate

                  

 

 

	Costs Per Unit	Product X21	Product Y37
	Direct materials cost	$120.00	$140.00
	Direct labor cost
	2 ´ $(1,000,000¸100,000)	20.00
	3 ´ $(4,500,000¸300,000)		45.00
	Manufacturing support cost
	$28.75 ´ (100,000¸50,000)	57.50
	$28.75 ´ (300,000¸100,000)		86.25
	Unit cost	$197.50	$271.25

 

	(b)			Cost	Cost	Costs Allocated to Products
		Activity	Capacity costs	Driver Quantity	Driver Rate	X21	Y37
		Handling	$3,000,000	60,000	50	50 ´ 40,000	50 ´ 20,000
		Number of parts	2,400,000	20,000	120	120 ´ 12,000	120 ´ 8,000
		Design changes	3,300,000	3,000	1,100	1,100 ´ 2,000	1,100 ´ 1,000
		Setups	2,800,000	14,000	200	200 ´ 8,000	200 ´ 6,000
		Total	$11,500,000			$7,240,000	$4,260,000

 

 

	Costs Per Unit	X21	Y37
	Direct materials cost	$120.00	$140.00
	Direct labor cost	20.00	45.00
	Manufacturing support cost
	$7,240,000 ¸ 50,000	144.80
	$4,260,000 ¸ 100,000		42.60
	Unit cost	$284.80	$227.60

 

(c)      Activity-based costing produces more accurate estimates of job costs because it takes into account the cost drivers that give rise to support costs.

 

 

(d)	Cost-based Prices	Product X21	Product Y37
	Traditional costing
	1.25 × unit costs in part (a)	$246.88	$339.06
	Activity-based costing
	1.25 × unit costs in part (b)	$356.00	$284.50

 

If Endo plans to continue to use cost-based pricing, it should use activity-based costs as the basis for its markups. Note X21’s current price is not even covering its manufacturing costs as determined using activity-based costing. Conversely, Y37 may be overpriced. Endo should consider raising X21’s price and could consider lowering Y37’s price if competitors are selling the same product for a lower price.

 

• The company sells half as many X21’s as Y37’s, but X21 has twice as many design changes and 50% more parts. These facts suggest that the company can explore ways to reduce the number of design changes and the number of parts. Management accountants would be involved in developing and communicating the cost of design changes and parts proliferation; design engineers would be directly involved in studying different designs and trying to reduce the number of parts. In addition, sales staff who communicate with customers could make greater efforts to understand customer needs and convey this information to the design engineers.

 

5-30  (a)     Total manufacturing support costs = $1,000,000

Total direct labor hours = [5,000 ´ 2 + 40,000 ´ 1] = 50,000

Manufacturing support cost rate = $20 per direct labor hour.

 

	(b)		Deluxe	Regular
		Direct material	$45	$30
		Direct labor	$20	$10
		Manufacturing support	$40	$20
		Unit cost	$105	$60

 

 

 

	(c)
		Purchase orders
		Quality control
		Production setups
		Machine maintenance

 

 

			Capacity costs Assigned to Products
			Deluxe		Regular
		Purchase orders	200 ´ $300 =	$60,000	400 ´ $300 =	$120,000
		Quality control	1,000 ´ $125 =	125,000	1,000 ´ $125 =	125,000
		Production setups	100 ´ $1,100 =	110,000	100 ´ $1,100 =	110,000
		Machine maintenance	20,000 ´ $10 =	200,000	15,000 ´$10 =	150,000
		Total manufacturing support costs		$495,000		$505,000
		Number of units		5,000		40,000
		Unit manufacturing support costs		$99		$12.625

 

			Deluxe	Regular
		Direct material	$45.000	$30.000
		Direct labor	$20.000	$10.000
		Manufacturing support	$99.000	$12.625
		Unit cost	$164.000	$52.625

 

 

 

	(d)		Deluxe	Regular	Ratio of Deluxe:Regular
		Purchase orders			4:1
		Quality control			8:1
		Production setups			8:1
		Machine maintenance			10.67:1

 

Unit costs are distorted by the old system because it assigns manufacturing support cost to products using direct labor hours as a base. Although the deluxe model requires twice as much labor time as the regular model, it was not allocated adequate support cost. Analyzing the company’s capacity costs reveals that the deluxe model is very expensive to manufacture as compared to the regular model because (i) the deluxe model requires 4 times as many purchase orders as the regular model, (ii) the deluxe model requires 8 times as many inspections and setups as the regular model, and (iii) the deluxe model requires over 10 times as many machine hours as the regular model.

 

(e)      No, the deluxe model is not as profitable as the company thinks. Under ABC, the following profitability analysis for each product line can be prepared:

 

			Deluxe	Regular
		Selling price per unit	$140.000	$80.000
		Unit cost	$164.000	$52.625
		Gross margin per unit	($24.000)	$27.375

 

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

 

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

 

5-31  (Unofficial CMA Answer, adapted)

 

(a)     At least four general advantages associated with activity-based costing include the following:

 

• Provides management with a thorough understanding of complex product costs and product profitability for improved resource management and pricing decisions.
• Provides estimates of unused capacity costs.
• Highlights the interrelationships (cause and effect) of activities and identifies opportunities to reduce costs, e.g., designing products with fewer parts to reduce the cost of the manufacturing process.
• Provides more appropriate means of charging support costs to products.

(b)     1.       Using standard costs, the total contribution expected this year from the TV board is $1,950,000, calculated as follows:

 

			Per Unit	Totals for 65,000 Units
		Revenue	$150	$9,750,000
		Direct material	80	5,200,000
		Material support (10% of material)	8	520,000
		Direct labor ($14 ´ 1.5 hours)	21	1,365,000
		Variable support ($4 ´ 1.5 hours)*	6	390,000
		Other mfg. support ($10 ´ 0.5 machine hour)	5	325,000
		Total cost	$120	$7,800,000
		Unit contribution	$30
		Total contribution (65,000 ´ 30)		$1,950,000

 

^* Variable support rate: $1,120,000 ¸ 280,000 hours = $4 per hour.

 

2. Using standard costs, the total contribution expected this year from the PC Board is $2,360,000, calculated as follows:

			Per Unit	Totals for 40,000 Units
		Revenue	$300	$12,000,000
		Direct material	140	5,600,000
		Material support (10% of material)	14	560,000
		Direct labor ($14 ´ 4 hours)	56	2,240,000
		Variable support ($4 ´ 4 hours)*	16	640,000
		Other mfg. support ($10 ´ 1.5 machine hours)	15	600,000
		Total cost	$241	$9,640,000
		Unit contribution	$59
		Total contribution (40,000 ´ $59)		$2,360,000

 

                                                ^* Variable support rate: $1,120,000 ¸ 280,000 hours = $4 per hour.

 

(c)      Shown below are the calculations of the cost drivers which apply to both (c)1 and (c)2.

 

		Procurement:
		Production scheduling:
		Packaging and shipping:
		Machine setups:
		Hazardous waste disposal:
		Quality control:
		General supplies:
		Machine insertion:
		Manual insertion:
		Wave soldering:

 

1. Using activity-based costing, the total contribution expected this year from the TV Board is $2,557,100 calculated as follows:

 

			Per Unit	Totals for 65,000 Units
		Revenue	$150.00	$9,750,000
		Direct material	80.00	5,200,000
		Material support:
		Procurement ($.10 ´ 25)	2.50	162,500
		Production scheduling	2.00	130,000
		Packaging and shipping	4.00	260,000
		Variable support:
		Machine setups ($1.60 ´ 2)	3.20	208,000
		Waste disposal ($3 ´ .02)	.06	3,900
		Quality control	3.50	227,500
		General supplies	.60	39,000
		Other manufacturing support:
		Machine insertion ($0.40 ´ 24)	9.60	624,000
		Manual insertion	4.00	260,000
		Wave soldering	1.20	78,000
		Total cost	$110.66	$7,192,900
		Unit contribution	$39.34
		Total contribution (65,000 ´ $39.34)		$2,557,100

 

 

2. Using activity-based costing, the total contribution expected this year from the PC Board is $1,594,000 calculated as follows:

 

			Per Unit	Totals for 40,000 Units
		Revenue	$300.00	$12,000,000
		Direct material	140.00	5,600,000
		Material support:
		Procurement ($.10 ´55)	5.50	220,000
		Production scheduling	2.00	80,000
		Packaging and shipping	4.00	160,000
		Variable support:
		Machine setups ($1.60 ´ 3)	4.80	192,000
		Waste disposal ($3 ´ .35)	1.05	42,000
		Quality control ($3.50 ´ 2)	7.00	280,000
		General supplies	0.60	24,000
		Other manufacturing support:
		Machine insertion ($0.40 ´ 35)	14.00	560,000
		Manual insertion ($4 ´ 20)	80.00	3,200,000
		Wave soldering	1.20	48,000
		Total cost	$260.15	$10,406,000
		Unit contribution	$39.85
		Total contribution (40,000 ´ $39.85)		$1,594,000

 

(d)     The analysis using standard costs shows that the unit contribution of the PC Board is almost double that of the TV Board. On this basis, Alaire’s management is likely to accept the suggestion of the production manager and concentrate promotional efforts on expanding the market for the PC Boards. However, the analysis using activity-based costs does not support this decision. This analysis shows that the total dollar contribution from the TV Board exceeds that of the PC Board by almost $1,000,000. As a percentage of selling price, the contribution from the TV Board is double that of the PC Board, e.g., 26% versus 13%.

 

CASES

 

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

 

(a)     A traditional cost system, which assigns direct materials and direct labor to products, and allocates factory support based on direct labor, cannot signal the cost of component and product variety. Marketing research may identify that consumers like to choose from a variety of options (especially when the alternatives are available without any cost associated with choosing; e.g., you can have any color of this or any variety of that). In this situation, product engineers can design lots of varieties and options. The cost system assigns cost only on the direct labor and materials content of these options. Thus making one million units of one steering column appears to cost the same as making 100,000 of 4 different steering columns, 10,000 each of 30 other steering columns, and 1,000 each of 300 other columns. But making 334 steering columns in batch sizes ranging from, for example, 100 to 10,000, and designing and supporting 334 different steering columns is much more expensive than just producing 5 or at most 40 different columns. A traditional cost system would report that production costs of labor and materials for the 1,000,000 steering columns is the same whether they are produced in 5 varieties, 40 varieties, or 334 varieties. Thus model and component proliferation is virtually impossible to stop when companies cost products using traditional cost systems.

 

(b)     In order to understand the cost of variety, the new cost system should identify the cost of introducing new varieties, colors, and options. The cost system will show the cost of setting up or changing over to make the new variety, color and option, a cost that will be independent of the number of units produced after the setup. Also the new cost system will show the cost of designing and supporting each new variety, color, and option (technically, in ABC terms, called the “product-sustaining” costs) that will be independent of the number of units produced. With the more accurate understanding of the costs of resources that perform batch and product-sustaining activities, the product engineers and marketing managers can jointly make better decisions on whether the higher cost of introducing another customized option will be compensated with higher sales volumes and/or higher margins.

 

As a specific example, one of General Motors’ competitors examined the cost of how many wire harnesses it used in a given car model. Currently it was producing 12 different wire harnesses, a number that seemed optimal using its traditional cost system. The ABC system—which incorporated the economics of batch production and product-sustaining expenses—revealed that the optimal number of harnesses was 5 or 6. And when the cost of stocking and servicing all the dealerships was incorporated into the analysis, the optimal number dropped to 2. In effect, the apparent savings in direct materials and labor from having customized wire harnesses for individual combinations of car options was far lower than the much higher support costs triggered by high engineering, production support, and service resources associated with having to produce, stock, and service 12 different wire harnesses for a single car model.

 

5-33  This situation is drawn from “Cott Corporation: Private Label in the 1990s.” Harvard Business School Case #9-594-031.

 

This is a truly challenging exercise since it requires students to think about the design of activity-based cost systems, not just the analysis of existing or proposed systems. But, if a good discussion can be generated in the class, it could motivate the work that will be done in the rest of the course. Students may feel that activity-based cost systems are only necessary for large organizations, like General Motors, Chrysler, Procter & Gamble, Coca Cola, Hewlett Packard, or John Deere. This discussion shows how even small, entrepreneurial ventures can benefit from knowing the cost of products, services, and customers.

 

Cott executives could use a variety of different activity-based cost systems. First, and perhaps most obvious, would be an analysis of production costs. Cott, as any small company, would start with producing a limited set of high volume, popular cola beverages such as regular cola and diet cola. So initially, they would have long runs, few setups, and little product variety. Traditional cost systems work fine in this environment. But if retailers want to use Cott as their only private label beverage provider, they will ask Cott to provide a fuller line of beverages, say caffeine-free and diet-caffeine free. Also, they may want a variety of packaging: 12 oz cans, and 1 and 2 liter plastic bottles. And they may start to request beverages beyond the cola category, such as sparkling water, mineral water, new-age beverages, ginger ale, flavored soft drinks, etc. Each new retailer that Cott signs up as a customer may also want its own slight variation in beverage formulation (ingredients) and labeling. As Cott begins to respond to the demand for higher variety, it will be performing many more activities: scheduling production runs, buying more different ingredients and packaging materials from more suppliers, setting up for each production run, changing over packaging lines, more quality control activities (required for each production run and each unique formulation), and more product support activities to maintain information required for each individual SKU. Cott will need an ABC system to understand the cost of these activities that are driven by increased variety and be sure that these costs are covered by the volume of business and prices received from retailers. Otherwise, its cost structure will increase and it will either lose money on the incremental orders or, as it attempts to raise prices, will lose much of its price advantage over the national brands. Cott will want to understand its costs by individual SKU, to be sure that the increased costs associated with offering and delivering customized, low-volume SKUs do not become spread on to the basic high volume beverages (say, regular and diet cola).

 

Second, Cott is customizing its product and service offering to individual retailers. For each retailer, Cott can offer unique product formulations, customized to the retailer’s specifications, design of a retailer-specific label for the beverages, and marketing, promotional, and consulting assistance to help the retailer launch and sustain a private-label cola line. Thus Cott can incur substantial customer-specific expenses with each new retailer. It will need to measure all these front-end, customer-specific expenses and link them to the revenues received, less product and customer-specific beverage costs [as described in the previous paragraph] to determine customer profitability. An ABC model of individual customer profitability will enable Cott to predict in advance the volume and mix of business required to payback heavy front-end investments in product design, package design, and consulting assistance. Ex post, Cott will use the ABC customer profitability model to assess whether the actual volume and mix of business, at actual prices and ABC-calculated product costs, are generating sufficient margin to repay the front-end and perhaps on-going customer-specific support expenses. Cott executives can use such a model to guide their negotiations with each retailer.

 

Third, one of Cott’s principal marketing devices with a retailer is to convince the retailer’s executives, (1) that Cott beverages are profitable for the retailer to sell, and (2) that Cott beverages may be even more profitable for the retailer than national-branded beverages. This will require Cott to work with the retailer to develop a retailer profitability model for the cola beverage category (one of the highest gross volume categories in a retail grocery store). From the retailer’s perspective, profit would be measured by the gross margin (net selling price less the price paid to Cott) minus retailer expenses to receive the beverage containers in a warehouse, store and then ship them to retail outlets, receive the shipments at the retail store, and then shelve and promote them at the store. This requires an ABC model to be built for the retailer’s operating expenses, including the cost of inventory and shelf-space occupancy. This is especially important since the national brands (Coke and Pepsi) charge the retailer much higher prices and the retailer marks these items up less than it might do for a private label beverage. But since the national brands are delivered directly to individual stores and shelved by the national brands’ personnel, the retailer does not use its warehouse, distribution, or in-store resources (other than shelf space) for these brands. Thus a fair comparison requires the ABC model to cost out the extra activities related to the Cott-supplied beverages but not required for Coke and Pepsi. But think about the power of the outcome from such a study. Wouldn’t you, as a supplier, like to be able to demonstrate to your customer that you are not just the lowest cost supplier but the most profitable supplier in a category?

 

Students may also suggest other, non-cost, aspects of the Coke vs. Cott decision. But thinking about these three ABC models: factory costs reflecting the cost of variety and customization, customer cost and profitability reflecting the cost of unique marketing, design, and promotional assistance, and, finally, customer’s profitability structures should give students ample opportunity to reflect on the strategic use of accurate product, distribution, and customer cost information.

 

5-34  This case on Gotham City is adapted from “Indianapolis: Activity-Based Costing of City Services (A) and (B),” Harvard Business School Case #9-196-115/ and –117. The material below reports on the Indianapolis experience.

 

(a)     There are at least two reasons for estimating ABC costs of current operations before contemplating a privatization decision. First, it may turn out that the municipal workers are doing the work at a lower cost than private sector alternatives. While this may seem fanciful, the Indianapolis experience revealed quite a few tasks where the work could be done by municipal workers at lower cost than by paying the lowest-bidding private contractor. Of course, for this comparison to be on a level playing field, the cost estimate for the municipal workers must include not only their direct labor cost but also the cost of equipment, supervision, and all resources performing support activities (since any private company must bid to cover the costs of these resources as well). The ABC approach provides a reasonable estimate of all direct and indirect costs associated with performing a given activity (such as filling potholes, picking up trash, sweeping streets, treating water and sewage, repaving roads, and operating an airport). The Mayor of Indianapolis, after seeing the ABC cost estimates for internal provision of these services, announced he was more interested in competition (between the public and private sector for the lowest cost supply of services) than in privatization.

 

The second reason for the ABC approach is that should a company in the private sector win the business, the city must then identify all the resources that are no longer needed when the work is done by the private contractor. Again, the city resources that should be reduced include not only the front-line municipal workers, but also all their equipment, supervisors, and support resources behind the front-line worker. Otherwise, the city will pay twice for the service, first for the contractor doing the work, and then for the people and other support resources who now have less or no work to perform. That is why a cross-functional, comprehensive total cost view is needed to provide transparency about all the resources in place to support a front-line worker.

 

(b)     They should identify all the resource units used such as trucks, machines, computers, and facilities. Then they need to identify all the costs incurred to supply the resources and the capacity supplied by each resource. A capacity cost rate (the cost of the indirect resource divided by the capacity supplied by the resource) can then be developed for each resource type. Estimates then need to be obtained for the amount of each resource’s capacity used by different activities performed to provide services to the community.

 

(c)      The answer to this question provides a third reason for building ABC models before considering privatizing municipal services. Before building an ABC cost model, workers would have no idea about the cost of performing the work. Once they see the cost of labor, equipment, supervision, and other support services, they can make suggestions to lower the cost of performing the work. As a specific example, in Indianapolis, the workers saw that there was one supervisor for every two workers, clearly an excessive amount. They also developed procedures so that a pothole could be filled with a three-person crew rather than a five- or six-person crew, to share equipment with other activities, to use their equipment more efficiently, and to perform other work (such as cleaning streets) while waiting for equipment or materials to be delivered to the site. The sum total of all these improvement suggestions enabled the municipal workers to submit a much lower bid than any private contractor, thereby retaining the business. This message reinforces the point that sharing cost information with front-line workers enables them to make suggestions for how to accomplish the same outcomes with fewer resources, resulting in substantial productivity improvements. Only good cost information can identify the opportunities for the largest improvements in resource expenses.

 

5-35	(a)	Stage 1: Allocation of S1 and S2 costs to production departments
			Department P1	Department P2
		Directly traceable costs	$480,000	$780,000
		S1	1,176,000 × = 420,000	1,176,000 ×  = 756,000
		S2	1,120,000 ×   = 280,000	1,120,000 ×  = 840,000
		Total support	$1,180,000	$2,376,000
		DLH	80, 000	120,000
		Cost driver rate	$14.75 per DLH	$19.80 per DLH

		Stage 2: Allocation of P1 and P2 costs to products
			Product R361	Product R572
		P1
		P2

 

Product costing

 

			Product R361	Product R572
		Direct materials
		Direct labor: P1
		Direct labor: P2
		Support
		Total cost
		Total units	500,000	400,000
		Unit cost	$17.0132	$16.0235
		Sales price
		Gross margin	$1.9868	$3.9765
		Gross margin %	10.4600%	19.88%

 

 

• Let x denote the number of hours required for each R361 setup. Then the number of hours required for each R572 setup = 1.5x.

 

			R361	R572
		Number of setups	2,000	4,000
		Setup hours	2,000x	6,000x = 4,000 ´ 1.5x
			(25%)	(75%)

 

				Number of transactions
		Activity Cost Drivers	Traceable Costs	Total	R361	R572	Capacity Cost Driver Rate
		P1-DLH	$240,000	80,000	60,000	20,000	$3/P1 DLH
		P2-DLH	360,000	120,000	72,000	48,000	$3/P2 DLH
		Setup hours	1,676,000	8,000x	2,000x	6,000x
		P1-MH	380,000	40,000	30,000	10,000	$9.50/P1 MH
		P2-MH	900,000	120,000	72,000	48,000	$7.50/P2 MH

 

 

			Total Support Costs
		Drivers	Product R361	Product R572
		P1-DLH	$3 ´ 60,000 = $180,000
		P2-DLH	$3 ´ 72,000 = 216,000
		Setup hours
		P1-MH
		P2-MH

 

Alternatively,

 

			Total Support Costs
		Drivers	Product R361	Product R572
		P1-DLH
		P2-DLH
		Setup hours
		P1-MH
		P2-MH

Product costing

 

			Product R361	Product R572
		Direct materials	$4,000,000	$4,000,000
		Direct labor: P1	900,000	300,000
		Direct labor: P2	1,296,000	864,000
		Support costs	$1,640,000	$1,916,000
		Total cost	$7,836,000	$7,080,000
		Total units	500,000	400,000
		Unit cost	$15.672	$17.700
		Sales price	19.000	20.000
		Gross margin	$3.328	$2.300
		Gross margin %	17.520%	11.500%

 

(c)      The old cost accounting system ignored the fact that a large part of support costs is driven by setup hours. Under the old cost accounting system, R572 was undercosted because it had disproportionally more setup hours compared to direct labor hours. The ratio of setup hours per unit of R361 to the setup hours per unit of R572 equals:

 

 

 

			Old Cost Accounting System		ABC System
			R361	R572	R361	R572
		Sales price	$19.0000	$20.0000	$19.0000	$20.0000
		Unit cost	17.0132	16.0235	15.6720	17.7000
		Gross margin	$1.9868	$3.9765	$3.3280	$2.3000
		Gross margin %	10.46%	19.88%	17.52%	11.50%

 

 

(d)     Recommendations for marketing:

 

1. R361 is more profitable than R572. Therefore, push R361 by increasing the commission on R361 or decreasing the commission on R572.

 

2. Raise the price of R572.

 

Recommendations for production:

 

1. A large part of support costs is driven by setup hours. Therefore, re-engineer the products to decrease setup hours.

 

2. Offer discounts to customers for larger batch sizes to reduce the number of setups. (This recommendation may also involve marketing staff.)

 

(e)      The experienced production manager is likely to have an intuitive understanding of the higher production complexity for R572 and will likely agree with the activity-based cost analysis. However, the sales manager will likely want to keep sales high and has already built up relations with R572 customers. Therefore, the sales manager will likely oppose increasing the price of R572 since it will reduce its sales.

 

 

5-36 Sippican Corporation (A) (HBS Case 9-106-058)

 

Teaching Plan

 

This is an introductory case, and yet it introduces a powerful new approach for building an ABC model. Considerable theory is illustrated in how we build the Sippican time-driven ABC (TDABC) model. Also, the (B) case introduces an important link, previously recognized but not exploited, in how to embed an ABC model into the budgeting process, replacing line-item budgeting with an integrated, analytic approach. The case discussion provides insight and confidence about the feasibility of building a TDABC model, especially in the face of resistance from finance people who claim that ABC is too complex to implement.

 

Q:      What is the competitive situation faced by Sippican?

 

• Mature products
• Declining profits
• Inability to explain pricing decisions in market place – high margins and little price competition in one line; continued price pressure in another

 

Q:      Why was Knight studying Sippican’s overhead costs?

 

The following two characteristics serve as indicators that a traditional costing approach to overhead costs is likely providing inaccurate costs:

1. The Willie Sutton rule:[1] Look for areas with large expenses in indirect and support resources, especially where such expenses have been growing over time. Operations where almost all expenses are direct labor and direct materials, which can already be directly traced to individual products by traditional costing systems, may have less need for ABC systems. In effect, if organizational activities are all at the unit level (virtually no batch or product-sustaining activities), then ABC systems and traditional cost systems will likely give very similar economic signals.
2. High Diversity rule: Look for a situation in which large variety exists in products, customers, or processes. For example, consider a facility that produces mature and newly introduced products, standard and custom products, high-volume and low-volume products. For marketing and selling expenses, companies may have a mixture of customers who order high-volume, standard products with few special demands as well as customers who order in small volumes, special products, and require large quantities of pre-sales and post-sales technical support.

Observation: Products such as pumps and valves may be commodities; but how they are produced (small lots, custom designs) and delivered (direct, expedited) is not a commodity. These special services create a basis for differentiation. But “differentiation is a successful strategy only when the delta value created by differentiation exceeds the cost to differentiate.”

 

∆ Revenues (from higher prices, higher sales volumes) > ∆ Costs

• Q: Should Sippican abandon its overhead cost allocation system and make managerial decision based on contribution margin; in effect use marginal costs rather than average costs?
• Sippican’s executives should not abandon overhead assignment to products. The contribution margin is revenues minus variable costs.
  • Analysis based on unit contribution margins can be useful for short-term decisions, such as whether to accept a one-time order when operating with excess capacity. In this case, management is concerned about recurring sales.
  • Overhead cost is sizable ($654,600, which exceeds either direct labor or direct material costs)
    • Management will benefit by understanding the impact of variety in the use of overhead resources by individual products.
    • The contribution margin approach, by definition, does not reveal the different demands that individual products make on overhead resources (for machine time, engineering design, setups, receiving, shipping, etc.).
  • Companies that cut prices based on contribution margin to get new business should be cautious about (i) competitive reactions, (ii) having to lower prices to existing customers, and (iii) filling up capacity with business that does not pay for capacity costs.
  • If a company cuts prices when near capacity, demand could increase beyond existing capacity. Consequently, the company may end up having to supply more capacity for support resources to handle the work, without being paid for supplying these capacity resources.

 

Using TDABC, only two parameters are needed for each department or process:

 

1. Calculate capacity cost rates for each department or process
2. Time required by products, orders, services, and customers on the organization’s capacity resources.

 

Q:      Let’s start building the time-driven ABC model. What are the various capacity cost rates?

 

(b) Capacity Cost Rates

	Cost/	Days Used	Paid Hrs	Nonprod.	Prod.	Prod.	Cost
	Month	Per Month	Per Day	Hours	Hrs/Day	Hrs/Mo	Per Hr
Production and Setup Labor	$3,900	20	7.5	1.5	6.0	120	$32.50
Machine Expenses	$5,400	20			12.0	240	$22.50
Receiving and Production Control	$3,900	20	7.5	1.0	6.5	130	$30.00
Engineering	$9,750	20	7.5	1.5	6.0	120	$81.25
Packaging and Shipping	$3,900	20	7.5	1.0	6.5	130	$30.00

 

Hours Used

	Valves*	Pumps	Flow Controllers*	Total Hours
Production Volume	7,500	12,500	4,000	24,000
DL (Production and Assembly)	2,850	6,250	1,600	10,700
Machine Runs	3,750	6,250	1,200	11,200
Machine Setups	100	600	2,700	3,400
Total Machine				14,600
Setup Labor	100	600	2,700	3,400
Receiving and Production Control	25	125	281	431
Engineers	60	240	600	900
Packaging and Shipping	1,033	1,750	700	3,483

 

*For valves,

DL hours = 7,500 valves × 0.38 DL hours per valve = 2,850

Machine run hours = 7,500 valves × 0.5 machine hours per valve = 3,750

Machine setup hours and labor setup hours (from case) = 100 (= 5 × 20)

Receiving and production hours = 1.25 × 20 production runs = 25

Engineering hours (from case): 60

Packaging and shipping hours = (40 shipments × 50/60) + (7,500 valves × 8/60) = 1,033

 

For flow controllers:

 

DL hours = 4,000 × 0.40 =1,600

Machine run hours= 4,000 × 0.30 =1,200

Machine setups (from case) = = 2,700 (= 225 × 12)

Labor setup hours (from case) = = 2,700 (= 225 × 12)

Receiving and production hours = 225 × 1.25 = 281

Engineering (from case): 600

Packaging and shipping hours = (200× 50/60) + (4,000 × 8/60) = 700

 

The figures for pumps are computed similarly.

 

Practical and Used Capacity

		Hours
Resources	Res.	Avail/	Hours	Hours	Avail −	% Cap.
	Quant.	Res. Unit	Avail.	Used	Used Hrs	Used
DL (Production and Assembly)	90	120	10,800	10,700	100	99%
Machines (Runs and Setup)	62	240	14,880	14,600	280	98%
Setup Labor	30	120	3,600	3,400	200	94%
Receiving and Production Control	4	130	520	431	89*	83%
Engineers	8	120	960	900	60	94%
Packaging and Shipping	28	130	3,640	3,483	157*	96%

*Rounded

Let’s assign the costs of these various resources/departments to the flow controller line:

 

Total Time        Cost Rate Cost Assigned Unit Cost (4,000)

Machine run time: 1,200             $22.50           $ 27,000              $ 6.75

Set-ups (labor)        2,700               32.50              87,750               21.94

Set-ups (machines) 2,700               22.50              60,750               15.19

Receive/Prod Ctrl   225×(75/60)

281.25           30.00                8,438                 2.11

Package & Ship  [200×50+4,000×8]/60

700               30.00              21,000                 5.25

Engineering               600               81.25              48,750               12.19

Total Overhead                                               $253,688             $63.42

Direct Labor                                                         52,000               13.00

Direct Materials                                                    88,000               22.00

                                                                                        $393,688            $ 98.42

 

Revenues                                                          $380,000               95.00

Gross Margin                                                    $(13,688)            ($ 3.42)

 

 

Hand out sheet of P&L of Sippican. Do you believe the revised P&L?

 

 

 

(c) (Small discrepancies in totals are due to calculations performed in a spreadsheet package.)

			Valves		Valves: per unit costs		Pumps		Pumps: per unit costs	Flow Contr.	FCs: per unit costs	Total	Unused Capacity*	Actual	Percent of Sales
Units			7,500				12,500			4,000
Sales			$592,500		$79.00		$875,000		$70.00	$380,000	$95.00	$1,847,500		$1,847,500	100%
Materials Expenses			120,000		16.00		250,000		20.00	88,000	22.00	$458,000		$458,000
DL Expenses			92,625		12.35		203,125		16.25	52,000	13.00	$347,750	$3,250	$351,000
Contribution Margin			379,875		50.65		421,875		33.75	240,000	60.00	$1,041,750	-$3,250	$1,038,500	56%
Manufacturing Overhead
Machine Expenses			84,375		11.25		140,625		11.25	27,000	6.75	$252,000	$6,300	$258,300
Setup Labor			3,250		0.43		19,500		1.56	87,750	21.94	$110,500	$6,500	$117,000
Machine Setup**			2,250		0.30		13,500		1.08	60,750	15.19	$76,500	$0	$76,500
Receiving and Production Control			750		0.10		3,750		0.30	8,438	2.11	$12,938	$2,663	$15,600
Engineering			4,875		0.65		19,500		1.56	48,750	12.19	$73,125	$4,875	$78,000
Packaging and Shipping			31,000		4.13		52,500		4.20	21,000	5.25	$104,500	$4,700	$109,200
Total Manufacturing Overhead			126,500		16.87		249,375		19.95	253,688	63.42	$629,563	$25,038	$654,600	35%
Total costs			339,125		45.22		702,500		56.20	393,688	98.42	$1,435,313	$28,288	$1,463,600
Gross Margin			253,375		33.78		172,500		13.80	-13,688	-3.42	$412,188	-$28,288	$383,900	21%
Gross Margin/Sales %			42.8%				19.7%			-3.6%		22.3%		20.8%
	Selling and Administrative Exps.													$350,000	19%
	Operating Profit													$33,900	2%
	Return on Sales													1.83%
* See the following table.
**Machine Setup unused capacity is included with Machine Expenses unused capacity.

 

 

Using the capacity rates and unused capacity hours computed in part (b), the cost of unused capacity is as follows.

Resources	Available −		Cost of
	Used Hrs	Cost/Hr	Unused Capacity
DL (Production and Assembly)	100.00	$32.50	$3,250
Machines (Runs and Setup)	280.00	$22.50	$6,300
Setup Labor	200.00	$32.50	$6,500
Receiving and Production Control	88.75	$30.00	$2,663
Engineers	60.00	$81.25	$4,875
Packaging and Shipping	156.67*	$30.00	$4,700

*Rounded

The following table summarizes the difference in reported product costs and profitability with the traditional cost system that Sippican used previously, and the time-driven activity-based costing (TDABC). The difference lies in the assigned manufacturing overhead costs. The traditional method assigns manufacturing overhead at 185% of direct labor cost, which results in pumps receiving the greatest overhead per unit, flow controllers the next highest overhead per unit, and valves the least. Based on the more accurate TDABC assignment of machine and support expenses, management can see that valves are even more profitable than they thought; pumps, while not earning the targeted 35% gross margin, are still strong profit contributors, and flow controllers – previously thought to be the most profitable product line – actually lose money because of the high costs of setups, engineering, and shipping. Most of the engineering work was for the customized flow controllers requested by customers.

 

 

Traditional Cost Analysis	Valves	Pumps	Flow Controllers
Selling price	$79.00	$70.00	$95.00
Direct labor cost	$12.35	$16.25	$13.00
Direct material cost	16.00	20.00	22.00
Manufacturing overhead at 185% of DL cost	22.85	30.06	24.05
Standard unit costs	$51.20	$66.31	$59.05
Gross margin	$27.80	$3.69	$35.95
Gross margin (%)	35%	5%	38%
Time-Driven ABC Analysis	Valves	Pumps	Flow Controllers
Selling price	$79.00	$70.00	$95.00
Direct labor cost	$12.35	$16.25	$13.00
Direct material cost	16.00	20.00	22.00
TDABC overhead	16.87	19.95	63.42
Standard unit costs	$45.22	$56.20	$98.42
Gross margin	$33.78	$13.80	($3.42)
Gross margin (%)	43%	20%	-3.6%

 

(d)     Yes, the approach can be extended to service companies and much larger companies than Sippican. The Towerton case in this chapter provides such an example.

 

Time-driven activity-based costing reduced some of the barriers associated with developing and updating the common approach to activity-based costing, which assigns many resource expenses to activities based on interviews and surveys. Nevertheless, barriers and difficulties associated with managing any major change remain. For example, individuals may feel vulnerable facing uncertainty about what the time-driven activity-based cost analysis may show. The analysis might reveal that products or customers thought to be very profitable are actually unprofitable, some processes are inefficient, or there is substantial unused capacity. 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 that was in place.

 

(e) The company should reconsider its product strategy and focus on its core products—valves and pumps. Sippican might attempt to increase market share in valves by offering discounts for large orders of valves. Furthermore, Sippican could reduce discounting for pumps, especially for small orders. Finally, Sippican should aggressively raise prices for flow controllers or accept orders to produce flow controllers only when the pricing and order size indicate that they can be sold at a profit; Sippican could establish a minimum order size.

 

Sippican can also focus on improving processes. For example, the company could reduce setup times or schedule production of components for multiple product orders to share components across multiple batches. These improvements, in conjunction with the focus on larger orders, should lead to many fewer production runs and shipments, allowing for the possibility of reducing capacity and related costs.

 

This discussion can be carried forward in the same context to include topics such as the Balanced Scorecard and activity-based budgeting by using the Sippican B case that follows (case 5-37) and the accompanying PowerPoint presentation slides.

 

5-37  Sippican Corporation (B) (HBS Case 9-106-060) (See also the teaching plan for case 5-36: Sippican Corporation (A) (HBS Case 9-106-058) and the PowerPoint presentation available to instructors.)

 

In Sippican (A), the company experiences declining profits and struggles to understand why it is encountering severe price competition on one product line. The controller collects data that will enable development of a time-driven, activity-based cost model to explain better the different demands of each product line on Sippican’s indirect and support resources. Applying the newly estimated capacity cost rates for the resources to the production statistics of the three product lines produces a radically different perspective on product line profitability. The (A) and (B) cases together illustrate motivation and design of a time-driven, activity-based system, the action steps that emerge from a more accurate cost analysis, and a powerful connection between strategic planning and operational budgeting.

 

The following figure diagrams the connections among the Balanced Scorecard and strategic planning, activity-based costing, and activity-based operational budgeting.

 

Teaching Plan

This case illustrates that fixed (capacity) costs are typically not one big piece of equipment. Most capacity costs come from having many machines and many people. These can be adjusted up or down based on forecasts of future capacity needs. Sippican currently has 62 machines, 120 production workers, 28 packaging and shipping workers, 4 receiving and production control workers, and 8 engineers. It is hard to argue that these are all “fixed” and not avoidable over some not very long time period. While one can have “fixed” costs with one machine and one indirect worker, 62 machines and 160 employees do not represent a “fixed” cost. But how do these resource levels and associated costs change as production levels change?

 

The company uses activity-based budgeting to translate the detailed sales and production plans into specific demands for labor and machine resources. Direct labor increases slightly, but setup labor demand drops dramatically because of fewer production runs and reductions in setup time. Small reductions also occur in indirect labor and engineering time. Activity-based budgeting is a powerful tool for creating bottoms-up operational budgets. However, it does require much finer granularity in the sales forecasts and production plan to estimate the demands for organizational resources, particularly those performing support functions.

 

(a)     The planned hours used can be computed based on the data provided in Exhibit 5-12 and case 5-36 (Sippican (A)):

 

	Valves	Pumps	Flow Controllers	Total
Production units	10,000	12,000	2,500	24,500
	Time in Hours
Total DL hours	3,800	6,000	1,000	10,800
Total machine run hours	5,000	6,000	750	11,750
Machine setup hours	160	192	480	832
Total machine hours	5,160	6,192	1,230	12,582
Labor setup hours	160	192	480	832
Receiving and production controla	50	50	62.5	163
Engineering hours	60	240	400	700
Packaging and shippingb	1,367	1,658	417	3,442

^a Receiving and Production Control Time Equation:

Valves:  1.25 × 40 production runs = 50 hours; Pumps: 1.25 × 40 = 50 hours

Flow Controllers:  1.25 × 50 production runs = 62.5 hours

 

^b Packaging and Shipping Time Equation:

Valves:  [40 × 50 + 10,000 × 8]/60 = 82,000/60 = 1,367 hours

Pumps:  [70 × 50 + 12,000 × 8]/60 = 99,500/60 = 1,658 hours

Flow Controllers:  [100 × 50 + 2,500 × 8]/60 = 25,000/60 = 417 hours

 

The units of each resource type needed to meet projected demand follow (see the Sippican (A) solutions for hours available per resource unit).

 

Resources Needed	Hours Needed	Hrs. Avail. per Resource Unit	#FTEs Needed	Actual
Direct labor	10,800	120	90.00	90
Setup labor	832	120	6.93	7
Machines	12,582	240	52.43	53
Receiving and production control	163	130	1.25	2
Packaging and shipping	3,442	130	26.48	27
Engineers	700	120	5.83	6

 

(b)     If Sippican can reduce its supply of resources to the estimated needs, Sippican estimated spending and profit next period are as presented in the following statement. If Sippican cannot reduce its supply of resources to the minimum needed for projected demand, or if Sippican wants to preserve some protective capacity, then spending in “Unused Capacity” will increase.

 

Sippican (B) Pro Forma	Valves	Pumps	Flow Controllers	Charged	Unused Capacity	Actual
Sales (units)	10,000	12,000	2,500
Sales revenue	$ 750,000	$ 960,000	$ 275,000	1,985,000		$1,985,000
Sales percentage	38%	48%	14%
DL expenses	$ 123,500	$ 195,000	$   32,500	$ 351,000		$   351,000
Material expenses	160,000	240,000	55,000	455,000		455,000
Contribution margin	466,500	525,000	187,500	1,179,000		1,179,000
	62%	55%	68%	59%	0%	59%
Machine run-time expense	112,500	135,000	16,875	264,375	3,105	267,480
Machine set-up expense	3,600	4,320	10,800	18,720
Setup labor	5,200	6,240	15,600	27,040	260	27,300
Receiving and production control	1,500	1,500	1,875	4,875	2,925	7,800
Engineering	4,875	19,500	32,500	56,875	1,625	58,500
Package & ship	41,000	49,750	12,500	103,250	2,050	105,300
Manufacturing overhead	168,675	216,310	90,150	475,135	9,965	$   485,100
Total costs	$ 452,175	$ 651,310	$ 177,650	1,281,135	$ 9,965	$1,291,100
Gross margin	$ 297,825	$ 308,690	$   97,350	$ 703,865	$(9,965)	$   693,900
Gross margin %	40%	32%	35%	35%		35%
S&A						350,000
Operating profit						$  343,900
Return on sales						17.3%

 

(c)      If Sippican can reduce the supply of support labor and machines to budgeted levels, the company will earn a 35% gross margin percent (of sales) and a 17.3% return on sales, a considerable improvement from the 21% gross margin percent and 2% return on sales of recent experience. All products now have projected gross margins around the targeted 35% level. Total gross margin increases by almost 81% and operating profit increases more than ten-fold. The huge profit increase assumes only a modest increase in unit sales and average selling prices. Although total units sold increase by only 2%, the company is selling more valves and fewer flow controllers. The changes in price and volume are projected to increase sales revenue by 7.4%. The major impact on profit is due to adjusting the types of orders accepted, and reducing the supply of resources no longer needed to handle the small unprofitable orders.

 

A comparison of product line profitability before and after the changes follows.

 

 

 

 

	Sippican (A) Product Line Profitability				Sippican (B) Product Line Profitability
	Valves	Pumps	Flow Controllers		Valves	Pumps	Flow Controllers
Production	7,500	12,500	4,000		10,000	12,000	2,500
Price	$ 79.00	$ 70.00	$ 95.00		$ 75.00	$ 80.00	$ 110.00
Direct labor	12.35	16.25	13.00		12.35	16.25	13.00
Direct materials	16.00	20.00	22.00		16.00	20.00	22.00
Contribution margin	$ 50.65	$ 33.75	$ 60.00		$ 46.65	$ 43.75	$ 75.00
Cont. margin %	64%	48%	63%		62%	55%	68%
Manufacturing overhead
Machine expenses	11.25	11.25	6.75		11.25	11.25	6.75
Setup labor	0.43	1.56	21.94		0.52	0.52	6.24
Machine setup cost	0.30	1.08	15.19		0.36	0.36	4.32
Receiving and production control	0.10	0.30	2.11		0.15	0.13	0.75
Engineering	0.65	1.56	12.19		0.49	1.63	13.00
Package & ship	4.13	4.20	5.25		4.10	4.15	5.00
Total manufacturing overhead	$ 16.87	$ 19.95	$ 63.42		$ 16.87	$ 18.03	$ 36.06
Total costs	45.22	56.20	98.42		45.22	54.28	71.06
Gross margin	$ 33.78	$ 13.80	$ (3.42)		$ 29.78	$ 25.72	$ 38.94
GM %	43%	20%	-4%		40%	32%	35%

 

 

 

 

5-38  (a)     Practical capacity for the personnel resources is calculated as follows:

 

	Paid Hours per Day	Nonpro-ductive Hours per Day	Productive Hours per Day	Days Used per Month	Practical Capacity Hours per Month
Brokers	8	1.5	6.5	20	130
Account Managers	8	1.5	6.5	20	130
Financial Planners	8	1.5	6.5	20	130
Principals	8	1.5	6.5	20	130
Customer service represen-tatives	8	1.0	7.0	20	140

 

Capacity cost rates are calculated as follows:

 

	Cost Per Person Per Month	Practical Capacity Hours Per Month	Capacity Cost Rate
Brokers	$   6,787	130	$  52.21
Account Managers	$   8,954	130	$  68.88
Financial Planners	$   8,828	130	$  67.91
Principals	$ 12,932	130	$  99.48
Customer service representatives	$   4,192	140	$  29.94

 

 

 

 

(b)     A summary table of time utilization appears below, and supporting computations appear in the subsequent table.

 

Time Utilization (Hours)a	Stock Trading	Mutual Fund Trading	Account Management	Financial Planning
Brokers	27,226	2,704
Account Managers			2,080
Financial Planners				2,154
Principals	2,643	262	418	130
Customer service represen-tatives	4,086	1,007	207	129

^a Computations are shown below.

 

Minutes of activity per month are calculated as follows and then divided by 60 to arrive at the time utilization in hours in the table above:

 

Minutes of Activity Per Month	Stock Trading	Mutual Fund Trading	Account Manage-ment	Financial Planning
Brokers
New accounts (minutes for new accounts opened)	595× 60 = 35,700	255× 60 = 15,300
Existing accounts (minutes for transactions)	305,288 × 5 = 1,526,440	26,325 × 5 = 131,625
Meetings with existing accounts (minutes for meetings)	3570 × 20 = 71,400	765× 20 = 15,300
Total minutes	1,633,540	162,225
Account Managers
New accounts (minutes for new accounts opened)			175 × 240 = 42,000
Existing accounts (minutes for transactions)			5,400 × 10 = 54,000
Meetings with existing accounts (minutes for meetings)			480 × 60 = 28,800
Total minutes			124,800
Financial Planners
New accounts (minutes for new accounts opened)				130 × 600 = 78,000
Existing accounts (minutes for transactions)
Meetings with existing accounts (minutes for meetings)				569 × 90 = 51,210
Total minutes				129,210
Principals
New Accounts (minutes for new accounts opened)	595 × 10 = 5,950	255 × 10 = 2,550	175 × 20 = 3,500	130 × 60 = 7,800
Existing Accounts (minutes for transactions or accounts)	305,288 × 0.5 = 152,644	26,325 × 0.5 = 13,163	5,400 × 4 = 21,600
Total minutes	158,594	15,713	25,100	7,800
Customer Service
New accounts (minutes for new accounts opened)	595 × 12 = 7,140	255 × 12 = 3,060	175 × 18 = 3,150	130 × 18 = 2,340
Existing accounts (minutes for calls)	47,600 × 5 = 238,000	11,475 × 5 = 57,375	1,320 × 7 = 9,240	540 × 10 = 5,400
Total minutes	245,140	60,435	12,390	7,740

 

 

 

 

(c)      A summary table of MIPS usage during peak and non-peak hours appears below, and sample computations appear in the subsequent table.

 

MIPS Usage	Stock Trading	Mutual Fund Trading	Account Manage-ment	Financial Planning	Total*	Available Productive Time
Peak	465,913	30,200	96,783	11,823	604,718	668,800
Non- peak	99,358	105,986	72,212	11,860	289,415	334,400

*The small discrepancies in the totals are due to rounding in the previous columns.

 

MIPS usage during peak and non-peak hours is calculated by multiplying MIPS per transaction by the number of transactions during peak and non-peak hours, respectively. The computations for stock trading appear below. The other computations are similar.

                 

Transactions Processed by Servers	MIPS Per Transaction	Number of Transactions: Stock Trading		MIPS for Stock Trading
		Peak	Non-Peak	Peak	Non-Peak
Order placements, trades and order clearing and settlement activities	1.4	305,288	0	427,403	0
Account balance inquiries	0.1	52,695	23,730	5,270	2,373
Quotation requests	0.1	332,400	177,100	33,240	17,710
Balance transfers	0.7	0	75,000	0	52,500
Account statement preparation	0.9	0	29,750	0	26,775
Total		690,383	305,580	465,913	99,358

 

Note: The cost of MIPS usage is provided in this case but the calculation can be assigned as an additional exercise, assuming the servers can process 50 MIPS per hour. The calculation for peak and non-peak usage is as follows:

 

Each server is available for (22 days) × (24 hours per day) = 528 hours per month. The average cost per hour is therefore $3,168/528 hours = $6 per hour. Non-peak-hour usage accounts for (19 servers) × (16 hours per day) = 304 hours per day. Peak-hour usage accounts for (76 servers) × (8 hours per day) = 608 hours per day. Moreover, the 57-server excess capacity during non-peak hours exists because of the peak-hour need. Therefore the cost of the excess capacity of 57 × 16 hours = 912 hours should be charged to peak-hour users. Thus, the peak-usage hourly rate is $6 × (608 + 912)/608 = $15 per hour.

 

The non-peak cost per MIPS is $6/50 = $0.12 and the peak cost per MIPS is $15/50 = $0.30, as stated in the case.

 

(d)     An income statement showing rounded costs and profits in thousands for each of Towerton’s four product lines, as well as the cost of unused capacity, appears below, with sample calculations following. The small discrepancies in the totals and margins are due to rounding.

 

(000s)	Stock Trad-ing	Mutual Fund Trad-ing	Account Manage-ment	Finan-cial Plan-ning	Total Used	Unused Capacity	Total Supplied
Sales	$2,687	$ 1,091	$  90	$156	$4,024		$4,024
Costs:
Brokers	1,421	141			1,563	(2)	1,561
Account Managers			143		143	18	161
Financial Planners			0	146	146	30	177
Principals	263	26	42	13	344	44	388
Customer service reps.	122	30	6	4	163	14	176
Computer server expenses	152	22	38	5	216	25	241
Total Costs	1,958	219	229	168	2,574	129	2,704
Margin	$ 728	$ 872	$ (139)	$ (12)	$1,450	$ (129)	$1,320
Margin %	27%	80%	-154%	-8%	36%	-3%	33%
S, G & A							1,300
Operating Income							$20
Operating Margin							0.5%

 

Stock trading sales = $8.80 × 305,288 = $2,686,534.

Mutual fund trading sales = $41.45 × 26,325 = $1,091,171.

Account management sales = 1.5% × $60,000 × 1,200/12 = $90,000.

Financial planning sales = (130 × $1,200) + ([90/60] × $125) = $156,188.

 

The personnel costs are computed by multiplying the capacity cost rates in part (a) by the hours of time utilization in part (b).

 

The computer server expenses are calculated by multiplying the peak-usage MIPS by $0.30 and the non-peak-usage MIPS by $0.12. For example, the computation for stock trading is (465,913 × $0.30) + (99,358 ×$0.12) = $151,697 (rounded).

 

The costs in the “total supplied” column are computed as follows:

 

	Cost Per Resource Month	Number of Resources	Total Cost
Brokers	$  6,787	230	$1,561,010
Account Managers	$  8,954	18	$   161,172
Financial Planners	$  8,828	20	$   176,560
Principals	$12,932	30	$   387,960
Customer service representatives	$  4,192	42	$   176,064
Computer server expenses	$  3,168	76	$   240,768
Total			$2,703,534

 

The core stock trading and mutual fund trading product lines are profitable, with mutual fund trading highly profitable. In contrast, the new product lines, investment account management and financial planning, are unprofitable; investment account management is highly unprofitable, with a return on sales of –154%. The large differences in profits across the product lines are due in part to the high cost of personnel (account managers and principals for account management, and financial planners for financial planning) in proportion to product line sales for the unprofitable product lines. In addition, computer server expenses are 41.9% of sales for account management. This percentage is far greater than for any of the remaining product lines. (See the table below.)

 

	Costs as a Percent of Own Product Line Sales
	Stock Trading	Mutual Fund Trading	Account Management	Financial Planning
Brokers	52.9%	12.9%	0.0%	0.0%
Account Managers	0.0%	0.0%	159.2%	0.0%
Financial Planners	0.0%	0.0%	0.0%	93.6%
Principals	9.8%	2.4%	46.2%	8.3%
Customer service representatives	4.6%	2.8%	6.9%	2.5%
Computer server expenses	5.6%	2.0%	41.9%	3.2%
Total	72.9%	20.1%	254.2%	107.6%

 

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

 

[1]  Willie Sutton was a successful bank robber in the United States during the 1950s. Willie, who was eventually captured at his home not far from a local police station, was asked during his initial interrogation, “Why do you rob banks?” Willie replied, with the wisdom that had made him successful for many years, “That’s where the money is!” When developing ABC systems, we should follow Willie’s sage advice (but not his particular application of the insight) to focus on high cost areas where improvements in visibility and action could produce major benefits to the organization. Applying an ABC analysis to a set of resource expenses that are below 1% of total spending will not lead to high payoffs to the organization.