Gazi University

Department of Industrial Engineering

IE 226 Cost Analysis
Study Set
Chapter 05 (Questions)

Terms to Learn: activity, activity-based costing (ABC), batch-level costs, cost hierarchy,
facility-sustaining costs, output unit-level costs, product overcosting, product-sustaining costs,
product undercosting, service-sustaining costs

5-16 Cost hierarchy. Hamilton, Inc., manufactures boom boxes (music systems with radio,
cassette, and compact disc players) for several well-known companies. The boom boxes differ
significantly in their complexity and their manufacturing batch sizes. The following costs were
incurred in 2011:
a. Indirect manufacturing labor costs such as supervision that supports direct manufacturing
labor, $1,450,000
b. Procurement costs of placing purchase orders, receiving materials, and paying suppliers
related to the number of purchase orders placed, $850,000
c. Cost of indirect materials, $275,000
d. Costs incurred to set up machines each time a different product needs to be manufactured,
$630,000
e. Designing processes, drawing process charts, making engineering process changes for
products, $775,000
f. Machine-related overhead costs such as depreciation, maintenance, production engineering,
$1,500,000 (These resources relate to the activity of running the machines.)
g. Plant management, plant rent, and plant insurance, $925,000
1. Classify each of the preceding costs as output unit-level, batch-level, product-sustaining, or
facility-sustaining. Explain each answer.
2. Consider two types of boom boxes made by Hamilton, Inc. One boom box is complex to make
and is produced in many batches. The other boom box is simple to make and is produced in few
batches. Suppose that Hamilton needs the same number of machine-hours to make each type of
boom box and that Hamilton allocates all overhead costs using machine-hours as the only
allocation base. How, if at all, would the boom boxes be miscosted? Briefly explain why.
3. How is the cost hierarchy helpful to Hamilton in managing its business?

5-17 ABC, cost hierarchy, service. (CMA, adapted) Vineyard Test Laboratories does heat
testing (HT) and stress testing (ST) on materials and operates at capacity. Under its current
simple costing system, Vineyard aggregates all operating costs of $1,190,000 into a single
overhead cost pool. Vineyard calculates a rate per test-hour of $17 ($1,190,000 ÷ 70,000 total
test-hours). HT uses 40,000 test-hours, and ST uses 30,000 test-hours. Gary Celeste, Vineyard’s
controller, believes that there is enough variation in test procedures and cost structures to
establish separate costing and billing rates for HT and ST. The market for test services is
becoming competitive. Without this information, any miscosting and mispricing of its services
could cause Vineyard to lose business. Celeste divides Vineyard’s costs into four activity-cost
categories.

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a. Direct-labor costs, $146,000. These costs can be directly traced to HT, $100,000, and ST,
$46,000.
b. Equipment-related costs (rent, maintenance, energy, and so on), $350,000. These costs are
allocated to HT and ST on the basis of test-hours.
c. Setup costs, $430,000. These costs are allocated to HT and ST on the basis of the number of
setuphours required. HT requires 13,600 setup-hours, and ST requires 3,600 setup-hours.
d. Costs of designing tests, $264,000. These costs are allocated to HT and ST on the basis of the
time required for designing the tests. HT requires 3,000 hours, and ST requires 1,400 hours.
1. Classify each activity cost as output unit-level, batch-level, product- or service-sustaining, or
facility-sustaining. Explain each answer.
2. Calculate the cost per test-hour for HT and ST. Explain briefly the reasons why these numbers
differ from the $17 per test-hour that Vineyard calculated using its simple costing system.
3. Explain the accuracy of the product costs calculated using the simple costing system and the
ABC system. How might Vineyard’s management use the cost hierarchy and ABC information
to better manage its business?

5-18 Alternative allocation bases for a professional services firm. The Walliston Group (WG)
provides tax advice to multinational firms. WG charges clients for (a) direct professional time (at
an hourly rate) and (b) support services (at 30% of the direct professional costs billed). The three
professionals in WG and their rates per professional hour are as follows:
Professional Billing Rate per Hour
Max Walliston $640
Alexa Boutin 220
Jacob Abbington 100
WG has just prepared the May 2011 bills for two clients. The hours of professional time spent on
each client are as follows:
Hours per Client
Professional San Antonio Dominion Amsterdam Enterprises
Walliston 26 4
Boutin 5 14
Abbington 39 52
Total 70 70
1. What amounts did WG bill to San Antonio Dominion and Amsterdam Enterprises for May
2011?
2. Suppose support services were billed at $75 per professional labor-hour (instead of 30% of
professional labor costs). How would this change affect the amounts WG billed to the two clients
for May 2011? Comment on the differences between the amounts billed in requirements 1 and 2.
3. How would you determine whether professional labor costs or professional labor-hours is the
more appropriate allocation base for WG’s support services?

5-19 Plant-wide, department, and ABC indirect cost rates. Automotive Products (AP) designs
and produces automotive parts. In 2011, actual variable manufacturing overhead is $308,600.
AP’s simple costing system allocates variable manufacturing overhead to its three customers
based on machine-hours and prices its contracts based on full costs. One of its customers has
regularly complained of being charged noncompetitive prices, so AP’s controller Devon Smith
realizes that it is time to examine the consumption of overhead resources more closely. He

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knows that there are three main departments that consume overhead resources: design,
production, and engineering. Interviews with the department personnel and examination of time
records yield the following detailed information:
Usage of Cost Drivers by Customer Contract
Variable
Manufacturing United Holden Leland
Department Cost Driver Overhead in 2011 Motors Motors Vehicle
Design CAD design hours $39,000 110 200 80
Production Engineering hours 29,600 70 60 240
Engineering Machine hours 240,000 120 2,800 1,080
Total $308,600

1. Compute the variable manufacturing overhead allocated to each customer in 2011 using the
simple costing system that uses machine-hours as the allocation base.
2. Compute the variable manufacturing overhead allocated to each customer in 2011 using
department based variable manufacturing overhead rates.
3. Comment on your answers in requirements 1 and 2. Which customer do you think was
complaining about being overcharged in the simple system? If the new department-based rates
are used to price contracts, which customer(s) will be unhappy? How would you respond to these
concerns?
4. How else might AP use the information available from its department-by-department analysis
of variable manufacturing overhead costs?
5. AP’s managers are wondering if they should further refine the department-by-department
costing system into an ABC system by identifying different activities within each department.
Under what conditions would it not be worthwhile to further refine the department costing
system into an ABC system?

5-20 Plant-wide, department, and activity-cost rates. Tarquin’s Trophies makes trophies and
plaques and operates at capacity. Tarquin does large custom orders, such as the participant
trophies for the Mishawaka Little League. The controller has asked you to compare plant-wide,
department, and activity based cost allocation.
Tarquin’s Trophies
Budgeted Information
For the Year Ended November 30, 2011
Forming Department Trophies Plaques Total
Direct materials $13,000 $11,250 $24,250
Direct labor 15,600 9,000 24,600
Overhead Costs
Setup 12,000
Supervision 10,386
Assembly Department Trophies Plaques Total
Direct materials $ 2,600 $ 9,375 $11,975
Direct labor 7,800 10,500 18,300
Overhead costs
Setup 23,000
Supervision 10,960

Other information follows:

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Setup costs vary with the number of batches processed in each department. The budgeted
number of batches for each product line in each department is as follows:
Trophies Plaques
Forming department 40 116
Assembly department 43 103
Supervision costs vary with direct labor costs in each department.
1. Calculate the budgeted cost of trophies and plaques based on a single plant-wide overhead
rate, if total overhead is allocated based on total direct costs.
2. Calculate the budgeted cost of trophies and plaques based on departmental overhead rates,
where forming department overhead costs are allocated based on direct labor costs of the
forming department, and assembly department overhead costs are allocated based on total direct
costs of the assembly department.
3. Calculate the budgeted cost of trophies and plaques if Tarquin allocates overhead costs in each
department using activity-based costing.
4. Explain how the disaggregation of information could improve or reduce decision quality.

5-21 ABC, process costing. Parker Company produces mathematical and financial calculators
and operates at capacity. Data related to the two products are presented here:
Mathematical Financial
Annual production in units 50,000 100,000
Direct material costs $150,000 $300,000
Direct manufacturing labor costs $ 50,000 $100,000
Direct manufacturing labor-hours 2,500 5,000
Machine-hours 25,000 50,000
Number of production runs 50 50
Inspection hours 1,000 500
Total manufacturing overhead costs are as follows:
Total
Machining costs $375,000
Setup costs 120,000
Inspection costs 105,000
1. Choose a cost driver for each overhead cost pool and calculate the manufacturing overhead
cost per unit for each product.
2. Compute the manufacturing cost per unit for each product.

5-23 Activity-based costing, manufacturing. Open Doors, Inc., produces two types of doors,
interior and exterior. The company’s simple costing system has two direct cost categories
(materials and labor) and one indirect cost pool. The simple costing system allocates indirect
costs on the basis of machine hours. Recently, the owners of Open Doors have been concerned
about a decline in the market share for their interior doors, usually their biggest seller.
Information related to Open Doors production for the most recent year follows:
Interior Exterior
Units sold 3,200 1,800
Selling price $ 125 $ 200
Direct material cost per unit $ 30 $ 45
Direct manufacturing labor cost per hour $ 16 $ 16

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Direct manufacturing labor-hours per unit 1.50 2.25
Production runs 40 85
Material moves 72 168
Machine setups 45 155
Machine-hours 5,500 4,500
Number of inspections 250 150
The owners have heard of other companies in the industry that are now using an activity-based
costing system and are curious how an ABC system would affect their product costing decisions.
After analyzing the indirect cost pool for Open Doors, six activities were identified as generating
indirect costs: production scheduling, material handling, machine setup, assembly, inspection,
and marketing. Open Doors collected the following data related to the indirect cost activities:
Activity Activity Cost Activity Cost Driver
Production scheduling $95,000 Production runs
Material handling $45,000 Material moves
Machine setup $25,000 Machine setups
Assembly $60,000 Machine-hours
Inspection $ 8,000 Number of inspections
Marketing costs were determined to be 3% of the sales revenue for each type of door.
1. Calculate the cost of an interior door and an exterior door under the existing simple costing
system. Required
2. Calculate the cost of an interior door and an exterior door under an activity-based costing
system.
3. Compare the costs of the doors in requirements 1 and 2. Why do the simple and activity-based
costing systems differ in the cost of an interior and exterior door?
4. How might Open Door, Inc., use the new cost information from its activity-based costing
system to address the declining market share for interior doors?

5-24 ABC, retail product-line profitability. Family Supermarkets (FS) operates at capacity and
decides to apply ABC analysis to three product lines: baked goods, milk and fruit juice, and
frozen foods. It identifies four activities and their activity cost rates as follows:
Ordering $100 per purchase order
Delivery and receipt of merchandise $ 80 per delivery
Shelf-stocking $ 20 per hour
Customer support and assistance $ 0.20 per item sold
The revenues, cost of goods sold, store support costs, the activities that account for the store
support costs, and activity-area usage of the three product lines are as follows:
Baked Goods Milk and Fruit Juice Frozen Products
Financial data
Revenues $57,000 $63,000 $52,000
Cost of goods sold $38,000 $47,000 $35,000
Store support $11,400 $14,100 $10,500
Activity-area usage (cost-allocation base)
Ordering (purchase orders) 30 25 13
Delivery (deliveries) 98 36 28
Shelf-stocking (hours) 183 166 24
Customer support (items sold) 15,500 20,500 7,900
Under its simple costing system, FS allocated support costs to products at the rate of 30% of cost
of goods sold.

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1. Use the simple costing system to prepare a product-line profitability report for FS.
2. Use the ABC system to prepare a product-line profitability report for FS.
3. What new insights does the ABC system in requirement 2 provide to FS managers?

5-27 Activity-based costing. The job costing system at Smith’s Custom Framing has five
indirect cost pools (purchasing, material handling, machine maintenance, product inspection, and
packaging). The company is in the process of bidding on two jobs; Job 215, an order of 15
intricate personalized frames, and Job 325, an order of 6 standard personalized frames. The
controller wants you to compare overhead allocated under the current simple job-costing system
and a newly-designed activity-based job-costing system.
Total budgeted costs in each indirect cost pool and the budgeted quantity of activity driver are as
follows:
Budgeted Overhead Activity Driver Budgeted Quantity
of Activity Driver
Purchasing $ 70,000 Purchase orders processed 2,000
Material handling 87,500 Material moves 5,000
Machine maintenance 237,300 Machine-hours 10,500
Product inspection 18,900 Inspections 1,200
Packaging 39,900 Units produced 3,800
$453,600
Information related to Job 215 and Job 325 follows. Job 215 incurs more batch-level costs
because it uses more types of materials that need to be purchased, moved, and inspected relative
to Job 325.
Job 215 Job 325
Number of purchase orders 25 8
Number of material moves 10 4
Machine-hours 40 60
Number of inspections 9 3
Units produced 15 6
1. Compute the total overhead allocated to each job under a simple costing system, where
overhead is allocated based on machine-hours.
2. Compute the total overhead allocated to each job under an activity-based costing system using
the appropriate activity drivers.
3. Explain why Smith’s Custom Framing might favor the ABC job-costing system over the
simple job costing system, especially in its bidding process.

5-35 Activity-based costing, merchandising. Pharmacare, Inc., a distributor of special

pharmaceutical products, operates at capacity and has three main market segments:
a. General supermarket chains b. Drugstore chains c. Mom-and-Pop single-store pharmacies
Rick Flair, the new controller of Pharmacare, reported the following data for 2011:
Pharmacare, 2011 General
Supermarket Drugstore Mom-and-Pop
Chains Chains Single Stores Pharmacare
Revenues $3,708,000 $3,150,000 $1,980,000 $8,838,000
Cost of goods sold 3,600,000 3,000,000 1,800,000 8,400,000
Gross margin $ 108,000 $ 150,000 $ 180,000 438,000
Other operating costs 301,080
Operating income $ 136,920

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For many years, Pharmacare has used gross margin percentage [(Revenue – Cost of goods sold)
÷ Revenue] to evaluate the relative profitability of its market segments. But, Flair recently
attended a seminar on activity-based costing and is considering using it at Pharmacare to analyze
and allocate “other operating costs.” He meets with all the key managers and several of his
operations and sales staff and they agree that there are five key activities that drive other
operating costs at Pharmacare:
Activity Area Cost Driver
Order processing Number of customer purchase orders
Line-item processing Number of line items ordered by customers
Delivering to stores Number of store deliveries
Cartons shipped to store Number of cartons shipped
Stocking of customer store shelves Hours of shelf-stocking
Each customer order consists of one or more line items. A line item represents a single product
(such as Extra-Strength Tylenol Tablets). Each product line item is delivered in one or more
separate cartons. Each store delivery entails the delivery of one or more cartons of products to a
customer. Pharmacare’s staff stacks cartons directly onto display shelves in customers’ stores.
Currently, there is no additional charge to the customer for shelf-stocking and not all customers
use Pharmacare for this activity. The level of each activity in the three market segments and the
total cost incurred for each activity in 2011 is as follows:
Activity-based Cost Data Activity Level
Pharmacare 2011 General Total Cost
Supermarket Drugstore Mom-and-Pop of Activity
Activity Chains Chains Single Stores in 2011
Orders processed (number) 140 360 1,500 $ 80,000
Line-items ordered (number) 1,960 4,320 15,000 63,840
Store deliveries made (number) 120 360 1,000 71,000
Cartons shipped to stores (number) 36,000 24,000 16,000 76,000
Shelf stocking (hours) 360 180 100 10,240
$301,080
1. Compute the 2011 gross-margin percentage for each of Pharmacare’s three market segments.
2. Compute the cost driver rates for each of the five activity areas.
3. Use the activity-based costing information to allocate the $301,080 of “other operating costs”
to each of the market segments. Compute the operating income for each market segment.
4. Comment on the results. What new insights are available with the activity-based costing
information?

5-39 Activity-based job costing, unit-cost comparisons. The Tracy Corporation has a
machining facility specializing in jobs for the aircraft-components market. Tracy’s previous
simple job-costing system had two direct-cost categories (direct materials and direct
manufacturing labor) and a single indirect-cost pool (manufacturing overhead, allocated using
direct manufacturing labor-hours). The indirect cost-allocation rate of the simple system for 2010
would have been $115 per direct manufacturing labor-hour. Recently a team with members from
product design, manufacturing, and accounting used an ABC approach to refine its job-costing
system. The two direct-cost categories were retained. The team decided to replace the single
indirect-cost pool with five indirect-cost pools. The cost pools represent five activity areas at the
plant, each with its own supervisor and budget responsibility.
Pertinent data are as follows:

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Activity Area Cost-Allocation Base Cost-Allocation Rate
Materials handling Parts $ 0.40
Lathe work Lathe turns 0.20
Milling Machine-hours 20.00
Grinding Parts 0.80
Testing Units tested 15.00
Information-gathering technology has advanced to the point at which the data necessary for
budgeting in these five activity areas are collected automatically.
Two representative jobs processed under the ABC system at the plant in the most recent period
had the following characteristics:
Job 410 Job 411
Direct material cost per job $ 9,700 $59,900
Direct manufacturing labor cost per job $750 $11,250
Number of direct manufacturing labor-hours per job 25 375
Parts per job 500 2,000
Lathe turns per job 20,000 59,250
Machine-hours per job 150 1,050
Units per job (all units are tested) 10 200
1. Compute the manufacturing cost per unit for each job under the previous simple job-costing
system. Required
2. Compute the manufacturing cost per unit for each job under the activity-based costing system.
3. Compare the per-unit cost figures for Jobs 410 and 411 computed in requirements 1 and 2.
Why do the simple and the activity-based costing systems differ in the manufacturing cost per
unit for each job? Why might these differences be important to Tracy Corporation?
4. How might Tracy Corporation use information from its ABC system to better manage its
business?