This assignment involves the use of a traditional (i.e., non-time-driven) ABC system to address the problem of measuring and managing the cost of capacity. As controller for Zen Company, you’ve been asked to provide input regarding the appropriate level of resource capacity needed to support the strategic initiatives of the company, as identified in the company’s strategic planning system (e.g., its balanced scorecard system and associated strategy maps—see Chapter 18). Because of the company’s focus on exceptional customer service, you’ve decided to run a pilot test by focusing on a single activity: handling customer orders. During the most recent year, total resource costs of this activity were $600,000. You’ve determined that, during the year, 8,000 customer orders were handled by the company. Observations of the process and your own interviews with knowledgeable personnel indicate that the current level of resource spending in this area provides the capacity to efficiently process approximately 10,000 customer orders. (That is, the practical capacity of resources supplied is 10,000 customer orders.) An analysis of past accounting data and the application of the cost-estimation techniques covered in Chapter 8 suggest that resource spending for this activity in the coming year will be approximately $720,000. The company expects to handle 9,000 customer orders during the coming year; practical capacity remains at 10,000 customer orders. Your basic task is to determine how the use of ABC data can facilitate decisions regarding the appropriate level of spending to support the handling of customer orders. 

Required

1. Distinguish between short-term variable costs and short-term fixed (i.e., capacity-related) costs. For many organizations today, including the Zen Company, which type of costs characterize support costs, such as the cost of handling customer orders?

2. ABC fundamentally deals with the issue of assigning costs to activities and then activity-based costs to outputs such as products, services, or customers. From the start, however, you are a bit bewildered: Which data at your disposal should be used to calculate the cost of handling a customer order? Include in your answer a discussion of choice of the capacity level (denominator volume) used to generate ABC costs, an explanation of the term practical capacity, and a short discussion of what is referred to as the death spiral effect.

3. How can the use of ABC data assist managers in managing spending on resource capacity? [Hint: Calculate each of the following for the support activity “handling customer orders”:

(a) Support cost rate (to 2 decimal places), per order handled; 

(b) The cost of unused capacity for order-handling activity (rounded to nearest whole dollar); 

(c) Percentage capacity utilization for order-handling activity (rounded to 2 decimal places, e.g., 87.872% = 87.87%).]Why is the management of resource capacity costs of strategic importance to companies such as Zen?

4. Assume that Zen, in an effort to improve the process of handling customer orders, implements a total quality management (TQM) or similar initiative, the effect of which is to increase the number of orders that can be handled efficiently. As a result, the practical capacity of the process increases to approximately 12,000 orders per year. Assume a total cost, as before, of $720,000 and that, as before, the company in the coming year expects to process 9,000 customer orders. After the TQM implementation: 

(a) What is the support cost rate, to 2 decimal places, for handling a customer order? 

(b) What is the estimated cost of unused capacity after TQM implementation (rounded to nearest whole dollar)? 

(c) What is the capacity utilization rate (percentage) after TQM implementation, rounded to 2 decimal places?

(d) What is the primary lesson based on a comparison of results from requirements 3 and 4?

5. What strategies are available to managers for reducing or eliminating unused capacity?

6. What recommendation would you make to management regarding how the cost of unused (i.e., idle) capacity should be assigned?