Q.) 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?

My name is Sam Smith. After I got my degree in accounting fifteen years ago. I began working for Armstrong Co., 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. I have been working in the controller's office, and one of my job responsibilities is to ggregate cost information for our products. Recently, I have become more and more concerned with the traditional costing system that we have been using for decades: 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 Armstrong 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 $90,000 Net operating income 1 My colleagues and KPMG have identified five activity cost pools and decided the distribution of overhead costs (manufacturing and nonmanufacturing) across the five pools below: Activity Cost Pools Machining Purcha Design Custo Segment Total alterations sustaining orders relatio se mer MIS 30% 10% 40% 0% 20% 100% Manufacturing overhead Fixed selling expenses Total administrative expenses 0% 25% 30% 35% 10% 100% 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 $600,000 $400.00 $1.000.000 Sales Direct costs Direct materials Direct labor Variable selling expenses Units sold Unit selling price Machine hours per unit 125.000 30,000 25,000 5,000 $120 75.000 200.000 20,000 50,000 15,000 40,000 2,000 $200 0.4 MH 0.6 MH Data from the activity-based costing system: Activity cost Activity measure pool Machining number of machine hours Purchase orders number of purchase orders Design alteration Number of design alterations Customer relations Number of customers Segment sustaining Not applicable Expected activity Standar Advanced Total d 2.000 1,200 3,200 200 300 0 400 400 20 80 100 500 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. My name is Sam Smith. After I got my degree in accounting fifteen years ago. I began working for Armstrong Co., 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. I have been working in the controller's office, and one of my job responsibilities is to ggregate cost information for our products. Recently, I have become more and more concerned with the traditional costing system that we have been using for decades: 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 Armstrong 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 $90,000 Net operating income 1 My colleagues and KPMG have identified five activity cost pools and decided the distribution of overhead costs (manufacturing and nonmanufacturing) across the five pools below: Activity Cost Pools Machining Purcha Design Custo Segment Total alterations sustaining orders relatio se mer MIS 30% 10% 40% 0% 20% 100% Manufacturing overhead Fixed selling expenses Total administrative expenses 0% 25% 30% 35% 10% 100% 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 $600,000 $400.00 $1.000.000 Sales Direct costs Direct materials Direct labor Variable selling expenses Units sold Unit selling price Machine hours per unit 125.000 30,000 25,000 5,000 $120 75.000 200.000 20,000 50,000 15,000 40,000 2,000 $200 0.4 MH 0.6 MH Data from the activity-based costing system: Activity cost Activity measure pool Machining number of machine hours Purchase orders number of purchase orders Design alteration Number of design alterations Customer relations Number of customers Segment sustaining Not applicable Expected activity Standar Advanced Total d 2.000 1,200 3,200 200 300 0 400 400 20 80 100 500 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