Montreal Electronics Company manufactures two large-screen television models: the Nova, which has been produced for 10 years and sells for $900, and the Royal, a new model introduced in early 20x0, which sells for $1,140. Based on the following income statement for 20x1, a decision has been made to concentrate Montreals marketing resources on the Royal model and to begin to phase out the Nova model. MONTREAL ELECTRONICS COMPANY Income Statement For the Year Ended December 31, 20x1 Royal Nova Total Sales $4,560,000 $19,800,000 $24,360,000 Cost of goods sold 3,192,000 12,540,000 15,732,000 Gross margin $1,368,000 $ 7,260,000 $ 8,628,000 Selling and administrative expense 978,000 5,830,000 6,808,000 Net income $ 390,000 $ 1,430,000 $ 1,820,000 Units produced and sold 4,000 22,000 Net income per unit sold $ 97.50 $ 65.00 The standard unit costs for the Royal and Nova models are as follows: Royal Nova Direct material $584 $208 Direct labor: Royal (3.5 hr. $12) 42 Nova (1.5 hr. $12) 18 Machine usage: Royal (4 hr. $18) 72 Nova (8 hr. $18) 144 Manufacturing overhead* 100 200 Standard cost $798 $570 *Manufacturing overhead was applied on the basis of machine hours at a predetermined rate of $25 per hour. Montreal Electronics Companys controller is advocating the use of activity-based costing and activity-based management and has gathered the following information about the companys manufacturing-overhead costs for 20x1. Number of Events Activity Center (cost driver) Traceable Costs Royal Nova Total Soldering (number of solder joints) $ 942,000 385,000 1,185,000 1,570,000 Shipments (number of shipments) 860,000 3,800 16,200 20,000 Quality control (number of inspections) 1,240,000 21,300 56,200 77,500 Purchase orders (number of orders) 950,400 109,980 80,100 190,080 Machine power (machine hours) 57,600 16,000 176,000 192,000 Machine setups (number of setups) 750,000 14,000 16,000 30,000 Total traceable costs $4,800,000 Required: Briefly explain how an activity-based costing system operates. Using activity-based costing, determine if Montreal Electronics should continue to emphasize the Royal model and phase out the Nova model. (CMA, adapted) Problem 555 Activity-Based Costing (LO 5-1, 5-2, 5-4, 5-5) Page 215 Manchester Technology, Inc. manufactures several different types of printed circuit boards; however, two of the boards account for the majority of the companys sales. The first of these boards, a television circuit board, has been a standard in the industry for several years. The market for this type of board is competitive and price-sensitive. Manchester plans to sell 65,000 of the TV boards in 20x1 at a price of $150 per unit. The second high-volume product, a personal computer circuit board, is a recent addition to Manchesters product line. Because the PC board incorporates the latest technology, it can be sold at a premium price. The 20x1 plans include the sale of 40,000 PC boards at $300 per unit. Manchesters management group is meeting to discuss how to spend the sales and promotion dollars for 20x1. The sales manager believes that the market share for the TV board could be expanded by concentrating Manchesters promotional efforts in this area. In response to this suggestion, the production manager said, Why dont you go after a bigger market for the PC board? The cost sheets that I get show that the contribution from a PC board is significantly larger than the contribution from a TV board. I know we get a premium price for the PC board. Selling it should help overall profitability. The cost-accounting system shows that the following costs apply to the PC and TV boards. PC Board TV Board Direct material $140 $80 Direct labor 4 hr. 1.5 hr. Machine time 1.5 hr. .5 hr. Variable manufacturing overhead is applied on the basis of direct-labor hours. For 20x1, variable overhead is budgeted at $1,120,000, and direct-labor hours are estimated at 280,000. The hourly rates for machine time and direct labor are $10 and $14, respectively. The company applies a material-handling charge at 10 percent of material cost. This material-handling charge is not included in variable manufacturing overhead. Total 20x1 expenditures for direct material are budgeted at $10,800,000. Andrew Fulton, Manchesters controller, believes that before the management group proceeds with the discussion about allocating sales and promotional dollars to individual products, it might be worthwhile to look at these products on the basis of the activities involved in their production. Fulton has prepared the following schedule to help the management group understand this concept. Using this information, Fulton explained, we can calculate an activity-based cost for each TV board and each PC board and then compare it to the standard cost we have been using. The only cost that remains the same for both cost methods is the cost of direct material. The cost drivers will replace the direct labor, machine time, and overhead costs in the old standard cost figures. Budgeted Cost Cost Driver Budgeted Annual Activity for Cost Driver Procurement $ 400,000 Number of parts 4,000,000 parts Production scheduling 220,000 Number of boards 110,000 boards Packaging and shipping 440,000 Number of boards 110,000 boards Total $ 1,060,000 Machine setup $ 446,000 Number of setups 278,750 setups Hazardous waste disposal 48,000 Pounds of waste 16,000 pounds Quality control 560,000 Number of inspections 160,000 inspections General supplies 66,000 Number of boards 110,000 boards Total $ 1,120,000 Machine insertion $ 1,200,000 Number of parts 3,000,000 parts Manual insertion 4,000,000 Number of parts 1,000,000 parts Wave-soldering 132,000 Number of boards 110,000 boards Total $ 5,332,000 Page 216 Required per Unit PC Board TV Board Parts: 55 25 Machine insertions 35 24 Manual insertions 20 1 Machine setups 3 2 Hazardous waste disposal, in lb .35 .02 Inspections 2 1 Required: Identify at least four general advantages associated with activity-based costing. On the basis of Manchesters unit cost data given in the problem, calculate the total amount that each of the two product lines will contribute toward covering fixed costs and profit in 20x1. (In other words, for each product line, calculate the total sales revenue minus the total variable costs. This amount is often referred to as a products total contribution margin.) Repeat requirement (2) but now use the cost data from the activity-based costing system. Explain how a comparison of the results of the two costing methods may impact the decisions made by Manchesters management group. (CMA, adapted) Problem 556 Activity-Based Costing (LO 5-1, 5-2, 5-4, 5-5, 5-7) World Gourmet Coffee Company (WGCC) is a distributor and processor of different blends of coffee. The company buys coffee beans from around the world and roasts, blends, and packages them for resale. WGCC currently has 15 different coffees that it offers to gourmet shops in one-pound bags. The major cost is raw materials; however, there is a substantial amount of manufacturing overhead in the predominantly automated roasting and packing process. The company uses relatively little direct labor. Some of the coffees are very popular and sell in large volumes, while a few of the newer blends have very low volumes. WGCC prices its coffee at full product cost, including allocated overhead, plus a markup of 30 percent. If prices for certain coffees are significantly higher than market, adjustments are made. The company competes primarily on the quality of its products, but customers are price-conscious as well. Data for the 20x1 budget include manufacturing overhead of $3,000,000, which has been allocated on the basis of each products direct-labor cost. The budgeted direct-labor cost for 20x1 totals $600,000. Based on the sales budget and raw-material budget, purchases and use of raw materials (mostly coffee beans) will total $6,000,000. The expected prime costs for one-pound bags of two of the companys products are as follows: Kona Malaysian Direct material $3.20 $4.20 Direct labor .30 .30 WGCCs controller believes the traditional product-costing system may be providing misleading cost information. She has developed an analysis of the 20x1 budgeted manufacturing-overhead costs shown in the following chart. Activity Cost Driver Budgeted Activity Budgeted Cost Purchasing Purchase orders 1,158 $ 579,000 Material handling Setups 1,800 720,000 Quality control Batches 720 144,000 Roasting Roasting hours 96,100 961,000 Blending Blending hours 33,600 336,000 Packaging Packaging hours 26,000 260,000 Total manufacturing-overhead cost $3,000,000 Page 217 Data regarding the 20x1 production of Kona and Malaysian coffee are shown in the following table. There will be no raw-material inventory for either of these coffees at the beginning of the year. Kona Malaysian Budgeted sales 2,000 lb. 100,000 lb. Batch size 500 lb. 10,000 lb. Setups 3 per batch 3 per batch Purchase order size 500 lb. 25,000 lb. Roasting time 1 hr. per 100 lb. 1 hr. per 100 lb. Blending time .5 hr. per 100 lb. .5 hr. per 100 lb. Packaging time .1 hr. per 100 lb. .1 hr. per 100 lb. Required: Using WGCCs current product-costing system: Determine the companys predetermined overhead rate using direct-labor cost as the single cost driver. Determine the full product costs and selling prices of one pound of Kona coffee and one pound of Malaysian coffee. Develop a new product cost, using an activity-based costing approach, for one pound of Kona coffee and one pound of Malaysian coffee. What are the implications of the activity-based costing system with respect to The use of direct labor as a basis for applying overhead to products? The use of the existing product-costing system as the basis for pricing?