Business Administration - Accounting & Financial Planning ECN502 Lecture Notes - Lecture 5: Net Income, Retained Earnings, Income Approach
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John Orland, controller of the JuiceCompany, has been concerned over the erosion of the recentfinancial results especially for the standard flavors (A and B)which used to earn a hefty 20 per cent of profit margin.
Recently, Dan Brun, the salesmanager has expanded the lines of products to encompass new flavors(D & C) which were in high demand by customers who were willingto pay 5 to 10 % premium.
Richard Dunn, the manufacturingmanager, was also excited to introduce the new flavors since theywere expected to generate higher margins while using the sametechnology as standard flavors. However, he noticed that theintroduction of new flavors added some technical complexities tothe production process. For instance, unlike flavors A & B,which were produced in huge volume and in long production runs,difficulties started to arise with the new flavors which wereproduced in smaller batches but required more changeovers and moreproduction runs (see Exhibit 3).
The Juice Company produced thedifferent flavors in the same factory. Each flavor had a bill ofmaterials that determines the quantity and cost of direct materialsused for the production of each flavor. Additionally, a routinesheet was used to track the direct labor expenses incurred at eachoperating step for each of the four flavors. All overhead costswere grouped at the plant level and allocated to each flavor on thebasis of direct labor cost. The rate was arbitrarily set at 400 %of direct labor costs (see Exhibit 2).
John was intrigued by the behaviorof their main competitors who were more interested in competing inlow margin flavors (A and B) than in high profit margins (Flavors C&D). Such behavior has led the controller to question theaccuracy of the costing system used by the company and to concludethat the current method of allocation of indirect costs isdistorting their productsâ costs thereby causing inappropriatepricing.
To remedy the distortions caused bythe traditional method of costing based on one single cost pool ofindirect costs, John decided to implement activity-based costing(ABC) method which focuses on the activities, how they areperformed, and the resources they consumed and to assign activitiescosts to products based on how much demand each of these productsputs on these activities. After careful analysis of themanufacturing operations of the company and input from engineers aswell as manufacturing and operating managers, the controlleridentified four main activities: process production run, set upequipment, manage products, and run machines.
The demand on these activities bydifferent flavors is illustrated in Exhibit 3.
In order to determine the costsincurred to perform these various activities, he began byidentifying the resources that were being consumed by theseactivities. These resources were then grouped in six categories asshown in Exhibit 1. To gather the required new cost information, heproceeded to interview the department heads in charge of supportstaff wages and benefits and insurance; he found out that theirservices are used by three activities: process production run(35%), set up (35%), and the remaining 30 % consumed to manageproducts.
Next, the controller tackled theinformation system item and determines, after interview with thehead of the information system department, that process productionruns accounts for 25 % of their services while 75 % are used tomanage products.
The results of his investigationsabout the usage of the equipment revealed that it was entirely usedto run machines. Maintenance services were shared equally betweenthe production run activity and run machine activity. Finally,utility was shared equally by the four activities.
Questions
Describe the problem the company is facing
Estimate the costs for the four pens products using ABC
Explain why the ABC costs are different from those provided bythe traditional method based one single cost pool of indirectcosts.
What are the managerial implications for the revised estimates?(i.e.,What would you do if you were the manager of the company andwhy?)
Exhibit 1 | |||
Resources Used | Costs of Resources | ||
Support staff wages | $ 40,000.00 | ||
Benefits and insurances | 15000 | ||
Information Systems | 12000 | ||
Equipment | 8000 | ||
Maintenance | 6000 | ||
Utilities | 2000 | ||
Total | $ 83,000.00 | ||
Exhibit 2: Traditional Income Statement | |||||
Flavor A | Flavor B | Flavor C | Flavor D | Total | |
Number of units produced | 80000 | 60000 | 12000 | 3000 | 155000 |
Sales | $ 82,000.00 | $ 55,000.00 | $ 16,000.00 | $ 4,000.00 | $ 157,000.00 |
Material Costs | $ 18,000.00 | $ 9,000.00 | $ 5,200.00 | $ 1,000.00 | $ 33,200.00 |
Direct Labor Costs | $ 10,900.00 | $ 7,800.00 | $ 1,600.00 | $ 450.00 | $ 20,750.00 |
Indirect Costs (400% of direct labor costs | $ 43,600.00 | $ 31,200.00 | $ 6,400.00 | $ 1,800.00 | $ 83,000.00 |
Total operating income | $ 9,500.00 | $ 7,000.00 | $ 2,800.00 | $ 750.00 | |
Profit margin percentage | 12% | 13% | 18% | 19% | |
Exhibit 3: Activity usage | |||||
Flavor A | Flavor B | Flavor C | Flavor D | Total | |
Production sales in units | 80000 | 60000 | 12000 | 3000 | 155000 |
Sales in Dollars | $ 82,000.00 | $ 55,000.00 | $ 16,000.00 | $ 4,000.00 | $ 157,000.00 |
Machine hours per unit | 0.1 | 0.1 | 0.1 | 0.1 | 15500 |
Production runs | 60 | 60 | 30 | 10 | 160 |
Total setup time (hours) | 160 | 130 | 180 | 90 | 560 |
Manage Products | 1 | 1 | 1 | 1 | 4 |
Bushman Case
The Bushman Company is a publicly traded corporation that produces different types of digital control systems. My name is Alan Smith and I have worked for this company for the last ten years in the controllerâs 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 $700,000,000 a year, Bushman has decided to adopt activity based costing over the next year or two.
Bushmanâs 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, delta and vega, 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 Bushman management believe they have very different demands on indirect overhead resources. Further, delta is sold in large quantities whereas vega 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
| delta | vega | |
| Direct material | $10 | $10 |
| Direct labor hours | 1 | 1 |
| Direct labor wage rate per hour | $20 | $20 |
| Sales price per unit | $160 | $170 |
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
| Activity cost pool | Total costs | Activity measure | Activity level |
| Equipment setups | $20,000,000 | number of setups | 50,000 |
| Purchase orders | $15,000,000 | number of purchase orders | 300,000 |
| Machining | $90,000,000 | number of machine hours | 2,000,000 |
| Testing | $13,300,000 | number of testing hours | 700,000 |
| 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 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
| delta | vega | |
| annual sales and production in units | 800,000 | 12,000 |
| number of units per batch | 200 | 150 |
| number of purchase orders | 400 | 100 |
| number of machine hours per unit | 0.2 | 3 |
| total number of testing hours | 7,000 | 21,000 |
| total number of containers | 5,000 | 2,000 |
REQUIRED:
1. (20 Points) Prepare an income statement for delta and an income statement for vega using the traditional accounting system where overhead is applied at a rate of 400% of direct labor costs. (For simplicity, there are no SG&A expenses for the firm.) 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:
delta vega
Sales $$$ $$$
Direct materials $$$ $$$
Direct labor $$$ $$$
Manufacturing overhead $$$ $$$
Total Costs $$$ $$$
Net operating income $$$ $$$
Average net operating income
per unit $$$ $$$
2. (20 Points) Calculate the five activity rates under activity based costing.
3. (35 Points) Prepare an income statement for delta and an income statement for vega using activity based costing. (For simplicity, there are no SG&A expenses for the firm.) 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:
delta vega
Sales $$$ $$$
Direct materials $$$ $$$
Direct labor $$$ $$$
Equipment Setups $$$ $$$
Purchase orders $$$ $$$
Machining $$$ $$$
Testing $$$ $$$
Packaging $$$ $$$
Total Costs $$$ $$$
Net operating income $$$ $$$
Average net operating income
per unit $$$ $$$
4. (10 Points) Assume next year that the activity rates remain the same as you calculated in question (2). Assume that the demand for delta is expected to increase significantly. Consequently, the firm expects to produce more batches of delta next year than this year and the firm plans to produce in batch sizes of 500 rather than 200. Calculate what the equipment setup cost per unit of delta 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 delta 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. Your grade will be lowered for poor writing (e.g., grammar).
5. (15 Points) Question 5 is independent of question 4. Next year, because of an expected increase in product demand, machine hours are expected to increase from 2,000,000 to 2,500,000. The company will not need any new machinery since the current machinery is highly underutilized. Also, the number of purchase orders will increase from 300,000 to 360,000. Assume that these new levels of operations are within the firmâs 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 purchase order 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. Your grade will be lowered for poor writing (e.g., grammar).
