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Source:

Cornerstones of Cost Management 4th edition, Don R. Hansen, Maryanne M. Mowen. Cengage Learning, 2017
Chapter 4 – Activity Based Costing; Making The Connection (Integrative Exercises)

MAKING THE CONNECTION


INTEGRATIVE EXERCISES

CableTech Bell Corporation (CTB) operates in the telecommunications industry. CTB has two
divisions: the Phone Division and the Cable Service Division. The Phone Division manufactures
telephones in several plants located in the Midwest. The product lines run from relatively
inexpensive touch-tone wall and desk phones to expensive, high-quality cellular phones. CTB
also operates a cable TV service in Ohio. The Cable Service Division offers three products: a
basic package with 25 channels; an enhanced package, which is the basic package plus 15
additional channels and two movie channels; and a premium package, which is the basic package
plus 25 additional channels and three movie channels.

The Cable Service Division reported the following activity for the month of March:

Basic Enhanced Premium


Sales (units) 50,000 500,000 300,000
Price per unit $16 $30 $40
Unit costs:
Directly traced $ 3 $ 5 $ 7
Driver traced $ 2 $ 4 $ 6
Allocated $10 $13 $15

The unit costs are divided as follows: 70 percent production and 30 percent marketing and
customer service. Direct labor cost is the only driver used for tracing. Typically, the division uses
only production costs to define unit costs. The preceding unit product cost information was
provided at the request of the marketing manager and was the result of a special study.

Bryce Youngers, the president of CTB, is reasonably satisfied with the performance of the Cable
Service Division. March’s performance is fairly typical of what has been happening over the past
two years. The Phone Division, however, is another matter. Its overall profit performance has
been declining. Two years ago, income before income taxes had been about 25 percent of sales.
March’s dismal performance was also typical for what has been happening this year and is
expected to continue — unless some action by management is taken to reverse the trend. During
March, the Phone Division reported the following results:

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Source:
Cornerstones of Cost Management 4th edition, Don R. Hansen, Maryanne M. Mowen. Cengage Learning, 2017
Chapter 4 – Activity Based Costing; Making The Connection (Integrative Exercises)

Inventories:
Materials, March 1 $ 23,000
Materials, March 31 40,000
Work in process, March 1 130,000
Work in process, March 31 45,000
Finished goods, March 1 480,000
Finished goods, March 31 375,000

Costs:
Direct labor $ 117,000
Plant and equipment depreciation 50,000
Materials handling 85,000
Inspections 60,000
Scheduling 30,000
Power 30,000
Plant supervision 12,000

Manufacturing engineering $ 21,000


Sales commissions 120,000
Salary, sales supervisor 10,000
Supplies 17,000
Warranty work 40,000
Rework 30,000

During March, the Phone Division purchased materials totaling $312,000. There are no significant
inventories of supplies (beginning or ending). Supplies are accounted for separately from materials.
CTB’s Phone Division had sales totaling $1,170,000 for March.
Based on March’s results, Bryce decided to meet with three of the Phone Division’s managers: Kim
Breashears, divisional manager; Jacob Carder, divisional controller; and Larry Hartley, sales
manager. A transcript of their recorded conversation is given next:
Bryce: “March’s profit performance is down once again, and I think we need to see if we can identify
the problem and correct it—before it’s too late. Kim, what’s your assessment of the situation?”
Kim: “Foreign competition is eating us alive. They are coming in with lower-priced phones of
comparable or higher quality than our own. I’ve talked with several of the retailers that carry our lines,
and they say the same. They are convinced that we can sell more if we lower our prices.”
Larry: “They’re right. If we could lower our prices by 10 to 15 percent, I think that we’d regain most
of our lost market share. But we also need to make sure that the quality of our products meets that
of our competitors. As you know, we are spending a lot of money each month on rework and
warranties. That worries me. I’d like to see that warranty cost cut by 70 to 80 percent. If we could do
that, then customers would be more satisfied with our products, and I bet that we would not only
regain our market share but increase it.”

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Source:
Cornerstones of Cost Management 4th edition, Don R. Hansen, Maryanne M. Mowen. Cengage Learning, 2017
Chapter 4 – Activity Based Costing; Making The Connection (Integrative Exercises)

Jacob: “Lowering prices without lowering per-unit costs will not help us increase our profitability. I
think we need to improve our cost accounting system. I am not confident that we really know how
much each of our product lines is costing us. It may be that we are overpricing some of our units
because we are overcosting them. We may be underpricing other units.”
Larry: “This sounds promising—especially if the overcosting is for some of our high-volume lines. A
price decrease for these products would make the biggest difference—and if we knew they were
over- costed, then we could offer immediate price reductions.”
Bryce: “Jacob, I need more explanation. We have been using the same cost accounting system for
the last 10 years. Why would it be a problem?”
Jacob: “I think that our manufacturing environment has changed. Over the years, we have added a
lot of different product lines. Some of these products make very different demands on our
manufacturing overhead resources. We trace—or attempt to trace—overhead costs to the different
products using direct labor cost, a unit-based cost driver. We may be doing more allocation than
tracing. If so, then we probably don’t have a very good idea of our actual product costs. Also, as you
know, with the way computer technology has changed over time, it is easier and cheaper to collect
and use detailed information—information that will allow us to assign costs more accurately.”
Bryce: “This may be something we should explore. Jacob, what do you suggest?”
Jacob: “If we want more accurate product costs and if we really want to get in the cost reduction
business, then we need to understand how costs behave. In particular, we need to understand activity
cost behavior. Knowing what activities we perform, why we perform them, and how well we perform
them will help us identify areas for improvement. We also need to know how the different products
consume activity resources. What this boils down to is the need to use an activity-based management
system. But before we jump into this, we need some idea of whether non-unit-based drivers add
anything. Activity-based management is not an inexpensive undertaking. So I suggest that we do a
preliminary study to see if direct labor cost is adequate for tracing. If not, then maybe some non-unit-
drivers might be needed. In fact, if you would like, I can gather some data that will provide some
evidence on the usefulness of the activity-based approach.”
Bryce: “What do you think, Kim? It’s your division.”
Kim: “What Jacob has said sounds promising. I think he should pursue it and do so quickly. I also
think that we need to look at improving our quality. It sounds like we have a problem there. If quality
could be improved, then our costs will drop. I’ll talk to our quality people. Jacob, in the meantime, find
out for us if moving to an activity-based system is the way to go. How much time do you need?”
Jacob: “I have already been gathering data. I could probably have a report within two weeks.”

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Source:
Cornerstones of Cost Management 4th edition, Don R. Hansen, Maryanne M. Mowen. Cengage Learning, 2017
Chapter 4 – Activity Based Costing; Making The Connection (Integrative Exercises)

MEMO

TO: Kim Breashears


FROM: Jacob Carder
SUBJECT: Preliminary Analysis

Based on my initial analysis, I am confident that an ABC system will offer significant improvement. For
one of our conventional phone plants, I regressed total monthly overhead cost on monthly direct labor
cost using the following 15 months of data:

Overhead Direct Labor Cost


$ 360,000 $ 110,000
300,000 100,000
350,000 90,000
400,000 100,000
320,000 90,000
380,000 100,000
300,000 90,000
280,000 90,000
340,000 95,000
410,000 115,000
375,000 100,000
360,000 85,000
340,000 85,000
330,000 90,000
300,000 80,000

The results were revealing. Although direct labor cost appears to be a driver of overhead cost, it really
doesn’t explain a lot of the variation. I then searched for other drivers—particularly non-unit drivers—
that might offer more insight into overhead cost behavior. Every time a batch is produced, material
movement occurs, regardless of the size of the batch. The number of moves seemed like a more
logical driver. I was able to gather only 10 months of data for this. (Our information system doesn’t
provide the number of moves, so I had to build the data set by interviewing production personnel.)
This information is provided next:

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Source:
Cornerstones of Cost Management 4th edition, Don R. Hansen, Maryanne M. Mowen. Cengage Learning, 2017
Chapter 4 – Activity Based Costing; Making The Connection (Integrative Exercises)

Materials-Handling Cost Number of Moves


$ 80,000 1,500
60,000 1,000
70,000 1,250
72,000 1,300
65,000 1,100
85,000 1,700
67,000 1,200
73,500 1,350
83,000 1,400
84,000 1,700

The regression results were impressive. There is no question in my mind that the number of moves is
a good driver of materials-handling costs. Using the number of moves to assign materials-handling
costs to products would likely be better than the cost assignment using direct labor cost. Furthermore,
since small batches use the same number of moves as large batches, we have some evidence that
we may be overcosting our high-volume products.
I looked at one more overhead activity: inspecting products. We have 15 inspectors who are paid an
average of $4,000 per month. Each inspector offers about 160 hours of inspection capacity per month.
However, it appears that they actually work only about 80 percent of those hours. The drop in demand
we have experienced explains this idle time. I see no evidence of variable cost behavior here. I’m not
exactly sure how to treat inspection cost, but I think that it is more related to inspection hours than
direct labor cost. Some of the other overhead activities seem to be non-unit-level, as well— enough,
in fact, to be concerned about how we assign costs.
After receiving the memo, Kim was intrigued. She then asked Jacob to use the same phone plant as
a pilot for a preliminary ABC analysis. She instructed him to assign all overhead costs to the plant’s
two products (Regular and Deluxe models), using only four activities. The four activities were rework,
moving materials, inspecting products, and a general catch-all activity labeled “other manufacturing
activities.” From the special study already performed, she knew that materials handling and inspecting
involved significant cost; from production reports, she also knew that the rework activity involved signif-
icant cost. If the ABC and unit-based cost assignments did not differ by breaking out these three major
activities, then ABC may not matter.

Pursuant to the request, Jacob produced the following cost and driver information:

Activity Expected Cost Driver Activity Capacity


Other activities $ 2,000,000 Direct labor dollars $ 1,250,000
Moving materials 900,000 Number of moves 18,000
Inspecting 720,000 Inspection hours 24,000
Reworking 380,000 Rework hours 3,800
Total overhead cost 4,000,000

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Source:
Cornerstones of Cost Management 4th edition, Don R. Hansen, Maryanne M. Mowen. Cengage Learning, 2017
Chapter 4 – Activity Based Costing; Making The Connection (Integrative Exercises)

Expected activity demands:

Regular Model Deluxe Model


Units completed 100,000 40,000
Direct labor dollars $ 875,000 $ 375,000
Number of moves 7,200 10,800
Inspection hours 6,000 18,000
Rework hours 1,900 1,900

Required:

1. Compute two different unit costs for each of the Cable Service Division’s products. What
managerial objectives are being served by these unit cost computations?
2. Three different cost categories are provided by the Cable Service Division: direct tracing, driver
tracing, and allocation. Discuss the meaning of each. Based on how costs are assigned, do
you think that the Cable Service Division is using a functional-based or an activity-based cost
accounting system? What other differences exist between functional-based and activity-based
cost accounting systems?
3. Discuss the differences between the Cable Service Division’s products and the Phone
Division’s products.
4. Prepare an income statement for the Cable Service Division for March.
5. Prepare an income statement for the Phone Division for March. Include a supporting cost of
goods manufactured statement.
6. The Phone Division has been using the same cost accounting system for over 10 years.
Explain why its cost accounting system may be outmoded. What factors determine when a
new cost accounting system is warranted?
7. Using the method of least squares, calculate two cost formulas: one for overhead using direct
labor cost as the driver, and one for materials handling cost using number of moves as the
driver. Comment on Jacob Carder’s observations concerning the outcomes.
8. How would you describe the cost behavior of the inspection activity? Assume that the quality
control manager implements a program that reduces the number of defective units by 50
percent. Because of the improved quality, the demand for inspection hours will also drop by
50 percent. What is the potential monthly reduction in inspection costs? How did knowledge
of inspection’s cost behavior help?
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Source:
Cornerstones of Cost Management 4th edition, Don R. Hansen, Maryanne M. Mowen. Cengage Learning, 2017
Chapter 4 – Activity Based Costing; Making The Connection (Integrative Exercises)

9. Calculate the overhead cost per unit for each phone model using direct labor cost to assign all
overhead costs to products.
10. Calculate the overhead cost per unit using the four activities and drivers identified by Kim and
Jacob. If you were Kim, would you be inclined to implement an ABC system based on the
evidence from this pilot test?
11. Suppose someone urged Kim to look into Time-Driven Activity-Based Costing (TDABC)
instead of ABC. What would be the advantages of using a TDABC approach?