Cost Behavior and ABC

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Objective:

Understanding cost behavior can help in selecting drivers to assign costs to products.

- Click here to refer to the question information.

Introduction:

CableTech Bell Corporation (CTB) operates in the telecommunications industry. CTB has two divisions: the Phone Division and the Cable Service Division. The Phone Division manufactures telephones in two plants located in the Midwest: (1) a conventional phone plant and (2) cellular phone plant. The product lines run from relatively inexpensive touch-tone wall and desk phones to expensive, high quality cellular phones. CTB also operates a cable TV service in Ohio. The Cable Service Division offers three products: a basic package with 25 channels; an enhanced package which is the basic package plus 15 additional channels and two movie channels; and a premium package which is the basic package plus 25 additional channels and three movie channels.

The Cable Service Division reported the following sale and unit cost activity for the month of March:

CableTech Bell Corporation Cable Service Division For the Month Ended March, 20XX
	Basic	Enhanced	Premium
Sales (units)	50,000	500,000	300,000
Price per unit	$16	$30	$40
Unit costs:
Directly traced	$3	$5	$7
Driver traced	$2	$4	$6
Allocated	$10	$13	$15

The unit costs are divided as follows: 70 percent production and 30 percent marketing and customer service. Direct labor cost is the only cost driver used for tracing. Typically, the Cable Service Division uses only production costs to define unit costs. The preceding unit product cost information was provided at the request of the marketing manager, Dan Moniker, and was the result of a special study.

Bryce Youngers, the President of CTB, is reasonably satisfied with the March performance of the Cable Service Division. The March numbers were fairly typical of what has been happening over the past two years. The Phone Division, however, is another matter as its overall profit performance has been declining. Two years ago the Phone Division's income before income taxes was about 15 percent of sales. March's dismal performance was typical of the entire calendar year. This performance trend is expected to continue unless management takes actions to reverse it. During March, the Phone Division reported the following results:

CableTech Bell Corporation Phone Division For the Month of March, 20XX
Inventories:
Materials, March 1	$23,000
Materials, March 31	40,000
Work in process, March 1	130,000
Work in process, March 31	45,000
Finished goods, March 1	480,000
Finished goods, March 31	375,000
Costs:
Direct labor	$117,000
Plant and equipment depreciation	50,000
Material handling	85,000
Inspections	60,000
Scheduling	30,000
Power	30,000
Plant supervision	12,000
Manufacturing engineering	21,000
Sales commissions	120,000
Salary, sales supervisor	10,000
Supplies	17,000
Warranty work	40,000
Rework	30,000

During March, the Phone Division purchased materials totaling $312,000. There are no significant inventories of supplies (beginning or ending). Supplies are accounted for separately from materials. CTB's Phone Division had sales totaling $1,170,000 for the month of March.

After the CBT managerial group agreed to take measures for the Phone Division to reduce inspection, rework, and warranty costs (by improving quality), the group had the following conversation:

Jacob: "In addition to reducing costs, I think we need to improve our cost accounting system. I am not confident that we really know how much each of our product lines is costing us. It may be that we are overpricing some of our units because we are overcosting them. We may be underpricing other units."

Kim: "This sounds promising-especially if the overcosting is for some of our high-volume lines. A price decrease for these products would make the biggest difference-and if we knew they were overcosted, then we could offer immediate price reductions."

Bryce: "Jacob, I need more explanation. We have been using the same cost accounting system for the last 10 years. Why would it be a problem?"

Jacob: "Our manufacturing environment has changed. Over the years, we have added a lot of different product lines. Some of these products make very different demands on our manufacturing overhead resources. We currently trace-or attempt to trace-overhead costs to the different products using direct labor cost, a unit-based cost driver. We may be doing more allocation than tracing. If so, then we probably don't have a very good idea of our actual product costs."

Bryce: "This may be something we should explore. Jacob, what do you suggest?"

Jacob: "If we want more accurate product costs and if we really want to get in the cost reduction business, then we need to understand how costs behave. In particular, we need to understand activity cost behavior and how the different products consume activity resources. I suggest that we do a preliminary study to see if direct labor cost is adequate for tracing. If not, then maybe some nonunit-drivers might be needed. In fact, if you would like, I can gather some data that will provide some evidence on the usefulness of the activity-based approach."

Kim: "Sounds promising. Jacob, I think we should pursue this and find out if moving to an activity-based system is the way to go. How much time do you need to assess this possibility?"

Jacob: "I have already been gathering data from the conventional phone plant. I could probably have a report within two weeks."

Two weeks later the following written memorandum was prepared for Jacob by Kim:

MEMO

TO:	Kim Breashears
FROM:	Jacob Carder
SUBJECT:	Preliminary Analysis

Based on my initial analysis, I am confident that an ABC system will offer significant improvement. For one of our conventional phone plants, I regressed the total monthly overhead cost on monthly direct labor cost using the following 15 months of data:

Overhead Cost	Direct Labor Cost
$144,000	$44,000
120,000	40,000
140,000	36,000
160,000	40,000
128,000	36,000
152,000	40,000
120,000	36,000
112,000	36,000
136,000	38,000
164,000	46,000
150,000	40,000
144,000	34,000
136,000	34,000
132,000	36,000
120,000	32,000

Direct labor cost appears to be a driver of overhead cost, but it really doesn't explain a lot of the variation. Other drivers, particularly nonunit drivers, might offer more insight into overhead cost behavior. To illustrate this possibility, I gathered 10 months of data for the moving activity. Moving materials seemed logically to be more related to number of moves than direct labor since moves occurred every time a batch was produced, regardless of the batch size.

Material-Handling Cost	Number of Moves
$32,000	600
24,000	400
28,000	500
28,800	520
26,000	440
34,000	680
26,800	480
29,400	540
33,200	560
33,600	680

The regression results indicate that the number of moves is a good driver of material-handling costs. Some of the other overhead activities seem to be nonunit-level, as well-enough, in fact, to be concerned about how we assign costs.

Required:

Using a regression program such as Microsoft Excel, calculate two cost formulas: (1) overhead using direct labor cost as the driver, and (2) materials handling cost using number of moves as the driver. Based on the outcomes, answer the following:

a.

Direct labor cost formula:

Intercept (rounded to nearest dollar):	$
Slope (Coefficient 1,rounded to the nearest cent):	$
R Square (rounded to two decimal places):

b.

Formula for material handling cost (based on number of moves):

Intercept (rounded to nearest dollar):	$
Slope (Coefficient 1,rounded to the nearest cent):	$
R Square (rounded to two decimal places):

Summary Questions:

1.	Intercept refers to - Select your answer -fixed costvariable cost per unittotal costItem 7 .
2.	Coefficient 1 refers to - Select your answer -fixed costvariable cost per unittotal costItem 8 .
3.	Based on - Select your answer -the interceptthe slopeR squareItem 9 direct labor cost - Select your answer -doesdoes notItem 10 explain enough of the variability in overhead cost to justify using direct labor cost as the only overhead driver to trace overhead to individual products.
4.	Using number of moves to assign material handling cost is - Select your answer -betterworseItem 11 than using direct labor cost to assign overhead cost.
5.	Since small batches use the same moves as large batches, but much less labor, then - Select your answer -largesmallItem 12 batches are receiving too much materials handling cost. Evidence thus exists that high-volume products are - Select your answer -undercostedovercostedItem 13 .