Activity-Based Costing Provides More Accurate Costs for Varied Product Mix

Atkinson, Solutions Manual t/a Management Accounting, 6E
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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Chapter 5: Activity-Based Cost Systems
warehouse or truck. For most resources (people, equipment, and machines),

capacity is measured by the time supplied. The resources capacity cost rate is
calculated by dividing its cost by the capacity it supplies, usually expressed as
a cost per hour or cost per minute. For warehouses, production space, and
trucks, the capacity cost rate would be measured by cost per square foot (or
square meter) of usable space. For computer memory, the resource capacity
cost rate would be the cost per megabyte or gigabyte.
5-7 Managers use the information on activity costs to identify opportunities for
operational improvements and reductions in operations costs, decisions about
product mix and pricing, and targeted customer segments. An example of an
operational change is requiring minimum order sizes to eliminate short,
unprofitable production runs. Another example is changing the facility layout
to reduce moves of work in progress. Product designs can be changed in order
to manufacture products with fewer parts or common parts to reduce material
handling support costs. Finally, as discussed in more detail in Chapter 6, if
activity-based cost analysis shows that full-pallet shipments are less costly per
unit than partial-pallet shipments, customers can be encouraged to receive full-
pallet shipments. Of course, customers who insist on very small order sizes or
partial-pallet shipments can be charged a price high enough to cover the extra
costs associated with such activities.
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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to be fixed. The large component of apparently fixed costs in service

companies arises because, unlike manufacturing companies, service
companies have virtually no material coststhe prime source of short-term
variable costs. Service companies must supply virtually all of their resources
in advance to provide the capacity to perform work for customers during each
period. Fluctuations during the period of demand by individual products and
customers for the activities performed by these resources do not influence
short-term spending to supply the resources.
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.
Unlike physical products, services cannot be inventoried for future sales.

Service companies must supply virtually all their resources in advance to
provide the capacity to perform work for customers during each period, and
demand often fluctuates. For some service industries, the increase in spending
resulting from an incremental transaction or customer is essentially zero.
Therefore, service companies making decisions about products and customers
based on short-term variable costs might provide a full range of all products
and services to customers at prices near zero, leading to little recovery of the
costs of all the committed resources supplied in order to deliver services to
customers.
It can be difficult to identify and measure the outputs for a service

organization. The variation in demand for organizational resources is much
more customer-driven in service organizations than in manufacturing
organizations. A service company can determine and control the efficiency of
its internal activities, but customers determine the quantity of demands for
these operating activities. For example, customers may vary greatly in the
number of transactions and the balances in their checking accounts. Service
companies must focus on customer costs and customer profitability;
measuring revenues and costs at the customer level provides service
companies with far more relevant and useful information than at the product
level. Finally, a customer may have multiple relationships with a service
company. Therefore, the cost system should provide information that supports
determining profitability of the entire relationship with the customer.
Customer costs and customer profitability are discussed in more detail in
Chapter 6.
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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.
5-13 Time-driven activity-based costing has a number of advantages over

traditional activity-based costing. The advantages include (1) It is easy and
fast to build an accurate model even for large enterprises; (2) It exploits the
detailed transactions data that are available from ERP systems; (3) It drives
costs to transactions and orders with time equations that use specific
characteristics of particular orders, processes, suppliers, and customers; (4) It
provides visibility to capacity utilization and the cost of unused capacity; (5) It
enables managers to forecast future resource demands, allowing them to
budget for resource capacity on the basis of predicted order quantities and
complexity; and (6) It is easy to update the model as resource costs and
process efficiencies change.
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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$19,400/308 = $62.99, which can be rounded to $63 per hour for

convenience.
(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
Changeovers (hours per

batch) 2.0 1.0 2.5 4.0
Number of employees
per changeover 3 3 3 3
Indirect labor hours per
changeover 6 3 7.5 12
Indirect labor time per

run (batch) 9 6 10.5 15
Number of production
runs 12 12 8 6
Indirect labor per run 108 72 84 90
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
Total revenues $890,000

Total direct labor cost $120,000
Total direct materials cost 90,000
OH applied to pumps 196,000
OH applied to valves 248,000 $654,000
Cost of unused practical capacity 16,000
SG&A expenses 100,000
Net income $120,000
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.
(b) The activity-based cost associated with Division 1s customers is

(0.5 1,000 + 1.0 4,000) $50 per hour
= 4,500 hours $50 per hour = $225,000.
(c) The activity-based cost associated with Division 2s customers is

(0.5 200 + 0.1 400) $50 per hour
= 140 hours $50 per hour = $7,000.
(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.
(b) Order 705, which consists of 40 items, requires packaging preparation

time of 0.25 hours plus 40 0.1 hours to bubble wrap and pack the 40
items in the carton, for a total of 4.25 hours The cost assigned to Order
705 is therefore 4.25 $30 per hour =$127.50.
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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%.
5-22 Activity-based costing provides a means to accurately trace costs to

operational processes, and these costs can be used as one of the operations
management measures in the process perspective of a Balanced Scorecard.
Activity-based costing can also provide a means to measure customer
profitability or percent of profitable customers, which many companies
include in the customer or financial perspective of their Balanced Scorecards
(this application will be discussed in Chapter 6).
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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translate the strategy to operational terms, and lead to communication of the

strategy throughout the organization.
Of course, both approaches are highly compatible with each other.
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.
5-25 (a) Cost Activity

Assigned Driver Cost Driver
Activity Percent Cost* Quantity Rate**
Handle customer $56.25 per
orders 75% $450,000 8,000 customer order
Process customer $150.00 per
complaints 10% $60,000 400 customer complaint
Perform customer $200.00 per
credit checks 15% $90,000 450 credit check
100% $600,000
* $600,000 times the given percentage.
** Assigned Cost divided by Cost Driver Quantity.
(b) Capacity cost rate = $600,000/10,000 = $60 per hour.

Unit
Time
Activity (Hours) Activity Cost Driver Rate
Handle customer orders 0.75 $45 Per customer order
Process customer complaints 3.50 $210 Per customer complaint
Perform customer credit checks 3.00 $180 Per credit check
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(c) Unit Quantity

Time of Total Cost
Activity (Hours) Activities Hours Assigned
Handle customer orders 0.75 8,000 6,000 $360,000
Process customer complaints 3.50 400 1,400 $84,000
Perform customer credit checks 3.00 450 1,350 $81,000
Total 8,750 $525,000
Practical capacity used = 8,750 10,000 = 87.5%

Unused capacity = 10,000 8,750 hours = 1,250 hours.
Unassigned cost = $600,000 $525,000 = $75,000.
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.
(d) Unit Quantity

Time of Total Cost
Activity (Hours) Activities Hours Assigned
Handle customer orders 0.75 8,500 6,375 $382,500
Process customer
complaints 3.50 350 1,225 $73,500
Perform customer credit
checks 3.00 500 1,500 $90,000
Total 9,100 $546,000
Practical capacity used = 9,100 10,000 = 91.0%

Unused capacity = 10,000 9,100 hours = 900 hours.
Unassigned cost = $600,000 $546,000 = $54,000.
(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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in part (a) overestimated the costs of performing activities by

apportioning all customer service costs to the three activities and
therefore assigned not only the costs of resource capacity used, but also
the cost of unused resources. Determining the unit times to complete
each activity in conjunction with the time-driven ABC system in part (b)
provides clearer information about the resources needed for each
activity and about the unused capacity.
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.
5-27 (Unofficial CMA Answer, adapted)

(a) 1. Manufacturing support costs include all indirect production costs
(all production costs except direct material and direct labor).
These costs cannot be practically or economically traced to end
products and, therefore, must be assigned by some allocation
methods. Typical manufacturing support costs include:
Indirect labor, e.g., lift-truck drivers wages, maintenance and

inspection labor, engineering labor, scheduling, purchasing
and supervisors.
Other indirect factory costs, e.g., building maintenance,
machine and tool maintenance, property taxes, property
insurance, pension costs, depreciation on plant and
equipment, rent expense, and utility expense.
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2. Companies develop manufacturing support cost driver rates to

facilitate the costing of products as they are completed and
shipped, rather than waiting until actual costs are accumulated at
the end of a fiscal period.
(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:
Accumulate separate costs into departmental accounts (or other

relevant pools), with one account for each production and service
department. Each department would allocate its support costs to
products on the basis that best reflects the use of these services.
Individual machines (or other more relevant allocation bases)
could be treated as separate cost centers with the machine costs
collected and charged to the products using the machine(s).
(d) An activity-based costing system might benefit Moss Manufacturing

because it
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.
(b) Product X Product Y

Previous system: Allocated support costs: $20,000 $5,000
5% of sales
Activity-based costs: $.70 per minute $4,900 $21,000
155
(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).
(d) Product Ys manager is likely to resist implementation of the activity-

based cost system if the manager understands the relative usage of call
center resources devoted to product Y. Call center staff may resist
implementation of activity-based costing because it will involve
tracking of staff activity. The staff may resent tracking the number of
calls or minutes of calls, and may resent the additional monitoring
because it may lead to pressure to reduce the minutes per call. The call
center staff may also fear that the desire for cost or efficiency
improvements will lead to staff reduction or to outsourcing the entire
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.
5-29 (a) Manufacturing support cost driver rate

$11,500, 000

100, 000 300, 000
$28.75perdirectlaborhour.
156
Costs Per Unit Product X21 Product Y37

Direct materials cost $120.00 $140.00
Direct labor cost
2 $(1,000,000100,000) 20.00
3 $(4,500,000300,000) 45.00
Manufacturing support cost
$28.75 (100,00050,000) 57.50
$28.75 (300,000100,000) 86.25
Unit cost $197.50 $271.25
(b) Cost Cost Costs Allocated to Products

Capacity Driver Driver
Activity costs Quantity Rate X21 Y37
Handling $3,000,000 60,000 50 50 40,000 50 20,000
Number
of parts 2,400,000 20,000 120 120 12,000 120 8,000
Design
changes 3,300,000 3,000 1,100 1,100 2,000 1,100 1,000
Setups 2,800,000 14,000 200 200 8,000 200 6,000
Total $11,500,000 $7,240,000 $4,260,000
Costs Per Unit X21 Y37

Direct materials cost $120.00 $140.00
Direct labor cost 20.00 45.00
Manufacturing support cost
$7,240,000 50,000 144.80
$4,260,000 100,000 42.60
Unit cost $284.80 $227.60
(c) Activity-based costing produces more accurate estimates of job costs

because it takes into account the cost drivers that give rise to support
costs.
157
(d) Cost-based Prices Product X21 Product Y37

Traditional costing
1.25 unit costs in part (a) $246.88 $339.06
Activity-based costing
1.25 unit costs in part (b) $356.00 $284.50
If Endo plans to continue to use cost-based pricing, it should use

activity-based costs as the basis for its markups. Note X21s current
price is not even covering its manufacturing costs as determined using
activity-based costing. Conversely, Y37 may be overpriced. Endo
should consider raising X21s price and could consider lowering Y37s
price if competitors are selling the same product for a lower price.
(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.
5-30 (a) Total manufacturing support costs = $1,000,000

Total direct labor hours = [5,000 2 + 40,000 1] = 50,000
Manufacturing support cost rate = $20 per direct labor hour.
(b) Deluxe Regular

Direct material $45 $30
Direct labor $20 $10
Manufacturing support $40 $20
Unit cost $105 $60
158
(c) Activity Rate Per Unit of Cost Driver

$180,000
Purchase orders $300
600
$250,000
Quality control $125
2,000
$220,000
Production setups $1,100
200
$350,000
Machine maintenance $10
35,000
Capacity costs Assigned to Products
Activity Deluxe Regular
Purchase orders 200 $300 = $60,000 400 $300 = $120,000
Quality control 1,000 $125 = 125,000 1,000 $125 = 125,000
Production
setups 100 $1,100 = 110,000 100 $1,100 = 110,000
Machine
maintenance 20,000 $10 = 200,000 15,000 $10 = 150,000
Total manufacturing support costs $495,000 $505,000
Number of units 5,000 40,000
Unit manufacturing support costs $99 $12.625
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
159
(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
Unit costs are distorted by the old system because it assigns

manufacturing support cost to products using direct labor hours as a
base. Although the deluxe model requires twice as much labor time as
the regular model, it was not allocated adequate support cost. Analyzing
the companys capacity costs reveals that the deluxe model is very
expensive to manufacture as compared to the regular model because (i)
the deluxe model requires 4 times as many purchase orders as the
regular model, (ii) the deluxe model requires 8 times as many
inspections and setups as the regular model, and (iii) the deluxe model
requires over 10 times as many machine hours as the regular model.
(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.
160
Design engineers can try to re-engineer the deluxe product to decrease

its high demand for activity resources.
5-31 (Unofficial CMA Answer, adapted)
(a) At least four general advantages associated with activity-based costing

include the following:
Provides management with a thorough understanding of complex

product costs and product profitability for improved resource
management and pricing decisions.
Provides estimates of unused capacity costs.
Highlights the interrelationships (cause and effect) of activities
and identifies opportunities to reduce costs, e.g., designing
products with fewer parts to reduce the cost of the manufacturing
process.
Provides more appropriate means of charging support costs to
products.
(b) 1. Using standard costs, the total contribution expected this year
from the TV board is $1,950,000, calculated as follows:
Per Totals for

Unit 65,000 Units
Revenue $150 $9,750,000
Direct material 80 5,200,000
Material support (10% of material) 8 520,000
Direct labor ($14 1.5 hours) 21 1,365,000
Variable support ($4 1.5 hours)* 6 390,000
Other mfg. support ($10 0.5
machine hour) 5 325,000
Total cost $120 $7,800,000
Unit contribution $30
Total contribution (65,000 30) $1,950,000
*
Variable support rate: $1,120,000 280,000 hours = $4 per hour.
161
2. Using standard costs, the total contribution expected this year

from the PC Board is $2,360,000, calculated as follows:
Per Totals for 40,000
Unit Units
Revenue $300 $12,000,000
Direct material 140 5,600,000
Material support (10% of material) 14 560,000
Direct labor ($14 4 hours) 56 2,240,000
Variable support ($4 4 hours)* 16 640,000
Other mfg. support ($10 1.5
machine hours) 15 600,000
Total cost $241 $9,640,000
Unit contribution $59
Total contribution (40,000 $59) $2,360,000
*
Variable support rate: $1,120,000 280,000 hours = $4 per hour.
(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
162
$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
1. Using activity-based costing, the total contribution expected this

year from the TV Board is $2,557,100 calculated as follows:
Per Totals for

Unit 65,000 Units
Revenue $150.00 $9,750,000
Direct material 80.00 5,200,000
Material support:
Procurement ($.10 25) 2.50 162,500
Production scheduling 2.00 130,000
Packaging and shipping 4.00 260,000
Variable support:
Machine setups ($1.60 2) 3.20 208,000
Waste disposal ($3 .02) .06 3,900
Quality control 3.50 227,500
General supplies .60 39,000
Other manufacturing support:
Machine insertion ($0.40 24) 9.60 624,000
Manual insertion 4.00 260,000
Wave soldering 1.20 78,000
Total cost $110.66 $7,192,900
Unit contribution $39.34
Total contribution (65,000 $39.34) $2,557,100
163
2. Using activity-based costing, the total contribution expected this

year from the PC Board is $1,594,000 calculated as follows:
Per Totals for 40,000

Unit Units
Revenue $300.00 $12,000,000
Direct material 140.00 5,600,000
Material support:
Procurement ($.10 55) 5.50 220,000
Production scheduling 2.00 80,000
Packaging and shipping 4.00 160,000
Variable support:
Machine setups ($1.60 3) 4.80 192,000
Waste disposal ($3 .35) 1.05 42,000
Quality control ($3.50 2) 7.00 280,000
General supplies 0.60 24,000
Other manufacturing support:
Machine insertion ($0.40 35) 14.00 560,000
Manual insertion ($4 20) 80.00 3,200,000
Wave soldering 1.20 48,000
Total cost $260.15 $10,406,000
Unit contribution $39.85
Total contribution (40,000 $39.85) $1,594,000
(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
164
$1,000,000. As a percentage of selling price, the contribution from the

TV Board is double that of the PC Board, e.g., 26% versus 13%.
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
165
of introducing another customized option will be compensated with

higher sales volumes and/or higher margins.
As a specific example, one of General Motors competitors examined

the cost of how many wire harnesses it used in a given car model.
Currently it was producing 12 different wire harnesses, a number that
seemed optimal using its traditional cost system. The ABC system
which incorporated the economics of batch production and product-
sustaining expensesrevealed that the optimal number of harnesses
was 5 or 6. And when the cost of stocking and servicing all the
dealerships was incorporated into the analysis, the optimal number
dropped to 2. In effect, the apparent savings in direct materials and labor
from having customized wire harnesses for individual combinations of
car options was far lower than the much higher support costs triggered
by high engineering, production support, and service resources
associated with having to produce, stock, and service 12 different wire
harnesses for a single car model.
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.
Cott executives could use a variety of different activity-based cost systems.

First, and perhaps most obvious, would be an analysis of production costs.
Cott, as any small company, would start with producing a limited set of high
volume, popular cola beverages such as regular cola and diet cola. So initially,
they would have long runs, few setups, and little product variety. Traditional
cost systems work fine in this environment. But if retailers want to use Cott as
their only private label beverage provider, they will ask Cott to provide a fuller
line of beverages, say caffeine-free and diet-caffeine free. Also, they may want
a variety of packaging: 12 oz cans, and 1 and 2 liter plastic bottles. And they
may start to request beverages beyond the cola category, such as sparkling
166
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).
Second, Cott is customizing its product and service offering to individual

retailers. For each retailer, Cott can offer unique product formulations,
customized to the retailers specifications, design of a retailer-specific label for
the beverages, and marketing, promotional, and consulting assistance to help
the retailer launch and sustain a private-label cola line. Thus Cott can incur
substantial customer-specific expenses with each new retailer. It will need to
measure all these front-end, customer-specific expenses and link them to the
revenues received, less product and customer-specific beverage costs [as
described in the previous paragraph] to determine customer profitability. An
ABC model of individual customer profitability will enable Cott to predict in
advance the volume and mix of business required to payback heavy front-end
investments in product design, package design, and consulting assistance. Ex
post, Cott will use the ABC customer profitability model to assess whether the
actual volume and mix of business, at actual prices and ABC-calculated
product costs, are generating sufficient margin to repay the front-end and
perhaps on-going customer-specific support expenses. Cott executives can use
such a model to guide their negotiations with each retailer.
Third, one of Cotts principal marketing devices with a retailer is to convince

the retailers executives, (1) that Cott beverages are profitable for the retailer
to sell, and (2) that Cott beverages may be even more profitable for the retailer
than national-branded beverages. This will require Cott to work with the
167
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.
5-34 This case on Gotham City is adapted from Indianapolis: Activity-Based

Costing of City Services (A) and (B), Harvard Business School Case #9-196-
115/ and -117. The material below reports on the Indianapolis experience.
(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,
168
supervision, and all resources performing support activities (since any

private company must bid to cover the costs of these resources as well).
The ABC approach provides a reasonable estimate of all direct and
indirect costs associated with performing a given activity (such as filling
potholes, picking up trash, sweeping streets, treating water and sewage,
repaving roads, and operating an airport). The Mayor of Indianapolis,
after seeing the ABC cost estimates for internal provision of these
services, announced he was more interested in competition (between the
public and private sector for the lowest cost supply of services) than in
privatization.
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
169
procedures so that a pothole could be filled with a three-person crew

rather than a five- or six-person crew, to share equipment with other
activities, to use their equipment more efficiently, and to perform other
work (such as cleaning streets) while waiting for equipment or materials
to be delivered to the site. The sum total of all these improvement
suggestions enabled the municipal workers to submit a much lower bid
than any private contractor, thereby retaining the business. This message
reinforces the point that sharing cost information with front-line
workers enables them to make suggestions for how to accomplish the
same outcomes with fewer resources, resulting in substantial
productivity improvements. Only good cost information can identify the
opportunities for the largest improvements in resource expenses.
5-35 (a) Stage 1: Allocation of S1 and S2 costs to production departments

Department P1 Department P2
Directly
traceable $480,000 $780,000
costs
120 216
1,176,000 336 = 420,000 1,176,000 336 = 756,000
S1
40 120
1,120,000 160
= 1,120,000 160 = 840,000
S2
280,000
Total support $1,180,000 $2,376,000
DLH 80, 000 120,000
Cost driver
rate $14.75 per DLH $19.80 per DLH
Stage 2: Allocation of P1 and P2 costs to products

Product R361 Product R572
P1 $14.75 60,000 $885,000 $14.75 20,000 295,000
P2 $19.80 72,000 1,425,600 $19.80 48,000 950,400
$2,310,600 $1,245,400
170
Product costing

Direct materials $8 500,000 $4,000,000 $10 400,000 4,000,000
Direct labor: P1 $15 60,000 900,000 $15 20,000 300,000
Direct labor: P2 $18 72,000 1,296,000 $18 48,000 864,000
Support $2,310,600 $1,245,400
Total cost $8,506,600 $6,409,400
Total units 500,000 400,000
Unit cost $17.0132 $16.0235
Sales price 19.0000 20.0000
Gross margin $1.9868 $3.9765
Gross margin % 10.4600% 19.88%
(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
171
Total Support Costs

Capacity Cost
Drivers Product R361 Product R572
P1-DLH $3 60,000 = $180,000 $3 20,000 $60,000
P2-DLH $3 72,000 = 216,000 $3 48,000 144,000
209.5 209.5
Setup hours 2000 x 419,000 6,000 x = 1,257,000
x x
P1-MH $9.5 30,000 285,000 $9.5 10,000 95,000
P2-MH $7.5 72,000 540,000 $7.5 48,000 360,000
$1,640,000 $1,916,000
Alternatively,
Capacity Total Support Costs

Cost
Drivers Product R361 Product R572
60 20
P1-DLH $240,000 $180,000 $240,000 $60,000
80 80
72 48
P2-DLH $360,000 $216,000 $360,000 144,000
120 120
Setup 2,000 x 6,000x
1,676,000 419,000 1,676,000 1,257,000
hours 8,000x 8,000 x
30 10
P1-MH $380,000 285,000 $380,000 95,000
40 40
72 48
P2-MH $900,000 540,000 $900,000 360,000
120 120
$1,640,000 $1,916,000
172
Product costing

Direct materials $4,000,000 $4,000,000
Direct labor: P1 900,000 300,000
Direct labor: P2 1,296,000 864,000
Support costs $1,640,000 $1,916,000
Total cost $7,836,000 $7,080,000
Total units 500,000 400,000
Unit cost $15.672 $17.700
Sales price 19.000 20.000
Gross margin $3.328 $2.300
Gross margin % 17.520% 11.500%
(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
Old Cost Accounting ABC

System System
R361 R572 R361 R572
Sales price $19.0000 $20.0000 $19.0000 $20.0000
Unit cost 17.0132 16.0235 15.6720 17.7000
Gross margin $1.9868 $3.9765 $3.3280 $2.3000
Gross margin % 10.46% 19.88% 17.52% 11.50%
173
(d) Recommendations for marketing:
1. R361 is more profitable than R572. Therefore, push R361 by

increasing the commission on R361 or decreasing the
commission on R572.
2. Raise the price of R572.
Recommendations for production:
1. A large part of support costs is driven by setup hours. Therefore, re-

engineer the products to decrease setup hours.
2. Offer discounts to customers for larger batch sizes to reduce the

number of setups. (This recommendation may also involve
marketing staff.)
(e) The experienced production manager is likely to have an intuitive

understanding of the higher production complexity for R572 and will
likely agree with the activity-based cost analysis. However, the sales
manager will likely want to keep sales high and has already built up
relations with R572 customers. Therefore, the sales manager will likely
oppose increasing the price of R572 since it will reduce its sales.
5-36 Sippican Corporation (A) (HBS Case 9-106-058)
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.
174
Q: What is the competitive situation faced by Sippican?
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
Q: Why was Knight studying Sippicans overhead costs?
The following two characteristics serve as indicators that a traditional costing

approach to overhead costs is likely providing inaccurate costs:
1. The Willie Sutton rule:1 Look for areas with large expenses in
indirect and support resources, especially where such expenses
have been growing over time. Operations where almost all
expenses are direct labor and direct materials, which can
already be directly traced to individual products by traditional
costing systems, may have less need for ABC systems. In
effect, if organizational activities are all at the unit level
(virtually no batch or product-sustaining activities), then ABC
systems and traditional cost systems will likely give very
similar economic signals.
2. High Diversity rule: Look for a situation in which large variety
exists in products, customers, or processes. For example,
consider a facility that produces mature and newly introduced
products, standard and custom products, high-volume and low-
volume products. For marketing and selling expenses,
companies may have a mixture of customers who order high-
volume, standard products with few special demands as well as
customers who order in small volumes, special products, and
require large quantities of pre-sales and post-sales technical
support.
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.
175
Observation: Products such as pumps and valves may be commodities; but

how they are produced (small lots, custom designs) and delivered (direct,
expedited) is not a commodity. These special services create a basis for
differentiation. But differentiation is a successful strategy only when the delta
value created by differentiation exceeds the cost to differentiate.
Revenues (from higher prices, higher sales volumes) > Costs
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:
1. Calculate capacity cost rates for each department or process

2. Time required by products, orders, services, and customers on the
organizations capacity resources.
176
Q: Lets start building the time-driven ABC model. What are the various capacity
cost rates?
(b) Capacity Cost Rates
Cost/ Days Used Paid Hrs Nonprod. Prod. Prod. Cost

Month Per Month Per Day Hours Hrs/Day Hrs/Mo Per Hr
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
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
177
For flow controllers:
DL hours = 4,000 0.40 =1,600

Machine run hours= 4,000 0.30 =1,200
Machine setups (from case) = = 2,700 (= 225 12)
Labor setup hours (from case) = = 2,700 (= 225 12)
Receiving and production hours = 225 1.25 = 281
Engineering (from case): 600
Packaging and shipping hours = (200 50/60) + (4,000 8/60) = 700
The figures for pumps are computed similarly.
Practical and Used Capacity
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
178
Lets assign the costs of these various resources/departments to the flow controller
line:
Total Time Cost Rate Cost Assigned Unit Cost (4,000)

Machine run time: 1,200 $22.50 $ 27,000 $ 6.75
Set-ups (labor) 2,700 32.50 87,750 21.94
Set-ups (machines) 2,700 22.50 60,750 15.19
Receive/Prod Ctrl 225(75/60)
281.25 30.00 8,438 2.11
Package & Ship [20050+4,0008]/60
700 30.00 21,000 5.25
Engineering 600 81.25 48,750 12.19
Total Overhead $253,688 $63.42
Direct Labor 52,000 13.00
Direct Materials 88,000 22.00
$393,688 $ 98.42
Revenues $380,000 95.00

Gross Margin $(13,688) ($ 3.42)
Hand out sheet of P&L of Sippican. Do you believe the revised P&L?
179
(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
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%
* See the following table.

**Machine Setup unused capacity is included with Machine Expenses unused capacity.
180
Atkinson, Solution Manual t/a Management Accounting, 4E
Using the capacity rates and unused capacity hours computed in part (b), the cost of unused capacity is as
follows.
Resources Available Cost of

Used Hrs Cost/Hr Unused Capacity
DL (Production and
Assembly) 100.00 $32.50 $3,250
Machines (Runs and Setup) 280.00 $22.50 $6,300
Setup Labor 200.00 $32.50 $6,500
Control 88.75 $30.00 $2,663
Engineers 60.00 $81.25 $4,875
Packaging and Shipping 156.67* $30.00 $4,700
*Rounded
The following table summarizes the difference in reported product costs and
profitability with the traditional cost system that Sippican used previously, and
the time-driven activity-based costing (TDABC). The difference lies in the
assigned manufacturing overhead costs. The traditional method assigns
manufacturing overhead at 185% of direct labor cost, which results in pumps
receiving the greatest overhead per unit, flow controllers the next highest
overhead per unit, and valves the least. Based on the more accurate TDABC
assignment of machine and support expenses, management can see that valves
are even more profitable than they thought; pumps, while not earning the
targeted 35% gross margin, are still strong profit contributors, and flow
controllers previously thought to be the most profitable product line actually
lose money because of the high costs of setups, engineering, and shipping. Most
of the engineering work was for the customized flow controllers requested by
customers.
181
Traditional Cost Analysis Valves Pumps Flow Controllers

Selling price $79.00 $70.00 $95.00
Direct labor cost $12.35 $16.25 $13.00

Direct material cost 16.00 20.00 22.00
Manufacturing overhead at 185% of 22.85 30.06 24.05
DL cost
Standard unit costs $51.20 $66.31 $59.05
Gross margin $27.80 $3.69 $35.95

Gross margin (%) 35% 5% 38%
Time-Driven ABC Analysis Valves Pumps Flow Controllers

Selling price $79.00 $70.00 $95.00
Direct labor cost $12.35 $16.25 $13.00

Direct material cost 16.00 20.00 22.00
TDABC overhead 16.87 19.95 63.42
Standard unit costs $45.22 $56.20 $98.42
Gross margin $33.78 $13.80 ($3.42)

Gross margin (%) 43% 20% -3.6%
(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.
Time-driven activity-based costing reduced some of the barriers associated

with developing and updating the common approach to activity-based
costing, which assigns many resource expenses to activities based on
interviews and surveys. Nevertheless, barriers and difficulties associated
with managing any major change remain. For example, individuals may feel
vulnerable facing uncertainty about what the time-driven activity-based cost
analysis may show. The analysis might reveal that products or customers
thought to be very profitable are actually unprofitable, some processes are
182
inefficient, or there is substantial unused capacity. 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 that was in place.
(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.)
In Sippican (A), the company experiences declining profits and struggles to

understand why it is encountering severe price competition on one product
line. The controller collects data that will enable development of a time-
driven, activity-based cost model to explain better the different demands of
each product line on Sippican's indirect and support resources. Applying the
newly estimated capacity cost rates for the resources to the production
statistics of the three product lines produces a radically different perspective
on product line profitability. The (A) and (B) cases together illustrate
motivation and design of a time-driven, activity-based system, the action
183
steps that emerge from a more accurate cost analysis, and a powerful
connection between strategic planning and operational budgeting.
The following figure diagrams the connections among the Balanced

Scorecard and strategic planning, activity-based costing, and activity-based
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?
The company uses activity-based budgeting to translate the detailed sales

and production plans into specific demands for labor and machine resources.
Direct labor increases slightly, but setup labor demand drops dramatically
because of fewer production runs and reductions in setup time. Small
184
reductions also occur in indirect labor and engineering time. Activity-based

budgeting is a powerful tool for creating bottoms-up operational budgets.
However, it does require much finer granularity in the sales forecasts and
production plan to estimate the demands for organizational resources,
particularly those performing support functions.
(a) The planned hours used can be computed based on the data provided
in Exhibit 5-12 and case 5-36 (Sippican (A)):
Valves Pumps Flow Total

Controllers
Production units 10,000 12,000 2,500 24,500
Time in Hours
Total DL hours 3,800 6,000 1,000 10,800
Total machine run hours 5,000 6,000 750 11,750
Machine setup hours 160 192 480 832
Total machine hours 5,160 6,192 1,230 12,582
Labor setup hours 160 192 480 832
Receiving and 50 50 62.5 163
production controla
Engineering hours 60 240 400 700
Packaging and shippingb 1,367 1,658 417 3,442
a
Receiving and Production Control Time Equation:
Valves: 1.25 40 production runs = 50 hours; Pumps: 1.25 40 = 50 hours
Flow Controllers: 1.25 50 production runs = 62.5 hours
b
Packaging and Shipping Time Equation:
Valves: [40 50 + 10,000 8]/60 = 82,000/60 = 1,367 hours
Pumps: [70 50 + 12,000 8]/60 = 99,500/60 = 1,658 hours
Flow Controllers: [100 50 + 2,500 8]/60 = 25,000/60 =417 hours
The units of each resource type needed to meet projected demand

follow (see the Sippican (A) solutions for hours available per resource
unit).
Hours Hrs. Avail. per #FTEs

Resources Needed Needed Resource Unit Needed Actual
Direct labor 10,800 120 90.00 90
Setup labor 832 120 6.93 7
Machines 12,582 240 52.43 53
Receiving and production
control 163 130 1.25 2
Packaging and shipping 3,442 130 26.48 27
Engineers 700 120 5.83 6
185
(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.
Sippican (B) Flow Unused

Pro Forma Valves Pumps Controllers Charged Capacity Actual
Sales (units) 10,000 12,000 2,500
Sales revenue $ 750,000 $ 960,000 $ 275,000 1,985,000 $1,985,000
Sales percentage 38% 48% 14%
DL expenses $ 123,500 $ 195,000 $ 32,500 $ 351,000 $ 351,000
Material
expenses 160,000 240,000 55,000 455,000 455,000
Contribution 187,50
margin 466,500 525,000 0 1,179,000 1,179,000
62% 55% 68% 59% 0% 59%
Machine run-
time expense 112,500 135,000 16,875 264,375 3,105 267,480
Machine set-up
expense 3,600 4,320 10,800 18,720
Setup labor 5,200 6,240 15,600 27,040 260 27,300
Receiving and
production
control 1,500 1,500 1,875 4,875 2,925 7,800
Engineering 4,875 19,500 32,500 56,875 1,625 58,500
Package & ship 41,000 49,750 12,500 103,250 2,050 105,300
Manufacturing
overhead 168,675 216,310 90,150 475,135 9,965 $ 485,100
Total costs $ 452,175 $ 651,310 $ 177,650 1,281,135 $ 9,965 $1,291,100
Gross margin $ 297,825 $ 308,690 $ 97,350 $ 703,865 $(9,965) $ 693,900
Gross margin % 40% 32% 35% 35% 35%
S&A 350,000
Operating profit $ 343,900
Return on sales 17.3%
(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
186
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.
A comparison of product line profitability before and after the changes

follows.
187
Sippican (A) Sippican (B)

Product Line Profitability Product Line Profitability
Valves Pumps Flow Valves Pumps Flow
Controllers Controllers
Production 7,500 12,500 4,000 10,000 12,000 2,500
Price $ 79.00 $ 70.00 $ 95.00 $ 75.00 $ 80.00 $ 110.00
Direct labor 12.35 16.25 13.00 12.35 16.25 13.00
Direct materials 16.00 20.00 22.00 16.00 20.00 22.00
Contribution $ 50.65 $ 33.75 $ 60.00 $ 46.65 $ 43.75 $ 75.00
margin
Cont. margin % 64% 48% 63% 62% 55% 68%
Manufacturing
overhead
Machine 11.25 11.25 6.75 11.25 11.25 6.75
expenses
Setup labor 0.43 1.56 21.94 0.52 0.52 6.24
Machine setup 0.30 1.08 15.19 0.36 0.36 4.32
cost
Receiving and 0.10 0.30 2.11 0.15 0.13 0.75
production
control
Engineering 0.65 1.56 12.19 0.49 1.63 13.00
Package & 4.13 4.20 5.25 4.10 4.15 5.00
ship
Total $ 16.87 $ 19.95 $ 63.42 $ 16.87 $ 18.03 $ 36.06
manufacturing
overhead
Total costs 45.22 56.20 98.42 45.22 54.28 71.06
Gross margin $ 33.78 $ 13.80 $ (3.42) $ 29.78 $ 25.72 $ 38.94
GM % 43% 20% -4% 40% 32% 35%
188
5-38 (a) Practical capacity for the personnel resources is calculated as follows:
Paid Nonpro- Productive Days Practical

Hours ductive Hours per Used Capacity
per Hours per Day per Hours per
Day Day Month Month
Brokers 8 1.5 6.5 20 130
Account
Managers 8 1.5 6.5 20 130
Financial
Planners 8 1.5 6.5 20 130
Principals 8 1.5 6.5 20 130
Customer
service
represen-
tatives 8 1.0 7.0 20 140
Capacity cost rates are 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
189
(b) A summary table of time utilization appears below, and supporting

computations appear in the subsequent table.
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
190
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
191
(c) A summary table of MIPS usage during peak and non-peak hours
appears below, and sample computations appear in the subsequent table.
Mutual Account Available

MIPS Stock Fund Manage- Financial Productive
Usage Trading Trading ment Planning Total* Time
Peak 465,913 30,200 96,783 11,823 604,718 668,800

Non-
peak 99,358 105,986 72,212 11,860 289,415 334,400
*The small discrepancies in the totals are due to rounding in the previous
columns.
MIPS usage during peak and non-peak hours is calculated by

multiplying MIPS per transaction by the number of transactions during
peak and non-peak hours, respectively. The computations for stock
trading appear below. The other computations are similar.
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:
192
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%
193
Stock trading sales = $8.80 305,288 = $2,686,534.

Mutual fund trading sales = $41.45 26,325 = $1,091,171.
Account management sales = 1.5% $60,000 1,200/12 = $90,000.
Financial planning sales = (130 $1,200) + ([90/60] $125) =
$156,188.
The personnel costs are computed by multiplying the capacity cost rates
in part (a) by the hours of time utilization in part (b).
The computer server expenses are calculated by multiplying the peak-

usage MIPS by $0.30 and the non-peak-usage MIPS by $0.12. For
example, the computation for stock trading is (465,913 $0.30) +
(99,358 $0.12) = $151,697 (rounded).
The costs in the total supplied column are computed as follows:
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
194
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.)
Costs as a Percent of Own Product Line Sales

Mutual
Stock Fund Account Financial
Trading Trading Management Planning
Brokers 52.9% 12.9% 0.0% 0.0%

Account
Managers 0.0% 0.0% 159.2% 0.0%
Financial
Planners 0.0% 0.0% 0.0% 93.6%
Principals 9.8% 2.4% 46.2% 8.3%
Customer
service
representatives 4.6% 2.8% 6.9% 2.5%
Computer
server expenses 5.6% 2.0% 41.9% 3.2%
Total 72.9% 20.1% 254.2% 107.6%
(e) Towertons management team could specify a minimum accounting

balance for investment account management and reprice its financial
planning services. Management could also consider raising prices on
stock trading and placing a greater emphasis on mutual fund trading,
which is its most profitable product line.
195

Activity-Based Costing Provides More Accurate Costs for Varied Product Mix

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Atkinson, Solutions Manual t/a Management Accounting, 6E

warehouse or truck. For most resources (people, equipment, and machines),

to be fixed. The large component of apparently fixed costs in service

Unlike physical products, services cannot be inventoried for future sales.

It can be difficult to identify and measure the outputs for a service

5-13 Time-driven activity-based costing has a number of advantages over

$19,400/308 = $62.99, which can be rounded to $63 per hour for

Changeovers (hours per

Indirect labor time per

Total revenues $890,000

(b) The activity-based cost associated with Division 1s customers is

(c) The activity-based cost associated with Division 2s customers is

(b) Order 705, which consists of 40 items, requires packaging preparation

5-22 Activity-based costing provides a means to accurately trace costs to

translate the strategy to operational terms, and lead to communication of the

Of course, both approaches are highly compatible with each other.

5-25 (a) Cost Activity

(b) Capacity cost rate = $600,000/10,000 = $60 per hour.

(c) Unit Quantity

Practical capacity used = 8,750 10,000 = 87.5%

(d) Unit Quantity

Practical capacity used = 9,100 10,000 = 91.0%

in part (a) overestimated the costs of performing activities by

5-27 (Unofficial CMA Answer, adapted)

Indirect labor, e.g., lift-truck drivers wages, maintenance and

2. Companies develop manufacturing support cost driver rates to

Accumulate separate costs into departmental accounts (or other

(d) An activity-based costing system might benefit Moss Manufacturing

(b) Product X Product Y

(d) Product Ys manager is likely to resist implementation of the activity-

5-29 (a) Manufacturing support cost driver rate

Costs Per Unit Product X21 Product Y37

(b) Cost Cost Costs Allocated to Products

Costs Per Unit X21 Y37

(c) Activity-based costing produces more accurate estimates of job costs

(d) Cost-based Prices Product X21 Product Y37

If Endo plans to continue to use cost-based pricing, it should use

5-30 (a) Total manufacturing support costs = $1,000,000

(b) Deluxe Regular

(c) Activity Rate Per Unit of Cost Driver

Unit costs are distorted by the old system because it assigns

Design engineers can try to re-engineer the deluxe product to decrease

5-31 (Unofficial CMA Answer, adapted)

(a) At least four general advantages associated with activity-based costing

Provides management with a thorough understanding of complex

Per Totals for

2. Using standard costs, the total contribution expected this year

1. Using activity-based costing, the total contribution expected this

Per Totals for

2. Using activity-based costing, the total contribution expected this

Per Totals for 40,000

$1,000,000. As a percentage of selling price, the contribution from the

of introducing another customized option will be compensated with

As a specific example, one of General Motors competitors examined

Cott executives could use a variety of different activity-based cost systems.

Second, Cott is customizing its product and service offering to individual

Third, one of Cotts principal marketing devices with a retailer is to convince

5-34 This case on Gotham City is adapted from Indianapolis: Activity-Based

supervision, and all resources performing support activities (since any

procedures so that a pothole could be filled with a three-person crew

5-35 (a) Stage 1: Allocation of S1 and S2 costs to production departments

Total support $1,180,000 $2,376,000

DLH 80, 000 120,000