ZHOU CORPORATION
The ZHOU CORPORATION manufactures two types of chairs, Alpha and Beta. Alpha has a complex design. Beta is simpler to manufacture. Last year ZHOU had the following revenues and costs:
Alpha
Beta
Total
Revenue
$195,000
$184,000
$379,000
Direct materials
55,000
50,000
105,000
Direct labor
40,000
20,000
60,000
Indirect costs
Administration
$19,500
Production setup
45,000
Quality control
30,000
Sales and marketing
60,000
ZHOU currently uses direct labor costs to allocate all indirect costs, but management is considering implementing an ABC system. After interviewing the sales and production staff, management decides to allocate administrative costs on the basis of direct labor costs but to use the following bases to allocate the remaining costs:
Activity
Cost Driver
Alpha
Beta
Production setup
Number of production runs
10
20
Quality control
Number of inspections
40
40
Sales and marketing
Number of advertisements
12
48
REQUIRED:
Develop a complete income statement using ABC and the given cost drivers.
Write a report indicating how management could use activity based management (ABM) to reduce costs.
Restate the income statement for ZHOU using direct labor costs as the only indirect cost allocation base.
Write a report to management stating why product line profits differ using ABC costing compared to the traditional approach. Indicate whether ABC provides more helpful information and why. Indicate in your report how the use of labor based overhead allocation could result in ZHOU management making suboptimal decisions.
ZHOU CORPORATION
The ZHOU CORPORATION manufactures two types of chairs, Alpha and Beta. Alpha has a complex design. Beta is simpler to manufacture. Last year ZHOU had the following revenues and costs:
| Alpha | Beta | Total | |
| Revenue | $195,000 | $184,000 | $379,000 |
| Direct materials | 55,000 | 50,000 | 105,000 |
| Direct labor | 40,000 | 20,000 | 60,000 |
| Indirect costs | |||
| Administration | $19,500 | ||
| Production setup | 45,000 | ||
| Quality control | 30,000 | ||
| Sales and marketing | 60,000 |
ZHOU currently uses direct labor costs to allocate all indirect costs, but management is considering implementing an ABC system. After interviewing the sales and production staff, management decides to allocate administrative costs on the basis of direct labor costs but to use the following bases to allocate the remaining costs:
| Activity | Cost Driver | Alpha | Beta |
| Production setup | Number of production runs | 10 | 20 |
| Quality control | Number of inspections | 40 | 40 |
| Sales and marketing | Number of advertisements | 12 | 48 |
REQUIRED:
Develop a complete income statement using ABC and the given cost drivers.
Write a report indicating how management could use activity based management (ABM) to reduce costs.
Restate the income statement for ZHOU using direct labor costs as the only indirect cost allocation base.
Write a report to management stating why product line profits differ using ABC costing compared to the traditional approach. Indicate whether ABC provides more helpful information and why. Indicate in your report how the use of labor based overhead allocation could result in ZHOU management making suboptimal decisions.
Related questions
Swiss Chocolateâs U.S. division will be diversifying its productline to include two product offerings, a basic plain milk-chocolatecandy bar, and a fruit-infused high cacao content premium candybar. The candy bars are processed through a molding operation inwhich molten chocolate is injected into a mold and cooled to roomtemperature, removed from the mold, and packaged for storage andbulk palletized shipment.
Below is information regarding the direct costs and volumes ofthe two major products:
Variable cost and volume data | Milk chocolate | Premium cacao |
Raw materials | $0.50 | $0.75 |
Direct labor | $0.25 | $0.40 |
Selling and general | $0.05 | $0.05 |
Volume in units | 300,000 | 100,000 |
Sales prices of the two products are $2.65 for milk chocolateand $4.99 for premium cacao. The number of hours required tomanufacture each unit was the same for both products.
After an interview process with the factory and productionpersonnel, the division controller, Steve Smith, completed thefollowing table. From its simple cost structure, the companydecided to reconsider its overhead pool and reallocate on the basisof activity-based costing. Its simple overhead pool has beenreclassified according to the ABC hierarchy within the followingtable:
| ABC Cost Pools | Indirect manufacturing labor | Factory Insurance & Utilities | Depreciation -- Machinery and factory | Repairs and maintenance -- factory | Selling, marketing and distrubution expenses | General & administrative expenses |
| Product Development | $ 25,000 | |||||
| Setup Candy Molding Equipment | $ 12,000 | $ 18,500 | ||||
| Equipment Operations | $ 15,500 | $ 31,500 | $ 20,000 | $ 10,000 | ||
| Shipment Preparation | $ 20,000 | |||||
| Distribution | $ 4,000 | |||||
| Administration | $ 20,000 | $ 60,000 | ||||
| Totals | $ 52,500 | $ 31,500 | $ 38,500 | $ 14,000 | $ 40,000 | $ 60,000 |
Smith also noted the following percentage allocations of costfor the activities which are required to manufacture eachproduct.
ABC cost allocation percentages | Milk chocolate | Premium cacao |
Product development | 20% | 80% |
Setup candy molding equipment | 60% | 40% |
Equipment operations | 75% | 25% |
Shipment preparation | 70% | 30% |
Distribution | 65% | 35% |
Administration | 50% | 50% |
From the cost information provided, respond to the followingquestions:
Compute the cost of each product under the simple/traditionalcosting method. For period costs, use the same basis of allocationas factory overhead.
Compute the net operating profit margin of each product usingthe simple/traditional costing method.
Categorize the production activities under activity-basedcosting according to the cost hierarchy. Indicate the type of costcategory that aligns with the activity.
Compute the total overhead and period cost allocation under ABCassumptions for each product.
Compute the per unit ABC cost of each product.
Compute the net profit margin of each product using the ABCcosting method.
Compare the net profit margin of the products under thesimple/traditional cost assignment and the ABC assignment for eachproduct. Evaluate the difference.
Write a brief explanation (approximately two paragraphs) thatSmith might deliver to management to justify the use of ABC forthese two products.
Your paper should meet the following requirements:
2-3 pages in length
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).
