CHAPTER 12

COVERAGE OF LEARNING OBJECTIVES

LEARNING
OBJECTIVE
LO1: Describe the
general framework for
cost allocation.
LO2: Allocate the
variable and fixed costs
of service departments to
other organizational
units.
LO3: Use the direct and
step-down methods to
allocate service
department costs to user
departments.
LO4: Integrate service
department allocation
systems with traditional
and ABC systems to
allocate total systems
costs to product or
service cost objects.
LO5: Allocate costs
associated with customer
actions to customers.
LO6: Allocate the
central corporate costs
of an organization.
LO7: Allocate joint costs
to products using the
physical-units and
relative-sales-value
methods

FUNDAMENTAL
ASSIGNMENT
MATERIAL
A2

CRITICAL
THINKING
EXERCISES
AND
EXERCISES

PROBLEMS

CASES, NIKE
10K, EXCEL,
COLLAB. &
INTERNET
EXERCISES

B1

26, 29

39, 40, 46

56

A1, A2, B2

32

47, 48, 49

59

A2

31

41, 42, 50, 51,

52

55, 60

A2, B3

28, 33, 34

43, 44, 45

55, 58, 60

A2, A3

27, 30

49

61

A4, B4

35, 36, 37

53

175

CHAPTER 12
Cost Allocation
12-A1(30-50 min.) The numerical answers for requirements 1 and
2 are in Exhibit 12-A1. Most students will favor the direct method
because the final allocations are not affected significantly.
Special Note: As an example of rounding errors, reconsider footnote
(4) in Table 12-A1. If fractions were used instead of percentages,
the computations in footnotes (5) and (6) would be changed, and the
allocations would become:
30/1080
100/1080
250/1080
600/1080
100/1080
Total

x
x
x
x
x

950,000
950,000
950,000
950,000
950,000

=
=
=
=
=

26,389
87,963
219,907
527,778
87,963
950,000

176

EXHIBIT 12-A1
Total labor hours
Percentage
Employees
Percentage
Engineering hours
Percentage
Cost Driver

Total
1,080,000
100.0%
650
100.0%
80,000
100.0%

Cost Drivers
Method 1, Direct Method
Total department overhead before allocation
General factory administration
Cafeteria
Engineering
Totals
Method 2, Step-Down Method
Total department overhead before allocation
General factory administration
Cafeteria
Engineering
Totals

General
Factory
Administration Cafeteria
30,000
2.8%
-

Engineering
100,000
9.3%
50
7.7%
-

Machining
250,000
23.1%
100
15.4%
50,000
62.5%

Assembly
600,000
55.5%
450
69.2%
20,000
25.0%

Finishing
and
Painting
100,000
9.3%
50
7.7%
10,000
12.5%

Total
Engineering
Labor Hours Employees
Hours
$950,000
(950,000)
(150,000)

$150,000
-

$2,500,000 - - - - - - - - - - Not Given- - - - - - - - - - - $ 250,000 1 $ 600,000

$100,000
25,000 2
112,500
12,500
(2,500,000) 1,562,500 3
625,000
312,500
$1,837,500 $1,337,500
$425,000

$950,000
(950,000)

$150,000 $2,500,000 - -- - - - - - - - Not Given- - - - - - - - - - 26,600 4

88,350
$219,450
$527,250
$88,350
5
(176,600)
13,598
27,197
122,207
13,598
6
(2,601,948) 1,626,217
650,487
325,244
$1,872,864 $1,299,944
$427,192

1 250 + 600 + 100 = 950; 250/950 x 950,000 = 250,000; 600/950 x 950,000 = 600,000; etc.
2 100 + 450 + 50 = 600; 100/600 x 150,000 = 25,000; 450/600 x 150,000 = 112,500; etc.
3 50 + 20 + 10 = 80; 50/80 x 2,500,000 = 1,562,500; 20/80 x 2,500,000 = 625,000; etc.
Rounding in (4), (5), and (6) can cause discrepancies of hundreds of dollars:
4 2.8% x 950,000 = 26,600; 9.3% x 950,000 = 88,350; etc.
5 7.7% x 176,600 = 13,598; 15.4% x 176,600 = 27,196; etc.
6 62.5% x 2,601,948 = 1,626,218; 25.0% x 2,601,948 = 650,487; etc.

177

178

12-A2 (30-40 min.)

1.
To properly classify an assigned cost, it is necessary to specify
the cost object. For example, power cost is a direct cost if the cost
object is the power department but an indirect cost if the cost
objective is the maintenance department, the assembly department,
or the display types.
Type of Cost Assignment
per Exhibit 12-1
Example from Exhibit 12-23
1. Directly traced cost to
Power cost in power department (power
departments
department is the cost object); $90,000 of direct
costs of the maintenance department
(maintenance department is the cost object); parts
and direct labor costs in the assembly department
(the cost object is the assembly department).
2. Indirect costs allocated to General costs such as occupancy allocated to the
departments
maintenance and the assembly departments.
3. Service department costs Power department costs allocated to the
allocated to other service
maintenance department.
departments
4. Service department costs Power costs allocated to the assembly
allocated to producing
departments; maintenance department costs
departments
allocated to the assembly department.
5. Producing department
Since there is only one producing department, no
costs allocated to other
example exists.
producing departments
6. Directly traced costs to
Parts and direct labor costs in the assembly
departments that an
department.
organization can also trace
directly to products and
services
7. Producing department
All assigned costs of setup and assembly activities,
costs that an organization
including assembly supervisor salaries, machine
allocates to products or
depreciation, power, maintenance, and
services
occupancy.
179

8. Directly traced costs to

service departments that an
organization can also trace
directly to customers
9. Service department costs
allocated to customers
10. Product/service costs
assigned to customers

In this problem requirement, we assume that

Darling does not determine customer costs.
In this problem requirement, we assume that
Darling does not determine customer costs.
In this problem requirement, we assume that
Darling does not determine customer costs.

2.
The assembly facility uses the step-down method. Power
department costs are first allocated to the maintenance service
department and the assembly department before the maintenance
department costs are allocated to the two major activities in the
assembly department.
3.
Power General Maintenance Setup
Department Costs
Department Activity
$ 60,000* $ 600,000 $ 90,000

Direct costs
Allocated general
Costs**
$(600,000)
60,000 $120,000
Allocated power
department costs*** $(60,000)
6,000
6,000
Allocated maintenance
department costs****
$(156,000)
52,000
Total
$178,000
* 10 x $600 + 10 x $600 + 80 x $600
** 10 + 20 + 70 = 100; (10 100) x $600,000; etc.
*** 10 + 10 + 80 = 100; (10 100) x $60,000; etc.
**** 2,000 + 4,000 = 6,000; (2,000 6,000) x $156,000; etc.

180

Assembly
Activity
$420,000
48,000
104,000
$572,000

4.
Cost
per
Driver
Unit
Parts
Direct labor
Setup
activity
Assembly
activity
Total
Displays
Cost per
display

Display Type A
Driver
Units _____Cost
$1,053,800
344,000

Display Type B
Driver
Units _____Cost
$ 575,000
303,000

Display Type C
Driver
Units ____Cost
$239,700
123,000

$1,310
20

26,200

60

78,600

120

157,200

1,000

203,000
$1,627,000
100,000

1,800

365,400
$1,322,000
50,000

1,200

243,600
$763,500
15,000

203

16.27

26.44

$ 50.90

5. First, L.A. Darling would decide what profitability measure it

needs. The most easily computed measure is the customer gross
profit. The more refined and difficult to compute measure assigns
costs to serve to each customer, giving a more complete profitability
profile. We take time in our class discussion to describe, in general
terms, how both of these measures are determined. Exhibit 12-A2
can be used to describe both costing systems. This exhibit shows
Exhibit 12-23 (page 564) in Panel A and how product cost is
incorporated in a refined customer profitability process model in
Panels B and C.

181

Panel B shows how customer gross profit is determined. Consider

display type A. How is the product cost of display type A is
incorporated into the customer-profitability system? The unit gross
profit for display type A is its price less the cost of goods sold of
$16.27 from requirement number 4. The total gross profit from sales
of display type A to a customer is then the unit gross profit times the
number of units sold. Customer profitability is a function of the
product mix purchased. Many companies opt for this rather simple
extension of the costing system because it is easy to understand and
less costly to maintain than the more complex profitability system
that incorporates costs to serve. The major drawback of this system
is its lack of costing accuracy if there is diversity among customers
regarding their use of resources associated with the costs to serve.
Panel C shows the more complex profitability system incorporating
costs to serve. A company opts for this more complex system if the
costs to serve vary substantially across its customer base. Customer
profitability is a function of the product mix purchased and the cost
to serve. This is the difference between the gross profit and the cost
to serve. To determine the costs to serve the three customers, L.A.
Darling would need to determine major activities required to serve
the customers along with related cost-allocation bases. Then for
each activity, fixed- and variable-cost resources consumed would be
assigned (directly traced or allocated). For each activity, the cost per
unit of the cost-allocation base would be determined and then
activity-cost pools would be allocated to the three customer objects
based on the proportion of the cost allocation base used. Finally,
customer profitability would be determined by deducting the cost to
serve from the customer gross profit.

182

Exhibit 12-A2

L.A. Darlings Refined Allocation System to Determine Customer Profitability

Panel A
Exhibit 12-23, L.A. Darlings Product-Cost
System

Panel B
L.A. Darlings Customer-Profitability System
without Cost-to-Serve

General Costs

Power Department

Power

Occupancy
(Plant)

Maintenance Department

MWH

Square Feet
O

Department
Resources

Assembly
Supervisors

Machines

SUP

SUP

SUP

GP Display
Type B =
Price of B $26.44

GP Display
Type C =
Price of C $50.90

GP Display
Type A =
Price of A $16.27

Machine Hours.

Assembly Activity

Setup Activity

Parts

Direct
Labor

Setups

Machine Hours

SA

AA

SA

AA

Display Type A
Product Cost =
$16.27

Parts

Direct
Labor

SA

AA

Parts

Direct
Labor

SA

AA

Display Type B Display Type C

Product Cost =
$26.44

Product Cost =
$50.90

Assembly Department
183

Mix of
WalMart

Mix of
Kmart

WMGP

KMGP

WGGP

WMGP

KMGP

WGGP

Wal-Mart
Profitability

Kmart
Profitability

Mix of
Walgreens

Walgreens
Profitability

Exhibit 12-A2 (Continued)

Panel A
Exhibit 12-23, L.A. Darlings Product-Cost
System

Panel C
L.A. Darlings Customer-Profitability System
with Cost-to-Serve
Resources used by the three cost-to-serve activities.

General Costs

Power Department

Power

Occupancy
(Plant)

Maintenance Department

MWH

Square Feet
O

Department
Resources

Cost-to-Serve
Activity 1

Cost-to-Serve
Activity 2

Cost-to-Serve
Activity 3

Act. 1

Act. 2

Act. 3

Machine Hours.

Assembly
Supervisors

Machines

SUP

SUP

SUP

Assembly Activity

Setup Activity

GP Display
Type B =
Price of B $26.44

GP Display
Type C =
Price of C $50.90

GP Display
Type A =
Price of A $16.27

Parts

Direct
Labor

Setups

Machine Hours

SA

AA

SA

AA

Display Type A
Product Cost =
$16.27

Parts

Direct
Labor

SA

AA

Parts

Direct
Labor

SA

Mix of
WalMart

Mix of
Kmart

WMGP

KMGP

Mix of
Walgreens

AA

Display Type B Display Type C

Product Cost =
$26.44

WMGP

Product Cost =
$50.90

Act. 1

Act. 2

Wal-Mart
Profitability

Assembly Department

184

Act. 3

KMGP

Act. 1

WGGP
Act. 2

Kmart
Profitability

Act. 3

WGGP

Act. 1

Act. 2

Walgreens
Profitability

Act. 3

12-A3 (15-20 min.)

1.

Allocations are in millions:

Divisions:
Northern
Midwest
Texas-Oklahoma
Total

2.

Actual
Revenue

Allocated
Costs

$120
200
280
$600

$ 6
10
14
$30

Northern's manager would probably be indifferent, Midwest's

would be pleased, and Plain's would be displeased.
The major weakness of using revenue as a basis for cost
allocation is that it often fails to portray underlying causeand-effect relationships. The major point of this problem is to
show how strange results occur when the costs being allocated
to a given segment are dependent on the activity of some other
segment. The Texas-Oklahoma Division has done the most to
reduce the unit cost of central services, but it is being charged
with a heavier dose of common costs. Indeed, Midwest may
have received more rather than less attention because of its
current competitive troubles.
Most of the central costs are discretionary. Pinpointing causeand-effect relationships is hard. Such costs are usually
predetermined by management fiat or by budgeted revenue.

185

Serious consideration should be given to one or more of the

following:
a. No allocation, because no convincing allocation base is
available.
b. Dividing the services into sub-categories and allocating by
the use of several different cost drivers.
c. Using budgeted revenues rather than actual revenues as a
cost driver for allocation. Of course, the use of budgeted
revenues may induce more "gamesmanship" than is
typically encountered during the budgetary process. There
is a tendency to "under-budget" whenever a lower cost
allocation will result.
3.

Allocations are in millions:

Budgeted
Revenue
Divisions:
Northern
Midwest
Texas-Oklahoma
Total

$120
240
280
$640

Allocated
Costs
$ 5.625
11.250
13.125
$30.000

Many managers prefer this method because it portrays causes

and effects somewhat better than in requirement (1). That is,
at least the overall level of costs tend to be planned rather than
just happen after the fact.
In requirement (1), the allocated costs were each 5% of actual
revenue. However, in requirement (3), the allocation is
predetermined, and therefore the percentages of actual
revenue vary:

186

(1)
Actual
Revenue
Divisions:
Northern
Midwest
Texas-Oklahoma
Total

$120
200
280
$600

(2)
(3)
Allocated Percentage
Costs
(2) (1)
$ 5.625
11.250
13.125
$30.000

4.7%
5.7%
4.7%

Note that Midwest's budgeted percentage would have been

$11.3 $240 = 4.7%. The resultant deviation of the actual
percentage (5.7%) from the budgeted percentage (2.3%)
would highlight the effects of Midwest's troubles.
4.

Many accountants and managers oppose allocating any

central costs when no convincing causes and effects can be
established in any economically feasible way. The opponents
of cost allocation feel that the managers of subunits will have
better attitudes and will make better decisions if no allocation
occurs.

187

12-A4 (20-30 min.)

Note that total joint costs are:
$12 x 800,000 + $4 x 800,000 = $12,800,000.
1.

Physical units method:

Pounds
A 200,000
B 600,000
800,000
2.

Weighting
(200 800) x $12,800,000
(600 800) x $12,800,000

Allocation of
Joint Costs
$ 3,200,000
9,600,000
$12,800,000

Relative sales value method:

Relative Sales Value

Allocation of
at Split-off
Weighting
Joint Costs
A $30 x 200,000 = $ 6,000,000 (6 15) x $12,800,000 $ 5,120,000
B $15 x 600,000 =
9,000,000 (9 15) x $12,800,000 7,680,000
$15,000,000
$12,800,000
3.
The sales value of B at the split-off point must be
approximated:
Sales value of B = Final sales value - Separable costs
= $21.50 x 600,000 [$300,000 + ($1 x 600,000)]
= $12,900,000 - $900,000
= $12,000,000
Relative Sales Value
at Split-off
Weighting
A $ 6,000,000
(6 18) x $12,800,000
B
12,000,000
(12 18) x $12,800,000
$18,000,000
188

Allocation of
Joint Costs
$ 4,266,667
8,533,333
$12,800,000

12-B1 (10-15 min.)

1.

Business
Fixed costs per month:
210 700, or 30% of $100,000
490 700, or 70% of $100,000
Variable costs @ $200 per hour:
210 hours
390 hours
Total costs

Engineering

$30,000
$ 70,000
42,000

2.
Fixed costs per month:
210/600 x $100,000
390/600 x $100,000
Variable costs, as before
Total costs

$72,000

78,000
$148,000

Business

Engineering

$35,000
42,000
$77,000

$ 65,000
78,000
$143,000

The dean of Business would probably be unhappy. The Business School

has operated exactly in accordance with the long-range plan.
Nevertheless, Business is bearing an extra $5,000 of fixed costs because of
what another consumer is using. The dean would prefer the method in
Requirement 1 because it insulates Business from short-run fluctuations
in costs caused by the actions of other users.

189

12-B2 (30-40 min.)

1.

See Exhibit 12-B2, Part 1

2.

See Exhibit 12-B2, Part 2

3. (a) Residential: $313,500 30,000 hours = $10.45 per directlabor

hour
(b) Commercial: $486,500 9,970,000 sq. ft. = $.0488 per square
foot

190

Exhibit 12-B2, Part 1

Direct method:
Personnel
Direct departmental
costs before allocation
Personnel
Administrative
Total costs after allocation

Administrative

$ 70,000
(70,000)

$ 90,000
(90,000)

Calculations:
24 + 36 = 60
(36 60) x $70,000 = $42,000
(24 60) x $70,000 = $28,000
240,000 + 400,000 = 640,000
(240,000 640,000) x $90,000 = $33,750
(400,000 640,000) x $90,000 = $56,250

191

Residential
$240,000
42,000
33,750
$315,750

Commercial
$400,000
28,000
56,250
$484,250

Exhibit 12-B2, Part 2

Step-down method:
Personnel
Direct departmental
cost before allocation
Personnel
Administrative
Total cost after allocation

Administrative

$ 70,000
(70,000)

$ 90,000
10,000
$(100,000)

Calculations:
10 + 24 + 36 = 70
(10 70) x $70,000 = $10,000
(36 70) x $70,000 = $36,000
(24 70) x $70,000 = $24,000
240,000 + 400,000 = 640,000
(240,000 640,000) x $100,000 = $37,500
(400,000 640,000) x $100,000 = $62,500

192

Residential
$240,000
36,000
37,500
$313,500

Commercial
$400,000
24,000
62,500
$486,500

12-B3 (30-40 min.)

1. The table below shows the calculation of gross profit margin
percentage for each of the three products. The process map can also
be used to visually show how the three products map onto the each
customer type.
Product X Product Y Product Z
Sales
$2,000
$6,000
$20,000
Cost of goods sold
1,000
2,000
14,000
Gross profit margin
$1,000
$4,000
$ 6,000
Gross profit margin percentage
50%
66.7%
30%
Product Y has the largest gross profit margin percentage.
PROCESS MAP

Y SALES
COGS
GP
GP%

X SALES $2,000
COGS
1,000
GP
$1,000
GP%
50%

Z SALES
COGS
GP
GP%

$6,000
2,000
$4,000
66.7%

X
50%

83.3%

MIX 1

16.7%

100%

MIX 2

CTS
$2,000

CTS
$13,000

CUSTOMER TYPE 2

CUSTOMER TYPE 1

193

COST TO
SERVE
$15,000

CTS

50%

$20,000
14,000
$ 6,000
30%

2-4.
CUSTOMER TYPE 1
Total Percent
Revenue
($1,000 + $5,000)
Cost of sales
($500 + $1,667)

$6,000
2,167

Gross profit
3,833
Cost to serve
2,000
Operating income $1,833

CUSTOMER TYPE 2
Total Percent

Revenue
100% ($1,000 + $1,000 +
$20,000)
Cost of sales
36
($500 + $333 +
$14,000)
64
Gross profit
33
Cost to serve
31% Operating income

$22,000

100%

14,833

67

7,167
13,000
($ 5,833)

33
59
(26%)

Customer type 1 is the profitable customer. This customer type

orders the most profitable products and has a low cost to serve.
Customer type 2 has a low gross profit due to purchasing large
volumes of product Z and has a large cost to serve.
5. A chart showing gross profit percentage and cost-to-serve
percentage for each customer is on the next page. Suggested
strategies for customer profit improvement are also shown on this
chart.

194

GROSS PROFIT PERCENTAGE

CUSTOMER PROFITABILITY
Customer Type 1
The most profitable customer should be protected
from possible actions of competitors.
Price discounts may be given to this customer to
encourage higher sales volume.

100%
90%
80%
70%
60%
50%

33%, 64%

40%
30%
20%

59%, 33%

Customer Type 2
Work with this customer to
lower the cost to serve.
Explore internal processes to
lower the cost to serve.
Emphasize sales of products X
and Y
Consider raising price of Z

10%
0%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100
%

COST TO SERVE PERCENTAGE

* The size of the data points in the above chart is proportional to the customer
sales volume.

195

12-B4 (15 min.)

The joint costs include the purchase cost of $500,000 and the
processing cost before the split-off point of $.30 x 1,000,000 =
$300,000, a total of $800,000.
1.
Pounds
Oat flour 800,000
Oat bran 200,000
1,000,000
2.

3.

Weighting
800/1,000 x $800,000
200/1,000 x $800,000

Allocation of
Joint Costs
$640,000
160,000
$800,000

Relative Sales
Allocation of
Value at Split-off*
Weighting
Joint Costs
Oat flour $1,200,000
1,200/1,600 x $800,000
$600,000
Oat bran
400,000
400/1,600 x $800,000
200,000
$1,600,000
$800,000
*$1.50 x 800,000 and $2.00 x 200,000
Estimated value of oat flour at split-off:
Sales value of oat flakes,
$2.80 x 800,000 pounds
Less: Processing cost after split-off
point, $.50 x 800,000 pounds + $240,000

$2,240,000
(640,000)
$1,600,000

Relative Sales
Allocation of
Value at Split-off
Weighting
Joint Costs
Oat flour $1,600,000 1,600/2,000 x $800,000 $640,000
Oat bran
400,000 400/2,000 x $800,000 160,000
$2,000,000
$800,000

196

12-1 For most companies, accountants can directly trace less than
60% of operating costs to products, services, and customers. For the
rest of a companys costs, accountants must either apply costallocation methods or leave costs unallocated. Most managers
prefer to allocate these indirect costs.
12-2 Yes. For external financial reporting purposes, only
production costs would be included in product cost and therefore
deducted in computing gross profit. For determining product
profitability for internal strategic decisions such as setting optimal
product mix, other value-chain costs might be allocated to products.
The costs to be included in product cost for internal decision making
depends on what decision is to be made.
12-3 Exhibit 12-1 shows the ten types of cost assignments.
1. Directly traced costs to departments
2. Indirect costs allocated to departments
3. Service department costs allocated to other service
departments
4. Service department costs allocated to producing
departments
5. Producing department costs allocated to other producing
departments
6. Directly traced costs to producing departments that an
organization can also trace directly to products and
services
7. Producing department costs that an organization allocates
to products or services
8. Directly traced costs to service departments that an
organization can also trace directly to customers
9. Service department costs allocated to customers
10. Product/service costs assigned to customers

197

12-4 When the cost objective is customers, allocating customerrelated service-department costs to products causes customer-cost
distortion because the customer costs-to-serve are allocated based
on production-related cost-allocation bases and product mix
percentages rather than allocation bases with a causal relationship
to customer actions.
12-5 What is worse, no allocation or inaccurate allocation based on
either unplausible or unreliable cost drivers? Most cost accountants
would opt for no allocation. This would preserve both the
plausibility and reliability of allocation bases and the accuracy of
the allocated cost. Managers who are held responsible for costs are
motivated to exert cost control when they see a clear cause-effect
relationship between actions that they take to manage cost drivers
and the resulting costs incurred.
12-6 The preferred guidelines for allocating service department
costs are:
a.

b.

c.

Evaluate performance using budgets for each service (staff)

department, just as they are used for each production or
operating (line) department. When feasible, maintain
distinctions between variable-cost pools and fixed-cost pools.
Allocate variable- and fixed-cost pools separately. This is
sometimes called the dual method of allocation. Note that one
service department (such as a computer department) can
contain a variable-cost pool and a fixed-cost pool. That is,
costs may be pooled within and among departments if desired.
Establish part or all of the details regarding cost allocation in
advance of rendering the service rather than after the fact.

198

12-7 The distinction between direct and indirect depends on the

cost object. A cost such as the salaries of service department
personnel are a direct cost when the cost object is the service
department. However, when the cost object is outside the service
department, such as a producing department that uses the services
of the service department, the salaries of the service department
must be allocated to the producing departments and hence are
indirect.
12-8 Using budgeted rather than actual cost rates protects the
using departments from inefficiencies in the service departments
and from intervening price fluctuations.
12-9 The motivation to underestimate long-run usage is a common
problem with allocation methods using lump-sums based on longrange plans. To counteract this tendency, management can evaluate
predictions of long-run usage and provide rewards for accurate
predictions.
12-10 Two methods of allocating service department costs are the
direct method and the step-down method. The direct method ignores
other service departments when any given service department's
costs are allocated. No costs are allocated from one service
department to another. The step-down method recognizes that
some service departments provide services to other service
departments as well as to producing departments. The costs of the
first service department are allocated to all other service
departments and the producing departments. Then the second
service department's costs are allocated to the remaining service
departments (i.e., all service departments except those whose costs
have already been allocated) and the producing departments. Once
a service department's costs have been allocated, no subsequent
service department's costs are allocated back to it. This procedure
continues until all service department costs have been allocated.
199

12-11 No. Both the direct and step-down methods allocate the same
total amount of costs to the producing departments.
12-12 Non-volume-related cost drivers are causes of costs that are
not proportional to the volume of output. For example, number of
hours of engineering design services is a non-volume-related cost
driver that can be used to allocate engineering costs. Another nonvolume-related cost driver is product complexity - more specifically,
possibly number of components in a final product.
12-13 First, managers identify the key activities in the organization,
and they collect overhead costs for each activity. Cost drivers are
then selected for each activity, and those cost drivers are used to
allocate the costs to the products, services, or customers.
12-14 It would be ideal if every cost pool would contain only fixed or
only variable costs. This should be the goal. In practice, there are
many reasons why this goal may not be achieved. For example, the
identification of fixed and variable costs is not perfect; most costs
have some fixed and some variable cost characteristics. Perfect
separation into fixed and variable cost categories may not be
possible. In addition, it may not be economically feasible to have
separate cost pools for fixed and variable costs if most (but not all)
of the cost fits into one of the categories. For example, if 90% of a
cost is variable and 10% is fixed, it may be best to treat the entire
cost as variable.
12-15 Some possible activities and cost drivers are:
Activity
Cost driver
Group of machines
Machine hours
Set-up costs
Number of set-ups
Quality inspection
Units passing inspection point
Personnel department Number of employees
200

12-16

among
12-17

Step 1: Determine the key components of the system.

Step 2: Develop the relationships between resources,
activities, and cost objects.
Step 3: Collect relevant data concerning costs and the
physical flow of cost-allocation base units
resources and activities.
Step 4: Calculate and interpret the new ABC information.
Low Cost to Serve
Large order quantity
Few order changes
Little pre-sales support

High Cost to Serve

Small order quantity
Many order changes
Large amount of pre-sales
support
Little post-sales support Large amount of post-sales
support
Regular scheduling
Expedited scheduling
Standard delivery
Special delivery requirements
Few returns
Frequent returns

12-18 Joint costs are allocated to products or services for purposes

of inventory valuation and income determination. They may also be
allocated for cost-reimbursement contracts.
12-19 The physical units method allocates joint costs in proportion
to some physical property of the products (e.g., weight or volume) at
the split-off point. The relative sales value method allocates joint
costs in proportion to the amounts for which the products can be
sold at the split-off point.

201

12-20 By-products, like joint products, are not separately

identifiable before the split-off point. However, by-products have
relatively insignificant sales values compared to main products.
Only separable costs are applied to by-products; no joint costs are
allocated to them. Revenues from by-products, less separable costs,
are deducted from the cost of the main product.
12-21 The simplest answer is to recommend a traditional costing
system for the Youngstown plant and an ABC costing system for the
Salem plant. Why? Because one of the primary purposes of any
costing system is to provide as accurate cost information as possible
subject to the benefit-cost criterion. There is always a tradeoff
between the accuracy of a system and the costs to implement and
maintain it. Generally, as the operations of a company become
more complex, the diversity of demands upon resources increases
across products (services). In order to accurately track resource
costs in such a diverse operating environment, many cost pools are
needed for the various activities -- that is, an ABC system. Because
the Youngstown plant operations are not complex, a simple
(traditional) costing system probably provides sufficiently accurate
cost information. Due to the complexity and diversity of the Salem
plant operations, an ABC costing system should be considered.
12-22 In two-stage ABC systems, there are only two levels of
allocation between resources used and the final cost objective. The
first stage often consists of percentages representing the amount of
effort used to perform the activities that consume the resources.
In multistage ABC systems, there is no limit on the number of
allocations between resources and the final cost objective. In
addition, multistage ABC systems have a distinctive operational
flavor. There are many consumption rates that reflect the
input/output relationships between activities and resources as well
as between cost objects and activities.
202

12-23 These rates represent input/output relationships. Process

improvements usually affect the input level required for a unit of
output. For example, suppose the time required to perform a setup
is currently 10 mechanic hours (say two persons working for 5
hours). By relocating tools needed to do the setup and providing
more training, the time is reduced to 6 hours. This process
improvement would be reflected in a lower resource consumption
rate (from 10 to 6 labor hours per setup). As another example, on
Exhibit 12-21, consider the resource consumption rate r2 = 25
computer transactions per account verified. The total computer
cost to verify 20,000 commercial accounts is (20,000 x 25 x $0.027) =
$13,500. Suppose the number of transactions can be reduced to only
10 by using a new verification software feature. Suppose further
that this new feature would raise the cost per transaction to $0.04.
Now the total computer cost to verify the 20,000 commercial
accounts is (20,000 x 10 x $0.04) = $8,000. This process improvement
would result in a net savings of $5,500.
12-24 Resource consumption rates are almost always non-financial
measures. The cost per driver unit is the total cost of an activity or
resource divided by the total output flow of cost driver units.
12-25 Suppose that not only are all of a companys products
profitable (that is, gross profit is positive), its average gross profit
margin percentage is 30%. What if the total costs of the distribution
and customer service value-chain functions is 35% of sales? In such
a case, even without considering unallocated costs associated with R
& D, design, and corporate support, the company is operating at a
loss.
The costs associated with customer actions, costs to serve, can often
be either directly traced or allocated to customers. Identifying those
customers whose costs to serve are greater than the gross profit they
generate will help the company develop a strategy for profit
improvement.
203

12-26 Fixed costs are often allocated separately from variable costs
because they are caused by different activities. Fixed costs are
affected primarily by long-range decisions about the overall level of
service. In contrast, variable costs depend on short-run fluctuations
in actual usage.
12-27 Sales dollars are often a poor basis for allocation of costs
because they reflect efficiency of sales effort and variations in
pricing margins, neither of which is related to costs. Further,
changes of sales in one department can affect costs allocated to the
other departments.
12-28 One way to allocate national advertising costs to territories is
on the basis of expected sales in each territory, computed by some
formula combining population, income, appeal, competition, and
supply capability.

204

12-29 (10-15 min.)

1.

Rate =

$2,000 + ($.05 x50,000)

50,000

= $.09 per copy

Cost allocated to Public Works in August

= $.09 x 21,000 = $1,890.
2.

Fixed cost pool allocated as a lump sum depending on

predicted usage:
To Public Works: (18,000 50,000) x $2,000 = $720 per month
Variable cost pool allocated on the basis of actual usage:
$.05 x number of copies
Cost allocated to Public Works in August: $720 + ($.05 x
21,000) = $1,770.

3.

The second method, the one that allocated fixed- and variablecost pools separately, is preferable. It better recognizes the
causes of the costs. The fixed cost depends on the size of the
photocopy machine, which is based on predicted usage and is
independent of actual usage. Variable costs, in contrast are
caused by actual usage.

205

12-30 (10 - 15 min.)

Sunnyville Wedgewood Capitol
1. Allocation based on
budgeted sales*
2. Allocation based on
actual sales**

$54,000

$90,000

$36,000

60,000

70,000

50,000

*$180,000 x 600/2,000; $180,000 x 1,000/2,000; $180,000 x 400/2,000

** $180,000 x 600/1,800; $180,000 x 700/1,800; $180,000 x 500/1,800

3.

The major argument against using actual sales as a cost driver

for cost allocation is that a department's allocation depends on
the success of other departments. Here, Sunnyville is
allocated an extra $6,000 because sales in the Wedgewood
store are below budget, even though Sunnyville's sales came in
right on target. Further, stores with poor sales results
probably do not cause reduced central office costs. If
anything, a department with poor performance requires more
central attention. Also, using budgeted sales reduces
surprises; managers know what amount of allocated cost to
expect. Often managers are more upset by unexpected
changes in allocated amounts than by the size of the allocation
itself.

206

12-31 (30 min.)

1. See Exhibit 12-31. Calculations for the exhibit follow:
3 + 12 + 18 + 8 = 41
(3 41) x $92,000 = $6,732
(12 41) x $92,000 = $26,927
(18 41) x $92,000 = $40,390
(8 41) x $92,000 = $17,951
$240,000 + $400,000 = $640,000
($240,000 $640,000) x $180,000 = $67,500
($400,000 $640,000) x $180,000 = $112,500
2. See Exhibit 12-31. Calculations for the exhibit follow:
5 + 3 + 12 + 18 + 8 = 46
(5 46) x $92,000 = $10,000
(3 46) x $92,000 = $6,000
(12 46) x $92,000 = $24,000
(18 46) x $92,000 = $36,000
(8 46) x $92,000 = $16,000
$240,000 + $400,000 = $640,000
($240,000 $640,000) x $190,000 = $71,250
($400,000 $640,000) x $190,000 = $118,750
3. The allocation bases used by each division to allocate activity
costs to products will be the cost drivers for activities 1 through 5.
For example, suppose activity 1 in the residential division is
cleaning windows, and the cost driver is number of windows.
Further assume that service type RA has a total of 3,000 units
(customers) with an activity-consumption rate of 6 (an average of
6 windows per RA-type customer) and service type RB has 500
207

units with an activity-consumption rate of 40. The allocation of

activity 1 cost using the step-down method would be:
Activity cost per driver unit =
$66,000 (3,000 RA Customers x 6 windows per customer +
500 RB Customers x 40 windows per customer)
= $66,000 38,000 windows
= $1.7368421 per window.
To service type RA: $1.7368 x 18,000 windows = $31,262.40
To service type RB: $1.7368 x 20,000 windows = $34,736.00

208

Exhibit 12-31
Direct method:

Directcosts
Personnel
Administrative
Total costsafter
allocation

Personnel
$92,000
(92,000)

ResidentialDivision
CommercialDivision
Admin.
Activity1 Activity2
Total
Activity3 Activity4 Activity5
$180,000
$60,000 $240,000 $300,000 $400,000
$90,000 $110,000
0*
6,732
26,927
33,659
40,390
0
17,951
(180,000)
0
67,500
67,500
112,500
0
0
$66,732 $334,427 $401,159 $552,890
$90,000 $127,951

Total
$600,000
58,341
112,500
$770,841

* Note that on the process map shown in Exhibit 12-24, the direct method ignores the link
and the related allocated costs from the Personnel Department to the Administrative
Department.
Step-down method:

Directcosts
Personnel
Administrative
Total costsafter
allocation

Personnel
$92,000
(92,000)

ResidentialDivision
CommercialDivision
Admin.
Activity1 Activity2
Total
Activity3 Activity4 Activity5
$180,000
$60,000 $240,000 $300,000 $400,000
$90,000 $110,000
10,000
6,000
24,000
30,000
36,000
0
16,000
(190,000)
0
71,250
71,250
118,750
0
0
$66,000 $335,250 $401,250 $554,750
$90,000 $126,000

209

Total
$600,000
52,000
118,750
$770,750

12-32 (15-20 min.)

1.

Direct method:
Personnel Custodial Machining Assembly
Direct department costs
before allocation
$32,000 $70,000 $600,000 $800,000
Personnel*
(32,000)
14,222
17,778
Custodial**
(70,000)
20,000
50,000
Total cost after allocation $
0 $
0 $634,222 $867,778
* (200 450) x $32,000; (250 450) x $32,000
**(10 35) x $70,000; (25 35) x $70,000

2.

Step-down method:
Personnel Custodial Machining Assembly
Direct department costs
before allocation
$32,000 $70,000 $600,000 $800,000
Personnel*
(32,000) 2,000
13,333
16,667
Custodial**
(72,000)
20,571
51,429
Total cost after allocation $
0 $
0 $633,904 $868,096
* (30 480) x $32,000; (200 480) x $32,000; (250 480) x $32,000
**(10 35) x $72,000; (25 35) x $72,000

210

12-33 (20-25 min.)

1. Product Y is most profitable with a 66.7% gross profit margin percentage.
Product
X
Sales

Product
Y

Product
Z

$200

$600

$2,000

Cost of sales

100

200

1,400

Gross profit

$100

$400

$ 600

Gross profit margin

percentage

50%

66.7%

30%

2. 4.
CUSTOMER TYPE 1
Total
$600
217
383
200
$183

Revenue ($100 + $500)

Cost of sales ($501 + $1672)
Gross profit
Cost to serve
Operating income

Percent
100%
36
64
33
31%

1. Percent of Product X sold to customer type 1 x total cost of X sales =

($100 $200) x $100
2. Percent of Product Y sold to customer type 1 x total cost of Y sales =
($500 $600) x $200

CUSTOMER TYPE 2
Total
$2,20
Revenue ($100 + $100 + $2,000)
0
Cost of sales ($50 + $33 + $1,400) 1,483
Gross profit
717
Cost to serve
1,300
Operating income
($583)

Percent
100%
67
33
59
(26%)

Customer type 1 is most profitable with a gross profit margin percentage

of 64% and cost-to-serve percentage of only 33% yielding a 31%
211

operating income percentage. Customer type 2 has a low gross profit

margin percentage (33%), which is much less than the cost-to-serve
percentage of 59%, yielding an operating loss percentage of 26%.

212

12-34 (30-40 min.)

Product Product Product Product
A
B
C
D
Sales
$32,000 $88,000 $280,000 $144,000
Cost of sales
20,000 70,400 224,000
81,000
Gross profit margin
$12,000 $17,600 $ 56,000 $ 63,000
Units sold
3,200
4,400
5,600
1,800
Gross profit margin per unit
$3.75
$4.00
$10.00
$35.00
Gross profit margin
percentage
37.5% 20.0%
20.0%
43.8%
Product D is the most profitable with a gross profit margin
percentage of 43.8%.
2. 4.
Exhibit 12-34 shows calculations for requirements 2 4.
The most profitable customer type depends on the measure of
profitability used. Customer type 1 has the greatest operating
income percentage (36.6% - 10.4% = 26.2%). However, customer
type 3 has the largest dollar contribution to operating income
($100,750 - $50,000 = $50,750).

213

Exhibit 12-34
Customer Type 1

Product

Sales
price
per
unit

Gross
profit
margin
per unit

$10.001

$ 3.75

200

B
C

20.00
50.00

4.00
10.00

200
200

80.00

35.00

Total
Cost to serve
Operating income
Customer gross margin
percentage
Cost to serve percentage
Customer profit margin
percentage
1. $32,000 3,200 units

Customer Type 2

Gross
profit Units Revenue

Units Revenue
$ 2,000 $

Customer Type 3

Gross
profit

Units

Revenue

Gross
profit

$ 10,000 $

3,750

750

2,000

$20,000

$ 7,500

1,000

4,000
10,000

800
2,000

1,200
400

24,000
20,000

4,800
4,000

3,000
5,000

60,000
250,000

12,000
50,000

400

32,000

14,000

400

32,000

14,000

1,000

80,000

35,000

1,000

$48,000

17,550

4,000

$96,000

30,300

10,000

$400,000

100,750

5,000

20,000

50,000

$12,550

$10,300

$50,750

36.6%
10.4%

31.6%
20.8%

25.2%
12.5%

26.2%

10.8%

12.7%

214

Focus on shifting the product mix towards

products A and D. This should improve the
customer gross profit margin percentage.

5. The chart below shows customer profitability for the three

customer types and suggested strategies for profit improvement.

CUSTOMER PROFITABILITY
Grow business with this customer type by focused
sales efforts and quantity discounts.

GROSS PROFIT MARGIN PERCENTAGE

40%

Customer
Type 1

35%

Customer
Type 2

30%

Customer
Type 3

25%
20%

Work with customers to lower

the cost to serve. Seek internal
process improvements to lower
those elements of the cost to
serve controllable by the
company.

15%
10%
5%
0%
0%

10%

20%

30%

COST TO SERVE PERCENTAGE

The area of the data points are proportional to total revenue

generated by the customers.
215

40%

12-35 (15-20 min.)

1.
Gallons
Weighting
Solvent A 9,000
9/15 x $300,000
Solvent B
6,000
6/15 x $300,000
15,000
2.

Allocation of
Joint Costs
$180,000
120,000
$300,000

Relative Sales
Value at Split-off*
Weighting
Solvent A $270,000
27/54 x $300,000
Solvent B
270,000
27/54 x $300,000
$540,000
* $30 x 9,000 and $45 x 6,000

Allocation of
Joint Costs
$150,000
150,000
$300,000

12-36 (10 min.)

1.
Solvent A
Solvent B
2.

Gallons
20,000
10,000
30,000

Weighting
20/30 x $400,000
10/30 x $400,000

Relative Sales
Value at Split-off* Weighting
Solvent A $ 400,000
400/1,000 x $400,000
Solvent B
600,000
600/1,000 x $400,000
$1,000,000
* $20 x 20,000 and $60 x 10,000

216

Allocation of
Joint Costs
$266,667
133,333
$400,000
Allocation of
Joint Costs
$160,000
240,000
$400,000

12-37 (10-15 min.)

1.

None. The entire joint cost is allocated to the main product.

2.

$30,000. The total inventory cost of the pulp is the separable

cost, that is, the cost incurred after the split-off point.

3.

Inventory cost of apples:

Direct materials (apples)
Pressing cost
Filter, pasteurize, and pack cost
Total
Less: Revenue less separable
costs of by-product
($50,000 - $30,000)
Net cost of apple juice

$ 800,000
130,000
150,000
$1,080,000
(20,000)
$1,060,000

12-38 (15-20 min.) The billing labor resource cost includes the
wages of the billing labor team, an allocation of supervisor resource
costs, and an allocation of occupancy resource costs. The billverifying labor resource cost includes the wages of the verifying
labor team and an allocation of occupancy resource costs.
There are two cost-allocation paths from the billing labor team
resource to the commercial accounts cost objective:
1. Billing labor Bill verifying labor source Bill verification
activity Commercial accounts
2. Billing labor Billing activity Commercial accounts
There is one cost-allocation path from the bill-verifying labor
resource to commercial accounts cost objective.
Bill-verifying labor Bill verifying labor source Bill verification
activity Commercial accounts
217

12-39 (20-25 min.)

1.

Annual costs for 24,000 miles: Fixed

$4,800
Variable ($.20 x 24,000) 4,800
$9,600
Cost per mile = $9,600 24,000 miles = $.40 per mile

2.

Two factors caused the April allocation of $.76 per mile to

exceed the average of $.40 per mile:
(1) The motor pool's operating inefficiencies are passed on to
the user departments. The cost of 50,000 miles in April
should have been [($4,800 12 months) x 50 autos] + ($.20
x 50,000 miles) = $20,000 + $10,000 = $30,000. Thus, $8,000
of "unnecessary" cost was assigned to user departments,
which is $8,000 50,000 miles = $.16 per mile.
(2) April was a month of low general usage. In an average
month, 100,000 miles are driven (2,000 miles per auto), and
the fixed cost per mile is ($4,800 12 months) 2,000 miles
= $400 2,000 miles = $.20 per mile. In April the $400
fixed cost of each auto was spread over only 1,000 miles, so
fixed cost per mile was $400 1,000 = $.40 per mile. This
factor accounts for an extra $.20 per mile.

3.

Undesirable behavioral effects include:

(a) The total actual motor pool cost is allocated. The manager
is not motivated to control these costs.
(b)Allocated costs are affected by auto usage in other
departments. A department is better off if its auto usage
falls in a month when other departments have high mileage.
Decisions about whether driving another mile is worth its
cost are not appropriately made. The city incurs only $.20

218

more expense for an additional mile, but departments are

charged more.
(d)The cost allocation is affected only by miles driven, not
number of autos assigned to a department. A department
with two autos each being driven 15,000 miles per year is
allocated the same cost as one with one auto driven 30,000
miles per year. But each auto causes the same average
fixed costs, so fixed costs should be allocated on the basis of
number of autos rather than miles driven. This may be the
reason the city planner was continually concerned with her
auto costs. Her departments autos were driven an
average of 3,000 miles per month, but the citys average
was only 2,000 miles. Because both fixed and variable
costs are allocated on a per-mile basis, her departments
autos are allocated more fixed cost than the average auto
in the city. If fixed costs were allocated on the basis of
number of autos, each auto would be charged $400 per
month. This becomes $.14 per mile for the city planners
autos compared to $.20 for the average auto in the city.
4.

Two basic principles should be applied:

(a) Allocate budgeted, not actual, costs. Inefficiencies of the
motor pool should not be passed on to user departments.
(b)Separate costs into fixed and variable cost pools. The fixed
costs should be allocated on the basis of number of autos
assigned to a department or long-run predicted use of
autos. Variable costs are appropriately assigned on a permile-driven basis.
This cost-allocation method illustrates why the city planner
has a legitimate complaint. In April she paid $.16 per mile
extra because of motor pool inefficiency, $.20 per mile extra
because other departments had light usage in April, and $.06

219

per mile extra because fixed costs are charged on a per-mile

basis rather than a per-auto basis.

220

12-40 (20-30 min.)

1. Actual costs
$1,125,000
Rate per thousand
ton-miles*
To North
To South

$750,000 + $.75(500,000) =
$1,125,000 500,000
250,000 x $2.25
250,000 x $2.25

=
=
=

$2.25
$562,500
$562,500

*Rate is per thousand net ton-miles

2. Actual costs
Rate per thousand
ton-miles
To North
To South

$750,000 + $.75(400,000) =
$1,050,000
$1,050,000 400,000
150,000 x $2.625
250,000 x $2.625

=
=
=

$2.625
$393,750
$656,250

Note that Souths costs increased from $562,500 to $656,250 or

16.7%, solely because Norths volume declined.
3.

Rate per thousand

ton-miles
$1,250,000 500,000
To North
250,000 x $2.50
To South
250,000 x $2.50

=
=
=

$2.50
$625,000
$625,000

Such allocation seems unjustified because the operating

departments have to bear another departments cost of
inefficiency. Note that the use of a predetermined or budgeted
total amount geared to the various levels of activity of the
operating departments would eliminate this difficulty. For
example, the $2.25 rate of part (1) would be used here despite
the excess of actual costs over budgeted costs.

221

4.

Basic maximum capacity:

360,000 + 240,000 = 600,000 ton miles.
Fixed costs:
To North, 36/60 x $750,000
To South, 24/60 x $750,000
Variable costs:
To North, $.75 x 150,000
To South, $.75 x 250,000
Total costs

North
South
$450,000 $
300,000
112,500
$562,500

187,500
$487,500

Note that Norths costs are $562,500 rather than the $393,750
in part (2).
This method has the following advantages:
a. The use of a predetermined unit rate for variable costs
prevents the total charges from being affected by the
efficiency of price changes of the service department.
b. The use of a predetermined lump-sum for fixed costs
prevents the total charges from being affected by the
consumption of service or the activity levels of other
operating departments or the activity level of the service
department.

222

12-41

(25-30 min.)

There a several ways to organize an analysis that provides product

costs. We like to focus first on determining total activity-cost pools
and activity cost per driver unit. Then, an analysis similar to the one
shown in Exhibit 12-8 on page 539 can be used.
Schedule a: Activity center cost pools
Resources Supporting the
Setup/Maintenance Activity Center
Assembly supervisors
Assembly machines
Facilities management
Power
Total assigned cost
Cost per driver unit (setup)
Resources Supporting the
Assembly Activity Center
Assembly supervisors
Assembly machines
Facilities management
Power
Total assigned cost
Cost per driver unit (machine
hour)

Allocation Calculation
$92,400 x 2.6%
$247,000 x (400 1,900)
$95,000 x (400 1,900)
$54,000 x (10 90)
$80,402 40
Allocation Calculation
$92,400 x 97.4%
$247,000 x (1,500 1,900)
$95,000 x (1,500 1,900)
$54,000 x (80 90)
$407,998 1,500

223

Allocated
Cost
$ 2,402
52,000
20,000
6,000
$80,402
$ 2,010
Allocated
Cost
$ 89,998
195,000
75,000
48,000
$407,998
$ 272

Exhibit 12-41
Contribution to cover other value-chain costs by product
Standard
Cost per
Driver Unit
Activity/Resource (Schedule a)
Setup/Maintenanc
e
$2,010
Assembly
$ 272
Parts
Direct labor
Total
Units
Cost per display
Selling price
Unit gross profit
Total gross profit

Driver
Units
20
1,000

Deluxe
Driver
Cost Units

$ 40,200
272,000
1,003,800
298,000
$1,614,000
100,000
$16.14
20.00
$ 3.86
$ 386,000

12
400

Custom
Driver
Cost Units

$ 24,120
108,800
115,080
72,000
$320,000
10,000
$32.00
50.00
$18.00
$180,000

8
100

The total contribution of these products is $386,000 + $180,000 + $122,740 = $688,740.

224

Cost
$ 16,080
27,200
15,980
68,000
$127,260
1,000
$127.26
250.00
$122.74
$122,740

12-42 (25-30 min.)

See solution to problem 12-41.

12-43 (10-15 min.)

Customer Type 1
Units
Gross
Sold
Profit
75,00
0
$289,500

Customer Type 2
Units
Sold Gross Profit
25,00
0
$ 96,500

18.00

5,000

90,000

5,000

90,000

122.74

0
$379,500

1,000

122,740
$309,240

Gross Profit
per Unit
Standard
display
Deluxe
display
Custom
display
Total

3.86

225

12-44 (15-20 min.)

1.
Sales ($460 x 2,800; $790 x 2,000)
Cost of sales
Purchase cost ($70 x 2,800; $120 x 2,000)
Indirect cost
Gross product margin

Footware
$1,288,000

Equipment
$1,580,000

196,000
630,0001
826,000
$ 462,000 $

240,000
750,0002
990,000
590,000

1 $1,380,000 (18.75 x 2,800 + 31.25 x 2,000) = $12.00 per pound. The

allocation to footware is $12 x 2,800 x 18.75 = $630,000.
2 $12 per pound x 31.25 x 2,000 = $750,000

2.
Specialty Stores
Department Stores
Footware Equipment Footware Equipment
Gross margin per case*
$165
$295
$165
$295
Cases
1200
400
1,600
1,600
Gross margin
$198,000
$118,000
$264,000
$472,000
Total gross margin
$316,000
$736,000
* $462,000 2,800 = $165; $590,000 2,000 = $295

3. The gross margin per case of equipment is much larger so more

emphasis should be placed on equipment sales, especially at
specialty stores.

226

12-45 (25-30 min.)

1.
Sales ($460 x 2,800; $790 x 2,000)
Cost of sales
Purchase cost ($70 x 2,800; $120 x 2,000)
Indirect cost

Footware
$1,288,000

Equipment
$1,580,000

196,000
378,0001
574,000
$ 714,000 $

Product gross margin

240,000
450,0002
690,000
890,000

1 ($1,380,000 - $552,000) (18.75 x 2,800 + 31.25 x 2,000) = $7.20 per pound.

The allocation to footware is $7.20 x 2,800 x 18.75 = $378,000.
2 $7.20 per pound x 31.25 x 2,000 = $450,000
2.

Specialty Stores

Department Stores

Footware

Equipment

Gross margin per case

$2551

$4452

$255

$445

Cases

1,200

400

1600

1600

$306,000

$178,000

$408,000

$712,000

Product gross margin

Customer gross margin

Footware Equipment

$484,000

$1,120,000

384,0003

168,0004

Customer profit margin

$100,000

$952,000

Revenue

$868,000

$2,000,000

Gross margin percentage

55.7%

56.0%

Cost-to-serve percentage

44.2%

8.4%

Customer profit percentage

11.5%

47.6%

Cost to serve

1 $714,000 2,800
2 $890,000 2,000
3 The cost per order = $552,000 (160 + 70) = $2,400. The allocation to
specialty stores is 160 x $2,400 = $384,000.
4 $2,400 x 70 = $168,000
227

Exhibit 12-45

CUSTOMER PROFITABILITY

GROSS PROFIT MARGIN PERCENTAGE

100%
90%
80%
Department
Stores

70%

Specialty
Stores

60%
50%
40%
30%
20%
10%
0%
0%

20%

40%

60%

80%

COST TO SERVE PERCENTAGE

228

100%

3. Exhibit 12-45 depicts the profitability of both customer types as a

function of product gross margin and the cost to serve. Note that
both customers have about the same product profitability based on
the mix of products they purchase. However, the cost to serve is
dramatically different, resulting in significant differences in overall
profitability. Specialty stores order 1,600 160 = 10 cases per order
compared to 3,200 70 46 cases per order by department stores.
Suggested strategies for profit improvement:
Department stores are clearly generating most of the profit for
MCD. The company should both protect this customer from
inroads by competitors through its pricing strategy (discounts)
and profile this customer type to see if it is possible to apply
actions to specialty stores that would reduce their cost to
serve.
The cost to serve of specialty stores needs to be reduced. If
there is a cause-effect relationship between number of orders
and the cost to serve, actions should be taken to increase the
order size.
4. A comparison of customer profitability based on the two
treatments of the costs to serve is shown in the table below.

Specialty store profit

Department store profit
Total MCD profit

Treatment of Cost to Serve

As Product Cost
As Customer Cost
(Problem 12-44)
(Problem 12-45)
$ 316,000
$ 100,000
736,000
952,000
$1,052,000
$1,052,000

229

The difference in profitability is due to the use of orders rather than

pounds purchased to allocate the $552,000 costs of the orderprocessing and customer-service activities. To the extent that orders
is a more plausible and reliable cost driver (cost-allocation base),
management should carefully evaluate their customer mix strategy.
For example, the table below gives some food for thought.

Percent of profit
Percent of cases sold
Percent of weight shipped
(purchased)
Percent of orders

Specialty
Stores
9.5%
33.3
30.4

Department
Stores
90.5%
66.7
69.6

69.6

30.4

The percent of overall MCD profit for specialty stores is

significantly lower than each of the non-financial metrics that drive
costs.

230

12-46 (20-30 min.)

1.

Basic long-run usage:

75 + 50 = 125 X-rays per month
Total costs incurred:
$12,000 + 100 X-rays ($30) = $15,000
University Childrens
Hospital Hospital
Fixed costs:
75/125 x $12,000
50/125 x $12,000
Variable costs:
50 x $30
50 x $30
Total allocated costs

2.

$ 7,200
$4,800
1,500
$8,700

1,500
$6,300

For budgetary control and motivation purposes, it is best not

to allocate the $1,500 efficiency variance ($16,500 minus the
$15,000 computed above). For cost recovery purposes, if
reimbursement is based on actual costs, it should be allocated.

231

3.

University Childrens
Hospital Hospital
Total costs incurred, $15,000:
50/100 x $15,000
$7,500
50/100 x $15,000
$7,500
Childrens Hospital bears $1,200 more costs than in part (1)
despite the fact that its volume was exactly in accordance with
its long-run average usage. In short, Childrens Hospital's
costs have increased solely because of a fellow consumer's
actions, not its own actions.
University Hospital's failure to reach its predicted usage
results in shifting $1,200 more fixed costs to Childrens
Hospital.
A behavioral effect of this method would be toward more
erratic scheduling (to the extent this discretion exists). For
instance, if University Hospital had a relatively light month, it
would be motivated toward not scheduling procedures during
the final week and bunching them in the first week of the
second month. In this way, its unit costs of the second month
would be lowered.

4.

Both University and Childrens Hospitals would be induced to

underestimate usage. Of course, if both play the same game,
the final fraction borne by each would be little changed. One
way to counteract these tendencies is to exert higher arbitrary
(and unreimbursable) cost allocations to both University and
Childrens Hospitals if they consistently exceed their predicted
usage. Also, first priority on scarce resources can be extended
to those consumers who are committed to the higher fractions.

232

12-47 (20-30 min.)

1.

Materials
Receiving
and
Mechanical Electronic
Handling Instruments Instruments

Building
Services
Direct department costs
before allocation
$150,000 $120,000 $680,000 $548,000
Building services
(150,000)
100,000
50,000
Materials receiving
and handling
(120,000) 40,000
80,000
Total costs after allocation
$820,000 $678,000
Calculations:
50,000 + 25,000 = 75,000
(50,000 75,000) x $150,000 = $100,000
(25,000 75,000) x $150,000 = $50,000

No. of components: 10 x 8,000 = 80,000; 16 x 10,000 = 160,000

80,000 + 160,000 = 240,000
(80,000 240,000) x $120,000 = $40,000
(160,000 240,000) x $120,000 = $80,000
2.

Mechanical instruments:
$820,000 30,000 hours = $27.33 per direct-labor hour
Electronic instruments:
$678,000 160,000 components = $4.24 per component

3.

Total cost = direct materials cost + manufacturing cost:

M1: $74 + ($27.33 x 4) = $74 + $109.32 = $183.32
M2: $86 + ($27.33 x 8) = $86 + 218.64 = $304.64
E1: $63 + ($ 4.24 x 10) = $63 + 42.40 = $105.40
E2: $91 + ($ 4.24 x 15) = $91 + 63.60 = $154.60

233

12-48 (20-30 min.)

1.

Materials
Receiving
and
Mechanical Electronic
Handling Instruments Instruments

Building
Services
Direct department costs
before allocation $150,000 $ 120,000 $680,000
Building services
(150,000)
9,375
93,750
Materials receiving and handling $(129,375)
43,125
Total costs after allocation
$816,875

$548,000
46,875
86,250
$681,125

Calculations:
5,000 + 50,000 + 25,000 = 80,000
(5 80) x $150,000 = $9,375
(50 80) x $150,000 = $93,750
(25 80) x $150,000 = $46,875
No. of components: 10 x 8,000 = 80,000; 16 x 10,000 = 160,000
80,000 + 160,000 = 240,000
(80 240) x $129,375 = $43,125
(160 240) x $129,375 = $86,250
2.

Mechanical instruments:
$816,875 30,000 hours = $27.23 per direct-labor hour
Electronic instruments:
681,125 160,000 components = $4.26 per component

3.

Total cost = direct materials cost + manufacturing cost

M1: $74 + ($27.23 x 4) = $74 + $108.92 = $182.92
M2: $86 + ($27.23 x 8) = $86 + $217.84 = $303.84
E1: $63 + ($ 4.26 x 10) = $63 + $ 42.60 = $105.60
E2: $91 + ($ 4.26 x 15) = $91 + $ 63.90 = $154.90

234

12-49 (40 min.)

1 & 2.The solution to requirements 1 and 2 is in Table 12-49 on the
following page.
3.
Single Plantwide Rate: $145,000 20,000 = $7.25 per directlabor hour.
4.

Comparison of methods:

Step-down method:
Job K10,
19 x $11 + 2 x $6 = $209 + $ 12 =
Job K12,
3 x $11 + 18 x $6 = $ 33 + $108 =
Total
Direct method:
Job K10, 19 x $10.855 + 2 x $6.048 = $206.25 + $12.10 =
Job K12, 3 x $10.855 + 18 x $6.048 = $32.57 + $108.86 =
Total =
Blanket rate:
Job K10, 21 x $7.25 =
Job K12, 21 x $7.25 =
Total

235

$221.00
141.00
$362.00
$218.35
141.43
$359.78
$152.25
152.25
$304.50

EXHIBIT 12-49
1. Step-downMethod
Directdepartmentcosts
(1)Building&grounds@20/sq.ft.
(2)Personnel@$8/employee
(3)Generalfactoryadmin.@$1.10/laborhour
(4)Cafeteria@$22/employee
(5)Storeroom@$1.20/requisition
(6)Total
(7)Divide(6)bydirectlaborhours
(8)Overheadrateperdirect-laborhour
2. DirectMethod
Directdepartmentcosts
(1)Building&grounds:

$20,000
(200
, 00)
(800
, 00)

=25

(2)Personnel:1/3&2/3

(14
, 30)
(150)

(5)Storeroom:

Personnel
$1,200
400
$1,600

$1,200

$28,020

Cafeteria
Operating
Loss
$1,430
800
80
1,100
$3,410

$1,430

Storeroom
$2,750
1,400
40
1,100
110
$5,400

Machining
$35,100
6,000
400
8,800
1,100
3,600
$55,000
5,000
$11.00

Assembly
$56,500
10,000
800
18,700
2,200
1,800
$90,000
15,000
$6.00

$2,750

$35,100

$56,500

7,500

12,500

400

800

8,966

19,054

477

953

1,833

917

$54,276
5,000
$10.855

$90,724
15,000
$ 6.048

(20,000)
(1,200)

(3)Generalfactoryadmin.:
(4)Cafeteria:

Building
&Grounds
$20,000
$20,000

General
Factory
Administration
$28,020
1,400
280
$29,700

(28,020)
(250
, 00)

=$1.1208

(28,020)

or1/3&2/3

(27
, 50)
(45
, 00)

(1,430)

or2/3&1/3

(2,750)

(6)Total
(7)Divide(6)bydirect-laborhours
(8)Overheadrateperdirect-laborhour

236

12-50 (15-25 min.)

1.

See Exhibit 12-50, Part 1.

2.

See Exhibit 12-50, Part 2.

The cost of the model 1 circuit boards decreases from 961,600 to

891,120, a decrease of 70,480. But because the decrease is due to a
lower allocation and this is from fixed costs that do not change, the
decrease is now allocated to models 2 and 3. The costs of models 2
and 3 increase to absorb the decrease in model 1 cost. So, why
would Yamaguchis management want to implement this process
improvement? Because the improved efficiencies will free up
processing capacity in resources used for these two activities. The
freed up capacity can be deployed to meet other needs such as an
increase in demand. The total cost (6,120,000) of all three models
does not change.

237

Exhibit 12-50, Part 1

Model1
Directmaterials:
Model1: 4,000x 80 boards
320,000
Model2: 6,000x 160 boards
Model3: 8,000x 300 boards
Materialhandlingactivity1:
Model1: 26 x 20 x 80
41,600
Model2: 26 x 15 x 160
Model3: 26 x 10 x 300
Assemblyactivity2:
Model1: 67 x 40 x 80
214,400
Model2: 67 x 30 x 160
Model3: 67 x 16 x 300
Solderingactivity3:
Model1: 47 x 60 x 80
225,600
Model2: 47 x 40 x 160
Model3: 47 x 20 x 300
Qualityassuranceactivity4:
Model1: 400x 5 x 80
160,000
Model2: 400x 3 x 160
Model3: 400x 2 x 300
Total cost for circuit boards
961,600
Cost per circuit board
12,020
1
182,000 (80 x 20 + 160 x 15 + 300 x 10) = 26 per distinctpart
2
857,600 (80 x 40 + 160 x 30 + 300 x 16) = 67 per automaticinsertion
238

Model2

Model3

960,000
2,400,000

62,400
78,000

321,600
321,600

300,800
282,000

192,000
1,836,800
11,480

240,000
3,321,600
11,072

3
4

808,400 (80 x 60 + 160 x 40 + 300 x 20) = 47 per part

592,000 (80 x 5 + 160 x 3 + 300 x 2) = 400per minute

239

Exhibit 12-50, Part 2

Model1
Directmaterials:
Model1: 4,000x 80 boards
320,000
Model2: 6,000x 160 boards
Model3: 8,000x 300 boards
Materialhandlingactivity1:
Model1: 29.35484x 10 x 80
23,484
Model2: 29.35484x 15 x 160
Model3: 29.35484x 10 x 300
Assemblyactivity2
Model1: 67 x 40 x 80
214,400
Model2: 67 x 30 x 160
Model3: 67 x 16 x 300
Solderingactivity3:
Model1: 47 x 60 x 80
225,600
Model2: 47 x 40 x 160
Model3: 47 x 20 x 300
Qualityassuranceactivity4:
Model1: 448.48485x 3 x 80
107,636
Model2: 448.48485x 3 x 160
Model3: 448.48485x 2 x 300
Total cost for circuit boards
891,120
Cost per circuit board
11,139
1
182,000 (80 x 10 + 160 x 15 + 300 x 10) = 29.35484per distinctpart
2
857,600 (80 x 40 + 160 x 30 + 300 x 16) = 67 per automaticinsertion
240

Model2

Model3

960,000
2,400,000

70,452
88,065

321,600
321,600

300,800
282,000

215,273
1,868,125
11,676

269,091
3,360,756
11,203

3
4

808,400 (60 x 80 + 40 x 160 + 20 x 300) = 47 per part

592,000 ( 3 x 80 + 3 x 160 + 2 x 300) = 448.48485per minute

241

12-51 (25 min.)

1.

Recording and record-keeping cost: $16.50 x 550 = $ 9,075

Labor cost: ($23,000 / 460,000) x 80,000 =
4,000
Inspection cost: $2.75 x 4,000 =
11,000
Total cost
$24,075

2.

Recording and record-keeping cost: $16.50 x 330 = $ 5,445

Labor cost: No savings; fixed cost *
0
Inspection cost: $2.75 x 1,500 =
4,125
Total cost
$9,570

* Capacity is made available. If there is a profitable use of that

capacity (that is, if the opportunity cost is not zero) a savings would result
equal to the benefit from the use of the capacity.

3.

Receiving cost per pound: $24,075 80,000 = $.30

Estimated cost saved from 20,000 pounds = $.30 x 20,000 =
$6,000

The company would have underestimated the savings by

$9,570 - $6,000 = $3,570, and they may have continued to purchase
and stock small-sales-level brands that are actually unprofitable.

242

12-52 (20 min.)

1.
Subcomponents
Receiving
Assembly
Inspection
Total
2.

Variable Cost Fixed Cost

$1,100
22
$ 22
144
144
56
____
$1,322
$166

Full Cost
$1,100
44
288
56
$1,488

Price = .9 x $1,990 = $1,791

On a full cost basis, the profit would be $1,791 - $1,488 = $303
per computer, or a total of 15 x $303 = $4,545. The
contribution margin on the order would be $1,791 - $1,322 =
$469 per computer, or a total of 15 x $469 = $7,035. (Of
course, some of this profit must be used to cover other
value-chain costs such as research and development, design,
marketing, distribution, and customer service.) If Dell had
excess capacity, so that this order did not require additional
resources and did not have any affect on the ability to fill
other orders, the extra profit from the order is $7,035.
However, in a long-term perspective, Dell has to pay for all its
resources, both those represented by variable costs and those
represented by fixed costs. On this basis, the profit is only
$4,545.

3.

Cost is an important factor, but by no means the only factor,

to consider in making pricing decisions. In this case, it tells
the Dell managers that this is a profitable product at the
discounted price. But it does not say whether it is the most
profitable product that could be produced with Dells
resources. Cost is important in answering one what-if
question: what would profits be if Dell accepts this order at a
particular predicted price. Cost data must be combined with a
great deal of other data, such as market data and capacity
data, to make intelligent pricing decisions.
243

12-53 (20-40 min.)

1.

(a) The allocation of joint costs would be in a 1:5 ratio:

Product Product
A
B
Total
Sales value
Joint costs
Separable costs
Total costs
Operating profit

$1,000 $1,000
$200 $1,000
350
200
$550 $1,200
$450 $ (200)

$2,000
$1,200
550
$1,750
$ 250

(b)No. Joint costs are not relevant for this decision because
you cannot stop incurring that part allocated to one
product and still continue to incur only the other part. If
the total process is profitable, you should process any
product that shows a positive contribution after the splitoff point. Although Product B shows a book loss of $200, it
has a contribution after the split-off point of $1,000 - $200,
or $800.
2.

(a) The relative sales value method deducts separable costs to

arrive at an imputed sales value at split-off point:
A
$1,000
350

Sales value
Separable costs
Sales value imputed at
split-off point
$650
Allocation of joint cost,
650/1,450 and 800/1,450,
respectively
538
Operating profit
$112
244

B
$1,000
200

Total
$2,000
550

$800

$1,450

662
$138

1,200
$ 250

(b)No. Product B does have the greater book profit and

contribution after the split-off point, but Product A has the
greatest contribution per pound, which is the scarce
resource in this case. If, for example, the engineer changes
the process by 40 pounds, so that we end up with 440
pounds of B and 40 pounds of A, separable costs would
become $175 for A and $220 for B, totaling $395 (assuming
separable costs are all variable). Sales values would
become $500 for A and $1,100 for B, and total of $1,600.
Total contribution after the split-off would drop from
$1,450 to $1,205 and total profit would drop from $250 to
$5.
Pounds
Sales value
Separable costs
Contribution to joint
costs
Joint costs
Operating profit

245

A
40

B
440

Total
480

$500
175

$1,100
220

$1,600
395

$325

$ 880

$1,205
1,200
$
5

12-54 (50-60 min.)

1.

RESIDENTIAL
COMMERCIAL
COST PER DRIVER
DRIVER
ACTIVITY DRIVER UNIT UNITS
COST
UNITS
COST
Account inquiry $13.806
20,000 $276,120
5,000 $ 69,030
Billing
0.06352 1,440,000
91,469 1,000,000
63,520
Verification
4.665
20,000
93,300
Other
0.03855 1,440,000
55,512 1,000,000
38,550
Total cost
$423,101
$264,400
No. of accounts
120,000
20,000
Cost per account
$ 3.5258
$ 13.2200
2. The service bureaus proposal is to provide billing and inquiry
services for AT&Ts customers for $4.30 per residential account and
$8.00 per commercial account. From a strictly financial perspective,
outsourcing commercial accounts would decrease AT&Ts costs.
3. A table and bar chart are given on the next page. Both the twostage and multistage ABC systems provide increased costing
accuracy compared to the traditional costing system. Because the
multistage system normally involves more detail as well as more
involvement by operating managers, it provides the most accurate
cost estimates of activities and final cost objectives.
For planning and control purposes, the multistage ABC system is
superior. Why? Because it focuses on operational relationships.
Many two-stage ABC systems do not model cost behavior. This is a
major drawback because planning almost always involves changes
in cost object levels. As the level of demand changes, so do variable
costs. Thus, assuming all costs are fixed in two-stage systems
effectively prohibits their use for planning purposes. Operational
control frequently involves process improvement efforts. Such
improvements can be easily modeled in multistage systems. Because
two-stage systems have limited operational data, their usefulness for
control purposes is also limited.
246

BILLING DEPARTMENT
$14

Cost Per Account

$12
$10
$8
$6
$4
$2
$0
Residential
Commercial

Traditional

Two-Stage

Multistage

$4.58
$6.88

$3.98
$10.50

$3.53
$13.22

247

12-55 (100 200 min.)

1. Exhibits 12-55A and 12-55B show the calculation of customer
gross margin percentage and customer cost-to-serve percentage for
the 4 customer types. Exhibit 12-55 C shows a plot of customer gross
margin percentage versus customer cost-to-serve percentage for the
4 customer types.
2. Suggested strategies for profit improvement for the 4 customer
types follow.
Customer type 1 - Mega stores. These stores have the lowest
cost-to-serve. Profitability can be improved by focusing on a
better product mix. A quarter of the sales (cases) to these
stores are from bulk and singles products both of which have
a negative gross margin. A shift in mix towards more regular
and fragile product types would improve profitability.
Customer type 2 Local small stores. These stores have a
product mix that contains a substantial amount (32%) of the
negative gross margin products. The same change in sales
focus that applies to mega stores can be applied to local small
stores.
But unlike mega stores, small stores are very costly to serve.
From Exhibit 12-55 B, the largest single cost to serve local
small stores is truck deliveries. The average number of cases
per order (the same as per truck delivery) is 6,000,000 80,000
= 75. Compare this to mega stores that average 7,680,000
32,000 = 240 cases per order (delivery). This is a significant
factor causing the high cost-to-serve.
248

For example, suppose that the average order size could be

increased from 75,000 to 150,000 cases. If the total annual
cases sold is unchanged (6,000,000), a total of 40 orders, a 50%
reduction, would be made. An estimate of the cost savings and
the impact on the cost-to-serve percentage can be made as
follows:
Activity
Truck
delivery
Order
processing
Regular
scheduling
Expedited
scheduling

Cost per Driver Unit

(Exhibit 12-55B)
$167.55

Reduction in Driver
Units of 50% (000)
34

27.49

40

1,099.60

5.83

36

209.88

19.44

4
Total cost savings (000)
Cost savings as a percent of revenue
New cost-to-serve as a percent of revenue

Cost Savings
(000)
$5,696.70

77.76
$7,083.94
24.9%
60.1%

In addition to the above savings, other activities would also be impacted by

the reduction in orders such as customer service. So while the total impact
of focusing on increasing order size can only be estimated, it is reasonable
to expect dramatic cost savings from the current 85% of revenue.
Other factors should be investigated include the high level of corporate
support and customer service.

249

 Customer type 3 Local large stores. Local large stores

generate $68,400 $136,230 = 50% of DSIs total revenue and
with a net margin of 58% - 47% = 11%. The key to local large
store profitability is sales of a large percentage (80%) of
regular product. The cost-to-serve percentage is 47%. This
could be reduced as for customer type 2 by increasing the
order size from the current level of 14,400,000 120,000 = 120
cases per order. But a dramatic improvement should not be
expected. In general, local large stores are sustaining DSIs
business and their loyalty should be cultivated.
Customer type 4 Specialty stores. Specialty stores have a low
gross margin of 22% coupled with a very large cost-to-serve
percent of 106%! Although these stores do not account for a
significant portion of DSIs revenue the company should
rationalize their business. Several actions could be suggested.
One is to charge a premium for all high-security products. The
vast majority of these products are sold to specialty stores with
only marginal sales to mega and local large stores. Another
action is to adopt a customer loyalty program based on volume
of sales. The list price of $7.25 per case would apply to
customers with sales volumes less than a specified level. Most
of DSIs customers would qualify for discounts (similar to
those currently existing) so prices would not be significantly
different. For specialty stores, prices would increase
dramatically. This may result in losing specialty-store business
so DSI needs to decide is this is a direction they wish to
consider.

250

TypeCustomer

Exhibit 12-55 A (Units and dollars are in thousands.)

Product Regular

Short

Fragile

Bulk

High
Security Singles

Gross
Profit
Total Percentage

Product mix percentage

60%

5%

5%

20%

5%

5%

100%

Cases sold

4,608

384

384

1,536

384

384

7,680
$36,48
0

35%

$12,73
3
100%
6,000
$28,50
0

29%

$
8,167
100%
14,400
$68,40
0

58%

Total Revenue

$ 21,888

$ 1,824

$ 1,824

$7,296

$ 1,824

$ 1,824

Gross Profit per Case

$ 2.74

$(1.44)

$ 0.54

$ (5.30)

3.28

1.58

Total Gross Profit

Product mix percentage
Cases sold

$ 15,114
50%
3,000

$ 607
5%
300

$ 1,052
5%
300

$(2,212)
30%
1,800

$ 207
8%
480

$(2,035)
2%
120

Total Revenue @ 4.75/case

Gross Profit per Case

$ 14,250
$
3.28

$ 1,425
$ 1.58

$ 1,425
$ 2.74

$ 8,550
$ (1.44)

$ 2,280
$ 0.54

$ 570
$ (5.30)

Total Gross Profit

Product mix percentage
Cases sold

$ 474
0%
-

$ 822
10%
1,440

$(2,592)
10%
1,440

259
0%
-

$ (636)
0%
-

Total Revenue @ 4.75/case

Gross Profit per Case

$ 54,720
$
3.28

$
$

$ 6,840
$ 2.74

$ 6,840
$ (1.44)

$
$ 0.54

$
$ (5.30)

Total Gross Profit

Product mix percentage
Cases sold

$ 37,786
10%
60

$
20%
120

$ 3,946
0%
-

$(2,074)
0%
-

$
70%
420

9,840
80%
11,520

1.58

251

0%
-

$39,65
8
100%
600

22%

Total Revenue @ 4.75/case

285

570

Gross Profit per Case

3.28

1.58

Total Gross Profit

197

190

$
$
$

$ 1,995

$ (1.44)

0.54

$ (5.30)

227

2.74
-

$
2,850

$
613

Parcel Delivery
Deliveries

DeliveryTruck
Deliveries

Shipping
Pallets

Expedited
Scheduling
Orders

Regular
Scheduling
Orders

Corporate
Support
Labor Hours

ChangesOrder
Number of
Changes

Customer
Service
Labor Hours

Orders

Customer Type

Activity

Order
Processing

Exhibit 12-55 B (Units and dollars are in thousands.)

Cost/Driver
Unit

$27.49

$43.34

$32.63

$51.66

$5.83

$19.44

$6.60

$167.55

$23.89

Driver Units
Cost to Serve

32
$879.68

18.7
$810.46

3.2
$104.42

29
$169.07

Cost
Driver

3
416
$58.32 $2,745.6

25.6
$4,289.28

1.6
$38.22

Revenue (See Exhibit 12-55A)

Cost-to-Serve Percentage
Driver Units

80

Cost to Serve

$2,199.2

100
$4,334

Total
$9,095.05
$36,480.00
24.9%

20

$261.04 $1,033.2

72
$419.76

Revenue (See Exhibit 12-55A)

8
$155.52

640
$4,224

68

$11,393.4

$191.12

$24,211.24
$28,500.00

Cost-to-Serve Percentage

85.0%
252

Parcel Delivery
Deliveries

DeliveryTruck
Deliveries

Shipping
Pallets

Expedited
Scheduling
Orders

Regular
Scheduling
Orders

Corporate
Support
Labor Hours

ChangesOrder
Number of
Changes

Customer
Service
Labor Hours

Orders

Customer Type

Activity

Order
Processing

Exhibit 12-55 B (continued)

Cost/Driver
Unit

$27.49

$43.34

$32.63

$51.66

$5.83

$19.44

$6.60

$167.55

$23.89

Driver Units

120

70

2.4

80

108

12

840

90

$78.31

$4,132.8

$629.64

$233.28

$5,544

$15,079.5

$143.34

Cost Driver

Cost to Serve

$3,298.8 $3,033.8

Revenue (See Exhibit 12-55A)

$32,173.47
$68,400.00

Cost-to-Serve Percentage

Total

47.0%

Driver Units

12

30

1.2

10

60

4.8

2.4

Cost to Serve

$329.88

$1,300.2

$39.16

$58.3

$38.88

$396

$804.24

$57.34

Revenue (See Exhibit 12-55A)

$3,023.99
$2,850.00

Cost-to-Serve Percentage

106.1%

253

Exhibit 55-C

CUSTOMER PROFITABILITY

GROSS PROFIT PERCENTAGE

100%
90%
80%
70%
60%

CT3, 47%, 58%

50%
40%
30%

CT1, 24.9%,
34.9%

20%

CT2, 85%, 29%

CT4, 106%, 22%

10%
0%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100 110 120
% % %
COST-TO-SERVE PERCENTAGE
254

255

12-56 (50-60 min.)

1.

Systems
Claims
Department Claims
Department
First Department
First
Quarter Historical
Quarter
Budget
Usage
Budget

Hardware and other

capacity-related costs
$150,000
Software development
141,750
Computer-related operations 189,000
Input/output-related operations 75,600
$556,350

50%
40
15
75

$ 75,000
56,700
28,350
56,700
$216,750

2.

Solution is in Exhibit 12-56.

3.

a. The new charging system should improve cost control in

the Systems Department (if the rates are valid) because
inefficiencies can no longer be passed on to the user
departments. Thus, the Systems Department would be
forced to watch its costs closely.
b. The recommended system for charging costs to user
departments should improve planning and cost control in
the user departments. Decisions that affect capacityrelated costs will affect the allocation of those costs, while
decisions affecting only short-run operating costs will
affect the allocation of only the operating costs.

256

EXHIBIT 12-56
Total
First Quarter
Systems
Department Not
Costs Allocated Total
Hardware and other capacityrelated costs
$155,000 $ 5,000 $150,000
Software development
130,000
2,500 127,500
Computer-related operations 187,000
3,000 184,000
Input-output-related operations 78,000 (1,000)
79,000
$550,000 $ 9,500 $540,500
(1) $150,000 x .25
(2) $150,000 x .50
(3) $150,000 x .20
(4) $150,000 x .05

(5) $30 x 450

(6) $30 x 1,800
(7) $30 x 1,600
(8) $30 x 400

(9) $200 x 540

(10) $200 x 194
(11) $200 x 126
(12) $200 x 60

Records

Outside

$ 37,500 (1) $ 75,000 (2) $ 30,000 (3) $ 7,500 (4)

13,500 (5) 54,000 (6) 48,000 (7) 12,000 (8)
108,000 (9) 38,800 (10) 25,200 (11) 12,000 (12)
15,400 (13) 55,400 (14) 4,100 (15) 4,100 (16)
$174,400
$223,200
$107,300
$35,600

(13) $10 x 1,540

(14) $10 x 5,540
(15) $10 x 410
(16) $10 x 410

257

Allocated
Department
Claims Finance

12-57 (60 min. or more)

1.

Before implementing the process modeling approach to ABC,

AT&T allocated some billing costs on the basis of number of
invoices produced.

2.

The business billing center was selected for the pilot study at
AT&T. The overall goals of the pilot study from the
managers perspective included gaining an understanding of
the centers operations and identifying value-adding activities.

3.

Cost objects were the product and service types. Activities

included printing, sorting, dispatching, validating data,
correcting errors, and monitoring the billing process.
Resources included labor pools, computers, facilities, and
paper. Cost drivers included square feet, pages printed,
printer hours, and labor hours.

4.

The billing activity (cost driver is pages printed)

consumes billing labor time (cost driver is labor hours) at
some rate. If it takes 1 labor hour for every 400 pages printed,
the rate, or consumption characteristic is, 1 400 = 0.0025
labor hours per page.

5.

AT&T considered the flowchart critical because it

revealed how the organization conducted business.
Managers were able to see how cost flows are a function of
operations (activities) and how they (activities) consume costly
resources. Recall that this was one of the overall goals for
the pilot study.

258

6.

From Exhibit 12-20, there were 20,000 inquiries (driver units)

for the inquiry activity and each inquiry costs $13.806 for a
total of $276,120. A similar calculation would be made for the
billing and other activities. The sum of these three activity
costs is the total cost to support residential customers.

7.

Using data from Exhibit 12-20, the percent of billing

department costs associated with inquiry investigation (both
account inquiry and correspondence) is $345,155.81
$687,500 = 50.2%.

8.

Account inquiry associates were given access to additional

operating systems allowing end-to-end responsibility for
inquiry investigation. Training was also given to associates in
the use of these systems. The elimination of referrals to other
working groups resulted in reductions in investigation time,
improved service, and cost reductions. This is a good example
of ABM -- how ABC is used to improve operations.

259

12-58 (15-20 min.)

Nike sells its products through various customer types including
Nike-owned retail outlets such as Nike factory stores, Nike stores,
NIKETOWNs, NIKE employee-only stores, Cole Haan stores,
Converse stores, and Hurley stores.
Nikes largest single customer in 2006 was Footlocker, Inc.,
accounting for 10% of consolidated sales. To determine the
profitability of Footlocker, Nike would need to develop a customer
profitability model such as the one shown in Exhibit 12-16 of the
text. A chart similar to Exhibit 12-17 could then be constructed to
compare Footlockers profitability to the other customer types and
thus evaluate Nikes strategy. Exhibit 12-58 on the next page
sketches a process map that shows the profitability model assuming
that Nike chooses to separately allocate the cost to serve its
customers.

260

Exhibit 12-58

Process Map for Customer Profitability at Nike

GROSS
PROFIT
PRODUCT 1

GROSS
PROFIT
PRODUCT N
ACTIVITY
COSTS FOR
COST-TOSERVE
MIX

PROFIT FROM
FOOTLOCKER

PROFIT FROM
OTHER
RETAILERS

PROFIT FROM
NIKE RETAILERS

261

PROFIT FROM
DISTRIBUTORS

PROFIT FROM
OTHER

12-59 (40-35 min.) For the solution, see the Prentice Hall Web site,
www.prenhall.com/

12-60 (100 min. or more)

The purposes of this exercise are to conduct library research in the
current management accounting literature and to gain a better
understanding of activity-based costing and activity-based
management. Students must find their own article on ABC or
ABM, and this will test their skills with library searches. Using
electronic search procedures is likely to be a time-saver, but names
of journals are given so that someone could just browse the library
holdings of one of the journals to find an appropriate article.
Textbooks are limited in the space they can devote to stories about
actual cost-accounting systems. This exercise requires students to
deal with real-world issues relating to ABC or ABM. All
applications of ABC or ABM are not successful, either because it
was not an appropriate techniques where applied or because of
mistakes in implementation. Although the literature will be
dominated by success stories (companies do not often advertise their
failures), by looking at several companies who have implemented
ABC or ABM, students should be able to make some of the
generalizations called for in requirement 2. By sharing information
among group members, students should get a broader perspective
on ABC and ABM than they would get from reading a single article.

262

12-61 (30-40 min.)

NOTE TO INSTRUCTOR. This solution is based on the web site as
it was in early 2007. Be sure to examine the current web site before
assigning this problem, as the information there may have changed.
1. Sears and Kmart operate over 3,800 stores in all 50 states and
Canada. Sears Holdings uses three segments: Kmart, Sears
Domestic, and Sears Canada. The number of these companies
listed in an area will be specific to the location of the school but in
most cases both companies should operate close to the student.
2. and 3.
In the 10K report for 2006, the company reports data such as
number of stores by geographic area and by segment. On the
notes to consolidated financial statements section for 2005, Sears
Holdings provides segment operating revenues, costs and
expenses, operating income, and total assets. The segments
operating incomes for 2005 sum to $767,000,000 + $909,000,000 +
$448,000,000 = $2,124,000,000. The operating income on the 2005
income statement is $2,124,000,000. These amounts are the same,
indicating that the company allocates 100% of its operating
expenses to segments. The percent of selling and administrative
costs allocated to segments is shown in Exhibit 12-61.
Exhibit 12-61 Allocation of Selling and Administrative Expenses
Cost-Allocation Basis
Actual bases used*
Revenue
Number of stores

Percent of Selling and Administrative Costs Allocated to:

Kmart
Sears Domestic
Sears Canada
3,804 10,759 = 35% 5,968 10,759 = 55%
987 10,759 = 9%
19,094 49,124 = 39% 25,868 49,124 = 53%
4,162 49,124 = 8%
1,416 3,843 = 37%
2,052 3,843 = 53%
375 3,843 = 10%

* The actual cost-allocation system is more complex than implied here but
the results are not too different for 2005 than if a simple allocation base
such as revenue or number of stores was used.
263