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# Traditional Costing / Activity Based Costing

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Cost distortions

At its manufacturing plant in Duluth, Minnesota, E Electronics Co. manufactures two products, X21 and Y37. For many years, the company has used a simple plantwide manufacturing support cost rate based on direct labor hours. A new plant accountant suggested that the company may be able to assign support costs to products more accurately by using an activity-based costing system that relies on a separate rate for each manufacturing activity that causes support costs.

After studying the plant's manufacturing activities and costs, the plant accountant has collected the following data for last year:

Item X21 Y37
Units produced & Sold 50,000 100,000
Direct labor hours used 100,000 300,000
Direct labor cost \$1,000,000 \$4,500,000
Number of times handled 40,000 20,000
Number of parts 12,000 8,000
Number of design changes 2,000 1,000
Number of product setups 8,000 6,000

The accountant has also determined that actual manufacturing support costs incurred last year were as follows:

Cost Pool Activity Costs

Handling \$3,000,000
Number of parts 2,400,000
Design changes 3,300,000
Setups 2,800,000
Total \$11,500,000

The direct materials cost for product X21 is \$120 per unit, while for product Y37 it is \$140 per unit.

A. Determine the unit cost of each product using direct labor hours to allocate all manufacturing, support costs.
B. Determine the unit cost of each product using activity-based costing.
C. Which of the two methods produces more accurate estimates of job costs? Explain.
D. Suppose E Co. has been setting its product prices by adding a 25% markup to its reported product cost. Compute the product prices on the basis of the costs computed in parts (a) and (b). What do you recommend to E Co. regarding the pricing?
E. What product-level changes do you suggest on the basis of the activity-based cost analysis? Who would be involved in bringing about your suggested changes?

Activity cost drivers

The SF Restaurant has identified the following activities performed by its staff:

Set tables Cook food Serve dessert
Seat customers Serve orders Present and collect bills
Take orders Take dessert orders Clean tables

A. For each of these activities, state whether the number of tables served or the number of customers at the tables is a better cost driver.
B. What distortions might result in assigning costs if only one of the two drivers in (a) is used?

Customer Profitability analysis

K Company, a growing mail-order clothing & accessory company, is concerned about its growing marketing, distribution, selling, and administration expenses. It therefore examined its customer ordering patterns for the past year and identified four different types of customers, as illustrated in the table below. K Co. sends catalogs and flyers to all its customers several times a year. Orders are taken by mail or over the phone. K Co. maintains a toll-free number for customers to use when placing orders over the phone. K Co. prides itself on the personal attention it provides shoppers who order over the phone. All purchases are paid for by check or credit card. K Co. has a very generous return policy if customers are not satisfied with the merchandise received. Customers must pay return shipping charges, but their purchase price is then fully refunded.

Customer 1 2 3 4

Initial Sales \$1000 \$1000 \$2500 \$3000
# of Items returned 0 4 2 24
Dollar value of items returned 0 \$200 \$500 \$1500
# of orders per year 1 6 4 12
# of phone orders per year 1 0 0 12
Time spent on phone placing orders .25 hour 0 0 1 hour
# of Overnight deliveries 1 0 0 12
# of regular deliveries 0 6 4 0

Prices are set so that cost of goods sold is on average about 75% of the sales price. Customers pay actual shipping charges, but extra processing is required for overnight deliveries. K Co. has developed the following activity cost driver rates for its support costs:

Activity Activity Cost Driver Rate

Process mail orders \$5 per order
Process phone orders \$80 per hour
Process returns \$5 per item returned
Process overnight delivery requests \$4 per request
Maintain customer relations
(Send catalogs & respond to customer
Comments or complaints) \$50 per year

A. Using activity-based costing, determine the yearly profit associated with each of the four customers described.
B. Comment on which customers are most profitable and why.
C. What advice do you have for K Co. regarding managing customer relationships with the different types of customers represented?