Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-42 (continued-1)
The budgeted unit costs per pound are:
Mona Loa Coffee Malaysian Coffee
Direct unit costs:
Direct materials $4.20 $3.20
Direct labor 0.30 $4.50 0.30 $3.50
Indirect unit costs:
Purchasing 0.02 1.00
(4 orders × $500 ÷ 100,000 lbs.) (4 orders × $500 ÷ 2,000 lbs.)
Quality control 0.02 0.40
(10 batches × $200 ÷ 100,000 lbs.) (4 batches × $200 ÷ 2,000 lbs.)
Roasting 0.10 0.10
(1,000 hours × $10 ÷ 100,000 lbs.) (20 hours × $10 ÷ 2,000 lbs.)
Blending 0.05 0.05
(500 hrs.× $10 ÷ 100,000 lbs.) (10 hrs.× $10 ÷ 2,000 lbs.)
The comparative cost numbers are:
Mona Loa Malaysian
Requirement 1 $6.00 $5.00
Requirement 2 4.82 7.46
The ABC system in requirement 2 reports a decreased cost for the high-
volume Mona Loa and an increased cost for the low-volume Malaysian.
5-31
Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-42 (continued-2)
3. Three of the indirect cost items can be classified as output-unit driven:
Mona Loa
Coffee
Malaysian
Coffee
Roasting $0.10 $0.10
Blending 0.05 0.05
The other three indirect cost items are batch-level driven:
Mona Loa
Coffee
Malaysian
Coffee
Purchasing $0.02 $1.00
Material handling 0.12 2.40
Malaysian coffee has a greater number of setups per output unit than
does Mona Loa coffee. The result is that the unit cost of the lower-
volume Malaysian coffee is much higher than that of the higher-volume
coffee, even though its cost of direct materials is lower.
With the current costing system, the high-volume Mona Loa is
overcosted, while the low-volume Malaysian is undercosted. Pricing of
Mona Loa can be reduced to make it more competitive. In contrast,
Malaysian should be priced at a much higher level if the strategy is to
cover the current period’s cost. CBI may wish to have lower margins
with its low-volume products such as Malaysian in an attempt to build
5-32
Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-42 (continued-3)
ABC cost data also point out that the reason for the Malaysian
coffee to have a higher unit cost is not because of high-priced
ingredients. In fact, Malaysian coffee has a lower cost of direct
materials than that of Mona Loa coffee. The costs of roasting, blending,
and packaging are $0.16 per pound for both coffees. The higher cost of
Malaysian is because of the way in which it is processed. The batch-
5-43 Cost of Capacity; Continuation of 5-42 (25 min)
1. The calculation of the new activity rates and the cost of unused capacity is
determined below.
Activity
Budgeted
Activity
Budgeted
Cost
Usage
Based
Rate
Practical
Capacity at
current
spending
Usage
%
Practical
Capacity
Rate
Unused
Capacity
Cost of
Unused
Capacity
Purchasing 1,158 $579,000 $500 1,400 83% $413.57 242 $100,084
Materials
handling 1,800 $720,000 $400 2,400 75% $300.00 600 $180,000
Quality
control 720 $144,000 $200 1,200 60% $120.00 480 $57,600
5-33
Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-43 (continued-1)
2. The information on cost of capacity can alert management to the total cost
of unused capacity, in this case $432,230 or approximately 14% of total
overhead cost. This information can be used to identify activities where there
is extensive over-capacity, and to consider how the capacity might be
3. The analysis below shows the number of employees “unused” in column
4. The analysis assumes that each employee (or machine) contributes an
equal share to the work of the activity. Note that the materials handling
activity appears to have as many as 5 unused employees.
1 2 3 4 5 6 7 8
Driver
Usage Cost
Capacity
at Current
Spending
Step:
Number of
Employees
or Machines
Unused
Capacity
Cost per Step
=(2)÷(4)
Step
Size
=(3)÷(4)
Steps
Not
Used
Purchasing
1,1
58 $579,000 1,400
8 242 $ 72,375 175 1.38
Materials
Handling
1,8
00
720,00
0 2,400 20 600 36,000 120 5.00
5-34
5-44 Activity-Based Costing (35-40 min)
(“Miami Valley Architects, Inc.” by Beth M. Chaffman, and John Talbott,
Management Accounting Campus Report, Fall 1992, p.4)
1. Overhead Cost assigned to each branch under the ABC costing:
Columbus Cincinnati Dayton Total
Direct labor dollar 37.61% 31.19% 31.20% 100%
Timesheet entries 45.11 28.57 26.32 100
Vendor invoices 44.93 37.44 17.62 100
Client invoices 52.13 39.36 8.51 100
Employees 34.33 38.81 26.87 100
New hires 42.11 21.05 36.84 100
Insurance claims filed 34.33 38.81 26.87 100
Proposals 39.22 49.02 11.76 100
Activity-based overhead allocation (000s)
Colum. Cinci. Dayton Total Cost Driver
General administration $153.82 $127.56 $127.60 $ 409 Direct labor dollar
Project costing 21.65 13.71 12.63 48 Timesheet entries
Accounts payable/receiving 62.46 52.05 24.49 139 Vendor invoices
Accounts receivable 24.50 18.50 4.00 47 Client invoices
Payroll/Mail sort & delivery 10.30 11.64 8.06 30 Employees
Personnel recruiting 16.00 8.00 14.00 38 New hires
Employee insurance process. 4.81 5.43 3.76 14 Insurance claims filed
Proposals 54.51 68.14 16.35 139 Proposals
Total $529.32 $453.40 $278.25 $1,261
Note: Results will vary slightly if % used from part 1 are rounded to 2 places
5-35
Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-44 (continued-1)
Calculation for general administration allocated to branches:
Total direct labor dollar: $382,413 + $317,086 + $317,188 = $1,016,687
Allocation of general administration based on direct labor dollar:
Proportion Allocated Amount
Columbus $382,413 ÷ $1,016,687 = 37.61% $409 × 37.61% = $153.82
Dayton $317,188 ÷ $1,016,687 = 31.20% $409 × 31.20% = $127.60
2. Contribution of each branch:
Columbus Cincinnati Dayton Total
Sales $1,500 $1,419 $1,067 $3,986
Less: Direct labor 382 317 317 1,016
3. Profitability of each branch using activity-based costing:
Columbus Cincinnati Dayton Total
Sales $1,500 $1,419 $1,067 $3,986
Less: Direct labor 382 317 317 1,016
Direct materials 281 421 185 887
Direct overhead 180 270 177 627
Contribution margin $657 $411 $388 $1,456
5-36
Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-44 (continued-2)
4. Evaluating management concerns:
Overhead costs are usually aggregated in pools and allocated to
products and other cost objects based on volume measures such as
direct labor dollars or machine hours. The cost object, therefore,
supposedly shares proportionally in those costs necessary for its
production or existence. If however, overhead varies in accordance with
variables other than volume, then product costs and other cost objects
will be erroneously determined.
As the solution indicates, the profitability of the Cincinnati and Dayton
offices is vastly different employing direct tracing and ABC than under
the current approach. The obvious benefit to the company is a more
concerning relative profitability.
This case also illustrates that ABC is applicable to service organizations
as well as to manufacturing and that cost objects can consist of projects,
locations, customers, etc., as well as products. In essence, the better
5-37
Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-45 Volume-Based Costing vs. ABC (30 min)
1. Current Costing System – Direct-Labor-Hour Based
Overhead rate = Budgeted overhead ÷ Budgeted direct labor hours
= $200,000 ÷ (7,200 + 6,800 + 2,000)
Overhead cost allocation:
Cost per capsule:
5-38
Diomycin Homycin Addolin
Direct labor-hours 7,200 6,800 2,000
Overhead rate $12.50 $12.50 $12.50
Total overhead $90,000 $85,000 $25,000
Diomycin Homycin Addolin
Direct Materials $205,000 $265,000 $258,000
Direct Labor 250,000 234,000 263,000
Overhead: 90,000 85,000 25,000
Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-45 (continued-1)
2. Overhead rates for Activity-Based Costing:
Activity Cost Driver
Budgeted
Overhead
Cost
Budgeted
Cost Driver
Volume
Overhead
Rate
Machine setup Setup hours $ 16,000 1,600 $10.00
Plant management Workers 36,000 1,200 $30.00
Supervision of
Direct labor–
46,000 1,150 $40.00
Overhead Costs Assigned to Products Using Activity-Based Costing:
Overhead
Rate
Diomycin Homycin Addolin
Driver
Volume
Applied
Overhead
Driver
Volume
Applied
Overhead
Driver
Volume
Applied
Overhead
Machine
setup
$10 200 $2,000 600 $6,000 800 $8,000
Plant
management
$30 200 $6,000 400 $12,000 600 $18,000
Supervision
of direct labor
$40 200 $8,000 300 $12,000 650 $26,000
production
orders
Total $26,800 $47,600 $125,600
5-39
Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-45 (continued-2)
Cost per capsule under Activity-Based Costing:
Diomycin Homycin Addolin
Direct Materials $205,000 $265,000 $258,000
Direct Labor 250,000 234,000 263,000
Overhead 26,800 47,600 125,600
Total Cost $481,800 $546,600 $646,600
3. Comparison of Product Costs Using Current Costing and ABC Costing:
Diomycin Homycin Addolin
Current Costing System
Overhead $90,000 $85,000 $25,000
Analysis of the Differences
Under the current costing system, ADA applies overhead based on direct
labor hour, and high-volume products such as Diomycin (1,000,000
capsules) are allocated relatively more overhead ($90,000) than the low-
volume products such as Addolin (300,000 capsules). High-volume
products “subsidize” low–volume products in this case. Because of lack of
5-40