P&P is a privately held company that produces different types of kitchen appliances. The company currently produces 50 products and does not anticipate any new products coming out in the near future. Overhead costs are allocated across products at a rate of $100 per machine hour. I have mentioned to my superiors that it is not appropriate for our company to use the traditional costing system, because different products require different amounts of indirect overhead resources. For example, under the traditional system all costs associated with customer requested design alterations are part of overhead costs and therefore allocated across products based on machine hours. Yet, some products require substantial design alterations whereas some products require few or no alterations at all. More importantly, the amount of machine hours is not driving the costs associated with customer requested design alterations. Given that traditional costing systems may result in significant cost distortions when determining products costs and given that the company is growing rapidly, the top management of Armstrong has decided to explore the option of adopting activity-based costing over the next year or two. The company has hired KPMG Consulting to help us evaluate the potential for implementing activity based costing and the controller has appointed me as the liaison between P&P and KPMG. As part of the initial implementation phase, I have asked KPMG to derive the activity-based costs and product margins associated with our pasta maker segment, which produces two pasta maker models, Standard and Advanced. We would like to compare model-specific product margins under the activity based system with gross margins under our current traditional costing system. I picked the pasta maker segment since the two models have very different demands on indirect overhead resources. Specifically, the standard model is residential grade and sold in large quantities to retailers with no customized design alterations. In contrast, the advanced model is commercial grade and sold in small quantities directly to small business owners with extensive design alterations to accommodate their special needs.

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 segment will assume that costs associated with purchase orders, design alterations, and customer relations are variable with respect to their respective activity measures. Currently, we believe our assumptions on cost behavior patterns are quite reasonable. Production volumes are set equal to sales volumes since the segment only produces products that they have orders for. Consequently, the segment never has a beginning or ending work in process inventory, and it does not have a beginning or ending finished goods inventory.

A) Calculate product margin for the two models, Standard and Advanced, separately using the activity-based costing system. The amount of product margin should be on a total basis and on a per-unit basis using the following template for guidance: (show calculations)

Standard Advanced

Sales $$$ $$$

Activity-based costs

Direct materials $$$ $$$

Direct labor $$$ $$$

Variable selling expense $$$ $$$

Machining $$$ $$$

Purchase orders $$$ $$$

Design alterations $$$ $$$

Product margin $$$ $$$

Average product margin per unit $$$ $$$

B) Then Explain why the unit cost for Advanced differs so much under the traditional costing system versus under the activity-based costing system. I hope I can convince the management that we should switch to the activity-based costing system.

The pasta maker segment reported a traditional income statement last year. Pasta Maker Segment Income Statement Year Ended December 31, 2020 Sales $1,000,000 Cost of goods sold Direct materials $200,000 Direct labor 50,000 Manufacturing overhead 320,000 570,000 Gross margin 430,000 Selling and administrative expenses Variable Selling expenses 40,000 Fixed Selling expenses 180,000 Total administrative expenses 120,000 340,000 Net operating income $90,000 1 KPMG has identified five activity cost pools and decided the distribution of overhead costs (manufacturing and nonmanufacturing) across the five pools below: Activity Cost Pools Total Machining Purchase orders Design alterations Customer relations Segment sustaining 30% 10% 40% 0% 20% 100% Manufacturing overhead Fixed selling expenses 0% 25% 30% 35% 10% 100% 25% 0% 0% 30% 45% 100% Total administrative expenses Information on the costs associated with the three activity cost pools can be found in the traditional income statement reported on the previous page. Model-specific data: Standard Advanced Total Sales $600,000 $400,000 $1,000,000 Direct costs Direct materials 125,000 75,000 200,000 Direct labor 30,000 20,000 50,000 Variable selling expenses 25,000 15,000 40,000 Units sold 5,000 2,000 Unit selling price $120 $200 Machine hours per unit 0.4 MH 0.6 MH Data from the activity-based costing system: Expected activity Activity cost pool Activity measure Standard Advanced Total Machining number of machine hours 2,000 1,200 3,200 Purchase orders number of purchase orders 200 300 500 Design alterations Number of design alterations 0 400 400 Customer relations Number of customers 20 80 100 Segment sustaining Not applicable Standard Advanced Sales 600,000 400,000 Activity based costs Direct Materials 125,000 75,000 Direct labor 30,000 20,000 Variable selling expense 25,000 15,000 Machining Purchase orders $ $ Design alterations $ Product margin $ Average product margin per unit $ $