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

Exhibit 3

	Classic	Artisan
annual sales and production in units	400,000	50,000
number of units per batch	400	80
number of purchase orders	600	300
number of machine hours per unit	0.4	2
total number of testing hours	8,000	100,000
total number of containers	5,000	20,000

REQUIRED:

3. (20 Points) Prepare an income statement for Classic and an income statement for Artisan using activity based costing. (For simplicity, SG&A expenses for the firm are not included in the income statement for the two products.) 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:

    Classic        Artisan

Sales $$$ $$$

Direct materials     $$$     $$$

Direct labor    $$$     $$$

Equipment Setups    $$$     $$$

Purchase orders    $$$     $$$

Machining     $$$     $$$

Testing    $$$     $$$

Packaging and shipping $$$     $$$      

Total Costs $$$ $$$

Net operating income $$$ $$$

Average net operating income

   per unit $$$ $$$

4. (20 Points) Can you help Mr. Smith explain to his colleagues why the unit cost for Artisan differs so much under traditional costing system versus under activity-based costing system? Your explanation should not be more than 1/2 page double spaced with a 12 font size.    

5. (10 Points) Assume next year that the activity rates remain the same as you calculated in question (2). Assume that the demand for Artisan is expected to increase significantly. Consequently, the firm expects to produce in batch sizes of 200 rather than 80. Calculate what the equipment setup cost per unit of Artisan 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 Artisan 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.    

6. (10 Points) Question 6 is independent of question 5. Next year, because of an expected increase in product demand, machine hours are expected to increase from 1,250,000 to 2,000,000. The company will not need any new machinery since the current machinery is highly underutilized. Also, the number of testing hours will increase from 600,000 to 800,000. Assume that these new levels of operations are within the firm’s relevant range. Calculate what the activity rate for the cost pool of machining would be next year if it can be calculated. Also, calculate what the activity rate for the cost pool of testing would be next year if it can be calculated. If one or both rates cannot be calculated, then explain in words why the calculations cannot be determined in the absence of more information.   Excluding any quantitative analysis, your explanation should not be more than 1/3 page double spaced with 12 font.    

Answer 1

Answer to Q#3 (First question in the list Cost Activity Cost Pool Equipment setup:s Purchase orders Machining Testing Packaging and shipping Suitable Cost Driver Number of setups Number of purchase orders $72,000,000 Number of machine hours $25,000,000 Number of testing hours $42,000,000 Number of containers Volume Activity Rate [$24,000,000 60,000] [$25,000,000/ 1,250,000] [$50,000,000 1,000,000] $24,000,000 60,000 $400 Per Setup 300,000 $240 Per Purchase order [$72,000,000/300,000] 1,250,000$20Per Machine hour esting hour $42,000,000/600,000] $70 PerTe $50 Per Container 600,000 $50,000,000 1,000,000 Classic Artisan Annual sales and production in units Number of units per batch Number of setups 400,000 400 1,000 50,000 -->(a) 80 > (b) 625 -->(a)/ (b)

Income Statement Classic Artisan $120,000,000 $22,500,000 [400,000 x $300; 50,000 x $450] $48,000,000 $10,000,000 [400,000 x $120; 50,000 x $200] Sales Direct materials Direct labor Equipment Setups Purchase orders Machining Testing Packaging and shipping Total Costs $9,600,000 $1,500,000 [400,000 x 1.2x $20; 50,000 x 1.5 x $20] $400,000 $250,000 [1,000 x $400; 625 x $400] $144,000 72,000 [600 x $240; 300 x $240] $3,200,000 $560,000 $250,000 $2,000,000 [400,000 x 0.4 x $20; 50,000 x 2 x $20] $7,000,000 [8,000 x $70; 100,000 x $70] $1,000,000 [5,000 x $50; 20,000 x $50] $62,154,000 $21,822,000 Net operating income $57,846,000 $678,000 [Sales - Total Costs] Avg. net operating income per unit $144.62 $13.56 [$57,846,000/400,000 units; $678,000/50,000 units]