Question

5-26 Activity-based costing, manufacturing. Decorative Doors, Inc., produces two types of doors, inte- rior and exterior. The company's simple costing system has two direct-cost categories (materials and labor) and one indirect-cost pool. The simple costing system allocates indirect costs on the basis of machine- hours. Recently, the owners of Decorative Doors have been concerned about a decline in the market share for their interior doors, usually their biggest seller. Information related to Decorative Doors production for the most recent year follows: Units sold Selling price Direct material cost per unit Direct manufacturing labor cost per hour Direct manufacturing labor-hours per unit Production runs Material moves Machine setups Machine-hours Number of inspections Interior 3,200 $ 125 $ 30 $ 16 1.50 40 72 45 5,500 250 Exterior 1,800 $ 200 $ 45 $ 16 2.25 85 168 155 4,500 150 The owners have heard of other companies in the industry that are now using an activity-based costing system and are curious how an ABC system would affect their product costing decisions. After analyzing the indirect-cost pool for Decorative Doors, the owners identify six activities as generating indirect costs: production scheduling, material handling, machine setup, assembly, inspection, and marketing, Decorative Doors collected the following data related to the indirect-cost activities:

Answer 1

1. Simple costing system: Total indirect costs = $95,000+ $45,000 + $25,000 + $60,000+ $8,000 + 3%[($125 x 3,200) + ($200 x 1,800)] = $255,800 Total machine-hours 5,500 + 4,500 = 10,000 Indirect cost rate per machine-hour = $255,800: 10,000 = $25.58 per machine-hour Simple Costing System Direct materials Direct manufacturing labor" Indirect cost allocated to each job ($25.58 x 5,500; 4,500 machine hours) Interior $ 96,000 76,800 Exterior $ 81,000 64,800 140,690 115,110 Total costs $313,490 $260,910 Total cost per unit ($313,490 = 3,200; $260,910 = 1,800) $ 97.97 $ 144.95 a $30 x 3,200 units; $45 x 1,800 units

2. Activity-based costing system Total Cost Cost of Driver Activity Activity Cost Driver Quantity Allocation Rate (1) (2) (3) (4) (5) = (2) + (4) Product per production scheduling $95,000 Production runs 1250 $760.00 run Material $45,000 Material moves per material handling 2404 $187.50 move Machine setup $25,000 Machine setups 200€ $125.00 per setup Assembly $60,000 Machine hours per machine 10,000 $ 6.00 hour Inspection $ 8,000 Inspections 400* $ 20.00 per inspection Marketing Percentage of $ 0.03 per dollar of revenues sales € 40+ 85 = 125; 72 +168 = 240; e 45+ 155 = 200; f 250 + 150 = 400 Interior $ 96,000 76,800 Exterior $ 81,000 64,800 ABC System Direct materials Direct manufacturing labor Indirect costs allocated: Production scheduling ($760 per run x 40; 85) Material handling ($187.50 per move x 72; 168) Machine setup ($125 per setup x 45; 155) Assembly ($6 per MH ~ 5,500; 4,500) Inspection ($20 per inspection 250; 150) Marketing (0.03 < $125 x 3,200; 0.03 × $200 x 1,800) Total costs 30,400 13,500 5,625 33,000 5,000 12,000 $272,325 64,600 31,500 19,375 27,000 3,000 10,800 $302.075 Total cost per unit ($272,325 = 3,200 units; $302,075 - 1,800 units) $ 85.10 $ 167.82

3. Cost per unit Simple Costing System Activity-based Costing System Difference (Simple – ABC) Interior $97.97 $85.10 $12.87 Exterior $144.95 $167.82 $ (22.87)

Relative to the ABC system, the simple costing system overcosts interior doors and undercosts exterior doors. Interior doors require 1.72 machine-hours per unit (5,500 hours ÷ 3,200 units) while exterior doors require 2.5 machine-hours per unit (4,500 hours ÷ 1,800 units). In the simple-costing system, overhead costs are allocated to the interior and exterior doors on the basis of the machine-hours used by each type of door. The ABC study reveals that the ratio of the cost of production runs, material moves, and setups for each exterior door versus each interior door is even higher than the ratio of 2.5 to 1.72 machine-hours for each exterior relative to each interior door. This higher ratio results in higher indirect costs allocated to exterior doors relative to interior doors in the ABC system.

4. Decorative Doors, Inc. can use the information revealed by the ABC system to change its pricing based on the ABC costs. Under the simple system, Decorative Doors was making an operating margin of 21.6% on each interior door ([$125 – $97.97] /$125) and 27.5% on each exterior door ([$200 – $144.95] /$200). But, the ABC system reveals that it is actually making an operating margin of about 32% ([$125 – $85.10] /$125) on each interior door and about 16% ([$200 – $167.82] /$200) on each exterior door. Decorative Doors, Inc., should consider decreasing the price of its interior doors to be more competitive. Decorative Doors should also consider increasing the price of its exterior doors, depending on the competition it faces in this market.  

Decorative Doors can also use the ABC information to improve its own operations. It could examine each of the indirect cost categories and analyze whether it would be possible to deliver the same level of service, but consume fewer indirect resources, or find a way to reduce the per-unit-cost-driver cost of some of those indirect resources. Making these operational improvements can help Decorative Doors to reduce costs, become more competitive, and reduce prices to gain further market share while increasing its profits.

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