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		$90,000

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	Machining	Purchase orders	Design alterations	Customer relations	Segment 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 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

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.

1). Do the activity-based costing system and the traditional costing system and explain the major differences between the 2.

2). Calculate total gross margin for each of the two models, Standard and Advanced, separately using the traditional costing system, where manufacturing overhead is applied at a rate of $100 per machine hour. The amount of gross margin should be on a total basis and on a per-unit basis using the following template for guidance:

Standard Advanced

Sales $$$ $$$

Cost of goods sold

Direct materials $$$ $$$

Direct labor $$$ $$$

Manufacturing overhead $$$ $$$ $$$ $$$

Gross margin $$$ $$$

Average gross margin per unit $$$ $$$

3). Make a chart showing the calculation of total cost allocated to each of the five activity cost pools under the activity-based costing system.

4). Make a chart showing the calculation of the four activity rates under the activity based costing system.

5). 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:

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 $$$ $$$

6). 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.

7). Next year, because of an expected increase in product demand, machine hours are expected to increase from 3,200 to 4,000. The company will not need any new machinery since the current machinery is highly underutilized. Assume that the new level of operations is within the segments relevant range. Will the activity rate for the cost pool of machining change next year? If so, how much? If not, could you explain why? Also, we expect that we will have a 10% increase in the number of customers, will the activity rate for the cost pool of customer relations change? If so, how much? If not, could you explain why?