Activity Based Costing (ABC)

Martinez Furniture Company (MFC) makes desks and chairs. Desks require 5 hours of direct labor per unit and chairs require 2 hours per unit. Each month MFC normally uses 500,000 hours of direct labor making 100,000 desks and 300,000 hours of direct labor making 150,000 chairs. The company incurs $1,088,000 of materials handling cost each month.

A. Select the most appropriate allocation base (labor hours or number of units) and compute the amount of the materials handling cost that should be allocated to the desks and the amount that should be allocated to the chairs.

B. A technological development enables MFC to automate the process for making desks. By installing robots, MFC reduces the amount of direct labor required to make one desk to .4 hours. It now takes 40,000 direct labor hours to make 100,000 desks (.4 hours x 100,000). It still takes 300,000 direct labor hours to make 150,000 chairs (2 hours x 150,000). Assume the same amount ($1,088,000) of materials handling cost. Allocate materials handling cost to desks and chairs using the reduced number of direct labor hours as the allocation base. For each product, compare the amount of allocated cost computed in requirement a with that computed in requirement b. Identify the product that is overcosted and explain how the overcosting is likely to affect the companys profitability, assuming that sales prices are calculated by adding a markup to the costs of products. Identify the product that is undercosted and explain how the undercosting affects profitability of the company.

C. Assume MFC adopts an activity-based costing (ABC) system. MFC identifies the following activities associated with handling materials: locating a supplier; placing an order; transporting materials from the supplier to MFC; inspecting the materials for defects; storing materials in a warehouse; preparing production requisitions; and issuing materials to the production department. After analysis, MFC concludes that the number of production requisitions prepared is the primary activity that drives the cost of handling materials. A count of production requisitions for a month shows MFC issued a total of 4,000 requisitions, 2,500 for materials used to make desks and 1,500 for materials used to make chairs. Using the number of production requisitions as the allocation base (cost driver), compute the amount of materials handling cost that should be allocated to desks and the amount that should be allocated to chairs. Assume materials handling cost is still $1,088,000. Comment on the differences between the allocations determined in part c and those determined in part b.

D. After reviewing the activities identified in part c, MFCs management team concluded that the portion of materials handling cost caused by storing materials in a warehouse was a nonvalue-added activity. In response, MFC implemented a just-in-time inventory system. It reduced the amount of inventory on hand and eliminated inventory storage costs such as warehouse rental cost, reporting cost, costs of lost and damaged materials, and processing costs. As a result, it reduced total monthly materials handling cost from $1,088,000 to $816,000. As part of the just-in-time system, MFC began filing materials purchase orders via e-mail. Production department personnel now issue purchase orders by sending e-mail directly to suppliers, and materials are delivered directly to the production department just in time for use. Analysis of e-mail records shows that MFC files 5,000 purchase orders each month, 3,000 for materials used to make desks and 2,000 for materials used to make chairs. Allocate the $816,000 materials handling cost between desks and chairs based on the number of e-mail purchase orders. Explain why the allocations determined in part d are lower than those determined in part c.

E. Comment on the possibility of eliminating other nonvalue-added activities such as transportation costs.