Activity-Based Costing
Need help with question 5 and 6. Questions 1-3 are posted below for reference.
The Watts Company is a publicly traded corporation that produces different types of air fryers. My name is Alan Smith and I have worked for this company for the last ten years in the controller's office. I was both an accounting and finance major in university. The company currently produces 300 products and does not anticipate any new products coming out over the next three years. I have previously mentioned to my superiors that it is not appropriate for our firm to use a traditional costing system (where overhead costs are allocated across products at a rate of $30 per direct labor hour) when different products require different amounts of indirect overhead resources. For example, under the traditional system all costs associated with testing of products for quality assurance purposes are part of overhead costs and therefore allocated across products based on direct labor hours. Yet, some of our products require as much as 5 hours of testing whereas some products require less than 1 minute of testing with no connection to direct labor hours. Given that traditional costing systems may result in significant cost distortions when determining products costs and given that the firm now has revenues of over $100 million a year, Watts Co. has decided to adopt activity-based costing over the next year or two. Watts' management has hired Deloitte Consulting to help us implement activity-based costing. I will be acting as the liaison between our firm and Deloitte. As part of the initial implementation phase, I have asked Deloitte to derive the costs and product margins associated with two of our products, Classic and Artisan, so that these costs and product margins could be compared with the costs and profit margins under our current traditional costing system. I picked these products since Watts' management believe they have very different demands on indirect overhead resources. Further, Classic is sold in large quantities whereas Artisan is sold in small quantities. Current information from our existing system on a per unit basis is shown in Exhibit 1. Exhibit 1 Classic $20 1.5 Artisan $40 Direct material Direct labor hours Direct labor wage rate per hour Sales price per unit $15 $15 $100 $150 My staff has identified for Deloitte five activity cost pools. Information on those cost pools and the related activity measures are provided in Exhibit 2. Level +-exhibit 2 Total Costs Allocation Base Equipment setups $4,000,000 number of setups Purchase orders $2,000,000 number of purchase orders Machining $5,000,000 number of machine hours Testing $7,000,000 number of testing hours Packaging and shipping $6,000,000 number of containers Level of Allocation Base 50,000 20,000 80,000 250.000 300,000 Although fixed costs are lumped in with variable costs across the five different cost pools, I am aware that machining related costs consists almost exclusively of depreciation costs. Hence, with respect to all questions asked in this case, machining costs will be treated as entirely fixed with respect to machine hours. Each machine is used in the production of multiple product lines. The resale value of machines is only affected by the passage of time and not by how much they are used in a given year In all questions asked in this case, the firm will assume that costs associated with equipment setups, purchase orders, testing, and packaging & shipping are variable with respect to their respective activity measures. Currently, we believe our assumptions on cost behavior patterns are quite reasonable. All products are produced in batches, where the size of a batch differs across products. For example, if we produce 80 units of a product in batch sizes of 40, then the product will be produced in two batches. An equipment setup must be performed before producing each batch of a product. Hence, in the example above, two equipment setups would be performed. Units of product are packaged in containers and sent to distributors. Production volumes are set equal to sales volumes since the company only produces products that they have orders for. Consequently, the firm never has a beginning or ending work in process inventory, and it does not have a beginning or ending finished goods inventory. Further information on our two products is provided in Exhibit 3 Exhibit 3 Classic 500,000 400 500 0.6 30,000 1.200 Artisan 80,000 50 320 annual sales and production in units number of units per batch number of purchase orders number of machine hours per unit total number of testing hours total number of containers 50,000 4,000 REQUIRED: 1. Calculate product margin for Classic and Artisan using the traditional costing system where overhead is applied at a rate of $30 per direct labor hour. The amount of product margin should be on a total basis and then show the average product margin unit using the following template for guidance: Classic Sales $$$ Direct materials SSS Direct labor Manufacturing overhead SSS Cost of goods sold Product margin $$$ Average product margin per unit $$$ Artisan $$$ SSS SSS $$$ SSS 2. Calculate the five activity rates under the activity-based costing system. 3. Calculate product margin for Classic and Artisan using the activity-based costing system. The amount of product margin should be on a total basis and then show the average product margin unit using the following template for guidance: Classic SSS $$$ Artisan SSS Sales Direct materials Direct labor Equipment Setups Purchase orders Machining Testing Packaging and shipping Total ABC Costs Product margin Average product margin per unit 2012 4. Can you help Mr. Smith explain to his colleagues why the unit cost for Artisan differs so much under traditional costing system versus under activity-based costing system? 5. Assume next year that the activity rates remain the same as you calculated in question (2). Assume that the demand for Artisan is expected to increase significantly Consequently, the firm expects to produce more batches of Artisan next year than this year and the firm plans to produce in batch sizes of 100 rather than 50. Calculate what the equipment setup cost per unit of Artisan will be next year if it can be calculated. If it cannot be calculated, then explain in words why the equipment setup cost per unit of Artisan cannot be determined in the absence of more information. 6. Question 6 is independent of question 5. Next year, because of an expected increase in product demand, machine hours are expected to increase from 80,000 to 200,000 The company will not need any new machinery since the current machinery is highly underutilized. Also, the number of testing hours will increase from 250,000 to 400,000 Assume that these new levels of operations are within the firm's relevant range. Calculate what the activity rate for the cost pool of machining would be next year if it can be calculated. Also, calculate what the activity rate for the cost pool of testing would be next year if it can be calculated. If one or both rates cannot be calculated, then explain in words why the calculations cannot be determined in the absence of more information. Question 1 Sales Direct Materials Direct Labor Manufacturing Overhead Cost of Goods Sold Product Margin Average Product Margin per unit $ $ $ $ $ $ $ Classic 50,000,000 $ 10,000,000 $ 11,250,000 $ 22,500,000 $ 43,750,000 $ 6,250,000 $ 13 $ Artisan 12,000,000 3,200,000 2,400,000 4,800,000 10,400,000 1,600,000 20 Question 2 Equipment setups Purchase orders Machining Testing Packaging and Shipping $ $ $ Total Costs Allocation Base 4,000,000 # of setups 2,000,000 # of purchase orders 5,000,000 # of machine hours 7,000,000 # of testing hours 6,000,000 # of containers Level of Allocation Base Activity Rates 50,000 $ 20,000 $ 100 80,000 $ 63 250,000 $ 300,000 $ Cost pool calculations Classic Artisan Classic 500,000 400 1,250 Artisan 80,000 50 1,600 $ Annual sales and production units # of units per batch # of batches (setups) Purchase orders Machine hours Testing hours Containers Total 100,000 50,000 18,750,000 840,000 24,000 19,764,000 $ $ $ $ $ $ 128,000 32,000 5,000,000 1,400,000 80,000 6,640,000 Question 3 Sales Direct Materials Direct Labor Equipment Setups Purchase orders Machining Testing Packaging and shipping Total cost pool costs Product margin Average product margin per unit $ $ $ $ $ $ $ Classic 50,000,000 $ 10,000,000 $ 11,250,000 $ 100,000 $ 50,000 $ 18,750,000 $ 840,000 $ 24,000 $ 19,764,000 $ 8,986,000 $ 18 $ Artisan 12,000,000 3,200,000 2,400,000 128,000 32,000 5,000,000 1,400,000 80,000 6,640,000 (240,000) $ $ $ $ (3)
