CHAPTER 14

DISCUSSION QUESTIONS

Q14-1.

Q14-2.

Q14-3.

Q14-4.

Q14-5.

Q14-6.

Q14-7.

Q14-8.

Q14-9.

Compared to traditional costing, ABC is a

more thorough application of cost traceability. Traditional costing traces only direct
material and direct tabor to output; ABC recognizes that many other costs are traceable,
if not to output, then to other cost objects
called activities.
The role of activities in assigning costs to
products, using ABC, is to serve as the link
between products and costs: activities are
required to produce output, and it is the
activities that consume resources, thus
causing costs to be incurred. This differs
from traditional costing in which output is
assumed to cause costs.
Examples of significant, costly activities in
manufacturing are setting up, changing
designs, receiving materials, requisitioning
materials, moving materials and products,
ordering from vendors, and inspecting.
The two circumstances that must be present
for a traditional costing system to report distorted product costs are a complex cost
structure and a diverse product line.
A complex cost structure is present if a significant part of overhead cost is not related
to the volume of output.
A diverse product line is one in which different products consume different mixes of volume-related and nonvolume-related costs.
The four levels of costs and drivers in ABC
are the unit level, the batch level, the product level, and the plant level.
If a product consumes 10% of all unit-level
activities and 30% of all batch-level activities, traditional costing will under-report its
cost by assigning 10% of all overhead costs
to the product, including 10% of batch-level
costs, when 30% of batch-level costs should
be assigned to the product.
When both low-volume and high-volume products are produced in a company using traditional costing, the low-volume product is likely
to have its cost distorted by a larger percentage than the high-volume product. The lowvolume products cost is generally distorted

Q14-10.

Q14-11.

Q14-12.

Q14-13.

Q14-14.

Q14-15.

Q14-16.

Q14-17.

14-1

downward by traditional costing, and the highvolume products cost is distorted upward.
In assigning plant-level costs to products,
ABC offers little or no advantage over traditional costing.
The difference between CM and ABC is primarily explained by the fact that ABC is a
long-run decision-making technique, while
CM is short-run analysis.
If a product is discontinued, the costs
reported for that product by ABC will not
necessarily be avoided, because ABC only
measures how resources are consumed by
products, not how spending will be affected
by discontinuing a product. Avoiding a cost
requires that less be spent on some
resource(s), and ABC does not predict
changes in spending. (This is also true of
traditional absorption costing.)
The relationship between ABC and ABM is
that ABM uses information obtained from
ABC to make improvements in the firm.
The area of ABM that follows directly from
ABCs revision of product costs is the strategic realignment of the firms pricing structure
and product line, permitting the firm to retain
or regain high-volume business in spite of
pricing pressure, and prompting management to reexamine the roles of some low-volume products.
The high costs of some activities, especially
non-value-added activities, can focus attention on the need to reduce or eliminate them.
ABC can lead to improved decisions in
designing a product because ABC tells the
cost of each activity required in producing
the product. This information permits designers to make design decisions more accurately, so that the most cost-effective design
can be selected.
The link between ABC and TQM is that ABC
reveals the costs of each activity, including
those that do not add value, and TQM seeks
to reduce or eliminate non-value-added activities. Thus, ABC can focus attention in a TQM
effort and can prioritize TQMs improvements.

14-2

Chapter 14

EXERCISES
E14-1 (a)
(b)
(c)
(d)

(e)
(f)
(g)

(h)
(i)
(j)
E 14-2 (a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)

B
U
U
Bbecause no finished goods inventory is maintained, each batch is
shipped immediately; therefore, shipments are most likely a batch-level
driver.
P
U
Pwhere large materials inventories are maintained, purchase orders are
not issued for each batch to be produced; instead, a withdrawal will be
made from inventory for each batch. Purchase orders are then identifiable
with the total annual requirements, which makes it a product-level driver,
i.e., it is traceable no farther than to products. If a purchased item is used
in several products, its purchase orders are at the level of the product
family or product line, which are even higher levels.
U
U
B
U
B
U
U
U
B
P
P

E14-3 The existing system allocated 1,500/30,000 = 5% of all overhead to Product #1

last year; but #1 accounted for only 30/1,000 = 3% of batch-level activity. So, with
respect to batch-level costs only, the existing system overstated #1s cost last
year by a total of:
(5% 3%) $100,000 = $2,000 overstatement
E14-4 The existing system allocated $15,000/$3,000,000 = 0.5% of materials-related
overhead to Product AA last year, but AA accounted for only 40/40,000 = 0.1% of
materials-related activity. So, with respect to materials-related overhead only, the
existing system overstated AAs cost last year by a total of:
(0.5% 0.1%) $1,200,000 = $4,800 overstatement

Chapter 14

14-3

E14-5 The existing system allocated only 600/50,000 = 1.2% of all overhead to Product
RK last year; but Product RK accounted for 132/6,000 = 2.2% of design change
activity last year. Therefore, with respect to design change costs only, the existing system understated RKs cost last year by a total of:
(2.2% 1.2%) $2,000,000 = $20,000 understatement
E14-6 The existing system allocated $40,000/$200,000 = 20% of all overhead to Product
BB last year; but BB accounted for only 6/200 = 3% of the activity of maintaining
supplies of purchased subassemblies last year. Therefore, with respect to the
cost of maintaining supplies of purchased subassemblies only, the existing system overstated BBs cost last year by a total of:
(20% 3%) $50,000 = $8,500 overstatement
E14-7
(1)
$126 of overhead cost will be allocated to a unit of #456, calculated as follows:
$1, 400, 000
90 machine hours = $12, 600;
10, 000 machine hours
$12, 600
= $126 per unit
100 units of Product # 456
(2)

$554 of overhead cost will be allocated to a unit of #456, calculated as follows:

$300, 000
6 setups = $15, 000 of batch level cost;
120 setups
$35,000 of
$500, 000
280 design hours = product-level cost;
4, 000 design hours
$5,400 of unit$200, 000 + $400, 000
and plant-level cost.
90 machine hours =
10, 000 machine hours
Therefore, the overhead allocated to a unit of Product #456 is:
($15,000 + $35,000 + $5,400)/100 units = $55,400/100 units = $554 per unit

14-4

Chapter 14

E14-8 Because the traditional system uses machine hours as the only allocation base,
Product #456 is allocated 90/10,000 = 0.9% of all overhead. The activity data indicate #456 should be assigned 6/120 = 5% of batch-level costs, 280/4,000 = 7% of
product-level costs, and 0.9% of all other overhead. The reconciliation is:

Cost of #456 from traditional system, as

calculated in part (1) of E14-7 .....................
Adjustments for.
Understatement of batch-level
costs, $300,000 (5% 0.9%).................
Understatement of product-level
costs, $500,000 (7% 0.9%).................
Total adjustments .........................................
Cost of #456 from ABC system, as
calculated in part (2) of E14-7 ....................

Total

Per
Unit

$12,600

$126

$42,800

428

$55,400

$554

$12,300
30,500

E14-9
(1)
$140 of overhead cost will be allocated to a unit of #456, calculated as follows:
$1, 400, 000
200 DL hours = $14, 000;
20, 000 DL hours
$14, 000
= $140 per unit
100 units of Product # 456
(2)

$740 of overhead cost will be allocated to a unit of #456, calculated as follows:

$300, 000
30 setuphours = $18, 000 of batch-level costt;
500 setup hours
$500, 000
$50,000 of product-level
4 design changes =
cost;
40 design hours
$200, 000 + $400, 000 200 direct labor
$6,000 of unit
=
hours
and
plant-level cost.
20, 000 DL hours
Therefore, the overhead allocated to a unit of Product #456 is:
($18,000 + $50,000 + $6,000)/100 units = $74,000/100 units = $740 per unit

Chapter 14

14-5

E14-10 Because the traditional system uses direct labor hours as the only allocation
base, Product #456 is allocated 200/20,000 = 1% of all overhead. The activity
data indicate #456 should be assigned 30/500 = 6% of batch-level costs, 4/40 =
10% of product-level costs, and 1% of all other overhead. The reconciliation is:
Total
Cost of #456 from traditional system, as
calculated in part (1) of E14-9 .....................
Adjustments for:
Understatement of batch-level
costs, $300,000 (6% 1%)....................
Understatement of product-level
costs, $500,000 (10% 1%)..................
Total adjustments ........................................
Cost of #456 from ABC system, as
calculated in part (2) of E14-9 .....................

Per
Unit

$14,000

$140

$60,000

600

$74,000

$740

$15,000
45,000

E14-11 Activities g, u, y, and dd are the only ones that definitely add value. Activity
k is questionable, because a single deburring after drilling should be sufficient to remove all burrs. The first deburring, k, is probably performed to
make it easier and safer for workers to handle the product in the interim. If
the need for so much handling can be eliminated (perhaps through automated material-handling equipment), then k could be eliminated with no loss
of value to the customer and perhaps with a net savings to the company, so
k is arguably a non-value-added activity.

14-6

Chapter 14

PROBLEMS
P14-1
(1)
The overhead rates in the existing costing system are $23 per machine hour, and
$14 per direct labor hour, calculated as follows:
$92, 000 of machine-related overhead
= $23 per machine hour
4, 000 machine hours
$280, 000 of remaining overhead costs
= $14 per direct labor hour
20, 000 DLH
(2)

Making only the changes suggested by the study, the structure of the ABC system would be:
Pool
machine operation .....................
setup and material handling .....
other materials-related overhead
all remaining overhead ..............

Driver
machine hours
setups
purchase orders
direct labor hours

The study did not suggest any change for machine operation cost, nor for the
other overhead category.
(3)

The ABC systems overhead rates (driver rates) are $16.25 per machine hour, $57
per setup, $50 per purchase order, and $10.75 per direct labor hour, calculated
as follows:
$65, 000 of machine operation overhead
= $16.25 per machine hour
4, 000 machine hours
$27, 000 of machine-setup overhead +
$30, 000 of materials handling overhead
= $57 per setup
1, 000 setups
$35, 000 of otherr materials-related cost
er
= $50 per purchase orde
700 purchase orders
$215, 000 of "other overhead"
= $10.75 per direct labor hour
20, 000 DLH

Chapter 14

14-7

P14-2
(1)

The three overhead rates in the existing costing system are $17.50 per machine
hour, $.96 per direct material dollar, and $1.25 per direct labor dollar, calculated
as follows:
$700,000 of machine-related overhead
= $17.50 per machine hour
40,000 machine hours
$960,000 of materialsrelated overhead
=
00 of direct
$1,000,00
material cost

96% of direct material cost or

$.96 per direct material dollar

$2,500,000 of other
125% of direct labor cost or
overhead cost
= $1.25 per direct labor dollar
$2,000,000 of
direct labor cost
(2)

Making only the changes suggested by the study, the structure of the ABC system would be:
Pool
machine operation .....................
setup and material handling .....
materials administration............
freight-in ......................................
all remaining overhead ..............

Driver
machine hours
setups
purchase orders
material pounds
direct labor cost

The study did not suggest any change for machine operation cost, nor for the
all remaining overhead category.
(3)

The ABC systems overhead rates are $12.50 per machine hour, $1,020 per setup,
$50 per purchase order, $.75 per pound of materials, and $1.25 per direct labor
dollar, calculated as follows:
$500, 000 of machineoperation overhead
= $12.50 per machine hour
40, 000 machine hours
$200, 000 of machine-setup overhead +
$310, 000 of materials handling overhead
= $1, 020 per setup
500 setups
$500,000 of materials
administration overhead
= $50 per purchase order
10, 000 purchase orders

14-8

Chapter 14

P14-2 (Concluded)
$150,000 of freight-in
= $.75 per pound off materials
200,000 pounds of materials
$2,500,000 of other
overhead cost
= 125% of direct labor cost or
$1.25 per direct labor dollar
$2,000,000 of
direct labor cost
P14-3
(1)
Overhead rate:

DRAPER COMPANY
Product Costs from Existing Costing System
$4,500,000 of overhead divided by $3,000,000 of direct labor cost =
150% of direct labor cost

Direct material
................................................
Direct labor
................................................
Overhead:
150% $2,910,000 ...........................................
150% $90,000 ................................................
Total cost
................................................
Units produced
Cost per unit

................................................
................................................

Custom
$ 12,500
90,000

Total
$ 894,500
3,000,000

$8,157,000

135,000
$237,500

4,500,000
$8,394,500

73,500
$ 110.98

125
1,900

Standard
$ 882,000
2,910,000
4,365,000

Chapter 14

14-9

P14-3 (Continued)
(2)

DRAPER COMPANY
Product Costs from Activity Based Costing System

Overhead rates:
$300,000 setup-related costs divided by 60 setups = $5,000 per setup
$900,000 design-related costs divided by 15,000 design hours = $60 per design hour
$3,300,000 other overhead divided by $3,000,000 DL cost = 110% of direct labor cost

Direct material......................................................
Direct labor...........................................................
Overhead:
$5,000 30 setups ............................................
$5,000 30 setups ............................................
$60 12,000 design hrs....................................
$60 3,000 design hrs......................................
110% $2,910,000 .............................................
110% $90,000 ..................................................
Total cost ..............................................................
Units produced ....................................................
Cost per unit ........................................................
(3)

Standard
$ 882,000
2,910,000

Custom
$ 12,500
90,000

Total
$ 894,500
3,000,000

150,000

300,000

180,000

900,000

$7,863,000

99,000
$531,500

3,300,000
$8,394,500

150,000
720,000
3,201,000

73,500
106.98

125
4,252

Because the existing system used direct labor cost as the only allocation base
and Custom consumed $90,000/$3,000,000 = 3% of direct labor cost, the existing system allocated 3% of all overhead to Custom. The activity information
indicates Custom consumed 30/60 = 50% of setup-related activity and
3,000/15,000 = 20% of design-related activity, so the reconciliation is as follows:

Cost of Custom from traditional system,

as calculated in requirement (1) .................
Adjustments for:
Understatement of setup-related
costs, $300,000 (50% 3%)..................
Understatement of design-related
costs, $900,000 (20% 3%)..................
Total adjustments .........................................
Cost of Custom from ABC system, as
calculated in requirement (2) ......................

P14-3 (Concluded)

Total

Per
Unit

$237,500

$1,900

294,000

2,352

$531,500

$4,252

$141,000
153,000

14-10

(4)

Chapter 14

The only costs handled differently by the two costing systems were the $300,000
of setup-related costs and $900,000 of design-related costs, for a total of
$1,200,000; this represents only 27% of the total overhead of $4,500,000.
The change in the costing system caused the reported cost of Custom to change
from $237,500 to $531,500, which is an increase of 124%.

P14-4
(1)
Overhead rate:

SHAUTON COMPANY
Product Costs from Existing Costing System
$1,200,000 of overhead divided by 30,000 direct labor
hours = $40 per direct labor hour

Direct material......................................................
Direct Labor .........................................................
Overhead:
$40 2,800 DLH ...............................................
$40 27,200 DLH .............................................
Total cost ..............................................................
Units produced ....................................................
Cost per unit ........................................................

Fancy
Plain
$ 60,000 $ 160,000
28,000
272,000

Total
$ 220,000
300,000

112,000
1,088,000
$200,000 $1,520,000

200
1,000 $

16,000
95

1,200,000
$1,720,000

Chapter 14

14-11

P14-4 (Continued)
(2)

SHAUTON COMPANY
Product Costs from Activity Based Costing System

Overhead rates:
$135,000 setup-related costs divided by 90 setups = $1,500 per setup
$240,000 design-related costs divided by 8,000 design hours = $30 per design hour
$825,000 other overhead divided by 30,000 direct labor hours = $27.50 per direct labor
hour
Fancy
Plain
Total
Direct material......................................................
$ 60,000 $ 160,000 $ 220,000
Direct labor...........................................................
28,000
272,000
300,000
Overhead:
$1,500 45 setups ..................................
67,500
$1,500 45 setups ..................................
67,500
135,000
$30 3,000 design hrs ...........................
90,000
$30 5,000 design hrs ...........................
150,000
240,000
$27.50 2,800 DLH .................................
77,000
$27.50 27,200 DLH ...............................
748,000
825,000
Total cost ..............................................................
$322,500 $1,397,500 $1,720,000
Units produced ....................................................
Cost per unit ........................................................
(3)

200
$1,612.50 $

16,000
87.34

Because the existing system used direct labor hours as the only allocation base
and Fancy consumed 2,800/30,000 = 9 1/3% of direct labor hours, the existing
system allocated 9 1/3% of all overhead to Fancy. The activity information indicates Fancy consumed 45/90 = 50% of setup-related activity and 3,000/8,000 =
37.5% of design-related activity, so the reconciliation is as follows:
Total
Cost of Fancy from traditional system,
calculated in requirement (1) ......................
Adjustments for:
Understatement of setup costs,
$135,000 (50% 9 1/3%) ...........................
Understatement of design costs,
$240,000 (37.5% 9 1/3%) ........................
Total adjustments .........................................
Cost of Fancy from ABC system, as
calculated in requirement (2) ......................

Per
Unit

$200,000 $1,000.00

$54,900
67,600
122,500

612.50

$322,500 $1,612.50

14-12

Chapter 14

P14-4 (Concluded)
(4)

The only costs handled differently by the two costing systems were the $135,000
of setup-related costs and $240,000 of design-related costs, for a total of
$375,000; this represents only 31.25% of the total overhead of $1,200,000.
The change in the costing system caused the reported cost of Fancy to change
from $200,000 to $322,500, which is an increase of 61.25%.

P14-5
(1)
Overhead rate:

TUNNEY COMPANY
Product Costs from Existing Costing System
$1,000,000 of overhead divided by 50,000 direct
labor hours = $20 per direct labor hour

Direct material ..........

Direct labor ...............
Overhead:
$20 45,000 DLH..
$20 4,500 DLH....
$20 500 DLH.......
Total cost...................
Units produced .........
Cost per unit .............

Normal
$ 60,000
300,000

Enhanced
$ 20,000
35,000

Super
$ 5,000
5,000

Total
$ 85,000
340,000

10,000
$20,000

50
$ 400

1,000,000
$1,425,000

900,000
90,000
$1,260,000
30,000
$
42

$145,000
1,000
$
145

Chapter 14

14-13

P14-5 (Concluded)
(2)

TUNNEY COMPANY
Product Costs from Activity Based Costing System

Overhead rates:
$400,000 batch-level overhead divided by 500 requisitions = $800 per requisition
$600,000 other overhead divided by 50,000 direct labor hours = $12 per direct labor hour

Direct material ..........

Direct labor ...............
Overhead:
$800 150 req ......
$800 200 req ......
$800 150 req ......
$12 45,000 DLH..
$12 4,500 DLH....
$12 500 DLH.......
Total cost...................
Units produced .........
Cost per unit .............
(3)

Normal
60,000
300,000

Enhanced
$ 20,000
35,000

Total
85,000
340,000

120,000
160,000
120,000

400,000

6,000
$136,000

50
$ 2,720

600,000
$1,425,000

540,000
54,000
$1,020,000
30,000
$
34

$269,000
1,000
$
269

Because the existing system used direct labor hours as the only allocation
base and Super consumed 500/50,000 = 1% of direct labor hours, the existing
system allocated 1% of all overhead to Super. The activity information indicates Super consumed 150/500 = 30% of batch-level activity, so the reconciliation is as follows:

Cost of Super from traditional system,

as calculated in requirement (1)..............................
Adjustment for understatement of batchlevel costs, $400,000 (30% 1%) .........................
Cost of Super from ABC system, as
calculated in requirement (2)...................................
(4)

Super
5,000
5,000

Total

Per
Unit

$ 20,000

$ 400

116,000

2,320

$136,000

$2,720

The only costs handled differently by the two costing systems were the $400,000
of batch-level costs, which represents only 40% of the total overhead of
$1,000,000.
The change in the costing system caused the reported cost of Super to
change from $20,000 to $136,000, which is an increase of 580%.

14-14

Chapter 14

P14-6
(1)

TEKSIZE COMPANY
Product Costs from Existing Costing System

Overhead rate:

$1,500,000 of overhead divided by 50,000 direct labor

hours = $30 per direct labor hour

Direct material .......................................

Direct labor ............................................
Overhead:
$30 10,000 DLH ..............................
$30 40,000 DLH ..............................
Total cost ...............................................
Units produced ......................................
Cost per unit ..........................................
(2)

Regular
$ 10,000
120,000

Large
$ 40,000
480,000

Total
$ 50,000
600,000

$430,000

1,200,000
$1,720,000

1,500,000
$2,150,000

10,000
$
43

300,000

10,000
172

TEKSIZE COMPANY
Product Costs from Activity Based Costing System

Overhead rates:

$515,000 setup-related costs divided by 103 setups

= $5,000 per setup
$985,000 other overhead divided by 50,000 direct labor
hours = $19.70 per DLH

Direct material .......................................

Direct labor ............................................
Overhead:
$5,000 51 setups ............................
$5,000 52 setups ............................
$19.70 10,000 DLH .........................
$19.70 40,000 DLH .........................
Total cost ...............................................
Units produced ......................................
Cost per unit ..........................................

Regular
$ 10,000
120,000

Large
$ 40,000
480,000

Total
$ 50,000
600,000

260,000

515,000

$582,000

788,000
$1,568,000

985,000
$2,150,000

10,000
$ 58.20

255,000
197,000

10,000
156.80

Chapter 14

14-15

P14-6 (Concluded)
(3)

Because the existing system used direct labor hours as the only allocation base
and Regular consumed 10,000/50,000 = 20% of direct labor hours, the existing
system allocated 20% of all overhead to Regular. The activity information indicates Regular consumed 51/103 = 49.51456% of setup-related activity, so the reconciliation is as follows:

Cost of Regular from traditional

system, as calculated in requirement (1) ...............
Adjustment for understatement of setuprelated costs, $515,000 (49.51456% 20%).........
Cost of Regular from ABC system, as
calculated in requirement (2)...................................
(4)

Total

Per
Unit

$430,000

$43.00

152,000

15.20

$582,000

$58.20

Yes, Teksize Company does have a diverse product line in the sense in which the
term is used in ABC. The fact that the two products have the same annual unit
volumes does not matter, because the existing cost system does not use units
as the allocation base. Regular represents only 20% of direct labor hours but
nearly 50% of setup-related costs, while Large has a very different mix, so a
diverse product line is present in Teksize Company.

14-16

Chapter 14

CASES
C14-1
(1)

DALLAS DIVISION
Product Costs from Existing Costing System

Overhead rate:

$800,000 of overhead divided by 20,000 direct

labor hours = $40 per direct labor hour

Direct material...............................................................
Direct labor....................................................................
Overhead:
$40 7,200 DLH ........................................................
$40 120 DLH ...........................................................
Total cost ......................................................................
Units produced .............................................................
Cost per unit .................................................................

#321
$ 6,000
30,000

#333
$ 150
600

288,000
4,800
$5,550

6
$ 925

$324,000
2,400
$
135

(2)
DALLAS DIVISION
Product Costs from Activity Based Costing System
Overhead rates:
$240,000 batch-level costs divided by 1,600 setups = $150 per setup
$200,000 product-level costs divided by 2,000 design hours = $100 per design hour
$360,000 other overhead divided by 20,000 direct labor hours = $18 per DLH

Direct material...............................................................
Direct labor....................................................................
Overhead:
$150 40 setups.......................................................
$150 4 setups.........................................................
$100 320 design hrs ..............................................
$100 200 design hrs ..............................................
$18 7,200 DLH ........................................................
$18 120 DLH ...........................................................
Total cost ......................................................................
Units produced .............................................................
Cost per unit .................................................................

#321
$ 6,000
30,000

#333
150
600

6,000
600
32,000
20,000
129,600
$203,600
2,400
$ 84.83

2,160
$ 23,510

6
$3,918.33

Chapter 14

14-17

C14-1 (Continued)

(3)

(4)

Usual selling price...............................................

Product cost.........................................................
Gross margin .......................................................

#321
$150
135
$ 15

#333
$1,500
925
$ 575

Percent of sales ...................................................

10%

38%

Usual selling price...............................................

Product cost.........................................................
Gross margin (loss).............................................

#321
$150.00
84.83
$ 65.17

#333
$ 1,500.00
3,918.33
$(2,418.33)

Percent of sales ...................................................

43%

(161%)

(5)

The ABC system shows that the relative profitabilities of the two products are
the reverse of what is shown by the existing system: the existing system shows
a very modest gross margin of 10% on #321, which is probably not enough to
cover its marketing and administrative costs, while showing a respectable 38%
gross margin on #333. In contrast, the ABC system shows a 43% gross margin
on #321 and a substantial loss on #333. The low-volume product appears to be
the more profitable of the two under the existing system, but appears to be a
money loser under ABC; the high-volume product appears weak under the existing system, but highly profitable under ABC.

(6)

Based on the results of the ABC study, Dallas division management should consider meeting the competitors prices on #321; this pricing strategy can be profitable in the long run and should avoid loss of market share. The strategy for
#333 is not as clear. Customers are not likely to accept the 200% price increase
needed to make #333 reasonably profitable, and Dallas could lose some customers who also buy large amounts of #321, if management discontinues #333
or increases its price too much. Management should consider several possibilities for low-volume products such as #333:
(a)
Reduce batch- and product-level costs enough to become an efficient producer of low-volume products. This may require creation of a small jobshop environment in a portion of the plant (or in another facility) where
low-volume products could be made more efficiently. The case indicates
the existing plant was designed to produce long runs efficiently, which
may explain the high batch- and product-level costs.

14-18

Chapter 14

C14-1 (Concluded)
(b) Reduce the number of products by designing a new one that can be substituted for several low-volume, unprofitable products that can then be discontinued; this essentially exchanges several low-volume products for one of
much higher volume, with substantial batch- and product-level savings.
(c) Convince one of the current buyers of the low-volume products to become
a distributor of several such products; buying them from Dallas in larger
quantities, maintaining small inventories, and selling them to other customers. This can reduce Dallas batch-level costs and marketing costs, but
it risks the loss of customers who like to buy the full line from one supplier.
(d) Raise prices gradually until all products are reasonably priced. This does
not mean all products must show profits. (It is acceptable for a good customer to occasionally buy a money-losing product.) Rather, it means that
the company should not continue making a money-losing product without
a good reason. It is not acceptable to have a customer who buys only the
money-losing products, nor for the company to continue making a moneylosing product that no good customers are buying.
(e) In addition to the usual per-unit prices, charge a lump-sum amount per
order for any small order of a low-volume product. This charge could be
set at a level to cover estimated batch- and product-level costs.
C14-2
(1)

WARRENTON DIVISION
Product Costs from OPICS

Overhead rate:

$1,930,000 of overhead divided by 25,000 direct

labor hours = $77.20 per DLH
#33
$15,000
6,000

#44
$120,000
60,000

Direct material...............................................................
Direct labor....................................................................
Overhead:
$77.20 450 DLH ......................................................
$77.20 6,000 DLH ...................................................
Total cost ......................................................................
Units produced .............................................................

$55,740
100

463,200
$643,200
2,000

Cost per unit .................................................................

$557.40

$ 321.60

34,740

Chapter 14

14-19

C14-2 (Continued)
(2)

WARRENTON DIVISION
Product Costs from TPICS

Overhead rates:
$340,000 machine-related costs divided by 20,000 machine hours = $17 per MH
$330,000 materials-related costs divided by $1,320,000 direct material cost = 25% of
direct material cost
$360,000 + $900,000 of remaining costs divided by 25,000 direct labor hours = $50.40
per direct labor hour

Direct material...............................................................
Direct labor....................................................................
Overhead:
$17 300 MH.............................................................
$17 3,000 MH..........................................................
25% $15,000 ...........................................................
25% $120,000 .........................................................
$50.40 450 DLH ......................................................
$50.40 6,000 DLH ...................................................
Total cost ......................................................................
Units produced .............................................................
Cost per unit ................................................................
(3)

#33
$15,000
6,000

#44
$120,000
60,000

5,100
51,000
3,750
30,000
22,680
$52,530
100
$525.30

302,400
$563,400
2,000
$ 281.70

TPICS is not an ABC system because all the allocation bases are at the unit level.
The changes management made do show many of the attributes typically associated with a change to ABC: the increase in the number of overhead cost pools, the
attempt to create homogeneous cost pools, and the use of three distinct allocation
bases. These changes show an attempt was made to capture differences among
the demands placed on resources by the different products. But because there are
no batch- or product-level drivers used, the system cannot capture the demands
placed on batch- and product-level activities, i.e., it is not an ABC system.

14-20

Chapter 14

C14-2 (Continued)
(4)

WARRENTON DIVISION
Product Costs from Proposed New Costing System

Overhead rates:
$100,000 troubleshooting costs + $140,000 machine setup costs divided by 3,000
setup hours = $80 per setup hour
$135,000 material handling costs divided by 15,000 loads = $9 per load
$195,000 materials administration costs divided by 10,000 vendor orders = $19.50 per
vendor order
$260,000 engineering design costs divided by 4,000 design hours = $65 per design
hour
$200,000 machine operation costs + $900,000 other overhead divided by 20,000
machine hours = $55 per machine hour

Direct material...............................................................
Direct labor....................................................................
Overhead:
$80 300 setup hrs ..................................................
$80 400 setup hrs ..................................................
$9 20 loads .............................................................
$9 60 loads .............................................................
$19.50 90 orders ....................................................
$19.50 150 orders ..................................................
$65 280 design hrs ................................................
$65 300 design hrs ................................................
$55 300 MH.............................................................
$55 3,000 MH..........................................................
Total cost ......................................................................
Units produced .............................................................
Cost per unit .................................................................
(5)

(6)

#33
$15,000
6,000

#44
$120,000
60,000

24,000
32,000
180
540
1,755
2,925
18,200
19,500
16,500
$81,635
100
$816.35

165,000
$399,965
2,000
$ 199.98

The proposed new costing system is an ABC system because it uses cost drivers that include non-unit-level drivers. The unit-level driver is machine hours, the
batch-level drivers are setup hours and loads handled, and the product-level
driver is design hours. Vendor orders could be either a batch- or product-level
driver, depending on whether orders are placed for each batch; the case does
not tell whether this is so.
For the low-volume product, #33, the proposed ABC system shows a substantially higher cost than did either of the other two systems. This is the general
result when ABC is implemented and compared with traditional systems. At the
usual selling price of $800, the ABC system says this product is a money loser.
Equally, or perhaps more importantly, the proposed ABC system shows that the
high-volume product can be priced very competitively.

Chapter 14

14-21

C14-2 (Concluded)
(7)

Based on the results of the ABC study, Warrentons management should consider meeting the competitors prices on #44; this pricing strategy can be profitable in the long run and should avoid loss of market share. The strategy for #33
is not as clear. Some customers may not accept the price increase needed to
make #33 reasonably profitable, and Warrenton could lose some customers who
also buy large amounts of #44 if management discontinues #33 or hikes its price
too much. Management should consider several possibilities for low-volume
products such as #33:
(a) Reduce batch- and product-level costs enough to become an efficient producer of low-volume products. This may require creation of a small job-shop
environment in a portion of the plant (or in another facility), where low-volume
products could be made more efficiently.
(b) Reduce the number of products by designing a new product that can be substituted for several low-volume, unprofitable products that can then be discontinued; this essentially exchanges several low-volume products for one
of much higher volume, with substantial batch- and product-level savings.
(c) Convince one of the current buyers of the low-volume products to become
a distributor of several such products; buying them from Warrenton in larger
quantities, maintaining small inventories, and selling them to other customers. This can reduce Warrentons batch-level and marketing costs, but it
risks the loss of customers who like to buy the full line from one supplier.
(d) Raise prices gradually until all products are reasonably priced. This does not
mean all products must show profits. (It is acceptable for a good customer
to occasionally buy a money-losing product.) Rather, it means that the company should not continue making a money-losing product without a good
reason. It is not acceptable to have a customer who buys only the moneylosing products, nor for the company to continue making a money-losing
product that no good customers are buying.
(e) In addition to the usual sales price, charge a lump-sum amount per order for
any small order of a low-volume product. This charge could be set at a level
to cover estimated batch- and product-level costs.