Question

The Watts 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 $100 per direct labor hour) 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 hours. 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 hours. 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, Watts has decided to adopt activity based costing over the next year or two.

Watts’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, Classic and Artisan, 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 Watts management believe they have very different demands on indirect overhead resources. Further, Classic is sold in large quantities whereas Artisan 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 Classic Artisan Direct material $120 $200 Direct labor hours 1.2 1.5 Direct labor wage rate per hour $20 $20 Sales price per unit $300 $450 My staff has identified for Deloitte five activity cost pools. Information on those cost pools and the related activity measures are provided in Exhibit 2. Exhibit 2 Total Costs Allocation Base Level of Allocation Base Equipment setups $24,000,000 number of setups 60,000 Purchase orders $72,000,000 number of purchase orders 300,000 Machining $25,000,000 number of machine hours 1,250,000 Testing $42,000,000 number of testing hours 600,000 Packaging and shipping $50,000,000 number of containers 1,000,000

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 is provided in Exhibit 3

Prepare an income statement for smatt and an income statement for pline using activity based costing. 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    $$$     $$$

Equipment setups $$$ $$$

Purchase orders $$$ $$$

Machining $$$ $$$

Testing $$$ $$$

Packaging $$$ $$$

Total costs $$$ $$$

Net operating income $$$ $$$

Average net operating income

   per unit $$$ $$$

Answer 1

Activity Based Costing involves allocating of expenses based on the activities for which the overheads are incurred.

Overhead Cost based on allocation:

Overhead Cost	Basis of Allocation	Total Cost	Allocation Basis	Cost per Allocation Basis
Equipment Setup	No. of Set-ups	$24,000,000	60,000	$ 400 per set-up
Purchase Orders	No. of Purchase Orders	$72,000,000	3,000,000	$240 per purchase order
Machining	No. of Machine Hours	$25,000,000	1,250,000	$20 per machine hour
Testing	No. of Testing Hours	$42,000,000	6,000,000	$70 per testing hour
Packing & Shipping	No. of Containers	$50,000,000	1,000,000	$50 per container

Income Statement

Particular	Smatt	Pline
Sales	$120,000,000 [40,000 units* $300 per unit]	$22,500,000 [50,000 units * $450 per unit]
Direct Materials	$48,000,000 [40,000 units * $120 per unit]	$10,000,000 [50,000 units * $200 per unit]
Direct Labor	$960,000 [40,000 units * 1.2 hours per unit* $20 per hour]	$1,500,000 [50,000 units * 1.5 hours per unit* $20 per hour]
Equipment Setups	$4,000,000 [(40,000 units/400 batches) = 1,000 set-ups * $400 per set-up]	$250,000 [(50,000 units/80 batches) = 625 set-ups * $400 per set-up]
Purchase Orders	$144,000 [600 purchase orders * $ 240 per purchase order]	$72,000 [300 purchase orders * $ 240 per purchase order]
Machining	$3,200,000 [40,000 units * 0.4 machine hours per unit * $20 per machine hour]	$2,000,000 [50,000 units * 2 hours per machine per unit * $20 per machine hour]
Testing	$560,000 [8,000 testing hours * $ 70 per testing hour]	$7,000,000 [100,000 testing hours * $ 70 per testing hour]
Packing	$250,000 [5,000 containers * $50 per container]	$1,000,000 [20,000 containers * $50 per container]
Total Costs	$50,314,000	$21,822,000
Net Operating Income	$69,686,000	$678,000
Average Net Operating Income per unit	$1,742.15 [$69,686,000/40,000]	$13.56 [$678,000/50,000]