CH5 - Traditional costing systems and original activity-based costing

Tuesday, June 04, 2013

2:09 PM



Traditional volume based cost system (Direct labour hours/ Machine hours)

Do not recognize the following:

  • Additional set-up, clean-up, scrap etc. related to more unique, complex, smaller products

Traditional ABC maybe as good as Time driver ABC. But

  • Relies on employee estimates (lack of accuracy)
  • Gives no recognition of excess capacity (included in cost driver rates)
  • Expensive to set up + update



Problem 1

Machine generated alternative text: b (Appendix) 5-28 Original activity-based costing for shared services, outsourcing,
implementation issues Smithers, Inc., manufactures and sells a wide
variety of consumer products. The products are viewed as sufficiently
profitable, but recently some product-line managers have complained about
the charges for the call center that handles phone calls from customers about
the products. Product lines are currently charged for call center support costs
on the basis of product sales revenues. The manager of product X is
particularly upset because he has just obtained a report that includes the
following information for last year:
Piooucr X PRooucr Y
Number of calls for information 2,000 4,000
Average length of calls for information 3 minutes 5 minutes
Number of calls registering complaints 200 1,000
Average length of complaint calls 5 minutes 10 minutes
Sales volume $400,000 $100,000
Product X is simple to use and consumers have little concern about adverse
health effects. Product Y is more complex to use and has many health hazard
warnings on its label. Smithers currently allocates call center support costs
using a rate of 5% of net sales dollars. The manager of product X argues that
the current system does not trace call center resource usage to specific
products. For example, product X bears four times the call center costs that
product Y does, although fewer calls are related to product X, and the calls
consume far less time.

Machine generated alternative text: (a) What activity cost driver would you recommend to improve the current system of assigning
call center support costs to product lines? Why is your method an improvement?
(b) Suppose Smithers announces that it will now assign call center support costs on the basis of
an activity-based cost system that uses minutes of calls (calls for information and calls for
complaints) as the activity cost driver. Suppose also that the rate is 70 cents per minute.
Compare the call center cost assignments to product X and product Y under the previous
system and the new activity-based cost system.
(c) What actions can the product managers take to reduce the center costs assigned to their
product lines under the previous system and the new system? What other functional areas
might help reduce the number of minutes of calls for product Y?
(d) Who might resist implementation of the new activity-based cost system? In your response,
discuss possible reactions of the call center staff and other staff who might be affected by
efforts to reduce minutes of calls.
(e) From the company’s point of view, how might the activity-based costing system help in the
assessment of whether to outsource the call center activities?


  1. Number of calls per product (simple.

Number of minutes of calls (duration cost driver)

  • Provide better linkage to costs





    Previous (5% of sales)



    Activity based (.70 per minute)




  1. Previous system: reduce allocation would be reduce sales
    • This is counter productive

New system: managers can find out methods to improve the system with other functional areas of the company.


  1. People who would resist:
    • Manager of product Y
      • Now we can see that most of the resources are allocated to Y
      • Stuck with more costs and more work to minimize costs
    • Call center
      • Cost more money to track
      • Additional work


  1. Fear of call centers to be outsourced. Push call center staff to improve efficiency and lower costs per minute.


Problem 2


Machine generated alternative text: — (Appendix) 5-29 Cost distortions, original activity-based costs At its manufacturing plant
in Duluth, Minnesota, Endo Electronics Company manufactures two
products, X21 and Y37. For many years, the company has used a simple
plantwide manufacturing support cost rate based on direct labor hours.
A new plant accountant suggested that the company may be able to assign
support costs to products more accurately by using an activity-based costing
system that relies on a separate rate for each manufacturing activity that
causes support costs.
After studying the plant’s manufacturing activities and costs, the plant
accountant has collected the following data for last year:
ITEM X21 Y37
Units produced and sold 50,000 100,000
Direct labor hours used 100,000 300,000
Direct labor cost $1,000,000 $4,500,000
Number of times handled 40,000 20,000
Number of parts 12,000 8,000
Number of design changes 2,000 1,000
Number of product setups 8,000 6,000
The accountant has also determined that actual manufacturing support
costs incurred last year were as follows:
Cî POOL Act ivrn’ Cosis
Handling $3,000,000
Number of parts 2,400,000
Design changes 3,300,000
Setups 2,800,000
Total $11,500,000
The direct materials cost for product X21 is $120 per unit, while for
product Y37 it is $140 per unit.
(a) Determine the unit cost of each product using direct labor hours to allocate all manufacturing
support costs.
(b) Determine the unit cost of each product using activity-based costing.

Machine generated alternative text: (c) Which of the two methods from parts a and b produces more accurate estimates of job costs?
(d) Suppose Endo has been determining its product prices by adding a 25% markup to its
reported product cost. Compute the product prices on the basis of the costs computed in
parts a and b. What do you recommend to Endo regarding its pricing?
(e) What product-level changes do you suggest on the basis of the activity-based cost analysis?
Who would be involved in bringing about your suggested changes?


  1. M support cost driver rate = 28.75/labour hour





Direct Materials Cost



Direct labour cost

= 20


M support cost



Unit cost








Unit cost




  1. Provides a better cost/effect relationship


  1. Endo should consider raising X21's price and lowering Y37's price. Right now the price set for X21 produces a loss based on the activity-based costing


  1. The company can explore ways to reduce design changes and the number of parts for X21 since it has twice as many design changes and 50% more parts compared to Y37.

Management should use collective efforts to reduce costs.



Problem 3


Machine generated alternative text: (Appendix) 5-30 Product cost distortions with traditional costing, original activity-based
costing analysis The Manhattan Company manufactures two models of
compact disc players: a deluxe model and a regular model. The company has
manufactured the regular model for years; the deluxe model was introduced
recently to tap a new segment of the market. Since the introduction of the
deluxe model, the company’s profits have steadily declined, and
management has become increasingly concerned about the accuracy of its
costing system. Sales of the deluxe model have been increasing rapidly.
The current cost accounting system allocates manufacturing support
costs to the two products on the basis of direct labor hours. The company has
estimated that this year it will incur $1 million in manufacturing support
costs and will produce 5,000 units of the deluxe model and 40,000 units of the
regular model. The deluxe model requires 2 hours of direct labor, and the
regular model requires 1 hour. Material and labor costs per unit and selling
price per unit are as follows:
Direct materials cost $45 $30
Direct labor cost 20 10
Selling price 140 80
ReL iro
(a) Compute the manufacturing support cost driver rate for this year.
(b) Determine the cost to manufacture one unit of each model.
(c) The company has decided to trace manufacturing support costs to four activities. Following
are the amount of manufacturing support costs traceable to the four activities this year:
Cc’sr DRIVER UMm DntAoro
Purchase orders Number of orders S180,000 600 200 400
Quality control Number of inspections 230,000 2.000 1.000 1,000
Productsetups Numberof setups 220,000 200 100 100
Machine main tenance Machine hours 350,000 35.000 20,000 15,000
Comp ute the total cost to manufacture one unit of each model.
(d) Compare the manufacturing activity resources demanded per unit of the regular model and
per unit of the deluxe model. Why did the old costing system undercost the deluxe model?
(e) Is the deluxe model as profitable as the company thinks it is under the old costing system?
(f) What should the Manhattan Company do to improve its profitability? Consider pricing and
product-level changes among your suggestions. Who should be involved in implementing
your recommendations?





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