EXERCISES: Activity-Based Costing of Customers: Rock Solid Bank & Trust.

a.
Sales revenue................... $375,000,000 x 5.2% $19,500,000
Costs:
Interest on deposits....... $375,000,000 x 0.5% 1,875,000
Operating costs............ (Given) 15,000,000
Total costs......................... 16,875,000
Operating profit.................. $2,625,000
b.
Customer A Customer B
Deposit................................. $6,000 $6,000

Sales revenue...................... $312a $312

Interest on deposits.............. 30b 30
Operating costs.................... 240c 240
Customer profit.................... $42 $42

a $312 = $6,000 deposit x 5.2%.

b $30 = $6,000 deposit x 0.5%.
c $240 = $6,000 deposit x 4% operating cost to deposit ratio
(= $15,000,000 ÷ $375,000,000).
c.

Activity Cost Driver Cost Driver Volume Rate

Number of
Use ATM $1,500,000 ÷ 2,000,000 = $0.75 per use
uses
Number of
Visit branch 900,000 ÷ 150,000 = $6 per visit
visits
Process Number of = $0.0825 per
6,600,000 ÷ 80,000,000
transaction transactions transaction
General bank
Total deposits 6,000,000 ÷ $375,000,000 =1.6% of deposits
overhead

Customer A Customer B
Units of Units of
Activity Cost Cost
Driver Driver
Sales revenue.....................................................$312.00 $312.00
Interest on deposit............................................... 30.00 30.00
Account margin.............................................$282.00 $282.00
Operating costs:
Use ATM.........................................................
100 $75.00a 200 $150.00
Visit branch......................................................
5 30.00b 20 120.00
Process transaction.........................................
40 3.30c 1,500 123.75
General bank overhead...................................
$6,000 96.00d $6,000 96.00
Total operating cost.......................................$204.30 $489.75
Customer profit................................................. $ 77.70 ($207.75)

a $75 = 100 uses x $0.75 per use.

b $30 = 5 visits x $6 per visit.
c $3.3 = 40 transactions x $0.0825 per transaction.
d $96.00 = $6,000 deposit x 1.6%.

Activity-Based Costing of Customers: Rock Solid Bank & Trust.

a. RSB&T can use this information to change the way banking services are priced.
Managers at the bank may want to consider ATM fees or require minimum
balances.
b. Any changes in fees have to be instituted with the understanding that Customer
A may be a relatively young customer who will enjoy increased income and
become a more profitable customer in the future. If they try to make Customer A
profitable today, they risk losing future business. On the other hand, customers
can be very fickle and it is unclear whether incurring losses today would have
any impact on customer loyalty.

EXERCISES: Activity-Based Costing of Suppliers: Kinnear Plastics.

The approach to this problem is to determine how much it costs to purchase a
ton of “good” plastic. The effective price is the quoted price divided by the
percentage of good tons that can be expected:
Tappan Hill
Tons purchased 4,400 8,200
Tons discarded 110 410
Percentage of good product 2.5% 5.0%
Quoted price $1,482 $1,463
Effective cost per ton (a) $1,520 $1,540
(a) $1,520 = $1,482 ÷ (100% – 2.5%); $1,540 = $1,463 ÷ (100% – 5%)

Activity-Based Costing of Suppliers: Kinnear Plastics.

a. $1,501.50. This can be answered as a breakeven calculation, solving for B,
the bid:
(B ÷ 97.5%) = $1,540
B = $1,501.50.
b. There are several reasons, including Kinnear not wanting to be dependent on
one supplier or capacity constraints at Tappan.

Resources Used versus Resources Supplied: Conlon Enterprises.

Resources Unused Resource

Resources Used Supplied Capacity
Setups.................................................................
$131,250 $135,000 $3,750
($375  350 runs) (given) ($135,000 – $131,250)

Clerical.................................................................
$45,000 $60,000 $15,000
 ($45  1,000 pages) (given) ($60,000 – $45,000)

Resources Used versus Resources Supplied: Conlon Enterprises.

a.
Sales revenue.......................... $ 240,000
Setup costs......................... $135,000
Clerical costs...................... 60,000 195,000
Operating profit $ 45,000

b.
Unused
Resources Resource Resources
Used Capacity Supplied
Sales revenue ........................ $ 240,000
Costs
Volume related
Clerical............................. $45,000 $15,000 $60,000
Batch related
Setups.............................. 131,250 3,750 135,000
Total costs............................... $176,250 $18,750 $195,000 195,000
Operating profits...................... $ 45,000

Assigning Cost of Capacity: Mimi’s Fixtures.

a. Because the plant was purchased with excess capacity for future growth, current
production should not be charged with excess capacity. Therefore, the cost
system should report a cost of $38 per tile computed as follows:
Variable cost per tile..................... (Given) $18
Allocated fixed capacity cost........($600,000 ÷ 30,000 tiles) 20
Cost per tile................................ $38

b. The cost of excess capacity is $100,000 [= $600,000 – ($20 × 25,000 tiles)].

c. If the minimum plant size was 30,000 tiles, then the capacity is for the customers’
benefit and the costing system should charge the cost of excess capacity to
current production. In this case, the cost of a tile is $42, computed as follows:
 Variable cost per tile..................... (Given) $18
Allocated fixed capacity cost........($600,000 ÷ 25,000 tiles) 24
Cost per tile................................ $42
and there is no excess capacity cost.

Costs of Quality: Domingo Corporation.

a. Prevention: Process inspection, quality training, preventive maintenance,
materials inspection.
Appraisal: Testing equipment, field testing.
Internal failure: Scrap, rework.
External failure: Warranty repairs, customer complaints.

b. March April
Prevention
 $41,450 ÷ $490,000.........................................
8.5%
 $29,180 ÷ $440,000.........................................
6.6%
Appraisal
 $16,400 ÷ $490,000.........................................
 3.4%
 $19,400 ÷ $440,000.........................................
 4.4%
Internal failure
 $18,850 ÷ $490,000.........................................
 3.9%
 $20,430 ÷ $440,000.........................................
 4.6%
External failure
 $7,100 ÷ $490,000...........................................
 1.5%
 $8,200 ÷ $440,000...........................................
 1.9%
10-1. (30 min.) Trading-Off Costs of Quality: Domingo Corporation.
Domingo Corporation
Cost of Quality Report

March % April %

Sales revenue.....................................................
$490,000 $440,000
Prevention costs:
 Process inspection........................................$ 1,650 $ 1,880
 Quality training..............................................19,800 13,000
 Preventive maintenance............................... 13,500 9,500
 Materials inspection...................................... 6,500 4,800
Total prevention costs.........................................
$ 41,450 8.5% $ 29,180 6.6%
Appraisal costs:
  Testing equipment........................................$ 7,000 $ 7,000
  Field testing...................................................
9,400 12,400
Total appraisal costs...........................................
$ 16,400 3.4 $ 19,400 4.4
Internal failure costs:
 Scrap...............................................................
$ 1,850 $ 1,930
 Rework............................................................
17,000 18,500
Total internal failure costs...................................
$ 18,850 3.9 $ 20,430 4.6
External failure costs:
 Warranty repairs............................................
$ 4,300 $ 4,800
 Customer complaints.................................... 2,800 3,400
Total external failure costs: ................................
$ 7,100 1.5 $ 8,200 1.9
Total Costs of Quality..........................................
$  83,800 17.1% $  77,210 17.6%

Activity-Based Reporting and Capacity: Carbon Company.

a.
Sales revenue................. $300,000
Materials...................... $98,000
Energy......................... 17,880
Setups.......................... 24,000
Purchasing.................. 21,000
Customer service....... 15,600
Long-term labor.......... 29,000
Administrative............ 28,000
 Total costs....................... 233,480
Operating profit.............. $66,520

b.
Sales revenue $300,000
Unused
Resources Resource Resources
Used Capacity Supplied
Costs
 Unit
  Materials.......................................................
$96,000 $ 2,000 $98,000
  Energy..........................................................
16,320 1,560 17,880
$112,320 $3,560 $115,880
 Batch
  Setups.........................................................
$ 24,000 $ -0- $ 24,000
  Purchasing..................................................
19,200 1,800 21,000
$ 43,200 $ 1,800 $ 45,000
Product and customer sustaining
  Customer service.......................................
$ 8,000 $7,600 $ 15,600
$ 8,000 $7,600 $ 15,600
 Capacity sustaining
  Long-term labor..........................................
$ 25,600 $ 3,400 $ 29,000
  Administrative............................................
25,200 2,800 28,000
$50,800 $ 6,200 $57,000
Total costs...........................................................
$214,320 $19,160 $233,480 233,480
Operating profit.................................................... $66,520

c. A traditional income statement shows management resources supplied, but gives

no indication of the resources used and unused resource capacity. Management
has no way of knowing the amount of unused resource capacity or the cost of
unused resource capacity ($19,160). The activity-based income statement
provides management with resources supplied information (as does the
traditional income statement) and includes resources used and unused resource
capacity. It also includes the type of cost (unit, batch, product & customer
sustaining, and capacity sustaining), which allows management to assess its
flexibility in controlling costs. Based on the information in (a) and (b), we can see
that customer service provides the majority of unused resource capacity
($7,600). This is useful for managers in that it indicates what actions might be
taken to reduce costs (for example, redeploy personnel in the customer service
activity to sales).
Customer Profitability: Carmel Company.
a.
Customer Costs Titanium Platinum
Number of customers.................................................... 6,000 24,000
Number of customer representatives(6k/200:24k/12)... 30 12
Average gross margin per customers........................... $1,500 $280

Total gross margin ($1,500 x 6,000; $280 x $9,000,000 $6,720,000

24,000)..........................................................................
Customer representative salary (@ $60,000 per
customer representative)........................................... 1,800,000 720,000
Customer representative bonus (@ 2% of gross
margin)9MX0.02%:6,720,000/2%................................. 180,000 134,400
Promotion costs (70% titanium; 30% platinum)....... 1,400,000 600,000
Excess of gross margin over customer cost........... $5,620,000 $5,265,600

b. Titanium customers are more profitable even after considering the cost of
representatives and the promotion costs.

Assigning Capacity Costs: Cathy and Tom’s Specialty Ice Cream Company.
Cathy and Tom's Specialty Ice Cream Company illustrates in a very simple way the
issues of cost system design when costing excess capacity. Although the problem
setting is simple, the basic issues and the resolution of those issues are applicable in a
large number of settings. The three problems (10-59, 10-60, and 10-61) illustrate
different aspects of the capacity costing problems and issues.
There are two customers who demand a total of 13,500 gallons, which is 75% of plant
capacity. The cost of the capacity (all assumed fixed) is $27,000.
There are two possible approaches to costing the ice cream:

1. Cost at capacity:
Overhead rate = ($27,000 ÷ 18,000 gallons) = $1.50/gallon
Product cost = $1.00 + $1.50 = $2.50/gallon
2. Cost at demand:
Overhead rate = ($27,000 ÷ 13,500 gallons) = $2.00/gallon
 Product cost = $1.00 + $2.00 = $3.00/gallon

How do you choose between the two? Why did Cathy and Tom buy a plant with a
capacity of 18,000 gallons? Possible reasons include:
(1) They hope to grow the market, i.e., for future expansion.
(2) Because capacity is “lumpy” and they can only buy in increments of, perhaps,
9,000 gallons.
(3) Because daily demand fluctuates and they need the surge capacity.
If it is reason (1), then the excess capacity is for Cathy and Tom and should not be
charged to product costs. Instead, they should use the lower cost ($2.50) and charge
the excess capacity (25% of $27,000) to Marketing or whoever benefits from the
capacity.
If, instead, they have the capacity for reasons (2) or (3), then the excess capacity is
providing a service to the customers and the product should bear the cost of the excess
capacity.

Assigning Capacity Costs—Seasonality: Cathy and Tom’s Specialty Ice Cream.

With seasonal demand fluctuations, the reason for the excess capacity is for the benefit
of the two customers (Cathy and Tom need all the capacity in the summer). The issue is
how to treat the excess capacity costs. The capacity costs in each season are $13,500
(= $27,000 ÷ 2 seasons). Two approaches to costing are:
1. Excess capacity costs assigned to season in which it is incurred, then to products
in that season. Thus,

Winter:
Overhead rate = ($13,500 ÷ 4,500 gallons) = $3.00/gallon
Product cost = $1.00 + $3.00 = $4.00/gallon
Summer
Overhead rate = ($13,500 ÷ 9,000 gallons) = $1.50/gallon
Product cost = $1.00 + $1.50 = $2.50/gallon

2. Excess capacity costs assigned to the season requiring it, then to products
produced in that season. Thus,

Winter:
Overhead rate = ($13,500  50%) ÷ 4,500
gallons) = $1.50/gallon
 Product cost = $1.00 + $1.50 = $2.50/gallon
Summer
Overhead rate = [$13,500 + ($13,500  50%)] ÷
9,000 gallons) = $2.25/gallon
Product cost = $1.00 + $2.25 = $3.25/gallon

Choosing method 1 would imply it is more costly to produce products when demand is
low. This would send exactly the wrong signal to marketing. You want them to be more
aggressive in going after business in winter and less aggressive in summer. The reason
for the excess capacity in the winter is the demand by the summer customers.
Therefore, the summer customers should be assigned the excess capacity costs, as is
done in method 2.
10-2. (30 min.) Assigning Capacity Costs—Seasonality: Cathy and Tom’s
Specialty Ice Cream.
With seasonal demand fluctuations, the reason for the excess capacity is for the benefit
of the two customers (Cathy and Tom need all the capacity in the summer). The issue is
how to treat the excess capacity costs. The capacity costs in each season are $9,000 (=
$27,000 ÷ 3 seasons).
We can use the approach in Problem 10-60 to answer this problem. There are now
three seasons and three levels of demand. First, note that there is still $6,750 (4,500
gallons) of unused capacity costs, as in Problems 10-59 and 10-60.
In the winter, 50 percent of the plant is idle and the capacity cost for one season is
$9,000. Thus, there is $4,500 (3,000 gallons) of unused capacity cost in the winter. Of
this, 50 percent (1,500 gallons) or $2,250 is needed in both the fall/spring and summer
seasons. Thus, we can split that cost between those two seasons ($1,125 each
season). The remaining $2,250 of unused capacity cost in the winter is required to
serve summer demand. Therefore, a total of $3,375 of unused winter capacity cost is
assigned to the summer.
In the fall/spring season, there is 25 percent unused capacity (1,500 gallons), with a
cost of $2,250. This cost is assigned to the summer because we require all the capacity
in the summer.
The capacity costs and capacity in each season is:

Capacity Costs Winter Fall/Spring Summer

Total.................................................................
$9,000 $9,000 $9,000
Unused...........................................................
(4,500) (2,250) –0–
Used...............................................................
$4,500 $6,750 $9,000
Charge for unused......................................... –0– 1,125a 5,625b
Total capacity costs.............................................
$4,500 $7,875 $14,625
Production (gallons)............................................
3,000 4,500 6,000
Rate.....................................................................
$1.50c $1.75 $2.44
Variable cost........................................................
1.00 1.00 1.00
Total cost.............................................................
$2.50 $2.75 $3.44

a $1,125 = 25% of the unused capacity cost from winter. (Cathy and Tom would only
require 13,500 gallons of capacity to meet the fall/spring demand.)
b $5,625 = $2,250 unused fall/spring capacity + $3,375 unused winter capacity.
c $1.50 = $4,500 capacity cost ÷ 3,000 gallons production.
10-3. (30 min.) Quality Improvement: Metallic, Inc.
a. There are two alternatives: continue with the current material or use the new
material. To determine the best alternative (considering only the financial
consequenses), compute profit under each alternative:

Current New Material

Material
Number of units sold ....................................................... 8,500 9,500
Price per unit ................................................................... $500 $500
Sales revenue ................................................................. $4,250,000 $4,750,000
Variable bending manufacturing costs (10,000
units):
Materials (@$125 for current; $180 for new).............. 1,250,000 1,800,000
Other variable (@$50) ................................................ 500,000 500,000
Fixed manufacturing costs (cutting)................................ 750,000 750,000
Variable welding costs (@$75) ....................................... 637,500 712,500
Fixed welding costs ........................................................ 500,000 500,000
Inspection and testing ..................................................... 120,000 100,000
Profit $ 492,500 $ 387,500

Alternatively, we can do a differential analysis:

Additional revenue ............................................. ($500 x 1,000 $500,000
units)
Inspection savings ............................................. 20,000
$520,000
Less additional material cost in bending ........... ($55 x 10,000) 550,000
Less additional variable cost in welding ............ ($75 x 1,000) 75,000
Net change in profit ........................................ $(105,000)

b. Based on the financial analysis, it appears to be more profitable to continue with

the current material. Other considerations include the cost of dealing with scrap.