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CHAPTER FOUR ACTIVITYBASED COSTING AND MANAGEMENT 41 Benefits of ABC The Brazos Mill does not need ABC because it makes a single product. No matter how complex the process, how many ingredients, how many processes, all of the costs of the mill relate to the one productflour. The River City Bakery is a perfect candidate for ABC. It makes a wide range of products that are highly diverse. It makes them in very different quantities. It uses a variety of materials and processes Some students think that ABC should be applied in any circumstances 42 Cost Analysis Levi Strauss probably did an ABC analysis looking at costs driven by the number of orders a store made, the dollar amount of each store’s orders, and by the number of stores the company services. Some costs of servicing a single order are as high for a small customer's order as they are for a large customer's. Small orders are relatively more costly than large orders and small customers probably place a good many orders (as opposed to ordering all year's worth of product at once). Simply having a customer generates costs related to recordkeeping, creditchecking, and other services 43 Cost Drivers One driver is probably the total base of customers, regardless of when they bought the packages, but recent sales probably are the key driver because buyers who have had the software for shorter time periods are more likely to require assistance 44 Costs and Activities Zydeco's narrower product line reduces costs generally regarded as fixed, because they do not change with volume. Such costs nonetheless increase or decrease with significant changes in activities. Zydeco's operations are less diverse and less complex than those of its competitors, so its costs are lower. Zydeco probably does not deal with as many suppliers, keep as many records, engage in as many transactions, use as much space, or employ as many people as its competitors. Therefore, Zydeco’s breakeven point should be lower than it’s competitors 41 45 Costs of Complexity Complexity drives costs because it makes operations less smooth and requires more people to accomplish tasks. Companies that make or sell a variety of products incur some costs simply because of the complexity of their operations. For instance, they must stock parts for more products, and must change machinery over from one product to another. They might need several sizes of cartons for shipping. They must schedule production and coordinate much more material and inprocess flow than a singleproduct operation 46 Quality Costs External failure costs are the hardest to estimate because so much of the cost is the opportunity cost of lost sales because of your defects. The other categories contain recorded costs and some involve allocations that generate disagreement, but not to the degree of external failure costs 47 Classifying Quality Costs 1. Prevention, though some of the cost is not qualityrelated 2. Prevention, though again some of the cost does not relate to quality 3. Prevention 4. Internal failure 5. Prevention, though some is not qualityrelated 6. External failure 7. Some relates to external failure, but some is related to color, size, and customer whim 48 Basic Allocation (5 minutes) $67,500 to residential, $112,500 to commercial Residential Commercial Total Allocated overhead, 6/16, 10/16 $67,500 $112,500 $180,000 Residential Commercial Totals Revenues $100,000 $300,000 $400,000 Labor costs (60,000) (100,000) (160,000) Overhead costs (67,500) (112,500) (180,000) Income (loss) ($27,500) $ 87,500 $ 60,000 49 ABC Estimates (Extension of 46) (15 minutes) 1. Cost Pool Cost in Pool Cost Driver Rate Maintenance $ 75,000 25,000 $3/hour Scheduling and transport 45,000 5,000 $9/hour General 60,000 $160,000 $0.375/hour Total $180,000 42 Residential Commercial Totals Revenues $100,000 $300,000 $400,000 Labor costs 60,000 100,000 160,000 Overhead costs: Maintenance, $3 x 5,000, 20,000 15,000 60,000 75,000 Scheduling, transport at $9/hour 9,000 36,000 45,000 General at $0.375/labor dollar 22,500 37,500 60,000 Total costs 106,500 233,500 340,000 Income ($ 6,500) $ 66,500 $ 60,000 3. Residential work still appears to be unprofitable in the long term. Roberts might think about raising prices to residential customers, making explicit charges for travel time, or dropping the residential business over time. In this situation, the conclusions one might reach do not differ between a singledriver analysis and an ABC analysis, but the numbers do differ Another reasonable suggestion is to leave the general overhead unassigned, though we are told that it is driven by labor cost. That labor cost does drive all of the general overhead is doubtful 410 Basic Allocations (15 minutes) 1. 110,000 hours, (10 x 10,000) + (20 x 500) 2. $6/hour, $660,000/110,000 Doodler Sketcher Material cost $ 20 $ 45 Assembly labor at $20/hour 200 400 Overhead at $6/assembly hour 60 120 Total cost $280 $565 Doodler Sketcher Revenue $320 $950 Cost 280 565 Profit $ 40 $385 411 ABC Estimates (Extension of 410) (15 minutes) Setups Testing Assembly Total cost in pool $140,000 $190,000 $330,000 Activity 350 4,750 110,000 Rate $400 $40 $3 43 Doodler Sketcher Material cost $ 20 $ 45 Assembly labor at $20/ hour 200 400 Overhead: Setuprelated, $400 x 1/100 4 $400 x 1/2 200 Testingrelated, $40 x 0.20 8 $40 x 5.5 220 Assembly laborrelated 30 60 Total cost $262 $925 Doodler Sketcher Revenue $320 $950 Cost 262 925 Profit $ 58 $ 25 4. The costs of the two workstations differ considerably under the two approaches. The ABC approach better captures the consumption of resources, especially setups and testing, than does the simple, onedriver approach. The profitability of the two products changes as well, with the Doodler now seeming more profitable, while the Sketcher is just barely profitable 412 Basic Allocations (5 minutes) 1. $18, $3,600,000/200,000 2. $0.45, $3,600,000/$8,000,000 3. $50,400, 2,800 x $18 $63,900, $142,000 x $0.45 The amounts differ because Barron used relatively highsalaried people. The actual average salary was $50.71 per hour ($142,000/2,800) on work done for Barron, compared to the $40 average ($8,000,000/200,000). Barron might argue that overhead costs are more likely to be driven by hours than by dollars. Why should a $70/hour consultant generate more overhead cost than a $30/hour one? The argument is reasonable, as far as it goes 413 ABC Estimates (Extension of 412) (15 minutes) 1. Market Product Research Promotion Feasibility Annual overhead $800,000 $1,800,000 $1,000,000 Annual billable hours 100,000 60,000 40,000 Rate $8 $30 $25 2. $21,700 Market Product Research Promotion Feasibility Total Billable hours 1,800 800 200 2,800 Overhead cost $14,400 $24,000 $5,000 $43,400 44 3. The method given here makes more sense because clients pay for the actual resources they consume. Barron used relatively more of the low overhead market research services than of the higheroverhead promotion and product feasibility services. You might wish to point out that, over time, charging based on hours or dollars without reference to the specific services (the approach used in 412) could influence the kinds of business the firm receives. Because users of market research services are overcharged, they will gravitate toward other firms, while users of promotion and product feasibility services will move toward Erffmeyer and Sutton 414 Quality Costs (15 minutes) If no inspection is made: 8% 1,000 units $300 = $24,000 external failure costs If inspection is made: 1,000 units $10 inspection cost = $10,000 appraisal cost 8% 95% 1,000 units $50 repair cost = $3,800 internal failure cost 8% 5% 1,000 units $300 = $1,200 external failure cost No inspection: $24,000 Inspect: $10,000 + 3,800 + 1,200 = $15,000 Acme should institute the additional inspection 415 Classifying Quality Costs (10 minutes) Prevention Quality training $ 65,000 Appraisal Incoming materials inspection $120,000 Product inspection 150,000 Total $270,000 Internal failure Rework $650,000 Scrap 375,000 Total $1,025,000 External failure Product warranty $950,000 416 ABC for Shipping Department (2025 minutes) 1. The rate per dollar of orders is $0.1043, $1,252,000/$12,000,000 Supermarkets Convenience Stores Shipping cost, $0.1043 x $9,000,000 $938,700 $0.1043 x $3,000,000 $312,900 The total allocated is $1,251,600, $400 off because of rounding 2. Amount Amount of 45 Cost Pool/Driver in Pool Activity Rate Dollar volume of orders $492,000 $12,000,000 $0.04100 Number of customers 360,000 560 642.86 Number of orders 160,000 1,360 117.65 Number of stocks 240,000 6,400 37.50 Total shipping costs $1,252,000 Supermarkets Convenience Stores Dollar volume of orders at $0.041 $369,000 $123,000 Number of customers at $643 102,880 257,200 Number of orders at $118 51,920 108,560 Number of stocks at $37.50 150,000 90,000 Totals $673,800 $578,760 The ABC costs total $1,252,560 because of rounding. Students need reminding that precision is not the issue here, no one will make a different decision based on $560 out of hundreds of thousands. The assignment also states that this analysis is rough and preliminary, so striving for computational accuracy is not useful 3. The results are quite different. Convenience stores use considerable amounts of resources that are not driven by dollar volume and so are undercosted using the single driver. It should prove worthwhile to extend and refine the analysis 417 Cost Drivers (20 minutes) Note to the Instructor: Good students will give a wide variety of answers here and will be able to justify most of them. One point to make is that drivers do not come up and introduce themselves: accountants and other managers must seek them out Machine maintenance Machine hours Wages of workers who reset machinery when Number of production runs products change Costs of inspecting incoming materials and Number of incoming shipments components Costs of keeping records on workershow much Number of employees they produce, what they earn Costs of inspecting finished products Production in units Costs to rework defective units Production in units, if defectives run a fairly constant relationship to output Building maintenance Space in factory Personnel department costs, including Number of employees payroll processing costs Purchasing department costs, including Number of vendors, soliciting bids from vendors Number of parts stocked preparing, reviewing, and auditing purchase orders Customer billing Number of customers 46 Some of these are arguable, and you might wish to discuss the conditions under which a different driver, listed or not, is appropriate. For instance, machine maintenance might depend partly on the number of runs because setting and tearing down generates additional wearandtear. Or, the costs of recordkeeping might be driven partly by the types of workers, whether salaried or on wages. Timekeeping for workers subject to overtime pay is costlier than for salaried employees The number of purchase orders probably drives some costs in the purchasing department. A more important driver in some purchasing departments is the complexity or uniqueness of orders. That is, the department might spend a lot of time obtaining and evaluating bids on major, unique items. This is characteristic of university purchasing departments 418 ActivityBased Cost Analysis (1520 minutes) Regression output from Excel including both units produced and number of products appears below SUMMARY OUTPUT Regression Statistics Multiple R 0.933578 R Square 0.871567 Adjusted R Square 0.820194 Standard Error 3,933.513 Observations 8 Intercept Units Produced Number of Products Standard Coefficients Error (25,580.10) 55,835.90 0.2348 0.1942 101.4761 17.8851 t Stat Pvalue Lower 95% Upper 95% 0.458 0.666 (169,110.63) 117,950.43 1.209 0.281 (0.2644) 0.7340 5.674 0.002 55.5010 147.4513 It is clear from the output that Units Produced is not a statistically significant variable since the 95% confidence interval includes a value of zero. Therefore, the regression should be performed using only Number of Products as the xvariable 47 SUMMARY OUTPUT Regression Statistics Multiple R 0.913248 R Square 0.834021 Adjusted R Square 0.806358 Standard Error 4,082.05 Observations 8 Intercept Number of Products Standard Coefficients Error 41,454.58 6,837.10 92.3155 16.8127 t Stat Pvalue Lower 95% Upper 95% 6.063 0.001 24,724.80 58,184.36 5.491 0.002 51.1764 133.4547 The output shows that the quarterly fixed costs are about $41,455 and that there is a variable component of $92.32 per product. The variable component is most likely stepvariable. Using quarterly data helps to make the point that some costs respond slowly to changes in activity The measures of fit are good. About 83.4% of the variation in cost is associated with changes in the number of products. The standard error of the estimate is 4,082, so that 68% of the observations should be within $4,082 of the predicted value and 95% within $8,160. The variable Number of Products has a 95% confidence interval ranging from 51.17 to 133.45. Since this range does not include zero, the variable is statistically significant. We can conclude that the number of products is a cost driver in the production scheduling department The major conclusion about cost reduction is that reducing the number of products will reduce these costs. It might be possible to achieve some reductions by standardizing products. 419 Product Line Report (25 minutes) 1. Paper Products Detergents Total Sales $2,000,000 $1,200,000 $3,200,000 Variable costs: Cost of goods sold* 1,400,000 720,000 2,120,000 Commissions at 10% 200,000 120,000 320,000 Total variable costs 1,600,000 840,000 2,440,000 Contribution margin 400,000 360,000 760,000 Line sustaining costs 110,000 150,000 260,000 Product line margin $ 290,000 $ 210,000 500,000 Company sustaining costs 350,000 Profit $ 150,000 * 70% of sales and 60% of sales 48 2. Paper products Paper Products Detergents Current contribution margin $400,000 $360,000 10% increase $ 40,000 $ 36,000 Less promotion cost 30,000 30,000 Increase in profit $ 10,000 $ 6,000 3. Detergent Paper Products Detergents Sales after increase $2,200,000 $1,320,000 Cost of goods sold* 1,540,000 792,000 Commissions at 12% 264,000 158,400 Total variable costs 1,804,000 950,400 Contribution margin $ 396,000 $ 369,600 Original contribution margin 400,000 360,000 Increase (decrease) in profit ($ 4,000) $ 9,600 * $1,400,000 x 110%; $720,000 x 110% Note to the Instructor: Some students will try to solve by dealing only with changes, as they could in requirement 2. Most of these students will reach an incorrect answer because of failure to recognize that the new commission rate applies to all sales, not just to the increased sales. Paper Products Detergents Sales increase $200,000 $120,000 times contribution margin percentage, 30% 12%; 40% 12% 18% 28% Contribution from sales increase $ 36,000 $ 33,600 Additional commissions on existing sales $2,000,000 x 2%; $1,200,000 x 2% 40,000 24,000 Increase (decrease) in profit ($ 4,000) $ 9,600 4. This format shows how each line is performing and also makes CVP analysis easier because the contribution margin percentage is readily calculated from the report. A report showing only the combined results does not permit you to make decisions about individual lines, only about the business as a whole (e.g., increase volume of both lines by the same percentage). Note to the Instructor: One purpose of this assignment is to show how profitability and changes in it depend on both volume and contribution margin. The answer to requirement 2 must be either paper products or neither line, because a 10% increase in volume will increase total contribution margin of that product line by 10%, and paper products have a higher total contribution margin than detergents. The question is then whether the increase in contribution margin is greater than the increase in fixed costs. In requirement 3, the problem is more subtle because not only is volume increasing but the contribution margin percentage is decreasing by two percentage points. It is therefore not so clear that one line will do better than the other, much less whether changing either commission will be profitable. The schedule below shows the effects in a different way. 49 Paper Products Detergents Original contribution margin percentage: $400,000/$2,000,000; $360,000/$1,200,000 20% 30% Less two points increased commission 18% 28% Times new volume $2,200,000 $1,320,000 Equals new total contribution margin $ 396,000 $ 369,600 In general, reducing contribution margin percentage (by dropping prices, increasing variable costs such as commissions) to increase volume is not profitable for low contribution margin products. It might be profitable for high contribution margin products but not necessarily. 420 Quality Costs (1015 minutes) Prevention Employee training $ 50,000 Product design 250,000 Vendor certification 80,000 Total $380,000 Appraisal Inspection of outgoing shipments $ 70,000 Salaries of laboratory personnel 150,000 Inspection of incoming shipments 40,000 Total $260,000 Internal failure Rework of defective units $ 40,000 External failure Salaries of customer service personnel, 40% $ 80,000 Some alternatives are possible. Some employee training might relate to quality inspection, an appraisal cost. Customer service personnel salaries are included above at 40%, the percentage of time spent fixing products. Some of the remaining 60% of those salaries might be prevention costs if service representatives take customer recommendations back to designers. 2. The point of this question is that opportunity costs of lost sales from external failure are not recorded, nor are internal costs of lost output from time spent making and reworking defective product Note to the Instructor: You might wish to introduce the question of allocating indirect costs. Some of the costs above are salaries only, but the company incurs costs to support the laboratory and the customer service representatives, as well as other qualityrelated activities. The rework costs might be labor only, or include applied overhead as well 410 Amount of Amount of Cost Driver Cost in Pool Activity Rate Total manufacturing costs $440,000 $8,600,000 $ 0.051 Number of shipments received 180,000 1,400 129.00 Number of orders requiring inspection 80,000 240 333.00 $700,000 The rates are rounded Line A Line B Line C Total manufacturing costs at $0.051 $229,500 $112,200 $ 96,900 Number of shipments received at $129 56,760 41,280 82,560 Orders requiring inspection at $333 3,333 8,325 68,265 Totals $289,593 $161,805 $247,725 Again, the totals are off because of rounding, but this should not be a concern because the analysis is preliminary 3. Line C costs increase considerably, while B's drop some and A's decrease considerably. Line C uses more resources than do the other lines. Allocations based on total manufacturing costs do not capture this resource use We cannot tell whether it would be desirable to do a fullblown ABC study because we do not know whether total costs would be significantly different. That is, we do not know whether receiving costs are material. If they are, the company should pursue ABC because the product lines consume quite different amounts of receiving department resources 427 Product Line Income Statements (35 minutes) 1. The first step is to find the number of each product sold Saws: 4,000 ($500,000 x 40%)/$50 Drills: 7,500 ($500,000 x 30%)/$20 Sanders: 3,750 ($500,000 x 30%)/$40 Mifflan Tool Company Income Statement for January 20X8 Total Saws Drills Sanders Sales $500,000 $200,000 $150,000 $150,000 Cost of sales (1) 307,500 120,000 112,500 75,000 Gross profit 192,500 80,000 37,500 75,000 Shipping and delivery (2) 23,000 8,000 7,500 7,500 Contribution margin 169,500 $ 72,000 $ 30,000 $ 67,500 Fixed costs (3) 140,000 Income before taxes $ 29,500 (1) Saws = 4,000 x $30 Drills = 7,500 x $15 Sanders = 3,750 x $20 (2) Saws = 4,000 x $2 Drills = 7,500 x $1 Sanders = 3,750 x $2 (3) Rent, salaries, and other expenses of $40,000, $70,000, and $30,000 414 2. At the expected mix the sales of each product would have been as follows: Saws: 3,000 ($500,000 x 30%)/$50 Drills: 5,000 ($500,000 x 20%)/$20 Sanders: 6,250 ($500,000 x 50%)/$40 Mifflan Tool Company Expected Income Statement for January 20X8 Total Saws Drills Sanders Sales $500,000 $150,000 $100,000 $250,000 Cost of sales 290,000 90,000 75,000 125,000 Gross profit 210,000 60,000 25,000 125,000 Shipping and delivery 23,500 6,000 5,000 12,500 Contribution margin 186,500 $ 54,000 $ 20,000 $112,500 Fixed costs 140,000 Income before taxes $ 46,500 3. Expected Percentages: Total Saws Drills Sanders Selling price $50.00 $20.00 $40.00 Cost of sales 30.00 15.00 20.00 Gross profit $20.00 $ 5.00 $20.00 Gross profit percentage 40% 25% 50% Mix percentage 30% 20% 50% Weighted average 42% 12% 5% 25% Gross margin, above $20.00 $ 5.00 $20.00 Less shipping and delivery 2.00 1.00 2.00 Contribution margin $18.00 $ 4.00 $18.00 Contribution margin percentage 36% 20% 45% Weighted average 37.3% 10.8% 4.0% 22.5% Actual Percentages: Total Saws Drills Sanders Gross profit percentage 40% 25% 50% Actual sales mix 40% 30% 30% Weighted average 38.5% 16% 7.5% 15% Contribution margin percentage 36% 20% 45% Weighted average 33.9% 14.4% 6.0% 13.5% The effect of the change in mix was to reduce the gross margin percentage to 38.5% from 42%, 3.5 percentage points. This resulted in a $17,500 drop in gross margin ($500,000 x 3.5%). The percentage of shipping and delivery expenses dropped from 4.7% ($23,500/$500,000) to 4.6% ($23,000/$500,000). This 0.1% decrease gained an additional $500 of contribution margin and profit. Some students will deal only with the change in the WACM (37.3% expected versus 33.9% actual), a drop of 3.4 percentage points, giving the $17,000 profit shortfall ($500,000 x 3.4%). Whether or not variable costs are discussed individually, the president can be told that the shift in mix was unfavorable because the lowest margin product, drills, increased its share and the highest margin product, sanders, reduced its share 415 428 Product Line Reporting, Activity Analysis (35 minutes) Kelly Company Productline Income Statement for April 20X7 (000s) Sport Suits Clothes Accessories Total Sales (1) $240.0 $400.0 $160.0 $800.0 Variable costs: Cost of sales (2) 192.0 300.0 80.0 572.0 Commissions (3) 14.4 24.0 9.6 48.0 Total variable costs 206.4 324.0 89.6 620.0 Contribution margin 33.6 76.0 70.4 180.0 Productline sustaining costs (4) 12.0 8.0 5.2 25.2 Shortterm margin 21.6 68.0 65.2 154.8 Direct committed fixed costs (5) 6.0 8.8 6.0 20.8 Longterm margin $ 15.6 $ 59.2 $ 59.2 134.0 Facilitysustaining costs: Salaries ($71.4 $25.2) 46.2 Rent 21.4 Shipping and delivery 15.2 Insurance 14.0 Total companysustaining costs 96.8 Income $ 37.2 (1) $800,000 times sales mix percentages of 30%, 50%, and 20% (2) Sales dollars times variable cost percentages of 80%, 75%, and 50% (3) Sales dollars times 6% (4) Salaries for managers and directly associated personnel, as given (5) Given Note to the Instructor: Some discussion points regarding the income statement follow Statements about profitability of departments assume independence among the departments. It is likely in this case that sales in other departments would be adversely affected if one were dropped. Students will understand this point even though it has not yet been explicitly introduced Suits have relatively low margins compared to the other lines, and we might ask whether this is normal. Students, especially marketing majors, might be aware that trade associations publish information that would help to determine whether the suit department is well below those of competitors. If there is reason to believe that the performance is poor, the manager of the suit department should have to explain the relatively lackluster performance 429 ABC for a Distributor (35 minutes) 1. A B C D E Sales $400,000 $440,000 $660,000 $800,000 $1,400,000 Gross profit 192,000 202,400 277,200 296,000 476,000 Order costs 82,600 48,750 39,600 29,400 25,500 Delivery costs 70,000 62,500 45,000 30,000 37,500 Stocking costs 13,440 20,000 17,280 33,600 45,600 Total costs 166,040 131,250 101,880 93,000 108,600 Margin $ 25,960 $ 71,150 $175,320 $203,000 $ 367,400 Order costs, $240 per order plus $5.00 per item ordered Customer A = ($240 x 140) + ($5.00 x 140 x 70) = $82,600 416 Delivery costs, $500 x number of deliveries Customer A $500 x 140 = $70,000 Shelfstocking costs, $0.16 x deliveries x total units per order Customer A = $0.16 x 140 x 600 = $13,440 2. You might wish to point out that the controller allocated $600,002 in costs to the customers, while the ABC estimates are $600,770, a slight difference that is likely to occur anytime. The picture is quite different under the ABC analysis. Customer A had appeared quite profitable under the controller’s analysis because of its high gross profit percentage, but its relatively higher servicing costs reduced its apparent profitability considerably under the ABC analysis. Customers C and D had appeared almost equally profitable under the controller’s analysis, but a sharp difference opens up under the ABC analysis. Customer E’s profitability jumped nearly 50% under the ABC analysis The reasons for the changes lie in the demands that the various customers place on Western’s resources. The smaller customers use relatively more resources because they order and receive deliveries more often. 430 Line of Business Reporting (60 minutes) Riparian Company Quarterly Income Statement Total Product A Product B Product C Sales $1,300,000 $500,000 $400,000 $400,000 Variable costs: Manufacturing 820,000 300,000(60%) 280,000(70%) 240,000(60%) Selling 31,000 15,000 (3%) 8,000(2%) 8,000 (2%) Total variable costs 851,000 315,000 288,000 248,000 Contribution margin 449,000 185,000 112,000 152,000 Product sustaining (1) 180,000 42,000 52,000 86,000 Product margin $ 269,000 $143,000 $ 60,000 $ 66,000 Company sustaining costs: Manufacturing (2) 50,000 Selling (3) 34,000 Administrative 52,000 Total 136,000 Income $ 133,000 (1) $40,000 avoidable, 30%, 30%, 40% to products, plus $140,000 product sustaining manufacturing costs, $30,000, $40,000, $70,000 (2) Total fixed manufacturing cost of $190,000 less $140,000 product sustaining (3) Total selling expense of $105,000 less $31,000 variable less $40,000 avoidable, direct selling costs 417 2. Riparian Company Quarterly Income Statement Total Domestic Foreign Sales $1,300,000 $1,000,000 $300,000 Variable costs: Manufacturing 820,000 630,000 (A) 190,000 (A) Selling 31,000 24,000 (B) 7,000 (B) Total variable costs 851,000 654,000 197,000 Contribution margin 449,000 346,000 103,000 Market sustaining costs (1) 184,000 126,000 (C) 58,000 (C) Market margin 265,000 $ 220,000 $ 45,000 Company sustaining costs Manufacturing 80,000 Administrative 52,000 Total 132,000 Income $ 133,000 (1) Selling costs of $36,000 and $38,000 (see below) plus $90,000 and $20,000 manufacturing costs Schedule AVariable Manufacturing Costs (1) (2) (3) (4) (5) (6) (7) Variable Variable Variable Cost Domestic Cost Foreign Cost Total Product Ratio Sales (2) x (3) Sales (2) x (5) (4) + (6) A 60% $400,000 $240,000 $100,000 $ 60,000 $300,000 B 70% 300,000 210,000 100,000 70,000 280,000 C 60% 300,000 180,000 100,000 60,000 240,000 Totals $630,000 $190,000 $820,000 Schedule BVariable Selling Expenses A 3% $400,000 $12,000 $100,000 $3,000 $15,000 B 2% 300,000 6,000 100,000 2,000 8,000 C 2% 300,000 6,000 100,000 2,000 8,000 Totals $24,000 $7,000 $31,000 Schedule CFixed Selling Costs by Market Domestic Foreign Total selling costs $60,000 $45,000 Variable (Schedule B) 24,000 7,000 Fixed $36,000 $38,000 418 3. The change would produce an increase in profit of $2,200 per quarter Sales Contribution Additional Product Increase Margin Percentage Contribution Margin A $ 80,000 37 (100 60 3) $29,600 B 80,000 28 (100 70 2) 22,400 C 40,000 38 (100 60 2) 15,200 Totals $200,000 $67,200 Lost shortterm marginforeign market (see Requirement 2) ($103,000 – 38,000) 65,000 Net increase $ 2,200 4. At least $166,000. Product C provides product margin of $136,000 per quarter and additional costs of $30,000 would be incurred. 431 Determining Variable Costs of ProductsActivityBased Analysis (25 minutes) 1. Product 816 uses 0.50 DLH ($8/$16) and product 389 uses 1.0 DLH ($16/$16) Amount of Driver Variable Overhead Cost Product 816 Product 389 Rates Product 816 Product 389 DLH 0.5 1 $4.00 $ 2.00 $ 4.00 MH 0.5 0.2 $20.00 10.00 4.00 Parts 120 185 $0.07 8.40 12.95 Processing time 10 5 $4.00 40.00 20.00 Total variable overhead $60.40 $40.95 Materials 15.00 13.00 Direct labor 8.00 16.00 Total variable cost $83.40 $69.95 Overhead 0.5 1 $50.00 $25.00 $50.00 Materials 15.00 13.00 Direct labor 8.00 16.00 Total variable cost $48.00 $79.00 3. We do not wish to focus attention too much on the specific differences between the costs, but rather on the general point that establishing cost pools might benefit the company through better information about the consumption of resources. The cost of product 816 is higher using the multiple pools, while that of product 389 is lower. The reason is the relative uses of the cost drivers. You might wish to show how the costs might change for products with, say, large numbers of parts or longer processing time. 419 432 Segmented Income Statements for a Distributor, Activity Analysis, Ethics (25 minutes) Total Eastern Southern Western Sales $2,896.0 $589.0 $752.0 $1,555.0 Variable costs: Cost of sales (1) 1,231.9 200.3 300.8 730.8 Selling expenses (2) 429.1 82.5 97.8 248.8 Total variable costs 1,661.0 282.8 398.6 979.6 Contribution margin 1,235.0 306.2 353.4 575.4 Districtsustaining costs Selling expenses (3) 514.0 152.0 155.0 207.0 Administrative expenses (4) 40.0 9.0 12.0 19.0 Total districtsustaining 554.0 161.0 167.0 226.0 District margin $ 681.0 $145.2 $186.4 $ 349.4 Companysustaining costs (5) 307.9 Income $ 373.1 (1) As originally given (2) Sales multiplied by variable cost percentages: $589 x .14; $752 x 13; $1,555 x .16 (3) Given (4) Given (5) Total costs less costs accounted for above Selling Costs Administrative Costs Total in problem $1,026.0 $265.0 Variable costs (429.1) 0 Districtsustaining costs (514.0) (40.0) Companysustaining costs $ 82.9 $225.0 Total company sustaining costs = $307.9, $82.9 + $225 2. The memorandum could make the following points The new income statements rearrange costs but do not change them. Notice that income for the company remains the same at $373.1 thousand. The new statements reflect the use of resources, or activities, for each region. Our previous income statements assumed that sales was the only cost driver. The new format does not attempt to allocate common costs to the regions The district margins are the best bases for evaluating the regions. These margins include all costs incurred to sustain the segments. The margin indicates how much the region contributes to covering company sustaining costs and providing a profit. Using the district margins, all territories appear to be doing well. We need time to assess performance in the new territories. The opening of these territories should also affect the Western territory, because costs that were formerly incurred only for the benefit of the West now are common to all three territories. Examples include corporate overhead costs and some data processing costs. A comparison of the income statement above with ones similarly prepared for previous periods would help us to see how the Western territory has been progressing The new territories have sizable district margins and their contribution margin percentages are even higher than that of the established Western territory. This higher return could be related to the product lines that we are selling. Taylor might be selling more of the highmargin lines in the 420 new territories, as the lower cost of sales ratios in the new territories suggest. The new statements should allow you to make better decisions and evaluations because they highlight contribution margin and segment margin for each region. 3. The following points are relevant for the memorandum. Regardless of how we prepare segmented income statements, we could have ethical issues with the allocations and assignments of costs to regions. The IMA objectivity standard requires that we communicate information fairly and objectively and disclose all relevant information. The competence standard requires that we maintain professional competence and employ it in developing reports. Taken together, these Standards require us to be sure that (1) we have reflected the costs of activities in a fair and reasonable way, (2) we have not favored any region over another in assigning costs, and (3) we have reflected the most relevant information in appropriate ways 433 Segmented Income StatementsCosts of Activities, Ethics (30 minutes) Sporting Total Goods Housewares Hardware Sales $3,337.0 $650.0 $921.0 $1,766.0 Variable costs: Cost of sales (1) 1,094.8 182.0 294.7 618.1 Selling expenses (2) 58.6 13.0 13.8 31.8 Administrative expenses (3) 47.6 5.9 6.4 35.3 Total variable costs 1,201.0 200.9 314.9 685.2 Contribution margin 2,136.0 449.1 606.1 1,080.8 Productline sustaining costs Cost of sales 496.0 158.0 141.0 197.0 Selling expenses 276.0 56.0 87.0 133.0 Administrative expenses 78.0 13.0 22.0 43.0 Total line sustaining costs 850.0 227.0 250.0 373.0 Product margin $1,286.0 $222.1 $356.1 $ 707.8 Company sustaining costs (4) 1,180.0 Income $ 106.0 (1) Sales x percentage variable cost, $650 x 28%; $921 x 32%, $1,766 x 35% (2) Sales x percentage variable cost, $650 x 2%; $921 x 1.5%, $1,766 x 1.8% (3) Sales x percentage variable cost, $650 x .9%; $921 x .7%, $1,766 x 2% (4) Costs remaining after others accounted for Administrative Cost of Sales Selling Costs Costs Total in problem $1,928.8 $787.6 $514.6 Variable costs (1,094.8) ( 58.6) ( 47.6) Linesustaining costs ( 496.0) (276.0) ( 78.0) Companysustaining costs $ 338.0 $453.0 $389.0 421 Total company sustaining costs are $1,180, $338 + $453 + $389 422 2. To: Controller From: Student Date: Today Subj: Alternative income statements I recommend that we adopt the new form of segmented income statement The new income statement isolates costs by behavior, which gives you and other managers better information for planning and for decisions about issues such as which segments to emphasize. The contribution margin percentages (69.1% for sporting goods, 65.8% for housewares, and 61.2% for hardware) are more helpful in evaluating the segments and in deciding which ones we might promote or downplay than are return on sales percentages. For instance, the 65.8% for housewares tells us that we would not be smart to ignore it, as the original income statement suggested. The product margins shown on the new statement show the contributions each line makes to covering common costs and providing a profit. Again, we see that the housewares line makes a significant contribution. These margins are more helpful than the gross margin or income figures on the original statement. Evaluating the profitability of segments should center on their margins without allocated common costs. We will then be better able than before to assess the effects of dropping segments or replacing them The new statement provides more relevant information for virtually any decision that you and other managers wish to make. The contribution margin percentages are valuable for any decision involving changes in volumes, prices, or variable costs. The product margins are helpful in assessing how well each line is doing. 3. The managers can expect that the accountants will prepare objective reports in a competent way. The IMA objectivity standard requires that we communicate information fairly and objectively and disclose all relevant information. The competence standard requires that we maintain professional competence and employ it in developing reports. Taken together, these Standards require us to be sure that (1) we have reflected the costs of activities in a fair and reasonable way, (2) we have not favored any region over another in assigning costs, and (3) we have reflected the most relevant information in appropriate ways 423 ... quarter? ?and? ?additional costs of $30,000 would be incurred. 431 Determining Variable Costs of Products? ?Activity? ?Based? ?Analysis (25 minutes) 1. Product 816 uses 0.50 DLH ($8/$16)? ?and? ?product 389 uses 1.0 DLH ... 1,000 units $10 inspection? ?cost? ?= $10,000 appraisal? ?cost 8% 95% 1,000 units $50 repair? ?cost? ?= $3,800 internal failure? ?cost 8% 5% 1,000 units $300 = $1,200 external failure? ?cost No inspection: $24,000... a strategic decision whether to continue doing business with convenience stores? ?and? ?if so, how to recover the costs 424 ? ?Cost? ?Drivers,? ?Activity? ?Based? ?Analysis (20 minutes) Regression output from Excel follows.