Cost Chap 010

Chapter 10 - Fundamentals of Cost Management
Chapter 10
Fundamentals of Cost Management
Solutions to Review Questions
10-1.
Activity-based costing provides management with detailed costing information about
products and services. Activity-based management focuses on the use of activity-based
costing information to make decisions. Activity-based management is based on activity
analysis and finding ways to be more efficient with activities within the organization.
10-2.
Activity-based management can be implemented without an activity-based costing
system. However, since the focus of activity-based management is on those activities
that cause the most costs, activity-based costing provides data useful to the
implementation of activity-based management.
10-3.
Value-added activities add value to the product or service whereas nonvalue-added
activities do not add value. By identifying activities that do not add value, management
is able to focus on eliminating or reducing nonvalue-added activities. By identifying
value-added activities, management knows which activities to retain and make more
efficient.
Common nonvalue-added activities include storing materials, reworking defective units,
correcting purchase orders that are incorrect, and moving materials and products.
10-4.
Customers affect costs by the way they interact with the company and place demands
on company activities. Common examples are ordering behavior and sales support.
Suppliers affect costs by the way they interact with the company and place demands on
the company activities. Common examples are deliveries that are late or product that
has to be inspected before use or sale.
10-5.
The cost of customers is the same as any cost allocation problem in that it requires
costs from cost pools to be allocated to the cost objects, in this case customers. It
differs in that it focuses on customers and not products.
10-1
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10-6.
Resources supplied represent the capacity of the organization. They are the resources
available for use. Resources consumed are those used in the manufacture of the
product or the provision of the service. The difference is important because the firm
pays for the resources supplied but benefits from the resources used. If the resources
supplied are greater than those used, the firm could benefit by selling or reducing the
excess resources supplied.
10-7.
Capacity costs, generally included in the fixed overhead allocation, affect reported
product costs. Managers use reported costs to make decisions such as what price to
set, whether to continue offering a product or service, or whether to outsource the
production. Incorrect allocation of capacity costs can distort the information managers
use and lead to incorrect decisions.
10-8.
Quality affects cost in two major ways. Conformance costs are those that the firm incurs
in order to ensure the product or service meets required quality levels. Examples
include inspection and preventative maintenance. Nonconformance costs are those
costs the firm incurs by producing below standard quality products or services.
Examples include the cost of rework and the lost revenue as unsatisfied customers buy
from competitors.
10-9.
The four categories of a cost of quality system are:
1. Prevention: Costs to ensure good quality (product design, training).
2. Appraisal: Costs to ensure poor-quality items are not shipped (inspection).
3. Internal failure: Costs of producing below-quality items that are not shipped (scrap,
rework).
4. External failure: Costs of producing and shipping below-quality items (warranty
costs, lost sales).
10-2
Solutions to Critical Analysis and Discussion Questions
10-10.
Answers will vary.
a) Health clinic: Waiting for test results and storing equipment.
b) Bank: Processing transactions with errors and waiting for manager to authorize a
transaction.
10-11.
Answers will vary.
a) Lumber: Recutting to correct size and repairing damaged equipment.
b) Furniture: Storing inventory and producing incorrect product (or scrap).
10-12.
It was not value added to the customers (students and faculty) unless the new
placement made the books easier to find and use.
10-13.
Answers will vary.
a) Clothing retail store: Returning defective product to suppliers and processing
customer returns.
b) Record store: Replacing items lost to shrinkage (inventory theft) and storing
inventory.
10-14.
Value is added in two ways. First, the customer prefers an answer quickly and will
prefer to do business with the faster processor, all else equal. Second, if the time
reduction comes from reduced handling, costs are saved as capacity is increased.
10-15.
The problem with first computing product costs and then customer costs is that it
assumes that all customers who buy the product have the same behavior of ordering
and using firm resources. Therefore, the firm cannot determine the type of customer
that is costly.
10-16.
While customers are the source of revenue, they make demands on company
resources and affect costs through their buying behavior.
10-3
10-17.
Two important factors managers need to consider are what competitors will do and how
the competitive environment will change over time. Focusing on customer profitability
for the year and not considering longer-term possibilities might lead managers to make
decisions that add to profit (or reduce costs) in the current year, but reduce profit in the
longer term. One reason some companies, such as banks, seek customers who might
not be profitable currently (college students, for example) is that they expect these
customers to become profitable in the future.
10-18.
There is an opportunity cost associated with idle capacity. Knowing that capacity is not
being used allows managers to decide what to do with it. They may decide to leave it in
place for growth or to dispose of it. It could be sold or used to produce something else.
The point is that reporting the cost of unused capacity forces managers to consider the
resources being supplied but not consumed.
10-19.
Raising prices when there is low demand will generally result in fewer rooms being
filled. The problem is that the reported product costs include unused capacity costs in
the off-season.
10-20.
Answers will vary but should include reasons why the elements are not important. For
instance, when purchasing a low-cost item, like paint to touch up minor scratches,
service may not be important. The color is visible through the bottle, so assistance
(“intangible” service) may not be required. Choosing to paint a house might require
considerable service to determine the right base, weathering, etc. In this case, the
choice of where to purchase may be driven more by the service than the quality of paint,
which is more likely to be consistent across a wide range of brands.
10-21.
Answers will vary. One example follows. The quality-based view would encourage
continuous improvement of the production process and might offer incentives (i.e. cash
bonuses) for production employees to make recommendations about how the
production process can be improved. The result would be fewer product defects and
more efficient operations. Conversely, the traditional view would assume that defective
products are a natural part of the production process and are very difficult to eliminate.
10-4
Thus, thorough inspections throughout the production process are necessary to ensure
minimal defects.
Solutions to Exercises
10-22. (10 min.) Activity-Based Cost Management in a College.

1. b. Improves efficiency. Renewing books no longer requires an intermediate
person, the librarian, as part of the transaction.
2. a. Reduces frequency of activity. Reducing the number of hours the library is
open reduces all of the activities required to keep it open.
3. b. Improves efficiency. Improving the training of student workers makes them
more efficient at their jobs. Of course, the cost of training has to be compared to
its benefits from improved efficiency.
10-23. (10 min.) Cost Hierarchy for a Not-for-Profit.

a. Facility level (will not vary over range of activity).
b. Facility level (will not vary over range of activity).
c. Unit level (likely to vary as activity changes).
d. Facility level (will not vary over range of activity).
e. Facility level (will not vary over range of activity).
f. Facility level (will not vary over range of activity).
g. Facility level (will not vary over range of activity).
h. Unit level (likely to vary as activity changes).
10-24. (20 min.) Driver Identification.

a. Number of calls to new commercial customers; records kept by sales reps.
b. Time spent on negotiation; time records kept.
c. Time spent on review; time records kept.
d. Number of customers; from accounting records.
e. Time spent on community activities, money spent.
f. Number of employees, time.
g. Number of commercial loans; from accounting records, employee time.
h. Number of consumer loans; from accounting records.
i. Number of consumer loans.
10-5
j. Number of calls to existing commercial customers; records kept by sales reps.

k. Number of products.
l. Number of transactions.
m. Number of transactions.
10-25. (20 min.) Activity-Based Costing of Customers: Marvin’s Kitchen Supply.
a. Delivery cost based on order value:

Order Delivery Charge
Customer Value (@10%)
City Diner ................................................
$75,000 $7,500
Le Chien Chaud ...................................
$90,000 9,000
b. Delivery cost based on activity-based costing:
Cost driver rates:
Activity Cost Driver Cost ÷ Driver Volume Rate
=
Processing Number of orders $110,000 5,000 orders = $22 per order
order .................... ÷
Loading truck ....... Number of items 225,000 100,000 items $2,25 per
÷ = item
Delivering Number of orders 135,000 5,000 orders = $27 per order
merchandise........ ÷
Processing Number of 108,000 4,000 invoices $27 per
invoice ................. invoices ÷ = invoice
Cost of delivery:
City Diner Le Chien Chaud
Units of Cost Units of Cost
Activity Driver Cost Driver Cost
Processing order ................... 52 orders $1,144a 110 orders $2,420
Loading truck ......................... 600 items 1,350b 1,500 items 3,375
Delivering merchandise ......... 52 orders 1,404c 110 orders 2,970
Processing invoice ................ 12 invoices 324d 150 invoices 4,050
Total cost............................ $4,222 $12,815
a $780 = 52 orders x $22 per order.
10-6
b $900 = 600 items x $2.25 per item.

c $936 = 52 orders x $27 per order.
d $216 = 12 invoices x $27 per invoice.
c. Marvin’s can use this information to change the way they price delivery service.
They can also use the information to work with customers to change the way
they (customers) order to reduce the costs of order and delivery.
10-26. (30 min.) Activity-Based Costing of Customers: Rock Solid Bank & Trust.
a.
Sales revenue ................... $187,500,000 x 5.2% $9,750,000
Costs:
Interest on deposits ....... $187,500,000 x 0.5% 937,500
Operating costs ............ (Given) 7,500,000
Total costs......................... 8,437,500
Operating profit ................. $1,312,500
b.
Customer A Customer B
Deposit ................................ $200 $6,000
Sales revenue ..................... $10.40a $312.00

Interest on deposits............. 1.00b 30.00
Operating costs ................... 8.00c 240.00
Customer profit ................... $1.40 $42.00
a $10.40 = $200 deposit x 5.2%.

b $1.00 = $200 deposit x 0.5%.
c $8.00 = $200 deposit x 4% operating cost to deposit ratio
(= $7,500,000 ÷ $187,500,000).
10-7
10-26. (continued)
c.
Activity Cost Driver Cost Driver Volume Rate

Number of
Use ATM $750,000 ÷ 10,000,000 = $0.075 per use
uses
Number of
Visit branch 2,250,000 ÷ 750,000 = $3 per visit
visits
Process Number of = $0.0375 per
1,500,000 ÷ 40,000,000
transaction transactions transaction
General bank
Total deposits 3,000,000 ÷ $187,500,000 =1.6% of deposits
overhead
Customer A Customer B
Units of Units of
Activity Cost Cost
Driver Driver
Sales revenue .................................................... $10.40 $312.00
Interest on deposit ............................................. 1.00 30.00
Account margin .............................................. $ 9.40 $282.00
Operating costs:
Use ATM........................................................
200 $15.00a 250 $18.75
Visit branch ....................................................
5 15.00b 20 60.00
Process transaction .......................................
40 1.50c 1,500 56.25
General bank overhead .................................
$200 3.20d $6,000 96.00
Total operating cost ........................................ $ 34.70 $231.00
Customer profit .................................................. $(25.30) $51.00
a $15 = 200 uses x $0.075 per use.

b $15 = 5 visits x $3 per visit.
c $1.50 = 40 transactions x $0.0375 per transaction.
d $3.20 = $200 deposit x 1.6%.
10-8
10-27. (15 min.) 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.
10-28. (15 min.) Activity-Based Costing of Customers—Ethical Issues: Red’s

Lumber.
a. Red could use the information to offer “discounts” for weekday orders, which is
equivalent to a premium for weekend orders. Before Red makes any changes, he
should try to understand the reason for the difference. Are the sales patterns
different? Do weekend customers buy more? Are weekend customers less
knowledgeable and, therefore, in need of greater assistance? As always, pricing
issues depend on market conditions. The cost information allows Red to make
better decisions.
b. Firms discriminate among customers using prices in many instances. There are
discount fares from airlines if you buy in advance (or often at the last minute).
Banks charge different fees depending on the balance in your account. State
colleges charge different fees depending on your residency. These are not illegal
and many people would say they are not unethical.
c. We emphasize again that Red needs to understand the statistical relation. Is
there, in fact, a reasonable explanation why men (or women) tend to incur higher
support cost for him? Discriminating in price based on gender is likely to lead to
legal issues.
10-9
10-29. (15 min.) Activity-Based Costing of Customers—Ethical Issues: Central

State College.
a. Possible allocation bases include number of students, student hours in the lab,
classes in the lab, and so on. We would like to link the use of the lab with the
cost, but it is not sufficient to say we will allocate on the basis of use. We need to
identify how to measure use.
b. This is a difficult question and answers will vary. The dean views the training
program as incremental and only considers the direct cost to be relevant. This
view can be supported. The ethical question is raised because of the implications
of doing this. By assigning all costs to the degree program, the dean expects the
state to support the computer lab allowing the business school to have more
discretionary funds
10-30. (15 min.) Activity-Based Costing of Suppliers: Davis Fabricators.

This can be answered using the format of Exhibit 10.9. First compute the cost of
a late delivery.
Number of tons delivered late (10,000 x 25% + 6,000 x 5%) 2,800

Cost of late deliveries ......................... (Given) $22,400
Cost of late delivery per ton ............... per ton
($22,400 ÷ 2,800) $8
Now compute the “effective” price of a ton.
Alpha First
Average purchase price per ton ................... $10.00 $12.00
Additional cost of late delivery per ton .......... $8 $8
Probability of late delivery ............................ 25% 5%
Expected cost of late delivery per ton ........... $2.00 $0.40
Effective cost per ton .................................... $12.00 $12.40
10-31. (10 min.) Activity-Based Costing of Suppliers: Davis Fabricators.

30%. This can be answered as a breakeven calculation, solving for P, the
percentage of late deliveries:
$10 + $8 x P = $12.40
P = 30%.
10-10
10-32. (20 min.) 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 2,200 4,100
Tons discarded 110 410
Percentage of good product 5% 10%
Quoted price $741 $720
Effective cost per ton (a) $780 $800
(a) $780 = $741 ÷ (100% – 5%); $800 = $720 ÷ (100% – 10%)
10-33. (10 min.) Activity-Based Costing of Suppliers: Kinnear Plastics.

a. $760. This can be answered as a breakeven calculation, solving for B, the bid:
(B ÷ 95%) = $800
B = $760.
b. There are several reasons, including Kinnear not wanting to be dependent on
one suppliers or capacity constraints at Tappan.
10-34. (15 min.) Resources Used versus Resources Supplied: Tri-State Mill.
Resources Unused Resource

Resources Used Supplied Capacity
Energy ................................................................
$5,400 $6,900 $1,500
($0.90  6,000 mh) (given) ($6,900 – $5,400)
Repairs ...............................................................
$9,600 $12,000 $2,400
($16  600 jobs ) (given) ($12,000 – $9,600)
10-11
10-35. (10 min.) Resources Used versus Resources Supplied: Tri-State Mill.
a.
Finishing sales ................................... $ 30,000
Energy costs.....................................................
$6,900
Repair costs .....................................................
12,000 18,900
Operating profit...................................................
$ 11,100
b.
Unused
Resources Resource Resources
Used Capacity Supplied
Finishing sales ................... $ 30,000
Costs
Volume related
Energy ......................... $5,400 $1,500 $6,900
Batch related
Repairs ........................ 9,600 2,400 12,000
Total costs .......................... $15,000 $3,900 $18,900 18,900
Finishing operating profits .. $ 11,100
10-36. (15 min.) Resources Used versus Resources Supplied: Gundy Press.

Resources Used Supplied Capacity
Setups ................................................................
$21,875 $22,500 $625
($125  175 runs) (given) ($22,500 – $21,875)
Clerical ...............................................................
$7,500 $10,000 $2,500
($15  500 pages) (given) ($10,000 – $7,500)
10-12
10-37. (10 min.) Resources Used versus Resources Supplied: Gundy Press.
a.
Sales revenue......................... $ 40,000
Setup costs........................ $22,500
Clerical costs ..................... 10,000 32,500
Operating profit $ 7,500
b.
Unused
Sales revenue ....................... $ 40,000
Costs
Volume related
Clerical ............................ $7,500 $2,500 $10,000
Batch related
Setups ............................. 21,875 625 22,500
Total costs .............................. $29,375 $3,125 $32,500 32,500
Operating profits ..................... $ 7,500
10-13
10-38. (40 min.) Resources Used versus Resources Supplied: Gunnison Supply.
a.
Resources Used Supplieda Capacity
$48,000 $49,000
Materials ............................................................ $ 1,000
($12  4,000)
Energy ................................................................
$8,160 $ 8,940 $ 780
($48  170)
Setups ................................................................
$12,000 $12,000 $ -0-
($300  40)
Purchasing .........................................................
$9,600 $10,500 $900
($240  40)
Customer service ...............................................
$4,000 $ 7,800 $ 3,800
($160  25)
Long-term labor ..................................................
$12,800 $14,500 $ 1,700
($80  160)
Administrative.....................................................
$12,600 $14,000 $ 1,400
($60  210)
a
Given
b. Unused resource capacity is the difference between resources supplied and

resources used. Unit-related costs typically have little or no unused resources
since they vary directly with output. At the other end of the cost spectrum are
capacity-related costs which typically have unused resources (unless the
company is operating at full capacity) since these costs are long-term costs and
cannot be changed quickly in the short term.
10-14
10-39. (20 min.) Assigning Cost of Capacity: Beth’s Supplies.

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 $21 per tile computed as follows:
Variable cost per tile ..................... (Given) $ 9
Allocated fixed capacity cost ........($300,000 ÷ 25,000 tiles) 12
Cost per tile ............................... $21
b. The cost of excess capacity is $60,000 [= $300,000 – ($12 × 20,000 tiles)].

c. If the minimum plant size was 25,000 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 $24, computed as follows:
Variable cost per tile ..................... (Given) $ 9

Allocated fixed capacity cost ........($300,000 ÷ 20,000 tiles) 15
Cost per tile ............................... $24
and there is no excess capacity cost.
10-40. (20 min.) Assigning Cost of Capacity: Curt’s Castings.

a. Because the plant was purchased for the benefit of Curt, current production
should not be charged with excess capacity. Therefore, the cost system should
report a cost of $8 per ton computed as follows:
Variable cost per ton .................... (Given) $ 4
Allocated fixed capacity cost ........
($600,000 ÷ 150,000 tons) 4
Cost per casting ........................ $8
b. The cost of excess capacity is $200,000 [= $600,000 – ($4 × 100,000 tons)].

This should be reported separately in the (management) income statement, to
facilitate Curt’s decision about whether to keep or dispose of the excess capacity.
10-15
10-41. (15 min.) Costs of Quality: Hastings Corporation.
Process inspection P
Scrap IF
Quality training P
Warranty repairs EF
Testing equipment A
Customer complaints EF
Rework IF
Preventive maintenance P
Materials inspection P
Field testing A
10-42. (20 min.) Costs of Quality: Trovatore 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 ÷ $245,000.........................................
16.9%
$29,180 ÷ $220,000.........................................
13.3%
Appraisal
$16,400 ÷ $245,000.........................................
6.7%
$19,400 ÷ $220,000.........................................
8.8%
Internal failure
$18,850 ÷ $245,000.........................................
7.7%
$20,430 ÷ $220,000.........................................
9.3%
External failure
$7,100 ÷ $245,000...........................................
2.9%
$8,200 ÷ $220,000...........................................
3.7%
10-16
10-43. (30 min.) Trading-Off Costs of Quality: Trovatore Corporation.

Trovatore Corporation
Cost of Quality Report
March % April %
Sales revenue ....................................................

$245,000 $220,000
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 16.9% $ 29,180 13.3%
Appraisal costs:
Testing equipment ..........................................
$ 7,000 $ 7,000
Field testing ....................................................
9,400 12,400
Total appraisal costs ..........................................
$ 16,400 6.7 $ 19,400 8.8
Internal failure costs:
Scrap ...............................................................
$ 1,850 $ 1,930
Rework.............................................................
17,000 18,500
Total internal failure costs ..................................
$ 18,850 7.7 $ 20,430 9.3
External failure costs:
Warranty repairs ..............................................
$ 4,300 $ 4,800
Customer complaints ....................................... 2,800 3,400
Total external failure costs: ...............................
$ 7,100 2.9 $ 8,200 3.7
Total Costs of Quality .........................................
$ 83,800 34.2% $ 77,210 35.1%
10-17
10-44. (20 min.) Costs of Quality: Nuke-It-Now.
a. Prevention: Redesign process, training on equipment, preventative maintenance.

Appraisal: Final inspection.
Internal failure: Discard defective units, rework.
External failure: Warranty claims, contract cancellations, product liability claims.
b. Year 1 Year 2
Prevention
$393,000 ÷ $3,500,000 ....................................
11.2%
$399,000 ÷ $3,800,000 ....................................
10.5%
Appraisal
$190,000 ÷ $3,500,000 ....................................
5.4%
$198,000 ÷ $3,800,000 ....................................
5.2%
Internal failure
$109,000 ÷ $3,500,000 ....................................
3.1%
$139,000 ÷ $3,800,000 ....................................
3.7%
External failure
$632,000 ÷ $3,500,000 ....................................
18.1%
$506,000 ÷ $3,800,000 ....................................
13.3%
10-18
10-45. (30 min.) Trading-off Costs of Quality: Nuke-It-Now.

Nuke-It-Now Corporation
Cost of Quality Report
Year 1 % Year 2 %
Sales revenue ....................................................
$3,500,000 $3,800,000
Prevention:
Redesign process ............................................
$ 29,000 $ 37,000
Training on equipment ............. 250,000 210,000
Preventive maintenance ..................................
114,000 152,000
Total prevention costs ........................................
$ 393,000 11.2% $ 399,000 10.5%
Appraisal:
Final inspection ................................................
$ 190,000 5.4 $ 198,000 5.2
Internal failure:
Discard defective units .......................................
$ 37,000 $ 43,000
Rework.............................................................
72,000 96,000
Total internal failure costs ..................................
$ 109,000 3.1 $ 139,000 3.7
External failure:
Warranty claims ...............................................
$ 129,000 $ 176,000
Contract cancellations......................................
201,000 154,000
Product liability claims ....................................
302,000 176,000
Total external failure costs .................................
$ 632,000 18.1 $ 506,000 13.3
Total Costs of Quality .........................................
$1,324,000 37.8% $1,242,000 32.7%
10-46. (15 min.) Cost of Quality—Environmental Issues.

a. Criminal penalties for illegal dumping. (EF)
b. Cleanup of leaks and spills on the plant floor. (IF)
c. Employee training of environmental policies. (P)
d. Lost sales from bad publicity after toxic spill. (EF)
e. Fines for being out of compliance with environmental regulations. (EF)
f. Maintenance of machinery that handles hazardous material. (P)
g. Monitoring costs of chemical processes. (A)
h. Design of processes to minimize leakage and waste. (P)
10-19
10-47. (15 min.) Cost of Quality—Financial Reporting Issues.

a. Extra work done by external auditors to complete the audit because new
employees made a lot of errors. (IF)
b. Effects of bad publicity on stock prices because publication of financial
statements was delayed to correct for errors in the statements. (EF)
c. Employee training for new accounting regulations. (P)
d. Drop in stock price from bad publicity after the chief executive gets sentenced to
10 years in prison. (EF)
e. Fines for failing to comply with accounting regulations. (EF)
f. Design information systems to keep out hackers. (P)
g. Design of internal control systems to minimize errors in data entry. (P)
h. Internal auditors' review of internal controls in item g above. (A)
Solutions to Problems
10-48. (50 min.) Activity-Based Reporting and Capacity: Gunnison Supply.

a.
Sales revenue ................. $150,000
Materials ...................... $49,000
Energy ......................... 8,940
Setups ......................... 12,000
Purchasing .................. 10,500
Customer service ........ 7,800
Long-term labor ........... 14,500
Administrative .............. 14,000
Total costs ....................... 116,740
Operating profit................ $33,260
10-20
b.
Sales revenue $150,000
Unused
Costs
Unit
Materials ........................................................
$48,000 $ 1,000 $49,000
Energy ...........................................................
8,160 780 8,940
$56,160 $1,780 $57,940
Batch
Setups .........................................................
$ 12,000 $ -0- $ 12,000
Purchasing ....................................................
9,600 900 10,500
$ 21,600 $ 900 $ 22,500
Product and customer sustaining
Customer service ..........................................
$ 4,000 $3,800 $ 7,800
$ 4,000 $3,800 $ 7,800
Capacity sustaining
Long-term labor .............................................
$ 12,800 $ 1,700 $ 14,500
Administrative ................................................
12,600 1,400 14,000
$25,400 $ 3,100 $28,500
Total costs .........................................................
$107,160 $9,580 $116,740 116,740
Operating profit .................................................. $33,260
10-21
10-48. (continued)
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 ($9,580). 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
($3,800). 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).
10-49. (50 min.) Activity-Based Reporting: Allcott Computer Services.

a.
Sales revenue .......................................... $1,350,000
Marketing ............................................. $120,000
Depreciation ......................................... 89,500
Training personnel ............................... 54,000
Energy .................................................. 85,500
Short-term labor ................................... 310,000
Long-term labor .................................... 425,000
Administrative....................................... 79,000
Repair verification ................................ 42,000
Total costs ................................................ 1,205,000
Operating profit ........................................ $ 145,000
10-22
b.
Sales revenue $1,350,000

Unused
Costs
Unit
Energy ...........................................................
$80,000 $5,500 $ 85,500
Short-term labor .............................................
225,000 85,000 310,000
$305,000 $90,500 $ 395,500
Batch
Repair verifications ........................................
$ 37,500 $ 4,500 $ 42,000
$ 37,500 $ 4,500 $ 42,000
Marketing .......................................................
$112,000 $ 8,000 $ 120,000
Training personnel .........................................
45,000 9,000 54,000
$157,000 $ 17,000 $ 174,000
Capacity sustaining
Depreciation...................................................
$87,000 $ 2,500 $ 89,500
Long-term labor .............................................
415,000 10,000 425,000
Administrative ................................................
70,000 9,000 79,000
$572,000 $ 21,500 $593,500
Total costs ..........................................................
$1,071,500 $133,500 $1,205,000 1,205,000
Operating profit .................................................. $ 145,000
10-49. (continued)
that short-term labor provides much of the unused resource capacity ($85,000).
This is useful for managers in that it indicates what actions might be taken to
reduce costs (for example, by reducing the short-term labor force).
10-23
10-50. (50 min.) Customer Profitability: SkiBlu, Ltd.

a.
Customer Costs Gold Silver
Number of customers ……… 30,000 70,000
Number of customer representatives 30 7
Average gross margin per customer ………. $330 $105
Total gross margin ($330 x 30,000; $105 x 70,000) $9,900,000 $7,350,000

Customer representative salary (@ $35,000 per 1,050,000 245,000
customer representative)
Customer representative bonus (@ 10% of gross 990,000 735,000
margin)
Promotion costs (90% gold; 10% silver)… 3,600,000 400,000
Excess of gross margin over customer cost $4,260,000 $5,970,000
b. Silver customers are more profitable than gold customers after considering the
costs of the representative.
10-51. (50 min.) Customer Profitability: Lighthouse Company.

a.
Customer Costs Premium Standard
Number of customers ................................................... 2,000 8,000
Number of customer representatives ........................... 20 8
Average gross margin per customers........................... $1,500 $150
Total gross margin ($1,500 x 2,000; $150 x 8,000) ...... $3,000,000 $1,200,000
Customer representative salary (@ $60,000 per
customer representative).............................................. 1,200,000 480,000
Customer representative bonus (@ 1% of gross
margin) ......................................................................... 30,000 12,000
Promotion costs (80% premium; 20% standard) .......... 800,000 200,000
Excess of gross margin over customer cost ................. $970,000 $508,000
b. Premium customers are more profitable even after considering the cost of
representatives.
10-24
10-52. (30 min.) Activity-Based Costing of Suppliers: JFI Foods.

The effective price is the price to buy a “good” ton of feedstock. This can be
computed as the bid price divided by the yield (the ratio of good output to total
input).
Rex Red Oak
Materials Chemicals
Tons purchased ............................. 1,350 2,250
Good output .................................. 1,242 1,548
Yield (good output ÷ purchased) .... 92.0% 68.8%
Quoted price .................................. $180 $140
Effective cost per ton (a) ................ $195.65
(a) $203.49
(a) $195.65 = $180 ÷ 92.0%; $203.49 = $140 ÷ 68.8%
10-53. (20 min.) Activity-Based Costing of Suppliers: JFI Foods.

a. $156.52. If Red Oak has an exclusive contract, the price per ton, adjusted for
an 80% yield, should be no more than the effective price that JFI pays Rex
Materials ($195.65). This price can be determined by solving the following
equation:
(P ÷ 80%) = $195.65
P = $156.52.
Note that the price to compare is the price of Rex Materials, the next best
opportunity, not the current price bid by Red Oak. (Note that Red Oak might ask
the question in the context of what it would be willing to pay to increase its yield
to 80%.)
b. JFI needs to consider the capacity of Red Oak, especially if it (JFI) expects to
grow. The company should also consider whether it wants to bear the risk of a
single supplier.
10-25
10-54. (50 min.) Activity-Based Reporting: Leidenheimer Corporation.

a.
Sales revenue ....................................................
$1,700,000
Parts management .............................................
$ 70,000
Energy................................................................
100,000
Quality inspections .............................................
100,000
Long-term labor..................................................
70,000
Short-term labor .................................................
48,000
Setups ................................................................
200,000
Materials ............................................................
300,000
Depreciation .......................................................
200,000
Marketing ...........................................................
150,000
Customer service ...............................................
40,000
Administrative ....................................................
140,000
Engineering changes .........................................
50,000
Outside contracts ...............................................
60,000
Total costs..........................................................
1,528,000
Operating profit ..................................................
$ 172,000
10-26
10-54. (continued)
b.
Sales revenue $1,700,000
Unused
Costs
Unit
Parts management ........................................
$ 60,000 $ 10,000 $ 70,000
Energy ...........................................................
100,000 0 100,000
Short-term labor .............................................
40,000 8,000 48,000
Materials ........................................................
300,000 0 300,000
Outside contracts ...........................................
60,000 0 60,000
$560,000 $ 18,000 $578,000
Batch
Quality inspections .........................................
$ 90,000 $ 10,000 $100,000
Setups............................................................
140,000 60,000 200,000
$230,000 $ 70,000 $300,000
Marketing .......................................................
$ 140,000 $ 10,000 $150,000
Customer service ...........................................
20,000 20,000 40,000
Engineering changes .....................................
50,000 0 50,000
$210,000 $ 30,000 $240,000
Capacity sustaining
Long-term labor .............................................
$ 50,000 $ 20,000 $ 70,000
Depreciation...................................................
120,000 80,000 200,000
Administrative ................................................
100,000 40,000 140,000
$270,000 $ 140,000 410,000
Total costs ..........................................................
$1,270,000 $258,000 $1,528,000 1,528,000
Operating profit .................................................. $ 172,000
10-27
10-54. (continued)
that depreciation and setups provide the majority of unused resource capacity
($80,000 and $60,000, respectively). This is useful for managers in that it
indicates what actions might be taken to reduce costs (for example, reduce
excess machine capacity by eliminating any unneeded machinery).
10-55. (30 min.) 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 (10-55, 10-56, and 10-57) 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.
10-28
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:
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.
10-29
10-56. (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 $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:
Summer
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
Summer
Overhead rate = [$13,500 + ($13,500  50%)] ÷
9,000 gallons) = $2.25/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.
10-30
10-57. (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 10-56 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 10-55 and 10-56.
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
$1.50c
Rate ................................................................... $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.
10-31
10-58. (30 min.) Quality Improvement: IPort Products.

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 Material New Material

Number of units sold ..................................................... 127,500 142,500
Price per unit ................................................................. $20 $20
Sales revenue ............................................................... $2,550,000 $2,850,000
Variable cutting manufacturing costs (150,000 units):
Materials (@$5 for current; $7.25 for new) ................. 750,000 1,087,500
Other variable (@$2) ................................................. 300,000 300,000
Fixed manufacturing costs (cutting)................................ 900,000 900,000
Variable sewing costs (@$3) ......................................... 382,500 427,500
Fixed sewing costs ........................................................ 75,000 75,000
Inspection and testing ................................................... 90,000 60,000
Profit $ 52,500 $ 0
Alternatively, we can do a differential analysis:

Additional revenue ..............................................($20 x 15,000 units) $300,000
Inspection savings .............................................. 30,000
$330,000
Less additional material cost in cutting ...............($2.25 x 150,000) 337,500
Less additional variable cost in sewing ..............($3 x 15,000) 45,000
Net change in profit ......................................... $(52,500)
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.
10-32
10-59. (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 Material New 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 units) $500,000
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.
10-33
Solutions to Integrative Cases
10-60. (50 Min) Cost Hierarchies, Cost of Customers, and Pricing: WSM
Corporation.
a.
($000)
Sales revenue .................. (40 Passengers $12,600
x 1,400 flights x $225)
Costs:
Flight related ............... (1,400 x $1,600) $2,240
(40 Passengers
Passenger related....... x 1,400 flights x $4) 224
Advertising related ...... (20 Promotions x $60,000) 1,200
Fixed costs ................. ($4,000 + $2,000 + $1,250) 7,250 10,914
Operating income ............ $1,686
10-60. (continued)
b.
We can first consider the incremental revenues and costs that would result:
Increase in revenues: (5% x 40 passengers x 1,400 flights x $225) = $630,000
Increase in costs: $1,000,000 – (1,400 flights x $100) + (5% x 40 x 1,400 x $4) =
$871,200
The net effect will be to lower profit by ($630,000 – $871,200) = $(241,200)
An analysis of total income would conclude that with the program, operating income
would be:
(40 Pass. x 1.05 x 1,400 $13,230.00
Revenue ($000) ............ flights x $225)
Costs ($000):
Flight related ............ (1,400 x $1,500) $2,100.00
(40 Pass. x 1.05 x 1,400
Passenger related.... flights x $4) 235.20
Advertising related ... (20 Promotions x $60,000) 1,200.00
Fixed costs .............. ($4,000 + $2,000 + $2,250) 8,250.00 11,785.20
Operating income ($000) ................................... $1,444.80
which is $241,200 less than the income calculated in requirement a above.

10-34
Based on a purely financial analysis, we might recommend that WSM not adopt the
Internet sales alternative. However, there are other considerations that may make this
alternative attractive. For example, some issues that would need to be considered
include:
1. Will we lose business to competitors that offer Internet sales?
2. Will we increase customer satisfaction if we offer Internet sales?
c.
This is a breakeven question. One approach is to set up the operating income in
equation form and set it equal to $1,700,000. Let X be the number of discount tickets
sold. Then:
(35,000 x $250) + $150X – (1,400 x $1,600) – (20 x $60,000) – (35,000 + X) x $4 –
$7,250,000 = $1,700,000
Solving for X yields, $146 X = $3,780,000, or
X = 25,890 discount tickets (approximately).
To check the answer, you can substitute this in the income statement and check that
WSM would have the same operating income as in part a.
10-61. (50 Min) Unused Capacity: The Grape Cola Caper.

(Refer to the solution for 9-53.)
a. Percentage utilization of resource by activities:
Activity
Production Machine
Setups Runs Products Time
Indirect labor (including fringe benefits) 50% 40% 10% 0%
Information technology (IT) 0 80 20 0
Machinery depreciation 0 0 0 100
Machinery maintenance 0 0 0 100
Energy 0 0 0 100
10-35
Costs assigned to activiities:

Activity
Production Machine
Cost Setups Runs Products Time
Indirect labor $28,000 $14,000 $11,200 $2,800 $ 0
IT 10,000 0 8,000 2,000 0
Machinery depreciation 8,000 0 0 0 8,000
Machinery maintenance 4,000 0 0 0 4,000
Energy 2,000 0 0 0 2,000
Total $52,000 $14,000 $19,200 $4,800 $14,000
÷ Activity 560 hours 110 runs 4 products 20,000 hrs
Cost driver rates $25 $174.55 $1,200 $0.70
10-36
10-61. (continued)
The only change is the cost driver rate for machine time:
Unit Costs on Cola Bottling Line
Diet Regular Cherry Grape Total
Materials $ 25,000 $ 20,000 $ 4,680 $ 550 $ 50,230
Direct labor 10,000 8,000 1,800 200 20,000
Fringe benefits on direct labor 4,000 3,200 720 80 8,000
a
Setup costs 5,000 1,500 6,000 1,500 14,000
b
Production run costs 6,982 5,236 5,236 1,746 19,200
c
Product costs 1,200 1,200 1,200 1,200 4,800
d
Machine costs 3,500 2,800 630 70 7,000
Total costs $55,682 $41,936 $20,266 $ 5,346 $123,230
Volume 50,000 40,000 9,000 1,000
Cost per unit $1.11 $1.05 $2.25 $5.35
a
$5,000 = $25 per setup hour x 200 setup hours
b
$6,982 = $174.55 per production run x 40 production runs
c
$1,200 = $1,200 per product
d
$3,500 = $0.70 per machine hour x 5,000 machine hours
b. The cost of the unused capacity is $7,000 (= 10,000 unused hours x $0.70).
Rockness should find a profitable use of the unused capacity. For example, he
could produce a fifth flavor or he could expand production and sales of existing
products.
10-61. (continued)
c.
First, compute the costs per unit of Diet Cola, except for the machine costs:
Diet cola costs:

Materials $ 25,000
Direct labor 10,000
10-37
Fringe benefits on direct labor 4,000

Setup costs 5,000
Production run costs 6,982
Product costs 1,200
$52,182
Diet cola volume (units) 50,000
Unit costs before machine $1.04364 (= $52,182 ÷ 50,000 units)
Machine costs 0.07000 (= $14,000 ÷ 200,000 units)
Vanilla unit costs $1.11364
Vanilla total costs for 100,000 units $111,364
10-38

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Chapter 10 - Fundamentals of Cost Management

Solutions to Review Questions

Solutions to Critical Analysis and Discussion Questions

10-22. (10 min.) Activity-Based Cost Management in a College.

10-23. (10 min.) Cost Hierarchy for a Not-for-Profit.

10-24. (20 min.) Driver Identification.

j. Number of calls to existing commercial customers; records kept by sales reps.

10-25. (20 min.) Activity-Based Costing of Customers: Marvin’s Kitchen Supply.

a. Delivery cost based on order value:

b $900 = 600 items x $2.25 per item.

Sales revenue ..................... $10.40a $312.00

a $10.40 = $200 deposit x 5.2%.

Activity Cost Driver Cost Driver Volume Rate

a $15 = 200 uses x $0.075 per use.

10-28. (15 min.) Activity-Based Costing of Customers—Ethical Issues: Red’s

10-29. (15 min.) Activity-Based Costing of Customers—Ethical Issues: Central

10-30. (15 min.) Activity-Based Costing of Suppliers: Davis Fabricators.

Number of tons delivered late (10,000 x 25% + 6,000 x 5%) 2,800

10-31. (10 min.) Activity-Based Costing of Suppliers: Davis Fabricators.

10-32. (20 min.) Activity-Based Costing of Suppliers: Kinnear Plastics.

10-33. (10 min.) Activity-Based Costing of Suppliers: Kinnear Plastics.

Resources Unused Resource

Finishing operating profits .. $ 11,100

Resources Unused Resource

b. Unused resource capacity is the difference between resources supplied and

10-39. (20 min.) Assigning Cost of Capacity: Beth’s Supplies.

b. The cost of excess capacity is $60,000 [= $300,000 – ($12 × 20,000 tiles)].

Variable cost per tile ..................... (Given) $ 9

10-40. (20 min.) Assigning Cost of Capacity: Curt’s Castings.

b. The cost of excess capacity is $200,000 [= $600,000 – ($4 × 100,000 tons)].

10-41. (15 min.) Costs of Quality: Hastings Corporation.

10-42. (20 min.) Costs of Quality: Trovatore Corporation.

10-43. (30 min.) Trading-Off Costs of Quality: Trovatore Corporation.

Sales revenue ....................................................

10-44. (20 min.) Costs of Quality: Nuke-It-Now.

a. Prevention: Redesign process, training on equipment, preventative maintenance.

10-45. (30 min.) Trading-off Costs of Quality: Nuke-It-Now.

10-46. (15 min.) Cost of Quality—Environmental Issues.

10-47. (15 min.) Cost of Quality—Financial Reporting Issues.

10-48. (50 min.) Activity-Based Reporting and Capacity: Gunnison Supply.

10-49. (50 min.) Activity-Based Reporting: Allcott Computer Services.

Sales revenue $1,350,000

10-50. (50 min.) Customer Profitability: SkiBlu, Ltd.

Total gross margin ($330 x 30,000; $105 x 70,000) $9,900,000 $7,350,000

10-51. (50 min.) Customer Profitability: Lighthouse Company.

10-52. (30 min.) Activity-Based Costing of Suppliers: JFI Foods.

10-53. (20 min.) Activity-Based Costing of Suppliers: JFI Foods.

10-54. (50 min.) Activity-Based Reporting: Leidenheimer Corporation.

There are two possible approaches to costing the ice cream:

10-56. (30 min.) Assigning Capacity Costs—Seasonality: Cathy and Tom’s

10-57. (30 min.) Assigning Capacity Costs—Seasonality: Cathy and Tom’s

Capacity Costs Winter Fall/Spring Summer

10-58. (30 min.) Quality Improvement: IPort Products.

Current Material New Material

Alternatively, we can do a differential analysis:

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

10-59. (30 min.) Quality Improvement: Metallic, Inc.

Current Material New Material

Alternatively, we can do a differential analysis:

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

Solutions to Integrative Cases

which is $241,200 less than the income calculated in requirement a above.

10-61. (50 Min) Unused Capacity: The Grape Cola Caper.