6-7 Overcosting may result in competitors entering a market and taking market share

for products that a company erroneously believes are low-margin or even unprofitable.

Undercosting may result in companies selling products on which they are in fact losing
money, when they erroneously believe them to be profitable.

6-22 (30 min.) Activity-based costing, manufacturing

1. Simple costing system:

Total indirect costs = A$95 000 + A$45 000 + A$25 000 + A$60 000 + A$8 000 +
3%[(A$125 3200) + (A$200 1800)]
= A$255 800
Total machine-hours = 5500 + 4500
= 10 000
Indirect cost rate per machine-hour= A$255 800 10 000
= A$25.58 per machine-hour

Simple Costing System Interior Exterior

Direct materialsa A$ 96 000 A$ 81 000
Direct manufacturing labourb 76 800 64 800
Indirect cost allocated to each job
(A$25.58 5 500; 4 500 machine
hours) 140 690 115 110

Total costs A$313 490 A$260 910

Total cost per unit
(A$313 490 3 200; A$260 910 1 800) A$ 97.97 A$ 144.95
a
A$30 3200 units; A$45 1800 units
b
A$16 1.5 3200 units; A$16 2.25 1800 units

2. Activity-based costing system:

Cost
Total Cost Driver
Activity of Activity Cost Driver Quantity Allocation Rate
(1) (2) (3) (4) (5) = (2) (4)
Product per production
scheduling A$95 000 production runs 125c A$ 760.00 run
Material A$ 45 000 material moves per material
handling 240d A$ 187.50 move
Machine setup A$ 25 000 machine setups 200e A$ 125.00 per setup
Assembly A$ 60 000 machine hours per machine
10 000 A$ 6.00 hour
Inspection A$ 8 000 inspections 400f A$ 20.00 per inspection
Marketing selling price A$ 0.03 per dollar of
sales
c
40 + 85 = 125; 72 + 168 = 240;
d
45 + 155 = 200;
e f
250 + 150 = 400
 ABC System Interior Exterior
Direct materials A$ 96 000 A$ 81 000
Direct manufacturing labour 76 800 64 800
Indirect costs allocated:
Product scheduling (A$760 per run 40; 85) 30 400 64 600
Material handling (A$187.50 per move 72;
168) 13 500 31 500
Machine setup (A$125 per setup 45; 155) 5 625 19 375
Assembly (A$6 per MH 5 500; 4 500) 33 000 27 000
Inspection (A$20 per inspection 250; 150) 5 000 3 000
Marketing (0.03 A$125 3 200; 0.03
A$200 1 800) 12 000 10 800
Total costs A$272 325 A$302 075
Total cost per unit
(A$272 325 3 200 units; A$302 075 1 800
units) A$ 85.10 A$ 167.82

3.
Cost per unit Interior Exterior
Simple Costing System A$97.97 A$144.95
Activity-based Costing System A$85.10 A$167.82
Difference (Simple ABC) A$12.87 A$(22.87)

Relative to the ABC system, the simple costing system overcosts interior doors and
undercosts exterior doors. Under the simple costing system, the doors require a similar
number of total machine hours (5500 for interior and 4500 for exterior), even though
interior doors take fewer machine hours per unit. Under the simple costing system, the
volume of the production of interior doors is driving the amount of overhead allocated to
that product. The ABC study reveals that each exterior door requires more production
runs, material moves, and setups. This is reflected in the higher indirect costs allocated
to exterior doors in the ABC system.

4. Smart Doors Ltd can use the information revealed by the ABC system to change
its pricing based on the ABC costs. Under the simple system, Smart Doors was making
an operating margin of 21.6% on each interior door ((A$125 A$97.97) A$125) and
27.5% on each exterior door ((A$200 A$144.95) $200). But, the ABC system
reveals that it is actually making an operating margin of about 32% ((A$125 A$85.10)
A$125) on each interior door and about 16% ((A$200 A$167.82) A$200) on each
exterior door. Smart Doors, Inc. should consider decreasing the price of its interior doors
to be more competitive. Smart Doors should also consider increasing the price of its
exterior doors, depending on the competition it faces in this market.

Smart Doors can also use the ABC information to improve its own operations. It could
examine each of the indirect cost categories and analyse whether it would be possible to
deliver the same level of service, but consume fewer indirect resources, or find a way to
reduce the per unit cost driver cost of some of those indirect resources. Making these
operational improvements can help Smart Doors to reduce costs, become more
competitive, and reduce prices to gain further market share while increasing its profits.
6-24 (30 min.) Cost allocation to divisions

1.

Hotel Restaurant Casino Total

Revenue A$16 425 000 A$5 256 000 A$12 340 000 A$34 021 000
Direct costs 9 819 260 3 749 172 4 248 768 17 817 200
Segment
margin A$6 605 740 A$1 506 828 A$8 091 232 16 203 800
Fixed
overhead
costs 14 550 000
Income
before taxes A$ 1 653 800
Segment
margin % 40.22% 28.67% 65.57%
 2.

Hotel Restaurant Casino Total

Direct costs A$9 819 260 A$3 749 172 A$4 248 768 A$17 817 200
Direct cost % 55.11% 21.04% 23.85% 100.00%
Square
metres 7 432 1 486.4 5 945.6 14 864
Square
metres % 50.00% 10.00% 40.00% 100.00%
Number of
employees 200 50 250 500
Number of
employees % 40.00% 10.00% 50.00% 100.00%

A: Cost allocation based on direct costs:

Hotel Restaurant Casino Total

Revenue A$16 425 000 A$ 5 256 000 A$12 340 000 A$34 021 000
Direct costs 9 819 60 3 749 172 4 248 768 17 817 200
Segment
margin 6 605 740 1 506 828 8 091 232 16 203 800
Allocated fixed
overhead costs 8 018 505 3 061 320 3 470 175 14 550 000
Segment pre-
tax income A$ (1 412 765) A$ (1 554 492) A$ 4 621 057 A$ 1 653 800
Segment pre-
tax income %
of rev. -8.60% -29.58% 37.45%

B: Cost allocation based on floor space:

Hotel Restaurant Casino Total
Allocated
fixed
overhead A$7 275 A$5 820
costs 000 A$1 455 000 000 A$14 550 000
Segment A$ (669 A$2 271
pre-tax 260) A$ 51 828 232 A$ 1 653 800
income
Segment
pre-tax
income %
of rev. -4.07% 0.99% 18.41%
 C: Cost allocation based on number of
employees
Hotel Restaurant Casino Total
Allocated
fixed
overhead A$5 820 A$7 275
costs 000 A$1 455 000 000 A$14 550 000
Segment
pre-tax A$ 785 A$ 816
income 740 A$ 51 828 232 A$ 1 653 800
Segment
pre-tax
income %
of rev. 4.78% 0.99% 6.61%

3. Requirement 2 shows the dramatic effect of choice of cost allocation base on

segment pre-tax income as a percentage of revenues:

Pre-tax Income Percentage

Allocation Base Hotel Restaurant Casino

Direct costs -8.60% -29.58% 37.45%

Floor space -4.07 0.99 18.41
Number of
employees 4.78 0.99 6.61

The decision context should guide (a) whether costs should be allocated, and (b) the
preferred cost allocation base. Decisions about, say, performance measurement, may be
made on a combination of financial and nonfinancial measures. It may well be that
management may prefer to exclude allocated costs from the financial measures to
reduce areas of dispute.
Where cost allocation is required, the cause-and-effect and benefits-received criteria are
recommended on page 212. The A$14 550 000 is a fixed overhead cost. This means that
on a short-run basis, the cause-and-effect criterion is not appropriate but management
could attempt to identify the cost drivers for these costs in the long run when they are
likely to be more variable. Management could consider the way in which the
A$14 550 000 cost benefits the three divisions, which would help guide the choice of an
allocation base in the short run.

4. The analysis in requirement 2 should not influence the decision on whether to

shut down any of the divisions. The overhead costs are fixed costs in the short run. It is
not clear how these costs would be affected in the long run if management shut down
one of the divisions. Also, each division is not independent of the other two. A decision
to shut down, say, the restaurant would probably negatively affect attendance at the
casino and possibly the hotel. Management should examine the future revenue and
future cost implications of different resource investments in the three divisions. This is a
future-oriented exercise, whereas the analysis in requirement 2 is an analysis of past
costs.
6-30 (1015 min.) Activity-based costing, process costing

1. Rates per unit cost driver:

Activity Cost Driver Rate
Machining Machine-hours A$375 000 (25 000 + 50 000)
= A$5 per machine-hour

Set up Production runs A$120 000 (50 + 50)

= A$1 200 per production run

Inspection Inspection-hours A$105 000 (1 000 + 500)

= A$70 per inspection-hour

Overhead cost per unit:

Mathematical Financial

Machining: A$5 25 000; 50 000 A$125 000 A$250 000

Set up: A$1 200 50; A$1 200 50 60 000 60 000
Inspection: A$70 1 000; A$70 500 70 000 35 000
Total manufacturing overhead costs A$255 000 A$345 000
Divide by number of units 50 000 100 000
Manufacturing overhead cost per unit A$ 5.10 A$ 3.45

2.
Mathematical Financial
Manufacturing cost per unit:
Direct materials
A$150 000 50 000 A$3.00
A$300 000 100 000 A$3.00
Direct manufacturing labour
A$50 000 50 000 1.00
A$100 000 100 000 1.00
Manufacturing overhead (from requirement 1) 5.10 3.45
Manufacturing cost per unit A$9.10 A$7.45

6-33 (30 min.) Activity-based costing, retail product-line profitability

1. The simple costing system (Panel A of Solution Exhibit 6-33 on the following
page) reports:
Baked Milk & Frozen
Goods Fruit Juice Products Total
Revenues A$57 000 A$63 000 A$52 000 A$172 000
Costs:
Cost of goods sold 38 000 47 000 35 000 120 000
Store support (30% of 11 400 14 100 10 500 36 000
COGS)
Total costs 49 400 61 100 45 500 156 000
Operating profit A$ 7 600 A$ 1 900 A$ 6 500 A$ 16 000

Operating income 13.33% 3.02% 12.50% 9.30%

Revenues
 2. The ABC system (Panel B of Solution Exhibit 6-33) reports the following:
Baked Milk & Frozen
Goods Fruit Juice Products Total
Revenues A$57 000 A$63 000 A$52 000 A$172 000
Costs:
Cost of goods sold 38 000 47 000 35 000 120 000
Ordering (A$100 30; 25;
13) 3 000 2 500 1 300 6 800
Delivery (A$80 98; 36; 28) 7 840 2 880 2 240 12 960
Shelf-stocking (A$20 183;
166; 24) 3 660 3 320 480 7 460
Customer support
(A$0.20 15 500; 20 500;
7900) 3 100 4 100 1580 7 380
Total costs 55 600 59 800 39 200 154 600
Operating income A$ 1 400 A$ 3 200 A$12 800 A$ 17 400
Operating income
Revenues 2.46% 5.08% 24.62% 10.12%

These activity costs are based on the following:

Baked Milk & Frozen
Activity Cost Allocation Rate Goods Fruit Juice Products
Ordering A$100 per purchase order 30 25 13
Delivery A$80 per delivery 98 36 28
Shelf-stocking A$20 per hour 183 166 24
Customer A$0.20 per item sold 15 500 20 500 900
support
3. The rankings of products in terms of relative profitability are:

Simple Costing System ABC System

1. Baked goods 13.33% Frozen products 24.60%
2. Frozen products 12.50 Milk & fruit juice 5.08
3. Milk & fruit juice 3.02 Baked goods 2.46

The percentage revenue, COGS and activity costs for each product line are:

Baked Milk & Frozen

Goods Fruit Juice Products Total
Revenues 33.14 36.63 30.23 100.00
COGS 31.67 39.17 29.16 100.00
Activity areas:
Ordering 44.12 36.76 19.12 100.00
Delivery 60.49 22.22 17.29 100.00
Shelf-stocking 49.06 44.50 6.44 100.00
Customer support 42.01 55.56 2.44 100.00

The baked goods line drops sizably in profitability when ABC is used. Although it
constitutes 31.67% of COGS, it uses a higher percentage of total resources in each
activity area, especially the high cost delivery activity area. In contrast, frozen products
draw a much lower percentage of total resources used in each activity area than its
percentage of total COGS. Hence, under ABC, frozen products are much more profitable.

Ocean Supermarkets may want to explore ways to increase sales of frozen products. It
may also want to explore price increases on baked goods.