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Chapter 5
Activity-Based Cost
Systems
QUESTIONS
5-1 Traditional volume-based cost allocation systems that use only drivers that
vary directly with the volume of products producedsuch as direct labor
dollars, direct labor hours, or machine hoursare likely to systematically
distort product costs because they break the link between the cause for the
costs and the basis for assignment of the costs to the individual products. Costs
may vary not only with respect to volume of production, but also, for example,
with batch-related activities (e.g., changeovers, setups, and inspection of the
first item of production run) and the number of products (e.g., scheduling
materials receipts and improving products). Also, cost distortions tend to be
greater with greater differences between relative proportions of indirect
resources used by cost objects because traditional cost assignments based on
volume-related measures do not accurately reflect these differences.
5-2 Volume-based traditional product costing systems that use only drivers that
vary directly with the volume of products producedsuch as direct labor
dollars, direct labor hours, or machine hoursare most likely to distort
product costs under the following two conditions: (1) Indirect and support
expenses are high, especially when they exceed the cost of the allocation base
itself (such as direct labor cost); and (2) Product diversity is high: the plant
produces both high-volume and low-volume products, standard and custom
products, and complex and simple products. The combination of these two
conditions will magnify the distortions that arise because volume-based
product costing systems do not accurately reflect differences in non-volume-
related resource usage across products or other cost objects.
Activity-based costing systems provide more accurate costs when these two
conditions hold by creating more accurate links between the causes of indirect
and support costs and the bases for assignment of the costs to cost objects. For
example, costs may vary not only with respect to volume of production, but
also activities such as changeovers, setups, and inspection of the first item of
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production run, which are not done in proportion to the number of units
produced. Moreover, some costs vary with the number of different products
(e.g., scheduling materials receipts and improving products).
5-3 Yes, traditional costing systems are more likely to overcost high-volume
products because all indirect and support costs are assigned to products in
proportion to the number of production units (through volume-based cost
drivers), and the low-volume products are likely to require higher indirect and
support costs per unit. The high-volume products essentially cross-subsidize
the low-volume products in the sense that indirect and support costs are
assigned uniformly in proportion to volume.
5-4 Companies producing a varied and complex mix of products require many
more resources to support their highly varied mix, and therefore have higher
costs. Examples of the greater resources required include a much larger
production support staff to schedule machine and production runs; perform
changeovers and setups between production runs; inspect items at the
beginning of each production run; move materials; ship and expedite orders;
develop new and improve existing products; negotiate with vendors; schedule
materials receipts; order, receive, and inspect incoming materials and parts;
and update and maintain the much larger computer-based information system.
5-5 A significant change in resource costs triggers an update of the capacity cost
rates. A significant and permanent change in operations, such as the efficiency
with which an activity is performed, triggers an update of the unit time
estimate. If new activities become part of operations, the time to perform the
activity will be estimated and then multiplied by the appropriate capacity cost
rate to determine the cost of the activity.
5-6 The two sets of parameters that must be estimated in time-driven activity-
based costing are 1) the capacity cost rate for each type of indirect resource;
that is, the unit cost of supplying capacity for each department or process,
based on practical capacity, and 2) the consumption of capacity, which is an
estimate of how much of a resources capacity (such as time or space) is used
by the activities performed to produce the various products, services, or
customers.
To compute a capacity cost rate, first identify all costs incurred to supply that
resource (such as a machine, an indirect production employee, the computer
system, factory space, a warehouse, or a truck). Then, identify the capacity
supplied by that resource. The capacity would be the hours of work provided
by the machine or production employee, or the space provided by the
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5-8 The capacity cost driver rate should reflect the underlying efficiency of the
processfor example, the cost of resources to handle each production order
and this efficiency is measured better by using the capacity of the resources
supplied (practical capacity) as the denominator when calculating capacity
cost driver rates. The numerator in a capacity cost driver rate calculation
represents the costs of supplying resource capacity to do work. The
denominator should match the numerator by representing the quantity of work
the resources can perform. Unassigned costs represent the cost of unused
capacity and should be used as feedback to managers on their supply and
demand decisions.
5-9 Immediate financial improvement may not follow even after process
improvements reduce the demand for indirect and support resources. This is
because the support costs are often committed. The organization must actively
manage the unused capacity by increasing the volume of business or reducing
the supply of unused resources.
5-10 Service organizations are often ideally suited for activity-based costing
because virtually all of the costs for a service company are indirect and appear
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5-11 As mentioned in 5-10, virtually all the costs for a service company are indirect
and appear to be fixed. Service companies have few or no direct materials and
many of their personnel provide indirect, not direct, support to products and
customers. Consequently, service companies do not have direct, traceable
costs to serve as convenient allocation bases.
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5-12 Individuals may feel vulnerable facing uncertainty about what the activity-
based cost analysis may show, or they may feel threatened by the suggestion
that their work could be improved. For example, the analysis might reveal that
products or customers thought to be very profitable are actually unprofitable,
or that some processes are inefficient. Individuals may be concerned that they
will then be judged as poor managers, even though they were making
decisions that others would agree were good decisions based on the cost
system in place.
EXERCISES
5-14 Potter Corporation should switch to activity-based costing because its current
system appears to be distorting product costs, resulting in prices of specialty
products that are too low (hence increasing their market share) and prices of
simple products that are too high (thus, lowering their market share). This, in
turn, leads to lower overall profitability as Potter pushes products that, in
reality, produce low profit margins or even lose money.
5-15 (a) The time-driven ABC model will now incorporate a capacity cost rate for
computer resources, computed as $18,000 divided by the practical capacity
computer hours per month. Usage of computer resources can be measured
in computer time per product or production run.
(b) Before the machinery energy costs were discovered, the machinery rate
was computed as $15,400 divided by 308 practical capacity hours, which
equals $50 per hour. The energy costs of $4,000 per month will be added to
the $15,400 monthly machinery costs, for a new machinery resource cost
of $19,400 per month, leading to a higher rate per hour. The new rate is
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(c) If the company introduces a new flavor, the new flavors consumption of
direct and indirect resources will need to be estimated and then multiplied
by the appropriate cost or cost rate. For example, start with the quantity of
direct materials and labor hours per gallon produced, and multiply these
amounts by the related cost per unit of direct materials and wage rate,
respectively. Next, estimate the quantity of indirect labor (for changeovers,
scheduling and product maintenance) and machine time (for production
runs and setups). These will then be multiplied by the associated capacity
cost rates of each indirect resource and added to the direct materials and
direct labor costs in order to compute the total cost of producing the new
flavor.
5-16 (a) A 10% increase in indirect labor costs will increase the indirect labor
capacity cost rate by 10% (from $35 to $38.50) and therefore will increase
the indirect labor costs assigned to products by 10%. The revised income
statement that is similar to Exhibit 5-5 will show indirect labor costs that
are 10% higher than in Exhibit 5-5, with correspondingly lower product
gross profits, as shown below. (Small differences may result if the
calculations are performed in a spreadsheet package.)
Mocha-
Vanilla Chocolate Strawberry Almond Total
Sales $30,000 $ 24,000 $3,960 $2,800 $60,760
Direct materials $6,000 $4,800 $720 $520 $12,040
Direct labor
(including fringes) $8,750 $7,000 $1,050 $700 $17,500
Indirect labor usage $4,967 $3,581 $3,889 $4,043 $16,480
Machine usage $6,700 $5,000 $1,660 $1,640 $15,000
Gross profit (loss) $3,583 $3,619 $(3,359) $(4,103) $(260)
Gross profit (loss)
as percent of sales 11.94% 15.08% 84.82% 146.54% 0.43%
(b) With the reduction in unit time for scheduling a production from four hours
per run to three hours per run, we first compute the revised indirect labor
hours per month and then multiply by the new indirect labor capacity cost
rate of $38.50 per hour.
The revised indirect labor hours per month are calculated as follows:
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Mocha-
Vanilla Chocolate Strawberry Almond
Schedule production
runs, purchasing, etc.
(hours per run) 3 3 3 3
Product-sustaining (hrs
per month) 9 9 9 9
Indirect labor hours per
month 117 81 93 99
Indirect rate per hour $38.50 $38.50 $38.50 $38.50
Indirect labor cost $4,504.50 $3,118.50 $3,580.50 $3,811.50
The new income statement shows lower indirect labor costs than in part (a)
because of the reduced scheduling time per run. (Small differences may result
if the calculations are performed in a spreadsheet package.)
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Mocha-
Vanilla Chocolate Strawberry Almond Total
Sales $30,000 $ 24,000 $3,960 $2,800 $60,760
Direct materials $6,000 $4,800 $720 $520 $12,040
Direct labor
(including fringes) $8,750 $7,000 $1,050 $700 $17,500
Indirect labor usage $4,505 $3,119 $3,581 $3,812 $15,017
Machine usage $6,700 $5,000 $1,660 $1,640 $15,000
Gross profit (loss) $4,045 $4,081 $(3,051) $(3,872) $1,203
Gross profit (loss)
as percent of sales 13.48% 17.00% 77.05% 138.29% 1.98%
Combining direct labor and indirect labor costs, the summary income
statement showing unused capacity costs is as follows:
Totals
Totals with Unused with
Assigned Capacity Capacity
Costs Costs Costs
Sales $60,760 $60,760
Direct materials $12,040 $12,040
Direct labor and indirect labora $32,517 $68 $32,585
Machine usage $15,000 400 $15,400
Gross profit (loss) $1,203 $(468) $735
Gross profit (loss) as percent of
sales 1.98% 1.21%
a
Labor capacity cost = $4,655 7 employees = $32,585. Employees perform
direct labor and indirect labor tasks.
5-17 (a)
Hours: Hours: Cost: Cost:
Pumps Valves Rate Pumps Valves
1,500 1,800 $20 $ 30,000 $ 36,000
5,000 6,000 $30 $150,000 $180,000
200 400 $80 $ 16,000 $ 32,000
$196,000 $248,000
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(b) The cost of unused capacity, which will be expensed on the income
statement, is calculated as follows:
Hours: Cost:
Unused Unused
Capacity Rate Capacity
300 $20 $ 6,000
200 $30 $ 6,000
50 $80 $ 4,000
$16,000
5-18 (a) Kens previous average fixed cost per meal was $3,300 600 = $5.50. With
the drop in demand, the average fixed cost is now $3,300 550 = $6. If
demand decreases further and Ken continues to use the same method to
determine his costs of serving a meal, the average fixed cost will
continue to increase, and Ken will want to raise his prices even more.
However, the rising prices may contribute to further declines in demand,
leading Ken into a downward (or death) spiral.
(b) Ken should use the practical capacity quantity of meals per day to
determine cost per meal in order to avoid the fluctuations described in
part (a) and to understand the cost rate at the point where the resources
used equal the practical capacity usage. If resource usage is less than
practical capacity, Ken should monitor the cost of unused capacity. He
may be able to reduce the capacity costs or to find other profitable uses
for the capacity. In this problem, one may assume the practical capacity
is 600 meals per day.
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PROBLEMS
5-19 (a) Capacity cost rate = $500,000/10,000 hours = $50 per hour.
(d) The change will result in (0.5 1,000 + 1.0 2,000 + 0.1 2,000) =
2,700 hours used, a reduction from the 4,500 hours in part (a). The new
activity-based cost associated with Division 1s customers is
2,700 hours $50 per hour = $135,000. The lower cost assigned to
Division 1 will not reduce Zetas costs unless Zeta also reduces the
$500,000 total resource cost. This can be accomplished in the following
way; with the change in the mix of more electronic and fewer manual
transactions, 1,800 fewer hours of accounts receivable time is required.
Since the capacity of each employee is about 1,667 hours per year
(10,000 6), Zeta can operate with one fewer employee, saving the full
cost of one employee, probably at least $60,000 per year.
5-20 (a) The practical capacity per month for each packaging and shipping
employee is (8 1.25 hours) per day 20 days per month = 135 hours
per month. The capacity cost rate = $4,050/135 hours = $30 per hour.
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5-21 (a) With the stated change, Madison Dairy will require 8 full-time
production employees and 3 machines, as shown below.
Straw- Mocha-
Labor Vanilla Chocolate berry Almond Total
Number of
production runs 18 16 4 3
Handle production
run (hours/run) 2.5 2.5 2.5 2.5
Indirect labor:
handle runs 45.0 40.0 10.0 7.5 102.5
Setup time per run
(hours) 2.0 1.0 2.0 3.2
Number of
employees per
changeover 2 2 2 2
Indirect labor
hours per run 4.0 2.0 4.0 6.4
Indirect labor: total
setup hours 72.0 32.0 16.0 19.2 139.2
Indirect labor:
maintain products 8.0 8.0 8.0 8.0 32.0
Total indirect labor
hours 125.0 80.0 34.0 34.7 273.7
1,6
Volume (gallons) 15,500 13,000 00 1,200 31,300
Direct labor hours
per gallon 0.025 0.025 0.025 0.025
Total direct labor
hours 387.5 325.0 40.0 30.0 782.5
Total labor hours 512.5 405.0 74.0 64.7 1,056.2
Productive hours
per employee per
month 133.0
Number of
employees needed 7.9
Number of full-
time employees 8.0
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Straw- Mocha-
Machines Vanilla Chocolate Berry Almond Total
Production
volume 15,500 13,000 1,600 1,200
Machine hours
per 1000 gallons 11 11 11 11
Total machine
run time (hours) 170.5 143.0 17.6 13.2 344.3
Number of
production runs 18 16 4 3
Setup time per
run (hours) 2.0 1.0 2.0 3.2
Machine setup
time (hours) 36.0 16.0 8.0 9.6 69.6
Total machine
hours 206.5 159.0 25.6 22.8 413.9
Productive
hours per month 154.0
Number of
machines
needed (rounded
up) 3.0
(b) Pro forma monthly product line income statement (total dollar amounts
are rounded):
Straw- Mocha-
Vanilla Chocolate berry Almond Total
Selling price $ 2.90 $ 2.90 $ 3.40 $ 4.00 $ 2.97
Sales volume 15,500 13,000 1,600 1,200 31,300
Revenues $44,950 $ 37,700 $ 5,440 $ 4,800 $ 92,890
Direct 9,30
materials 0 7,800 960 780 18,840
Direct labor
(including 13,56
fringes) 3 11,375 1,400 1,050 27,388
Indirect labor 4,375 2,800 1,190 1,215 9,580
Machinery 10,325 7,950 1,280 1,140 20,695
Gross profit $7,387 $ 7,775 $610 $ 615 $16,387
Gross profit 16.4% 20.6% 11.2% 12.8% 17.6%
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(% of sales)
(c) The cost of the 8 production employees is 8 $4,655 = $37,240 and the
unused labor capacity cost is therefore $37,240 $27,388 $9,580 =
$272. The cost of the 3 machines is 3 $7,700 = $23,100 and the
unused machine capacity cost is $23,100 $20,695 = $2,405. After
incorporating the unused capacity cost, the pro forma monthly gross
profit is $16,387 $272 $2,405 = $13,710 and gross profit as a
percent of sales is $13,710/$92,890 = 14.8%.
5-23 The choice really depends on what short-term problems the company faces. If
it is experiencing large, rising, and difficulty-to-control indirect and support
costs, as well as a proliferation of products and customers, then an activity-
based costing system will supply valuable information to management
decisions on process improvements, product mix, pricing, and managing
customer relationships. This is because activity-based costing requires
understanding processes and their underlying activities, as well as what drives
support costs. The development of the activity-based costing model, as well as
the model itself, will help the organization identify costly and inefficient
processes. Additional potential benefits include identifying costly customers or
understanding how costly complex products are. The company can improve
inefficient processes, encourage costly customers to interact at a lower cost to
the company, revise product pricing, and find new revenue-generating uses of
freed-up capacity or attempt to reduce capacity costs.
If, however, the biggest issue the company faces is moving to a new strategy,
particularly one focused on customers and a new value proposition, then
implementing the Balanced Scorecard will be highly beneficial in
communicating the new strategy and providing a systematic mechanism for
monitoring and improving the new strategy. The Balanced Scorecard process
can greatly facilitate and speed the major change that is desired, lead to team
building and commitment to the new strategy among the executive team,
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5-24 (a) Each server is available for (22 days) (24 hours per day) = 528 hours
per month. The average cost per hour is therefore $3,696/528 hours = $7
per hour. Non-peak-hour usage accounts for (20 servers) (16 hours per
day) = 320 hours per day. Peak-hour usage accounts for (80 servers)
(8 hours per day) = 640 hours per day. Moreover, the 60-server excess
capacity during non-peak hours exists because of the peak-hour need.
Therefore the cost of the excess capacity of 60 16 hours = 960 hours
should be charged to peak-hour users. Thus, the peak-usage hourly rate
is $7 (640 + 960)/640 = $11,200/640 = $17.50 per hour.
(b) As discussed in part (a), the peak-usage hours should bear the cost of
the excess capacity that exists during non-peak usage. The non-peak
hourly rate is then the average cost of $7 per hour.
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Managers can try to reduce the unused capacity and its associated
expense. Alternatively, managers can try to generate new uses for the
unused capacity by introducing new products or expanding into new
markets. The cost system provides information to assist managers in
deciding whether these new uses of capacity can be handled with the
current capacity or require additional resources and spending.
(e) The costs driver rates in (a) and (b) likely differ because not all the
practical capacity of the resources supplied during the period was used
for productive work, as illustrated in parts (c) and (d). The ABC system
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5-26 (a) The resource units would depend on the organizations facilities and
resources. If the organization is self-contained with operating rooms,
recovery rooms, and radiology and pharmacy facilities, then these
resource units would be part of Riverdales activity-based cost system.
Other likely resource units include personnel performing scheduling,
admissions, and record-keeping; medical personnel, such as nurses and
surgeons; equipment (such as rehabilitation equipment and examination
tables); the cost of computers used in the clinic.
(b) Capacity cost rates must be developed for each resource. Then, for each
patient, track their routing through the clinic to identify which resources
the patient uses, and how much time is spent with each resource.
Finally, sum up the costs of all the resources used by the patient as he or
she gets processed, treated, and, eventually, released by the hospital.
This will yield the total cost associated with the complete cycle of care
for this patient episode.
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(b) The cost driver rate increase should not have a negative impact on Moss
Manufacturing because the increase in indirect costs was offset by a
decrease in direct labor costs.
(c) Rather than using a universal plantwide rate, Moss Manufacturing could
implement separate cost pools for different activities. Examples are as
follows:
measures the cost of unused resource capacity and provides more accurate
resource consumption and cost information as input to decisions that increase
company profitability
costs products according to the activities involved in the
production process.
5-28 (a) A call-related activity cost driver would better identify the linkage to
call center support costs. The number of calls (a transaction driver) per
product can be used because of its simplicity. The number of minutes of
calls (a duration driver) provides better linkage to call center support
costs, but it is more time-consuming to measure.
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(c) Under the previous system, product managers can only reduce the
assigned call center costs by reducing sales. Under the new system,
product managers can work with other functional areas to find ways to
reduce the number of calls or to reduce the length of calls. For example,
product Ys manager can work with package designers or the marketing
group to develop clearer instructions for consumers. The instructions
might include a company web address that provides answers to
frequently asked questions (based on calls to the call center).
(e) The company will need to consider the broader management issues related
to job loss if the call center activities are outsourced. As an input to that
decision, however, the company can benchmark its costs per minute to
other call centers, or compare it to the cost of outsourcing. The company
may also pursue an intermediate course of communicating the current costs
per minute and benchmarked or competitive costs, and allowing the call
center staff to improve efficiency and lower costs per minute.
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(e) The company sells half as many X21s as Y37s, but X21 has twice as
many design changes and 50% more parts. These facts suggest that the
company can explore ways to reduce the number of design changes and
the number of parts. Management accountants would be involved in
developing and communicating the cost of design changes and parts
proliferation; design engineers would be directly involved in studying
different designs and trying to reduce the number of parts. In addition,
sales staff who communicate with customers could make greater efforts
to understand customer needs and convey this information to the design
engineers.
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Deluxe Regular
Direct material $45.000 $30.000
Direct labor $20.000 $10.000
Manufacturing support $99.000 $12.625
Unit cost $164.000 $52.625
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(d) Ratio of
Activity Deluxe Regular Deluxe:Regular
200 400
Purchase orders 0.04 0.01 4:1
5,000 40,000
1,000 1,000
Quality control 0.2 0.025 8:1
5,000 40,000
100 100
Production setups 0.02 0.0025 8:1
5,000 40,000
20,000 15,000
Machine maintenance 4 0.375 10.67:1
5,000 40,000
(e) No, the deluxe model is not as profitable as the company thinks. Under
ABC, the following profitability analysis for each product line can be
prepared:
Deluxe Regular
Selling price per unit $140.000 $80.000
Unit cost $164.000 $52.625
Gross margin per unit ($24.000) $27.375
(f) The regular model is more profitable than the deluxe model. Therefore,
marketing staff can (i) push the regular model (increase commissions on
the regular model, and/or decrease commission on the deluxe model),
and/or (ii) raise the price of the deluxe model.
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(c) Shown below are the calculations of the cost drivers which apply to
both (c)1 and (c)2.
$400,000
Procurement: $.10 per part
4,000,000
$220,000
Production scheduling: $2.00 per board
110,000
$440,000
Packaging and shipping: $4.00 per board
110,000
$446,000
Machine setups: $1.60 per setup
278,750
$48,000
Hazardous waste disposal: $3.00 per pound
16,000
$560,000
Quality control: $3.50 per inspection
160,000
$66,000
General supplies: $.60 per board
110,000
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$1,200,000
$.40 per machine insertion
Machine insertion: 3,000,000
$4,000,000
Manual insertion: $4.00 per manual insertion
1,000,000
$132,000
Wave soldering: $1.20 per board
110,000
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(d) The analysis using standard costs shows that the unit contribution of the
PC Board is almost double that of the TV Board. On this basis, Alaires
management is likely to accept the suggestion of the production
manager and concentrate promotional efforts on expanding the market
for the PC Boards. However, the analysis using activity-based costs
does not support this decision. This analysis shows that the total dollar
contribution from the TV Board exceeds that of the PC Board by almost
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CASES
5-32 This question is designed to get students to think about the factors creating the
demand for activity-based cost systems.
(a) A traditional cost system, which assigns direct materials and direct labor
to products, and allocates factory support based on direct labor, cannot
signal the cost of component and product variety. Marketing research
may identify that consumers like to choose from a variety of options
(especially when the alternatives are available without any cost
associated with choosing; e.g., you can have any color of this or any
variety of that). In this situation, product engineers can design lots of
varieties and options. The cost system assigns cost only on the direct
labor and materials content of these options. Thus making one million
units of one steering column appears to cost the same as making
100,000 of 4 different steering columns, 10,000 each of 30 other
steering columns, and 1,000 each of 300 other columns. But making 334
steering columns in batch sizes ranging from, for example, 100 to
10,000, and designing and supporting 334 different steering columns is
much more expensive than just producing 5 or at most 40 different
columns. A traditional cost system would report that production costs of
labor and materials for the 1,000,000 steering columns is the same
whether they are produced in 5 varieties, 40 varieties, or 334 varieties.
Thus model and component proliferation is virtually impossible to stop
when companies cost products using traditional cost systems.
(b) In order to understand the cost of variety, the new cost system should
identify the cost of introducing new varieties, colors, and options. The
cost system will show the cost of setting up or changing over to make
the new variety, color and option, a cost that will be independent of the
number of units produced after the setup. Also the new cost system will
show the cost of designing and supporting each new variety, color, and
option (technically, in ABC terms, called the product-sustaining costs)
that will be independent of the number of units produced. With the more
accurate understanding of the costs of resources that perform batch and
product-sustaining activities, the product engineers and marketing
managers can jointly make better decisions on whether the higher cost
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5-33 This situation is drawn from Cott Corporation: Private Label in the 1990s.
Harvard Business School Case #9-594-031.
This is a truly challenging exercise since it requires students to think about the
design of activity-based cost systems, not just the analysis of existing or
proposed systems. But, if a good discussion can be generated in the class, it
could motivate the work that will be done in the rest of the course. Students
may feel that activity-based cost systems are only necessary for large
organizations, like General Motors, Chrysler, Procter & Gamble, Coca Cola,
Hewlett Packard, or John Deere. This discussion shows how even small,
entrepreneurial ventures can benefit from knowing the cost of products,
services, and customers.
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water, mineral water, new-age beverages, ginger ale, flavored soft drinks, etc.
Each new retailer that Cott signs up as a customer may also want its own
slight variation in beverage formulation (ingredients) and labeling. As Cott
begins to respond to the demand for higher variety, it will be performing many
more activities: scheduling production runs, buying more different ingredients
and packaging materials from more suppliers, setting up for each production
run, changing over packaging lines, more quality control activities (required
for each production run and each unique formulation), and more product
support activities to maintain information required for each individual SKU.
Cott will need an ABC system to understand the cost of these activities that are
driven by increased variety and be sure that these costs are covered by the
volume of business and prices received from retailers. Otherwise, its cost
structure will increase and it will either lose money on the incremental orders
or, as it attempts to raise prices, will lose much of its price advantage over the
national brands. Cott will want to understand its costs by individual SKU, to
be sure that the increased costs associated with offering and delivering
customized, low-volume SKUs do not become spread on to the basic high
volume beverages (say, regular and diet cola).
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retailer to develop a retailer profitability model for the cola beverage category
(one of the highest gross volume categories in a retail grocery store). From the
retailers perspective, profit would be measured by the gross margin (net
selling price less the price paid to Cott) minus retailer expenses to receive the
beverage containers in a warehouse, store and then ship them to retail outlets,
receive the shipments at the retail store, and then shelve and promote them at
the store. This requires an ABC model to be built for the retailers operating
expenses, including the cost of inventory and shelf-space occupancy. This is
especially important since the national brands (Coke and Pepsi) charge the
retailer much higher prices and the retailer marks these items up less than it
might do for a private label beverage. But since the national brands are
delivered directly to individual stores and shelved by the national brands
personnel, the retailer does not use its warehouse, distribution, or in-store
resources (other than shelf space) for these brands. Thus a fair comparison
requires the ABC model to cost out the extra activities related to the Cott-
supplied beverages but not required for Coke and Pepsi. But think about the
power of the outcome from such a study. Wouldnt you, as a supplier, like to
be able to demonstrate to your customer that you are not just the lowest cost
supplier but the most profitable supplier in a category?
Students may also suggest other, non-cost, aspects of the Coke vs. Cott
decision. But thinking about these three ABC models: factory costs reflecting
the cost of variety and customization, customer cost and profitability reflecting
the cost of unique marketing, design, and promotional assistance, and, finally,
customers profitability structures should give students ample opportunity to
reflect on the strategic use of accurate product, distribution, and customer cost
information.
(a) There are at least two reasons for estimating ABC costs of current
operations before contemplating a privatization decision. First, it may
turn out that the municipal workers are doing the work at a lower cost
than private sector alternatives. While this may seem fanciful, the
Indianapolis experience revealed quite a few tasks where the work could
be done by municipal workers at lower cost than by paying the lowest-
bidding private contractor. Of course, for this comparison to be on a
level playing field, the cost estimate for the municipal workers must
include not only their direct labor cost but also the cost of equipment,
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The second reason for the ABC approach is that should a company in
the private sector win the business, the city must then identify all the
resources that are no longer needed when the work is done by the
private contractor. Again, the city resources that should be reduced
include not only the front-line municipal workers, but also all their
equipment, supervisors, and support resources behind the front-line
worker. Otherwise, the city will pay twice for the service, first for the
contractor doing the work, and then for the people and other support
resources who now have less or no work to perform. That is why a
cross-functional, comprehensive total cost view is needed to provide
transparency about all the resources in place to support a front-line
worker.
(b) They should identify all the resource units used such as trucks,
machines, computers, and facilities. Then they need to identify all the
costs incurred to supply the resources and the capacity supplied by each
resource. A capacity cost rate (the cost of the indirect resource divided
by the capacity supplied by the resource) can then be developed for each
resource type. Estimates then need to be obtained for the amount of
each resources capacity used by different activities performed to
provide services to the community.
(c) The answer to this question provides a third reason for building ABC
models before considering privatizing municipal services. Before
building an ABC cost model, workers would have no idea about the cost
of performing the work. Once they see the cost of labor, equipment,
supervision, and other support services, they can make suggestions to
lower the cost of performing the work. As a specific example, in
Indianapolis, the workers saw that there was one supervisor for every
two workers, clearly an excessive amount. They also developed
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40 120
1,120,000 160
= 1,120,000 160 = 840,000
S2
280,000
Cost driver
rate $14.75 per DLH $19.80 per DLH
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Product costing
(b) Let x denote the number of hours required for each R361 setup. Then
the number of hours required for each R572 setup = 1.5x.
R361 R572
Number of setups 2,000 4,000
Setup hours 2,000x 6,000x = 4,000 1.5x
(25%) (75%)
Number of transactions
Activity
Cost Traceable Capacity
Drivers Costs Total R361 R572 Cost Driver Rate
P1-DLH $240,000 80,000 60,000 20,000 $3/P1 DLH
P2-DLH 360,000 120,000 72,000 48,000 $3/P2 DLH
Setup $209.5
hours 1,676,000 8,000x 2,000x 6,000x / setup hour
x
P1-MH 380,000 40,000 30,000 10,000 $9.50/P1 MH
P2-MH 900,000 120,000 72,000 48,000 $7.50/P2 MH
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Alternatively,
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Product costing
(c) The old cost accounting system ignored the fact that a large part of
support costs is driven by setup hours. Under the old cost accounting
system, R572 was undercosted because it had disproportionally more
setup hours compared to direct labor hours. The ratio of setup hours per
unit of R361 to the setup hours per unit of R572 equals:
2,000 x 6,000 x
4.15
500,000 400,000
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Teaching Plan
This is an introductory case, and yet it introduces a powerful new approach for
building an ABC model. Considerable theory is illustrated in how we build the
Sippican time-driven ABC (TDABC) model. Also, the (B) case introduces an
important link, previously recognized but not exploited, in how to embed an
ABC model into the budgeting process, replacing line-item budgeting with an
integrated, analytic approach. The case discussion provides insight and
confidence about the feasibility of building a TDABC model, especially in the
face of resistance from finance people who claim that ABC is too complex to
implement.
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Mature products
Declining profits
Inability to explain pricing decisions in market place high margins and little
price competition in one line; continued price pressure in another
1 Willie Sutton was a successful bank robber in the United States during the 1950s. Willie, who
was eventually captured at his home not far from a local police station, was asked during his initial
interrogation, Why do you rob banks? Willie replied, with the wisdom that had made him
successful for many years, Thats where the money is! When developing ABC systems, we
should follow Willies sage advice (but not his particular application of the insight) to focus on
high cost areas where improvements in visibility and action could produce major benefits to the
organization. Applying an ABC analysis to a set of resource expenses that are below 1% of total
spending will not lead to high payoffs to the organization.
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Q: Should Sippican abandon its overhead cost allocation system and make
managerial decision based on contribution margin; in effect use marginal costs
rather than average costs?
(a) Sippicans executives should not abandon overhead assignment to products.
The contribution margin is revenues minus variable costs.
Analysis based on unit contribution margins can be useful for short-term
decisions, such as whether to accept a one-time order when operating
with excess capacity. In this case, management is concerned about
recurring sales.
Overhead cost is sizable ($654,600, which exceeds either direct labor or
direct material costs)
Management will benefit by understanding the impact of
variety in the use of overhead resources by individual
products.
The contribution margin approach, by definition, does not
reveal the different demands that individual products make on
overhead resources (for machine time, engineering design,
setups, receiving, shipping, etc.).
Companies that cut prices based on contribution margin to get new
business should be cautious about (i) competitive reactions, (ii) having
to lower prices to existing customers, and (iii) filling up capacity with
business that does not pay for capacity costs.
If a company cuts prices when near capacity, demand could increase
beyond existing capacity. Consequently, the company may end up
having to supply more capacity for support resources to handle the
work, without being paid for supplying these capacity resources.
Using TDABC, only two parameters are needed for each department or process:
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Q: Lets start building the time-driven ABC model. What are the various capacity
cost rates?
Production and Setup Labor $3,900 20 7.5 1.5 6.0 120 $32.50
Machine Expenses $5,400 20 12.0 240 $22.50
Receiving and Production
Control $3,900 20 7.5 1.0 6.5 130 $30.00
Engineering $9,750 20 7.5 1.5 6.0 120 $81.25
Packaging and Shipping $3,900 20 7.5 1.0 6.5 130 $30.00
Hours Used
Flow Total
Valves* Pumps Controllers* Hours
Production Volume 7,500 12,500 4,000 24,000
DL (Production and
Assembly) 2,850 6,250 1,600 10,700
Machine Runs 3,750 6,250 1,200 11,200
Machine Setups 100 600 2,700 3,400
Total Machine 14,600
Setup Labor 100 600 2,700 3,400
Receiving and Production
Control 25 125 281 431
Engineers 60 240 600 900
Packaging and Shipping 1,033 1,750 700 3,483
*For valves,
DL hours = 7,500 valves 0.38 DL hours per valve = 2,850
Machine run hours = 7,500 valves 0.5 machine hours per valve = 3,750
Machine setup hours and labor setup hours (from case) = 100 (= 5 20)
Receiving and production hours = 1.25 20 production runs = 25
Engineering hours (from case): 60
Packaging and shipping hours = (40 shipments 50/60) + (7,500 valves 8/60) =
1,033
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Hours
Resources Res. Avail/ Hours Hours Avail % Cap.
Quant. Res. Unit Avail. Used Used Hrs Used
DL (Production and
Assembly) 90 120 10,800 10,700 100 99%
Machines (Runs and
Setup) 62 240 14,880 14,600 280 98%
Setup Labor 30 120 3,600 3,400 200 94%
Receiving and
Production Control 4 130 520 431 89* 83%
Engineers 8 120 960 900 60 94%
Packaging and
Shipping 28 130 3,640 3,483 157* 96%
*Rounded
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Lets assign the costs of these various resources/departments to the flow controller
line:
Hand out sheet of P&L of Sippican. Do you believe the revised P&L?
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(c) (Small discrepancies in totals are due to calculations performed in a spreadsheet package.)
Valves: Pumps: FCs: per
per unit per unit Flow unit Unused Percent
Valves costs Pumps costs Contr. costs Total Capacity* Actual of Sales
Units 7,500 12,500 4,000
$380,00
Sales $592,500 $79.00 $875,000 $70.00 0 $95.00 $1,847,500 $1,847,500 100%
Materials Expenses 120,000 16.00 250,000 20.00 88,000 22.00 $458,000 $458,000
DL Expenses 92,625 12.35 203,125 16.25 52,000 13.00 $347,750 $3,250 $351,000
Contribution Margin 379,875 50.65 421,875 33.75 240,000 60.00 $1,041,750 -$3,250 $1,038,500 56%
Manufacturing Overhead
Machine Expenses 84,375 11.25 140,625 11.25 27,000 6.75 $252,000 $6,300 $258,300
Setup Labor 3,250 0.43 19,500 1.56 87,750 21.94 $110,500 $6,500 $117,000
Machine Setup** 2,250 0.30 13,500 1.08 60,750 15.19 $76,500 $0 $76,500
Receiving and Production
Control 750 0.10 3,750 0.30 8,438 2.11 $12,938 $2,663 $15,600
Engineering 4,875 0.65 19,500 1.56 48,750 12.19 $73,125 $4,875 $78,000
Packaging and Shipping 31,000 4.13 52,500 4.20 21,000 5.25 $104,500 $4,700 $109,200
Total Manufacturing Overhead 126,500 16.87 249,375 19.95 253,688 63.42 $629,563 $25,038 $654,600 35%
Total costs 339,125 45.22 702,500 56.20 393,688 98.42 $1,435,313 $28,288 $1,463,600
Gross Margin 253,375 33.78 172,500 13.80 -13,688 -3.42 $412,188 -$28,288 $383,900 21%
Gross Margin/Sales % 42.8% 19.7% -3.6% 22.3% 20.8%
Selling and Administrative Exps. $350,000 19%
Operating Profit $33,900 2%
Return on Sales 1.83%
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Using the capacity rates and unused capacity hours computed in part (b), the cost of unused capacity is as
follows.
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(d) Yes, the approach can be extended to service companies and much larger
companies than Sippican. The Towerton case in this chapter provides such
an example.
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Atkinson, Solution Manual t/a Management Accounting, 4E
(e) The company should reconsider its product strategy and focus on its core
productsvalves and pumps. Sippican might attempt to increase market
share in valves by offering discounts for large orders of valves. Furthermore,
Sippican could reduce discounting for pumps, especially for small orders.
Finally, Sippican should aggressively raise prices for flow controllers or
accept orders to produce flow controllers only when the pricing and order
size indicate that they can be sold at a profit; Sippican could establish a
minimum order size.
Sippican can also focus on improving processes. For example, the company
could reduce setup times or schedule production of components for multiple
product orders to share components across multiple batches. These
improvements, in conjunction with the focus on larger orders, should lead to
many fewer production runs and shipments, allowing for the possibility of
reducing capacity and related costs.
This discussion can be carried forward in the same context to include topics
such as the Balanced Scorecard and activity-based budgeting by using the
Sippican B case that follows (case 5-37) and the accompanying PowerPoint
presentation slides.
5-37 Sippican Corporation (B) (HBS Case 9-106-060) (See also the teaching plan
for case 5-36: Sippican Corporation (A) (HBS Case 9-106-058) and the
PowerPoint presentation available to instructors.)
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steps that emerge from a more accurate cost analysis, and a powerful
connection between strategic planning and operational budgeting.
Teaching Plan
This case illustrates that fixed (capacity) costs are typically not one big piece
of equipment. Most capacity costs come from having many machines and
many people. These can be adjusted up or down based on forecasts of future
capacity needs. Sippican currently has 62 machines, 120 production
workers, 28 packaging and shipping workers, 4 receiving and production
control workers, and 8 engineers. It is hard to argue that these are all fixed
and not avoidable over some not very long time period. While one can have
fixed costs with one machine and one indirect worker, 62 machines and
160 employees do not represent a fixed cost. But how do these resource
levels and associated costs change as production levels change?
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(a) The planned hours used can be computed based on the data provided
in Exhibit 5-12 and case 5-36 (Sippican (A)):
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Chapter 4: Activity-Based Cost Systems
(b) If Sippican can reduce its supply of resources to the estimated needs,
Sippican estimated spending and profit next period are as presented in
the following statement. If Sippican cannot reduce its supply of
resources to the minimum needed for projected demand, or if Sippican
wants to preserve some protective capacity, then spending in Unused
Capacity will increase.
(c) If Sippican can reduce the supply of support labor and machines to
budgeted levels, the company will earn a 35% gross margin percent (of
sales) and a 17.3% return on sales, a considerable improvement from the
21% gross margin percent and 2% return on sales of recent experience.
All products now have projected gross margins around the targeted 35%
level. Total gross margin increases by almost 81% and operating profit
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Atkinson, Solution Manual t/a Management Accounting, 4E
increases more than ten-fold. The huge profit increase assumes only a
modest increase in unit sales and average selling prices. Although total
units sold increase by only 2%, the company is selling more valves and
fewer flow controllers. The changes in price and volume are projected to
increase sales revenue by 7.4%. The major impact on profit is due to
adjusting the types of orders accepted, and reducing the supply of
resources no longer needed to handle the small unprofitable orders.
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Atkinson, Solution Manual t/a Management Accounting, 4E
5-38 (a) Practical capacity for the personnel resources is calculated as follows:
Practical
Cost Per Capacity
Person Per Hours Per Capacity
Month Month Cost Rate
Brokers $ 6,787 130 $ 52.21
Account Managers $ 8,954 130 $ 68.88
Financial Planners $ 8,828 130 $ 67.91
Principals $ 12,932 130 $ 99.48
Customer service
representatives $ 4,192 140 $ 29.94
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Chapter 4: Activity-Based Cost Systems
Time Mutual
Utilization Stock Fund Account Financial
a
(Hours) Trading Trading Management Planning
Brokers 27,226 2,704
Account
Managers 2,080
Financial
Planners 2,154
Principals 2,643 262 418 130
Customer
service
represen-
tatives 4,086 1,007 207 129
a
Computations are shown below.
Minutes of activity per month are calculated as follows and then divided
by 60 to arrive at the time utilization in hours in the table above:
Minutes of Account
Activity Per Mutual Fund Manage- Financial
Month Stock Trading Trading ment Planning
Brokers
New accounts
(minutes for new 595 60 = 255 60 =
accounts opened) 35,700 15,300
Existing accounts
(minutes for 305,288 5 = 26,325 5 =
transactions) 1,526,440 131,625
Meetings with
existing accounts
(minutes for 3570 20 = 765 20 =
meetings) 71,400 15,300
Total minutes 1,633,540 162,225
Account
Managers
New accounts 175 240
(minutes for new = 42,000
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Atkinson, Solution Manual t/a Management Accounting, 4E
accounts opened)
Existing accounts
(minutes for 5,400 10
transactions) = 54,000
Meetings with
existing accounts
(minutes for 480 60 =
meetings) 28,800
Total minutes 124,800
Financial
Planners
New accounts
(minutes for new 130 600 =
accounts opened) 78,000
Existing accounts
(minutes for
transactions)
Meetings with
existing accounts
(minutes for 569 90 =
meetings) 51,210
Total minutes 129,210
Principals
New Accounts
(minutes for new 595 10 = 255 10 = 175 20 = 130 60 =
accounts opened) 5,950 2,550 3,500 7,800
Existing Accounts
(minutes for
transactions or 305,288 0.5 26,325 0.5 5,400 4 =
accounts) = 152,644 = 13,163 21,600
Total minutes 158,594 15,713 25,100 7,800
Customer Service
New accounts
(minutes for new 595 12 = 255 12 = 175 18 = 130 18 =
accounts opened) 7,140 3,060 3,150 2,340
Existing accounts 47,600 5 = 11,475 5 = 1,320 7 = 540 10 =
(minutes for calls) 238,000 57,375 9,240 5,400
Total minutes 245,140 60,435 12,390 7,740
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Chapter 4: Activity-Based Cost Systems
(c) A summary table of MIPS usage during peak and non-peak hours
appears below, and sample computations appear in the subsequent table.
Transactions Number of
Processed by MIPS Per Transactions: MIPS for Stock
Servers Transaction Stock Trading Trading
Non- Non-
Peak Peak Peak Peak
Order placements,
trades and order
clearing and
settlement activities 1.4 305,288 0 427,403 0
Account balance
inquiries 0.1 52,695 23,730 5,270 2,373
Quotation requests 0.1 332,400 177,100 33,240 17,710
Balance transfers 0.7 0 75,000 0 52,500
Account statement
preparation 0.9 0 29,750 0 26,775
Total 690,383 305,580 465,913 99,358
Note: The cost of MIPS usage is provided in this case but the calculation
can be assigned as an additional exercise, assuming the servers can
process 50 MIPS per hour. The calculation for peak and non-peak usage
is as follows:
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Atkinson, Solution Manual t/a Management Accounting, 4E
Each server is available for (22 days) (24 hours per day) = 528 hours
per month. The average cost per hour is therefore $3,168/528 hours = $6
per hour. Non-peak-hour usage accounts for (19 servers) (16 hours per
day) = 304 hours per day. Peak-hour usage accounts for (76 servers) (8
hours per day) = 608 hours per day. Moreover, the 57-server excess
capacity during non-peak hours exists because of the peak-hour need.
Therefore the cost of the excess capacity of 57 16 hours = 912 hours
should be charged to peak-hour users. Thus, the peak-usage hourly rate
is $6 (608 + 912)/608 = $15 per hour.
The non-peak cost per MIPS is $6/50 = $0.12 and the peak cost per
MIPS is $15/50 = $0.30, as stated in the case.
(d) An income statement showing rounded costs and profits in thousands for
each of Towertons four product lines, as well as the cost of unused
capacity, appears below, with sample calculations following. The small
discrepancies in the totals and margins are due to rounding.
Mutual Finan-
Stock Fund Account cial
Trad- Trad- Manage Plan- Total Unused Total
(000s) ing ing -ment ning Used Capacity Supplied
Sales $2,687 $ 1,091 $ 90 $156 $4,024 $4,024
Costs:
Brokers 1,421 141 1,563 (2) 1,561
Account
Managers 143 143 18 161
Financial
Planners 0 146 146 30 177
Principals 263 26 42 13 344 44 388
Customer
service
reps. 122 30 6 4 163 14 176
Computer
server
expenses 152 22 38 5 216 25 241
Total Costs 1,958 219 229 168 2,574 129 2,704
Margin $ 728 $ 872 $ (139) $ (12) $1,450 $ (129) $1,320
Margin % 27% 80% -154% -8% 36% -3% 33%
S, G & A 1,300
Operating
Income $20
Operating
Margin 0.5%
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Chapter 4: Activity-Based Cost Systems
The personnel costs are computed by multiplying the capacity cost rates
in part (a) by the hours of time utilization in part (b).
Cost Per
Resource Number of
Month Resources Total Cost
Brokers $ 6,787 230 $1,561,010
Account Managers $ 8,954 18 $ 161,172
Financial Planners $ 8,828 20 $ 176,560
Principals $12,932 30 $ 387,960
Customer service
representatives $ 4,192 42 $ 176,064
Computer server
expenses $ 3,168 76 $ 240,768
Total $2,703,534
The core stock trading and mutual fund trading product lines are
profitable, with mutual fund trading highly profitable. In contrast, the
new product lines, investment account management and financial
planning, are unprofitable; investment account management is highly
unprofitable, with a return on sales of 154%. The large differences in
profits across the product lines are due in part to the high cost of
personnel (account managers and principals for account management,
and financial planners for financial planning) in proportion to product
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line sales for the unprofitable product lines. In addition, computer server
expenses are 41.9% of sales for account management. This percentage is
far greater than for any of the remaining product lines. (See the table
below.)
195