ACCTG 102 Lecture Notes - Lecture 10: Activity-Based Costing, Cost Driver
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Grady and Associates performs a variety of activities related to information systems and e-commerce consulting in Toronto, Canada. The firm, which bills $125 per hour for services performed, is in a very tight local labor market and is having difficulty finding quality help for its overworked professional staff. The cost per hour for professional staff time is $45. Selected information follows.
- Billable hours to clients for the year totaled 5,000, consisting of information systems services, 3,100; e-commerce consulting, 1,900.
- Administrative cost of $342,000 was (and continues to be) allocated to both services based on billable hours. These costs consist of staff support, $180,000; in-house computing, $136,400; and miscellaneous office charges, $25,600.
A recent analysis of staff support costs found a correlation with the number of clients served. In-house computing and miscellaneous office charges varied directly with the number of computer hours logged and number of client transactions, respectively. A tabulation revealed the following data:
| Information Systems Services | E-Commerce Consulting | Total | |||||||||
| Number of clients | 200 | 50 | 250 | ||||||||
| Number of computer hours | 2,600 | 1,800 | 4,400 | ||||||||
| Number of client transactions | 400 | 600 | 1,000 | ||||||||
Required:
2. Assume that the firm uses traditional costing procedures, allocating total costs on the basis of billable hours. Determine the profitability of the firmâs information systems and e-commerce activities, expressing your answer both in dollars and as a percentage of activity revenue.
3. Assume that the firm uses activity-based costing. Determine the profitability of the firmâs e-commerce and information systems activities, expressing your answer both in dollars and as a percentage of activity revenue.
4. Jeffrey Grady, one of the firmâs partners, doesnât care where his professionals spend their time because, as he notes, âmany clients have come to expect both services and we need both to stay in business. Also, information systems and e-commerce professionals are paid the same hourly rate.â Should Gradyâs attitude change?
Miami Valley Architects Inc. provides a wide range ofengineering and architectural consulting services through its threebranch offices in Columbus, Cincinnati, and Dayton, Ohio. Thecompany allocates resources and bonuses to the three branches basedon the net income reported for the period. Presented below are theresults for the 2016 fiscal year ($ in thousands).
| Columbus | Cincinnati | Dayton | Total | |
| Sales | $1,500 | $1,419 | $1,067 | $3,986 |
| Less: | ||||
| Direct Labor | (382) | (317) | (317) | (1,016) |
| Direct Materials | (281) | (421) | (185) | (887) |
| Overhead | (710) | (589)) | (589) | (1,888) |
| Net Income | $127 | $92 | ($24) | $195 |
Overhead items are accumulated in one overhead pool for theentire firm and then allocated to the branches based on directlabor dollars. For fiscal 2016 this predetermined rate was $1.859for every direct labor dollar incurred by an office. The overheadpool includes rent, depreciation, taxes, etc. regardless of whichoffice incurred the expense. Management is concerned with theresults of the fiscal 2016 performance reports. During a review ofthe overhead, it became apparent that many items of overhead werenot correlated with the direct labor dollars. Management decided toapply overhead based on direct tracing where possible and to applyActivity Based Costing (ABC) to model the profitability of eachbranch. Results of Overhead Analysis An analysis of the overheadrevealed that facility sustaining costs for rent, utilities,depreciation, property taxes, etc. could be traced directly to theoffice where the costs were incurred ($ in thousands).
| Columbus | Cincinnatti | Dayton | Total | |
| Direct Overhead | $180 | $270 | $177 | $627 |
Activity pools and activity drivers determined from theaccounting records and staff surveys are presented in the table
| Activity | By | Location | |||||
| Activity Pools | Activity Driver | Columbus | Cincinnati | Dayton | |||
| General Admission | $409,000 | Direct Labor Dollars | $382,413 | $317,086 | $317,188 | ||
| Project Costing | $48,000 | # of Timesheet Entries | 6,000 | 3,800 | 3,500 | ||
| AccountsPayable/Receivable | $139,000 | # of Vendor Invoices | 1,020 | 850 | 400 | ||
| Accounts Receivable | $47,000 | # of Client Invoices | 588 | 444 | 96 | ||
| Payroll/Mail Sort &Delivery | $30,000 | # of Employees | 23 | 26 | 18 | ||
| Personell Recruiting | $38,000 | # of New Hires | 8 | 4 | 7 | ||
| Employee InsuranceProcessing | $14,000 | # of Claims Filed | 230 | 260 | 180 | ||
| Proposals Accepted byClients | $139,000 | # of Proposals Accepted | 200 | 250 | 60 | ||
| Sales Meeting / SalesAids | $202,000 | Contracted Sales | $1,824,439 | $1,399,617 | $571,208 | ||
| Shipping | $24,000 | # of Projects | 99 | 124 | 30 | ||
| Ordering | $48,000 | # of Purchase Orders | 135 | 110 | 80 | ||
| Duplicating Costs | $46,000 | # of Copies Duplicated | 162,500 | 146,250 | 65,000 | ||
| Blueprinting | $77,000 | # of Blueprints | 39,000 | 31,200 | 16,000 | ||
| $1,261,000 |
1.) Activity based costing is one approach to thedifficult problem of cost allocation. However, the results maystill be arbitrary and too imprecise for some applications.Consider the case of a large, national architectural firm withoffices located throughout the country. Assume this firm needs toestablish a transfer price to charge different profit centersacross the country for their use of a centralized PersonnelRecruiting service located within a centralized Human Resourcesgroup. Using the example of Personnel Recruiting in this problem,discuss reasons why activity based costing as it is implemented inthis model by Miami Valley Architects for Personnel Recruitinglacks the precision needed for the large, national architecturalfirm seeking to establish a transfer price.
Bushman Case
The Bushman Company is a publicly traded corporation that produces different types of digital control systems. My name is Alan Smith and I have worked for this company for the last ten years in the controllerâs office. I was both an accounting and finance major in university. The company currently produces 300 products and does not anticipate any new products coming out over the next three years. I have previously mentioned to my superiors that it is not appropriate for our firm to use a traditional accounting system (where overhead costs are allocated across products at a rate of 400% of direct labor costs) when different products require different amounts of indirect overhead resources. For example, under the traditional system all costs associated with testing of products for quality assurance purposes are part of overhead costs and therefore allocated across products based on direct labor costs. Yet, some of our products require as much as 5 hours of testing whereas some products require less than 1 minute of testing with no connection to direct labor costs. Given that traditional costing systems result in significant cost distortions when determining products costs and given that the firm now has revenues of over $700,000,000 a year, Bushman has decided to adopt activity based costing over the next year or two.
Bushmanâs management has hired Deloitte Consulting to help us implement activity based costing. I will be acting as the liaison between our firm and Deloitte. As part of the initial implementation phase, I have asked Deloitte to derive the costs and product margins associated with two of our products, delta and vega, so that these costs and product margins could be compared with the costs and product margins under our current traditional accounting system. I picked these products since Bushman management believe they have very different demands on indirect overhead resources. Further, delta is sold in large quantities whereas vega is sold in small quantities and traditional accounting systems can cause large cost distortions in different directions for products sold in large and small quantities.
Current information from our existing system on a per unit basis is shown in Exhibit 1.
Exhibit 1
| delta | vega | |
| Direct material | $10 | $10 |
| Direct labor hours | 1 | 1 |
| Direct labor wage rate per hour | $20 | $20 |
| Sales price per unit | $160 | $170 |
My staff has identified for Deloitte five activity cost pools. Information on those cost pools and the related activity measures are provided in Exhibit 2.
Exhibit 2
| Activity cost pool | Total costs | Activity measure | Activity level |
| Equipment setups | $20,000,000 | number of setups | 50,000 |
| Purchase orders | $15,000,000 | number of purchase orders | 300,000 |
| Machining | $90,000,000 | number of machine hours | 2,000,000 |
| Testing | $13,300,000 | number of testing hours | 700,000 |
| Packaging | $24,000,000 | number of containers | 2,000,000 |
Although fixed costs are lumped in with variable costs across the five different cost pools, I am aware that machining related costs consists almost exclusively of depreciation costs. Hence, with respect to all questions asked in this case, machining costs will be treated as entirely fixed with respect to machine hours. Each machine is used in the production of multiple product lines. The resale value of machines is only affected by the passage of time and not by how much they are used in a given year.
In all questions asked in this case, the firm will assume that costs associated with equipment setups, purchase orders, testing, and packaging are variable with respect to their respective activity measures. Currently, we believe our assumptions on cost behavior patterns are quite reasonable.
All products are produced in batches, where the size of a batch differs across products. For example, if we produce 80 units of a product in batch sizes of 40, then the product will be produced in two batches. An equipment setup must be performed before producing each batch of a product. Hence, in the example above, two equipment setups would be performed. Units of product are packaged in containers and sent to distributors.
Production volumes are set equal to sales volumes since the company only produces products that they have orders for. Consequently, the firm never has a beginning or ending work in process inventory, and it does not have a beginning or ending finished goods inventory.
Further information on our two products is provided in Exhibit 3
Exhibit 3
| delta | vega | |
| annual sales and production in units | 800,000 | 12,000 |
| number of units per batch | 200 | 150 |
| number of purchase orders | 400 | 100 |
| number of machine hours per unit | 0.2 | 3 |
| total number of testing hours | 7,000 | 21,000 |
| total number of containers | 5,000 | 2,000 |
REQUIRED:
1. (20 Points) Prepare an income statement for delta and an income statement for vega using the traditional accounting system where overhead is applied at a rate of 400% of direct labor costs. (For simplicity, there are no SG&A expenses for the firm.) The income statements should be prepared on a total basis and then show the average net operating income per unit using the following template for guidance:
delta vega
Sales $$$ $$$
Direct materials $$$ $$$
Direct labor $$$ $$$
Manufacturing overhead $$$ $$$
Total Costs $$$ $$$
Net operating income $$$ $$$
Average net operating income
per unit $$$ $$$
2. (20 Points) Calculate the five activity rates under activity based costing.
3. (35 Points) Prepare an income statement for delta and an income statement for vega using activity based costing. (For simplicity, there are no SG&A expenses for the firm.) The income statements should be prepared on a total basis and then show the average net operating income per unit using the following template for guidance:
delta vega
Sales $$$ $$$
Direct materials $$$ $$$
Direct labor $$$ $$$
Equipment Setups $$$ $$$
Purchase orders $$$ $$$
Machining $$$ $$$
Testing $$$ $$$
Packaging $$$ $$$
Total Costs $$$ $$$
Net operating income $$$ $$$
Average net operating income
per unit $$$ $$$
4. (10 Points) Assume next year that the activity rates remain the same as you calculated in question (2). Assume that the demand for delta is expected to increase significantly. Consequently, the firm expects to produce more batches of delta next year than this year and the firm plans to produce in batch sizes of 500 rather than 200. Calculate what the equipment setup cost per unit of delta will be next year if it can be calculated. If it cannot be calculated, then explain in words why the equipment setup cost per unit of delta cannot be determined in the absence of more information. Excluding your quantitative analysis if any, your explanation should not be more than 1/3 page double spaced with a 12 font size. Your grade will be lowered for poor writing (e.g., grammar).
5. (15 Points) Question 5 is independent of question 4. Next year, because of an expected increase in product demand, machine hours are expected to increase from 2,000,000 to 2,500,000. The company will not need any new machinery since the current machinery is highly underutilized. Also, the number of purchase orders will increase from 300,000 to 360,000. Assume that these new levels of operations are within the firmâs relevant range. Calculate what the activity rate for the cost pool of machining would be next year if it can be calculated. Also, calculate what the activity rate for the cost pool of purchase order would be next year if it can be calculated. If one or both rates cannot be calculated, then explain in words why the calculations cannot be determined in the absence of more information. Excluding any quantitative analysis, your explanation should not be more than 1/3 page double spaced with 12 font. Your grade will be lowered for poor writing (e.g., grammar).
