Question

5-17 ABC, cost hierarchy, service. (CMA, adapted) Vineyard Test Laboratories does heat testing (HT) and stress testing (ST) on materials and operates at capacity. Under its current simple costing system, Vineyard aggregates all operating costs of $1,190,000 into a single overhead cost pool. Vineyard calculates a rate per test-hour of $17 ($1,190,000 = 70,000 total test-hours). HT uses 40,000 test-hours, and ST uses 30,000 test-hours. Gary Celeste, Vineyard's controller, believes that there is enough variation in test procedures and cost structures to establish separate costing and billing rates for HT and ST. The market for test services is becoming competitive. Without this information, any miscosting and mispricing of its services could cause Vineyard to lose business. Celeste divides Vineyard's costs into four activity-cost categories. a. Direct-labor costs, $146,000. These costs can be directly traced to HT, $100,000, and ST, $46,000. b. Equipment-related costs (rent, maintenance, energy, and so on), S350,000. These costs are allocated to HT and ST on the basis of test-hours. c. Setup costs, $430,000. These costs are allocated to HT and ST on the basis of the number of setup-hours required. HT requires 13,600 setup-hours, and ST requires 3,600 setup-hours. d. Costs of designing tests, $264,000. These costs are allocated to HT and ST on the basis of the time required for designing the tests. HT requires 3,000 hours, and ST requires 1,400 hours. 1. Classify each activity cost as output unit-level, batch-level, product- or service-sustaining, or facility- sustaining. Explain each answer. 2. Calculate the cost per test-hour for HT and ST. Explain briefly the reasons why these numbers differ from the $17 per test-hour that Vineyard calculated using its simple costing system. 3. Explain the accuracy of the product costs calculated using the simple costing system and the ABC system. How might Vineyard's management use the cost hierarchy and ABC information to better manage its business?

Answer 1

Answer-1:

		Cost Type	Explanation
a	Direct labor costs	Output unit-level costs	because they are incurrec on each unit of material tested i.e for every hour of testing.
b	Equipment related cost (rent, maintenance, energy, and so on)	Output unit-level costs
c	Set up costs	Batch-level costs	because they are incurred each time a batch of materialsis set up for either HT or ST, regardless of the number of hours for which the tests aresubsequently run
d	Cost of designing tests	Service-sustaining costs	because they are incurred to design the HT andST tests, regardless of the number of batches tested or the number of hours of test time

Answer-2:

Heat Testing (HT) Total Per Hour (1) (2) = (1)+ 40,000 $100,000 $ 2.50 Stress Testing (ST) Total Per Hour (3) (4) =(3) + 30,000 $ 46,000 $ 1.53 200,000 5.00 150,000 5.00 Direct labor costs (given) Equipment-related costs $5 per hour* x 40,000 hours $5 per hour* x 30,000 hours Setup costs $25 per setup-hour* x 13,600 setup-hours $25 per setup-hour" x 3,600 setup-hours Costs of designing tests $60 per hour** x 3,000 hours $60 per hour** x 1,400 hours Total costs 340,000 8.50 90,000 3.00 180,000 4.50 84.000 $370.000 2.80 $12.33 $820.000 $20.50

*$350,000 / (40,000 + 30,000) hours = $5 per test-hour

†$430,000 / (13,600 + 3,600) setup hours = $25 per setup-hour

**$264,000 / (3,000 + 1,400) hours = $60 per hour

At a cost per test-hour of $17, the simple costing system undercosts heat testing ($20.50) andovercosts stress testing ($12.33). The reason is that heat testing uses direct labor, setup, anddesign resources per hour more intensively than stress testing. Heat tests are more complex, takelonger to set up, and are more difficult to design. The simple costing system assumes that testingcosts per hour are the same for heat testing and stress testing

Answer-3:

The ABC system better captures the resources needed for heat testing and stress testing because it identifies all the various activities undertaken when performing the tests andrecognizes the levels of the cost hierarchy at which costs vary. Hence, the ABC system generatesmore accurate product costs.

Vineyard ’s management can use the information from the ABC system to make better pricing and product mix decisions. For example, it might decide to increase the prices chargedfor the more costly heat testing and consider reducing prices on the less costly stress testing.Vineyard should watch if competitors are underbidding Vineyard in stress testing, and causing itto lose business. Vineyard can also use ABC information to reduce costs by eliminating processes and activities that do not add value, identifying and evaluating new methods to dotesting that reduce the activities needed to do the tests, reducing the costs of doing variousactivities, and planning and managing activities.