Activity based costing is considered a better method ofallocating manufacturing overhead than the more simplified"plant-wide" overhead allocation method.
a. Activity based costing doesrequire more work than a plant-wide allocation. Under whatcircumstances is it worth the extra effort?
b. What is the typically result when activity based costing isadopted, in terms of cost allocation between differentproducts?
c. Name three advantages of activity based costing overplant-wide allocation.
Please describe with details ALL questions, do not submitincomplete answer
Activity based costing is considered a better method ofallocating manufacturing overhead than the more simplified"plant-wide" overhead allocation method.
a. Activity based costing doesrequire more work than a plant-wide allocation. Under whatcircumstances is it worth the extra effort?
b. What is the typically result when activity based costing isadopted, in terms of cost allocation between differentproducts?
c. Name three advantages of activity based costing overplant-wide allocation.
Please describe with details ALL questions, do not submitincomplete answer
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Dakota Motors produces electric motors for commercial use. Until the end of 1994, only 2 models were produced, the âStandardâ modelâ and the âDeluxeâ model. The Deluxe model had more expensive components and raw materials, required more quality control and required more labor hours per unit to produce than the Standard model. Both models were produced in fairly large volume. Since 1994, in an attempt to grow its business, and in response to competitive pressures, Dakota Motors has begun producing many different varieties of electric motors, in addition to its regular models. These new models are tailor made to the needs of individual customers and are produced only on demand, and are typically low volume lines.
Dakota Motors has a simple (traditional) costing system which traces the costs of direct materials, components, and direct labor to each of its product lines. All support costs are assigned to product lines via a single plant wide overhead rate based on direct labor hours. Its volume of manufacturing activity has grown from 20,000 direct labor hours in 1994 to 30,000 direct labor hours in 1997.
Dakota Motorsâ accounting system is reporting a rapid escalation in the costs per unit of producing the Standard and Deluxe models. Management is puzzled and vexed by these cost increases, since the prices of various production inputs (such as labor, raw materials, components, engineers, supervisors, etc.) have increased only marginally during these years, and the production methods for producing the Standard and Deluxe models have not changed.
Below, is data regarding support activities, annual support costs and driver volumes:
Support Costs | |||
Support Activity | Cost driver | 1994 | 1997 |
Supervision | Direct labor hours | $144,000 | $220,000 |
Machine maintenance | Machine hours | $ 80,000 | $140,000 |
Quality control | # of inspections | $ 40,000 | $100,000 |
Machine set ups | # of setups | $ 20,000 | $120,000 |
Process engineering | Engineering hours | $ 10,000 | $150,000 |
Total support costs | $294,000 | $730,000 |
Standard | Deluxe | New Models | Total | |
Direct labor hours | 12,000 | 8,000 | 10,000 | 30,000 |
Machine hours | 14,000 | 12,000 | 14,000 | 40,000 |
# of inspections | 400 | 400 | 600 | 1400 |
# of setups | 11 | 9 | 100 | 120 |
Engineering hours | 120 | 140 | 1,740 | 2,000 |
Assume that the production quantities and driver volumes for the Standard and Deluxe models have not changed between 1994 and 1997.
Questions:
1) Determine the total support costs assigned to the Standard model and to the Deluxe model in 1994 and in 1997 under the traditional costing system.
2) Calculate the cost driver rates and determine the support costs that would be assigned to the Standard, Deluxe and New models in 1997 under an activity based costing system. Be sure to display and label all your calculations.
3) Write a paragraph explaining to top management how the traditional costing system distorts product costs in Dakota Motors. Use the data on engineering hours and direct labor hours to quantitatively support your argument.
John Orland, controller of the JuiceCompany, has been concerned over the erosion of the recentfinancial results especially for the standard flavors (A and B)which used to earn a hefty 20 per cent of profit margin.
Recently, Dan Brun, the salesmanager has expanded the lines of products to encompass new flavors(D & C) which were in high demand by customers who were willingto pay 5 to 10 % premium.
Richard Dunn, the manufacturingmanager, was also excited to introduce the new flavors since theywere expected to generate higher margins while using the sametechnology as standard flavors. However, he noticed that theintroduction of new flavors added some technical complexities tothe production process. For instance, unlike flavors A & B,which were produced in huge volume and in long production runs,difficulties started to arise with the new flavors which wereproduced in smaller batches but required more changeovers and moreproduction runs (see Exhibit 3).
The Juice Company produced thedifferent flavors in the same factory. Each flavor had a bill ofmaterials that determines the quantity and cost of direct materialsused for the production of each flavor. Additionally, a routinesheet was used to track the direct labor expenses incurred at eachoperating step for each of the four flavors. All overhead costswere grouped at the plant level and allocated to each flavor on thebasis of direct labor cost. The rate was arbitrarily set at 400 %of direct labor costs (see Exhibit 2).
John was intrigued by the behaviorof their main competitors who were more interested in competing inlow margin flavors (A and B) than in high profit margins (Flavors C&D). Such behavior has led the controller to question theaccuracy of the costing system used by the company and to concludethat the current method of allocation of indirect costs isdistorting their productsâ costs thereby causing inappropriatepricing.
To remedy the distortions caused bythe traditional method of costing based on one single cost pool ofindirect costs, John decided to implement activity-based costing(ABC) method which focuses on the activities, how they areperformed, and the resources they consumed and to assign activitiescosts to products based on how much demand each of these productsputs on these activities. After careful analysis of themanufacturing operations of the company and input from engineers aswell as manufacturing and operating managers, the controlleridentified four main activities: process production run, set upequipment, manage products, and run machines.
The demand on these activities bydifferent flavors is illustrated in Exhibit 3.
In order to determine the costsincurred to perform these various activities, he began byidentifying the resources that were being consumed by theseactivities. These resources were then grouped in six categories asshown in Exhibit 1. To gather the required new cost information, heproceeded to interview the department heads in charge of supportstaff wages and benefits and insurance; he found out that theirservices are used by three activities: process production run(35%), set up (35%), and the remaining 30 % consumed to manageproducts.
Next, the controller tackled theinformation system item and determines, after interview with thehead of the information system department, that process productionruns accounts for 25 % of their services while 75 % are used tomanage products.
The results of his investigationsabout the usage of the equipment revealed that it was entirely usedto run machines. Maintenance services were shared equally betweenthe production run activity and run machine activity. Finally,utility was shared equally by the four activities.
Questions
Describe the problem the company is facing
Estimate the costs for the four pens products using ABC
Explain why the ABC costs are different from those provided bythe traditional method based one single cost pool of indirectcosts.
What are the managerial implications for the revised estimates?(i.e.,What would you do if you were the manager of the company andwhy?)
Exhibit 1 | |||
Resources Used | Costs of Resources | ||
Support staff wages | $ 40,000.00 | ||
Benefits and insurances | 15000 | ||
Information Systems | 12000 | ||
Equipment | 8000 | ||
Maintenance | 6000 | ||
Utilities | 2000 | ||
Total | $ 83,000.00 | ||
Exhibit 2: Traditional Income Statement | |||||
Flavor A | Flavor B | Flavor C | Flavor D | Total | |
Number of units produced | 80000 | 60000 | 12000 | 3000 | 155000 |
Sales | $ 82,000.00 | $ 55,000.00 | $ 16,000.00 | $ 4,000.00 | $ 157,000.00 |
Material Costs | $ 18,000.00 | $ 9,000.00 | $ 5,200.00 | $ 1,000.00 | $ 33,200.00 |
Direct Labor Costs | $ 10,900.00 | $ 7,800.00 | $ 1,600.00 | $ 450.00 | $ 20,750.00 |
Indirect Costs (400% of direct labor costs | $ 43,600.00 | $ 31,200.00 | $ 6,400.00 | $ 1,800.00 | $ 83,000.00 |
Total operating income | $ 9,500.00 | $ 7,000.00 | $ 2,800.00 | $ 750.00 | |
Profit margin percentage | 12% | 13% | 18% | 19% |
Exhibit 3: Activity usage | |||||
Flavor A | Flavor B | Flavor C | Flavor D | Total | |
Production sales in units | 80000 | 60000 | 12000 | 3000 | 155000 |
Sales in Dollars | $ 82,000.00 | $ 55,000.00 | $ 16,000.00 | $ 4,000.00 | $ 157,000.00 |
Machine hours per unit | 0.1 | 0.1 | 0.1 | 0.1 | 15500 |
Production runs | 60 | 60 | 30 | 10 | 160 |
Total setup time (hours) | 160 | 130 | 180 | 90 | 560 |
Manage Products | 1 | 1 | 1 | 1 | 4 |