Question

The Zealand Company is a publicly traded corporation that produces different types of commercial food processors. My name is Alan Smith and I have worked for this company for the last ten years in the controller’s office. I was both an accounting and finance major in university. The company currently produces 300 products and does not anticipate any new products coming out over the next three years. I have previously mentioned to my superiors that it is not appropriate for our firm to use a traditional accounting system (where overhead costs are allocated across products at a rate of 400% of direct labor costs) when different products require different amounts of indirect overhead resources. For example, under the traditional system all costs associated with testing of products for quality assurance purposes are part of overhead costs and therefore allocated across products based on direct labor costs. Yet, some of our products require as much as 5 hours of testing whereas some products require less than 1 minute of testing with no connection to direct labor costs. Given that traditional costing systems result in significant cost distortions when determining products costs and given that the firm now has revenues of over $100 million a year, Zealand has decided to adopt activity based costing over the next year or two.

Zealand’s management has hired Deloitte Consulting to help us implement activity based costing. I will be acting as the liaison between our firm and Deloitte. As part of the initial implementation phase, I have asked Deloitte to derive the costs and product margins associated with two of our products, smatt and pline, so that these costs and product margins could be compared with the costs and product margins under our current traditional accounting system. I picked these products since Zealand management believe they have very different demands on indirect overhead resources. Further, smatt is sold in large quantities whereas pline is sold in small quantities and traditional accounting systems can cause large cost distortions in different directions for products sold in large and small quantities.  

Current information from our existing system on a per unit basis is shown in Exhibit 1.

Exhibit 1

	smatt	pline
Direct material	$32	$32
Direct labor hours	0.3	0.3
Direct labor cost per hour	$30	$30
Sales price per unit	$80.00	$100.00

My staff has identified for Deloitte five cost pools. Information on those cost pools and the related allocation bases are provided in Exhibit 2.

Exhibit 2

	Total Costs	Allocation Base	Level of Allocation Base
Equipment setups	$13,200,000	Number of setups	60,000
Purchase orders	$17,600,000	number of purchase orders	220,000
Machining	$69,600,000	number of machine hours	1,200,000
Testing	$16,000,000	number of testing hours	800,000
Packaging	$24,000,000	number of containers	2,000,000

Although fixed costs are lumped in with variable costs across the five different cost pools, I am aware that machining related costs consists almost exclusively of depreciation costs. Hence, with respect to all questions asked in this case, machining costs will be treated as entirely fixed with respect to machine hours. Each machine is used in the production of multiple product lines. The resale value of machines is only affected by the passage of time and not by how much they are used in a given year.   

In all questions asked in this case, the firm will assume that costs associated with equipment setups, purchase orders, testing, and packaging & shipping are variable with respect to their respective activity measures. Currently, we believe our assumptions on cost behavior patterns are quite reasonable.  

All products are produced in batches, where the size of a batch differs across products. For example, if we produce 80 units of a product in batch sizes of 40, then the product will be produced in two batches. An equipment setup must be performed before producing each batch of a product. Hence, in the example above, two equipment setups would be performed. Units of product are packaged in containers and sent to distributors.

Production volumes are set equal to sales volumes since the company only produces products that they have orders for. Consequently, the firm never has a beginning or ending work in process inventory, and it does not have a beginning or ending finished goods inventory.

Further information on our two products are provided in Exhibit 3

Exhibit 3

	smatt	pline
annual sales and production in units	200,000	40,000
number of units per batch	50	25
number of purchase orders	250	200
number of machine hours per unit	0.20	0.90
total number of testing hours	6,000	4,000
total number of containers	2,000	1,000

1. (20 Points) Prepare an income statement for smatt and an income statement for pline using the traditional accounting system where overhead is applied at a rate of 400% of direct labor costs. The income statements should be prepared on a total basis and then show the average net operating income per unit using the following template for guidance:

smatt pline

Sales $$$ $$$

Direct materials $$$ $$$

Direct labor $$$ $$$

Manufacturing overhead $$$ $$$

Total Costs $$$ $$$

Net operating income $$$ $$$

Average net operating income

    per unit $$$ $$$

Answer 1

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The Zealand Company
	Smatt		Pline
	Per Unit	Total	Per Unit	Total
Units	200,000.00		40,000.00
Sales	80.00	16,000,000.00	100.00	4,000,000.00	This is sales price* Units.
Direct material	32.00	6,400,000.00	32.00	1,280,000.00	This is Direct material* Units.
Direct labor hours	0.30	60,000.00	0.30	12,000.00	This is Direct labor hours* Units.
Direct labor cost	30.00	1,800,000.00	30.00	360,000.00	This is Direct labor rate* Direct labor hours.
Manufacturing overhead		7,200,000.00		1,440,000.00	This is 400% of Direct labor cost.
Income statement	Smatt	Pline
Sales	16,000,000.00	4,000,000.00	A
Direct material	6,400,000.00	1,280,000.00
Direct labor	1,800,000.00	360,000.00
Manufacturing overhead	7,200,000.00	1,440,000.00
Total Costs	15,400,000.00	3,080,000.00	B
Net operating income	600,000.00	920,000.00	C=A-B
Units	200,000.00	40,000.00	D
Average net operating income per unit	3.00	23.00	E=C/D