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.

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 $90,000Purchase Design Customer Segment Activity Cost Pools Machining orders alterations relations sustaining Total Manufacturing overhead 30% 10% 40% 0% 20% 100% Fixed selling expenses 0% 25% 30% 35% 10% 100% Total administrative expenses 25% 0% 0% 30% 45% 100% Information on the costs associated with the three activity cost pools can 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 applicableStandard Advanced Sales $$$ $$$ Cost of goods sold Direct materials $$$ $$$ Direct labor $$$ $$$ Manufacturing overhead w m m m Gross margin m E Average gross margin per unit $$$ $$$ Sales Activity-based costs Direct materials Direct labor Variable selling expense Machining Purchase orders Design alterations Product margin Average product margin per unit Standard $$$ $$$ $$$ $$$ $$$ $$$ $$$ $$$ Advanced $$$ $$$ $$$ $$$ $$$ $$$ $$$ E