CHAPTER 14

DISCUSSION QUESTIONS

14-1

Q14-1. Compared to traditional costing, ABC is amore thorough application of cost traceabil-ity. Traditional costing traces only directmaterial and direct tabor to output; ABC rec-ognizes that many other costs are traceable,if not to output, then to other cost objectscalled activities.

Q14-2. The role of activities in assigning costs toproducts, using ABC, is to serve as the linkbetween products and costs: activities arerequired to produce output, and it is theactivities that consume resources, thuscausing costs to be incurred. This differsfrom traditional costing in which output isassumed to cause costs.

Q14-3. Examples of significant, costly activities inmanufacturing are setting up, changingdesigns, receiving materials, requisitioningmaterials, moving materials and products,ordering from vendors, and inspecting.

Q14-4. The two circumstances that must be presentfor a traditional costing system to report dis-torted product costs are a complex coststructure and a diverse product line.

Q14-5. A complex cost structure is present if a sig-nificant part of overhead cost is not relatedto the volume of output.

Q14-6. A diverse product line is one in which differ-ent products consume different mixes of vol-ume-related and nonvolume-related costs.

Q14-7. The four levels of costs and drivers in ABCare the unit level, the batch level, the prod-uct level, and the plant level.

Q14-8. If a product consumes 10% of all unit-levelactivities and 30% of all batch-level activi-ties, traditional costing will under-report itscost by assigning 10% of all overhead coststo the product, including 10% of batch-levelcosts, when 30% of batch-level costs shouldbe assigned to the product.

Q14-9. When both low-volume and high-volume prod-ucts are produced in a company using tradi-tional costing, the low-volume product is likelyto have its cost distorted by a larger percent-age than the high-volume product. The low-volume product’s cost is generally distorted

downward by traditional costing, and the high-volume product’s cost is distorted upward.

Q14-10. In assigning plant-level costs to products,ABC offers little or no advantage over tradi-tional costing.

Q14-11. The difference between CM and ABC is pri-marily explained by the fact that ABC is along-run decision-making technique, whileCM is short-run analysis.

Q14-12. If a product is discontinued, the costsreported for that product by ABC will notnecessarily be avoided, because ABC onlymeasures how resources are consumed byproducts, not how spending will be affectedby discontinuing a product. Avoiding a costrequires that less be spent on someresource(s), and ABC does not predictchanges in spending. (This is also true oftraditional absorption costing.)

Q14-13. The relationship between ABC and ABM isthat ABM uses information obtained fromABC to make improvements in the firm.

Q14-14. The area of ABM that follows directly fromABC’s revision of product costs is the strate-gic realignment of the firm’s pricing structureand product line, permitting the firm to retainor regain high-volume business in spite ofpricing pressure, and prompting manage-ment to reexamine the roles of some low-vol-ume products.

Q14-15. The high costs of some activities, especiallynon-value-added activities, can focus atten-tion on the need to reduce or eliminate them.

Q14-16. ABC can lead to improved decisions indesigning a product because ABC tells thecost of each activity required in producingthe product.This information permits design-ers to make design decisions more accu-rately, so that the most cost-effective designcan be selected.

Q14-17. The link between ABC and TQM is that ABCreveals the costs of each activity, includingthose that do not add value, and TQM seeksto reduce or eliminate non-value-added activ-ities. Thus, ABC can focus attention in a TQMeffort and can prioritize TQM’s improvements.

EXERCISES

E14-1 (a) B(b) U(c) U(d) B—because no finished goods inventory is maintained, each batch is

shipped immediately; therefore, shipments are most likely a batch-leveldriver.

(e) P(f) U(g) P—where large materials inventories are maintained, purchase orders are

not issued for each batch to be produced; instead, a withdrawal will bemade from inventory for each batch. Purchase orders are then identifiablewith the total annual requirements, which makes it a product-level driver,i.e., it is traceable no farther than to products. If a purchased item is used in several products, its purchase orders are at the level of the product family or product line, which are even higher levels.

(h) U(i) U(j) B

E 14-2 (a) U(b) B(c) U(d) U(e) U(f) B(g) P(h) P

E14-3 The existing system allocated 1,500/30,000 = 5% of all overhead to Product #1last year; but #1 accounted for only 30/1,000 = 3% of batch-level activity. So, withrespect to batch-level costs only, the existing system overstated #1’s cost lastyear by a total of:

(5% – 3%) × $100,000 = $2,000 overstatement

E14-4 The existing system allocated $15,000/$3,000,000 = 0.5% of materials-relatedoverhead to Product AA last year, but AA accounted for only 40/40,000 = 0.1% ofmaterials-related activity. So, with respect to materials-related overhead only, theexisting system overstated AA’s cost last year by a total of:

(0.5% – 0.1%) × $1,200,000 = $4,800 overstatement

14-2 Chapter 14

E14-5 The existing system allocated only 600/50,000 = 1.2% of all overhead to ProductRK last year; but Product RK accounted for 132/6,000 = 2.2% of design changeactivity last year. Therefore, with respect to design change costs only, the exist-ing system understated RK’s cost last year by a total of:

(2.2% – 1.2%) × $2,000,000 = $20,000 understatement

E14-6 The existing system allocated $40,000/$200,000 = 20% of all overhead to ProductBB last year; but BB accounted for only 6/200 = 3% of the activity of maintainingsupplies of purchased subassemblies last year. Therefore, with respect to thecost of maintaining supplies of purchased subassemblies only, the existing sys-tem overstated BB’s cost last year by a total of:

(20% – 3%) × $50,000 = $8,500 overstatement

E14-7(1) $126 of overhead cost will be allocated to a unit of #456, calculated as follows:

(2) $554 of overhead cost will be allocated to a unit of #456, calculated as follows:

Therefore, the overhead allocated to a unit of Product #456 is:

($15,000 + $35,000 + $5,400)/100 units = $55,400/100 units = $554 per unit

$ ,$ ,

$ ,

300 000120

6 15 000

500 00

setupscost;× = −setups of batch level

004 000

280

200 000 400 00010 000

,

$ , $ ,,

design hoursdesign hours

m

× =

+aachine hours

machine hours× =90

$ , ,,

$ , ;

$ ,

1 400 00010 000

90 12 600

12 60

machine hoursmachine hours× =

00100 456

126units of Product

per unit#

$=

Chapter 14 14-3

$35,000 ofproduct-level cost;

$5,400 of unit-and plant-level cost.

E14-8 Because the traditional system uses machine hours as the only allocation base,Product #456 is allocated 90/10,000 = 0.9% of all overhead.The activity data indi-cate #456 should be assigned 6/120 = 5% of batch-level costs, 280/4,000 = 7% ofproduct-level costs, and 0.9% of all other overhead. The reconciliation is:

PerTotal Unit

Cost of #456 from traditional system, ascalculated in part (1) of E14-7 ..................... $12,600 $126

Adjustments for.Understatement of batch-level

costs, $300,000 × (5% – 0.9%)................. $12,300Understatement of product-level

costs, $500,000 × (7% – 0.9%)................. 30,500Total adjustments......................................... $42,800 428

Cost of #456 from ABC system, ascalculated in part (2) of E14-7 .................... $55,400 $554

E14-9(1) $140 of overhead cost will be allocated to a unit of #456, calculated as follows:

(2) $740 of overhead cost will be allocated to a unit of #456, calculated as follows:

Therefore, the overhead allocated to a unit of Product #456 is:

($18,000 + $50,000 + $6,000)/100 units = $74,000/100 units = $740 per unit

$ ,$ ,

300 000500

30 18 000setup hours

setuphours× = of batch-level costt;

$ ,

$ , $ ,

500 00040

4

200 000 400 0002

design hoursdesign changes× =

+00 000, DL hours

× =

$ , ,,

$ , ;

$ ,

1 400 00020 000

200 14 000

14 000100

DL hoursDL hours× =

units oof Product #$

456140= per unit

14-4 Chapter 14

$50,000 of product-levelcost;

200 direct laborhours

$6,000 of unit-and plant-level cost.

E14-10 Because the traditional system uses direct labor hours as the only allocationbase, Product #456 is allocated 200/20,000 = 1% of all overhead. The activitydata indicate #456 should be assigned 30/500 = 6% of batch-level costs, 4/40 =10% of product-level costs, and 1% of all other overhead.The reconciliation is:

PerTotal Unit

Cost of #456 from traditional system, ascalculated in part (1) of E14-9 ..................... $14,000 $140

Adjustments for:Understatement of batch-level

costs, $300,000 × (6% – 1%).................... $15,000Understatement of product-level

costs, $500,000 × (10% – 1%).................. 45,000Total adjustments ........................................ $60,000 600

Cost of #456 from ABC system, ascalculated in part (2) of E14-9 ..................... $74,000 $740

E14-11 Activities g, u, y, and dd are the only ones that definitely add value. Activityk is questionable, because a single deburring after drilling should be suffi-cient to remove all burrs. The first deburring, k, is probably performed tomake it easier and safer for workers to handle the product in the interim. Ifthe need for so much handling can be eliminated (perhaps through auto-mated material-handling equipment), then k could be eliminated with no lossof value to the customer and perhaps with a net savings to the company, sok is arguably a non-value-added activity.

Chapter 14 14-5

PROBLEMS

P14-1(1) The overhead rates in the existing costing system are $23 per machine hour, and

$14 per direct labor hour, calculated as follows:

(2) Making only the changes suggested by the study, the structure of the ABC sys-tem would be:

Pool Drivermachine operation ..................... machine hourssetup and material handling ..... setupsother materials-related overhead purchase ordersall remaining overhead .............. direct labor hours

The study did not suggest any change for machine operation cost, nor for the“other overhead” category.

(3) The ABC system’s overhead rates (driver rates) are $16.25 per machine hour, $57per setup, $50 per purchase order, and $10.75 per direct labor hour, calculatedas follows:

$ ,,

$ .65 000

4 00016 25

of machine operation overheadmachine hours

p= eer machine hour

of mate$ ,$ ,

27 00030 000

of machine-setup overhead+rrials handling overhead

setupsper setup

1 00057

35 000

,$

$ ,

=

of otherr materials-related costpurchase orders700

50= $ per purchase ordeer

DLHper direct labor

$ ,,

$ .215 000

20 00010 75

of "other overhead"= hhour

$ ,,

$92 000

4 00023

of machine related overheadmachine hours

per ma-

= cchine hour

DLHper

$ ,,

$280 000

20 00014

of remaining overhead costs= ddirect labor hour

14-6 Chapter 14

P14-2

(1) The three overhead rates in the existing costing system are $17.50 per machinehour, $.96 per direct material dollar, and $1.25 per direct labor dollar, calculatedas follows:

(2) Making only the changes suggested by the study, the structure of the ABC sys-tem would be:

Pool Drivermachine operation ..................... machine hourssetup and material handling ..... setupsmaterials administration............ purchase ordersfreight-in...................................... material poundsall remaining overhead .............. direct labor cost

The study did not suggest any change for machine operation cost, nor for the“all remaining overhead” category.

(3) The ABC system’s overhead rates are $12.50 per machine hour, $1,020 per setup,$50 per purchase order, $.75 per pound of materials, and $1.25 per direct labordollar, calculated as follows:

$ ,

,$ .

500 000

40 00012

of machine-operation overhead

machine hours= 550

200 000310 000

per machine hour

$ ,$ ,

of machine-setup overheado

+ff materials handling overhead

$500,00

5001 020

setupsper setup= $ ,

00 of materialsadministration overhead10 000

5,

$purchase orders

= 00 per purchase order

$700,000 of machine-related overhead40,000 machine hours

= $17.50 pper machine hour

$960,000 of materials-related overhead

$1,000,0000 of directmaterial cost

$2,500,000 of otheroverhead cost$2,00

=

00,000 ofdirect labor cost

=

Chapter 14 14-7

96% of direct material cost or$.96 per direct material dollar

125% of direct labor cost or$1.25 per direct labor dollar

P14-2 (Concluded)

P14-3(1) DRAPER COMPANY

Product Costs from Existing Costing System

Overhead rate: $4,500,000 of overhead divided by $3,000,000 of direct labor cost =150% of direct labor cost

Standard Custom TotalDirect material ................................................ $ 882,000 $ 12,500 $ 894,500Direct labor ................................................ 2,910,000 90,000 3,000,000Overhead:

150% × $2,910,000 ........................................... 4,365,000150% × $90,000 ................................................ 135,000 4,500,000

Total cost ................................................ $8,157,000 $237,500 $8,394,500

Units produced ................................................ ÷ 73,500 ÷ 125Cost per unit ................................................ $ 110.98 $ 1,900

$150,000 of freight-in200,000 pounds of materials

= $.75 per pound off materials

$2,500,000 of otheroverhead cost$2,000,000 of

direct llabor cost

=

14-8 Chapter 14

125% of direct labor cost or$1.25 per direct labor dollar

P14-3 (Continued)

(2) DRAPER COMPANYProduct Costs from Activity Based Costing System

Overhead rates:$300,000 setup-related costs divided by 60 setups = $5,000 per setup$900,000 design-related costs divided by 15,000 design hours = $60 per design hour$3,300,000 other overhead divided by $3,000,000 DL cost = 110% of direct labor cost

Standard Custom TotalDirect material...................................................... $ 882,000 $ 12,500 $ 894,500Direct labor........................................................... 2,910,000 90,000 3,000,000Overhead:

$5,000 × 30 setups ............................................ 150,000$5,000 × 30 setups ............................................ 150,000 300,000$60 × 12,000 design hrs.................................... 720,000$60 × 3,000 design hrs...................................... 180,000 900,000110% × $2,910,000 ............................................. 3,201,000110% × $90,000 .................................................. 99,000 3,300,000

Total cost.............................................................. $7,863,000 $531,500 $8,394,500

Units produced .................................................... ÷ 73,500 ÷ 125Cost per unit ........................................................ $ 106.98 $ 4,252

(3) Because the existing system used direct labor cost as the only allocation baseand Custom consumed $90,000/$3,000,000 = 3% of direct labor cost, the exist-ing system allocated 3% of all overhead to Custom. The activity informationindicates Custom consumed 30/60 = 50% of setup-related activity and3,000/15,000 = 20% of design-related activity, so the reconciliation is as follows:

PerTotal Unit

Cost of Custom from traditional system,as calculated in requirement (1) ................. $237,500 $1,900

Adjustments for:Understatement of setup-related

costs, $300,000 × (50% – 3%).................. $141,000Understatement of design-related

costs, $900,000 × (20% – 3%).................. 153,000Total adjustments......................................... 294,000 2,352

Cost of Custom from ABC system, ascalculated in requirement (2) ...................... $531,500 $4,252

P14-3 (Concluded)

Chapter 14 14-9

(4) The only costs handled differently by the two costing systems were the $300,000of setup-related costs and $900,000 of design-related costs, for a total of$1,200,000; this represents only 27% of the total overhead of $4,500,000.

The change in the costing system caused the reported cost of Custom to changefrom $237,500 to $531,500, which is an increase of 124%.

P14-4

(1) SHAUTON COMPANYProduct Costs from Existing Costing System

Overhead rate: $1,200,000 of overhead divided by 30,000 direct labor hours = $40 per direct labor hour

Fancy Plain TotalDirect material...................................................... $ 60,000 $ 160,000 $ 220,000Direct Labor ......................................................... 28,000 272,000 300,000Overhead:

$40 × 2,800 DLH............................................... 112,000$40 × 27,200 DLH............................................. 1,088,000 1,200,000

Total cost.............................................................. $200,000 $1,520,000 $1,720,000

Units produced .................................................... ÷ 200 ÷ 16,000Cost per unit ........................................................ $ 1,000 $ 95

14-10 Chapter 14

P14-4 (Continued)

(2) SHAUTON COMPANYProduct Costs from Activity Based Costing System

Overhead rates:$135,000 setup-related costs divided by 90 setups = $1,500 per setup$240,000 design-related costs divided by 8,000 design hours = $30 per design hour$825,000 other overhead divided by 30,000 direct labor hours = $27.50 per direct laborhour

Fancy Plain TotalDirect material...................................................... $ 60,000 $ 160,000 $ 220,000Direct labor........................................................... 28,000 272,000 300,000Overhead:

$1,500 × 45 setups .................................. 67,500$1,500 × 45 setups .................................. 67,500 135,000$30 × 3,000 design hrs ........................... 90,000$30 × 5,000 design hrs ........................... 150,000 240,000$27.50 × 2,800 DLH ................................. 77,000$27.50 × 27,200 DLH ............................... 748,000 825,000

Total cost.............................................................. $322,500 $1,397,500 $1,720,000

Units produced .................................................... ÷ 200 ÷ 16,000Cost per unit ........................................................ $1,612.50 $ 87.34

(3) Because the existing system used direct labor hours as the only allocation baseand Fancy consumed 2,800/30,000 = 9 1/3% of direct labor hours, the existingsystem allocated 9 1/3% of all overhead to Fancy. The activity information indi-cates Fancy consumed 45/90 = 50% of setup-related activity and 3,000/8,000 =37.5% of design-related activity, so the reconciliation is as follows:

PerTotal Unit

Cost of Fancy from traditional system,calculated in requirement (1) ...................... $200,000 $1,000.00

Adjustments for:Understatement of setup costs,$135,000 × (50% – 9 1/3%) ........................... $54,900Understatement of design costs,$240,000 × (37.5% – 9 1/3%) ........................ 67,600Total adjustments......................................... 122,500 612.50

Cost of Fancy from ABC system, ascalculated in requirement (2) ...................... $322,500 $1,612.50

Chapter 14 14-11

P14-4 (Concluded)

(4) The only costs handled differently by the two costing systems were the $135,000of setup-related costs and $240,000 of design-related costs, for a total of$375,000; this represents only 31.25% of the total overhead of $1,200,000.

The change in the costing system caused the reported cost of Fancy to changefrom $200,000 to $322,500, which is an increase of 61.25%.

P14-5

(1) TUNNEY COMPANYProduct Costs from Existing Costing System

Overhead rate: $1,000,000 of overhead divided by 50,000 direct labor hours = $20 per direct labor hour

Normal Enhanced Super TotalDirect material .......... $ 60,000 $ 20,000 $ 5,000 $ 85,000Direct labor ............... 300,000 35,000 5,000 340,000Overhead:

$20 × 45,000 DLH.. 900,000$20 × 4,500 DLH.... 90,000$20 × 500 DLH....... 10,000 1,000,000

Total cost................... $1,260,000 $145,000 $20,000 $1,425,000Units produced ......... ÷ 30,000 ÷ 1,000 ÷ 50Cost per unit ............. $ 42 $ 145 $ 400

14-12 Chapter 14

P14-5 (Concluded)

(2) TUNNEY COMPANYProduct Costs from Activity Based Costing System

Overhead rates:$400,000 batch-level overhead divided by 500 requisitions = $800 per requisition$600,000 other overhead divided by 50,000 direct labor hours = $12 per direct labor hour

Normal Enhanced Super TotalDirect material .......... $ 60,000 $ 20,000 $ 5,000 $ 85,000Direct labor ............... 300,000 35,000 5,000 340,000Overhead:

$800 × 150 req ...... 120,000$800 × 200 req ...... 160,000$800 × 150 req ...... 120,000 400,000$12 × 45,000 DLH.. 540,000$12 × 4,500 DLH.... 54,000$12 × 500 DLH....... 6,000 600,000

Total cost................... $1,020,000 $269,000 $136,000 $1,425,000Units produced ......... ÷ 30,000 ÷ 1,000 ÷ 50Cost per unit ............. $ 34 $ 269 $ 2,720

(3) Because the existing system used direct labor hours as the only allocationbase and Super consumed 500/50,000 = 1% of direct labor hours, the existingsystem allocated 1% of all overhead to Super. The activity information indi-cates Super consumed 150/500 = 30% of batch-level activity, so the reconcilia-tion is as follows:

PerTotal Unit

Cost of Super from traditional system,as calculated in requirement (1).............................. $ 20,000 $ 400

Adjustment for understatement of batch-level costs, $400,000 × (30% – 1%) ......................... 116,000 2,320

Cost of Super from ABC system, ascalculated in requirement (2)................................... $136,000 $2,720

(4) The only costs handled differently by the two costing systems were the $400,000of batch-level costs, which represents only 40% of the total overhead of$1,000,000.

The change in the costing system caused the reported cost of Super tochange from $20,000 to $136,000, which is an increase of 580%.

Chapter 14 14-13

P14-6

(1) TEKSIZE COMPANYProduct Costs from Existing Costing System

Overhead rate: $1,500,000 of overhead divided by 50,000 direct laborhours = $30 per direct labor hour

Regular Large TotalDirect material ....................................... $ 10,000 $ 40,000 $ 50,000Direct labor ............................................ 120,000 480,000 600,000Overhead:

$30 × 10,000 DLH .............................. 300,000$30 × 40,000 DLH .............................. 1,200,000 1,500,000

Total cost ............................................... $430,000 $1,720,000 $2,150,000

Units produced...................................... ÷ 10,000 ÷ 10,000Cost per unit .......................................... $ 43 $ 172

(2) TEKSIZE COMPANYProduct Costs from Activity Based Costing System

Overhead rates: $515,000 setup-related costs divided by 103 setups= $5,000 per setup$985,000 other overhead divided by 50,000 direct laborhours = $19.70 per DLH

Regular Large TotalDirect material ....................................... $ 10,000 $ 40,000 $ 50,000Direct labor ............................................ 120,000 480,000 600,000Overhead:

$5,000 × 51 setups ............................ 255,000$5,000 × 52 setups ............................ 260,000 515,000$19.70 × 10,000 DLH ......................... 197,000$19.70 × 40,000 DLH ......................... 788,000 985,000

Total cost ............................................... $582,000 $1,568,000 $2,150,000

Units produced...................................... ÷ 10,000 ÷ 10,000Cost per unit .......................................... $ 58.20 $ 156.80

14-14 Chapter 14

P14-6 (Concluded)

(3) Because the existing system used direct labor hours as the only allocation baseand Regular consumed 10,000/50,000 = 20% of direct labor hours, the existingsystem allocated 20% of all overhead to Regular. The activity information indi-cates Regular consumed 51/103 = 49.51456% of setup-related activity, so the rec-onciliation is as follows:

PerTotal Unit

Cost of Regular from traditionalsystem, as calculated in requirement (1) ............... $430,000 $43.00

Adjustment for understatement of setup-related costs, $515,000 × (49.51456% – 20%)......... 152,000 15.20

Cost of Regular from ABC system, ascalculated in requirement (2)................................... $582,000 $58.20

(4) Yes,Teksize Company does have a diverse product line in the sense in which theterm is used in ABC. The fact that the two products have the same annual unitvolumes does not matter, because the existing cost system does not use unitsas the allocation base. Regular represents only 20% of direct labor hours butnearly 50% of setup-related costs, while Large has a very different mix, so adiverse product line is present in Teksize Company.

Chapter 14 14-15

CASES

C14-1

(1) DALLAS DIVISIONProduct Costs from Existing Costing System

Overhead rate: $800,000 of overhead divided by 20,000 directlabor hours = $40 per direct labor hour

#321 #333Direct material............................................................... $ 6,000 $ 150Direct labor.................................................................... 30,000 600Overhead:

$40 × 7,200 DLH........................................................ 288,000$40 × 120 DLH........................................................... 4,800

Total cost ...................................................................... $324,000 $5,550Units produced ............................................................. ÷ 2,400 ÷ 6Cost per unit ................................................................. $ 135 $ 925

(2)DALLAS DIVISION

Product Costs from Activity Based Costing System

Overhead rates:$240,000 batch-level costs divided by 1,600 setups = $150 per setup$200,000 product-level costs divided by 2,000 design hours = $100 per design hour$360,000 other overhead divided by 20,000 direct labor hours = $18 per DLH

#321 #333Direct material............................................................... $ 6,000 $ 150Direct labor.................................................................... 30,000 600Overhead:

$150 × 40 setups....................................................... 6,000$150 × 4 setups......................................................... 600$100 × 320 design hrs .............................................. 32,000$100 × 200 design hrs .............................................. 20,000$18 × 7,200 DLH........................................................ 129,600$18 × 120 DLH........................................................... 2,160

Total cost ...................................................................... $203,600 $ 23,510Units produced ............................................................. ÷ 2,400 ÷ 6Cost per unit ................................................................. $ 84.83 $3,918.33

14-16 Chapter 14

C14-1 (Continued)

#321 #333(3) Usual selling price............................................... $150 $1,500

Product cost......................................................... 135 925Gross margin ....................................................... $ 15 $ 575

Percent of sales ................................................... 10% 38%

#321 #333(4) Usual selling price............................................... $150.00 $ 1,500.00

Product cost......................................................... 84.83 3,918.33Gross margin (loss)............................................. $ 65.17 $(2,418.33)

Percent of sales ................................................... 43% (161%)

(5) The ABC system shows that the relative profitabilities of the two products arethe reverse of what is shown by the existing system: the existing system showsa very modest gross margin of 10% on #321, which is probably not enough tocover its marketing and administrative costs, while showing a respectable 38%gross margin on #333. In contrast, the ABC system shows a 43% gross marginon #321 and a substantial loss on #333. The low-volume product appears to bethe more profitable of the two under the existing system, but appears to be amoney loser under ABC; the high-volume product appears weak under the exist-ing system, but highly profitable under ABC.

(6) Based on the results of the ABC study, Dallas division management should con-sider meeting the competitor’s prices on #321; this pricing strategy can be prof-itable in the long run and should avoid loss of market share. The strategy for#333 is not as clear. Customers are not likely to accept the 200% price increaseneeded to make #333 reasonably profitable, and Dallas could lose some cus-tomers who also buy large amounts of #321, if management discontinues #333or increases its price too much. Management should consider several possibili-ties for low-volume products such as #333:(a) Reduce batch- and product-level costs enough to become an efficient pro-

ducer of low-volume products. This may require creation of a small job-shop environment in a portion of the plant (or in another facility) wherelow-volume products could be made more efficiently. The case indicatesthe existing plant was designed to produce long runs efficiently, whichmay explain the high batch- and product-level costs.

Chapter 14 14-17

C14-1 (Concluded)

(b) Reduce the number of products by designing a new one that can be substi-tuted for several low-volume, unprofitable products that can then be discon-tinued; this essentially exchanges several low-volume products for one ofmuch higher volume, with substantial batch- and product-level savings.

(c) Convince one of the current buyers of the low-volume products to becomea distributor of several such products; buying them from Dallas in largerquantities, maintaining small inventories, and selling them to other cus-tomers. This can reduce Dallas’ batch-level costs and marketing costs, butit risks the loss of customers who like to buy the full line from one supplier.

(d) Raise prices gradually until all products are reasonably priced. This doesnot mean all products must show profits. (It is acceptable for a good cus-tomer to occasionally buy a money-losing product.) Rather, it means thatthe company should not continue making a money-losing product withouta good reason. It is not acceptable to have a customer who buys only themoney-losing products, nor for the company to continue making a money-losing product that no “good customers” are buying.

(e) In addition to the usual per-unit prices, charge a lump-sum amount perorder for any small order of a low-volume product. This charge could beset at a level to cover estimated batch- and product-level costs.

C14-2

(1) WARRENTON DIVISIONProduct Costs from OPICS

Overhead rate: $1,930,000 of overhead divided by 25,000 direct labor hours = $77.20 per DLH

#33 #44Direct material............................................................... $15,000 $120,000Direct labor.................................................................... 6,000 60,000Overhead:

$77.20 × 450 DLH...................................................... 34,740$77.20 × 6,000 DLH................................................... 463,200

Total cost ...................................................................... $55,740 $643,200Units produced ............................................................. ÷ 100 ÷ 2,000

Cost per unit ................................................................. $557.40 $ 321.60

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(2) WARRENTON DIVISIONProduct Costs from TPICS

Overhead rates:$340,000 machine-related costs divided by 20,000 machine hours = $17 per MH$330,000 materials-related costs divided by $1,320,000 direct material cost = 25% ofdirect material cost$360,000 + $900,000 of remaining costs divided by 25,000 direct labor hours = $50.40per direct labor hour

#33 #44Direct material............................................................... $15,000 $120,000Direct labor.................................................................... 6,000 60,000Overhead:

$17 × 300 MH............................................................. 5,100$17 × 3,000 MH.......................................................... 51,00025% × $15,000 ........................................................... 3,75025% × $120,000 ......................................................... 30,000$50.40 × 450 DLH...................................................... 22,680$50.40 × 6,000 DLH................................................... 302,400

Total cost ...................................................................... $52,530 $563,400Units produced ............................................................. ÷ 100 ÷ 2,000Cost per unit ................................................................ $525.30 $ 281.70

(3) TPICS is not an ABC system because all the allocation bases are at the unit level.The changes management made do show many of the attributes typically associ-ated with a change to ABC: the increase in the number of overhead cost pools, theattempt to create homogeneous cost pools, and the use of three distinct allocationbases. These changes show an attempt was made to capture differences amongthe demands placed on resources by the different products. But because there areno batch- or product-level drivers used, the system cannot capture the demandsplaced on batch- and product-level activities, i.e., it is not an ABC system.

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C14-2 (Continued)

(4) WARRENTON DIVISIONProduct Costs from Proposed New Costing System

Overhead rates:$100,000 troubleshooting costs + $140,000 machine setup costs divided by 3,000setup hours = $80 per setup hour$135,000 material handling costs divided by 15,000 loads = $9 per load$195,000 materials administration costs divided by 10,000 vendor orders = $19.50 pervendor order$260,000 engineering design costs divided by 4,000 design hours = $65 per designhour$200,000 machine operation costs + $900,000 other overhead divided by 20,000machine hours = $55 per machine hour

#33 #44Direct material............................................................... $15,000 $120,000Direct labor.................................................................... 6,000 60,000Overhead:

$80 × 300 setup hrs .................................................. 24,000$80 × 400 setup hrs .................................................. 32,000$9 × 20 loads............................................................. 180$9 × 60 loads............................................................. 540$19.50 × 90 orders .................................................... 1,755$19.50 × 150 orders .................................................. 2,925$65 × 280 design hrs ................................................ 18,200$65 × 300 design hrs ................................................ 19,500$55 × 300 MH............................................................. 16,500$55 × 3,000 MH.......................................................... 165,000

Total cost ...................................................................... $81,635 $399,965Units produced ............................................................. ÷ 100 ÷ 2,000Cost per unit ................................................................. $816.35 $ 199.98

(5) The proposed new costing system is an ABC system because it uses cost driv-ers that include non-unit-level drivers.The unit-level driver is machine hours, thebatch-level drivers are setup hours and loads handled, and the product-leveldriver is design hours. Vendor orders could be either a batch- or product-leveldriver, depending on whether orders are placed for each batch; the case doesnot tell whether this is so.

(6) For the low-volume product, #33, the proposed ABC system shows a substan-tially higher cost than did either of the other two systems. This is the generalresult when ABC is implemented and compared with traditional systems. At theusual selling price of $800, the ABC system says this product is a money loser.Equally, or perhaps more importantly, the proposed ABC system shows that thehigh-volume product can be priced very competitively.

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(7) Based on the results of the ABC study, Warrenton’s management should con-sider meeting the competitor’s prices on #44; this pricing strategy can be prof-itable in the long run and should avoid loss of market share.The strategy for #33is not as clear. Some customers may not accept the price increase needed tomake #33 reasonably profitable, and Warrenton could lose some customers whoalso buy large amounts of #44 if management discontinues #33 or hikes its pricetoo much. Management should consider several possibilities for low-volumeproducts such as #33:(a) Reduce batch- and product-level costs enough to become an efficient pro-

ducer of low-volume products. This may require creation of a small job-shopenvironment in a portion of the plant (or in another facility), where low-volumeproducts could be made more efficiently.

(b) Reduce the number of products by designing a new product that can be sub-stituted for several low-volume, unprofitable products that can then be dis-continued; this essentially exchanges several low-volume products for oneof much higher volume, with substantial batch- and product-level savings.

(c) Convince one of the current buyers of the low-volume products to becomea distributor of several such products; buying them from Warrenton in largerquantities, maintaining small inventories, and selling them to other cus-tomers. This can reduce Warrenton’s batch-level and marketing costs, but itrisks the loss of customers who like to buy the full line from one supplier.

(d) Raise prices gradually until all products are reasonably priced.This does notmean all products must show profits. (It is acceptable for a good customerto occasionally buy a money-losing product.) Rather, it means that the com-pany should not continue making a money-losing product without a goodreason. It is not acceptable to have a customer who buys only the money-losing products, nor for the company to continue making a money-losingproduct that no “good customers” are buying.

(e) In addition to the usual sales price, charge a lump-sum amount per order forany small order of a low-volume product. This charge could be set at a levelto cover estimated batch- and product-level costs.

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