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

4. (10 Points) Assume next year that the activity rates (predetermined overhead rates) remain the same as you calculated in question (2). Assume that the demand for smatt is expected to increase significantly. Consequently, the firm expects to produce more batches of smatt next year than this year and the firm plans to produce in batch sizes of 80 rather than 50. Calculate what the equipment setup cost per unit of smatt will be next year if it can be calculated. If it cannot be calculated, then explain in words why the equipment setup cost per unit of smatt cannot be determined in the absence of more information. Excluding your quantitative analysis if any, your explanation should not be more than 1/3 page double spaced with a 12 font size.

Answer 1

Computation of ABC Rate

Overhead Costs	Base Units	No of Units	Total Cost	Activity Rate
Equipment Set up	No of Set ups	60000	13200000	220
Purchase Orders	No of Orders	220000	17600000	80
Machining	No of Machine Hours	1200000	69600000	58
Testing	No of Tesing Hours	800000	16000000	20
Packaging	No of Containers	2000000	24000000	12
			140400000

Limitation of Activity Based Costing: Machining Costs: Though the machining costs is fixed in nature completely, the no of hours of machine is also fixed and the depreciation/etc. needs to be allocated on some basis, where Machine hours seems most appropriate.

Workings

	Computation		Amounts per unit
	Smatt	Pline	Smatt	Pline
Direct Material	Given	Given	32	32
Direct Labour Cost	0.3 x 30	0.3 x 30	9	9
Selling Price Per unit	Given	Given	80	100
No of Units Produced	Given	Given	200000	40000
No of Units per batch	Given	Given	50	25
No of batches	200000/50	40000/25	4000	1600
No of Purchase Order	Given		250	200
No of Machine Hours per unit			0.2	0.9
Total Machine Hours	200000*0.20	40000*0.90	40000	36000
Total Testing Hours			6000	4000
Total Number of Containers			2000	1000

Solution:

	Computation		Amounts per unit
	Smatt	Pline	Smatt	Pline
Direct Costs	$	$	$	$
Direct Material Cost	200000*32	40000*32	6400000	1280000
Direct Labour Cost	200000*9	40000*9	1800000	360000
Overheads
Equipment Set up	4000*220	1600*220	880000	352000
Purchase Orders	250*80	200*80	20000	16000
Machining	40000*58	36000*58	2320000	2088000
Testing	6000*20	4000*20	120000	80000
Packaging	2000*12	1000*12	24000	12000
Total Cost			11564000	4188000
Sales	200000*80	40000*100	16000000	4000000
Profit/(Loss)			44,36,000	-1,88,000

Answer B: Since we would be increasing the volume of Smatt production next year, there would be increase decrease in number of batched to accomodate for the increase in volume. It is not clearly specified here that just increasing the batch size from 50 to 80 would suffice the increase in volume production. The number of set ups which is the base figure to compute the set up cost per batch should be identified first.

Now further assuming that just increasing the batch size is sufficient to compensate the increase in production volume of Smatt and no other parameters (like total number of set ups, set up overhead costs, etc) change,

Set up cost per unit = Set up cost per batch / no of units per batch = 220/80 = $2.75 per unit (On the basis of above assumption)