ACTIVITY BASED COSTING

Shaw Wallace makes 2 wines: a regular wine and a premium wine. Shaw Wallace distributes the regular wine and the premium wine through different distribution channels. It distributes 2,40,000 cases of regular wine through 10 general distributors and 1,60,000 cases of premium wine through 30 specialty distributors. Shaw Wallace incurs Rs.42,60,000 in distribution costs. Under its existing costing system, Shaw Wallace allocates distribution costs to products on the basis of cases shipped.

To understand better the demands on its resources in the distribution area, Shaw Wallace identifies 3 activities and related activity costs.

a. Promotional costs- Shaw Wallace estimates it incurs Rs.16,000 per distributor.

b. Order handling costs- Shaw Wallace estimates costs of Rs.600 pertaining to each order. Shaw Wallace records show that distributors of regular wine place an average of 10 orders per year, whereas distributors of premium wine place an average of 20 orders per year.

c. Delivery costs – Rs.8 per case.

Required:

1. Using Shaw Wallace existing costing system, calculate the total distribution costs and distribution cost per case for the regular wine and the premium wine.

2. Using Shaw Wallace activity based costing system, calculate the total distribution costs and distribution cost per case for the regular wine and the premium wine.

3. Explain the cost differences and the accuracy of the product costs calculated using the existing costing system and the ABC system. How might Shaw Wallace management use the information from the ABC system to manage its business better?

Problem 1

Required:

1. Using Shaw Wallace existing costing system, calculate the total distribution costs and distribution cost per case for the regular wine and the premium wine.

2. Using Shaw Wallace activity based costing system, calculate the total distribution costs and distribution cost per case for the regular wine and the premium wine.

3. Explain the cost differences and the accuracy of the product costs calculated using the existing costing system and the ABC system. How might Shaw Wallace management use the information from the ABC system to manage its business better?

Problem 1

Nirula decides to apply ABC analysis to 3 products lines; Ice-creams, Milk shakes with ice-creams and Food products. It identifies 4 activities and activity cost rates for each activity as

Problem 2

Activity Cost per activity

Ordering Rs.1,000 per purchase order

Delivery and receipt of merchandise

Rs.800 per delivery

Shelf-stocking Rs.200 per hour

Customer support and assistance Rs.2 per item sold

Inder the previous costing system, Nirula allocated support cost

Problem 2

Ice-creams

Milk shakes with ice-creams

Food Products

Financial data:

Revenues Rs.5,70,000

Rs.6,30,000 Rs.5,20,000

Cost of goods sold 3,80,000 4,70,000 3,50,000

Store support 1,14,000 1,41,000 1,05,000

Activity area usage (cost allocation base)

Ordering (purchase orders 30 25 13

Delivery (deliveries) 98 36 28

Shelf-stocking (hours) 183 166 24

Customer support (items sold)

15,500 20,500 7,900

The revenues, cost of goods sold, store support costs & activity wise usage of the 3 product lines are:

Under the previous costing system, Nirula allocated support costs to products at the rate of 30% of the cost of goods sold.

Required:

1. Use the previous costing system to prepare a product line profitability report for Nirula’s.

2. Use the ABC system to prepare a product line profitability report for Nirula’s.

3. What new insights does the ABC system requirement 2 provide to Nirula’s managers?

Problem 2

State Bank of India (SBI) is examining the profitability of its Premier Account, a combined savings and checking account. Depositors receive a 7% annual interest rate on their average deposit. SBI earns an interest rate spread of 3% (the difference between the rate at which it lends money and the rate it pays depositors) by lending money for home loan purposes at 10%. Thus, SBI would gain Rs.60 on the interest spread if a depositor has an average Premier Account balance of Rs.2,000, that is, Rs.2,000 x 3% = Rs.60.

The Premier Account allows depositors unlimited use of services such as deposits, withdrawals, checking accounts, and foreign currency drafts. Depositors with Premier Account balances of Rs.1,000 or more receive unlimited free use of services. Depositors with minimum balances of less than Rs.1,000 pay Rs.20 a month service fee for their Premier Account.

SBI recently conducted an activity based costing study of its services. It assessed the following costs for six individual services. The use of these services in current year by 3 customers is as follows:

Problem 3

Assume Nitin and Sanjay always maintain a balance above Rs.1,000, whereas Arvinder has a balance below Rs.1,000.

Particulars Activity based Cost per Transaction

Nitin Arvinder

Sanjay

Deposit/ withdrawal with teller

Rs.2.50 40 50 5

Deposit/ withdrawal with automatic teller machine (ATM)

0.80 10 20 16

Deposit/ withdrawal on prearranged monthly basis

0.50 0 12 60

Bank checks written 8.00 9 3 2

Foreign currency drafts 12.00 4 1 6

Inquiries about account balance

1.50 10 18 9

Average premier account balance for current year

Rs.1,100

Rs.800 Rs.25,000

Problem 3

Required:1. Compute the current year profitability of Nitin,

Arvinder and Sanjay’s Premier Accounts at SBI.2. What evidence is there of cross-subsidization

among three Premier Accounts? Why might SBI worry about this cross-subsidization if the Premier Account product offer in is profitable as a whole?

3. What changes would you recommend for SBI’s Premier Account?

Problem 3

Sony Electronics, a division of Sony Corporation, manufactures two large screen television models the Flatron, which has been produced since 1998 and sells for Rs.45,000 and Wega, a newer model introduced in early 2011 that sells for Rs.57,000. Based on the following income statement for the current year ended March 31, senior management at Sony have decided to concentrate Sony’s marketing resources on the Wega and to phase out the Flatron model.

Income Statement for the Current Fiscal Year Ended March 31

Particulars Flatron Wega Total

Revenues Rs.1,98,00,000

Rs.45,60,000 Rs.2,43,60,000

Cost of goods sold 1,25,40,000

31,92,000 1,57,32,000

Gross margin 72,60,000 13,68,000 86,28,000

Selling and administration expenses

58,30,000 9,78,000 68,08,000

Operating income 14,30,000 3,90,000 18,20,000

Units produced and sold

440 80

Operating income per unit sold

Rs.3,250 Rs.4,875

Problem 4

Unit Cost for Flatron and Wega are as follows:

Particulars Flatron Wega

Direct materials Rs.10,400 Rs.29,200

Direct manufacturing labor

Flatron (1.5 hours x Rs.600)

900

Wega (3.5 hours x Rs.600)

2,100

Machine costs#

Flatron (8 hours x Rs.900)

7,200

Wega (4 hours x Rs.900)

3,600

Manufacturing overhead other than machine costs*

10,000(8 hours x Rs.1250)

5,000(4 hours x Rs.1250)

Total costs 28,500 39,900

# Machine costs include lease costs of the machine, repairs and maintenance• Manufacturing overhead was allocated to products based on machine-

hours at the rate of Rs.1,250 per hour.

Sony’s controller, Mr. Thomas, is advocating the use of activity-based costing and activity –based management and has gathered the following information about the company’s manufacturing overhead costs for the current year ended March 31

Problem 4

Units of the Allocation Base

Activity Center (Cost-Allocation Base)

Total Activity Costs

Flatron Wega Total

Soldering (number of solder points)

Rs.9,42,000

11,85,000

3,85,000

15,70,000

Shipments (number of shipments)

8,60,000 16,200 3,800 20,000

Quality control (number of inspection)

12,40,000 56,200 21,300 77,500

Purchase orders (number of orders)

9,50,400 80,100 1,09,980

1,90,080

Machine power (machine –hours)

57,600 1,76,000 16,000 1,92,000

Machine setups (number of setups)

7,50,000 16,000 14,000 30,000

Total manufacturing overhead

48,00,000

Problem 4

After completing his analysis Thomas shows the result to friend Sam, the Sony division president. Sam does not like what he sees. “If you show headquarters this analysis, they are going to ask us to phase out the Wega line which we have just introduced. This whole costing stuff has been a major problem for us. First Flatron was not profitable and now Wega.”

“ Looking at the ABC analysis, I see two problems. First, we do, many more activities than the ones you have listed. If you had included all activities, maybe your conclusions would be different. Second, you used number of setups and number of inspections as allocation bases. The numbers would be different has you used setup-hours and inspection-hours instead. I know that measurement problems precluded you from using these other cost-allocation bases, but I believe you ought to make some adjustments to our current numbers to compensate for these issues. I know you can do better. We can’t afford to phase out either product.”

Problem 4

Thomas knows his numbers are fairly accurate. On limited sample, he calculated the profitability of Wega and Flatron using more and different allocation bases. The set of activities and activity rates he had used resulted in numbers that closely approximate those based on more detailed analyses. He is confident that headquarters, knowing that Wega was introduced only recently, will not ask Sony to phase it out. He is also aware that a sizable portion of Sam’s bonus is based on division revenues. Phasing out either product would adversely affect his bonus. Still, he feels some pressure from Sam to do something.

Required:

1. Using activity-based costing, calculate the profitability of the Wega and Flatron models.

2. Explain briefly why these numbers differ from the profitability of the Wega and Flatron models calculated using Sony’s costing system.

3. Comment on Sam’s concerns about the accuracy and limitation of ABC.

Problem 4

Citizen Company produces mathematical and financial calculators. Data related to the two products is presented below:

Both products pass through Department 1 and Department 2. The department’s combined manufacturing overhead costs are:

Required:

1. Compute the manufacturing overhead cost per unit for each product.

2. Compute the manufacturing cost per unit for each product.

Mathematical

Financial

Annual production in units 50,000 1,00,000

Direct materials costs Rs.1,50,000 Rs.3,00,000

Direct manufacturing labor costs Rs.50,000 Rs.1,00,000

Direct manufacturing labor-hours 2,500 5,000

Machine-hours 25,000 50,000

Number of production runs 50 50

Inspection hours 1,000 500

Machining costs Rs.3,75,000

Setup costs Rs.1,20,000

Inspection costs Rs. 1,05,000

Problem 5

Nicholas Pharma Ltd specializes in the distribution of pharmaceutical products. Nicholas Pharma Ltd. buys from pharmaceutical companies and sells to each 3 different markets:

a. General supermarket chains

b. Drugstore chains

c. Ma & Pa single store pharmacies

Anand, the new controller of Nicholas Pharma, reported the following data for August:

For many years, Nicholas Pharma has used gross margin percentage (Revenue-Cost of goods sold) / Revenue to evaluate the relative profitability of its groups (distribution outlets).

Particulars General Supermarket

Drugstore Chains

Ma & Pa Single Stores

Average revenue per delivery Rs.15,450 Rs.5,250 Rs.990

Average cost of goods sold per delivery

15,000 5,000 900

Number of deliveries 120 300 1,000

Problem 6

Activity Area Cost Driver

Customer purchase order processing

Purchase orders by customers

Line item ordering Line items per purchase order

Store delivery Store deliveries

Cartons shipped to stores Cartons shipped to a store per delivery

Shelf stocking at customer stores Hours of shelf stocking

Anand recently attended a seminar on activity based costing and decides to consider using it at Nicholas Pharma. Anand meets with all the key managers and many staff members. Generally, these individuals agree that there are five key activity areas at Nicholas Pharma

Each customer purchase order consists of one or more line items. A line item represents a single product (such as Extra Strength Tylenol Tablets). Each store delivery entails delivery of one or more cartons of products to a customer. Each product delivered in one or separate cartons. Nicholas Pharma staff pack cartons directly onto display shelves in a store. Currently, there is no charge for this service, and not all customers use Nicholas Pharma for this activity.

Problem 6

Activity Area Total Costs in August

Total Units of Cost Allocation base Used in August

Customer purchase order processing

Rs.40,000 1,000 orders

Line item ordering 31,920 10,640 line items

Store deliveries 35,500 710 store deliveries

Cartons shipped to stores 38,000 38,000 cartons

Shelf stocking at customer stores 5,120 320 hours

1,50,540

The August operating costs (other than costs of goods sold) of Nicholas Pharma are Rs.1,50,540. These operating costs are assigned to the 5 activity areas. The costs in each area and the quantity of the cost allocation base used in that area for August are as follows:

Problem 6

Required:

1. Compute the August gross margin percentage for each of its three distribution markets. What is the operating income of Nicholas Pharma? Also determine its operating income margin.

2. Compute the August rate per unit of the cost allocation base for each of the five activity areas.

3. Compute the operating income of each distribution market in August the activity based costing information. Comment on the results. What new insights are available with the activity based information?

Other data for August include the following:

Particulars General Supermar

ket

Drugstore

Chains

Ma & Pa Single Stores

Total number of orders 70 180 750

Average number of line items per order

14 12 10

Total number of store deliveries 60 150 500

Average number of cartons shipped per store delivery

300 80 16

Average number of hours of shelf stocking per store delivery

3 0.6 0.1

Problem 6

The Birla Company manufactures and sells two products, A and B. The manufacturing activity is organized in two departments. Manufacturing costs at its Portland plant are allocated to each product using a plant-wide rate of Rs.170 per direct manufacturing labor-hour. This rate is based on budgeted manufacturing overhead of Rs.34,00,000 and 20,000 budgeted direct manufacturing labor-hours.

The number of direct manufacturing labor-hours required to manufacture each product is

Manufacturing department

Budgeted manufacturing overhead

Budgeted direct manufacturing labor-hours

1 Rs.24,00,000 10,000

2 10,00,000 10,000

Total 34,00,000 20,000

Manufacturing department Product A Product B

1 4 1

2 1 4

Total 5 5

Problem 7

Per unit cost costs for the two categories of direct manufacturing costs are

At the end of the year, there was no work in progress. There were 200 finished units of product A and 600 finished units of product B on hand.

Birla sets the selling price of each product by adding 120% to its unit manufacturing costs; that is, if the unit manufacturing costs are Rs.1,000, the selling price is rs.2,200 (Rs.1,000 + Rss.1,200). This 120% markup is designed to cover costs upstream to manufacturing (R&D and design) and costs downstream from manufacturing (marketing, distribution and customer service), as well as to provide a profit.

Direct Manufacturing costs Product A Product B

Direct materials costs Rs.1,200 Rs.1,500

Direct manufacturing labor costs

800 800

Required:1. How much manufacturing overhead cost would be

included in the inventory of products A and B if Birla used (a) a plant-wide overhead rate and (b) department overhead rates?

2. By how much would the selling prices of product A and product B differ if Birla used a plant-wide overhead rate instead of department overhead rates?

3. Should Birla Company prefer plant-wide or department overhead rates?

4. Under what conditions should Birla company further subdivide the department cost pools into activity cost pools?