Revising a time-driven activity-based cost system involves adding products. In the Madison Dairy ice cream plant example mentioned in this chapter, there was an oversight of production-related computer resource expenses of $18,000 per month in the cost system. To incorporate this cost, the time-driven activity-based costing model should be updated. The model estimates two parameters and allocates indirect costs in a similar manner to direct costs.
Cost rate for each type of indirect resource:
Identify all costs incurred to supply the resource.
Identify the practical capacity supplied by the resource.
Determine the capacity cost rate of the resource by dividing its cost by the practical capacity.
The time-driven BBC model will now include a capacity cost rate for computer resources = $18,000 divided by the practical capacity computer hours per month.
The computer resources Usage can measure in computer time per product or production run.
(b) Suppose that energy costs of $4,000 per month to run the machinery have also been inadvertently overlooked for inclusion in the cost system.
How should the activity-based cost model be updated to include this cost, and what will be the effect on the machine hour rate? Answer: Before the machinery energy costs were calculated, the machinery rate was computed as $15,400 divided by 308 practical capacity hours, which equals $50 per hour. The energy costs of $4,000 per month will be added to the $15,400 monthly machinery costs. This will result in a correct machinery resource cost of $19,400 per month, leading to a higher rate per hour. The new rate is $19,400/308 = $62.99, which can be rounded to $63 per hour for convenience.
If the company wishes to introduce a new flavor, what information is needed in order to determine the cost of producing this new flavor? Answer: If the company introduces a new flavor, the new flavor’s consumption of direct and indirect resources will need to be estimated and then multiplied by the appropriate cost or cost rate. For example, start with the quantity of direct materials and labor hours per gallon produced and multiply these amounts by the related cost per unit of direct materials and wage rate, respectively.
Next, calculate the amount of indirect labor (including changeovers, scheduling, and product maintenance) and machine time (for production runs and setups). These values will be multiplied by the corresponding capacity cost rates of each indirect resource and added to the costs of direct materials and direct labor. This will give us the total cost of producing the new flavor.
5_16 (a) Assuming all other information remains unchanged, let’s suppose that indirect labor costs have increased from their original setting.
The task at hand is to determine the total time-driven activity-based costs assigned to each of the four products (flavors) after incorporating a 10% increase in indirect labor costs. This will be depicted in an income statement similar to Exhibit 5-5. The 10% increase in indirect labor costs will cause the indirect labor capacity cost rate to increase from $35 to $38.50, consequently leading to a 10% increase in the costs allocated to products. The resulting revised income statement, resembling Exhibit 5-5, will show indirect labor costs that are 10% higher than before, resulting in reduced product gross profits. Please note that slight variations may occur if calculations are performed using a spreadsheet package.
In addition to the changes mentioned above, another alteration is the reduction of unit time for scheduling a production run. Previously, it took four hours per run, but now it only takes three hours per run. With this adjustment, the task is to determine the new total time-driven activity-based costs assigned to each flavor and prepare an income statement akin to Exhibit 5-5. Furthermore, this revised income statement should also indicate the total cost of unused capacity.
The reduction in unit time for scheduling production from four hours per run to three hours per run results in a decrease in indirect labor costs. To calculate the revised indirect labor hours per month, we consider the hours per run for each flavor and multiply by the number of production runs. The indirect labor hours per month are as follows: Vanilla – 108 hours, Chocolate – 72 hours, Strawberry – 84 hours, Mocha-Almond – 90 hours. We then multiply these hours by the new indirect labor rate of $38.50 per hour to determine the indirect labor cost for each flavor.
In the new income statement, we can observe that the indirect labor costs are lower due to the reduced scheduling time per run. However, it should be noted that small discrepancies may occur if the calculations are performed in a spreadsheet package. The total sales amount is $60,760. The direct materials cost is $12,040 and the direct labor cost, including fringes, is $17,500. The indirect labor usage amounts to $15,017 and the machine usage is $15,000. The gross profit (loss) is $4,045 for Vanilla, $4,081 for Chocolate, and $1,203 for Strawberry. The gross profit (loss) as a percentage of sales is 13.48% for Vanilla, 17.00% for Chocolate, -77.05% for Strawberry, and -138.29% for Mocha-Almond.The summary income statement displays the total costs of both direct and indirect labor, incorporating the costs associated with unused capacity. The statement includes both the totals with assigned costs and the specific costs related to unused capacity.
Totals with Capacity Costs Direct labor and indirect labor $32,517 $68 $32,585 400 $15,400 $(468) $735 1. 21% a Labor capacity cost = $4,655 x 7 employees = $32,585. Employees perform direct labor and indirect labor tasks. 5-32 Part proliferation: role for activity-based costing An article in the Wall Street Journal by Neal Tempting and Joseph B. White (June 23, 1993) reported on the major changes occurring at General Motors. Its new chief executive officer, John Smith, had been installed after the board of directors requested the resignation of Robert Steppes, the previous chief.
John Smith’s North American Strategy Board identified 30 components that could be simplified for 1994 models. GM had 64 different versions of the cruise control/turn signal mechanism. It planned to reduce that to 24 versions the next year and the following year to just 8. The tooling for each one cost Gem’s A. C. Rochester division about $250,000. Smith said, ‘We’ve been talking about too many parts doing the same job for 25 years, but we weren’t focused on it.”
(Note that the tooling cost is only one component of the cost of proliferating components.)
Other costs include the expenses for designing and engineering each unique component, the costs of purchasing, setting up and scheduling, as well as the expenses for stocking and servicing every individual component in all GM dealerships across the United States. The extensive variety of parts at Gem was astonishing. GM produced or acquired 139 different hood hinges, in contrast to Ford’s sole option. Saginaw Plant Six dealt with parts for 167 distinct steering columns, a decrease from the previous year’s 250 but still distant from the objective of fewer than 40 by the end of the decade. This approach led to a significant increase in Gem’s costs.
General Motors faced several challenges in its manufacturing process. Firstly, the company paid higher wages to its engineers compared to its competitors for designing steering columns. Additionally, it required additional tools and manpower to handle the various parts involved in the process. This complexity led to quality issues as workers often confused one steering column with another.
One factor that could have contributed to this over proliferation of parts and components is an inaccurate and distorted product costing system. General Motors used a traditional cost system which allocated costs based on direct materials and direct labor, and factory support was determined by the amount of direct labor. However, this system failed to accurately calculate the cost of component and product variety.
To address the issue of over proliferation and improve efficiency, General Motors should consider implementing a more comprehensive product costing system that takes into account the complexities and variations in its manufacturing process.
Marketing research indicates that consumers prefer having a wide range of options, especially when there are no additional costs involved in choosing. For example, customers may enjoy the freedom to choose any color or type of product. To cater to these preferences, product engineers can develop numerous variations and choices. The cost system only factors in the direct labor and materials involved in producing these options. Consequently, manufacturing one million units of a single steering column would seemingly cost the same as producing 100,000 units each of four different steering columns, 10,000 units each of thirty other steering columns, and 1,000 units each of three hundred other columns.
Producing 334 steering columns in different batch sizes and supporting 34 variations is much more expensive compared to producing only 5 or a maximum of 40 different columns. Traditional cost systems would consider the production costs of labor and materials for all the steering columns, regardless of whether they are produced in 5, 40, or 334 varieties. This makes it difficult to prevent the proliferation of models and components in companies that use traditional cost systems.
However, a new cost system should possess certain characteristics that would accurately signal to product designers and market researchers about the cost of customization and variety. It should be able to identify the costs associated with introducing new varieties, colors, and options. This would include the cost of setting up or changing over production for the new variety, color, or option, which would remain constant regardless of the number of units produced after setup.
Additionally, the new cost system will display the expenses associated with developing and maintaining each new type, shade, and feature (referred to as “product-sustaining” costs in BBC terms) that are not dependent on the quantity of units manufactured. By gaining a more precise comprehension of the costs related to resources utilized for batch and product-sustaining tasks, product engineers and marketing managers can collaborate to make more informed choices regarding whether the elevated cost of introducing another personalized option will be offset by increased sales volumes and/or higher profits.
One of General Motors’ competitors analyzed the cost of wire harnesses in a specific car model. The competitor currently produced 12 different wire harnesses, which was considered optimal under the traditional cost system. However, the BBC system, which considered attach production economics and product-sustaining expenses, showed that 5 or 6 harnesses were actually optimal. When taking into account the cost of stocking and servicing all dealerships, the optimal number decreased to 2.
The perceived cost savings from using custom wire harnesses for various car options was overshadowed by the significant costs of engineering, production support, and servicing that were needed to produce, stock, and service 12 different harnesses for a single car model. To evaluate Treason’s personnel resources, calculate the practical capacity and capacity cost rates for brokers, account managers, financial planners, principals, and customer service representatives (5-36).
Answer: (b) Determine the practical capacity and capacity cost rates for Spinach’s resources, including production and setup employees, machines, receiving and production control employees, shipping and packaging employees, and engineers. Answer: (c) Utilize these capacity cost rates and the production data presented in Exhibits 5-10 and 5-11 to compute revised costs and profits for Spinach’s three product lines. How does your cost allocation affect reported product costs and profitability? What factors contribute to any changes in cost and profitability?
