EX. 6.

18

The receiving department has three activities: unloading, counting goods and
inspecting. Unloading uses a forklift that is leased for $15 000 per year. The forklift
is used only for unloading. The fuel for the forklift is $3600 per year. Other operating
costs (maintenance) for the forklift total $1500 per year. Inspection uses some
special testing equipment that has a depreciation of $1200 per year and an
operating cost of $750. Receiving has three employees who have an average salary
of $50 000 per year. The work distribution matrix for the receiving personnel is as
follows:

Activity Percentage of Time

Unloading 40%

Counting 25

Inspecting 35
No other resources are used for these activities.

1. Calculate the cost of each activity.

2. Explain the two methods used to assign costs to activities.

EX. 6-20

Tristar Manufacturing produces two types of battery-operated toy soldiers: infantry

and special forces. The soldiers are produced by using one continuous process. Four
activities have been identified: machining, set-ups, receiving and packing. Resource
drivers have been used to assign costs to each activity. The overhead activities, their
costs and the other related data are as follows:

Product Machine Set-Ups Receiving Orders Packing Orders

Hours

Infantry 20 000 300 900 1 600

Special forces 20 000 100 100 800

Costs $80 000 $24 000 $18 000 $30 000

Required:
1. Calculate the total overhead assigned to each product by using only machine hours
to calculate a plant-wide rate.
2. Calculate consumption ratios for each activity. (Note: Round to two significant
digits.)
3. Calculate a rate for each activity by using the associated driver.
4. Assign the overhead costs to each product by using the activity rates computed in
requirement 3.
5. Comment on the difference between the assignment in requirement 1 and the
activity-based assignment.
P. 6-23

For years, Tamarindo Company produced only one product: backpacks. Recently,
Tamarindo added a line of duffel bags. With this addition, the company began
assigning overhead costs by using departmental rates. (Prior to this, the company
used a predetermined plant-wide rate based on units produced.) Surprisingly, after
the addition of the duffel-bag line and the switch to departmental rates, the costs to
produce the backpacks increased and their profitability dropped.

Josie, the marketing manager, and Steve, the production manager, both complained
about the increase in the production cost of backpacks. Josie was concerned because
the increase in unit costs led to pressure to increase the unit price of backpacks. She
was resisting this pressure because she was certain that the increase would harm
the company’s market share. Steve was receiving pressure to cut costs also, yet he
was convinced that nothing different was being done in the way the backpacks were
produced. After some discussion, the two managers decided that the problem had to
be connected to the addition of the duffel-bag line.

Upon investigation, they were informed that the only real change in product costing
procedures was in the way overhead costs are assigned. A two-stage procedure was
now in use. First, overhead costs are assigned to the two production departments:
Patterns and Finishing. Second, the costs accumulated in the production
departments are assigned to the two products by using direct labour hours as a
driver (the rate in each department is based on direct labour hours). The managers
were assured that great care was taken to associate overhead costs with individual
products. So that they could construct their own example of overhead cost
assignment, the controller provided them with the information necessary to show
how accounting costs are assigned to products:
 Department

Patterns Finishing Total

Accounting cost $30 000 $90 000 $120 000

Transactions processed 20 000 60 000 80 000

Total direct labour hours 15 000 30 000 45 000

Direct labour hours per backpack 0.10 0.20 0.30

Direct labour hours per duffel bag 0.20 0.40 0.60

The controller remarked that the cost of operating the accounting department had
doubled with the addition of the new product line. The increase came because of the
need to process additional transactions, which had also doubled in number.

During the first year of producing duffel bags, the company produced and sold 100
000 backpacks and 25 000 duffel bags. The 100 000 backpacks matched the prior
year’s output for that product.

1. Compute the amount of accounting cost assigned to a backpack before the duffel-bag
line was added by using a plant-wide rate approach based on units produced. Is this
assignment accurate? Explain.
2. Suppose that the company decided to assign the accounting costs directly to the
product lines by using the number of transactions as the activity driver. What is the
accounting cost per unit of backpacks? Per unit of duffel bags?
3. Compute the amount of accounting cost assigned to each backpack and duffel bag by
using departmental rates based on direct labour hours.
4. Which way of assigning overhead does the best job – the functional-based approach
by using departmental rates or the activity-based approach by using transactions
processed for each product? Explain. Discuss the value of ABC before the duffel-bag
line was added.
 P.6-24

Ramsey Company produces speakers (Model A and Model B). Both products pass
through two production departments. Model A’s production is much more labour-
intensive than that of Model B.

Model B is also the more popular of the two speakers. The following data have been
gathered for the two products:

Required:
1. Compute the overhead cost per unit for each product by using a plant-wide rate
based on direct labour hours. (Note: Round to two decimal places.)
2. Compute the overhead cost per unit for each product by using ABC. (Note: Round
rates and unit overhead cost to two decimal places.)
3. Suppose that Ramsey decides to use departmental overhead rates. There are two
departments: Department 1 (machine intensive) with a rate of $3.50 per machine
hour and Department 2 (labour intensive) with a rate of $0.90 per direct labour
hour. The consumption of these two drivers is as follows:

Department 1 Machine Hours Department 2 Direct Labour Hours

Model A 10 000 130 000

Model B 170 000 270 000

4. Compute the overhead cost per unit for each product by using departmental rates.
(Note: Round to two decimal places.)

5. Using the activity-based product costs as the standard, comment on the ability of
departmental rates to improve the accuracy of product costing. Did the
departmental rates do better than the plant-wide rate?

C.6-27
Sharp Paper Pty Ltd has three paper mills, one of which is located in Perth, Western
Australia. The Perth mill produces 300 different types of coated and uncoated
specialty printing papers. Management was convinced that the value of the large
variety of products more than offset the extra costs of the increased complexity.

During 2016, the Perth mill produced 120 000 tonnes of coated paper and 80 000
tonnes of uncoated paper. Of the 200 000 tonnes produced, 180 000 were sold. Sixty
products account for 80 per cent of the tonnage sold. Thus, 240 products are
classified as low-volume products.

Lightweight lime hopsack in cartons (LLHC) is one of the low-volume products.

LLHC is produced in rolls, converted into sheets of paper and then sold in cartons. In
2016 the cost to produce and sell one tonne of LLHC was as follows.

Overhead is allocated by using a two-stage process. First, overhead is allocated to

the paper and finishing machines by using the direct method of allocation with
carefully selected cost drivers. Second, the overhead assigned to each machine is
divided by the budgeted tonnes of output. These rates are then multiplied by the
number of kilograms required to produce one good tonne.

In 2016, LLHC sold for $2400 per tonne, making it one of the most profitable
products. A similar examination of some of the other low-volume products revealed
that they also had very respectable profit margins. Unfortunately, the performance
of the high-volume products was less impressive, with many showing losses or very
low profit margins. This situation led Ryan Chesser to call a meeting with his
marketing director, Jennifer Woodruff, and his controller, Kaylin Penn.

RYAN:
The above-average profitability of our low-volume specialty products and the poor
profit performance of our high-volume products make me believe that we should
switch our marketing emphasis to the low-volume line. Perhaps we should drop some
of our high-volume products, particularly those showing a loss.
JENNIFER:
I’m not convinced that solution is the right one. I know our high-volume products are
of high quality, and I’m convinced that we are as efficient in our production as other
firms. I think that somehow our costs are not being assigned correctly. For example,
the shipping and warehousing costs are assigned by dividing these costs by the total
tonnes of paper sold. Yet …

KAYLIN:
Jennifer, I hate to disagree, but the $30-per-tonne charge for shipping and
warehousing seems reasonable. I know that our method to assign these costs is
identical to a number of other paper companies.

JENNIFER:
Well, that may be true, but do these other companies have the variety of products that
we have? Our low-volume products require special handling and processing, but when
we assign shipping and warehousing costs, we average these special costs across our
entire product line. Every tonne produced in our mill passes through our mill shipping
department and is either sent directly to the customer or to our distribution centre and
then eventually to customers. My records indicate quite clearly that virtually all of the
high-volume products are sent directly to customers, whereas most of the low-volume
products are sent to the distribution centre. Now, all of the products passing through
the mill shipping department should receive a share of the $2 000 000 annual shipping
costs. I’m not convinced, however, that all products should receive a share of the
receiving and shipping costs of the distribution centre as currently practised.

RYAN:
Kaylin, is this true? Does our system allocate our shipping and warehousing costs in
this way?

KAYLIN:
Yes, I’m afraid it does. Jennifer may have a point. Perhaps we need to re-evaluate our
method to assign these costs to the product lines.

RYAN:
Jennifer, do you have any suggestions concerning how the shipping and warehousing
costs should be assigned?

JENNIFER:
It seems reasonable to make a distinction between products that spend time in the
distribution centre and those that do not. We should also distinguish between the
receiving and shipping activities at the distribution centre. All incoming shipments are
packed on pallets and weigh one tonne each (there are 14 cartons of paper per pallet).
In 2016, the receiving department processed 56 000 tonnes of paper. Receiving
employs 15 people at an annual cost of $600 000. Other receiving costs total about
$500 000. I would recommend that these costs be assigned by using tonnes processed.

Shipping, however, is different. There are two activities associated with shipping:
picking the order from inventory and loading the paper. We employ 30 people for
picking and 10 for loading, at an annual cost of $1 200 000. Other shipping costs total
$1 100 000. Picking and loading are more concerned with the number of shipping
items than with tonnage. That is, a shipping item may consist of two or three cartons
 instead of pallets. Accordingly, the shipping costs of the distribution centre should be
assigned by using the number of items shipped. In 2016, for example, we handled 190
000 shipping items.

RYAN:
These suggestions have merit. Kaylin, I would like to see what effect Jennifer’s
suggestions have on the per-unit assignment of shipping and warehousing for LLHC. If
the effect is significant, then we will expand the analysis to include all products.

KAYLIN:
I’m willing to compute the effect, but I’d like to suggest one additional feature.
Currently, we have a policy to carry about 25 tonnes of LLHC in inventory. Our current
costing system totally ignores the cost of carrying this inventory. Since it costs us
$1665 to produce each tonne of this product, we are tying up a lot of money in
inventory – money that could be invested in other productive opportunities. In fact, the
return lost is about 16 per cent per year. This cost should also be assigned to the units
sold.

RYAN:
Kaylin, this also sounds good to me. Go ahead and include the carrying cost in your
computation.

To help in the analysis, Kaylin gathered the following data for LLHC for 2016:

Tonnes sold 10

Average cartons per shipment 2

Average shipments per tonne 7

Required:
1. Identify the flaws associated with the current method of assigning shipping and
warehousing costs to Sharp’s products.
2. Compute the shipping and warehousing cost per tonne of LLHC sold by using the
new method suggested by Jennifer and Kaylin.
3. Using the new costs computed in requirement 2, compute the profit per tonne of
LLHC. Compare this with the profit per tonne computed by using the old method. Do
you think that this same effect would be realised for other low-volume products?
Explain.
4. Comment on Ryan’s proposal to drop some high-volume products and place more
emphasis on low-volume products. Discuss the role of the accounting system in
supporting this type of decision making.
5. After receiving the analysis of LLHC, Ryan decided to expand the analysis to all
products. He also had Kaylin re-evaluate the way in which mill overhead was
assigned to products. After the restructuring was completed, Ryan took the
following actions: (a) the prices of most low-volume products were increased, (b)
the prices of several high-volume products were decreased and (c) some low-
volume products were dropped. Explain why his strategy changed so dramatically.

Summary of Q6-27:
The company produces 300 types of papers.

60 high volume and low profitability sent directly to the customers (80% of total sales).

240 low volume and high profitability sent to the distribution canter.

The problem is how to allocate the Shipping and warehousing costs? Currently, these costs allocated to both types of
products that is sent to the customer, and that is sent to the distribution centre, using tonnes processed. However,
they should be only allocated to products that are sent to the distribution canter.

After the investigation, they found:

Receiving= $600,000 and $500,000, the allocation base is tonnes processed (56000 tonnes).

Shipping= $1200000 and $1100000, allocation base is the number of items shipped (190 000 shipping items).

the cost of carrying = 16% of the cost of inventory (for LLHC: 25 tonnes x $1665). This cost should be assigned to the
units sold (10 tonnes).

For LLHC (low volume product), we have 10 Tonnes sold; 7 shipments per tonne; previous shipping and warehousing
cost is $30.

Required:

1. Identify the flaws associated with the current method of assigning shipping and warehousing costs to Sharp’s
products.

2. Compute the shipping and warehousing cost per tonne of LLHC sold by using the new method suggested by
Jennifer and Kaylin.

3. Using the new costs computed in requirement 2, compute the profit per tonne of LLHC. Compare this with
the profit per tonne computed by using the old method. Do you think that this same effect would be realised for
other low-volume products? Explain.

4. Comment on Ryan’s proposal to drop some high-volume products and place more emphasis on low-volume
products. Discuss the role of the accounting system in supporting this type of decision making.

5. After receiving the analysis of LLHC, Ryan decided to expand the analysis to all products. He also had Kaylin
re-evaluate the way in which mill overhead was assigned to products. After the restructuring was completed, Ryan
took the following actions: (a) the prices of most low-volume products were increased, (b) the prices of several high-
volume products were decreased and (c) some low-volume products were dropped. Explain why his strategy
changed so dramatically.

C. 6-28

Consider the following conversation between Leonard Bryner, chief executive officer
and manager of a firm engaged in job manufacturing, and Charlie Davis, certified
management accountant, the firm’s controller.

LEONARD:
Charlie, as you know, our firm has been losing market share over the past three years.
We have been losing more and more bids and I don’t understand why. At first, I
thought that other firms were undercutting simply to gain business, but after
 examining some of the public financial reports, I believe that they are making a
reasonable rate of return. I am beginning to believe that our costs and costing
methods are at fault.

CHARLIE:
I can’t agree with that. We have good control over our costs. Like most firms in our
industry, we use a normal job-costing system. I really don’t see any significant waste in
the plant.

LEONARD:
After talking with some other managers at a recent industrial convention, I’m not so
sure that waste by itself is the issue. They talked about activity-based management,
activity-based costing and continuous improvement. They mentioned the use of
something called ‘activity drivers’ to assign overhead. They claimed that these new
procedures can help to produce more efficiency in manufacturing, better control of
overhead and more accurate product costing. A big deal was made of eliminating
activities that added no value. Maybe our bids are too high because these other firms
have found ways to decrease their overhead costs and to increase the accuracy of their
product costing.

CHARLIE:
I doubt it. For one thing, I don’t see how we can increase product costing accuracy. So
many of our costs are indirect costs. Furthermore, everyone uses some measure of
production activity to assign overhead costs. I imagine that what they are calling
‘activity drivers’ is just some new buzzword for measures of production volume. Fads
in costing come and go. I wouldn’t worry about it. I’ll bet that our problems with
decreasing sales are temporary. You might recall that we experienced a similar
problem about 12 years ago – it was two years before it straightened out.
Required:
1. Do you agree or disagree with Charlie Davis and the advice that he gave Leonard
Bryner? Explain.
2. Was there anything wrong or unethical in the behaviour that Charlie Davis
displayed? Explain your reasoning.
3. Do you think that Charlie was well informed – that he was aware of the accounting
implications of ABC and that he knew what was meant by activity drivers? Should he
have been well informed? Review (in Chapter 1) the first category of the Statement
of Ethical Professional Practice for management accountants. Do any of these
standards apply in Charlie’s case?