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Activity-Based Costing: a tool to Aid Decision Making

Activity rate for wages and cleaning carpets.

Problem 8-23 (continued)

4. The product margin can be easily computed using the costs along the right-most column of the cost table prepared in part (3).

Sales

$140.00

Green costs:

Wages

$63.75

Cleaning supplies

10.00

Cleaning equipment depreciation

4.00

Vehicle expenses

 60.00

 137.75

Green margin

2.25

Yellow costs:

Office expenses

 13.50

   13.50

Yellow margin

(11.25)

Red costs:

President's compensation

 16.00

   16.00

Red margin

($ 27.25)

5. At most, Gallatin Carpet Cleaning is making only $2.25 on the Flying N Ranch job. If more than $2.25 of the $13.50 in Office Expenses are actually avoidable if the job were not accepted, then the job is actually losing money.

There is a point at which travel costs eat up all of the profit from a job. With the company’s current policy of charging a flat fee for carpet cleaning irrespective of how far away the client is from the office, there clearly is some point at which jobs should be turned down. (What if a potential customer is located in Florida?)

Problem 8-23 (continued)

6. The company should consider charging a fee for travel to outlying customers based on the distance traveled and a flat fee per job. At present, close-in customers are in essence subsidizing service to outlying customers and large-volume customers are subsidizing service to low-volume customers. With fees for travel and for job support, the fee per hundred square feet can be dropped substantially. This may result in losing some low-volume jobs in outlying areas, but the lower fees per hundred square feet may result in substantially more business close to Bozeman. (If the fees are low enough, the added business may not even have to come at the expense of competitors. Some customers may choose to clean their carpets more frequently if the price were more attractive.)

Before making such a radical change, the data should be carefully reviewed. For example, the wage cost of $37.50 for a 75-mile trip seems rather high. Are two people sent out on jobs? Can the remote jobs be done with one person?

Problem 8-24 (60 minutes)

1. The company’s estimated direct labor-hours can be computed as follows:

Deluxe model: 5,000 units × 2 DLHs per unit

10,000 DLHs

Regular model: 40,000 units × 1 DLH per unit

40,000 DLHs

Total

50,000 DLHs

Using just direct labor-hours as the base, the predetermined overhead rate would be:

Using this predetermined manufacturing overhead rate, the unit product cost of each model can be computed as follows:

Deluxe

Regular

Direct materials

$40

$25

Direct labor

14

7

Manufacturing overhead:

$18 per DLH × 2 DLHs

36

$18 per DLH × 1 DLH

     

 18

Total unit product cost

$90

$50

Problem 8-24 (continued)

2. Overhead rates by activity are computed below:

Activity Cost Pool

(a)
Estimated Overhead Cost

(b)
Expected Activity

(a) ÷ (b)
Predetermined
Overhead Rate

Purchasing

$204,000

600

purchase orders

$340

per purchase order

Processing

$182,000

35,000

machine-hours

$5.20

per machine-hour

Scrap/rework

$379,000

2,000

orders

$189.50

per order

Shipping

$135,000

900

shipments

$150

per shipment

Problem 8-24 (continued)

3. a. The overhead applied to each product can be determined as follows:

The Deluxe Model

Activity Cost Pool

(a)
Predetermined
Overhead Rate

(b)
Activity

(a) × (b)
Overhead Applied

Purchasing

$340

per purchase order

200

purchase orders

$ 68,000

Processing

$5.20

per machine-hour

20,000

machine-hours

104,000

Scrap/rework

$189.50

per order

1,000

orders

189,500

Shipping

$150

per shipment

250

shipments

   37,500

Total overhead cost

$399,000

Manufacturing overhead cost per unit = $399,000 ÷ 5,000 units = $79.80 per unit

The Regular Model

Activity Cost Pool

(a)
Predetermined
Overhead Rate

(b)
Activity

(a) × (b)
Overhead Applied

Purchasing

$340

per purchase order

400

purchase orders

$136,000

Processing

$5.20

per machine-hour

15,000

machine-hours

78,000

Scrap/rework

$189.50

per order

1,000

orders

189,500

Shipping

$150

per shipment

650

shipments

   97,500

Total overhead cost

$501,000

Manufacturing overhead cost per unit = $501,000 ÷ 40,000 units = $12.53 per unit

Problem 8-24 (continued)

b. The unit product cost of each model under an activity costing approach would be:

Deluxe

Regular

Direct materials

$ 40.00

$25.00

Direct labor

14.00

7.00

Manufacturing overhead (above)

   79.80

 12.53

Total unit product cost

$133.80

$44.53

4. It is risky to draw any definite conclusions based on the above analysis. The activity-based costing system used in this company is not completely suitable for making decisions. Product costs probably include costs of idle capacity and organization-sustaining costs. They also exclude nonmanufacturing costs that may be caused by the products. Nevertheless, the above analysis is suggestive.

Unit costs appear to be distorted as a result of using direct labor-hours as the base for assigning overhead cost to products. Although the deluxe model requires twice as much labor time as the regular model, it still is not being assigned enough overhead cost, as shown in the analysis in part 3(a).

When the company’s overhead costs are analyzed on an activities basis, it appears that the deluxe model is more expensive to manufacture than the company realizes. Note that the deluxe model accounts for a majority of the machine-hours worked, even though it accounts for only 20% of the company’s direct labor-hours. Also, it requires just as many scrap/rework orders as the regular model, and scrap/rework orders are very costly to the company.

When activity-based costing is used and the company’s transactions are analyzed by product, the overhead cost jumps for the deluxe model from $36.00 per unit to $79.80 per unit. This suggests that less than half the overhead cost is being assigned to the deluxe model that ought to be assigned, and unit costs for the deluxe model are badly understated. If these costs are being used as a basis for pricing, then the selling price for the deluxe model may be too low. This may be the reason why profits have been steadily declining over the last several years. It may also be the reason why sales of the deluxe model have been increasing rapidly.

Problem 8-25 (45 minutes)

1. The results of the first-stage allocation appear below:

Job Size

Estimating and Job Setup

Working on Nonroutine Jobs

Other

Totals


Wages and salaries

$150,000

$ 30,000

$  90,000

$ 30,000

$   300,000

Disposal fees

420,000

0

280,000

0

700,000

Equipment depreciation

36,000

4,500

18,000

31,500

90,000

On-site supplies

30,000

15,000

5,000

0

50,000

Office expenses

20,000

70,000

50,000

60,000

200,000

Licensing and insurance

 120,000

           0

 200,000

   80,000

    400,000

Total cost

$776,000

$119,500

$643,000

$201,500

$1,740,000