3-49 Choice of Cost Driver Study Appendix 3. Richard Ellis, the director of cost operations of American Micro Devices, wishes to develop an accurate cost function to explain and predict support costs in the company's printed circuit board assembly operation. Mr. Ellis is concerned that the cost function that he currently uses based on direct labor costsis not accurate enough for proper planning and control of support costs. Mr. Ellis directed one of his financial analysts to obtain a random sample of 25 weeks of support costs and three possible cost drivers in the circuit-board assembly department: direct labor hours, number of boards assembled, and average cycle time of boards assembled. (Average cycle time is the average time between start and certified completion-after quality testing-of boards assembled during a week.) Much of the effort in this assembly operation is devoted to testing for quality and reworking defective boards, all of which increase the average cycle time in any period. Therefore, Mr. Ellis believes that average cycle time will be the best support cost driver, Mr. Ellis wants his analyst to use regression analysis to demonstrate which cost driver best explains support costs. Week 1 2 3 4 5 6 7 8 9 10 12 13 Circuit Board Assembly Direct Labor Number of Boards Support Costs, Y Hours, X1 Completed, X2 $66,402 7.619 2,983 56,943 7,678 2,830 60,337 7,816 2,413 50.096 7.659 2,221 64,241 7,646 2,701 60.846 7,765 2,656 43.119 7,685 2,495 63,412 7.962 2.128 59,283 7.793 2.127 60,070 7.732 2.127 53,345 7,771 2,338 65,027 7.842 2,685 58,220 7.940 2,602 65,406 7.750 2,029 35,268 7.954 2.136 46,394 7.768 2,046 71,877 2,786 61,903 7,635 2,822 50,009 7.849 2,178 49,327 7.869 2,244 44,703 7.576 2,195 45,582 7,557 2,370 43.818 7,569 2,016 62.122 7,672 2,515 52,403 7.653 2.942 Average Cycle Time (Hours), X 186.44 139.14 151.13 138.30 158.63 148.71 105.85 174.02 155.30 162,20 142.97 176.08 150.19 194.06 100.51 137.47 197.44 164.69 141.95 123.37 128.25 106.16 131.41 154.88 140,07 7,764 15 16 17 18 19 20 21 22 23 24 25 Instructions: 1- Determine the cost function using the High-low method for each cost driver (X1, X2, and X3) to prepare a prediction of the Assembly support cost. 2- Determine the cost function using the visual analysis method for each cost driver to predict the assembly cost. You need to plot support costs (y) versus each possible cost driver, X1, X2, and X3 using excel. 3. Use the regression analysis method to measure cost function using each of the cost driver. Which is the best cost driver for support cost? 4. Which prediction method you prefer? Why? [10 Marks) Q2: 1- Define activity-based costing. Explain why this approach to cost assignment is superior to the traditional method of using a plantwide overhead cost pool and overhead rate. 2- In the early 1990s, president Will Thomas, son of the founder, realized that Thomas-Britt could not depend on government contracts for long-term growth and stability. Consequently, he began planning for diversified commercial growth. By the end of 2003, Thomas-Britt had succeeded in reducing government contract sales to 50% of total sales. Traditionally, the costs of the Materials Handling Department have been allocated to other departments as a percentage of the dollar value of direct materials. Peter Anderson, manager of the government contracts unit, has been complaining about this allocation for several months. He believes that since his unit's materials costs are high and materials handling activities are low relative to the commercial unit, he is absorbing more than his fair share of this overhead. He wants to find a way to transfer some of these charges to another unit, thereby increasing the government contracts unit's profitability and his year-end performance bonus. Peter shared his views in a recent meeting with Sarah Lindley, the newly hired cost accounting manager, and Reese Mason, manager of the commercial unit. After a heated discussion, Sarah agreed to investigate the current allocation method and, if appropriate, recommend an alternative method. After doing some research, Sarah learned the following: The majority of the direct materials purchases for government contracts are high-dollar, low-volume purchases. Direct materials purchases for commercial contracts are mostly low-dollar, high-volume purchases. There are other departments that use the services of the Materials Handling Department on a limited basis, but they have never been charged for materials handling costs. One purchasing agent with a direct phone line is assigned exclusively to purchasing high-dollar, low-volume materials for government contracts, at an annual salary of $36,000. His employee benefits are estimated to amount to 20% of his annual salary. The dedicated phone line costs $2,800 a year. The Materials Handling Department's budget for 2017, as proposed by Sarah Lindley's predecessor, follows. Payroll $ 180,000 Employee benefits 36,000 Telephones 38,000 Other utilities 22,000 Materials and supplies 6,000 Depreciation 6,000 Total materials handling costs $288,000 Direct materials budget Government contracts $ 1,958,400 Commercial products 921,600 Total direct materiale budget $2,880,000 After reviewing the situation, Lindley has recommended that allocating materials handling costs based on the number of purchase orders issued is preferable to the current allocation based on direct materials cost. She estimated the number of purchase orders to be processed in 2017 as follows: Government contracts 79,860 Commercial products 154,880 Other 7,260 Total 242,000 Using the 2017 estimates, she provided the following analysis to Anderson and Mason. Government Contracts Unit Commercial Unit Materials handling cost based on purchase orders issued $ 95,040 $184.320 Materials handling cost based on direct materials cost 195,840 92.160 Difference in coet allocated to unit ($100,800 $ 92,160 When Mason saw the projected increase in the commercial unit's costs, he exploded. He was not going to lose any of his year- end performance bonus just because Lindley wanted to change the way she calculated the numbers. He marched into Lindley's office and reminded her that he had been with the company for 25 years and had "plenty of pull" with Thomas as a member of the senior management team. He then told her to "adjust" her numbers and modify her recommendation so that the results would be more favorable to the commercial unit. He added that since materials handling costs were only allocated to the government contract and commercial units, she could just hide some of the commercial unit's purchase order volume in those other units. Given her new position, Lindley is not sure how to proceed. She questions Mason's motivation. To complicate matters, Thomas has asked her to prepare a three-year forecast of the two units' results, for which she believes the new allocation method would provide the most accurate data. Using the new method would put her in direct opposition to Mason's directives, however. Lindley has assembled the following forecasted data to project the units' direct materials handling costs. 2018 2017 $ 288,000 2019 $ 374,420 $ 326,785 Total materials handling costs Direct materials cost Government contracte unit Commercial unit Total direct materials cost $1,958,400 $2,275,000 $2,576,000 921,600 9775.000 1,104,000 $2,380,000 $3,250,000 $3,680,000 2017 2018 2019 Purchase orders Government contracts unit Commercial unit Other units Total purchase orders 79,860 85,024 89,400 154,880 164.734 172,840 7,260 15,942 135.760 242,000 265.700 298,000 Required d. Using the forecasted information, calculate the materials handling costs that would be allocated to each unit under both allocation methods. Show the cumulative dollar impact over the three-year period 2017-2019. bi Why might the number of purchase orders be a better cost driver for materials handling costs than direct materials cost? Are there other factors in the allocation that Lindley should consider? d. In a recent meeting between Sarah Lindley and Reese Mason, Mason said that there is nothing in any accounting pronouncement that requires the use of activity-based costing. Therefore, there is no reason to make Lindley's recommended change in allocation methods. Do you agree with Mason? Why or why not? 3-49 Choice of Cost Driver Study Appendix 3. Richard Ellis, the director of cost operations of American Micro Devices, wishes to develop an accurate cost function to explain and predict support costs in the company's printed circuit board assembly operation. Mr. Ellis is concerned that the cost function that he currently uses based on direct labor costsis not accurate enough for proper planning and control of support costs. Mr. Ellis directed one of his financial analysts to obtain a random sample of 25 weeks of support costs and three possible cost drivers in the circuit-board assembly department: direct labor hours, number of boards assembled, and average cycle time of boards assembled. (Average cycle time is the average time between start and certified completion-after quality testing-of boards assembled during a week.) Much of the effort in this assembly operation is devoted to testing for quality and reworking defective boards, all of which increase the average cycle time in any period. Therefore, Mr. Ellis believes that average cycle time will be the best support cost driver, Mr. Ellis wants his analyst to use regression analysis to demonstrate which cost driver best explains support costs. Week 1 2 3 4 5 6 7 8 9 10 12 13 Circuit Board Assembly Direct Labor Number of Boards Support Costs, Y Hours, X1 Completed, X2 $66,402 7.619 2,983 56,943 7,678 2,830 60,337 7,816 2,413 50.096 7.659 2,221 64,241 7,646 2,701 60.846 7,765 2,656 43.119 7,685 2,495 63,412 7.962 2.128 59,283 7.793 2.127 60,070 7.732 2.127 53,345 7,771 2,338 65,027 7.842 2,685 58,220 7.940 2,602 65,406 7.750 2,029 35,268 7.954 2.136 46,394 7.768 2,046 71,877 2,786 61,903 7,635 2,822 50,009 7.849 2,178 49,327 7.869 2,244 44,703 7.576 2,195 45,582 7,557 2,370 43.818 7,569 2,016 62.122 7,672 2,515 52,403 7.653 2.942 Average Cycle Time (Hours), X 186.44 139.14 151.13 138.30 158.63 148.71 105.85 174.02 155.30 162,20 142.97 176.08 150.19 194.06 100.51 137.47 197.44 164.69 141.95 123.37 128.25 106.16 131.41 154.88 140,07 7,764 15 16 17 18 19 20 21 22 23 24 25 Instructions: 1- Determine the cost function using the High-low method for each cost driver (X1, X2, and X3) to prepare a prediction of the Assembly support cost. 2- Determine the cost function using the visual analysis method for each cost driver to predict the assembly cost. You need to plot support costs (y) versus each possible cost driver, X1, X2, and X3 using excel. 3. Use the regression analysis method to measure cost function using each of the cost driver. Which is the best cost driver for support cost? 4. Which prediction method you prefer? Why? [10 Marks) Q2: 1- Define activity-based costing. Explain why this approach to cost assignment is superior to the traditional method of using a plantwide overhead cost pool and overhead rate. 2- In the early 1990s, president Will Thomas, son of the founder, realized that Thomas-Britt could not depend on government contracts for long-term growth and stability. Consequently, he began planning for diversified commercial growth. By the end of 2003, Thomas-Britt had succeeded in reducing government contract sales to 50% of total sales. Traditionally, the costs of the Materials Handling Department have been allocated to other departments as a percentage of the dollar value of direct materials. Peter Anderson, manager of the government contracts unit, has been complaining about this allocation for several months. He believes that since his unit's materials costs are high and materials handling activities are low relative to the commercial unit, he is absorbing more than his fair share of this overhead. He wants to find a way to transfer some of these charges to another unit, thereby increasing the government contracts unit's profitability and his year-end performance bonus. Peter shared his views in a recent meeting with Sarah Lindley, the newly hired cost accounting manager, and Reese Mason, manager of the commercial unit. After a heated discussion, Sarah agreed to investigate the current allocation method and, if appropriate, recommend an alternative method. After doing some research, Sarah learned the following: The majority of the direct materials purchases for government contracts are high-dollar, low-volume purchases. Direct materials purchases for commercial contracts are mostly low-dollar, high-volume purchases. There are other departments that use the services of the Materials Handling Department on a limited basis, but they have never been charged for materials handling costs. One purchasing agent with a direct phone line is assigned exclusively to purchasing high-dollar, low-volume materials for government contracts, at an annual salary of $36,000. His employee benefits are estimated to amount to 20% of his annual salary. The dedicated phone line costs $2,800 a year. The Materials Handling Department's budget for 2017, as proposed by Sarah Lindley's predecessor, follows. Payroll $ 180,000 Employee benefits 36,000 Telephones 38,000 Other utilities 22,000 Materials and supplies 6,000 Depreciation 6,000 Total materials handling costs $288,000 Direct materials budget Government contracts $ 1,958,400 Commercial products 921,600 Total direct materiale budget $2,880,000 After reviewing the situation, Lindley has recommended that allocating materials handling costs based on the number of purchase orders issued is preferable to the current allocation based on direct materials cost. She estimated the number of purchase orders to be processed in 2017 as follows: Government contracts 79,860 Commercial products 154,880 Other 7,260 Total 242,000 Using the 2017 estimates, she provided the following analysis to Anderson and Mason. Government Contracts Unit Commercial Unit Materials handling cost based on purchase orders issued $ 95,040 $184.320 Materials handling cost based on direct materials cost 195,840 92.160 Difference in coet allocated to unit ($100,800 $ 92,160 When Mason saw the projected increase in the commercial unit's costs, he exploded. He was not going to lose any of his year- end performance bonus just because Lindley wanted to change the way she calculated the numbers. He marched into Lindley's office and reminded her that he had been with the company for 25 years and had "plenty of pull" with Thomas as a member of the senior management team. He then told her to "adjust" her numbers and modify her recommendation so that the results would be more favorable to the commercial unit. He added that since materials handling costs were only allocated to the government contract and commercial units, she could just hide some of the commercial unit's purchase order volume in those other units. Given her new position, Lindley is not sure how to proceed. She questions Mason's motivation. To complicate matters, Thomas has asked her to prepare a three-year forecast of the two units' results, for which she believes the new allocation method would provide the most accurate data. Using the new method would put her in direct opposition to Mason's directives, however. Lindley has assembled the following forecasted data to project the units' direct materials handling costs. 2018 2017 $ 288,000 2019 $ 374,420 $ 326,785 Total materials handling costs Direct materials cost Government contracte unit Commercial unit Total direct materials cost $1,958,400 $2,275,000 $2,576,000 921,600 9775.000 1,104,000 $2,380,000 $3,250,000 $3,680,000 2017 2018 2019 Purchase orders Government contracts unit Commercial unit Other units Total purchase orders 79,860 85,024 89,400 154,880 164.734 172,840 7,260 15,942 135.760 242,000 265.700 298,000 Required d. Using the forecasted information, calculate the materials handling costs that would be allocated to each unit under both allocation methods. Show the cumulative dollar impact over the three-year period 2017-2019. bi Why might the number of purchase orders be a better cost driver for materials handling costs than direct materials cost? Are there other factors in the allocation that Lindley should consider? d. In a recent meeting between Sarah Lindley and Reese Mason, Mason said that there is nothing in any accounting pronouncement that requires the use of activity-based costing. Therefore, there is no reason to make Lindley's recommended change in allocation methods. Do you agree with Mason? Why or why not