CHAPTER 3

ACTIVITY-BASED MANAGEMENT
Questions, Exercises, and Problems: Answers and Solutions
3.1

See text or glossary at the end of the book.

3.2

Disagree. This chapter deals with the problem of allocating indirect costs
to products.
Indirect costs can be the overhead costs incurred in
manufacturing a good or providing a service.

3.3

Step 2 of ABC is to identify the cost drivers associated with each activity.
These cost drivers can be selected based on causal relation, benefits
received, or reasonableness.

3.4

Companies using a single plantwide rate for their allocation of indirect

costs usually select a volume based allocation factor, such as direct labor
hours, machine hours, volume of activity, or material costs.

3.5

1.

Identify the activities that consume resources.

2.

Identify the cost drivers of those activities.

3.

Compute a cost rate per cost driver unit.

4.

Allocate costs to products by multiplying the cost driver rate times the
cost driver volume consumed by the product.

1.

Causal relation. Allocate costs to the product that causes the cost.

2.

Benefits received.
most benefit.

3.

Reasonableness. Some costs cannot be linked to products based on

either causality or benefits received, so they must be allocated on the
basis of fairness or reasonableness.

3.6

3.7

Allocate costs to the product that receives the

The traditional approach uses one allocation rate to allocate indirect costs
(typically based on direct-labor hours or machine hours), and therefore is
simple and relatively inexpensive to implement.
The activity-based
costing approach uses multiple allocation rates using several different
allocation bases (for example, machine setups, number of purchase
orders, etc.), and therefore requires more accounting resources to
implement.

3-1

Solutions

3.8

Cultures that focus on long-term results are more likely to accept activitybased costing. ABC takes time to be implemented effectively, and
requires participation across the organization. Cultures that focus on
short-term results are less likely to accept activity-based costing.

3.9

A cost driver is a term used in activity-based costing. It simply refers to

any activity that causes a cost. It can be anything from machine hours,
labor hours, or number of machine setups, to the number of parts in a
product.

3.10

Activity based costing identifies cost drivers (activities that cause costs)
that were not previously accounted for by the costing system. Once
known, the production managers can control costs by managing these
cost drivers. Furthermore, by providing marketing managers with more
accurate product costs, they can make informed decisions about pricing.

3.11

False. The lesson learned from activity-based costing is that costs are a
function not only of output volume, but also of other factors such as
complexity. A complex multi-product operation will cost more than a
simple single product operation, for example.

3.12

Low volume products often require more machine setups and purchase
orders for a given level of production output because they are produced in
smaller batches. Further, the low volume product adds complexity to the
operation by disrupting the production flow of the high volume items.
Thus, when overhead is applied based on the volume of output, high
volume products are allocated relatively more overhead than low volume
products, while low volume products cause more costs.

3.13

Non-value added activities are activities that could be eliminated without

reducing product quality, performance, or value. Examples are,

Solutions

University

litter pickup
equipment storage

Restaurant

hiring new employees

throwing out spoiled food

Bike Shop

sending incorrectly ordered parts back to

suppliers
sales returns

3-2

3.14

Disagree. The total estimated overhead for the year is independent of

cost allocation method. Different allocation methods allocate different
amounts ot cost objects, but the total cost is not determined by allocation
method.

3.15

Many companies have seen the proportion of direct labor costs to total
product costs fall dramatically as production has been automated. When
labor is such a small part of product costs, the relationship between labor
costs and overhead is weak. Hence, product costs may be erroneous,
especially if overhead is a large portion of product costs. Also, small
errors in assigning labor to products may be magnified when overhead
rates are several hundred percent of labor costs.

3.16

No. One of the benefits of activity-based costing is more accurate product

cost information.
This can help marketing people to price more
competitively, and to expand or withdraw a product offering. Ideally, the
implementation of an activity-based costing system involves marketing
people, so they in turn better understand the costs they use and the
system which generates the costs.

3.17

Nurses are employed in shifts of several hours, not in increments of

minutes. A reduction of a few minutes for a patient generally would not
affect nurse staffing.

3.18

No cost system can measure costs perfectly. For example, the allocation
of overhead costs will probably vary according to the cost system and
allocation base you use. Some systems measure costs using market
values (e.g., measure the change in the market value of an asset used in
a job); others use historical costs (e.g., conventional historical cost
measures of depreciation of an asset used on a job). Some cost systems
include a measure of opportunity costs of resources used on a job; others
do not. In short, there are many alternative ways to measure costs, and
none of them are perfect.

3.19

No. While activity-based costing may yield more detailed product cost
information, it must pass a cost-benefit test. Activity-based costing
requires a much more detailed breakdown of costs into activities that
cause costs. This can be a complex task involving the teamwork of
management, production, accounting, purchasing, marketing, and many
others. A company should implement ABC only if it thinks the benefit
from improved management decisions will outweigh the cost of
establishing and maintaining the new cost system.

3.20

Capacity sustaining costs are essentially fixed costs unrelated to the level
of service or production for the period, such as rent. These costs are
likely to be indirect costs. Unit-level costs are variable costs that vary
directly with the volume of production. These costs are likely easily
attributable to products or services. A hierarchy of product costs can help
managers to better establish the relationships between products and
costs to better understand cost behavior.

3-3

Solutions

3.21

You would most expect to have unused resources in the capacity

sustaining activities because they are the least changeable in the short
term.

3.22

Unused resources are measured as resources supplied minus resources

used.

3.23

Knowing what costs are incurred by activities and what activities are
caused by decisions helps managers know how their decisions affect
costs.

3.24

Most companies that adopt activity-based costing would likely add to

shareholder value, as evidenced by a study of ABC in U.K. companies.
Answers will vary as to how added shareholder value can be measured.
One possible approach is to compare return on assets for companies that
adopt ABC with return on assets for companies in the same industry that
did not adopt ABC. Another measure is to compare a companys return
on assets over time after adopting ABC with the same companys return
on assets prior to adopting ABC.

Solutions

3-4

3.25

(Ciudad Juarez; activity-based costing.)

a.
Activity
Purchasing Materials................................
Machine Setup..........................................
Inspections...............................................
Operating Machines.................................
Total Overhead.........................................

Cost-Driver
Rate
$ 20 Per Frame
$2,000 Per Setup
$ 100 Per Hour
$ 30 Per Hour

Mountain Bikes
Actual Cost
Driver Units
1,000 Frames
7 Setups
200 Hours
1,500 Hours

Costs Allocated to
Mountain Bikes
$ 20,000
14,000
20,000
45,000
$ 99,000

6 Setups X $2,000 = $12,000

Savings from Reduced Setups

Racing Bikes
Actual Cost
Driver Units
200 Frames
15 Setups
200 Hours
500 Hours

Costs Allocated
to Racing Bikes
$ 4,000
30,000
20,000
15,000
$ 69,000

15 Setups X $2,000 = $30,000

The cost-driver rate for machine setups remains unchanged since the cost of machine setups changes proportionally to number
of setups.
The total overhead is reduced by $42,000 with $30,000 of the savings in racing bikes and $12,000 of the savings in mountain bikes.

3-5

Solutions

3.25 continued.
b.

3.26

Using activity-based costing revealed that machine setups were a

costly activity; if the company could reduce the number of setups it
could save a lot of money. The company was able to reduce the
number of setups and thereby reduce the cost of setups by about 50
percent, resulting in a savings of $42,000.
Activity-based costing identifies the activities that cause costs. It
allows managers to monitor those activities and control them.
However, activity-based costing requires employee teamwork and
increased record-keeping costs.

(Wildwater Adventures; activity-based costing.)

a. and b.
Activities

Float Trips
(3 day)
215

White Water Trips

(3 day)
$ 215

Advertising............ $
Permit to Use
the River.............
30
50
Equipment Use......
160 [= ($5 X 28) + 20]
264 [= ($8 X 28) + 40]
Insurance...............
75
127
Paying Guides........ 1,200 (= $300 X 4 Guides)
1,600 (= $400 X 4
Guides)
Food....................... 1,680 (= $60 X 28)
1,680 (= $60 X 28)
Total................ $ 3,360
$ 3,936
c.

Solutions

If the manager wants to cover her costs, she should charge $140 per
customer for the 3 day float trip ($3,360/24 paying customers), and
$164 per customer for the 3 day white water trip (= $3,936/24 paying
customers).

3-6

3.27

(ABC versus traditional costing.)

a.

Using the Three Cost Drivers

Rate

High
Standard Grade
Total
a
$ 125,000 $ 114,000 $ 239,000
$ 160,000b $ 80,000 $ 240,000

Direct Materials.................
Direct Labor.......................
Overhead Costs:
Number of Production
Runs............................ $10,000c $ 200,000f $ 100,000
Number of Quality
Tests........................... 12,000d 144,000g 216,000
Number of Shipping
Orders.........................
1,466.67e146,667h
220,000.......................
Total Overhead..................
$ 490,667 $ 389,333
Total Costs........................
$ 775,667 $ 583,333
1,359,000
Total Unit Cost...................
$2.42i
$4.86i

$ 300,000
360,000
73,333
$ 880,000
$

aData given in the text.

bData given in the text.
c$10,000 per run = $300,000 in production costs/30 total runs.
d$12,000 per test = $360,000 in quality costs/30 total tests.
e$1,466.67 per order = $220,000 in shipping costs/150 shipping
orders.
f$200,000 = $10,000 per production run X 20 runs for Standard.
g$144,000 = $12,000 per quality test X 12 tests for Standard.
h$146,667 = $1,466.67 per order shipped X 100 orders shipped for
Standard.
i$2.42 = $775,667 total costs for Standard/320,000 units produced;
$4.86 = $583,333 total costs for High Grade/120,000 units produced.

3-7

Solutions

3.27 continued.
b.

Using Direct Labor as the Allocation Base

Rate

High
Standard
Grade
Total
a
$ 125,000 $114,000 $ 239,000
160,000b
80,000
240,000

Direct Materials...................
Direct Labor.........................
Total Overhead (Labor
Dollar Allocation)............... 3.66667c586,667d 293,333
880,000
Total Costs...........................
$ 871,667 $ 487,333 $1,359,000
Total Unit Cost.....................
$2.72e
$4.06
aData given in the first table.
bData given in the first table.
c3.66667 = $880,000 total overhead/$240,000 total direct labor
costs.
d$586,667 = 3.66667 X $160,000.
e$2.72 = $871,667/320,000 Standard units produced.

c.

By allocating overhead on the basis of direct labor costs, the company

has been understating the cost to manufacture High-Grade units and
overstating the cost to manufacture Standard units. As a result, ABC
shows that the Standard unit is more profitable than originally
thought and the High-Grade unit is less profitable:
Traditional Costing Method
ABC
Standard High-Grade
Standard High-Grade
Price...............
$ 3.60
$ 5.80
$ 3.60
$ 5.80
Cost................
2.72
4.06
2.42
4.86
Profit..............
$ 0.88
$ 1.74
$ 1.18
$ .94

Solutions

3-8

3.28

(Activity-based costing in a nonmanufacturing environment.)

a.

Using Labor Hours

Commercial

Residential

Revenue............................... $ 66,500a
Direct Labor.........................
31,500c
Overhead.............................
21,700e
Profit.................................... $ 13,300

$ 143,000b
58,500d
40,300f
$ 44,200

Total

$209,500
90,000
62,000
$ 57,500

a$66,500 = 3,500 hours X $19 per hour.

b$143,000 = 6,500 hours X $22 per hour.
c$31,500 = 3,500 hours X $9 per hour.
d$58,500 = 6,500 hours X $9 per hour.
e$21,700 = ($62,000/10,000 hours) X 3,500 hours.
f$40,300 = ($62,000/10,000 hours) X 6,500 hours.
b.

Using the Three Cost Drivers

Rate

Revenuea......................
Direct Labora.................
Overhead:
Office Supplies............ $ 133.33b
Equipment Costs......... $ 3.00c
Garden Supplies.......... $ 0.36d
Total Overhead..............
Profit (Loss)...................

Commercial Residential

$ 66,500
$ 31,500
2,000e
10,500f
23,400g
$ 35,900
$
(900)
$

Total

$ 143,000 $ 209,500
$ 58,500 $ 90,000
$ 6,000
7,500
12,600
$ 26,100
$ 58,400

$ 8,000
18,000
36,000
$ 62,000
$ 57,500

aSee Part a. above.

b$133.33 per client = $8,000/60 clients served.
c$3.00 per hour = $18,000/6,000 equipment hours.
d$0.36 per square yard = $36,000/100,000 square yards.
e$2,000 = $133.33 X 15 commercial clients.
f$10,500 = $3.00 X 3,500 equipment hours.
g$23,400 = $0.36 X 65,000 square yards.

3-9

Solutions

3.28 continued.
c.

3.29

From the results in Part b., commercial work is not profitable, while
the residential business is making a profit. The cost driver analysis
shows that commercial work, which provides only about 30 percent of
the revenues, incurs 60 percent of the equipment and garden supplies
overhead costs. Allocating overhead costs based on direct labor, as in
Part a., implies that the commercial business incurs about 35 percent
of the total overhead, whereas the cost driver analysis in Part b.
shows the commercial business incurs more than one-half of the total
overhead.

(ABC versus traditional costing.)

a.
Cost Driver
Rate
Production Setup................. $5,000a
Material Handling and
Requisition........................ $ 200b
Packing and Shipping.......... $ 1.00
Total Overhead..................

Cell
Phones
$ 60,000d

Pagers
$ 40,000

14,000e
120,000f
$194,000

6,000
40,000
$ 86,000

a$5,000

per setup = $100,000/20 setups.

per part = $20,000/100 parts.
c$1.00 per unit shipped = $160,000/160,000 units shipped.
d$60,000 = $5,000 X 12 setups.
e$14,000 = $200 X 70 parts.
f$120,000 = $1.00 X 120,000 units shipped.
b$200

b.

Cell
Phones
Overhead............................. $210,000a

Pagers
$ 70,000

Total
$280,000

a$210,000

= [$280,000 overhead/(60,000 hours + 20,000 hours)]) X

60,000 hours for cell phones.
c.

Solutions

Perhaps. Activity-based costing provides a more detailed allocation of

overhead costs; however, the more detailed method is also more
expensive. The ABC system should be adopted if the benefits from
improved decisions exceed the additional costs required to obtain the
information that results in better decisions.

3-10

3.30

(ABC versus traditional costing.)

a.

Account
Revenue....................
Expenses:
Filing, Scheduling
and Data Entry....
Supplies..................
Computer Costs......
Profit..........................

Rate

Tax
$80,000

Consulting
Total
$120,000 $ 200,000

$333.33a
$ 18.00b
$ 12.50c

24,000d
14,400e
12,500f
$29,100

16,000
21,600
7,500
$ 74,900

40,000
36,000
20,000
$ 104,000

a$333.33 per client = $40,000/120 clients.

b$18 per hour billed = $36,000/2,000 hours billed.
c$12.50 per computer hour = $20,000/1,600 hours.
d$24,000 = $333.33 per client X 72 clients.
e$14,400 = $18 per hour X 800 hours.
f$12,500 = $12.50 per computer hour X 1,000 hours.
b.

Account
Revenue....................
Expenses...................
Profit..........................

Rate
$48a

Tax
Consulting
Total
$ 80,000
$120,000 $ 200,000
38,400b
57,600
96,000
$ 41,600
$ 62,400 $ 104,000

a2,000 hours billed = $200,000 revenue/$100 per hour. $48 per labor
hour = $96,000 expenses/2,000 hours.
b$38,400 = $48 per labor hour X 800 hours of labor.
c.

3.31

ABC implies that consulting is more profitable than it appears using

labor-based allocation. According to labor-based allocation, tax and
consulting generate a profit of 52% of revenue (52% =
$62,400/$120,000 or $41,600/$80,000). Believing this, management
might be indifferent as to which area to focus ontax or consulting.
ABC implies the profit rate for consulting is actually 62%. (62% =
$74,900/$120,000.)

(When do ABC and traditional methods yield similar results?)

ABC and traditional costing systems generally yield comparable productline overhead costs/allocations when overhead is a small portion of costs,
or when cost drivers are highly correlated with the volume-related
allocation base. In this case, billable labor hours were distributed 40
percent to Tax and 60 percent to Consulting. If each of the three cost
drivers were also distributed 40 percent to Tax and 60 percent to
Consulting, the labor-based allocation and ABC would have been identical.

3-11

Solutions

3.32

(Resources used versus resources supplied.)

Resources:

3.33

Supplied

Energy...................

$ 3,300

Used
=
Unused
($6 X 500)
= $3,000
$ 300 (= 50 hours)

Marketing...............
calls)

$ 6,000

($25 X 200)
= $5,000

$1,000 (= 40 sales

(Resources used versus resources supplied.)

a.
Resources:

Supplied

Setups....................
............................

$ 6,600

Used
=
($80 X 60)
= $4,800

Administrative.......
............................

$ 3,000

($150 X 15)
= $2,250

Unused
$
1,800
(27% unused)
$ 750
(25% unused)

b. The company has more unused capacity than management wants.

Management might decide to reduce personnel if there is no prospect of
increasing capacity usage (e.g., from increased production).
3.34

(Benefits of activity-based costing. [CMA adapted])

If management implemented an activity-based costing system, it should
expect to have a more thorough understanding of product costs. By
breaking down costs into cost drivers, i.e., those activities that drive the
costs, management should be able to see the relationship between
product complexity, product volume, and product cost. This would be
vital information for pricing decisions and profitability strategies.
Management should also be able to streamline the production process by
reducing those nonvalue-adding activities such as setups and travel time
between stations or departments. (Management might consider running
larger batches, or redesigning the plant layout.)

3.35

(Benefits of activity-based costing. [CMA adapted])

Any time one reduces direct labor and increases overhead, a labor-based
overhead allocation rate will increase. Activity-based costing would help
to clear her confusion by identifying the activities that drive overhead
costs. For instance, she might find that the additional overhead costs
come from the additional maintenance and depreciation required for the
new equipment.

Solutions

3-12

3.36

(Comparative income statements and management analysis.)

a.

SLEEP TIGHT CORPORATION

Income Statement
Rate
Dreamer
Revenue.........................
$ 695,000
Direct Materials..............
250,000
Direct Labor....................
100,000
Indirect Costs:
Administration............. 0.33333a $ 33,333e
Production Set-up........ $3,000b
30,000f
Quality Control............. $1,000c
20,000g
Sales & Marketing........ $1,875d
46,875h
Total Indirect Costs.........
$ 130,208
Operating Profit (Loss)....
$ 214,792

Sleeper
Total
$ 280,000 $ 975,000
110,000
360,000
50,000
150,000
$ 16,667i $ 50,000
45,000
75,000
70,000
90,000
103,125
150,000
$ 234,792 $ 365,000
$(114,792) $ 100,000

a0.33333 = $50,000 administrative costs/$150,000 direct labor costs.

b$3,000 = $75,000 production setup costs/25 production setups.
c$1,000 = $90,000 quality control costs/90 inspections.
d$1,875 = $150,000 sales and marketing costs/80 advertisements.
e$33,333 = 0.33333 X $100,000 direct labor costs.
f$30,000 = $3,000 per setup X 10 production runs.
g$20,000 = $1,000 per inspection X 20 inspections.
h$46,875 = $1,875 per advertisement X 25 advertisements.
i$16,667 = (.33333 X $50,000).

3-13

Solutions

3.36 continued.
b.

c.

Activity-based costing can be used to identify activities that cause

costs and to what extent those activities should be scrutinized relative
to other activities. Focusing on activities can also indicate where
waste occurs by identifying non-value added activities, and hence,
costs that could be eliminated without detriment to the output. For
example, better production methods might reduce inspections. Better
planning might reduce the number of production setups.
SLEEP TIGHT CORPORATION
Income Statement
Rate
Revenue...........................
Direct Materials................
Direct Labor.....................
Overhead Costs................
Operating Profit................

2.43a

Dreamer Sleeper
Total
$ 695,000 $ 280,000 $ 975,000
250,000
110,000
360,000
100,000
50,000
150,000
b
243,333
121,667
365,000
$ 101,667 $ (1,667) $ 100,000

a2.43 = $365,000 overhead costs/$150,000 direct labor costs.

b$243,000 = 2.43 overhead rate X $100,000 direct labor costs.
d.

Solutions

Report
The purpose of this report is to present a comparison of the profits, of
our Dreamer and Sleeper product lines, using activity-based costing
and the traditional method of allocating overhead based on labor
costs.
Activity-based costing focuses on the activities that drive costs,
recognizing that activities consume resources. ABC applies the costs
of those resources to the product using the activity. With each line
assigned the costs incurred by activities, the Dreamer line is the more
profitable. The allocation of overhead under the traditional method is
based on the amount of labor each line consumes. This may not be
related to overhead. Despite requiring more setups, inspections and
advertisements, the Sleeper line is assigned less overhead under the
traditional method because its production is less labor intensive than
the Dreamer line. Thus, under the traditional method, the Sleeper
line appears to be nearly at break even, whereas it shows a large loss
when ABC is used.
Activity-based costing provides more detailed and accurate
information than the traditional method because it is based on the
activities used to produce and sell each product. The traditional
method allocates overhead costs based on direct labor usage, which
may not represent the actual consumption of setups, inspections and
advertisements.
Based on the profit presented under the traditional method,
management could decide to discontinue the Dreamer line since it is
operating at a minimal profit, and increase production of the Sleeper
line. ABC implies the Dreamer line is the most profitable line.

3-14

3.37

(Comparative income statements and management analysis.)

a.

MARATHON, INC.
Income Statement
Rate
Court
X-Trainer
Total
Revenue...........................
$ 800,000 $ 720,000 $ 1,520,000
Direct Materials................
100,000
100,000
200,000
Direct Labor.....................
360,000
240,000
600,000
Indirect Costs:
Administration
0.16667a
$ 60,000e $ 40,000
$
100,000
Production Setup
$213.33b
64,000f
96,000
160,000
Quality Control.............. $150c
90,000g
60,000
150,000
d
h
Sales & Marketing......... $300
30,000
30,000
60,000
Total Indirect Costs..........
$ 244,000 $ 226,000 $ 470,000
Operating Profit...............
$ 96,000 $ 154,000 $ 250,000
a0.16667 = $100,000 administrative costs/$600,000 of direct labor
costs.
b$213.33 = $160,000 production setup costs/750 production runs.
c$150 = $150,000 quality control costs/1,000 inspections.
d$300 = $60,000 sales and marketing costs/200 advertisements.
e$60,000 = 0.16667 X $360,000 direct labor costs.
f$64,000 = $213.33 per setup X 300 production runs.
g$90,000 = $150 per inspection X 600 inspections.
h$30,000 = $300 per advertisement X 100 advertisements.

b. Activity-based costing can be used to identify activities that cause

costs.
For instance, management has identified three cost driving
activities; production setups, quality control inspections, and advertising.
Management has assigned a cost to each. If those activities can be
reduced without reducing the value of the product to customers, then the
company can reduce its costs. Focusing on activities can also indicate
where waste occurs by identifying non-value added activities, and hence
costs that could be eliminated without detriment to the output.

3-15

Solutions

3.37 continued.
c.

MARATHON, INC.
Income Statement
Rate
Revenue...........................
Direct Materials................
Direct Labor.....................
Overhead Costs
.........................470,000
Operating Profit................

Court X-Trainer
Total
$ 800,000 $ 720,000 $ 1,520,000
100,000
100,000
200,000
360,000
240,000
600,000
a
b
0.78333
282,000
188,000
$ 58,000 $ 192,000 $

250,000

a0.78333 = $470,000 of overhead costs/$600,000 direct labor costs.

b$282,000 = 0.78333 overhead rate X $360,000 direct labor
costs.
d.

Solutions

Report
The purpose of this report is to present a comparison of the profits of
our Court and X-Trainer product lines, using activity-based costing
and the traditional method of allocating overhead based on labor
costs.
Activity-based costing focuses on the activities that drive costs,
recognizing that activities consume resources. The allocation of
overhead under the traditional method is based on the amount of
labor that each line consumes. This may not be related to overhead.
The Court line for instance has 150 fewer setups, the most costly
activity related to its production, yet is assigned more overhead
because its production is more labor intensive than the X-Trainer
production.
Activity-based costing provides more detailed and accurate
information than the traditional method because ABC is based on the
consumption of resources by production of a product line and assigns
the costs according to actual usage. The traditional method allocates
overhead costs based on direct labor, which may not represent the
actual consumption of indirect resources by the product lines
production.

3-16

3.38

(Resources used versus resources supplied.)

MnM Productions, Inc.
Activity-Based Management Income Statement
a.

Resources:

Supplied

Used
=
($5 X 5,000)
= $25,000

Materials...........................

$25,000

Energy...............................

3,500

($1 X 3,200)
= $3,200

Setups...............................
....................................250

1,750

($50 X 30)
= $1,500

Purchasing........................
....................................300

1,500

($40 X 30)
= $1,200

Customer Service..............
....................................100

1,600

($50 X 30)
= $1,500

Long-Term Labor...............
.................................2,000

6,000

($40 X 100)
= $4,000

Administrative...................

14,000

($50 X 200)
= $10,000

Unused
$

0
300

4,000

b.

Managers should know what resources are unused so they can make
better decisions regarding eliminating unused resources or utilizing
them for some other purpose or product, and for decisions regarding
increasing production (what impact increasing production will have on
costs). For instance, the company can do two more setups without
increasing costs.

c.

The company is meeting managements expectations of less than 20

percent unused capacity for materials, energy, setups and customer
service, but not for long-term labor and administrative costs. Longterm labor and administrative costs tend to be in the facility
sustaining category of costs that are fixed in the short run, but can be
changed in the long-run. Reducing the supply of long-term labor and
administrative costs might require changes in company strategy. If
production and sales increase, the use of long-term labor and
administration will likely increase and, holding the supply of resources
constant, unused capacity will decrease.

3-17

Solutions

3.39

(ABC and predetermined overhead rates.)

a.

Activity

Recommended Base

Allocation Rate

Production Setup

Number of Production
Runs

$300 Per Run (= $60,000/

200 Runs)

Order Processing

Number of Orders

$250 Per Order (= $100,000/

400 Orders)

Materials Handling

Pounds of Material

$2.50 Per Pound (= $40,000/

16,000 Pounds)

Equipment Depreciation
and Maintenance

Machine Hours

Quality Management

Number of Inspections

$125 Per Inspection

(=
$100,000/800

Units Shipped

$1.00 Per Unit (= $80,000/

80,000 Units)

$6.00 Per Hour (= $120,000/

20,000 Hours)

Inspections)
Packing & Shipping

Direct Labor Hour Rate...........................................

b.
Direct Materials...................
Direct Labor.........................
Overhead Costs:
Production Setup...............
Order Processing...............
Materials Handling............
Equipment Depreciation
and Maintenance...........
Quality Control..................
Shipping............................
Total Overhead....................
Total Cost............................

Razors
$ 8,000
8,000

$50 Per Hour (= $500,000/

10,000 Hours)

Slims
$ 5,000
6,000

Eagles
$ 4,000
3,480

600a
4,000b
2,000c

$ 1,200
4,000
1,000

$ 3,600
2,000
1,000

4,800d
2,500e
3,000f
$16,900
$32,900

2,400
2,500
2,000
$13,100
$24,100

2,400
2,500
1,000
$12,500
$19,980

a$600 = $300 per run X 2 runs.

b$4,000 = $250 per order X 16 orders.
c$2,000 = $2.50 per pound X 800 pounds.
d$4,800 = $6.00 per hour X 800 hours.
e$2,500 = $125 per inspection X 20 inspections.

Solutions

3-18

f$3,000 = $1.00 per unit X 3,000 units.

3.39 continued
c.

Difference between Product Costs

Here are the cost numbers generated by the traditional method:
Direct Materials...................
Direct Labor.........................
Overheada..........................
Total Costs........................

Razors
$ 8,000
8,000
20,000
$36,000

Slims
$ 5,000
6,000
15,000
$26,000

Eagles
$ 4,000
3,480
8,700
$16,180

aNumber of hours X $50 per hour.

Re: Product-Cost Discrepancy

The discrepancy between product costs is due to the manner in

which overhead is assigned to the products using activity-based
costing versus the traditional method of allocating overhead
based on labor hours. The allocation of overhead under the
traditional method is based on the amount of labor each line
consumes. This may not be related to overhead resource
consumption.
For instance, consider setups. Note that one setup is required for
each production run. The Eagles line uses 0.012 setups per unit (= 12
setups/1,000 units produced) while the Razors line uses 0.00067
setups per unit (= 2 setups/3,000 units). The Eagles line uses 18
times as many setup resources per unit, yet is assigned only 2.3
times as much overhead on the basis of labor hours (2.3 = 400 hours
for Razors/174 hours for Eagles).
Activity-based costing provides more detailed and probably more
accurate information than the traditional method. ABC focuses on the
activities that drive costs, recognizing that activities consume
resources. The costs of those resources are then assigned to the
product for which the activity is required. Thus, each line is assigned
the costs that are incurred due to actual usage of resources.

3-19

Solutions

3.40

(Choosing an ABC system.)

a.

FreeWheeler, Ltd.
Income Statement
Featherweight

Peak

Raider

Total

Sales.............................. $ 760,000 $1,120,000 $ 950,000 $2,830,000

Direct Costs:
Direct Materials........... $ 300,000 $ 480,000 $ 400,000 $1,180,000
Direct Labor................
28,800
48,000
108,000
184,800
a
Variable Overhead ....... 104,400
167,040
250,560
522,000
Contribution Margin....... $ 326,800 $ 424,960 $ 191,440 $ 943,200
Plant and Administration.............................
176,000
Other Fixed Overhead. . .
280,000
Operating Profit.............
$ 487,200
aOverhead rate = $10.44 = $522,000/50,000 hours.
$104,400 = $10.44 X 10,000 hours;
$167,040 = $10.44 X 16,000 hours;
$250,560 = $10.44 X 24,000 hours.

Solutions

3-20

3.40 continued.
b.

FreeWheeler, Ltd.
Income Statement
Featherweight

Peak

Raider

Total

Sales.............................. $ 760,000 $1,120,000 $ 950,000 $2,830,000

Direct Costs:
Direct Materials........... $ 300,000 $ 480,000 $ 400,000 $1,180,000
Direct Labor................
28,800
48,000 108,000
184,800
Variable Overhead:
Machine Setupa..........
10,400
18,200
23,400
52,000
b
Order Processing .......
32,000
48,000
48,000
128,000
c
Warehousing .............
46,500
46,500
93,000
186,000
Depreciation of Machineryd..................
16,800
26,880
40,320
84,000
e
Shipping ....................
4,800
19,200
48,000
72,000
Contribution Margin....... $ 320,700 $ 433,220 $ 189,280 $ 943,200
Plant Administration......
176,000
Other Fixed Overhead. . .
280,000
Operating Profit.............
$ 487,200
a$10,400 = $52,000/80 production runs X 16 production runs; etc.
b$32,000 = $128,000/1,600 X 400; etc.
c$46,500 = $186,000/800 X 200; etc.
d$16,800 = $84,000/50,000 X 10,000; etc.
e$4,800 = $72,000/15,000 X 1,000; etc.
c.

The activity-based costing method provides a more detailed

breakdown of costs.
This additional information should enable
management to make better decisions. For example, if management
wants to reduce costs then activity-based costing will identify the
activities on which management should focus its cost reducing efforts.
For example, warehousing costs are high and particularly high for the
Raider in view of its sales volume.

d.

Some costs may have no relationship to any volume or activity base.

To artificially allocate these costs would distort the accounting
information used for pricing, evaluation, etc. A preferable method of
handling these costs might be to require a contribution margin from
each product that must cover a portion of unallocated costs.

3-21

Solutions

3.41

(Resources used versus resources supplied.)

a.

b.

Solutions

Resources:

Supplied

Used
=
($5 X 2,500)
= $12,500

Materials...........................

$12,500

Short-Term Labor..............
....................................750

7,000

($25 X 250)
= $6,250

Setups...............................
....................................100

2,500

($80 X 30)
= $2,400

Purchasing........................
....................................100

4,600

($60 X 75)
= $4,500

Customer Service..............

650

($30 X 17)
= $510

Marketing..........................
....................................700

5,500

($40 X 120)
= $4,800

Administrative...................
......................................50

3,800

($30 X 125)
= $3,750

Unused
$

140

Managers should know what resources are unused so they can make
better decisions regarding eliminating unused resources or utilizing
them for some other purpose or product, and for decisions regarding
increasing production (what impact increasing production will have on
costs). For instance, management might use the information to
eliminate a portion of short-term labor.

3-22

3.42

(Activity-based reporting.)
a.

Flodesk, Ltd.
Traditional Income Statement
for the Month Ending March 31
Sales..................................................................................... $ 100,000
Costs:
Parts Management.....................................
$ 3,500
Energy.......................................................
5,000
Quality Inspections....................................
5,000
Long-Term Labor.......................................
3,500
Short-Term Labor.......................................
2,400
Setups........................................................
10,000
Materials....................................................
15,000
Depreciation..............................................
10,000
Marketing...................................................
7,500
Customer Service......................................
2,000
Administrative...........................................
7,000
Engineering................................................
2,500
Contracts...................................................
3,000
Total Costs............................................................................
76,400
Operating Profits.................................................................. $ 23,600

b.

Flodesk, Ltd.
Activity-Based Income Statement
for the Month Ending March 31
Sales..................................................................................... $ 100,000
Resources Unused Resources
Used
Capacity Supplied
Costs:
Parts Management...... $ 3,000 $
500 $ 3,500
Energy........................
5,000
0
5,000
Quality Inspections.....
4,500
500
5,000
Long-Term Labor........
2,500
1,000
3,500
Short-Term Labor........
2,000
400
2,400
Setups.........................
7,000
3,000
10,000
Materials.....................
15,000
0
15,000
Depreciation...............
6,000
4,000
10,000
Marketing....................
7,000
500
7,500
Customer Service........
1,000
1,000
2,000
Administrative.............
5,000
2,000
7,000
Engineering.................
2,500
0
2,500
Contracts....................
3,000
0
3,000
Total Costs..................... $ 63,500 $ 12,900 $ 76,400
Operating Profits.................................................................. $ 23,600

3-23

Solutions

3.42 continued.
c.

Solutions

Activity-based reports differentiate between resources used and those

supplied. Providing information on unused resources helps managers
make better decisions to lower costs or use resources more
efficiently.

3-24

3.43

(Activity-based reporting.)
a.

HALLOWAY CORPORATION
Traditional Income Statement
for the Month Ending March 31
Sales..................................................................................... $350,000
Costs:
Marketing...................................................
$ 30,000
Depreciation..............................................
40,000
Outside Contracts......................................
12,000
Materials....................................................
60,000
Setups........................................................
20,000
Energy.......................................................
21,000
Parts Management.....................................
16,000
Engineering Changes.................................
12,000
Short-Term Labor.......................................
7,000
Long-Term Labor.......................................
14,000
Administrative...........................................
26,000
Quality Inspections....................................
22,000
Customer Service......................................
8,000
Total Costs...................................................
288,000
Operating Profits................................................................... $ 62,000

b.

HALLOWAY CORPORATION
Activity-Based Income Statement
for the Month Ending March 31
Sales..................................................................................... $ 350,000
Resources Unused Resources
Used
Capacity Supplied
Costs:
Marketing................. $ 28,000 $ 2,000 $ 30,000
Depreciation.............
24,000
16,000
40,000
Outside Contracts.....
12,000
0
12,000
Materials..................
60,000
0
60,000
Setups......................
14,000
6,000
20,000
Energy......................
20,000
1,000
21,000
Parts Management. . .
15,000
1,000
16,000
Engineering Changes
10,000
2,000
12,000
Short-Term Labor.....
7,000
0
7,000
Long-Term Labor......
10,000
4,000
14,000
Administrative..........
20,000
6,000
26,000
Quality Inspections...
20,000
2,000
22,000
Customer Service.....
6,000
2,000
8,000
Total Costs.................. $ 246,000 $ 42,000 $ 288,000
Operating Profits.................................................................. $ 62,000

3-25

Solutions

3.43 continued.
c.

3.44

Activity-based reports differentiate between resources used and those

supplied. Providing information on unused resources helps managers
make better decisions to lower costs or use resources more
efficiently.

(The Grape Cola Caper.)

a.

Cost driver rates are shown in the far right column

below:

Activity

Cost Driver

Machine Setups........... Setup labor hrs.

Production Runs.......... Number of runs
Manage Products......... Number of
products
Machine Capacity........ Machine hours
Total Indirect Costs...............................

Estimated
Overhead
Cost
for the
Activity

Estimated
Number
of Cost
Driver
Units

Rate

$ 11,200a 560 hours $20 per hour

22,000b 110 runs $200 per run
4,800c 4 products $1,200 per product
14,000d 10,000 hrs. $1.40 per hour
$ 52,000

a$11,200 = $20,000 indirect laborX 40% X 1.4 fringe benefits.

b$22,000= ($20,000 indirect labor X 50% X 1.4 fringe benefits) +
($10,000 IT costs X 80%).
c$4,800= ($20,000 indirect labor X 10% X 1.4 fringe benefits) +
($10,000 IT costs X 20%).
d$14,000 = $52,000 total indirect costs $11,200 $22,000 $4,800.
b.

Unit product costs are displayed in the chart below.

Calculations are shown below the chart.

Materials........................
Direct Labor...................
Fringe Benefits on DL....
Machine Setups.............
Production Runs............
Managing Products........
Machine Capacity..........
Cost per Unit...............

Diet
$ 0.50
0.20
0.08
0.08
0.16
0.024
0.14
$ 1.184

(See following page for Calculations)

Solutions

3-26

Regular
$ 0.50
0.20
0.08
0.03
0.15
0.03
0.14
$ 1.13

Cherry
$ 0.52
0.20
0.08
0.533
0.667
0.133
0.14
$ 2.273

Grape
$ 0.55
0.20
0.08
1.20
2.00
1.20
0.14
$ 5.37

3.44 b. continued.
Calculations: Unit costs for the Diet product are calculated below.
Materials:
$0.50 = $25,000 (given)/50,000 units
Direct Labor:
$0.20 = $10,000 (given)/50,000 units
Fringe Benefits
on DL:
$0.08 = $4,000 (given)/50,000 units
Machine Setups:
$0.08 = ($20 rate X 200 hours)/50,000 units
Production Runs:
$0.16 = ($200 rate X 40 runs)/50,000 units
Managing Production: $0.024 = $1,200 rate/50,000 units
Machine Capacity:
$0.14 = ($1.40 rate X 5,000 hours)/50,000
units
c.

Monthly Report on Cola Bottling Line

Sales.........................
Less:
Materials................
Direct Labor...........
Fringe Benefits
on DL.................
Machine Setups.....
Production Runs.....
Managing
Production..........
Machine Capacity. .
Gross Margin......
Return on Sales........
13.53%
Volume.....................
Unit Price..................
Unit Cost..................

Diet
Regular
$ 75,000 $60,000

Cherry
$13,950

Grape
Total
$ 1,650 $ 150,600

25,000
10,000

20,000
8,000

4,680
1,800

550
200

50,230
20,000

4,000
4,000
8,000

3,200
1,200
6,000

720
4,800
6,000

80
1,200
2,000

8,000
11,200
22,000

1,200
1,200
7,000
5,600
$ 15,800 $14,800
21.07%
24.67%

1,200
1,200
4,800
1,260
140
14,000
$ (6,510) $ (3,720) $ 20,370
(46.67%)
(225.45%)

50,000
$1.50
$1.184

9,000
$1.55
$2.273

40,000
$1.50
$1.13

1,000
$1.65
$5.37

100,000
$1.506
$1.302

Calculations: Total costs for the Diet product are calculated below.
Materials:
$25,000 (given)
Direct Labor:
$10,000 (given)
Fringe Benefits
on DL:
$4,000 (given)
Machine Setups:
$4,000 = $20 rate X 200 hours
Production Runs:
$8,000 = $200 rate X 40 runs
Managing Production: $1,200 rate X 1 product
Machine Capacity:
$7,000 = $1.40 rate X 5,000 hours.

3-27

Solutions

3.44 continued.
d.

Answers will vary, but should address a comparison of

unit profit and cost data using the traditional approach
versus activity-based costing.
The data below
summarize some important differences between the two
approaches. These data show that the Diet and Regular
products are significantly more profitable than originally
thought, and the Cherry and Grape products are
significantly less profitable than originally thought. As
sales increase for the Cherry and Grape products, the
company will see declining profits.
Diet

Unit Price
Unit Cost
Unit Profit
Return on Sales

3.45

ABC
$ 1.50
1.18
$ 0.32
21.1%

Tradl.
$ 1.50
1.30
$ 0.20
13.3%

Regular
ABC
$1.50
1.13
$0.37
24.7%

Cherry

Tradl.
$1.50
1.30
$0.20
13.3%

ABC
$1.55
2.27
($0.72)
(46.5%)

Grape

Tradl.
$1.55
1.32
$0.23
14.8%

ABC Tradl.
$1.65 $1.65
5.37
1.35
($3.72) $0.30
(225%)18.2%

(The Grape Cola Caper; unused capacity.)

a. Cost driver rates are shown in the far right column

below.
Note that the rate for Machine capacity
decreases to $0.70 if practical capacity is 20,000 hours
instead of 10,000 hours (new information is in boldface
type).

Activity

Cost Driver

Machine Setups........ Setup labor hrs.

Production Runs....... Number of runs
Manage Products...... Number of
products
Machine Capacity..... Machine hours

Estimated
Overhead
Cost
for the
Activity

Estimated
Number
of Cost
Driver
Units

$ 11,200
22,000

560 hours
110 runs

2,000
14,000

Rate

$20 per hour

$200 per run

4 products $1,200 per product

20,000 hrs. $0.70 per hour

Unit product costs are displayed in the chart below. Calculations are
the same as for Part b. of Case 3.44 except for machine capacity.
Materials........................
Direct Labor...................
Fringe Benefits on DL....
Machine Setups.............
Production Runs............
Managing Products........
Machine Capacity..........
Cost per Unit...............

Solutions

Diet
$ 0.50
0.20
0.08
0.08
0.16
0.024
0.07
$ 1.114

3-28

Regular
$ 0.50
0.20
0.08
0.03
0.15
0.03
0.07
$ 1.06

Cherry
$ 0.52
0.20
0.08
0.533
0.667
0.133
0.07
$ 2.203

Grape
$ 0.55
0.20
0.08
1.20
2.00
1.20
0.07
$ 5.30

3.45 continued.

b. The cost of unused capacity is $7,000 (= 10,000

machine hours of unused capacity X $0.70 per hour
rate).
Recommendations could include increasing
production of current products if demand allows,
introducing new product lines, or leasing the unused
capacity to other divisions or outside firms.
c.

Costs for the Vanilla product are as follows:

Materials....................................................
Direct Labor...............................................
Fringe Benefits on DL................................
Machine Setups.........................................
Production Runs.........................................
Managing Production.................................
Machine Capacity......................................
Total Cost per Unit..................................

Cost
Per Unit
$ 0.50
0.20
0.08
0.08
0.16
0.024
0.07
$ 1.114

Total
Cost
$ 50,000
20,000
8,000
8,000
16,000
2,400
7,000
$ 111,400

Note that the answer above assumes that the Vanilla product is
assigned all machine capacity costs. However, if this is a short run
decision, machine capacity costs should be excluded from the unit
costs. (That is, the machine capacity costs will be incurred in the
short run regardless of whether a new product is introduced.)
3.46

(Chocolate
Bars,
Inc.;
distortions
caused
inappropriate overhead allocation bases.)

a.
Product Costs:
Labor Hours per Unit...........
Total Units Produced............
Material Cost per Unit..........
Direct Labor Cost per
Unit..................................
Labor Hours per Product......

by

Almond
Dream

Krispy
Krackle

Creamy
Crunch

7
1,000
$ 8.00

3
1,000
$ 2.00

1
1,000
$ 9.00

$42.00
7,000

$18.00
3,000

$ 6.00
1,000

Total overhead = $69,500.

Total Labor Hours = 11,000.
Direct Labor Costs per Hour = $6.00.
Allocation Rate per Labor Hour = $6.32 per Labor Hour.

3-29

Solutions

3.46 a. continued.
Costs of Products:
Material Cost per Unit..........
Direct Labor Cost per
Unit..................................
Allocated Overhead per
Unit..................................
Product Cost........................
Selling Price............................
Gross Profit Margin.................
Drop Product..........................

$ 8.00

$ 2.00

$ 9.00

42.00

18.00

6.00

44.24
$ 94.24
$ 85.00
10.87%
Yes

18.96
$ 38.96
$ 55.00
29.16%
No

6.32
$ 21.32
$ 35.00
39.09%
No

From the table above, we can see that the overhead allocation system
used by CBI would lead them to drop Almond Dream and keep the
remaining two bars, Krispy Krackle and Creamy Crunch.
b.

Almond Dream has a much higher proportion of direct labor hours

than Krispy Krackle or Creamy Crunch, so Almond Dream is allocated
a greater share of the overhead costs.

c.
Direct Labor Cost per Hour.............................
Direct Labor Hours per Unit............................
Total Units Produced.......................................
Labor Hours per Product.................................
Total Labor Hours: 5,000
Allocation Rate per Labor Hour

3-30

Creamy
Crunch
$ 6.00
1
2,000
2,000

= Total Overhead/Total Labor Hours

= $69,500/5,000
= $13.90 per Labor Hour

Allocated Production Costs:

Material Cost per Unit.................................
Direct Labor Cost per Unit..........................
Allocated Overhead per Unit ($13.90 per
Labor Hour).............................................
Product Cost...............................................

Solutions

Krispy
Krackle
$ 6.00
3
1,000
3,000

Krispy
Krackle

Creamy
Crunch

$ 2.00
18.00

$ 9.00
6.00

41.70
$ 61.70

13.90
$ 28.90

3.46 c. continued.
Gross Profit Margins:
Selling Price................................................
Product CostDirect Labor Allocation
Base........................................................

$ 55.00

$ 35.00

61.70
28.90
$ (6.70) $ 6.10
Profit Margin Percentage............................ ($6.70)/$55 $6.10/$35
= (12.2)%
= 17.4%

The recommendation to management is to drop Krispy Krackle and

increase production of Creamy Crunch.
d.

Creamy
Crunch
$ 6.00
1
3,000
3,000

Direct Labor Cost per Hour...............................................

Direct Labor Hours per Unit..............................................
Total Units Produced.........................................................
Labor Hours per Product...................................................
Total Labor Hours: 3,000
Allocation Rate per Labor Hour

= Total Overhead/Total Labor Hours

= $69,500/3,000
= $23.17 per Labor Hour
Creamy
Crunch

Allocated Production Costs:

Material Cost per Unit.............................................
Direct Labor Cost per Unit......................................
Allocated Overhead per Unit ($13.90 per
Labor Hour).........................................................
Product Cost...........................................................
Gross Profit Margins:
Selling Price............................................................
Product CostDirect Labor Allocation
Base....................................................................
Profit Margin Percentage........................................

9.00
6.00

23.17
$ 38.17
$ 35.00
38.17
$ (3.17)
($3.17)/$35.00
= (9.1)%

The recommendation to management is to drop Creamy Crunch and

sell out!

3-31

Solutions

3.46 continued.
e.

The policies and allocation method employed by CBI encourage poor

decision making. The direct labor hours are inappropriate as an
allocation base and give misleading information.
The allocation
method and policy to drop products with gross profit margins less
than 10 percent could lead to the systematic elimination of all
products. CBI is a profitable firm, in total, and misallocation of
overhead can lead management to make unprofitable decisions.

3.47

(Chocolate Bars, Inc.; multiple allocation bases.)

a.

Almond
Dream

Krispy
Krackle

Creamy
Crunch

Total

Total Direct
Labor Hoursa...... 7,000 (63.6%) 3,000 (27.3%) 1,000 (9.1%) 11,000 (100%)
Total Machine
Hoursa................ 2,000 (13.3%) 7,000 (46.7%) 6,000(40.0%) 15,000 (100%)
Factory Space
(Sq. Ft.)............... 1,000 (10.0%) 4,000 (40.0%) 5,000(50.0%) 10,000 (100%)

aTotals equal hours per unit times 1,000 units.

Total Rent for Factory Space:
Total Machine Operating Costs:
Total Other Overhead:
Total Units Produced/Month:

$15,000 per Month

$30,000 per Month
$24,500 per Month (= $69,500
$15,000 $30,000)
3,000 Units

Product Allocation Base:

Fraction:
Almond Dream.................
Krispy Krackle..................
Creamy Crunch................

Labor (%)
63.6
27.3
9.1

Machine
Hours (%)
13.3
46.7
40.0

Allocated Costs:
Total
Almond Dream (63.6% X $24,500) +
(13.3% X $30,000) + (10% X $15,000). . = $21,072
Krispy Krackle (27.3% X $24,500) +
(46.7% X $30,000) + (40% X $15,000)... = 26,699
Creamy Crunch (9.1% X $24,500) +
(40% X $30,000) + (50% X $15,000)...... = 21,730

Solutions

3-32

Factory
Space (%)
10
40
50
Per
Unit
$ 21.07
$ 26.70
$ 21.73

3.47 a. continued.

Allocated Production Costs:

Material Cost.............................
Direct Labor..............................
Allocated Overhead...................
Production Cost per Unit...........
Selling Price..............................
Product Cost.............................
Gross Profit (Loss).....................
Profit Margin Ratio....................
b.

Almond
Dream

Krispy
Krackle

Creamy
Crunch

$ 8.00
42.00
21.07
$ 71.07
$ 85.00
71.07
$ 13.93
16.4%

$ 2.00
18.00
26.70
$ 46.70
$ 55.00
46.70
$ 8.30
15.1%

$ 9.00
6.00
21.73
$ 36.73
$ 35.00
36.73
$ (1.73)
(4.9)%

Based upon the table above and the gross profit margin rule,
management would recommend dropping Creamy Crunch.
Two
characteristics of Creamy Crunch appear to make it appear relatively
unprofitable: one, the selling price is comparatively low as compared
to the other two products; two, Creamy Crunch uses 50% of the
factory space and thus is allocated half of the rent costs.

c.
Direct Labor Hours per Unit..........
Machine Hours per Unit................
Factory Space (Sq. Ft.)a................
Units of Output per Month............
Labor Hours Required...................
Machine Hours Required...............

Almond
Dream
7
2
2,000 (33.3%)
2,000
14,000 (82.4%)
4,000 (36.4%)

Krispy
Krackle
3
7
4,000 (66.7%)
1,000
3,000 (17.6%)
7,000 (63.6%)

aThis product mix leaves 4,000 square feet of space available.

Total
Total
Total
Total
Total
Total

Rent for Factory Space:

Machine Operating Costs:
Other Overhead:
Labor Hours:
Units Produced:
Machine Hours:

$15,000 per Month

$30,000 per Month
$24,500 per Month
17,000 per Month
3,000 Units per Month
11,000 Hours

Product Allocation Base:

Fraction:
Almond Dream.................
Krispy Krackle..................

Machine
Factory
Labor (%) Hours (%) Space (%)
82.4
36.4
33.3 (Rounded)
17.6
63.6
66.7 (Rounded)

3-33

Solutions

3.47 c. continued.
Allocated Costs:
Total
Almond Dream (82.4% X $24,500) +
(36.4% X $30,000) + (33.3% X $15,000) .... =
$
$ 18.05
Krispy Krackle (17.6% X $24,500) +
(63.6% X $30,000) + (66.7% X $15,000) .... =
$
$ 33.39

Allocated Production Costs:

Material Cost..............................................
Direct Labor...............................................
Allocated Overhead...................................
Production Cost per Unit............................
Selling Price...............................................
Product Cost..............................................
Gross Profit................................................
Profit Margin Ratio:
Ratio = Gross Profit/Price.......................

Per
Unit
36,103
33,397

Almond
Dream

Krispy
Krackle

$ 8.00
42.00
18.05
$ 68.05
$ 85.00
68.05
$ 16.95

$ 2.00
18.00
33.39
$ 53.39
$ 55.00
53.39
$ 1.61

19.9%

2.9%

Based on the gross profit margins of Almond Dream and Krispy

Krackle, management should drop Krispy Krackle and continue to
produce Almond Dream. Almond Dream appears to be the most
profitable product. In fact, its margin ratio is only 13.9%, computed
as follows:
Units Produced = 3,000.
Overhead Allocation = $69,500/3,000 = $23.17.
Almond
Dream
Allocated Production Costs:
Material Cost..............................................
Direct Labor...............................................
Allocated Overhead...................................
Production Cost per Unit............................
Selling Price...............................................
Product Cost..............................................
Gross Profit................................................
Profit Margin Ratio:
Ratio = Gross Profit/Price.......................

$ 8.00
42.00
23.17
$ 73.17
$ 85.00
73.17
$ 11.83
13.9%

If we compute the gross profit for the three products at maximum

production, we find Almond Dream and Krispy Krackle to be equally
profitable, computed as follows:

Solutions

3-34

3.47 c. continued.
Almond
Dream
3,000

Units....................................
Costs:
Materials........................... $ 24,000
Labor................................. 126,000
Overhead..........................
69,500
$ 219,500
Revenue............................... $ 255,000
Minus Total Costs................. 219,500
Gross Profit (Loss)............... $ 35,500

Krispy
Krackle
3,000
$

6,000
54,000
69,500
$ 129,500
$ 165,000
129,500
$ 35,500

Creamy
Crunch
3,000
$ 27,000
18,000
69,500
$ 114,500
$ 105,000
114,500
$ (9,500)

Moral: Allocated cost numbers can mislead decision makers.

This page is intentionally left blank

3-35

Solutions