Rao Case

ACBU 2223

Fall 2020

The Rao Company is a publicly traded corporation that produces different types of air fryers. My name is Alan Smith and I have worked for this company for the last ten years in the controller's office. I was both an accounting and finance major in university. The company currently produces 300 products and does not anticipate any new products coming out over the next three years. I have previously mentioned to my superiors that it is not appropriate for our firm to use a traditional costing system (where overhead costs are allocated across products at a rate of 400% of direct labor costs) when different products require different amounts of indirect resources. For example, under the traditional system all costs associated with testing of products for quality assurance purposes are part of overhead costs and therefore allocated across products based on direct labor costs. Yet, some of our products require as much as 5 hours of testing whereas some products require less than 1 minute of testing with no connection to direct labor costs. Given that traditional costing systems may result in significant cost distortions when determining products costs and given that the firm now has revenues of over $100 million a year, Rao has decided to adopt activity based costing over the next year or two.

Rao's management has hired Deloitte Consulting to help us implement activity-based costing. I will be acting as the liaison between our firm and Deloitte. As part of the initial implementation phase, I have asked Deloitte to derive the costs and product margins associated with two of our products, Ole and Duo, so that these costs and product margins could be compared with the costs and profit margins under our current traditional costing system. I picked these products since Rao management believe they have very different demands on indirect overhead resources. Further, Ole is sold in large quantities whereas Duo is sold in small quantities.

Current information from our existing system on a per unit basis is shown in Exhibit 1.

Exhibit 1

Ole

Duo

Direct material

$38

$38

Direct labor hours

0.25

0.25

Direct labor cost per hour

$36

$36

Sales price per unit

$90.00

$95.00

My staff has identified for Deloitte five activity cost pools. Information on those cost pools and the related allocation bases are provided in Exhibit 2.

Exhibit 2

Total Costs

Allocation Base

Level of Allocation Base

Equipment setups

$7,500,000

Number of setups

50,000

Purchase orders

$10,800,000

number of purchase orders

180,000

Machining

$105,000,000

number of machine hours

1,500,000

Testing

$13,500,000

number of testing hours

900,000

Packaging

$24,000,000

number of containers

1,200,000

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 firm will assume that costs associated with equipment setups, purchase orders, testing, and packaging & shipping are variable with respect to their respective activity measures. Currently, we believe our assumptions on cost behavior patterns are quite reasonable.

All products are produced in batches, where the size of a batch differs across products. For example, if we produce 80 units of a product in batch sizes of 40, then the product will be produced in two batches. An equipment setup must be performed before producing each batch of a product. Hence, in the example above, two equipment setups would be performed. Units of product are packaged in containers and sent to distributors.

Production volumes are set equal to sales volumes since the company only produces products that they have orders for. Consequently, the firm never has a beginning work in process inventory or a beginning finished goods inventory. (Hence, the firm never has ending inventories.)

Further information on our two products are provided in Exhibit 3

Exhibit 3

Ole

Duo

annual sales and production in units

240,000

100,000

number of units per batch

40

20

number of purchase orders

300

200

number of machine hours per unit

0.30

0.8

total number of testing hours

5,000

3,500

total number of containers

3,000

2,000

1. (20 Points) Calculate product margin for Ole and Duo using the traditional costing system where overhead is applied at a rate of 400% of direct labor costs. The amount of product margin should be on a total basis and then show the average product margin per unit using the following template for guidance:

Ole Duo

Sales $$$ $$$

Direct materials $$$ $$$

Direct labor $$$ $$$

Manufacturing overhead $$$ $$$

Cost of goods sold $$$ $$$

Product margin $$$ $$$

Average product margin per unit $$$ $$$

2. (20 Points) Calculate the five activity rates (predetermined overhead rates) under activity-based costing.

3. (30 Points) Calculate product margin for Ole and Duo using the activity-based costing system. The amount of product margin should be on a total basis and then show the average product margin per unit using the following template for guidance:

Ole Duo

Sales $$$ $$$

Direct materials $$$ $$$

Direct labor $$$ $$$

Equipment Setups $$$ $$$

Purchase orders $$$ $$$

Machining $$$ $$$

Testing $$$ $$$

Packaging and shipping $$$ $$$

Total ABC Costs $$$ $$$

Product margin $$$ $$$

Average product margin per unit $$$ $$$

4. (10 Points) Assume next year that the activity rates (predetermined overhead rates) remain the same as you calculated in question (2). Assume that the demand for Ole is expected to increase significantly. Consequently, the firm expects to produce more batches of Ole next year than this year and the firm plans to produce in batch sizes of 60 rather than 40. Calculate what the equipment setup cost per unit of Ole will be next year if it can be calculated. If it cannot be calculated, then explain in words why the equipment setup cost per unit of Ole cannot be determined in the absence of more information.

5. (10 Points) Question 5 is independent of question 4. Next year, because of an expected increase in product demand, machine hours are expected to increase from 1,500,000 to 1,750,000. The company will not need any new machinery since the current machinery is highly underutilized. Also, the number of testing hours will increase from 900,000 to 1,000,000. Assume that these new levels of operations are within the firm's relevant range. Calculate what the activity rate for the cost pool of machining would be next year if it can be calculated. Also, calculate what the activity rate for the cost pool of testing would be next year if it can be calculated. If one or both rates cannot be calculated, then explain in words why the calculations cannot be determined in the absence of more information.

6. (10 Points) Question 6 is independent of questions 4 and 5. Assume that the two accounting systems discussed in the case are allowed under GAAP. If the income statement for last year was restated using activity-based costing, would the company's total net operating income under activity-based costing differ from the company's total net operating income under their traditional accounting system? Why?