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34 Cost Management Chapter 7 Activity-Based Costing and Management LEARNING OBJECTIVES Chapter 7 addresses the following questions: LO1 Differentiate activity-based costing (ABC) from traditional costing. LO2 Use cost hierarchy to help assign costs to activities. LO3 Apply an ABC system in assigning costs. LO4 Describe the characteristics and use of activity-based management (ABM). LO5 Explain GPK and RCA. LO6 Describe how ABC, GKP, and RCA affect managers’ incentives and decisions. These learning questions (LO1 through LO6) are cross-referenced in the textbook to individual exercises and problems. © 2012 John Wiley and Sons Canada, Ltd. 35 Cost Management QUESTIONS 7.1 If direct labour hours are used for tending machines and equipment, small batches take fewer direct labour hours and so are allocated less overhead. However, if overhead costs increase more with setup time than with direct labour costs, the cost to set up for a large batch is likely similar to the cost of setting up a small batch. The cost per unit is then probably much lower for the large batch than for the small batch. 7.2 Organization-sustaining activities are activities related to the overall organization and unaffected by customers served or by quantities of products, batches, or units. Facility- sustaining activities are activities related to the overall operations of a production facility and unaffected by customers served or by quantities of products, batches, or units. Customer-sustaining activities are customer service activities that are independent of sales volumes and mix. Product-sustaining activities occur to support a product line or a single product if it is not part of a product line. Batch-level activities increase as the number of batches increase. These activities include setup and monitoring batches of product. Unit-level activities increase proportionately with production volumes or sales volumes. 7.3 Because ABC uses more cost pools and more cost drivers to reflect cause and effect relationships, ABC costs usually map the relation between cost and use of resources more accurately. Hence ABC costs reflect different proportions of the resource costs than do traditional costs. 7.4 No, increasing the number of cost pools and cost drivers can increase measurement error because small measurement errors for each pool and each driver can distort total cost once costs are allocated, simply from the increase in calculations that take place. In addition, if the production process is very simple and products use the same amount of resources each, increasing the number of cost pools will not increase the accuracy of the allocations. 7.5 No, because it is expensive to implement, the costs outweigh the benefits for some firms. Firms that are already operating efficiently may not benefit from an ABC system, especially if they have available capacity. Research has shown that ABC is more successful within organizations that use flexible systems, have integrated information systems, and produce a variety of products. 7.6 Yes, ABC can be used in service industries. In service organizations, ABC may be especially helpful if there are capacity limits. Service industries often have a large proportion of fixed resources, and understanding the relationship between cost and the use of these resources can improve the efficiency of the organization. 7.7 Measurement error could decrease because ABC can do a better job of allocating costs to the use of resources. Better allocation reduces problems such as product cross- subsidization, in which costs are overallocated to some products and underallocated to © 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 36 others. However, measurement error could increase because increasing the number of cost pools and cost drivers results in small measurement errors for each pool and each driver. As the number of calculations increase, these small measurement errors interact as costs are allocated (rates are developed and used as multipliers), and so the size of measurement error is likely to increase. 7.8 Several costs that are incurred when implementing an ABC system include the time it takes employees or consultants to determine appropriate cost pools and cost drivers, the cost to track and measure the number of activities because these may not be recorded in the accounting system, and the cost to set up an information system to develop ABC reports. Several benefits include the ability to identify non-value added activities, and a better understanding of the use of overhead resources. 7.9 First, meet with accounting employees to learn about all of the different activities they perform. Identify activities that are homogeneous and can be pooled together. For example, budget preparation for each department is probably similar, but it may take different amounts of time according to the complexity of the department. Pool all of the various budgeting activities. Once a list of activities has been identified, employees’ opinions about appropriate cost drivers can be solicited. Activities that have the same cost drivers could probably be pooled. 7.10 Yes, research has shown that ABC is more successful within organizations that use flexible systems, have integrated information systems, and produce a variety of products. With ABC, a better mapping of the use of resources to each product line allows managers to choose the optimal product mix. In addition, if the processes are complex, ABC allows analysis of the activities underlying complex processes so improvements are easier to identify, as are non-value added activities. In these cases, the costs are likely less than the benefits achieved. 7.11 Activity-based costing analyzes the activities performed in manufacturing and service production. Once the activities are identified, costs for each activity are collected into separate cost pools. Next a cost driver is chosen that reflects changes in the costs of activities. The cost driver is used to allocate the costs of the activity to products, services, or some other cost object. There are multiple cost pools and drivers. Traditional costing uses only a few overhead cost pools and allocates the costs based on drivers such as direct labour hours, direct labour cost, or machine hours. In a traditional cost system, the cost pools are very large and so it is impossible to find an allocation base that reflects resource use. It is merely a logical system of assigning part of overhead costs to each product or service. ABC, on the other hand, selects cost pools around activities so that a cost driver can be chosen to better reflect a product or service’s use of resources. Therefore, ABC systems have more cost pools and drivers. Because an ABC system is more complex, more time, effort, and money are required to implement ABC systems than traditional costing systems. 7.12 Activity-based costing is a method of allocating costs to products or other cost objects. Activity-based management is the process of using ABC information to improve © 2012 John Wiley and Sons Canada, Ltd. 37 Cost Management operations and profitability by analyzing the actual activities and processes to reduce non-value added activities, and improve the efficiency of activities. In addition, managers may be able to better understand different products’ uses of fixed resources, which could be important if there are capacity constraints. 7.13 There are several reasons for using ABC and ABM to improve an organization’s environmental performance. Environment-related activities, such as disposing of hazardous substances and cleaning up spills of these substances, are non-value added. If those types of activities can be minimized, costs are also likely to be reduced. In addition, most companies would prefer to avoid the negative reputation effects that are associated with pollution problems. Once managers become aware of environmental costs, they may realize that investing in prevention activities will actually reduce costs in the long run. 7.14 Prevention activities are activities performed to insure defect-free production. These activities could include • inspecting incoming direct materials • designing and redesigning products and manufacturing processes to reduce defect rates • identifying areas where defects arise and solving the underlying cause of the defects Appraisal activities are activities performed to identify defective units, and include the following activities: • Inspection of products • Inspection of manufacturing process • Monitoring of service delivery process • Testing Production activities are activities undertaken in the production or rework of failed units. These include • Labour tasks and materials to produce spoiled units • Reworking spoiled units Post-Sales activities are activities undertaken after the product has been sold to remedy problems caused by defects and failed units. These activities include • Accepting returned products and exchanging them for good products or refunding their cost • Repairing defective units • Preparing for and participating in legal actions that result from defective units 7.15 ABC, GPK, and RCA are costing systems that use multiple cost pools and more accurately map costs to the use of resources than traditional costing systems. Implementation for all three methods requires identifying multiple cost pools and analyzing activities or resources to discover cause-and-effect relationships of cost and © 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 38 cost drivers. ABC analyzes activities and uses a specific hierarchy. GPK considers cost centres that are usually smaller than departments, perform a single repetitive activity and are under the control of one manager. RCA analyzes cost centres and resource cost pools. Both GPK and RCA focus on volume of time. GPK uses practical or budgeted capacity for the denominator level of the cost driver, while RCA uses theoretical capacity. ABC is best used for cost control, improving efficiency and understanding the relationship between costs and the use of resources. GPK focuses on marginal costs and so it can be used for short term decisions, RCA can be used for short-, mid-, and long-term decisions. © 2012 John Wiley and Sons Canada, Ltd. 39 Cost Management MULTIPLE-CHOICE QUESTIONS 7.16 Which of the following statements best describes the objective of kaizen costing? a) To accumulate costs that are associated with a short-term or long-term project b) To determine all costs related to the quality of a product c) To reduce costs and improve quality through continuous improvement d) To simplify cost accounting in a just-in-time environment Ans: C 7.17 Which of the following statements best describes activity-based management? a) ABM is an approach developed in response to the competitive pressures of today’sglobal market. b) ABM does not use activity-based costing to improve a business. c) ABM is designed to set the goals and objectives of an organization. d) ABM focuses on functional areas and products. Ans: D 7.18 Which of the following statements is correct? a) Machine-related costs are batch-level activities. b) Engineering costs are unit-level activities. c) Inspection and testing costs are organization-sustaining activities. d) Supervision and scheduling costs are facility-sustaining activities. Ans: A 7.19 What is the overhead cost per unit using activity-based costing? VE1 VE2 a) $42.00 $84.00 b) $67.86 $66.76 c) $77.00 $61.00 d) $84.00 $56.00 Ans: B (VE1 Machine-related: $62,000/(1,000*2 + 1,500*4) * 2 MH = $15.50 ) (VE1 Supervision and scheduling: $48,000/(140+180) * 140/1000 = $21.00) (VE1 Engineering: $32,000/(240+260) * 240/1000 = $15.36) (VE1 Inspection and testing: $26,000/(320+200) * 320/1000 = $16.00) (VE1 $15.50 + $21.00 + $15.36 + $16.00 = $67.86) © 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 40 7.20 What is the overhead cost per unit using traditional costing? VE1 VE2 a) $42.00 $84.00 b) $67.20 $66.20 c) $73.50 $63.00 d) $80.64 $58.24 Ans:A($168,000/(1,000*2+1,500*4) * 2 = $42.00) © 2012 John Wiley and Sons Canada, Ltd. 41 Cost Management EXERCISES 7.21 Mapping Costs to the Cost Hierarchy – Fairgood& Hernandez, CA A. Receptionist salary is an organization-sustaining activity (1) because the receptionist serves everyone who comes through the door and thus cannot be identified with one product or unit. B. Financial forecasting software is an organizational-sustaining activity (1) if it is used to forecast sales for the entire company. However if it used only by one product line, it is a product-sustaining activity (4). C. Photocopy machine rental is anorganization-sustaining activity (1) when everyone uses the machine, but could be a product, batch or unit related cost if a password were used to keep track of copies made for each client or department. D. Janitorial service is anorganization-sustaining activity (1) because the entire facility uses this evenly. E. Audit manager’s salary is a unit-level activity (6)because the manager is in charge of a number of different audits and bills his or her time to each audit. F. Long distance telephone charges are unit-level activity (6) if the bill includes details of to whom the calls were made, and could be product-sustaining activity (4) if the calls are marketing a particular product. It just depends upon the purpose of the calls. Some companies have Watts lines and pay a flat fee for all long distance calls. In this case the cost is an organization-sustaining activity (1). G. Meal costs for entertaining clients could be a customer-sustaining activity (3)if related only to that particular customer, or product sustaining activity(4)if the customer is associated with only one product. H. Costs of annual employee golf party is an organization-sustaining activity (1)because it benefits all departments. I. Office supplies such as paperclips and tablets of paper are organization-sustaining activity (1)costs unless they can be traced to a particular product or batch. J. Annual subscription for income tax regulations is a product-sustaining activity (4)if it pertains to one department of the firm. If it pertains to the entire firm, it is a facility- sustaining activity (2). © 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 42 7.22 Identifying Costs Using the ABC Cost Hierarchies – Steam Whistle Brewing Following are the CMA answers to this question. However, one could argue that some of the unit-level costs could instead be categorized as batch-level. A. Facility-sustainingcosts: Manufacturing facility $1,500,000 B. Product-sustaining costs: Product development $1,250,000 C. Batch-level costs: Production setup $700,000 D. Unit-level costs: Materials handling $ 850,000 Production line labour 2,500,000 Power (assuming most power is to cool beer and run machines, not for overhead) 500,000 Total unit-level costs $3,850,000 7.23 ABC Cost Hierarchy A. Unit-level activities and costs relate to each unit produced, in this case, each car rented. The cost of washing each car between rentals is an example of a unit level cost. Costs for the activities of making the reservation, turning the vehicle over to the renter, and completing the paperwork at the end of the rental are also unit-level. B. Batch-level activities and costs relate to the number of batches produced. For a car rental fleet, cars at a number of outlets are probably sent for oil changes or other routine maintenance in batches. Car rental companies located off-site near an airport usually operate a shuttle service from the airport to the rental car location. Multiple passengers are usually picked up and dropped off on each run of the shuttle. Batch-level costs for the shuttle would include vehicle depreciation, maintenance, and gasoline, plus the driver’s labour costs. C. Product-sustaining activities and costs relate to entire product lines. For a car rental company, the different types of cars for rent could be considered product lines, for example economy cars, mid-sized cars, and so on. Or the company might see its product lines more broadly, such as a product line of cars and a separate line for trucks. Advertising and marketing costs are likely to be product-line related if the company advertises either trucks or cars, but not both. D. Customer-sustaining activities and costs relate to the different clients. Sometimes businesses establish a relationship with car rental agencies if employees need to travel by car for business. These customers may require special attention, such as car delivery, or last minute rentals. The costs of these services are customer-sustaining. Rental companies also have programs such as the Hertz #1 Club, where members receive © 2012 John Wiley and Sons Canada, Ltd. 43 Cost Management preferential treatment. Special costs for these programs include extra personnel to process the rental and park the vehicle in an easily accessible location. E. Facility-sustaining activities and costs relate to the facility. For a car rental agency, these could include depreciation and maintenance of the building and parking lots for each outlet. Facility-sustaining costs would also include the facility manager’s salary, electricity and janitorial service, computer terminals, and property taxes. F. Organization-sustaining activities and costs relate to the entire organization. The CEO’s salary, and building lease, rent or depreciation costs at the company’s headquarters are all organization-sustaining costs. Companies such as Hertz also have large organization- wide costs for computerized reservation and vehicle inventory systems. 7.24 Cost Pools and Cost Drivers F Machining (As machine hours increase, costs such as maintaining machines increase) D Purchasing activities (As number of invoices increases, costs such as wages for employees filling out invoices and supplies used by these employees increase.) G Inspection (As the number of units produced increases, the number of units inspected also increases.) B Assembly (As the number of parts increases, it takes more overhead cost in material handling, etc. to assemble the product.) A Payroll (As number of employees increases, more employee time and supplies are needed to produce paychecks.) E A special quick freezing process for food (Food is usually frozen in batches. As the number of batches increases, costs such as electricity and quick-freezing supplies increases.) C Laundry in a hospital (As the number of laundry pounds increases, more labour and supplies costs are incurred because more batches of clothes are washed. 7.25 Traditional Versus ABC Costing - Kalder Products A. Total engineering change cost 6 change orders *$300 each $1,800 Total machine hours 1 MHr + 1.5 MHr 2.5 MHr Rate $1,800 / 2.5 MHr $720/MHr Total allocated cost for AJ40 1 MHr * $720/MHr $ 720 Total allocated cost for AJ60 1.5 MHr * $720/MHr 1,080 Total allocated costs $1,800 © 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 44 B. Total engineering change cost 6 change orders *$300 each $1,800 Total allocated cost for AJ40 4 change orders *$300 $1,200 Total allocated cost for AJ60 2 change orders * $300 600 Total allocated costs $1,800 C. Comparison of costs allocated under the two systems: AJ40 AJ60 Total Traditional costing $ 720 $1,080 $1,800 ABC costing 1,200 600 1,800 Product Cross Subsidization Overcharge (Undercharge) $ (480) $ 480 $ 0 Percent Overcharge (Undercharge) (40)% 80% Cross-subsidization means that one product is allocated more overhead cost relative to its use of overhead resources and, therefore, other products’ overhead cost is less than their use of resources. 7.26 ABC Cost Hierarchy, Traditional Versus ABC Costing – Yonex Company A. Activity Classification Testing and Inspections Batch level activities and costs Machine Setup Batch level activities and costs Machine Stamping Unit level activities and costs Plant Maintenance Facility sustaining level activities and costs B. Total Labour Hours for two products: 1,500 + 2,500 = 4,000 hours $400,000 / 4,000 hours = $100 per labour hour MB-R: $100 x 1,500 = $150,000 MB-X: $100 x 2,500 = $250,000 Using the traditional costing method, MB-R is allocated $150,000 of the overhead costs, while MB-X is allocated $250,000. © 2012 John Wiley and Sons Canada, Ltd. 45 Cost Management C. The overhead rate cost per activity is calculated as follows: Total OH Rate Activity MB-R MB-X Activity TotalCost Cost/Activity Testing and Inspections 400 400 800 $120,000 $150 Machine Setup 120 80 200 $80,000 $400 Machine Stamping 25,000 15,000 40,000 $160,000 $4 Plant Maintenance 1,500 2,500 4,000 $40,000 $10 MB-R MB-X Activity OH Rate MB-R OH MB-X OH Testing and Inspections $150 400 $60,000 400 $60,000 Machine Setup $400 120 $48,000 80 $32,000 Machine Stamping $4 25,000 $100,000 15,000 $60,000 Plant Maintenance $10 1,500 $15,000 2,500 $25,000 Total Overhead Allocated $223,000 $177,000 D. Using the traditional costing method, MB-X is over costed $250,000 versus $177,000. This is likely to lead to inaccurate pricing and make the product less competitive in the market. ABC costing better matches resources usage to the overhead costs, and thus can help managers make better decisions, especially in resources usage, pricing, product mix, or performance evaluation. 7.27 Traditional Versus ABC Costing – CompuTrain Learning Centre A. Overhead rate for each type of activity: Overhead Rate Cost Activity Cost/Activity Registration $10,000 120 + 280 = 400 students $25 per student Computer Depreciation $36,000 1,400 + 1,000 = 2400hrs $15 per hour $1,000 per Rent $26,000 16 + 10 = 26 classrooms classroom Total Overhead Costs $72,000 © 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 46 Overhead Rate IT Training Office Training Registration $25 120 $3,000 280 $ 7,000 Computer Depreciation $15 1,400 $21,000 1,000 $ 15,000 Rent $1,000 16 $16,000 10 $ 10,000 Total Overhead Costs $40,000 $ 32,000 B. The average cost per student for each service: IT Training Office Training Direct Materials (books & courseware) $9,000 $6,000 Direct Labour (instructors) 15,000 9,000 Overhead: Registration 3,000 7,000 Computer Depreciation 21,000 15,000 Rent 16,000 10,000 Total Overhead costs 40,000 32,000 Total Costs $64,000 $47,000 # of students 120 280 Cost per student $533.33 $167.86 C. Under the traditional costing method, IT Training was over charged by $5,000 for the overhead costs, which subsidized Office Training. As a result, IT Training per student was over costed by $41.67, and Office Training per student was under costed by $17.86. IT Training was over costed because based on the traditional costing method, IT Training had higher labour cost, and overhead was proportionally costed more to the IT Training. Using the ABC method, the overhead was charged based on the resources usage, which better matched the activities to the costs. © 2012 John Wiley and Sons Canada, Ltd. 47 Cost Management 7.28 ABC Costing, ABM - Applewood Electronics A. 1. Manufacturing cost per unit under traditional cost accounting In the traditional cost accounting system, overhead is allocated to products based on machine hours. The rate per hour is calculated as follows: Total estimated overhead $4,800,000 Estimated machine hours: Monarch (8.0 hours x 22,000 units) 176,000 Regal (4.0 hours x 4,000 units) 16,000 Total estimated machine hours 192,000 Estimated allocation rate per machine hour ($4,800,000/192,000) $25.00 The total manufacturing cost per unit is the sum of per unit direct material, direct labour, machine usage, and allocated overhead, as follows: Monarch Regal Direct material $208.00 $584.00 Direct labour 1.5 DL hrs x $12 18.00 3.5 DL hrs x $12 42.00 Machine usage 8 machhrs x $18 144.00 4 machhrs x $18 72.00 Overhead 8 machhrs x $25 200.00 4 machhrs x $25 100.00 Total $570.00 $798.00 2. Manufacturing cost per unit under ABC First, calculate the allocation rate for each of the ABC pools: Soldering ($942,000/1,570,000 solder joints) $0.60 per solder joint Shipments ($860,000/20,000 shipments) $43.00 per shipment Quality control ($1,240,000/77,500 units inspected) $16.00 per inspection Purchase orders ($950,400/190,080 purchase orders) $5.00 per purchase order Machine power ($57,600/192,000 machine hours) $0.30 per machine hour Machine setups ($750,000/30,000 setups) $25.00 per setup Next, calculate total manufacturing costs allocated to each product under the ABC system and then calculate the total manufacturing cost per unit: © 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 48 Monarch___________ Regal__________ Soldering 1,185,000 solder jts x $0.6$ 711,000 385,000 solder jts x $$ 231,000 Shipments 16,200 shipments x $43 696,600 3,800 shipment x $43 163,400 Quality control 56,200 inspections x $16 899,200 21,300 inspections x $16 340,800 Purchase orders 80,100 POs x $5 400,500 109,980 POs x $5 549,900 Machine power 176,000 machhrs x $0.30 52,800 16,000 machhrs x $0.30 4,800 Machine setups 16,000 x $25 400,000 14,000 x $25 350,000 Total ManufacturingOverhead $3,160,100 $1,639,900 Total Manufacturing Overhead Per Unit $3,160,100/22,000 units $143.64 $1,639,900/4,000 units$ 409.98 Direct material 208.00 584.00 Direct labour 1.5 DL hrs x $12 18.00 3.5 DL hrs x $12 42.00 Machine usage 8 machhrs x $18 144.00 4 machhrs x $18 72.00 Total ManufacturingCost Per Unit $513.64 $1,107.98 B. The traditional costing system allocates a lump sum of overhead based only on machine hours, while the ABC system uses six cost pools to allocate the overhead. Allocations using these cost pools and cost drivers more accurately reflect the flow of resources. C. 1. Operating profit per unit under traditional cost accounting: Monarch Regal Selling Price $ 900.00 $1,140.00 Manufacturing (570.00) (798.00) Selling, General, and Administrative (265.00) (244.60) Traditional costing operating profit $ 65.00 $ 97.40 2. Operating profit per unit under ABC: Monarch Regal Selling Price $900.00 $1,140.00 Manufacturing (513.64) (1,107.98) Selling, General, and Administrative (265.00) (244.60) ABC costing operating profit $121.36 $ (212.58) D. Based on the profit information using ABC, Applewood should concentrate on the Monarch. Under ABC, it appears that the organization incurs a loss for each unit sold of Regal. Using this ABC information would definitely affect the recommendation because one product appears to have a negative profit margin. Note: This problem is from an old CMA exam. The calculations shown in this problem probably include fixed costs. Remember from Chapter 4 that organizations need to emphasize the product with the highest contribution margin to maximize profits; however, that product cannot be identified with the information given in this problem. Applewood would need to separate costs into flexible (those that vary with activity) and committed (those that do not vary with activity) to determine the ABC contribution © 2012 John Wiley and Sons Canada, Ltd. 49 Cost Management margin for each product. Once this is done, the product with highest contribution margin can be identified and emphasized. 7.29 ABC Costing, ABM - Palmer Company A. Manufacturing cost per unit: Machine setup 2 setups x $50.00 $ 100 Material handling 100 units x 19 parts x $0.50 950 Machining 100 units x 1.25 machine hours x $26.00 3,250 Assembly 100 units x 1.5 direct labour hours x $22.00 3,300 Inspection 100 units x $12.00 1,200 Direct materials 100 units x $100.00 10,000 Total Costs $18,800 Cost Per Unit $18,800/100 units $188 B. Full cost per unit Total manufacturing cost per unit $188 Research and marketing costs per unit 140 Other non-manufacturing costs per unit 320 Total full cost per unit $648 C. Cost savings required: First, calculate the maximum full cost that would allow the company to achieve a profit of 10% based on full cost: Selling price = Full Cost + 10% x Full Cost $650.00 = 100% x Full Cost + 10% x Full Cost $650.00 = 110% x Full Cost Full Cost = $650.00/110% Full Cost = $590.91 Next, calculate the difference between the maximum full cost calculated above and the current full cost. This is the amount of cost savings required to achieve the desired profit. Full cost per unit $648.00 Full cost needed to achieve desired profit 590.91 Cost savings required $ 57.09 © 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 50 7.30 ABC in Job Costing, ABM, Non-Value-Added Activities - Kestral Manufacturing A. Following are the ABC allocation rates: Activity Cost / Activity level Allocation rate Machine set-up $ 40,000 / 400 $100 Material handling 160,000 / 16,000 $10 Product design 100,000 / 2,000 $50 Number of inspection 260,000 /13,000 $20 $560,000 For job 42, overhead costs = (2x$100)+(60x$10)+ (40x$20) +(20x$50) = $2,600 B. For job 43, overhead costs = (4x$100)+(20x$10)+(20x$20)+(100x$50) = $6,000 For the 100 units completed the cost per unit would be calculated as follows: Direct Materials 24,000 Direct Labour 4,000 Overhead Allocated 6,000 Total Job cost 34,000 Cost per unit = 34,000 / 100 units = $340 C. Non-value added activities are tasks or functions that are unnecessary and waste resources because they do not increase the worth of an organization’s goods or services to customers. At Kestral, non-value-added activities include moving materials from place to place (such as from receiving dock to warehouse to one work area and then to another work area). The company could reduce costs by minimizing the handling of materials. Another non-value-added activity is inspection. With sufficient quality improvements and continuous inspection by workers during production processes, the need for a separate inspection process can be reduced or eliminated. Set-up costs are also considered non-value added and the set-up activity could be analyzed to reduce steps and materials if possible so that costs are reduced. 7.31 Design ABC System, Per-Unit ABC Costs, Uncertainties - Elite Daycare A. There are several cost objects that could be chosen for Elite Daycare, depending on the planned use of information. The director may want to develop a function for total costs of the daycare for budget or benchmarking purposes. In that case, the cost object is the daycare itself. Alternatively, she might choose the type of service (full-time or part-time) as the cost object. If she wanted to better understand the cost per child, she could choose a per-child cost object. This problem focuses on the daycare cost function, so the cost object is the daycare program. © 2012 John Wiley and Sons Canada, Ltd. 51 Cost Management Next, cost pools need to be developed. For Elite Daycare, there appear to a number of different activities: greeting and leaving, preparing and serving food, supervising naps, supervising recreation, and activity time. The greeting and supervising activities can probably be combined into one cost pool. However, supplies are probably used during activity time, and the director may want to know an approximate cost per child for activity time. Therefore, a single pool can be used for greeting, supervising naps, and recreation; a pool for supervising activities; and another pool can be used for meal-related activities (preparing and serving food, monitoring behavior). Next, cost drivers for each pool need to be chosen. Cost drivers for greeting and supervising activities could be number of children or time spent. Because supervising naps and recreation activities are similar to greeting, cost driver choices would be similar for these two pools. A number of different children can be supervised at one time, so time spent would be probably be easiest to track and provide an appropriate accounting of costs related to supervising activities. Cost drivers for preparing and serving food could be either the number of meals served or the number of children served. Tracking meals served is probably just as easy as tracking number of children, but meals are more closely related to food preparation, so number of meals served will be used as the cost driver. Cost drivers for supplies could be number of art activities or number of children, among others. It would be easiest to track number of children, and it is likely that each child uses similar amounts of supplies. B. Annual cost per child The percentage of time for the greeting and supervising pool is 30% (20%+10%), 20% for meal-related activities, and 50% for supervising educational activities. These times can be further categorized into full-time and after-school by considering the percentage of total hours each program uses. There are 10 hours available per full-time child, and 3 hours per child after school. Therefore, there are 300 (10 hours x 30 children) full-time child hours available per day and 30 (3 hours x 10children) after-school child hours available. Of the total 330 hours available, 91% (300/330) of the hours are full-time child hours, and 9% are after-school child hours. Now the calculation of the ABC meal related activities cost requires several steps, as follows: Estimated annual volume of snacks/meals: (Assume 5 days per week x 50 weeks = 250 days) Full-time (30 children x 3 snacks & meals x 250 days) 22,500 After-school (10 children x 1 snack x 250 days) 2,500 Number of meals served 25,000 Total food cost $20,000 Time spent on meal preparation (20% x $100,000) 20,000 Total cost of snacks and meals per year $40,000 Estimated cost per snack/meal ($40,000/25,000) $1.60 © 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 52 The total annual ABC cost per child is calculated as follows: Full-Time After-School Snacks/meals: Full-time (3 snacks/meals x 250 days x $1.60) $1,200 After-school (1 snack/meal x 250 days x $1.60) $ 400 Supplies: Full-time ($10,000/30 children) 333 After-school ($8,000/10 children) 800 Supervising educational activities: Full-time (50% x 91% x $100,000)/30 1,517 After-school (50% x 9% x $100,000)/10 450 Supervising naps, recreation, and greeting: Full-time (30% x 91% x $100,000)/30 910 After-school (30% x 9% x $100,000)/10 ______ 270 Total Annual Cost Per Child $3,960 $1,920 C. The employees work with both full-time and after-school children, and there are uncertainties about how much time they spend with each type of student. If the two groups of children are combined for some activities, then any allocation of salaries or wages to each service is arbitrary and unlikely to reflect the two services’ use of employee time. If the two services are completely separate, the cost of salaries and wages can be traced directly to the service. However, for activities such as snacks, some employee time is probably spent preparing snacks for both groups at once, and allocating this cost would be an uncertain and arbitrary process. It is impossible for employees to track exact time spent per service for activities undertaken for both services, such as snacks and possibly meeting parents at the end of the day. There are uncertainties about whether allocation bases reflect the use of resources because these are fixed resources, and the cost does not vary proportionately with any type of volume measure. Therefore, any allocation is arbitrary and will not accurately reflect use of those fixed resources. 7.32 ABM, Customer Profitability A. Activity-based management involves the use of ABC cost information to develop a comparison of the costs and benefits of tasks and procedures undertaken within the organization to identify improvements that can be made in quality and efficiency or cost reductions. B. A high-cost customer is one for whom contribution margin is low, relative to other customers, but who requires costly services such as special customized products, special shipping procedures, small production and delivery quantities, specialized post-sales © 2012 John Wiley and Sons Canada, Ltd. 53 Cost Management service, or customer services before purchasing, and so on. Low-cost customers would provide relatively more contribution from their orders with little special treatment. These customers may order large quantities of regular products and not require any special delivery or help before or after the sale. C. There are many possible ways to write this paragraph, and the wording depends on the assumptions that are made about the particular audience for the paragraph, the customer, and the nature of the company’s business. Below is a sample paragraph. Several approaches can be taken to improve profitability for high-cost customers. Accountants can identify costs for these types of customers, and the company can negotiate with each customer to either charge for some of the specialized services or motivate the customers to reduce the amount of costly services required. Ways to reduce costs include improving the predictability of orders, reducing the amount of engineering changes or other product changes required, and finding standard products that might substitute for customized products. Customers requiring large amounts of technical support following a purchase might be willing to pay for this service. 7.33 Quality Costs Using ABC Versus Traditional Costing - New-Rage Cosmetics A. 1. Quality control cost per order using ABC Incoming material inspection 12 types of material x $11.50 $ 138.00 In-process inspection 17,500 units x $0.14 2,450.00 Product certification 25 orders x $77.00 1,925.00 Total quality control costs $4,513.00 Quality control cost per order $4,513.00/25 orders $180.52 2. Quality control cost per order using traditional cost accounting Total quality control costs assigned = Directlabour costs x 14.5% = $27,500 x 14.5% = $3,987.50 Quality control cost per order = $3,987.50/25 orders = $159.50 B. Under the ABC system, the costs are more related to the resources used to insure quality control. These costs are primarily product inspection and certification costs, and the allocated costs change as the types of materials and number of units inspected change. Under traditional cost accounting, direct labour costs may be related to number of units inspected if it takes more labour to produce more units, but in automated manufacturing © 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 54 settings this is not always the case. In addition, direct labour costs are not related to types of materials. Therefore, using direct labour costs to assign quality costs provides poor quality information about the variation in quality control costs among different orders. Accordingly, the ABC system provides more accurate costs for quality control. 7.34 Categorizing Quality Activities Please see Exhibit 7.7 for more details about these answers. ___A___ 1. Inspection of units when they are 100% complete to remove defective units. ___P___ 2. Design of a process with as few parts as possible to reduce the chance of defects. ___PS__ 3. Warranty costs for defective products returned to the factory for rework. ___PR__ 4. Reworking of spoiled units before they leave the factory. ___PS__ 5. Costs to defend the company against lawsuits for damages caused by defective products. _P or A_ 6. Tracking number of defects for each manufacturing team and posting of daily defect rates on a plant-wide bulletin board. (Used to motivate employees to improve quality, also requires appraisal) ___PR__ 7. Redesign of a manufacturing process to reduce the rate of defects. 7.35 GPK Multi-Level Income Statement -- Krishnan Manufacturing Following is a multilevel income statement for the Krishnan Manufacturing Plant using a GPK approach. Revenues $800,000 Variable costs 200,000 Contribution margin 1 600,000 Fixed costs, product 150,000 Idle capacity costs 75,000 Contribution margin 2 375,000 Fixed costs, company 200,000 GPK profit $175,000 The problem states that “Krishnan’s accountant aggregates the idle capacity costs.” Thus, the solution above assumes that the $75,000 idle capacity cost relates only to the Krishnan plant, not to the entire company. © 2012 John Wiley and Sons Canada, Ltd. 55 Cost Management 7.36 GPK, RCA, Cost Rates -- Diagnostic Services A and B. Cost function calculations: X-ray supplies Fixed costs: $3,000 per year Proportional costs: $2.10 per X-ray hour × 5,000 budgeted X-ray hours = $10,500 Electricity Fixed costs: 6,000 kWh × $0.10 per kWh = $600 Proportional costs: 4kWh per hour of X-ray use × 5,000 budgeted X-ray hours × $0.10 per kWh = $2,000 X-ray technician Fixed costs: 300 technician hours × $45 per labour hour = $13,500 Proportional costs: 1 technician hour per hour of X-ray use × 5,000 budgeted X-ray hours × $45 per labour hour = $225,000 Maintenance Fixed costs: 100 maintenance hours × $20 per hour = $2,000 Proportional costs: 0.0424 maintenance hour per hour of X-ray use × 5,000 budgeted X-ray hours × $20 per maintenance hour = $4,240 Facilities Fixed costs: 1,000 square feet × $25 per square feet = $25,000 © 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 56 A and B (continued). Cost rates under GPK and RCA: GPK RCA Cost Centre: X-Ray Resource Cost Pool: X-Ray Fixed Proportional Fixed Proportional Output Measure – X-Ray Hours: Output Measure – X-Ray Hours: Practical capacity 5,600 Theoretical capacity 8,760 Budgeted capacity 5,000 Budgeted capacity 5,000 Primary Costs: Primary Costs: Depreciation $ 93,100 $ 0 Depreciation $ 93,100 $ 0 Supplies 3,000 10,500 Supplies 3,000 10,500 Electricity 600 2,000 Electricity 600 2,000 Total Primary Costs 96,700 12,500 Total Primary Costs 96,700 12,500 From Other Cost Pools (i.e., From Other Resources (i.e., Secondary Costs): Secondary Costs): Labour (technician) 13,500 225,000 Labour (technician) 13,500 225,000 Maintenance - equipment 2,000 4,240 Maintenance - equipment 2,000 4,240 Maintenance - facilities 25,000 0 Maintenance - facilities 25,000 0 Fully Assigned Resource Costs $137,200 $241,740 Fully Assigned Resource Costs $137,200 $241,740 Fully Assigned Cost Rate Per Hour $24.50 $48.348 Fully Assigned Cost Rate Per Hour $15.662 $48.348 C. Cost for patient requiring 0.5 hour of time: GPK cost = ($24.50 + $48.348) × 0.5 hour = $36.424 RCA cost = ($15.662 + $48.348) × 0.5 hour = $32.005 D. GPK cost is higher than RCA cost because RCA uses theoretical capacity for fixed costs. Theoretical capacity is larger than budgeted capacity in the denominator, resulting in a smaller cost rate. © 2012 John Wiley and Sons Canada, Ltd. 57 Cost Management E. The technician needs to be on hand for the hours that the diagnostic centre is open. There are likely certain tasks that need to be done on a daily basis to prepare the machine. Costs for maintenance are similar; some routine maintenance is done on a regular basis and does not depend on the number of X-ray hours. Even though these costs are proportional in the technician and maintenance cost pools, a portion of each cost is fixed with respect to X-ray equipment usage. 7.37 GPK, RCA Capacity Analysis – Diagnostic Services Budgeted Practical Theoretical Capacity Capacity Capacity Estimated volume – X-ray hours 5,000 5,600 8,760 Fixed cost rate per X-ray hour $27.44 * $24.50 $15.662 Fixed costs allocated to patient services (5,200 hours × fixed cost rate) $142,688 $127,400 $81,443 Assigned to idle capacity: Unplanned idle capacity (5,000 – 5,200) hours × fixed cost rate ($5,488) ($4,900) ($3,132) Planned idle capacity: (5,000-5,000) hours × $27.44 0 (5,600-5,000) hours × $24.50 14,700 (8,760-5,000) hours × $15.662 58,889 Total Fixed Costs Assigned $137,200 $137,200 $137,200 * $137,200 fixed costs ÷ 5,000 budgeted capacity = $27.44 © 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 58 PROBLEMS 7.38 Setting Up an ABC System, Uncertainties A. 3 Identify and sum the costs into activity-based cost pools 4 Choose a cost driver for each activity 6 For each ABC cost pool, allocate overhead costs to the product or service 1 Identify the relevant cost object 2 Identify the activities necessary for production or service delivery 5 For each ABC cost pool, calculate a cost allocation rate B. All of these steps include uncertainties. After a cost object is chosen, uncertainty exists about whether all of the activities necessary to produce the good or service are identified. Some activities may be overlooked, or the set of activities may include ones that rarely occur and would be an immaterial part of the process. In addition, uncertainties exi
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